Managing Director of NENE Ltd - Assignment Example

Finance and accounting report Table of Contents Question Project evaluation 3 a)Projected cash flows, NPV, ARR and Payback period calculation 3 b)Recommendations based on calculation 5 c)Critical discussion on four important investment appraisal techniques 5 Net Present Value method 5 Internal Rate of Return 6 Payback period 6 Accounting rate of return 6 Question 2: Financial assessment 8 a)Ratio calculation 8 b)Report to Managing director of NENE Ltd 9 Profitability outlook 9 Liquidity position 11 Working capital management 12 c)Primary limitations of financial assessment using ratio analysis 15 Question 3: Costing 16 a)1. Cost determination by traditional costing method 16 a)2. Cost determination by activity based costing method 16 b)Difference between activity based costing and traditional costing 17 Reference list 19 Question 1: Project evaluation a) Projected cash flows, NPV, ARR and Payback period calculation Cash flow of Alpha: 　 Cash inflow/outflow £000 Depreciation £000 Disposal proceeds £000 Cash Flows £000 Cumulative cash flows £000 Immediately -100 0 0 -100 -100 1 years time 15 18 0 33 -67 2 years time 18 18 0 36 -31 3 years time 20 18 0 38 7 4 years time 32 18 0 50 57 5 years time 18 18 10 46 103 6 years time 2 0 0 2 105 Cash flow of Beta: 　 Cash inflow/outflow £000 Depreciation £000 Cash Flows £000 Cumulative cash flows £000 Immediately -90 0 -90 -90 1 years time 20 30 50 -40 2 years time 25 30 55 15 3 years time -50 30 -20 -5 4 years time 10 25 35 30 5 years time 3 25 28 58 6 years time 0 25 25 83 NPV, ARR and Payback period calculation: Project Alpha Initial Outlay £000 -100 years Inflows £000 Depreciation £000 1 33 18 2 36 18 3 38 18 4 50 18 5 46 18 6 2 0 Cost of capital 14% NPV £ 36.70 Average accounting income £ 16.17 Average investment £ 55.00 ARR 29.39% Payback period (years) 2.82 Project Beta Initial Outlay £000 -90 -75 years Inflows £000 Depreciation £000 1 50 30 2 55 30 3 -20 30 4 35 25 5 28 25 6 25 25 Cost of capital 14% NPV £ 29.34 Average accounting income £ 1.33 Average investment £ 82.50 ARR 1.62% Payback period (Years) 3.14 b) Recommendations based on calculation In Project Alpha, the net cash inflows were determined to be positive. Alongside, the depreciated asset generated a positive cash flow £10000. Net present value, accounting rate of return and payback period was measured for precise appraisal of investment. In project Beta, it was determined that the machinery became obsolete at the end of the third year with zero disposal proceeds. Additional investment in machinery was conducted in the third year and the same was disposed at the end of the sixth year bearing zero disposal value. Based on the level of investment, it can be suggested that Project Alpha should be accepted. Capital budgeting decisions fundamentally places strong emphasis on time value of money. In this regard, net present value method is very effective as it takes in consideration discounting of the inflow. The NPV of project Alpha was determined to be £36,700 while that of project Beta was determined to be £29,340. Both NPVs are positive but project Alpha has higher NPV, hence the firm should accept project Alpha. Accounting rate of return has been measured by establishing proportionate relationship between average accounting income and average investment for a specific period. The ARR of project Alpha was determined to be 29.39% while that of project Beta was determined to be 1.62%. The reason for low ARR in project Beta is significant investment in new purchases in the third year. Based on ARR, project alpha should be accepted. Additionally, payback period is least for project Alpha and based on the argument that a project with quicker returns should be accepted, project Alpha is better investment that Project Beta. Nonetheless, the overall assessment favours project Alpha over project Beta. Therefore, Project Alpha is a better investment (Froot and Stein, 1998). c) Critical discussion on four important investment appraisal techniques Capital budgeting decisions can be evaluated using discounted and non-discounted techniques: the discounted techniques comprise NPV and IRR method while non-discounted techniques include ARR and Payback period. Net Present Value method NPV is referred to the difference between initial investment in a project and the discounted future net cash flows from the project. The NPV of a project ranges among positive, negative or breakeven (equivalent to zero). The first criterion for accepting a project is positive NPV as negative NPV indicates unfeasible project while zero indicates breakeven. The second criterion for accepting or rejecting a project is that an investment with highest NPV will be accepted. Discounting cash flows using a discounting factor, which is generally the cost of capital, is an important aspect of NPV method. NPV method is very useful for evaluating and selecting mutually exclusive as well as independent projects. However, the major disadvantages of NPV method are complexity in the measurement process and dependence on assumptions regarding timing and value of future cash flows (Froot and Stein, 1998). Internal Rate of Return IRR accounts for being one of the most useful discounted cash flow methods within the area of capital budgeting. Herein, a project’s acceptance depends on return rate being higher than cost of capital while the rate is equal to the discount rate when NPV breakevens. The metric evaluates investment proposals from the perspective of shareholders and investors. IRR is often considered as a financial risk measurement tool as it compares a project’s return with respect to its cost of capital. IRR technique is appropriate for evaluating independent projects. However, one major fallacy in this technique is that it generates multiple return rates in case of mutually exclusive projects (Graham and Harvey, 2002). Payback period Payback period is a non-discounted metric of capital budgeting where the time period for recovering initial investment outlay by means of cash inflows. Payback period method is very simple to perform and is devoid of complexities related to discounting factor. However, absence of discounting factor diminishes effectiveness of the method as time value of money is neglected in this method. Payback period collectively with other metrics such as NPV is used for effective appraisal of investment. The main acceptance criterion of payback period method is a project with least recovery period shall be accepted. Another shortcoming of payback period is that it deliberately neglects the cash flows that take place after the determined period (Ross, Westerfield and Jordan, 2008). Accounting rate of return Accounting rate of return is another technique of capital budgeting where cash flow is not discounted and average return from a particular project is determined on the basis of present value. The estimation process of ARR is simple and easy to understand. This technique lays considerable emphasis on incremental revenue in place of the net inflow. Furthermore, ARR method disregards time value of money. Nonetheless, this process is chiefly used for determining attractiveness of a specific investment among others (Tirole, 2010). Question 2: Financial assessment a) Ratio calculation Ratio Analysis Particulars Benjamin Ltd Peters Ltd Operating profit £ 10,000.00 £ 15,000.00 Capital employed £ 42,000.00 £ 44,000.00 Return on capital employed 23.81% 34.09% Gross profit £ 20,000.00 £ 24,000.00 Sales £ 80,000.00 £ 120,000.00 Gross profit margin 25.00% 20.00% Operating profit £ 10,000.00 £ 15,000.00 Sales £ 80,000.00 £ 120,000.00 Operating profit margin 12.50% 12.50% Liquid asset £ 30,000.00 £ 22,500.00 Current liabilities £ 5,000.00 £ 10,000.00 Acid test ratio 6 2.25 Total number of days 365 365 Inventory turnover ratio 4 5.49 Inventory days 91 67 Total number of days 365 365 Receivables turnover ratio 3.2 6 Receivables turnover days 114 61 Total number of days 365 365 Payables turnover ratio 12 9.6 payables turnover days 30 38 b) Report to Managing director of NENE Ltd Based on the above calculated ratio, an analysis has been presented to the managing director of NENE Limited where profitability, liquidity and working capital position of Peters Ltd and Benjamin Ltd have been critically examined and compared. Profitability outlook The profitability positions of the prospect firms have been measured and evaluated using return on capital employed, gross profit margin and operating profit margin. Return on Capital employed Capital employed implies a firm’s total assets after deducting its current liabilities thereof. The ratio indicates firm’s effectiveness in employing the capital and generating return from the same. Return on capital employed fundamentally highlights financial relationship between total capital of a company and its operating profit. In the assessment, it was determined that both Peter Ltd and Benjamin Ltd have strong profitability position in terms of their capital deployment. Return on capital employed is essential for investors and an organisation with higher return has greater investment prospect. Based on the evaluation in the figure 1, it is proposed that NENE Ltd should acquire Peter Ltd as the return on capital employed ratio is comparatively good for the company (Fridson and Alvarez, 2011). Figure 1 (Source: Author’s creation) Gross profit margin Gross profit is earned by a company after deducting its cost of sales from the net revenue generated for a specific accounting period. The profitability ratio is measured by comparing gross profit with respect to net revenue. The gross profit margin was determined to be 20% for Peters Ltd while that of Benjamin Ltd was calculated as 25%. Arguably, the gross profit position of Benjamin Ltd is better. However, it is noteworthy that the revenue of Peters Ltd is fairly better than that of Benjamin Ltd and the low profit margin can be justified in terms of high cost of sales for Peters Ltd. Based on gross profit margin, NENE Ltd can acquire Benjamin Ltd (Palepu and Healy, 2007). Figure 2 (Source: Author’s creation) Operating profit margin Operating profit is determined after deducting various operational expenses from gross profit of a business organisation. Operating profit is essentially useful in determining operating efficiency of a firm with respect to the revenue it has earned over a specific period of time. The operating profit margin was determined to be same for both the companies and consequently, it is difficult to determine the company that has better operational efficiency. However, analysis of operating profit of both the companies suggests that the operational cost of Benjamin Ltd is higher than that of Peters Ltd (Palepu and Healy, 2007; Fridson and Alvarez, 2011). Figure 3 (Source: Author’s creation) Liquidity position The liquidity position of both the firms has been evaluated using acid test ratio as it is one of the most efficient ratios used for determination of liquidity level in business. Acid test ratio The acid test or liquid ratio is a relatively rigorous method of measuring liquidity position of a firm compared to the current ratio as unlike the current ratio, acid test ratio aims at evaluating immediate liquid position of a concern by taking into account relatively more liquid assets such as cash equivalents and receivables. It determines proportion of current liabilities with respect to liquid assets. The benchmark for liquid ratio is 1:1, whereas that of Peters Ltd and Benjamin Ltd was determined to be 2.25:1 and 6:1 respectively. Benjamin Ltd is a highly liquid company and excessive liquidity has been induced as a result of high receivables. Excessive liquidity indicates idle fund and is considered unsuitable from business perspective. Consequently, NENE Ltd should acquire Peters Ltd on the basis of its stable liquid position (Penman, 2007). Figure 4 (Source: Author’s creation) Working capital management The Working capital position of the companies has been assessed using activity ratios such as inventory turnover days, receivables turnover days and payables turnover days. Inventory turnover days The inventory turnover period is measured after dividing the total number of days/months/weeks in an accounting period by the inventory turnover ratio. The turnover ratio is measured by calculating proportion of average inventory to cost of sales. Inventory turnover ratio as well as the turnover period represents the effectiveness of a firm’s purchasing system. Poor inventory turnover ratio and the resulting high turnover period indicate inefficient purchase management or poor sales strategy resulting to greater warehousing of inventory and increased cost. In the assessment, the inventory turnover period of Benjamin Ltd was determined to be 91 days while that of Peters Ltd was determined to be 67 days. Arguably, the inventory management system of Peters Ltd is better (Kaplan, Atkinson and Morris, 1998). Figure 5 (Source: author’s creation) Receivables turnover period Receivables management is essentially associated with credit management policy of a corporation. The receivables turnover period is measured in the similar manner as done for inventory turnover period. However, receivable turnover ratio is determined by comparing average receivables with respect to credit sales of a firm. The ratio indicates the rapidness with which debtors of a firm clear their payment. A high receivables turnover period indicates ineffective credit policy of the company as well as increases scope of bad debt and default conditions. The turnover period of Peters Ltd was determined to be significantly less than that of Benjamin Ltd and based on this, it is suggested that Peters Ltd will be a more suitable choice for acquiring by NENE Ltd (Subramanyam, Wild and Halsey, 2009). Figure 6 (Source: Author’s creation) Payables turnover period Accounts payable mainly comprises the amount that a firm will be paying to its creditors for various purchases. Payables turnover ratio is measured with respect to cost of goods sold and it reflects a firm’s credit worthiness to its creditors. Payables turnover period is calculated by multiplying inverse of the ratio with the total span of time (week/days/months) in the accounting cycle. In this regard, a low turnover ratio and high turnover period is preferred. Contextually, Benjamin Ltd has 30 days and Peters Ltd has 38 days as payables turnover period indicating that Peters Ltd is a more creditworthy firm (Drury, 2008). Figure 7 (Source: Author’s creation) Based on the complete ratio assessment, Peters Ltd is recommended for acquisition by NENE Ltd. c) Primary limitations of financial assessment using ratio analysis Ratio analysis is considered as an indispensable method for examining financial position and performance of an organization, but the technique is not free from distortions and drawbacks. Consequently, heavy reliance on ratio analysis should be avoided for critical decision making. Some of the prominent drawbacks of ratio analysis are discussed as follows (Kaplan, Atkinson and Morris, 1998; Cooper and Kaplan, 1991): a) Ratio analysis is useful as a comparison tool when two or more companies operate in a common industry. It is impossible to compare companies belonging to different industries because average ratios for different industries differ significantly. b) Ratio analysis only depicts numerical relationship between two financial entities and consequently fails to take into account qualitative aspects of the entities such as seasonal, environmental and economic factors. c) The ratio analysis can be affected by accounting norms and techniques such as valuation methods (LIFO and FIFO). Additionally, ratios do not evaluate an organization in terms of its development phase. As a result, scope of misinterpretation increases with different companies being in different development phases. d) Ratio analysis is ineffective when financial position of a firm is distorted by economic factors such as inflation, high interest rate and so on. Question 3: Costing a) 1. Cost determination by traditional costing method Traditional costing Particulars A per unit Total B per unit Total C per unit Total Material cost £ 25.00 £ 500,000.00 £ 62.50 £ 62,500.00 £ 105.00 £ 1,050,000.00 direct labour hours 0.5 10000 1 1000 1 10000 direct labour cost £ 8.00 £ 80,000.00 £ 8.00 £ 8,000.00 £ 8.00 £ 80,000.00 Overhead cost £ 2,100,000.00 £ 210,000.00 £ 2,100,000.00 Total cost £ 134.00 £ 2,680,000.00 £ 280.50 £ 280,500.00 £ 323.00 £ 3,230,000.00 Selling price £ 160.80 £ 336.60 £ 387.60 Overhead Calculation Total overhead £ 4,410,000.00 Total labour hour 21000 Overhead per hour £ 210.00 a) 2. Cost determination by activity based costing method Activity Based Costing Particulars A per unit Total B per unit Total C per unit Total Material cost £ 25.00 £ 500,000.00 £ 62.50 £ 62,500.00 £ 105.00 £ 1,050,000.00 Direct labour cost £ 8.00 £ 80,000.00 £ 8.00 £ 8,000.00 £ 8.00 £ 80,000.00 Overhead cost £ 1,826,100.00 £ 639,600.00 £ 1,944,300.00 Total cost £ 120.31 £ 2,406,100.00 £ 710.10 £ 710,100.00 £ 307.43 £ 3,074,300.00 Selling price £ 144.37 £ 852.12 £ 368.92 Overhead calculation A B C Machine hour £ 1,112,000.00 £ 417,000.00 £ 1,251,000.00 Machine order £ 277,300.00 £ 35,400.00 £ 277,300.00 Space £ 436,800.00 £ 187,200.00 £ 416,000.00 Total £ 1,826,100.00 £ 639,600.00 £ 1,944,300.00 b) Difference between activity based costing and traditional costing Prior to discussing differences between traditional costing method and activity based costing method, it is essential to understand that the difference is created because of various indirect costs, commonly termed as overheads. In traditional costing method, overhead costs are assigned either in terms of total number of units produced or in terms of number of labour hours consumed by a product. The traditional cost method suffers from serious fallacy as it fails to allocate the overheads as per consumption as in production of more than one products, it is often difficult to allocate the indirect expenses in a direct manner. For instance, the traditional costing method has allocated overhead to product A, B and C using labour hours resulting to highest cost consumption for product with greater number of labour hours (Alnestig and Segerstedt, 1996; Cardinaels, Roodhooft and Warlop, 2004). Contrastingly, activity based costing technique is more suave and logical as it distributes the overheads in terms of various activities (cost drivers and cost pools) that is covered under production of each product. Total cost determination by means of cost allocation to each activity brings about efficiency. The difference can be observed in the price determined by each costing method for the three products of NENE Ltd. It can be observed that, product B is the most expensive one based on cost of activities. Correspondingly, activity based costing recognizes various hidden costs and contributes towards increase in profit (Akyol, Tuncel and Bayhan, 2005; Drury, 1992). Reference list Akyol, D. E., Tuncel, G. and Bayhan, G. M., 2005. A comparative analysis of activity-based costing and traditional costing. World Academy of Science, Engineering and Technology, 3, pp. 44-47. Alnestig, P. and Segerstedt, A., 1996. Product costing in ten Swedish manufacturing companies. International Journal of Production Economics, 46, pp. 441-457. Cardinaels, E., Roodhooft, F. and Warlop, L., 2004. The value of activity-based costing in competitive pricing decisions. Journal of management accounting research, 16(1), pp. 133-148. Cooper, R. and Kaplan, R. S., 1991. Profit priorities from activity-based costing. Harvard Business Review, 69(3), pp. 130-135. Drury, C., 1992. Activity-based costing. US: Springer. Drury, C., 2008. Management and cost accounting. Mason, OH: South-Western/Cengage Learning. Fridson, M. S. and Alvarez, F., 2011. Financial statement analysis: a practitioners guide. New Jersey: John Wiley & Sons. Froot, K. A. and Stein, J. C., 1998. Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach. Journal of Financial Economics, 47(1), pp. 55-82. Graham, J. and Harvey, C., 2002. How do CFOs make capital budgeting and capital structure decisions? Journal of applied corporate finance, 15(1), pp. 8-23. Kaplan, R. S., Atkinson, A. A. and Morris, D. J., 1998. Advanced management accounting. Upper Saddle River, NJ: Prentice Hall. Palepu, K. and Healy, P., 2007. Business analysis and valuation: Using financial statements. Connecticut: Cengage Learning. Penman, S. H., 2007. Financial statement analysis and security valuation. New York: McGraw-Hill. Ross, S. A., Westerfield, R. and Jordan, B. D., 2008. Fundamentals of corporate finance. New York: McGraw-Hill Education. Subramanyam, K. R., Wild, J. J. and Halsey, R. F., 2009. Financial statement analysis. Boston, MA: McGraw-Hill Irwin. Tirole, J., 2010. The theory of corporate finance. Princeton: Princeton University Press. Read More