What is The Cash Flows - Essay Example

 Case Study Question 1 i. Projected Cash flows The Cash flows are obtained by adding the cash inflow/outflow for a specific year and the depreciation value for the year. The depreciation being a non cash item is deducted in the income statement as an expense, the net cash flow is obtained by adding back the depreciation value that was charged as an expense before (Francis, 2004; Pandey, 2009; Plewa, 1995; Jury, 2012). In the mentioned case the company's policy is to depreciate the assets using the straight-line method. Cash Flow of Project Alpha Cash inflow/outflow £ Depreciation £ Cash Flows £ Initial Investment (100,000) Year 1 15,000 18,000 33,000 Year 2 18,000 18,000 36,000 Year 3 20,000 18,000 38,000 Year 4 32,000 18,000 50,000 Year 5 18,000 18,000 36,000 Year 6 2,000 - 2,000 Calculation for Depreciation Straight Line Method Formula: cost of asset-scrap value/useful life in years 100,000-10,000/5 Investment in Asset 100,000 Scrap Value 10,000 Useful life in years 5 Depreciation Value 18,000 Cash Flow of Project Beta Cash inflow/outflow £ Depreciation £ Cash Flows £ Initial Investment (90,000) Year 1 20,000 30,000 50,000 Year 2 25,000 30,000 55,000 Year 3 (50,000) 30,000 (20,000) Year 4 10,000 25,000 35,000 Year 5 3,000 25,000 28,000 Year 6 - 25,000 25,000 Calculation for Depreciation Straight Line Method Machine (A) 90,000-0/3 Investment in Asset 90,000 Scrap Value - Useful life in years 3 Depreciation Value 30,000 Calculation for Depreciation Straight Line Method Machine (A) 75,000-0/3 Investment in Asset 75,000 Scrap Value - Useful life in years 3 Depreciation Value 25,000 ii. Payback Period Project Alpha Project Beta Cash Flows £ Payback Period Cash Flows £ Payback Period (100,000) (90,000) 33,000 (67,000) 50,000 (40,000) 36,000 (31,000) 55,000 15,000 38,000 7,000 (20,000) (5,000) 50,000 57,000 35,000 30,000 36,000 93,000 28,000 58,000 2,000 95,000 25,000 83,000 a) The payback period for Project Alpha is equal to: 2 years + (31,000/38,000) = 2.8 years (Mulford & Comiskey, 2005). b) The payback period for Project Beta is equal to: 3 years + (5,000/35,000) = 3.1 years. iii. Accounting Rate of Return a) The Accounting Rate of Return (project Alpha) can be calculated by using the formula: Accounting Rate of Return = Average Accounting Profit / Average Investment Annual Depreciation: (100,000 - 10,000) / 5 = £18,000. Average Accounting Profit (before depreciation): (33,000 + 36,000 + 38,000 + 50,000 + 46,000 + 2,000) / 6 = £34,200. Average Accounting Profit (after depreciation): Average accounting profit - Annual depreciation = 34,200 - 18,000 = £16,200. Now Average Investment = (100,000 + 10,000) / 2 = £55,000 Accounting Rate of Return = £16,200 / £55000 b) The Accounting Rate of Return (project Beta) can be calculated by using the formula: Accounting Rate of Return = Average Accounting Profit / Average Investment Annual Depreciation: (90,000 + 75,000) / 6 = £27,500. Average Accounting Profit (before depreciation): (50,000 + 55,000 - 20,000 + 35,000 + 28,000 + 25,000) / 6 = £28,800. Average Accounting Profit (after depreciation): Average accounting profit - Annual depreciation = 28,800 - 27,500 = £1,300. Now Average Investment = (90,000 + 75,000) / 2 = £82,500 Accounting Rate of Return = £1,300 / £82,500 iv. Net present value Net Present Value (project Alpha) Discounting Percentage 14% Initial Investment 100,000 Years 1 2 3 4 5 6 Cash Flows £000 33,000 36,000 38,000 50,000 46,000 2,000 Initial Investment (100,000) 28947.37 27700.83 25648.92 29604.01 23890.96 911.17 Sum of all the Present Value 136,703 Net Present Value of Project Alpha 36,703 Net Present Value (project Beta) Discounting Percentage 14% Initial Investment 90,000 1 2 3 4 5 6 Cash Flows £000 50,000 55,000 (20,000) 35,000 28,000 25,000 Initial Investment (90,000) 43859.65 42320.71 -13499.43 20722.81 14542.32 11389.66 Sum of all the Present Value 119,336 Net Present Value of Project Alpha 29,336 I. The above calculation illustrate that NENE Limited must undertake project Alpha. The decision is based on two reasons: Net Present Value The net present values (NPV) for both the projects are positive (Project Alpha- £36,703 and Project Beta- £29,336). This means that both the investment opportunities are profitable. The decision to invest in project alpha is due to the higher net present value (that is £36,703). Investment must be done in those opportunities where the NPV value is highest and in this situation spending money on project Alpha will result in highest NPV. Payback Period The payback period of investing in project alpha is also higher than that of investing in project Beta. The company NENE Limited will be able to get back its initial invested amount in 2.8 years. II. Four Main Investment Appraisal Methods The four main investment appraisal technique methods are Payback Period (PP), Accounting Rate of Return (ARR), Net Present Value (NPV) and Internal Rate of Return (IRR). The four main investment appraisal methods used are segmented into two techniques. Non-discounted cash flow technique includes PP and ARR and discounted cash flow technique includes NPV and IRR. Payback Period (PP) is the time acquired to equal the cash inflows and outflows. In the book ‘Financial Accounting for Decision Makers’ and ‘Accounting: An Introduction’ it is discussed that PBP method is important for future context and it is totally cash based. It is also mentioned that it ignores sunk cost and committed cost when applied (Atrill & McLaney, 2013). Advantages and Disadvantages of Payback Period: Payback period is simple to calculate and useful in short term and consider the cash flows of the projects which makes it easier to evaluate the liquidity position of the company and decisions about the investment proposals. It explains the management about the time during which investment will be recovered and how quick it could be utilized into another project. On the other hand, this method completely ignores the qualitative aspects of decision making. It is also not possible to analyze the useful life of the asset and does not consider how much cash flow will be generated after payback period is achieved. Payback period ignores the profitability of the company and decision taken on the basis of this method may cause the management to undertake project which is not profitable. ARR is also known as return on investment and is used to make analysis over a project, which may take at least a year long time. A proper calculation of the project is conducted to calculate it for the upcoming years. Atrill, et al.(2014) mentioned in his book that if ARR is high it is a desirable investment for the company (Atrill et al., 2014). Advantages and Disadventages of ARR: ARR is useful in assessment of comparative returns of the projects. It focuses on net operative income of the project which makes it easier to understand by the investors since they use operating income to evaluate the efficiency of the management. ARR may be useful in assessment of comparative returns of the projects. However, it ignores the fact that future returns may not be sufficient and does not give clear picture of the period over which initial investments would be recovered. This method ignores the cash flows from the project and hence liquidity of the project could not be assessed accurately. Furthermore, it does not consider the terminal value of the roject undertaken. NPV as mentioned by Berry & Jarvis in their book ‘Accounting in a Business Context’, is the sum of all the present values of inflow and outflows.While calculating the NPV there can be two outcome either of a positive value or a negative value. If the result of calculation is positive then it is an acceptable investment for the business (Berry & Jarvis, 2005). Advantages and Disadvantages of NPV: Unlike PBP, NPV does take into account the interest rates ad look more closely at the profitability of the project. It also provides the picture of the fact whether the future returns are valuable tha current returns, hence taking into considerations the oppurtunity cost of he project. NPV helps the management in evaluating cash flows both before and after the project and liquidity position of the company during the life span of project. Qualitative aspect of decision making is, however, not considered by NPV. Decision taken on the basis of NPV may prove to be incorrect if the projects compared are of unequal life. IRR is a discount rate which has an impact on the NPV of a project as it can be nill because of it.The higher the IRRthan the cost of capital the moredesireable it is (Götze et al., 2007). Advantages and Disadvantages of IRR: IRR is fairly simple to calculate and interpret which is its biggest advantage. Unlike ARR, IRR considers the time value of money. Additionally, rate of return is also not required to calculate IRR. Managers can simply estimate a rough rate of return since the calculation is not entirely dependent on the rate of return. IRR cannot be used to compare two mutually exclusive projects. It can only assist in decision making for investment in a single project. Secondly, since the IRR do not compare the cost of capital, it cannot be used to compare the projects of different durations. This method can also produce multiple values if the cash flows are negative and positive at different levels of the projects. This could confuse the decision maker in taking the valid decision. Question 2 The ratio analysis of both the companies (Benjamin Ltd & Peters Ltd) was done using Microsoft Excel in accordance of the profitability, liquidity and working capital management (Palmer, 1983; Peterson & Fabozzi, 2012; Gibson, 2008). The analysis revealed the following: Ratios Benjamin Ltd Peters Ltd Return on capital employed 0.2381 0.3409 Gross profit margin 0.25 0.20 Operating profit margin 0.125 0.125 Acid test ratio 6.00 2.25 Inventory days 91.25 66.54 Trade receivable days 114.06 60.83 Trade payable days 30.42 38.02 I. Profitability Ratios Return on Capital Employed (ROCE): The financial ratio was calculated to determine the efficiency of the companies regarding the capital employed. The higher value of Return on Capital Employed indicates that the company is efficient in the utilization of the Capital. The results show that Benjamin Ltd has a value of 0.2381 and Peters Ltd has a value of 0.34. This shows that Peters Ltd is more efficient in the utilization of the capital that is employed in the operations of the company. (Andrijasevic & Pasic, 2014; Oruç Erdoğana et al., 2015). Gross Profit Margin (GPM): This financial ratio is used to identify the financial health of the organization/company as it reveals the value of money that is left after the deduction of the Cost of Goods Sold (COGS). The high value for GPM ratio indicates that the company is able to pay off for the operating expenses and has a potential to grow and build a future. The current position reveals that Benjamin Ltd is stronger company with a GPM value of 0.25 in comparison with 0.20 of Peters Ltd. Operating Profit Margin: The profitability ratio used to identify and measure the pricing strategy of a company and its efficiency with regards to the operations. This indicates the portion of the money left after the payments of the variable costs. Both the companies (Benjamin Ltd and Peters Ltd) have the same value of the Operating Profit Margin. This means that both the companies are capable of paying for the fixed cost such as the interest on borrowing. However, the fact that Benjamin Ltd had a higher GPM than Peters Ltd but both the companies are having same OPM indicates that Benjamin Ltd is having higher proportion of operating expenses as compared to Peters Ltd. Benjamin Ltd should adopt cost control measures to overcome the situation. Liquidity Ratios Acid Test Ratio: The acid test ratio is used to identify the position of the company to pay off its current liabilities. It indicates that if the firm has enough of its current assets except the inventory to pay off for the liabilities it has. Benjamin Ltd is more effective in the allocation of their assets; the value indicates that the company is stronger with respect to paying off its liabilities (the value for Benjamin Ltd is 6.00 and Peters Ltd has a value of 2.25). Working Capital Management Ratios The ratios are calculated to notice the conversion cycle. Inventory days: The inventory days provide the insight to the investors about the days a company takes to convert its raw materials into finished goods (that are ready for sales). The smaller the value of the Inventory days the better are the chances for the company to sell the products and earn revenues. Peters Ltd has an inventory days period of 66 days and has a chance to earn quick revenues. Trade Receivable Days: The trade receivable days indicate the companies’ policy of receiving its payments due on the debtors. Peters Ltd is efficient in receiving its due payments from its debtors. Trade Payable Days: The ratio indicates the policy of the company to pay off its credits to the creditors. The higher the value of the ratio the better is the company's working capital management. Peters Ltd has a better Trade Payable day’s ratio. Benjamin Ltd receives payments from its customers after 114 days on average while it pays off its creditors in 30 days. Benjamin Ltd policy to receive payments late from the customer may be the reason for their higher ROCE as it may be used by the company as a motivator to attract customers in order to increases its total turnover. On long term basis, Benjamin Ltd must adopt an effective credit policy to overcome the problem of late receipts. Otherwise bad debts of the company may be increased and this may seriously harm the working capital of the company and it may lose the ability to pay off its expenses and creditors on timely basis. Peter Ltd is performing better in terms of efficiency since it is having a receivable days average of around 60 days, which is comparatively better than Benjamin Ltd. However, Peter Ltd is required to speed up the payments to the creditors in order to sustain long term relationship with suppliers and to manage its supply chain effectively. Peter Ltd seem to have a control on operating expenses which makes its net profits equivalent to Benjamin Ltd but the company is required to put controls on cost of goods sold to increase its gross profits. Timely payments to suppliers may lead the company to discounts and lower than usual prices which may decrease the cost of goods sold of the company. NENE Limited must acquire Peters Ltd as the ratio indicates a better future for the company. The acquisition would help the company to earn more and more profits in the future. II. Limitations of Ratio Analysis The different environmental and industrial conditions of the companies have different impacts on the operations of the companies. Ratio analysis done for the comparison of two companies of different industries or sectors may be misleading and in appropriate. Financial accounting is sometimes based on expectations and assumptions and the accounting standards have imposed many policies. The ratio analysis done in such conditions would be less useful and true and fair. The ratio analysis is done using the historical data. The investors who want to invest are also concerned about the future conditions of the company as well. Ratio analysis explains the link and relationship with respect to the past information. Furthermore, change in the rate of inflation subsequently change the purchasing power of money and thus the amounts compared across two periods are not useful for decision making. Operational changes made by the company can change the results of the ratios. If ratios are calculated for the period before change and compared to the ratios after the change, they will produce results that could be severely misleading. Often the ratios are also not considered by managers as an effective tool because different companies have different strategies to pursue and to achieve their long term goal. Managers often take a decision which may not produce good ratio but could be effective for the achievement of the goal of the company. For example one company may have a low cost strategy and may have a lower gross margin but higher market share. On the other hand, their competitor may be charging higher prices in exchange of better quality services and may have a higher gross margin. Question 3 a) Traditional Costing Method: Per unit cost of Model A: $ Direct material ($/unit) 25 Direct labor (0.5 * 8) 4 Total direct cost 29 Indirect cost (0.5 * 210) 105 TOTAL PER UNIT COST OF Model A 134 Per Unit cost of Model B: $ Direct material ($ / unit) 62.5 Direct labor (1 * 8) 8 Total direct cost 70.5 Indirect cost (1 * 210) 210 Total per unit cost of Model B 280.5 Per unit cost of Model C: $ Direct Material ($ / unit) 105 Direct Labor (1 * 8) 8 Total Direct Cost 113 Indirect Cost (1* 210) 210 Total per unit cost Of Model C 323 Total cost of 20000 units of Model A = 20000 * 134 2680000 Total cost of 1000 units of Model B = 1000 * 280.5 280500 Total cost of 10000 units of Model C = 10000 * 323 3230000 Total Cost of production 6190500 Selling Price: Model A: Selling Price = cost (1 + r) Selling Price =134 (1 + 0.20) Selling price per unit = 160.8 Total Selling price for 20000 units of A = 20000 * 160.8 = 3216000 Model B: Selling price = 280.5 (1+ 0.20) Selling price per unit of B = 336.6 total selling price for 1000 units of B = 1000 * 336.6 = 336600 Model C: Selling Price = 323 (1 + 0.20) Selling price per unit of C = 387.6 Total Selling price for 10000 units of C = 10000 * 387.6 = 3876000 Calculations: Calculation For total Labor Hours: Total labor hours required for 3 models: A 1/2 * 20000 10000 B 1 * 1000 1000 C 1 * 10000 10000 Total labor hours required 21000 Calculation for Overhead expense: Nene limited use direct labor hours as a base for charging indirect cost to the jobs. Hence indirect cost would be absorbed as follows: Overhead absorption rate = total indirect cost / total labor hours overhead absorption rate = 4410000 / 21000 overhead absorption rate = 210 per direct labor hour. (Drury, 2005) b) Activity based costing: Activity based costing: Total machine hours overheads: Model A (2780000 * 40%) = 1112000 Model B (2780000 * 15%) = 417000 Model C (2780000 * 45%) = 1251000 the cost per unit of Machine Hour : A = 1112000 / 20000 = 55.6 B = 417000 / 1000 = 417 C = 1251000 / 10000 = 125.1 Material orders in the Logistics activity could be calculated as follows: Model A (590000 * 47%) = 277300 Model B (590000 * 6%) = 35400 Model C (590000 * 47%) = 277300 The cost per unit of Material order could be obtained by dividing total cost of logistics by total material orders: COST PER UNIT OF MATERIAL ORDER: Model A = 277300 / 20000 = 13.865 Model B = 35400 / 1000 = 3.54 Model C = 277300 / 10000 = 27.73 Space requirements in establishments cost could be calculated as follows: Model A (1040000 * 42%) = 436800 Model B (1040000 * 18%) = 187200 Model C (1040000 * 40%) = 416000 The cost per unit of space: Model A = 436800 / 20000 = 21.84 Model B = 187200 / 1000 = 187.2 Model C = 416000 / 10000 = 41.6 Total cost of each product will include cost of machine hours, material orders and space. It could be calculated as: Cost of Model A Cost of Model B Cost of Model C Machine hours 55.6 417 125.1 Material orders 13.865 3.54 27.73 Space 21.84 187.2 41.6 Total cost 91.30 607.74 194.43 Selling Price per unit of A = 91.30 * 1.2 = 109.56 Selling price for 20000 units = 20000 * 91.30 = 2191200 Selling price of B = 607.74 * 1.2 = 729.2 Selling price for 1000 units = 1000 * 607.74 = 729288 selling price of C = 194.43 * 1.2 = 233.31 selling price of 10000 units = 10000 * 194.43 = 2333160 3c) Explanation to the directors: In traditional costing, indirect manufacturing costs are allocated to products on the basis of different cost drivers such as machine hours or labor hours. On the other hand, activity based costing allocates manufacturing cost on the basis of activities that are required to produce a product. Advantage of using traditional coting is that it is in accordance with the generally accepted accounting principles. (Lal, 2009) However, it only uses direct labor hours as the cost drivers while ignoring the other cost drivers due to which cost of the product calculated on traditional basis is often inaccurate. Traditional costing is based on the assumption that products are the cause of costs. This assumption is correct up to certain level but it does not work for those activities that are not performed directly on the products but they do incur costs. In short, cost calculated through traditional method explains what is spent does not explain why it is spent. Limitation of Traditional costing is overcome by the Activity based costing in which all the activities are taken into consideration, which adds cost to the product. Cost of those activities is then made the cost of product on a systematic basis. (Baker, 1998) in activity based system, activities perofrmed are the basis or fundamental cost objects. By using activity based costing, control over the costs is improved and oganization can easily relate costs to customers, management and processess. Overhead costs are assigned to cost pools and each activity performed can be then taken as a cost driver. Thus activity based costing helps the management to identify fixed costs and remove an costs that are unnecessary. It increases the efficiency of the management as a whole. List of References Andrijasevic, M. & Pasic, V., 2014. A blueprint of ratio analysis as information basis of corporation financial management. Problems of Management in the 21st Century, 9(2), pp.117-23. Atrill, P. & McLaney, E., 2013. Financial Accounting for Decision Makers. New York: Pearson Education. Atrill, P., McLaney, E. & Harvey, D., 2014. Accounting: An Introduction. 6th ed. Melbourne: Pearson Higher Education AU. Baker, J., 1998. Activity based costing. New York: Aspen Publication. Berry, A. & Jarvis, R., 2005. Accounting in a Business Context. 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Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance. illustrated ed. Hoboken: John Wiley & Sons. McMenamin, J., 2002. Financial Management: An Introduction. London: Routledge. Oruç Erdoğana, E., Erdoğan, M. & Ömürbek, V., 2015. Evaluating the Effects of Various Financial Ratios on Company Financial Performance: Application in Borsa Đstanbul. Business & Economics Research Journal, 6(1), pp.35-42. Palmer, J.E., 1983. Financial Ratio Analysis. New York: American Institute of Certified Public Accountants. Pandey, I.M., 2009. Essentials Of Financial Management, 1E. reprint ed. Delhi: Vikas Publishing House Pvt Ltd. Peterson, P.P. & Fabozzi, F.J., 2012. Analysis of Financial Statements. 2nd ed. Hoboken: John Wiley & Sons. Plewa, J..F.J., 1995. Understanding Cash Flow. illustrated ed. Hoboken: John Wiley & Sons. Serfas, S., 2010. Cognitive Biases in the Capital Investment Context: Theoretical Considerations and Empirical Experiments on Violations of Normative Rationality. Beerlin: Springer Science & Business Media. Röhrich, M., 2007. Fundamentals of Investment Appraisal: An Illustration Based on a Case Study. Hamburg: Oldenbourg Verlag. Read More