Budgeting Analysis and Internal Decisions for NENE Limited - Assignment Example

CASE STUDY 02085 By of the of the School Introduction Organizations are often faced with situations that require deep analysis so as to arrive at informed decisions. In doing so, organizations are required to carry out financial ratio analysis, capital budgeting analysis and as well as internal decisions (management accounting. the report presents ratio analysis and interpretation, capital budgeting analysis and internal decisions for NENE Limited. Question 1 a) Computation of investment appraisal methods i) Projected Cash flows Cash flows of Beta 　 Cash flow (000) Depreciation (£000) Cash Flows £000 Cumulative cash flows £000 Year 0 -£90 0 -£90 -£90 1 20 30 50 -40 2 25 30 55 15 3 -50 30 -20 -5 4 10 25 35 30 5 3 25 28 58 6 0 25 25 83 Depreciation for years 1-3= 90/3=£30 Depreciation for years 4-6 =75/3= £25 Cash flows of Alpha 　 Cash flow (£000) Depreciation (£000) Disposal proceeds (£000) Cash Flows (£000) Cumulative cash flows (£000) 0 -£100 0 0 -£100 -£100 1 15 18 0 33 -67 2 18 18 0 36 -31 3 20 18 0 38 7 4 32 18 0 50 57 5 18 18 10 46 103 6 2 0 0 2 105 Depreciation= (100-10)/5= £18 ii) Payback period (PP) Alpha PP =2 years + [31)/38] = 2 31/38 years Beta PP= 3 year + (5/35) = 35/35 years iii) Accounting Rate of Return (ARR) ARR= (Average annual operating profit/Average investment) 100 Project Beta: Average annual operating profit= (50+55-20+35+28+25)/6) = £28.8*1000= £28800 Annual depreciation using straight line method = (cost-salvage value) 6 Annual depreciation charge= £ (90 – 0 + 75 - 0)/6) = £27.5*1000=£27500 Average annual operating profit after depreciation is (£28,800 - £27,500) = £1,300 Average investment = (cost of machinery + disposal value)/2 = (£90 + £75)/2 = £82.5= £82,500 Hence, ARR = (£1,300/£82,500)*100% = 1.6%. Project Alpha: Average annual operating profit= £ (33+36+38+50+46+2)/6) = £34.2*1000= £34,200 Annual depreciation using straight line method = (cost-salvage value) 6 Annual depreciation charge= £ (100 – 10)/5) = £18*1000= £18,000 Average annual operating profit after depreciation is (£34,200 - £18,000) =£16,200 Average investment = (cost of machinery + disposal value)/2 = (£100 + £10)/2 = £55*1000= £55,000 Hence, ARR = (£16,200/£55,000)*100% = 29.4%. iv) NPV NPV of project Alpha: Time Cash flows PVIF (14%) Present value 0 -100000 1 -100,000 1 33000 0.877 28,941 2 36000 0.770 27720 3 38000 0.6750 25650 4 50000 0.592 29,600 5 46000 0.519 23,874 6 2000 0.456 912 NPV £36,697 NPV of project Beta: Time Cash flows PVIF (14%) Present value £ 0 -£90,000 1 -90,000 1 50,000 0.877 43,850 2 55,000 0.770 42,350 3 -20,000 0.6750 -13,500 4 35,000 0.592 20,720 5 28,000 0.519 14,532 6 25,000 0.456 11,400 NPV £29,352 b) Recommendation and explanation From the above analysis, it is clear that Project Alpha is viable and NENE should undertake it. Project Alpha has not only a positive NPV, but also a higher NPV than project Beta meaning it has more cash inflows making it an attractive investment. It also has a shorter payback period, which indicates that it takes a shorter time period to recoup its initial investment. Finally, project Alpha has a greater accounting rate of return, 29.4% to 1.6% of Beta. Project Alpha is more profitable than Project Beta. Therefore, it should be undertaken because it is more attractive. c) Critical discussion of the four main investment appraisal methods i) Payback period (PP) In capital budgeting, payback period refers to the period of time taken by a project to recoup the funds expended or it is simply the time taken by a project to reach the breakeven point (Lucey, 2003: 412). This investment appraisal technique requires that a target payback period be set so that a project is accepted only is the resultant payback period is less than the targeted one. And in case of multiple projects, the one with the shortest payback period is accepted. Although PP is more realistic because it uses cash flows rather than accounting profit, it ignores time value of money, indicating that cash flow in the future is worth as much as today’s cash flow. This is not true because today’s cash flow is worth more that future’s cash flow. PP allows management and stakeholders to easily understand when the initial investment is recovered, however, the method ignore cash flows generated after initial investment is recouped (Shim & Siegel, 2007: 44). The method is therefore very biased against long term investments or projects. This is a serious drawback because it is able to lead to wrong decisions. ii) Accounting Rate of Return (ARR) ARR measures the profitability of an investment from the standpoint of conventional accounting by relating average investment to the future annual net income. ARR clearly indicates the profitability of an investment, however, it fails to consider the expected cash flows timing from such an investment. Also, despite being easy to calculate, ARR does not recognize the project’s life. It ignores time value of money; hence it varies over the life of the project (Needles et al. 2010: 1167). Cash is very crucial for each business. An investment that generates cash inflow quickly enables a firm to invest in other very profitable projects. Yet ARR method focuses on operating income instead of cash flow. This limits its applicability even though the technique is suitable as it recognizes the investment’s profitability factor (Needles et al. 2014: 1108). iii) Net Present Value (NPV) NPV is the difference between cash inflows’ present value and the cash outflows’ present value. It is often used in capital budgeting in analyzing the profitability of a project or investment. Theoretically, NPV is a sound method; however, it poses several computation problems. In practice, it is very difficult to obtain estimated cash flows due to uncertainty (Shim & Siegel, 2007: 47). In addition, it is quite difficult to accurately measure the discount rate. NPV takes into account inflation, making it the most relevant investment technique; however, it may not give unambiguous answers in case alternative projects have unequal lives. NPV takes into account time value of money; however, it fails to provide an overall picture of the loss or gain of undertaking a certain project (Peterson & Fabozzi, 2002: 106). NPV assist in the maximization of the value of the firm, however, it does not tell when a project will achieve a positive NPV but rather tell us to undertake projects that have an NPV of greater than zero. iv) Internal Rate of Return (IRR) IRR refers to the interest rate at which all cash flows’ net present (both positive and negative) from an investment or project is equal to zero. IRR is utilized in assessing the attractiveness of an investment or project. If the IRR of an investment exceeds the required return of a company, that investment is desirable and if it falls below the company’s required return, the investment should be rejected. Though IRR is useful because it takes into account time value of money and the whole life of the investment, financial analysts have no way of precisely predicting the future discount rate because depending on market conditions, it changes each year (Peterson & Fabozzi, 2002: 106). IRR is mostly preferred because of its clarity as well as easy conceptualization, however, it may not result in one singular rate, and instead it may result in multiple or no IRRs in case the cash flows have different signs. This further complicates management’s decisions especially because, in the first case, the assumptions are inherently uncertain (Ryan, 2007: 40). IRR results in the maximization of the shareholder’s wealth, by assuming that the value of the calculated future cash flows can be reinvested at a rate equal to the IRR, however, this assumption is impractical due to the fact that IRR is normally so high that opportunities that can yield such a return is significantly limited or unavailable (Shim & Siegel, 2007: 50). Question 2 a) Ratio computation 1. Return on capital employed ROCE= [operating profit/ (Share capital + Reserves + Non-current liabilities)] 100 Benjamin Ltd ROCE= [10/ (47-5)] 100=23.81% Peters Ltd ROCE=[15/ (54-10)] 100 =34.09% 2. Gross profit margin Gross profit margin= (gross profit/sales revenue) 100 Benjamin Ltd GP= (20/80)100= 25% Peters Ltd GP= 24/120)100= 20% 3. Operating profit margin Operating profit margin= (operating profit/sales revenue) 100 Benjamin Ltd OP= (10/80)100= 12.5% Peters Ltd OP= 15/120)100= 12.5% 4. Acid test ratio Acid test ratio= (current assets-inventories)/current liabilities Benjamin Ltd Acid test ratio= (45-15)/5= 6:1 Peters Ltd Acid test ratio= (40-17.5)/10= 2.25:1 5. Inventory days Inventory days = (inventory/cost of sales) 365 Benjamin Ltd Inventory days= (15/60)365= 91.3 days Peters Ltd = (17.5/96)365= 66.6 days 6. Trade receivable days Trade receivable days= (trade receivables/credit sales revenue) 365 Benjamin Ltd: (25/80)365= 114.1days Peters Ltd: (20/120)365= 60.9 days 7. Trade payable days Trade payable days= (trade payables/ credit purchases) 365 Benjamin Ltd: (5/(60+15)365= 24.4days Peters Ltd: (10/(96+17.5)365= 32.2 days b) Critical interpretation of the ratios Liquidity This category shows the ability of a firm to meet its current liabilities as they become due (Graham & Smart, 2012: 41). From the above acid test ratio, Benjamin Ltd is more liquid than Peters Ltd. In terms of this ratio category, it should be acquired because it has a higher ability to meet its current obligation with its most liquid assets. It has an acid test ratio of 6:1 compared to 2.25: 1 of Peters Limited. The higher Benjamin’s acid test ratio could be due to uncertainty of the business environment. However, the company has a higher risk of loss from its extremely high quick ratio. However, the excess spare cash can be invested in new ventures to earn more returns (Mclean, 2003: 70). Profitability ratios These ratios measure the overall performance of a firm (Graham & Smart, 2012: 49). From the analysis it is clear that both the companies are profitable however, Benjamin Ltd appears to be more profitable. It has a higher profit margin of 25% compared to 20% of Peters Ltd. Benjamin is more effective in managing its expenses as it has high profit margin. This implies that most of venues are turned into profit. According to ROCE, Peters Ltd is very effective in utilizing its funds because it has a higher value (34.09%) than Benjamin (23.81%). From the operating profit margin, it is evident that both companies make the same amount on every dollar of sales. They both make £0.25 before interest and taxes for every dollar of sales. Operating margin excludes nonrecurring cash flows like cash paid out in settlement of lawsuits, and hence fails to represent the true operating performance of a firm (Kimmel et al.2008: 683). The companies have equivalent cost control and their sales are increasing quicker than costs. With a higher ROCE, Peter Ltd is very efficient in utilising the invested capital and should therefore be acquired by NENE Limited. Working capital management Working capital management aims at maintaining efficient levels of current assets and current liabilities. It focuses on accounts payable and receivable management, inventory management (Sagner, 2011:11). From the above ratio calculation, Peter Ltd appears to be more efficient in managing inventories. It turns over inventories faster than Benjamin (66.6 days to 91.3 days). In terms of accounts receivable management, it is also very efficient as it collects cash from its trade receivables in 60.9 days compared to Benjamin LTD (114.1 days). Benjamin is very inefficient because it takes more days, almost twice the one taken by Peters. This means the firm is less efficient in its operations compared to Peters. In addition, it is also more efficient in managing trade payables (Graham & Smart, 2012:50). Relatively higher payable days provide the company with free finance from suppliers which it can use to generate additional returns (Mclean, 2003: 70). In summation, Peters Limited should be acquired instead of Benjamin because it is more profitable, more liquid and efficient in managing working capital (Kimmel et al.2008: 683). c) Limitations of ratio analysis Despite their usefulness, financial ratio analysis has a number of disadvantages that limits their applicability. Some of such key demerits include; First, financial accounting information is impacted by assumptions and estimates. Accounting standards permit diverse accounting policies, which hinder comparability thus making ratio analysis less important in such circumstances (Besley & BRIGHAM, 2000: 111). Second, different organizations operate in distinctive industries each having distinctive environmental conditions. It is hard to compare companies that have different business structures. Such factors are significant to the point that a comparison of two organizations from different industries tends to be misleading (Guerard & Schwartz, 2007: 93). In addition, numerous large firms operate different divisions in a number of industries. For these organizations it is hard to arrive at a meaningful set of industry-average ratios. Thirdly, financial ratio analysis explains relationships that exist between past information however; the users are more interested in the current and future information (Ehrhardt & Brigham, 2010: 118). Fourthly, financial ratio analysis only gives numbers and not the causation factors. They only consider the quantitative information and fail to take into account qualitative point of view of the organization (Taparia, 2003: 92). An organization may have a number of good as well as a number of bad ratios, making it very difficult to tell if it is a weak or good organization. It is also hard to generalize about whether a given ratio is good or bad. A high cash ratio on one hand is a good assign and on the other hand indicates that the firm is no longer growing and should have lower valuations. A fifth limitation is that inflation greatly distorts the company’s balance sheet thereby making a ratio look bad or good over time, in case trends are examined (Grier, 2007: 77). Companies may use window dressing in manipulating their financial statements leading to wrong values and inaccurate ratios. Question 3: a) Computation of each product’s full cost and selling price i) Traditional costing ,method Overhead Rate = Total Budgeted Overheads/Total Budgeted Direct Labor Hours Total budgeted Direct Labour Hours= 1*1000+1*10000+0.5*20000+= 21,000 Overhead Rate= £4,410,000/21000= £210 per direct labour hour Model A Manufacturing overhead (210*0.5) 105 Direct material 25 Direct labour (8*0.5) 4 Full cost £134 Selling price (1.2*134) £160.8 Model B Manufacturing overhead (210*1) 210 Direct material 62.5 Direct labour (8*1) 8 Full cost £280.5 Selling price (1.2*280.5) £336.6 Model C Manufacturing overhead (210*1) 210 Direct material 105 Direct labour (8*1) 8 Full cost £323 Selling price (1.2*323) £387.6 b) Activity-based costing method activity Cost driver Total cost A B C Machining Machine hours £2,780,000 1112000 417000 1251000 Logistics Material orders £590,000 277300 35400 277300 Establishment Space £1,040,000 436800 187200 416000 Total £4,410,000 £1826100 £639600 £1944300 Manufacturing over head per unit= total overhead/total units A: 1826100/20000= £91.31 B: 639600/1000= £639.6 C: 1944300/10000= £194.43 Model A Manufacturing overhead £91.31 Direct material 25 Direct labour 4 Full cost £120.31 Selling price (1.2*120.31) £144.37 Model B Manufacturing overhead 639.6 Direct material 62.5 Direct labour 8 Full cost £710.1 Selling price (1.2*710.1) £852.12 Model C Manufacturing overhead 194.43 Direct material 105 Direct labour 8 Full cost £307.43 Selling price (1.2*307.43) £368.92 c) Differences between activity based costing (ABC) and traditional costing Businesses use costing methods in allocating costs to several products and services (Ellis-Newman, 12). Activity based costing is refers to a method that allocates costs based on the value or amount of resources a service or a product consumes (Innes et al. 2005, 12). The use of this costing method is particularly crucial to businesses providing customized services or products (Clement et al. 2009, 381). Under traditional costing method, businesses sum up all costs of producing a product so as to assign total costs to it. Even though ABC provides benefits such as better allocation of resources, it places too much stress on detail and control on processes (Latshaw & Cortese-Danile 2002, 31). It causes the organization to lose sight of their long term objectives at the expense of short-term or small savings thus obscuring the bigger picture. Under ABC, product cost determination is more precise and dependable in light of the fact that it concentrates on the cause and effect linkage of activities and costs in the context of manufacturing goods (Tuncel et al. 2005, 562). However, the method is hard to assess on the basis of activities (Schulze et al. 2012, 720). The fixation of selling prices for multi-products under ABC is correct and fair since overheads are often allocated on the basis of relevant cost drivers, however, under ABC; it is not easy to choose the most suitable cost driver. It is not easy to identify the overall activities influencing the costs (Cagwin & Bouwman 2002, 24). Traditional costing method allocates factory overheads on the basis of just one factor. The method implies that there is just one driver of the factory overhead, the driver is either labour hours or machine hours. In reality there are a number of drivers (Mishra & Vaysman 2001, 620). Although traditional costing method provides a better idea of a product’s manufacturing costs for a business that produces large volumes of a few products (Kaplan & Anderson, 42). However, traditional costing method becomes less reliable as the level of diversity in the output rises (O’Byrne 2007, 1385). Conclusion NENE Ltd should undertake project Alpha because it is more profitable. And in the evaluation NENE should use NPV because it is the most reliable technique. In addition, Peters Limited should be acquired because it is more profitable, more liquid and efficient in managing working capital. NENE Ltd should incorporate both qualitative and quantitative data in evaluating Peters and Benjamin Ltd to arrive at an informed decision. Finally, ABC system should be used because it provides accurate costs. References Cagwin, D. & Bouwman, M.J., 2002. The association between activity-based costing and improvement in financial performance. Management Accounting Research, 13, pp.1–39. Available at: http://www.sciencedirect.com/science/article/pii/S1044500501901751. Clement, F.M. et al., 2009. 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