The Sophisticated and Unsophisticated Techniques - Assignment Example

Management Accounting Introduction The paper aims to discuss the sophisticated and unsophisticated techniques that enables the firm to access a better project for future growth. It deals with a case study of up and coming Holloway catering. Sidney rich is the ambitious accountant of the firm and want to leave the firm after 3 years by providing better services to the firm. His better services enable him to gain a better job in a huge and well-renowned firm. In the present case he is dealing with three projects and wants to select the best that will provide an efficient growth to the firm. The Chairman of the firm uses non-sophisticated technique and is unable to know other latest financial techniques. Sidney is required to present a better capital budgeting technique that not only show the statistical data but also provide a better understanding of the technique used. The paper first present the techniques used previously by the firm and later a sophisticated technique of finance is used by the accountant to show more accurate techniques. Net present value of the project with profitability index is sued to provide accurate results presenting time value of money associated with each project. Later assumption of stock market behaviour with respect to Project C is presented. Payback Period The payback period shows the time required to recover the initial investment. The payback period is the unsophisticated technique of capital budgeting as this tool does not include the time of money. Payback period for annuity and for mixed stream is calculated as accumulate Payback period for annuity= initial investment/annual cash inflows Payback period for mixed stream= initial investment/ accumulated yearly cash inflows Project A B C Initial Investment 350,000 350,000 350,000 Expected Cash Inflows in Year 1 £100,000 £40,000 £200,000 Year 2 £110,000 £100,000 £150,000 Year 3 £104,000 £210,000 £240,000 Year 4 £112,000 £260,000 £40,000 Year 5 £138,000 £160,000 Year 6 £160,000 Year 7 £180,000 Payback Period 3 years 4 month 3 years 2 years Decision criteria If the payback period is less than the period accepted by the firm, accept the project If the payback period is more than the accepted time for the firm, reject the project. Accounting rate of return The accounting rate of return is an investment appraisal technique used to measure the profitability of the project. It shows comparison between the projects and it shows the income streams earn by the project but it is not capable to inform the time period of the earning. The accounting rate of return in measured by the formula Accounting rate of return = average annual rate of return/initial cost of investment 1. Accounting rate of return for the project A = 27.5/20 =1.375% 2. Accounting rate of return for the Project B = 26.4/20 = 1.32% 3. Accounting rate of return for the Project C = 33/20= 1.65% Decision Criteria The accounting rate of the project C is highest than the other two project, therefore, it is recommended to adopt the Project C. Report for the Chairman The above two mentioned techniques do not involve the time value of money and thus more sophisticated techniques are required to access a better profit in the year. The time and the money of the project are inextricably related. One of the principal ideas in the accounting is the relationship between the time and money known as time value of money. This economic principal is used by the firms to recognize that the passage of time affects the money, and thus advise you that you’d be better off to take dollar today. To recognize that which project is better for the firm in the coming future sophisticated techniques (techniques involve time value of money) are advised to be used by the account and finance manager. What are these techniques and how it helps to recognise the worth of each project, is discussed below Net present value Net present value technique provides explicit consideration to the time value of money therefore, it is consider as the sophisticated technique of capital budgeting in Finance. All the techniques which use to discount the firm’s cash flows at some specific rate is categorized as sophisticated and most accepted technique of capital budgeting. The discounted rate of the project shows the minimum rate of return that is earned on an investment by the firm. It not shows that the interest rate greatly affect the value of money but also provide comparison between different investments. The net present value of the firm is calculated as NPV = present value of the Cash flows-Initial Investment NPV = CF/ (1-i) n - Initial Investment Whereas, i = Interest Rate n = Number of Years Net Present Value of the Project A Project A cash inflows of project a Present Value Interest Factor PVIF Present Value 1 [(1)(2)] = 3 Expected Cash Inflows in Year 1 £100,000 0.833 83300 Year 2 £110,000 0.694 76340 Year 3 £104,000 0.579 60216 Year 4 £112,000 0.482 53984 Year 5 £138,000 0.402 55476 Year 6 £160,000 0.335 53600 Year 7 £180,000 0.279 50220 Present value of the cash inflows 433136 (Initial Investment) -350,000 Net Present Value 83136 Net present Value for the project B Project B Cash Inflows Present Value Interest Factor PVIF Present Value 1 2 [(1)(2)] = 3 Expected Cash Inflows in Year 1 £40,000 0.833 33320 Year 2 £100,000 0.694 69400 Year 3 £210,000 0.579 121590 Year 4 £260,000 0.482 125320 Year 5 £160,000 0.402 64320 Present value of the cash inflows 413950 (Initial Investment) -350,000 Net Present Value 63950 Net present Value of the Project C Project C Cash Inflows Present Value Interest Factor PVIF 1 2 [(1)(2)] = 3 Expected Cash Inflows in Year 1 £200,000 0.833 166600 Year 2 £150,000 0.694 104100 Year 3 £240,000 0.579 138960 Year 4 £40,000 0.482 19280 Present value of the cash inflows 428940 (Initial Investment) -350,000 Net Present Value 78940 Conclusion Net Present Value of the Project A is Maximum therefore, it is recommended that Project A must be adopted as it is providing more value. Profitability Further the Profitability Index is recommended as it provides a more clear comparison of the project by including both the cost and benefits of the project. Profitability index is calculated as Profitability index = Net present Value/Investment required 1. Profitability index of Project A = 83136/350,000 = 0.237 = 23.7 % 2. Profitability Index of Project B = 63950/350,000 = .1827 = 18.27% 3. Profitability Index of Project C = 78940/ 350,000 = .2255 = 22.55% Conclusion The profitability index of the Project A is higher than other projects and thus this again confirms that the Project A would be useful for the firm. Key Consideration for Investment Appraisal During selection of any technique for Investment Appraisal different points are needed that should be kept in mind. The technique used by the manager must be simple and easy so that you can handle it easily. More complex the technique is more will be difficulty in finding the results. The technique used by the manager must accurately measure the future cash flows. The moiré accurate the technique is the more fine results it will show in the future. Moreover, the more the future interest rate is considered by the technique the more enhanced results will be predicted by the manager. Therefore, the technique used by the manager should consider all the factors which can directly and indirectly affect the future cash flows. Above all, the effect of inflation should be considered by the manager to know the accurate results. Assumption of Stock Market behaviour that Implicit on Project C The objective of the firm is to grow at faster rate in the market over time. The growth is only possible when you can gain more from your projects. The more you get from the project, the more you invest in other new projects. Some time the project show higher rate of return but in future you feel more risk associated with the project. Project C of the firm is providing maximum internal rate of return. But this project might provide risk if the prices in the stock exchange fluctuate. The stock market behaviour mostly effect on the future cash flows of the project. According to efficient market techniques only the fundamental factors affect the future cash flows of the project. These fundamental factors are the profit, dividend and share price. If the share price of the firm shares decreases in the stock market than it will highly affect on the cash inflows of the project in the near future. This large price movement in the stock exchange provide maximum risk to the Project C. But this risk can be controlled by many techniques such as stop-loss limits and value at risk limits. Economist always shows that higher the rate of return of the project more the risk is associated with the project. The reason is that this internal rate of return is affected by different factors of the stock market. Suppose the firm is unable to access a define level of profit. If this level of profit decreases than the firm is unable to cover the cost of capital associated with the project and thus it will provide a huge cost to the firm. Earnings of project C and stock Price The relation of earnings and stock price meant a lot, earning drives the price of the stock if the inflation remains adjusted. Greater the earnings of the firm higher will be the price of the stock. Suppose the project C is unable to provide the earnings in the end than this directly affect the stock price of the firm. The earnings of the project C is calculated by the use of Capital budgeting techniques. The better the technique used to know the future earnings of the project, better you can deal with the stock market behaviour. Inflation and Earnings Relation When the inflation ends it provide more benefit on the old earning growth and new growth and provide a double boost in the market. The investors become more optimistic about the earnings of the firm as it provide a low risk on the future value of investment. Therefore, if the Project C is providing more earnings in the future and boost the growth of the firm than it will hunt more investors that will invest in your firm. Analysis As the above technique used by the accountant show that project A is better than the Project C. if the project C is chosen by the firm than it will affect the firm in stock market. The earnings of the Project C in the future is less, thus this unable the firm to invest more in new project. The over all result will be decline in the firm growth. Conclusion Holloway catering firm was using techniques that were unable to access the time value of money but a better accounting technique is presented by the paper providing a better result in the future. The better the technique used to evaluate the future cash flows; the better will be the condition of the firm in the stock market. Therefore, the paper presented better capital budgeting techniques that enable them to gain maximum return and better investment in the near future. References Garrison Noreen “Managerial Accounting” 10th Edition James Jiambalvo, Rex A. Schildhouse (2000) “Managerial Accounting” Carl S. Warren, James M. Reeve, Philip F. (2005) “Managerial Accounting” Garrison Noreen and Peter C. Brewer (2007) “Managerial Accounting” Lawrence J. Gitman “Managerial Finance” 9th Edition Robert S. Pindyck, Daniel L. Rubinfeld (2004) “Microeconomics” 1st Edition Richard G. Lipsey, Alec Chrystal (2003) “Economics” 10th Edition N. Gregory Mankiw (1998) “Principles of Microeconomics” 1st Edition Read More