Principles of Finance Used in Decision-Making Process at Working Computers - Assignment Example

PRINCIPLES OF FINANCE USED IN DECISION MAKING PROCESS Student’s name: Institution’s Name: Instructor’s Name: Course Code: Submission Date: Table of Contents Introduction 3 Question 1 4 Cash Flow Statement 4 Question 1 5 Performance Appraisal 5 a).Payback Period 6 Decision Criteria 6 Decision Criteria 7 b). Net Present Value 7 Decision Criteria 8 c). Internal Rate of Return 9 Decision Criteria 10 Question 3 10 a). Sensitivity Analysis of NPVs to unit sales and cost of capital 10 b). The impact of maintaining projected units Sale and offering 20% discount on the unit price 11 c). Calculating the Minimum Level of Annual Sales 11 d). The Treatment of the Terminal Value as the Payment from Perpetuity 12 Question 4 12 Recommendation 12 Task 5 12 Appropriate Price for the Investment 12 Question 6 13 Appropriate considerations when a firm is considering eliminating a product line or selling a division. 13 Returns on investment 13 Risks Associated with the future Operations of the business 13 Competitive Factors 13 Conclusion 13 Works Cited 14 Introduction Working Computers, Inc is company that processes and produces different electronics in UK. The company published its audited financial report annually as a legal requirement for all limited companies quoted in the Stock Exchange (Bailey and McIntyre, 2005). These books of accounts are made in accordance with the requirement of accounting principles and policies so that the users can easily understand them and examine them so that appropriate decision can be made on their investment strategies (Cagwin, 2002). The finance managers make strategic decisions based on the financial information collected from the financial statements to demystify and clarify for non financial stakeholders or executives the basics of financial analysis. Question 1 Cash Flow Statement Cash flow statement is a financial statement which indicates the movement of cash in and out of the business. This is a very important financial statement which is used in evaluating and analyzing the viability of the different projects in an organization. Cash flow Statement of Project 1 Year 2003 $000 2004 $000 2005 $(000) 2006 $ (000) 2007 $(000) 2008 $(000) 2009 $(000) Units 180 150 189 246 264 264 264 Unit price 495 495 495 495 495 495 495 revenues 89100 74250 93555 121770 121770 121770 121770 Cogs 60% 53460 44550 56133 73062 73062 73062 73062 Gross profit 35640 29700 37422 48708 48708 48708 48708 Expen 24% 21384 17820 22453.2 29224.8 29224.8 29224.8 29224.8 Net profit 14256 11880 146880 19483.3 19483.3 19483.3 19483.3 Debtors (6000) (6000) (6000) (6000) (6000) (6000) (6000) creditors 3000 3000 3000 3000 3000 3000 33000 inventory (2000) (2000) (2000) (2000) (2000) (2000) (2000) Dep - - - - - - (56000) Cash flow 7256 4880 7888 12483.3 12483.3 12483.3 68483.3 Cash Flow statement of project 2 Year 2003 2004 2005 2006 2007 2008 2009 Unit sales 180 150 102 57 48 48 48 Unit price 495 495 495 495 495 495 495 Revenues 89100 74250 50490 28215 23760 23760 23760 Cogs 54% 53460 44550 30294 16929 14256 14256 14256 profit 35640 29700 20196 11286 9504 9504 9504 Expense 26% 23166 19305 13127.4 7335.9 6177.6 6177.6 6177.6 Net profit 12474 10395 7068.6 3950.1 3326.4 3326.4 3326.4 Debtors (6000) (6000) (6000) (6000) (6000) (6000) (6000) Creditors 3000 3000 3000 3000 3000 3000 33000 Inventory (2000) (2000) (2000) (2000) (2000) (2000) (2000) Dep. (56000) cash flow 5474 3395 68.6 (3049.9) (3673.6) (3673.6) 52326.4 Depreciation is added back since it is a non cash element which does not involve the movement of cash in the business (Bailey and McIntyre, 2005). The increase in account receivable and inventory are subtracted from this financial statement. This is because increase in current assets makes cash to move out of the business to the debtors or suppliers. Current liabilities such as increase in account payable increases the cash available in the company and they are added in the financial statement under operating activities. Question 1 Performance Appraisal The financial appraisal methods which can be used to analyze two or more competing investments are traditional or artificial methods (Teall, 2007). Traditional methods include payback period and accounting rate of return. Artificial method includes net present value and internal rate of return. These two classes of appraisal techniques are able to provide decision criteria. a).Payback Period This is the expected number of years required to recover the investment cost (Bailey and McIntyre, 2005). The method uses the cash flows of the company not accounting profits which are affected by the accounting policies. This method of appraisal does not consider time value of money and also partially use the cash flows of the project. The method also does not consider the cash flows of the payback period (Baines and Langfield, 2003). The shortest payback period is selected and rejects the project with long payback period. Capital employed $ 18,000,000 Project 1 Year Cash Flow $000 Accumulative Cash flow $000 1 7256 7256 2 4880 12136 3 7888 20024 Payback period = 3 years Decision Criteria The project is viable since it has a shorter payback period which indicates that the investors are able to maximize their goal of profit and wealth maximization. Project 2 Year Cash Flow $000 Accumulative Cash Flow $000 1 5474 5474 2 3395 8869 3 68.6 8937.6 4 (3049.9) 5,887.7 5 (3673.6) 2,214.1 6 (3673.6) 1459.6 7 52326.4 50866.6 Payback period = 7 years Decision Criteria This project is not viable as it has very long payback period. It is not a good project to be invested in since it is not able to produce enough cash flow to payback the capital employed within a short time. b). Net Present Value This method of project appraisal involves the discounting of all the company cash flows at a given discounting rate called cost of capital, opportunity cost or required rate of return (Mick and John, 2003). It is then followed by deducting the initial cash outlay from the total present value to reach the net present value. It is possible to rank different projects in relation to their performance level hence useful for decision making on the best project to be invested in (Bailey and McIntyre, 2005). The method of evaluation also has some disadvantages such as its ability to conflict with the internal rate of return in terms of ranking and it also assumes that the discounting rate is constant throughout the year which is not the case (Baines and Langfield, 2003). This is because the risk and uncertainty of the firm changes over time and therefore cost of capital also changes over time. Project 1 Year Cash Flow PVIF 10% 7years PV 1 7256 0.909 6595.7 2 4880 0.826 4030.88 3 7888 0.751 5923.90 4 12483.3 0.683 8526.10 5 12483.3 0.621 7752.13 6 12483.3 0.564 7040.58 7 68483.3 0.513 3513.93 Total 75001.22 Capital employed (18000) NPV 57001.222 Project 2 Year Cash Flow $000 PVIF 10% 7 YEARS PV $000 1 5474 0.909 4975.90 2 3395 0.826 2804.3 3 68.6 0.751 5152 4 (3049.9) 0.683 (2083) 5 (3673.6) 0.621 (2281.3) 6 (3673.6) 0.564 (2071.9) 7 52326.4 0.513 26843.44 Present value 33339.443 Capital employed (18000) Net Present Value 15339.443 Decision Criteria Project 1 is more viable than 1 since its net present value is bigger than 0 and it is more positive than that of project 2 c). Internal Rate of Return This is the rate of return of an individual project when they are evaluated on their own independent of others (Bailey and McIntyre, 2005). It is the rate of return which equates the net present value to 300 which means that at internal rate of return the total present value of all the cash flows should be equal to initial cash outlay (Baines and Langfield, 2003). At this point the net present value is equal to zero. It is computed using trial and error method but if the discounting rate is provided it should be used to compute rate which will equate net present value to zero. Project 1 Year Cash flow PVIF, 12% 7 years PV 1 7256 0.893 6479.61 2 4880 0.797 3889.36 3 7888 0.712 5616.256 4 12483.3 0.636 7939.40 5 12483.3 0.567 7078.03 6 12483.3 0.507 6329.03 7 68483.3 0.452 30954.50 Total 68285.20 Capital employed (18000) 50285.20 Project 2 IRR = 10 + (57001.222 – 0)/ (57001.222 - 50285.20) X 0.02 10% + 57001.222/6716.02 X 0.02 26.23% Year Cash Flow PVIF 12% Year PV 1 5474 0.893 4888.30 2 3395 0.797 2705.8 3 68.6 0.712 49.50 4 (3049.9) 0.636 (1939.70) 5 (3673.6) 0.567 (2082.9) 6 (3673.6) 0.507 (1862.5) 7 52326.4 0.452 23651.5 Total PV 25410.20 Capital employed (18000) NPV 7410.2 IRR = 10% + (15339.443 – 0)/ (15339.443 - 7410.2)2% 10% + 15339.443/7629.24 14.02% Decision Criteria This project is also viable but in comparison with project 1 it is less viable since project 1 can produce high returns on investment than project 2 (Horngren & Datar, 2009). Question 3 a). Sensitivity Analysis of NPVs to unit sales and cost of capital This is an examination process that determines the degree of sensitivity of an output in any given change in the level of input while other factors are kept constant. These changes in the level of input affect the net present value and internal rate of return (Baines and Langfield, 2003). This analysis is very important as it provide the information on how dependent the level of output figures is on a single input (Dyson, 2007). This makes the analysts to have adequate information on the probability of each variable is able to be adverse thereby evaluating the riskiness of the business. Assume the cost of capital grows 12% instead of 10% keeping other things constants (Anthony & Govindarajan, 2007). This provides net present value of $50.28520millions and the capital employed is $18 millions. The percentage change in the cost of capital is 3% (($50.28520millions X 57.00million) / 57.001million) which is 0.35% and the corresponding change in sales 10 %(( 12% - 10%)/ 12%). The percentage change in sales per 1% change in input is 1.66%. The result of this shows that there is a relationship between unit sales and input and it is also that sales units is sensitive to each unit of input (Hilton & Sainty, 2001). The positive sensitivity means that the sales level (net present value) increases with the increase in the input (Bailey and McIntyre, 2005). It is therefore important to conclude that net present value is very sensitive to estimate the value of sales revenues and also to determine the cost of capital. b). The impact of maintaining projected units Sale and offering 20% discount on the unit price This increases the net present value as the sales revenues increases due to reduction in unit price (Colin, 2007). This increases the cost of capital since the earnings of the company increases due to increase in the possible quantity of goods which can be sold. c). Calculating the Minimum Level of Annual Sales Breakeven point is the point where location where the profits of the company are zero and marginal costs is equal to marginal revenues (Cagwin, 2002). It is computed by dividing the fixed costs and the contribution to determine the unit sales which the company can sell to star getting profit. Contribution = price per unit – variable cost per unit $495 – $297 = $198 Fixed costs = 18millio n 18000000/ 198 = 90.91milliom. d). The Treatment of the Terminal Value as the Payment from Perpetuity This is a value which captures the value of the company past the forecast in a DCF examination. It is the present value of all the successive cash flows (Bailey and McIntyre, 2005). This terminal value is computed using perpetual growth rate technique which assumes that the business organization will be in business and provide FCFs at a constant rate for the rest of its life (Cagwin, 2002). The growth rate is determined between historical inflation rate f 0-3% and the GDP growth rate of 4-6%. Question 4 Recommendation Computers should contribute the requested $18 million to the Bernoulli division. This is because the project is able to produce adequate returns to pay the requested funds (Anthony & Govindarajan, 2007). It is important to provide this fund to Bernoulli division as these projects is able to pay back the source of finance within a short time and also is a less risky source of capital with only an interest rate of 13% which this business organization can pay and still remain with some profits to distribute to the owners. Task 5 Appropriate Price for the Investment The selling price should be 90 millions. This will ensure that the business will start making profits immediately to start paying for the cost of investment (Bailey and McIntyre, 2005). It will also allow the investors to be able to get some revenues from their projects since the main goal of forming a business organization is to maximize profit and wealth. Question 6 Appropriate considerations when a firm is considering eliminating a product line or selling a division. Returns on investment The return on investment of that particular product line can influence the organization to eliminate a given product line (Cagwin, 2002). If the business has been recording low earnings, it has to sell it so that it can involve in a different product line which can make the investors get high returns on their investment. Risks Associated with the future Operations of the business The product line which is possible to face future risk both financially nor economically can force the management to replace the product line (Bailey and McIntyre, 2005). If a particular product is likely to face systematic risks, the sale of that particular product line can make the owners to reduce the risks which the business is more vulnerable to. Competitive Factors The product line which is facing high competition is recommended to be replaces if the business has made serious attempts to increase its competitiveness but it has failed to gain high competitive advantage (Anthony & Govindarajan, 2007). Conclusion International corporations could have not experienced their current growth if they could not find a good source of finance to finance their internal projects. The primary sources of finance which large corporations have are equity capital, loan stock, retained earnings also called after profit, bank borrowings and venture capital. These sources of finance enable large corporations to manage their operations effectively. Works Cited Anthony, R. & Govindarajan, V. (2007). Management Control Systems, 12th Edition, R. D. Irwin. Vol.4 #2, pp. 396-410. Bailey, C. and McIntyre, E. (2005). Some Evidence on the Nature of Relearning Curves, in: The Accounting Review, Volume 67, 1992, pp. 368-378. Baines, A and Langfield, K. (2003). Antecedents to Management Accounting Change: A Structural Equation Approach, in: Accounting, Organizations and Society, Volume 28, pp. 675-698 Cagwin, D, (2002). The Association between Activity-Based Costing and Im-provement in Financial Performance, in: Management Accounting Research, Volume 13, pp 56 Colin, D. (2007). Differences between management accounting and financial accounting, Management and Cost Accounting, p. 7, ISBN 9781844805662 Dyson, R. (2007). Accounting for Non-Accounting Students.Financial Times/Prentice Hall. ISBN: 9780273709220 Hilton, R. & Sainty, G. (2001). Cost Management:Strategies for Business Decisions, 1st Canadian Edition, McGraw-Hill.Vol 2 pp456. Horngren, A. & Datar, M. (2009). Cost Accounting: A Managerial Emphasis, 13th Edition, Prentice Hall.Vol 12 pp 23. Mick, B. and John, C. (2003). Managing Financial Resources .A Butterworth-Heinemann; 2003, 3rd edition ISBN: 0750657553. Teall, H. (2007). Cost Accounting: AManagerial Emphasis, 4th Canadian Edition, Prentice Hall.Vol 11 pp 345- 456. Read More