Management of Mitt Telecoms - Case Study Example

Managerial Accounting Assignment Costing for PUSH Co. Mitt Telecoms Inc. (MT Co.) is interested in bidding a competitive price for a project for Push Co. Towards this end, a cost statement is required to be drawn, which may also support future business with Push Co. consisting of replacement systems and support contracts. (1) The cost of the demonstration of the new system and complimentary lunch should not be included as they do not form part of the project (Bhattacharyya, 2005). They precede the start of the contract and comprise the firm’s regular costs of business. Not included - $400 (2) The actual costs of labor of three engineers for the project are included. However, the one-off penalty of $500 as a result of pulling out two engineers from Contract X is not included. This is because penalties or damages paid to statutory authorities or other third parties do not form part of the cost ((Bhattacharyya, 2005; Wildman, 2009). Included - $3,000. Not included – $500. (3) The technical advisor will work for eight hours at an hourly rate of $40. However, because he is currently occupied, he will be paid overtime. The cost pertaining to the eight regular hours are included. The extra cost of overtime is not included. Overtime pay is an abnormal cost, for which reason it will not form part of the project cost (Bhattacharyya, 2005; Van Derbeck, 2007). Included - $320. Not included - $160. (4) The site inspector, an independent contractor not connected with MT Co, charged his two visits directly to Push Co., at $200 per visit. This is not included in the costing as it has not been incurred by MT Co. (Wildman, 2009) Not included - $400 (5) MT Co’s trainer will deliver one day’s training at Push Co., equivalent to $50 of his regular salary ($1500/30). He is also paid a commission of $125 for onsite training, which is justified for extra expenses incurred, effort expended, and risks assumed in conducting onsite rather than in-house training, and therefore a variance due to normal reasons. These expenses are both regular and normal for the project, and hence should form part of the costing (Van Derbeck, 2007; Wildman, 2009). Included - $125 and $50. (6) Materials shall be charged at their actual cost. The actual costs of the first 80 telephone handsets were bought at $16.80, and the next 40 units will be acquired at $18.20. Assuming the company’s inventory management is on a first-in-first out (FIFO) basis, the 80 telephone handsets will be provided to Push Co. at the actual costs they were acquired (Bhattacharyya, 2005). Included - $1,344 and $728. (7) The specified computerised control system for Push Co.’s system is Swipe 2. As such, only Swipe 2 should be used in the system, at its acquisition cost. Included - $10,800. (8) Assuming that MT Co. manages its inventory on an FIFO basis, it should cost its cable according to acquisition cost (Bhattacharyya, 2005). The first 200 metres would cost $1.20 per metre while 800 metres would cost $1.30. Included - $240 and $1,040. On the basis of the foregoing discussion, the cost statement is prepared and presented in the following table: What Managers Should Know About IRR and Why A Report 1. The Internal Rate of Return: Definition and Description 1.1. Definition: The internal rate of return is the discount rate that equates the present value of the net cash flows from a project with the present value of the net investment. 1.2. The IRR in equation form is denoted by: Or The left side of the equation represents the sum of the present value of all future cash flows that the project is expected to realize, and the right side of the equation represents the net investment that is needed for the project to be implemented. While the cash flows, the net investment, and the time t are all known, r – the discount rate – is unknown. The discount rate that will be determined, therefore, is that which will balance the equation, the rate at which the cash flows should be discounted to the present so that the total of all these present values is the net investment. The rate of return becomes the indicator by which management decides on the investment or capital budgeting decision. 1.3. Means of calculating IRR: The IRR may be manually calculated or it may be figured out with the help of a simple calculator, but in both cases a table of present value factors will be needed. The table will be useful in estimating the first guess at the discount rate, which shall be made the basis of an iteration process that eventually leads to the closest possible discount rate that makes the equation true; this is the IRR. The manual method may appeal to some but this method is time consuming and unnecessary. The IRR function already provided for in all financial calculators, as well as in spread sheet and statistical softwares. Therefore, managers are encouraged to use these devices for greater expediency. 2. Decision criteria in applying the IRR for investment appraisal purposes Describing the decision criteria is best undertaken by an illustrative problem. The table following shows three projects, the initial investment that is required for each project, and the cash flows that are expected to be yielded by each project for the next five years. Projects' Cash Flows Year A B C Initial Investment 0 (11,400) (7,500) (7,700) Cash flow 1 1 3,000 - 2,000 Cash flow 2 2 3,000 - - Cash flow 3 3 3,000 - 5,000 Cash flow 4 4 3,000 - - Cash flow 5 5 3,000 15,000 8,000 From the above information, it may be calculated that the IRR of each project is: Project A IRR = 10%, Project B IRR = 15%, and Project C IRR = 20%. At this point, there is no decision that can still be made based on the constraints of the investment decision. If it is determined that the cost of capital is 12%, then Project A should be eliminated because it yields an internal rate of return of 10%, resulting in losses. Projects B and C are both acceptable because they each provide rates of return of 15% and 20% respectively, above the cost of 12%. If the capital available for investment is sufficient for all projects the IRRs of which exceed the cost of capital, then all such projects should be accepted as long as they are not mutually exclusive. If they are mutually exclusive or the available capital is not sufficient, then the project with the highest IRR is accepted. A decision table which summarizes these outcomes follow: Projects A B C   IRR 10% 15% 20% Decision Criterion Assume cost of capital is 12% Reject Accept Accept Assume non-exclusive Reject Accept Accept Assume mutually exclusive Reject Reject Accept Assume fund equals 20,000 Reject Accept Accept Assume fund equals 10,000 Reject Reject Accept Assume fund equals 5,000 Reject Reject Reject Construction of a decision table similar to the preceding is advisable to help structure managers’ decision-making more effectively. 3. The IRR as sensitivity analysis tool The IRR is a sensitivity analysis tool, as it helps to measure likely changes in outcome based on changes in variables to which the project decision may be sensitive. The goal is to ultimately understand those variables when subtly modified could significantly change the results of the outcome, and to identify what actions can mitigate possible adverse effect on the project (Iloiu & Csiminga, 2009, p.33). The detail of the process is beyond the scope of this report, but the basics will be explained. The fundamental technique for sensitivity analysis is to establish the base case for an investment project identifying the important variables, an example of which is shown below. Base Case of an Investment Project Source: Iloiu & Csiminga, 2009, p.37 From the base case, the effects of changes made in each explanatory variable on the outcome are calculated to yield the sensitivity indicators and switching values. Sensitivity indicators point to which variables the project result is sensitive and to which it is not, while switching values measure the extent of change a variable may undergo without changing the project decision. These are shown for Net Present Value (NPV), another assessment tool, and IRR in the table following. Sensitivity Analysis – Numerical Example Source: Iloiu & Csiminga, 2009, p.37 4. The practical problems of using IRR for investment appraisal purposes 4.1. Numerical problems: multiple or no solution, ranking and sale problems. Some problems yield many or no solution when the IRR, which is the root of the polynomial, wander found. This mathematical problem can be solved by computer software which returns the closest estimate (Brown, 2006). 4.2. IRR assumes that the cash flows earned throughout the life of the investment are reinvested at the same rate of return, which is not always the case particularly since the project life usually spans years. 4.3. In many cases, IRR and NPV give conflicting signals, making decision-making difficult (Guerard & Schwartz, 2007; Hansen & Mowen, 2010; Guilding, 2012). 4.4. Comparing the projects on the basis of IRR does not distinguish among mutually exclusive projects that differ in time and scale – that is, because it provides only a percentage return, it does not take into consideration the scale of investment (Raj, Walters & Rashid, 2009). 4.5. When cash flows switch signs repeatedly, it is possible that there is not just one IRR, but either multiple or no IRR at all. (Lumby, 1988; Campbell & Brown, 2003; Raj, et al., 2009). 5. Comparison of IRR with other investment appraisal methods The following table presents a comparison of the IRR, the Payback Period, the Net Present Value (NPV), and the Profitability Index (PI). Table of comparison among capital budgeting methods Payback period Net present value Profitability index Internal Rate of Return Decision criterion Payback period – or period within which initial investment shall be recovered from cash flows generated by the project – must be within the life of the project. NPV must be positive for project to be accepted; if NPV is negative then project must be rejected. For mutually exclusive projects, the project with highest positive NPV is accepted PI must be greater than 1 for project to be accepted; if PI is less than 1, project must be rejected. For mutually exclusive projects, the project with the highest PI above 1 is accepted. IRR must be positive and equal to or higher than the cost of capital for project to be accepted; if IRR is below the cost of capital, project must be rejected. For mutually exclusive projects, the project with the highest IRR that is above the cost of capital is accepted. Complexity of application Simplest of the methods to apply, requires straightforward arithmetical deduction of cash flows Requires application of DCF formula Difficulty in accurately estimating discount rate (cost of capital) Requires application of DCF formula Difficulty in accurately estimating discount rate (cost of capital) Most complicated, requires estimation, iteration, and /or programmed software Eliminates the need of estimating the discount rate Time value of money Not accounted for Accounted for Discount rate is estimated to be minimum expected rate of return Accounted for Discount rate is estimated to be minimum expected rate of return Accounted for; the IRR is itself the discount rate Multiple rates of return problem (Moyer, et al., 2012, p. 370). Risk appraisal Provides crude measure of project risk (Moyer, et al., 2012, p. 370). Risk is judgmental and imputed in using a risk-adjusted rate of return (Kinney, et al., 2012) May be quantified through statistical analysis of historical cash flows (Brigham & Daves, 2012) Risk is judgmental and imputed in using a risk-adjusted rate of return (Kinney, et al., 2012) May be quantified through statistical analysis of historical cash flows (Brigham & Daves, 2012) Risk is not reflected in the IRR, and the IRR method does not allow for risk adjustment, thus IRR is often used with NPV or PI to establish confirmation (Loos, 2006; References Bhattacharyya, A K 2005 Principles and Practice of Cost Accounting, 3rd edition. PHI Learning Pvt. Ltd. Brigham, E F & Daves, P R 2012 Intermediate Financial Management, 11th edition. South-Western Cengage Learning. Mason, OH. Brown, R J 2006 ‘Sins of the IRR’ Journal of Real Estate Portfolio Management. 12, 2, pp.195-199 Campbell, H F & Brown, R P C 2003 Benefit-Cost Analysis: Financial and Economic Appraisal using Spreadsheets. Cambridge University Press, Cambridge Guerard, J B Jr & Schwartz, E 2007 Quantitative Corporate Finance, Springer Science + Business Media, New York, NY Guilding, C 2012 Financial Management for Hospitality Decision Makers, Butterworth-Heinemann, Oxford Hansen, D R; Mowen, M M 2010 Cornerstones of Cost Accounting, South Western Cengage Learning, Mason, OH Iloiu, M & Csiminga, D 2009 ‘Project Risk Evaluation Methods – Sensitivity Analysis’ Annals of the University of Petrosani, Economics. 9, 2, pp. 33-38 Kinney, MR & Raiborn, C A 2012 Cost Accounting: Foundations and Evolutions. South-Western Cengage Learning, Mason, OH Loos, N 2006 Value Creation in Leveraged Buyouts. Springer Lumby S 1988 Investment Appraisal and Financing Decisions. Berkshire, England. Moyer, R C; McGuigan, J R; Rao, R P; & Kretlow, W J 2012 Contemporary Financial Management, 12th edition. South-Western Cengage Learning, Mason, OH Raj, R; Walters, P; & Rashid, T 2009 Events Management and Integrated and Practical Approach. Sage Publications, Ltd., London VanDerbeck, E J 2007 Principles of Cost Accounting, 14th edition. Thomson South-Western, Mason, OH Wildman, J R 2009 Principles of Cost Accounting. General Books, LLC Read More