Financial Resources and Decision - Essay Example

05 March 2006 Financial Resources and Decision Task 1. Calculate the following: a. Average annual return on average capital invested. Project A Average Annual Cash Flow = Total Cash Flow/ Years = $80,000/4 = $20,000 Average Annual Return on Capital Invested = $20,000/$50,000 = 40% Project B Average Annual Cash Flow = $70,000/4 = $17,500 Average Annual Return on Capital Invested = $17,500/$50,000 = 35% b. Payback Period Payback Period is computed as ratio between the total capital investment and the annual cash inflows. Since depreciation does not require cash outflow, depreciation is added back to the profit at year end. Payback Period: Project A. Year 1 = $50,000 - $37,500 = $12,500 Year 2 = $12,500 - $32,500 = -$20,000 = $12,500/$32,500 = 0.38 Payback Period for Project A is 1.38 years. Project B. Year 1 = $50,000 - $22,500 = $27,500 Year 2 = $27,500 - $22,500 = $5,000 Year 3 = $5,000 - $26,500 = -$21,500 = $5,000/$26,500 = 0.18 Payback Period for Project B is 2.18 years. c. Net Present Value Project A. Project B. 2. Briefly discuss the merits of the three methods of evaluation. The annual average return on investment is a very simple formula in order to find the expected annual return of a prospective project. It is relatively easy to calculate and apply. Through it, the company can see if a prospective project can meet the annual returns that it expects to generate. The payback period is regarded also because of its simplicity. Managers prefer to use it because it is generally easy to memorize and to use. However, this technique disregards the additional cash flow which can be recouped from the project as it only focuses on the time when the whole investment will be recovered. The Net Present Value (NPV) analysis is very much different from the other two techniques discussed as it takes into account the time value of money. This method recognizes that the value of a pound today is greater than its expected value tomorrow. This technique is favored by more economists and managers because it is more realistic. It also takes into account the total cash flow from the investment including the depreciation and the tax shield from it. 3. Explain which project you will recommend for acceptance. After utilizing the three capital budgeting techniques, I strongly recommend project A as it generates a higher annual rate of return on average investment, shortest payback period, and higher net present value. Task 2. The following table shows the computed unit costs of products A, B, and C. It should be noted that to ensure accuracy, Microsoft Excel Spreadsheet is employed in calculation. The overheads are allocated according to machine hours in the case of machining department, and labor hours in the pressing and cutting department. The overhead rates are computed as follows: 1. For machining overhead costs, the total amount of overhead costs is computed and is divided with the total machine hours; 2. For cutting, the total overhead allocated to cutting is divided by the total number of labour hours both skilled and unskilled; 3. For pressing, the total overhead allocated to pressing is divided by the total number of labour hours used. Thus, machining has an overhead rate of 2.33/ machine hour, cutting has an overhead rate of 1.83 labor hour, and pressing has an overhead rate of 1.42/labor hour. For the services department, these are the cost allocations: The overhead costs for the services departments are allocated based on machine and labor hours computed above. For example, the overhead rate for cutting is allocated by dividing the total costs for cutting by the total number of skilled and unskilled labor hours for cutting. The following are the computed overhead rates for the engineering department: while the following are the computed overhead rates for the personnel department: It should be noted that in the case of personnel department costs allocated to the engineering department and vice versa is computed by dividing the total cost to the total number of units produced for each product. For example, in the personnel department's costs in engineering department: Per unit personnel services cost = 5600/13000 = 0.43. Task 3. The following tables show the budgetary control statements for each of the activities. Please, note that the values are in thousand. B. Price setting Price setting is an essential decision which is made by a business organization. It should be noted that the right price of a product should be able to meet the all the costs incurred by the business organization. However, the price should not be set too high that it offsets consumer demand. ABC Plc, instead of using the cost plus method can set the price through the utilization of sensitivity analysis. The sensitivity analysis shows the company how the company's profit will drop in relation to price of its product. Through this, the company can set its target profit and take into account the variances in product costs. ABC Plc can also set its price by identifying the customers' perceived value of its products. The company can do this by conducting a survey or observing customers reaction in price increases or decreases. Lastly, the company can price the same way that its competitor prices its products. Task 4. A. Financial Statements Financial statements show a business organization is performing in quantitative terms. Specifically, these record the numerous transactions that the organization became involved with for a certain period of time. Financial statements have become the primary measure of the financial performance of companies and other organizations. The balance sheet is a list of the entities assets both current and fixed, liabilities which are classified into short-term and long-term, and equity. Basically, the main function of the balance sheet is to show the company's resources (assets) and how they are financed (liabilities and equity). Through the balance sheet, a potential investor in the company whether creditor or stockholder is informed about the capital structure and the risks that the organization is exposed to. The profit and loss account lists the amount and source of the company's revenue as well as the different costs incurred. At the end of this statement, it shows whether the company has been spending more than what it generates or vice versa. The profit and loss account becomes a very essential tool in ascertaining the profitability of an entity. The statement of cash flow shows how the cash account of the business organization changes within the fiscal period considered. It lists the sources and amount of cash inflows together with cash outflows. In the case of a school's Parents and Teachers Association (PTA) and a charitable institution, the main financial statements are in the form of statement of cash flows. Since these organizations are typically considered not-for-profit, their main concern is in the generation of funds which they will use in funding their different activities and programs. They also present their assets and liabilities, yet, almost all of their assets are liquid. On the other hand, a sole trader of involved in property rental and the public limited company will be preparing the three aforementioned financial statements. These organizations would want an in-depth knowledge of their business operations as well as how to improve their performance. B. Financial Ratios For this analysis, we use the financial statements of two entities, namely, a school Parent's Teacher's Organization and a public limited company. For the Parent's Teacher's Association, the only ratio which can be computed is the current ratio. However, since the financial statement reports zero liabilities, this will give an undefined current ratio. For the public limited company, the following ratios are computed. The company shows a fairly stable profitability evidenced by the return on capital employed of 0.27, gross profit margin of 0.16 and net profit margin of 0.08. It should be noted that the company earns a very low margin on its sales (16%) yet is able to efficiently manage its costs yielding a net income which is 8% of the total sales. There is an efficient utilization of assets as explained by the return on assets and equity. It should be noted that the net income of the company accounts for 12% of the total assets. For the fiscal year 2006, the business organization's stockholders gains 26% of their investments. This shows the ability of the company to generate adequate shareholder value. The company suffers from poor liquidity. It should be noted that if all the current obligations of business organization become due immediately, its liquid assets will only be able to pay 24%. Deducting the stocks, this ratio drops to 21%. Based on the computed gearing, the company has a risky capital structure because of its preference for more risky financing which is debt. During the fiscal year, the ratio of its debt compared to equity is 1.20 implying a capital structure of 54:46 in favor of creditors. Bibliography Fraser, L. & Ormiston A 2004, Understanding Financial Statements, Pearson-Prentice Hall: Upper Saddle New Jersey Horngren , C. et. al..2000, Accounting.4th ed. New Jersey: Prentice Hall Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F, 2005, Financial Management principles and applications, Pearson/Prentice Hall International Edition, 10th Edition. Read More