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Acconting And Finance Question 1(A)
Project Alpha Project Alpha
Projected Cash Flows Projected Cash Flows
Initial Cost -100,000 Initial Cost -90,000
year 1 15,000 year 1 20,000
year 2 18,000 year 2 25,000
year 3 20,000 year 3 -125,000
year 4 32,000 year 4 10,000
year 5 28,000 year 5 3,000
year 6 2,000 year 6 0
Payback period Payback period
year C.F C.C.F year C.F C.C.F
0 -100,000 -100,000 0 -90,000 -90,000
1 15,000 -85,000 1 20,000 -70,000
2 18,000 -67,000 2 25,000 -45,000
3 20,000 -47,000 3 -50,000 -95,000
4 32,000 -15,000 4 10,000 -85,000
5 28,000 13,000 5 3,000 -82,000
6 2,000 15,000 6 0
1 Payback period 3.5yrs
Net Present Value -25,094 Net Present Value -129,524
Discounting rate 0 Discounting rate 0
IRR/ ARR 0 IRR/ ARR 0
Analysis
Acconting And Finance, There are two projects available for the company. One of the two has to be select on the basis of investment appraisal analysis. Project alpha that offers the discount rate of 14% with the initial investment ofGBP100,000. Following are the projected cash flows mentioned in the above table for next years, by looking into depth it is calculated that the initial investment of the project alpha will be recovered in 4.2 years and the net present value is a negative number that is not good for the company to go for it. The IRR of the project is less than the cost of capital so it means the required rate of return is less than the investment rate so we are paying more rather than receiving.
Acconting And Finance As far as concerned for the project beta the initial investment for the project is GBP90000 with the discounting rate of 14% annually. The project beta has to replace the machinery at the end of year 3 that’s cost GBP75000. So after looking into these factors being as an analyst it has been concluded that the cost of capital of project is greater than the required rate of return and the investment will be recovered 3.5 years and net present value is negative GBP129524. While this is a very difficult stage for a company to make decision in which project to go, Acconting And Finance so as an analyst I would prefer to go for the alpha project because it seems more pretty well as compared to project beta in terms of investment being covered so project alpha it is.
Question 1(B)
Appraisal Methods
These are the most important tools of capital budgeting for the investment purpose and to expect the level of required rate of returns for the level of investments made and estimates the future cash flows over the entire project life. Value can be created by investment. Companies invest in order to make a rate of return and governments attempt to promote growth by encouraging investment through both taxation and grants.
Pay-Back Period
This is most simple and often widely used method of investment appraisal. It considers the time period to recover the initial cost at particular rate. There are many advantages and disadvantages of this method. The first is simplicity and time saving to recover the initial cost of the project. Second, managers use payback method to make quick evaluations of projects with small investments. Problems with this kind of approach are it ignores time value of money concept. Second it also ignores the cash inflows from a project that may occur after the cost of the project has been recovered, Acconting And Finance since it focuses more on short term projects.
Let suppose the initial investment of a project cost $400,000 and there were two relevant scrap values amounting to $26000. This means net initial cost is $374000. The net income from the project is $180,000. It will take approximately 2 years and 1 month for the returns on the project to pay back the net investment. Since the investment has a project life of 5 years and seems to be a good investment, if the sales volumes are actually achieved.
Payback period = net investment/benefits
= $374000/$18000
=2.1 years.
Net Present Value (NPV)
It is one of the most important tools that take into consideration inflation rate and focuses on realistic required rate of return from a project. The primary purpose for discounting the cash flows is to bring the future cash flows in the present value and then the differences are calculated between outflows and inflows. There are many advantages and disadvantages of Net present value. It takes into consideration the time value of money concept. Profitability and risk are given the highest priorities. Acconting And Finance It also helps in maximizing share holder wealth and the firm’s value. The problems with NPV are; it is difficult to calculate and interpret. The most important thing is that if projects are mutually exclusive then there is a lack of accurate decisionmaking because it also makes it difficult to calculate the appropriate discount rate at the same time.
For example, a company has an opportunity in invest in a project that cost initially $400,000 in year 1 and provide the following cash flows in the upcoming years; year 2 $150,000 years 3 $ 170000, year 4 $155000. If the cost of capital for a particular project is 5%, should it be considered by the company or not?
To obtain the answer we multiplied each cash flow with discounting factor in order to get the PV of the future cash flows. After deducting the initial value from the future cash flows we get Net present value that is +$29695 so the required rate of return id greater than the cost of the capital. So on the basis of NPV rules the company should consider the project.
Return on Capital Employed (ROCE)
This is also called the Acconting And Finance rate of return (ARR). It ensures the level of expected annual return before interest and taxes in proportion to the capital cost incurred. ROCE can be calculated by different methods and it can be calculated by different combinations. It is also important when comparing ROCE between two companies make sure you are comparing a like-with-like method. It is mostly used to compare mutually exclusive projects. The major problem with ROCE is it does not contain the proper timing of the cash flows. However, on the other hand, it is simplest and easily understood method that can be used with other methods as long as its limitations are understood by users.
Internal Rate of Return
This tool represents the rate at which net present value (NPV) of an investment becomes zero. It represents a breakeven cost of capital. Normally projects with higher rate of return than cost of capital are normally accepted. Positive of IRR are; it takes into consideration the time value of money, uses predicted cash flows not profits, Acconting And Finance considers the entire life of project and finally leads to the increasing of shareholder wealth. The drawbacks of IRR could be; it is not the proper source of measuring the profitability, it is complicated and lengthy to calculate and interpolation method gives an estimation of rate of return.
Conclusion
These four techniques are the most frequently used in profit maximizing for the company. However, not all organizations simply seek to maximize the return on investments but also to maximize share holder wealth. In any analysis each variable has some kind of assumptions and estimations. In appraisal methods it wise to undertake sensitivity analysis.
Question 2
Benjamin Ratios Peters Ratios
sales 80,000 sales 12,0000
COGS 60,000 COGS 96,000
G.P 20,000 G.P 24,000
Operating Profit 10,000 Operating Profit 15,000
Current Assets 45,000 Current Assets 40,000
Accounts receivables 25,000 Accounts receivables 20,000
Inventory 10,000 Inventory 17,500
Current Liabilities 5,000 Current Liabilities 10,000
payables 5,000 payables 10,000
capital employed 42,000 capital employed 44,000
Calculations
Gross margin 25% Gross margin 20%
Operating Margin 12.5% Operating Margin 12.5%
Acid test Ratio 30000 Acid test Ratio 22500
Acid test Ratio 6 Acid test Ratio 2.25
Inventory Days 164.3836 Inventory Days 263.0137
91 67
Trade receivables days 219.1781 Trade receivables days 328.7671
114 61
Trade Payable days 164.3836 Trade Payable days 263.0137
30 38
ROCE 24% ROCE 35%
Benjamin Analysis
The net sales of Benjamin at the end of June 2014 were 80000 pounds. The cost of goods sold is composed of 75% of sales, resulting the gross margin of 25%. The cost of goods sold is mainly composed of raw material, fuel, energy and depreciation. The cost of goods sold is well maintained by the production and manufacturing departments of the company, because 25% of gross margin represents a well maintained figure, mainly Cost of goods sold is composed of raw material, fuel, energy and the depreciation expense, while at the same time operating margin for the company is 12.5% that shows a leniency from the administration or the management of the company because it is mostly composed of selling and administration expenses. The selling and admin expenses are composed of fuel allowances for the employees, insurance of cars, medical allowances and pension funds for the employees working in the company. Analyzing the balance sheet for the Benjamin that shows how well the company has managed its overall liquidity and working capital. Acid ratio of company is 6times that indicates to pay off one pound current Liability Company has enough current assets to pay off it and that will not lead into the liquidity crisis. In Acid ratio we deduct inventory because it is the least liquid asset to be sold out. Efficiency ratios for the Benjamin Company are less attractive comparative to the competitor. The company is converting cost of goods sold into inventory by around in 90 days that show how the production department and technology is obsolete in the competitive environment. While the credit policy is so lenient of the company as receivables and payables are being collected and paid after a long time that indicates the conversion cycles of the company is longer which is not good for some time.
Peters Analysis
The net sales of Peters at the end of June 2014 were 120000 pounds. The cost of goods sold is composed of 80% of sales resulting the gross margin of 20%. As we compared to Benjamin sales the peters sales are slightly higher than Benjamin and so its COGS are high because of the systematic impact of sales on the COGS. The cost of goods sold is mainly composed of raw material, fuel, energy and depreciation. The cost of goods sold is not maintained up to the mark as it was supposed to be , as the higher sales is resulting in low gross margin that shows the excess use of raw material and fuel by the production departments comparative to Benjamin. While the operating margin is well maintained by the company as the admin and selling expenses are pretty well controlled by the management that shows a strict policy regarding the allowances such as fuel, medical and advertising expenses. Analyzing the balance sheet for the Peters that show how the company has managed its overall liquidity and working capital. Acid ratio of company is 2.25times that indicates to pay off one dollar current Liability Company has enough current assets to pay off it and that will not lead into the liquidity crisis. In Acid ratio we deduct inventory because it is the least liquid asset to be sold out. The Benjamin liquidity position is not much well maintained by the company comparatively to Peter’s. Efficiency ratios for the Peter Company are much attractive comparative to the competitor. The company is converting cost of goods sold into inventory by around in 65 days that show how the production department and technology is way better than the Benjamin’s. While the credit policy is way strict of the company as receivables and payables are being collected and paid in a short period of time that indicates the conversion cycles of the company is smaller which is good for company.
Limitations of Ratio Analysis
Despite there are many benefits of using ratio analysis, but at the same time they are not the authentic solution provide for accurate financial analysis. Following are the limitations of ratios that an analyst must be aware of:
• Difference in concepts and logics make it more complex to compare the ratios from different sources. There are different ways to calculate the same ratio. This can cause confusion for an analyst to interpret the same ratio.
• There is a difference in Acconting And Finance proceduresthat makes it difficult to compare ratios for different firms. Acconting And Finance procedure can include different inventory valuation methods such as LIFO and FIFO and depreciation methods that include straight line or double declining balance.
• It is very difficult to draw a conclusion on financial position of the company by using ratios.
• Ratio analysis is probably most accurate for the companies with narrow portfolio.
• Inflation can distort the financial statements. Any problem due to inflation can be passed on to ratios.
• Comparing ratios between two firms is the most difficult task because of different economic environment and production technology even though they produce same products.
• Companies may use window dressing to manipulate their financial statements for the attraction of investors.
Question 3
A)
A B C Total
Material Cost 50,0000 62,500 1,050,000 1,612,500
Direct Labor 80,000 8,000 80,000 168,000
Factory OH 2,100,000 210,000 2,100,000 4,410,000
2,680,000 280,500 3,230,000 6,190,500
Cost/ unit 134 280.5 323
Sales 3,216,000 336,600 3,876,000
Selling Price/ unit 160.8 336.6 387.6
B)
A B C Total
Material Cost 500,000 62,500 1,050,000 1,612,500
Direct Labor 80,000 8,000 80,000 168,000
Factory OH
machining 1,112,000 417,000 1,251,000 2,780,000
logistics 277,300 35,400 27,7300 590,000
establishment 436,800 187,200 416,000 1,040,000
2,406,100 710,100 3,074,300 6,190,500
Answer (B)
Costing helps companies to determine per unit cost of the product. There are two common costing systems that are traditional costing and activity based costing used in business. Traditional costing assign total overhead cost on the basis of volume, such as how much the amount of direct labor hours are needed to produce the item. Overhead cost mainly includes machines hours, direct labor hours and material hours. Activity based costing allocate cost on the basis of activities to produce the items. So managers should analyze the pros and cons of both systems to meet the business needs.
Traditional Costing Method
Large multinationals corporations use traditional costing system to assign manufacturing cost per unit. It is based on the assumptions that the volume metric is underlying factor of manufacturing overhead cost. In this type of approach accountants assign manufacturing cost to the products and fails to assign the nonmanufacturing cost such as admin and selling expenses.
Pros and Cons of Traditional Costing
First, traditional costing is merely linked with Generally Accepted Acconting And Finance Principles or GAAP. It is easier to implement and time saving. However, it is an outdated system because now in companies accounts use computers and machines for the production purpose so that machines and computers make the system obsolete as it uses direct labour hours to calculate the cost. It also negates other cost drivers that also contribute to the cost of an item.
Activity- Based Costing
It provides a better understanding of product cost, but large manufacturing and multinational sectors typically use it as a secondary costing system. It determines each and every activity that is related to the production of units. It assigns cost based on production activity and also on the basis of products.
Advantages and Disadvantages
The primary benefit of activity based costing is to provide correctness in terms of cost per product. Firms assign cost only to the products that require the activity for production. It eradicates the irrelevant cost to an item. It is easier to interpret of cost for internal management but on the other hand implementation of activity-based costing requires substantial resources. This proves a negative for a company with limited funds. It can be misinterpreted by some users…
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