Essay Available:
Pages:
8 pages/≈2200 words
Sources:
5
Style:
Harvard
Subject:
Accounting, Finance, SPSS
Type:
Essay
Language:
English (U.S.)
Document:
MS Word
Date:
Total cost:
$ 37.44
Topic:
Financial and Managerial Accounting for Decision Making
Essay Instructions:
You are a graduate trainee at Pevensey PLC and as part of your training you have been seconded to the company secretary Mary Fulton. She has requested that you look at a project to help the company purchase a machine. There are 4 potential machines that are being investigated, the details of which are shown below. Only one can be chosen. :
Year Net cash flow (ALL FIGS IN £000)
Machine A B C D
0 Capital cost (80) (100) (120) (140)
1 15 35 25 10
2 25 40 35 20
3 25 40 40 50
4 30 15 20 50
5 30 10 10 50
The above figures are estimates of the net cash flow; these are projected revenues minus the machine operating costs for each year. At the end of the period, in year 6, each machine will be sold for £10,000, except for Machine D, which will be sold for £50,000.
You are required to write a structured business report for Mary Fulton. In the report you will need to appraise this project for her using discounted and non-discounted cash flow techniques. The report should explain which machine you would recommend that the company purchases together with your reasoning. As part of the report she has requested that you include full calculations in an appendix. The report will be used by the Board of Directors, many of whom do not understand finance. To ensure that the Directors fully understand all of the issues Mary has asked that you clearly explain the techniques that you have used, drawing attention to the techniques' strengths and weaknesses. In recommending a particular machine she has asked that you consider the risks and problems with the figures provided above.
The project will be funded by internal funds and the company's cost of capital data is below (based on the first letter of your surname):
Your Company's
Surname Cost of capital (%)
A,L,W.I 8
B,M,X,T 9
C,N,Y 10
D,O,Z 11
E,P,K 12
F,Q,V 13
G,R,J 14
H,S,U 15
Please ignore taxation. The total word count is 2,000 words (this excludes the appendices)
Essay Sample Content Preview:
Name
Course
Institution
Professor
Date
COVER LETTER
PEVENSEY PLC
MARY FULT0N
THE COMPANY SECRETARY
Dear Mary
The major objective of this structure business report is to appraise the various machines give and in the process recommend the best machine to be purchased by the company.
The major objective of this report is to use the discounting and non-discounting techniques in the process of finding out which of the four machines given should actually be bought.
I hope the Board of Management and other decision makers will find this carefully prepared report to be of great use.
Regards
XYZ
Abbreviations
PVpresent value
ROIReturns on Invetsment
INTRODUCTION
The Board of Management had commissioned the company secretary Mary Furton to prepare a structured business report that accurately employs the appraisal tools to help the company directors in making their decisions on the type of machine to be bought.
In the appendices, I have included an exhaustive record of all the necessary calculations to aid you in understanding of this particular report. The terms used have been well defined to make even someone who has never been to an Accounting class to fully understand the contents therein.
There are very many methods that are employed in appraisal of prospective investments. Generally, the methods can be classified into two:
1 The Non-discounted cash flow technique. This method includes the use of Payback and Average return on book value
2 Discounted cash flow technique. The discounted technique involves the use of Net Present Value and IRR. The Discounted cash flow focus on the opportunity cost of the corporation money.
When making a decision to invest, all the machines that have a present value greater than zero are accepted and those that have NPV<0 should always be rejected.
Internal Rate of Return (IRR) is the return that is equal to the initial investment with present value of cash flows.
It should always be understood that the projects with IRR> r should be accepted. On the other hand, Projects with IRRPAY BACK PERIOD (PBP)
This is the period of time required for the cumulative expected cash flows from an investment project like the one our consideration.
PBP Strengths and Weaknesses
The Strengths
* Easy to understand
* Can be used to measure liquidity
Weaknesses
* Cut-off period is subjective
* Does not consider cash flows beyond the Pay Back Period(PBP)
Internal Rate of Return (IRR)
Strengths
* Less subjectivity
* Considers all cash flows
Weaknesses
* Assumes that all cash flows are reinvested at the IRR
* Difficulties with project ranking
PROJECT JUSTIFICATION
The world is ever becoming complex each and every day. There are a myriad of factors needed to be taken into account before making any decision in the world of business today. New techniques of project appraisal have been put into place and whoever employs them well makes the greatest gain in terms of competitiveness or profitability. Leave these techniques behind at your own peril.
OBJECTIVES
There are two major objectives of this structural business report:
* To evaluate the four machines on offer for sale and determine which is the most appropriate for purchasing.
* To guide the prospective users of this report on other non-economic benefits of this appraisal report.
EXPLANATION OF THE TECHNIQUES USED IN THIS REPORT
There are two major techniques that have been extensively employed in this report. The two techniques are used the world over in project appraisal procedures. In this report for the purpose of clarity I will explain the methods in a very clear language. This will be my priority to ensure the report serves its intended use.
* DISCOUNTING CASH FLOW TECHNIQUE
The Present Value Method (PV)
This is the net cash flow of the machines minus the initial cash flow. When the NPV is negative, it shows that the project is reducing shareholder wealth. Therefore, the machines with negative value should be reject accordingly.
The first method is the Discounting Cash flow technique. It is generally believed that future benefits are less valuable than the present ones.
To illustrate this technique, I will give a general example:
Given:
Β0, β1…….βn are benefits of machines in years 1,2,3,…..N, then
In this report, we discount benefits to base year equivalent. The following are the Present Value (PV) of the four machines A, B, C and D.
PVA = £ 101.42;PVB = £ 122.56
PVC= £ 111.85; PVD = £ 141.22
Decision
For the discounting cash flow method, machine D has the largest value at QUOTE 141.22. Therefore, machine D should be bought considering that it raises QUOTE 50,000 when we have to note here that purchase of the machine will be fully be financed by internal funds.
Internal financing emanates from depreciation and retained earnings. To get retained earnings, you less dividends from after tax profits. As profits increase, the amount of internal funds which are available for investment will also increase. This shows that there is need to purchase a good machine which will contribute to the productivity of Pevensey PLC
Strengths and Weaknesses of NPV
Strengths
* The Cash flow is assumed to be reinvested at the hurdle rate
* Considers all cash flows.
Weaknesses
* Managerial options embedded in the project may not be included.
CHOICE OF DISCOUNT RATE
STRENGTHS
The rationale for using private rate of discount is that it reflects consumer choice between present and future consumption.
WEAKNESSES
1 There is uncertainty on the future level of interest rate. This leads to differences between short-term and long-term rates of interest in the capital market.
2 Gross rates of return differ by the amount of risk premiums.
3 Macro-policy: Considering that there is unemployment and inflation, there is need for the government to intervene in rectifying the situation. The market does not reveal the correct level of interest.
PROFITABILITY INDEX (PI)
This is the ratio of the PV of a machine`s future net cash flows to the machine`s initial cash flow.
The method used to find the Profitability Index (PI) is illustrated below:
PI = 1+ [NPV/ ICO]
Any machine whose PI is less than 1 is quite unprofitable; hence that machine should never be bought. The following are the values of PI of the 4 machines:
A = £101.42/80 = 1.27
B= £122.56/100 =1.23
C= £ 111.85/120= 0.932
D= £141.22/140= 1.009
Evaluating the four machines based on the profitability Index, we discover that machine C should never be bought because it is unprofitable. Machine A is the most profitable of the four.
PI Strengths and Weaknesses
Updated on
Course
Institution
Professor
Date
COVER LETTER
PEVENSEY PLC
MARY FULT0N
THE COMPANY SECRETARY
Dear Mary
The major objective of this structure business report is to appraise the various machines give and in the process recommend the best machine to be purchased by the company.
The major objective of this report is to use the discounting and non-discounting techniques in the process of finding out which of the four machines given should actually be bought.
I hope the Board of Management and other decision makers will find this carefully prepared report to be of great use.
Regards
XYZ
Abbreviations
PVpresent value
ROIReturns on Invetsment
INTRODUCTION
The Board of Management had commissioned the company secretary Mary Furton to prepare a structured business report that accurately employs the appraisal tools to help the company directors in making their decisions on the type of machine to be bought.
In the appendices, I have included an exhaustive record of all the necessary calculations to aid you in understanding of this particular report. The terms used have been well defined to make even someone who has never been to an Accounting class to fully understand the contents therein.
There are very many methods that are employed in appraisal of prospective investments. Generally, the methods can be classified into two:
1 The Non-discounted cash flow technique. This method includes the use of Payback and Average return on book value
2 Discounted cash flow technique. The discounted technique involves the use of Net Present Value and IRR. The Discounted cash flow focus on the opportunity cost of the corporation money.
When making a decision to invest, all the machines that have a present value greater than zero are accepted and those that have NPV<0 should always be rejected.
Internal Rate of Return (IRR) is the return that is equal to the initial investment with present value of cash flows.
It should always be understood that the projects with IRR> r should be accepted. On the other hand, Projects with IRR
This is the period of time required for the cumulative expected cash flows from an investment project like the one our consideration.
PBP Strengths and Weaknesses
The Strengths
* Easy to understand
* Can be used to measure liquidity
Weaknesses
* Cut-off period is subjective
* Does not consider cash flows beyond the Pay Back Period(PBP)
Internal Rate of Return (IRR)
Strengths
* Less subjectivity
* Considers all cash flows
Weaknesses
* Assumes that all cash flows are reinvested at the IRR
* Difficulties with project ranking
PROJECT JUSTIFICATION
The world is ever becoming complex each and every day. There are a myriad of factors needed to be taken into account before making any decision in the world of business today. New techniques of project appraisal have been put into place and whoever employs them well makes the greatest gain in terms of competitiveness or profitability. Leave these techniques behind at your own peril.
OBJECTIVES
There are two major objectives of this structural business report:
* To evaluate the four machines on offer for sale and determine which is the most appropriate for purchasing.
* To guide the prospective users of this report on other non-economic benefits of this appraisal report.
EXPLANATION OF THE TECHNIQUES USED IN THIS REPORT
There are two major techniques that have been extensively employed in this report. The two techniques are used the world over in project appraisal procedures. In this report for the purpose of clarity I will explain the methods in a very clear language. This will be my priority to ensure the report serves its intended use.
* DISCOUNTING CASH FLOW TECHNIQUE
The Present Value Method (PV)
This is the net cash flow of the machines minus the initial cash flow. When the NPV is negative, it shows that the project is reducing shareholder wealth. Therefore, the machines with negative value should be reject accordingly.
The first method is the Discounting Cash flow technique. It is generally believed that future benefits are less valuable than the present ones.
To illustrate this technique, I will give a general example:
Given:
Β0, β1…….βn are benefits of machines in years 1,2,3,…..N, then
In this report, we discount benefits to base year equivalent. The following are the Present Value (PV) of the four machines A, B, C and D.
PVA = £ 101.42;PVB = £ 122.56
PVC= £ 111.85; PVD = £ 141.22
Decision
For the discounting cash flow method, machine D has the largest value at QUOTE 141.22. Therefore, machine D should be bought considering that it raises QUOTE 50,000 when we have to note here that purchase of the machine will be fully be financed by internal funds.
Internal financing emanates from depreciation and retained earnings. To get retained earnings, you less dividends from after tax profits. As profits increase, the amount of internal funds which are available for investment will also increase. This shows that there is need to purchase a good machine which will contribute to the productivity of Pevensey PLC
Strengths and Weaknesses of NPV
Strengths
* The Cash flow is assumed to be reinvested at the hurdle rate
* Considers all cash flows.
Weaknesses
* Managerial options embedded in the project may not be included.
CHOICE OF DISCOUNT RATE
STRENGTHS
The rationale for using private rate of discount is that it reflects consumer choice between present and future consumption.
WEAKNESSES
1 There is uncertainty on the future level of interest rate. This leads to differences between short-term and long-term rates of interest in the capital market.
2 Gross rates of return differ by the amount of risk premiums.
3 Macro-policy: Considering that there is unemployment and inflation, there is need for the government to intervene in rectifying the situation. The market does not reveal the correct level of interest.
PROFITABILITY INDEX (PI)
This is the ratio of the PV of a machine`s future net cash flows to the machine`s initial cash flow.
The method used to find the Profitability Index (PI) is illustrated below:
PI = 1+ [NPV/ ICO]
Any machine whose PI is less than 1 is quite unprofitable; hence that machine should never be bought. The following are the values of PI of the 4 machines:
A = £101.42/80 = 1.27
B= £122.56/100 =1.23
C= £ 111.85/120= 0.932
D= £141.22/140= 1.009
Evaluating the four machines based on the profitability Index, we discover that machine C should never be bought because it is unprofitable. Machine A is the most profitable of the four.
PI Strengths and Weaknesses
Get the Whole Paper!
Not exactly what you need?
Do you need a custom essay? Order right now: