March 15, 2019 /
admin
/ 0 Comments

This is a study of the present choices of our company Tenon Manufacturing, Ltd. on what equipment the company will purchase. Hence this will look primarily into the financial nature of the decision on which will be more beneficial to the company. Is it the first equipment or the second equipment? I have therefore compiled financial estimates from the proposed project and I will apply investment methods to evaluate the proposal to buy either Machine A (the first) or Machine B (the second).

It found out that methods are not that easy to apply as there are conditions and limitations of their applications but there are also advantages. Between non-discounted and discounted cash flow methods, the former is simple but the latter is more logical for it considers the time value of money and which considers business risks. In the comparisons of the two options I applied quantitative investment appraisal techniques that includes the Pay back method (PBM), the Accounting rate of return (ARR), the Net present value method and the Internal rate of return (IRR) method.

The Business Environment

It is a fact that our business is facing big competition from Multi-national drug companies, like and even other major local drug manufacturers. For the company to survive, its decision must be theoretically and practically sound in order for the company will attain its target of maximizing profit

The Investment Decision

The major investment decision that Tenon Manufacturing is faced with is whether to acquire machine A or machine B for production purposes. The decision is necessary because it could not opt to buy an old machine because repairs and maintenance could high. Convinced with the demand for its products, the company will now have to cross the “big bridge” of decision-making. Is it Machine A or Machine B? The result of the analysis in Appendix A was with due consideration of the capacity of the Machine to adjust production based on estimated number of possible orders for the next five years. After deciding to pursue with the project, the remaining options are which Machine will yield the better return given its cost of capital.

Investment Decision Making Process

The Company wants to enter into investment that would assure it the profitability to cover its expenses and that would give the owners a reasonable amount of return or profits above the opportunity cost of just having their money in the bank where it would surely earn a given interest rate.

Since the business organization would most likely be partnership, the process of decision-making is not as cumbersome as that of a corporation. The only major requirement is the agreement of the owners and their decision to proceed with the purchase of the machine.

Investment Appraisal Method/S Adopted

The investment appraisal methods used are the following: Pay back method (PBM), Accounting rate of return (ARR), Net present value (NPV), and Internal Rate of return (IRR)

Each is described, analyzed and applied to Tenon in the next topic.[1]

Evaluation of the Company’s Process and Method/S Adopted

Appendix A showed the result application of the different appraisal methods. Now we will see how the decision maker decides based on the information in the said appendix. It must be noted that before the above could be formulated, it is required that there must be available information as to the cost of capital. But what is cost of capital?

The company’s Cost of Capital means is what will be used to discount the cash inflows that will be generated from forecasted cash flow[2] as a result of buying either equipment appraisal methods.

The PAY back method

The payback method does not measure in percentage the profitability of a project or an investment proposal. It rather measures how long the money invested will come back. In other words, every decision maker expects a certain number of years to wait in order to recover an investment made.

It is thus computed by dividing the net investment by the annual cash flow after tax. By applying this method the result is as follows: For Machine A, above the payback period is 3.18 years while 2.94 years for Machine B. Now to decide which one is better one will depend on company policy. If projects, for example will be accepted if pay back is exactly 3 years and below, then Machine B fails to qualify. See Appendix A.

The ARR

The ARR on the other hand is generated from the historical financial report of the business. The formula is Net income divided by the total investment for the year, and the rate obtained is called the ARR or the ROI representing return on investment or ROA, which means return on investments. The net income figure is providing in the income statement of a business and the figure for the total investment or assets is provided by balance sheet Unlike the PBM, the ARR now expresses the measurement in rates, which now may be compared with the cost of capital. There is however, a criticism as to its use because it does not consider the time value of money. For machine A, ARR’s are 8%, 11%, 14%, 24% and 24% for five consecutive years respectively. For machine B, we have 18%, 13%, 12%, 26% and 26% for the five consecutive years respectively. To evaluate which should be accepted depends also on company, policy. If say projects having ARR of below 10% in any year will be rejected then Machine A fails. See Appendix A.

Before the other methods could be applied, there is a need to discuss the concept of time value of money. What is the time value of money? Why is it important?

If we go back to the definition of the cost of capital, it may be recalled that it is the discount factor that will be used to discount future cash inflows that will be generated by the project. We will understand better the meaning of time value of money by relating the same with the concept of “discounted cash flow”. Brigham and Houston in Fundamentals of Financial Management says that “the most important, but also the most difficult, step in capital budgeting is estimating projects’ cash flows—the investment outlays and the annual net cash inflows after a project goes into operation. Many variables are involved and many individuals and department participate in the process.” From this statement, we thus can see the preparation of cash flow based on estimates from the different departments of an organization. Mr. Brigham and Mr. Houston give the following formula to compute cash flow (page 539)[3]: “Free cash flow= After-tax operating income plus depreciation less capital expenditure less change in operating working capital

The NPV

The NPV evaluates a project in such a way at the dollar received immediately is preferable to a dollar received at some future date. It discounts the cash flow to take into the account the time value of money. This approach finds the present value of expected net cash flows of an investment, discounted at cost of capital and subtract from it the initial cash outlay of the project. To apply the formula to the case at hand, it may be observed that in the case of Machine A above, its NPV discounted at an assumed cost of capital of 12%, yields 375,269.88 pounds while Machine B yields 342,396.17 pounds. The one with higher NPV is better and in this case, it is machine A. See Appendix A

Note however, NPV has also limitations[4] and these include difficulty to explain to non-finance people and that the solution is in figures, not percentage rates of return.

The IRR

The IRR also is a method that uses time value of money but uses rates to express the answer. It is very much related with NPV in the sense that if NPV is set to zero, the discount rate that is used in computing the NPV is actually the IRR of the project. For purposes of using this method of whether to accept a project proposal, the IRR of said proposal must be higher than the cost of capital of 12% ; otherwise, the proposal must be rejected.

Using the given data as gathered the IRR for Machine A is 19% and 26% for Machine B. The better option is one with the greater IRR, hence Machine B is better. See Appendix A

Conclusion and Recommendations

Based on the comparison made among the different appraisal methods there is a trade off between too simple and being just logical if non-discounted cash flow methods are compared with discounted cash flow methods. The technique may be too simple yet it is not sound, hence the decision maker must be prepared to be logical to avoid the disadvantages of becoming too simple. To be simple, use PBM or ARR. To be more logical use IRR or NPV

Based on analysis made, this paper recommend acquiring Machine over Machine B. This is based on the premise the use of NPV over IRR is better in case of conflict between the two method which both considered time value of money and there both are better than the simpler methods.

APPENDICES, REFERENCES AND BIBLIOGRAPHY

Appendix A.

Appendix A

Tenon Manufacturing. Ltd

Application of the investment appraisal methods

Machine A

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Sales

1,100,000

1,210,000

1,440,000

1,800,000

1,950,000

Variable cost

350,000

400,000

550,000

700,000

855,000

Fixed Cost

200,000

200,000

210,000

215,000

220,000

Depreciation*

400,000

400,000

400,000

400,000

400,000

Net Income

150,000

210,000

280,000

485,000

475,000

Less : Tax at 0%*

–

–

–

–

–

Net income after tax

150,000

210,000

280,000

485,000

475,000

Add back: Depreciation**

400,000

400,000

400,000

400,000

400,000

Annual Cash flow, net of tax

(2,100,000)

550,000

610,000

680,000

885,000

875,000

* 2000000/5

Initial Outflow

NPV (£)

375,269.88

IRR

19%

ARR

0.08

0.11

0.14

0.24

0.24

Pay back

3.18

years

Machine B

year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Sales

1,100,000

1,210,000

1,440,000

1,800,000

1,950,000

Variable cost

600,000

770,000

960,000

1,200,000

1,350,000

Fixed Cost

120,000

130,000

150,000

150,000

150,000

Depreciation*

200,000

200,000

200,000

200,000

200,000

Net Income

180,000

110,000

130,000

250,000

250,000

Less : Tax at 0%

–

–

–

–

–

Net income after tax

180,000

110,000

130,000

250,000

250,000

Add back: Depreciation*

200,000

200,000

200,000

200,000

200,000

Annual Cash flow, net of tax

(1,000,000)

380,000

310,000

330,000

450,000

450,000

NPV (£)

323,775.46

IRR

25%

ARR

0.18

0.11

0.13

0.25

0.25

Pay back

2.94

years

Works Cited:

Bernstein (1993) Financial Statement Analysis, IRWIN, Sydney, Australia

Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, London, UK

Helfert, Erich (1994), Techniques for Financial Analysis, IRWIN, Syndey, Australia

Meigs and Meigs (1995) Financial Accounting, McGraw-Hill, London, UK

Van Horne (1992) Financial Management Policy, Prentice-Hall, Inc., London, UK

Weston and Brigham (1993) Essential of Managerial Finance, Dryden Publishers London, UK

[1] Bernstein (1993) Financial Statement Analysis, IRWIN, Sydney, Australia; Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, London, UK

[2] Van Horne (1992) Financial Management Policy, Prentice-Hall, Inc., London, UK; Weston and Brigham (1993) Essential of Managerial Finance, Dryden Publishers London, UK

[3] Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, London, UK

[4] Helfert, Erich (1994), Techniques for Financial Analysis, IRWIN, Syndey, Australia; Meigs and Meigs (1995) Financial Accounting, McGraw-Hill, London, UK

No related essays.

- Does Romantic Love Guarantee Long Time Relationships? Essay
- Addressing the Challenges of Application Ownership in the Education Sector Essay
- Application of the CSS in Correctional Institutions Essay
- RECENT STATUTORY REQUIREMENTS AND CASE LAW Essay
- Application of Psychology Essay
- Application of Organization Theory to Leadership: Role of Director of Nursing Essay
- Application of Leadership in the Workplace Essay
- Application of Goldratt’s The Goal Essay
- Application of Evolutionary Psychology in the Organization Essay
- Ethnic and Cultural Awareness Essay