ACCOUNTING FOR DECISION MAKERS
ACCOUNTING FOR DECISION MAKERS
Introduction
The new machine that Webster Plc or the company is contemplating to buy would be a replacement of the current one. A company can always conduct capital budgeting in any one of two ways. The first of these is a replacement such as the one the company is currently considering (Brealey, Myers and Allen, 2011, p.242). The second type of capital project is often an expansion of existing capital capacity of the business which simply adds on what is already in existence. Whatever the type of capital project, the decision as to whether to go ahead with it would partly depend on the outcome of the necessary financial analysis. It is on that footing that the present report analyses whether the company should go ahead with the project.
Objective of the report
As has already been alluded to in the introduction above, the present report aims to assess the viability of the new machine that the company intends to buy. The analysis will largely be financial but some non financial factors will also be taken into account in arriving at the ultimate recommendation. Analyses such as the one proposed to be carried in this report are often considered as capital budgeting due to the fact that they assess the viability of long term projects (Aigheyisi, 2013, p.211). Capital expenditures can be contrasted with revenue expenditures in the sense that former are not concerned with benefits accruing to the business beyond the particular financial period in which they are incurred (Aigheyisi, 2013, p.212).
From the instructions given, the financial analysis will be restricted to the two capital budgeting techniques of the payback period and the net present value. The analysis will, however, be alive to the fact that there are other techniques such as the internal rate of return (IRR) and the profitability index (Kengatharan, 2016, p.21).It is the results of applying the two mentioned techniques coupled with additional financial and non financial considerations that will inform the recommendation of the report.
Relevant costs and assumptions
As a background to the financial analysis, there is need to determine the relevant cash flows and set out the necessary assumptions that will inform the analysis. The distinction between relevant and irrelevant cash flows is important because only the relevant costs are important in making financial decisions. They are costs or incomes that change as a result of the decision to implement the investment project (Laux, 2011, p.32).
The £40,000 already spent in conducting a market study is an irrelevant cost because the company cannot reverse the fact that it has already spent the amount whether the project is accepted or not. Costs like this are often called sunk costs (Laux, 2011, p.36). The treatment of the £15,000 that the company would have earned in rent had it rented out the additional space to be occupied by the machine is also important given that capital budgeting focuses on cash as opposed to accounting profits. Foregoing the rent is an opportunity cost that should be considered in estimating the project cash flows. All the other costs are relevant.
It is also important to incorporate tax in the analysis as the benefits that accrue to a company from any investment can only be seen as benefits after factoring taxes. The analysis will, therefore, assume a tax rate of 20 %( Denton, 2016, 1). Some of the figures given are in € as opposed to £ such that the report has to adopt an appropriate exchange rate. The current GBPEUR: CURR rate is 1.1947(Bloomerg, 2016).
The analysis further makes the assumption that the current machine is fully depreciated and has no scrap value. It is also assumed that the company will depreciate the new machine on a straight line basis for the 4 years it will be in the company before eventually selling it at £50,000 at the end of the fourth year.
Moreover, it would assumed that the company will only produce what it can successfully sell so that the cash flows will only be computed on the basis of 12,000 expected weekly demand as opposed to the 20,000 total weekly capacity of the new machine. The incremental sales above what the company currently sells is, therefore, 4,000(12,000-8,000) soothers. Detailed calculations can be seen in the APPENDIX.
Below is a summary of the relevant flows
| Y | 0 | 1 | 2 | 3 | 4 |
| Net Cash Flows(£) | (431,741) | 220,040 | 220,040 | 220,040 | 38,482 |
| Cumulative Net Cash Flows(£) | (431,741) | (211,701) | 8,339 | 228,379 | 266,861 |
Applying the appraisal techniques
Having successfully identified the relevant cash flows and proceeded further to compute the net cash flows for the different years as well as the cumulative net cash flows, the next step is to subject these cash flows to the two investment appraisal techniques as instructed in the terms of reference requesting for the present report.
The payback period
This investment appraisal technique assesses an investment on the basis of how fast it can be able to recoup the initial investment (Ardalan, 2012, p.12). The word payback is, therefore, connected with the ability of the cash flows from the project to pay back the amount initially invested into the project.
Decision criteria
The rule under the payback method is to accept all independent projects with payback periods that are either less than or equal to the company cut-off payback period. The current project will pay back in 1.96 years against Webster Plc’s cut-off payback period of 2 years. Since 1.96 is less than 2, Webster Plc should accept this project under the payback period.
Net present value (NPV)
The NPV approach expresses the net cash flows of a project in their current monetary terms (Arshad, 2012, p.213). This means that the cash flows that occur into the future are discounted using a chosen discount rate to get their value in present terms. Below is the calculation of the NPV for this project.
Three of the cash flows represent an annuity so that their Present Values can be calculated using the annuity formula as shown below:
The initial investment is not discounted since it occurs at Year zero. Its present value remains as it is.
The present value of the terminal cash flow is computed by discounted the terminal net cash flow using the given discount rate. That calculation is shown below:
The present value of the terminal cash flow is computed as hereunder:
Net Present Value (NPV) of the project is the sum of the various present values given as below:
.
Decision rule
The test under the NPV approach is to accept all independent projects with NPVs that are greater than £0(Arshad, 2012, p.213). It is obvious from above that £141,750 is greater than zero so that the company should accept the project under the NPV approach.
Advantages and disadvantages
Payback period
Simplicity is the most outstanding advantage of this technique (Gitman and Zutter, 2012, p.394). The fact that a business should recoup its investment as early as possible is easily understood by most managers even without a deeper understanding of finance. In the present case, the board at Webster would easily understand that projects that recoup their investments as early as possible are preferable.
Despite the simplicity, the payback period has been criticised for lacking any objective criterion for arriving at the cut-off payback period (Gitman and Zutter, 2012, p.395). This is true for many other businesses just as it is true for Webster Plc in which there cannot be any objective explanation for the choice of 2 years as the appropriate cut-off payback period.
In addition, the method ignores all cash flows that occur after the payback period. For example, using the payback period ignores a total of £266,861 which is the cumulative net cash flows at the end of Year 4.Ignoring cash flows occurring after the payback period may lead to the rejection of projects that may have added value to the firm while accepting those that may have reduced value.
Lastly, the payback period also fails to take time value of money into account (Gitman and Zutter, 2012, p.395). The 1.96 years payback period in this case has been arrived at without discounting the cash flows for their present values. This means that cash flows received today are treated the same as those received sometimes in the future.
Net present value
Unlike the payback period, the approach is an objective basis for evaluating projects on their ability to maximise shareholder wealth (Atrill and McLaney, 2009, p.278). Knowing that the NPV for the project is £141,750 objectively indicates that shareholders of Webster Plc will be better off by the same amount. In addition, this approach fully accounts for the time value of money. This can be seen in the Webster Plc case when the various yearly cash flows are discounted at the given company cost of capital of 10%.
Despite its many advantages, the NPV has two major advantages. For one, the approach fails to provide a means of gauging the profitability of a project (Atrill and McLaney, 2009, p.279).Webster Plc would is not in a position to know how profitable the proposed project is simply by looking at the NPV. After all, a project of a different initial cash outlay may also end up with the same NPV.
Lastly, many people find it difficult to understand NPV in contrast to the perception of payback period. The consequence of this is that managers without a proper grounding in finance may completely fail to appreciate the approach.
Recommendation
From a purely financial perspective, the board should authorise the buying of the new machine. The first justification for this recommendation is the fact that Webster will be able to recoup its initial investment in the project in 1.96 years which is slightly less than the 2 year firm cut-off recovery period. In addition, buying the machine will increase shareholder wealth in present value terms of £141,750.
The firm should, however, consider other non financial factors such as the strategic significance of buying the machine. The facts already show that the soother will be out of the market in the next three years. Perhaps it would be appropriate if the firm can outsource the production of the 4,000 extra units demanded per week above the current machine capacity. The ultimate decision taken by the board must factor these qualitative factors.
B
MEMORANDUM
To: The Board of Directors
From: The Financial Controller
Subject: Opinion for wider participation in Budgeting process
Date: December 16, 2016
Thank you for having discussed with you about the lack of accuracy of the financial budgets that have been prepared for the last two year. I am happy to present my opinion on the wider participation in the budget process.
Participatory budgeting is a process through which the people who are impacted by the budget are actively involved in its creation (Sholihin et al., 2011, p. 2). It is a bottom-up approach where employees are allowed to contribute their views in budgeting process. The bottom-up approach is better than the current approach which namely top-down where budgets are imposed on the company by a small group of senior executives (Corus and Ozanne, 2012, p. 13).
Advantages:
It creates budget that is more achievable because the people who execute the roles are involved and are able to include targets that they can meet within the specified time. It promotes morale in the employees who will increase their efforts in order to achieve what they predicted in the budget so as to satisfy their employer (Gilman, 2016, p. 2). Participatory budgeting enhances communication between various departments and also units within the company. This offers an opportunity to share best practices employed by the best performing departments which will positively impact the poor performing departments of the company (Abata, 2014, p. 156). It results to an accurate budget because the budget is thoroughly scrutinized and reviewed by various skills and experts. They will include all company’s requirement since every department is represented and chances to overlook or omit necessary requirements are limited. It allows comparison and more relevant variance analysis: This is applicable because all departments propose their budgetary requirement and hence offers an opportunity to compare and determine the most wasteful and economic departments which may need further improvement. The department’s requirements should be proportional to their output hence it act as quality control opportunity (Kewo, 2014, p. 85).
Disadvantages
It takes longer to create because of the large number of employees involved in the formulation where many opinions are presented that needs to be factored unlike in top-down where few senior managers are involved. It needs a relatively high labor cost because many resources such as writing materials, organizing cost, foods, water and refreshment. It also needs daily allowance in terms of per diem for the participating employees. It may not include high-level strategic considerations since the employees do not determine the goals and objectives of the companies. They are not involved in stakeholders meetings where strategies and directions are developed hence it needs a management to provide employees with guidelines regarding the overall direction of the company in which they should align their departments budgetary requirements (Harry, 2011, p. 2). It may lead to a budget that is conservative with expense padding: This is because the employees are the ones responsible in achieving the budget goals and therefore they won’t set high targets which they cannot meet since the evaluation of the budget is done against their productivity. It may create demotivation of employees in future participation after the review of the budget by management where they delete most of items proposed by the participating employees. The review process of the budget created by employees is very important and it is done by management to certain whether the budget reflects directs of the company. They also check the accuracy of the budget and if they delete most proposals by the employees, future participation may have few employees in attendance because they think their proposals are not accepted by the management (Syahputra, 2014, p.97).
What major firms are currently using
Organizing participants in small groups of about 6 to 8 people: This is because human beings do not collaborate well in large groups and the small groups are manageable. The small group allows each employee present to contribute effectively in the processing by presenting and supporting their ideas which are then consolidated form the final budget. The small groups have shown to produce unique results about the budget which then is aggregated and analyzed to identify key patterns that produce results which relate to the company’s directions (Gomez, Rios-Insua, Lavin and Alfaro, 2013, p. 15). Use of subject matter experts: This is where the main experts such as fire chief, human resources, accounts head and mainly all the heads of each department are involved in the process. They help the employees understand complex system dynamics during the budgeting process so as not overlook or omit the main issues of the great importance to the company. The experts assist in building relationships with the management and are critical to restoring trust between the employees and the senior executives (Hohmann, 2014, p. 1).
The use of certified facilitators: It has proved to create a well-designed session which tackles complex issues directly, exploring multiple perspectives and scenarios. The participatory budgeting process receives many proposals from the employees and it is good to understand that there is no right or wrong proposal what is important is to weigh competing factors, explore options and find ways to reach meaningful outcomes. The global team of Certified Collaboration Architects has helped many such processes and produced best results (Hohmann, L., 2014).
It is important that our company have an accurate budget that depicts the real financial situation of our business. Research shows that participatory budgeting process offers an economic entity advantages that cannot be, and should not be neglected (Tanase, 2013, p. 3). I would be pleased to provide any clarification that you may require on the issues raised in this opinion paper.
Yours faithfully
Certified Public Accountants
APPENDIX
Computing the relevant cash flows
Finding the initial investment
These are the cash flows that occur at time zero (Gitman and Zutter, 2012, p.433).The basic format for their computation is given below:
| £
Cost of new machine (400,000) Removal and preparation costs(20000/1.1947) (16,741) Forgone rent revenues from additional space (15,000) Initial investment (431,741) |
Finding the incremental operating cash flows
| Year 1 2 3 4
£ Sales net variable costs(0.2*7*4,000*48) 268,800 268,800 268,800 0 Depreciation(400000/4) (100,000) (100,000) (100,000) (100,000) Net profit before tax 168,800 168,800 168,800 (100,000) Income tax(20%*profit/loss) (33,760) (33,760) (33,760) 20,000 After tax net income 135,040 (135,040) (135,040) (80,000) Depreciation 100,000 100,000 100,000 100,000 Forgone rent from additional space (15,000) (15,000) (15,000) (15,000) Net cash flow 220,040 220,040 220,040 5,000 |
Finding the terminal cash flows
Terminal cash flows are the cash flows occurring at the end of the project (Gitman and Zutter, 2012, p.443). The can be computed as shown below:-
| £
Proceeds from sale of new machine(50,000/1.1947) 41,852 Tax on sale on new asset(20%*41,852) (8,370) After tax proceeds from sale of new machine 33,482 |
Summary of the relevant cash flows
| Year | 0 | 1 | 2 | 3 | 4 |
|
Initial investment Operating cash flows Terminal cash flows
Net Cash flows |
£
(431,741)
|
£
220,040
|
£
220,040
|
£
220,040
|
£
5,000 33,482
|
| (431,741) | 220,040 | 220,040 | 220,040 | 38,482 |
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