Unit 2 Managing Financial Resources and Decisions Solution

Programme	Diploma in Business
Unit Number and Title	Unit 2 Managing Financial Resources and Decisions
QFC Level	Level 5
Unit Code	H/601/0548

Introduction

The financial statement of the company helps the various stakeholder of the company to provide various information in relation to the business. The stakeholder can use the various ratios analyze to interpretation the performance of the business. The investment appraisal technique helps the owner of the business to make various decisions in relation to the business.

Task 2

Q1 Investment appraisal techniques

The term investment appraisal helps in making decision regarding proposed long term capital decision.

It is an important process followed by the Midway limited to effectively and efficiently utilize the resources in the long term investments, the benefits of whose will be derived over a long span of time. There always exists an uncertainty attached to various alternatives available to the Midway limited regarding investment decision making. The investment appraisal decision helps in gathering long term fund investment decision in anticipation of expected future cash flows. It helps in putting an impact on basic character of the enterprises. The decision generally involves of outflow of funds which is irreversible (Suopajärvi, et. al., 2013). There are some features of the investment appraisal decisions which are to be kept in mind while evaluating the investment proposal-

• Investment should be made for long term purpose
• Benefits arise during the operations of the business will be checked over the life span of the project
• The currents investment made are exchanged with the benefits arise in the future

Before making a decision regarding acceptability of the proposal the profitability arise from capital expenditure alternatives should also be checked which will help us to derive whether to accept the decision or not. For the evaluation of investment related decision in the proposed capital expenditure there are various methods available to us under the investment appraisal techniques. Any method can be used, on the basis of which selection of alternatives is determined. Sometimes there is possibility of selecting one or more alternatives in the order or priority or in the order of profitability. The importance should be given to the proposals resulting in more profit generation comparison to those alternatives where there are either no profits or fewer profits with the previous best alternative (Hosoya & Yashima, 2013). There are number of techniques or methods which may be taken into consideration while evaluating the investment appraisal decision are as follows

Investment appraisal techniques
Traditional or non discounted cash flow techniques	Modern or discounted cash flow techniques
Average rate of return technique	1. Net present value technique
Payback period technique	2.Profitability index technique
	3.Internal rate of return technique
	4.Modified internal rate of return
	5. Discounted payback period technique
	6. Net present value technique

Facts of the problem: There are two proposals or investment scenario available to the Midway Limited, a manufacturing company. The company can choose either of the two available options. Both the projects involve investment in particular machinery which will cost £125,000 to the company. It is given that outflow will be made at the first day of the year and it has been further assumed that inflow will come to the company at the end of the year
First proposal that is machine 1 which will cost around £125,000 to the organization and will give returns for 3 years then the machine 1 will be disposed of at a scrap value of £25,000after that company will purchase a new machinery for £ 60,000 which will further give return to the company for next five years.
Second proposal involves purchase of machine 2 which will also cost £125,000 to the company and will give returns or inflows for 6 years. In this case there will be no scrap or residual value at the end of 6^th year.
Further it is given in the problem that Midway Limited uses straight line method of depreciation and the cost of infusing capital in the organization is 20%
Solution to the problem: Payback period method is most important, popular and widely used method to calculate the investment appraisal technique. It is number of years it takes a firm to recover its original investment from net cash flows. It is calculated by dividing the after tax cash inflows relating to the results or performance of investments made over a span of time. As in our case of Midway limited in both the available proposals the yearly returns or cash flows are unequal payback period is calculated by adding up the cash inflow until the total is equal to initial cash outlay (Huerta & Gair, 2011).

PROJECT A payback period					amount in £ 000's
year		2016	2017	2018	2019	2020	2021
cash flow	-125	60	60	60	50	50	40
Depreciation		33.33	33.33	33.33	12	12	12
Residual value- purchase of new machinery				-35
cash flow before depreciation	-125	93	93	58	62	62	52
cumulative cash flow		-32	62
		1 year	4.1290323	months

(Elmassri, et. al., 2016)

PROJECT B payback period						amount in £ 000's
year		2016	2017	2018	2019	2020	2021
cash flow	-125	20	30	40	70	80	65
Depreciation		20.833	20.833	20.833	20.833	20.833	20.833
Residual value
cash flow before depreciation	-125	41	51	61	91	101	86
cummulative cash flow		-84	-33
			2 years	6.4918033	months

Net present value method: Net present value method or NPV method is a discounted cash flow analysis technique in which inflow received in future over the span of time are discounted at the rate of cost of capital that would cost to the Midway limited. In our case cost of capital is 20%. The present value of the total returns or inflows than compared with the initial outlay or present value of outflow invested over the period of time (Locatelli, et. al., 2016).
Formulae of Net present Value (NPV) = present value of cash inflow – present value of cash outflow

Calculation of depreciation
Project A		33333.333	(125000-25000)/3
		12000	60000/5
Project B		20833.333	125000/6

 

PROJECT A NPV
							amount in £ 000's
		2016	2017	2018	2019	2020	2021	total
cash flow	-125	60	60	60	50	50	40
Depreciation		33.33	33.33	33.33	12	12	12
Residual value- purchase of new machinery				-35
Net profit before depreciation		93	93	58	62	62	52
Discount rate	1	0.8333333	0.6944444	0.5787037	0.4822531	0.4018776	0.334898
discounted cash flows after tax before depreciation	-125	77.775	64.8125	33.755787	29.899691	24.916409	17.414695	123.5741
PROJECT B NPV
							amount in £ 000's
		2016	2017	2018	2019	2020	2021	total
cash flow	-125	20	30	40	70	80	65
Depreciation		20.833	20.833	20.833	20.833	20.833	20.833
Residual value
Net profit before depreciation		41	51	61	91	101	86
Discount rate	1	0.8333333	0.6944444	0.5787037	0.4822531	0.4018776	0.334898
discounted cash flows after tax before depreciation	-125	34.0275	35.300694	35.204282	43.804495	40.522521	28.745298	92.60479

 

Accounting rate of return ARR helps to create the ratio analysis by comparing average income to the investment made in the project ARR= average income of the firm / Average capital outflows This is one of the non discounted cash flow technique which helps to calculate estimate of net annual income which is not based on net annual cash inflows. It helps in choosing the project between two or more mutually exclusive projects such the project with more ARR can be chosen. It do not consider time value of money.

 

Average rate of return (ARR)
PROJECT A
Average Profit		53
Average Investment		80
ARR		67%
PROJECT B
Average Profit		51
Average Investment		62.5
ARR		81%

Comparison analysis                                                                                     amount in £ 000's

	Project A	Project B
NPV Basis	The NPV of project A is 123.5741 which is 30.96 more than what Midway limited is receiving from project 2.	The NPV of project B is 92.60479 which is 30.96 less than what Midway limited is receiving from project 1.
Payback period basis	The payback period for the project A is 1 year and 4.2 months which is 1 year and 2.2 months less than project B	The payback period for the project B is 2 years and 6.49 months which is 1 year and 2.2 months more than project A
Average rate of return	The average rate of return of project A is 67 %	The average rate of return of project B is 81 %
Overall conclusion	If company is looking for long term profitability than company should go for project A and wants to receive funds in short span of time	In no case Midway limited should opt for the project A

(Herbener & Rapp, 2016)

Limitation of investment appraisal techniques in decision making

	Limitation of using Payback	Limitation of using NPV
1	More importance to liquidity rather than profitability	Difficult to understand and use
2	does not consider time value of money	Cost of capital changes with the period of time
3	Does not measure risks in the projects	Miscalculations in mutually exclusive project for different project span
4	It is subjective decision

                              (Herbener & Rapp, 2016)

Q2 Limitation on relying on financial ratios to interpret firm’s performance

There are various limitations to ratio analysis. Some of them are discussed below

• Ratio analysis has no substitutes – financial ratio analysis is merely a tool of getting and reviewing information on the basis of financial statements of organisation. Hence ratio become useless if they are separately shown from the statements from whom they are computed

• Personal bias- ratios are only mean of managing financial analysis and not an end in itself. Ratios have to be interpreted and different people may interpret the same ratio in the different ways (McCluskey, et. al., 2014).

• Window dressing- financial statements can be window dressed to present a better picture of financials and profitability position of the enterprise to the outsiders. Hence one has to be very particular and vigilant in calculating ratios from these financial statements

• Misleading result in absolute data – in the absence of actual data the size of the business is unknown. For example if gross profit ratio given to us is 10% of two different firm, then we cannot analyse the balance sheet value of the two firms and its turnover that is first firm might got calculation of 10 % on turnover of £ 25,000 and another firm might be working on £ 300,000 turnover which makes huge difference (McCluskey, et. al., 2014).

Conclusion

So it may be concluded that the ratio analyze helps in various stakeholder to make various decision in relation to the business. The management of the business strategy can use various investment appraisal techniques to determine the feasibility of any project.

References

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