Accounting and Finance for Capital Budgeting Tools - myassignmenthelp

Question: Discuss about theAccounting and Finance for Capital Budgeting Tools. Answer: Introduction Capital budgeting tools and techniques are used to analyse an investment proposal. Various methods like Net Present Value, Internal Rate of Return, Pay-Back Period are been applied to check the effectiveness of the proposal. It is considered to be the most challenging task for the management because it involves the process of decision making about the investment in a particular plan. This includes allocation of funds to a specific project for a specific period of time in order to achieve the goals and objectives of the organization. A company can choose its investment proposal on the basis of capital budgeting methods. Cost- Volume Profit analysis is a method of determining changes in cost and volume which directly affect operating profit of an organization. The analysis also helps in calculating contribution per unit, analysis of limiting factor and to identify the profit maximising sales mix. Dangerous Dessert Company (DDC) is an enterprise that deals in the production of desserts and offers a wide range of products like bakery items, fresh fruit products, dairy products and ice creams. The company has set a division range for one of its product that is vanilla ice cream. The division range of the ice cream is Single Whammy, Double Whammy and Triple Whammy. Recently the company has opted for an investment proposal for delivering vanilla ice cream directly to the general public. It has also prepared a budget for the same product. Bespoke Golf Club is an organization which is financed by the employees of Bespoke Built Ltd. Peter Kwok has recently joined the club and want to know about the final accounts of the club. The report presented by the treasurer in the meeting did not show a clear picture of the financial position of the club and was not according to the rules of accounting. Peter wanted the accounts to be reported in a proper format and also according to standard rules and guidelines. This report consist of the analysis of the investment proposal chosen by DDC and the calculation of contribution per unit, sales mix and analysis of limiting factor as per the budget prepared by DDC. The report also contains the information about the accounting rules which are required to be adopted by the treasurer of Bespoke along with their explanation. Preparation of clubs accounts in proper format and as per rules is also done in this report. Investment Appraisal DDC is evaluating an investment proposal which is concerned with the direct delivery of ice-creams to the public. NPV method and Pay-Back Period method is used to evaluate this project. Calculation of Net Present Value Cash Outflows ($ million) Years 0 1 2 3 4 5 Cost of Vans 60000 Pre-launch advertising 100000 Salary of van drivers 50000 50000 125000 125000 125000 Van running cost 10000 12000 14000 16000 18000 cost of running central services 60000 60000 80000 80000 80000 Advertising Budget cost 50000 50000 50000 50000 50000 Total 160000 170000 172000 269000 271000 273000 The above table shows the cash outflow that occurs during the five years. The purchase cost of two vans is $30000 each which have an expected life of 5 years. Pre-launch advertising expenses amounted to $100000 and the advertising budget prepared by the marketing department for 5 years is expected to be $50000 per annum. Van drivers employed will have a salary of $25000 each per annum. Running costs of van are expected to $10000 in first year and then it will gradually increase by $2000 for the rest of the years. Cost of central services like accounting will increased by $60000 in year first and second and then by $80000 in year third, fourth and fifth. These are the total cash outflow occurred by the company in order to implement this project. Cash Inflow ($ million) Years 0 1 2 3 4 5 Cash Inflow 114000 228000 304000 342000 380000 The cash inflows presented in the above table are nothing but the contribution derived as per the estimated demand of vanilla ice-creams. The contribution is calculated on the basis of sales and variable cost. Average selling price is expected to be $5 per litre and the demand for the year 1 is 30000 litres, for year 2, 60000 litres and for third, fourth and fifth year, the demand is 80000, 90000 and 100000 litres respectively. Variable cost per unit of all the ingredients is $1.00 per litre and packaging cost is $.20 per litre. Contribution is calculated by subtracting total variable cost from total sales for each year. It is considered as the cash inflows occurred during the five years. Evaluation of NPV Years Cash outflows Cash Inflows Net Cash Inflow pvf@10% Present Value 0 160000 0 -160000 1 -160000 1 170000 114000 -56000 0.909091 -50909.09091 2 172000 228000 56000 0.826446 46280.99174 3 269000 304000 35000 0.751315 26296.01803 4 271000 342000 71000 0.683013 48493.95533 5 273000 380000 107000 0.620921 66438.58157 NPV ? -23,399.54 After calculating cash inflows and outflows, the next step is to calculate Net Present Value. NPV method is used to know about the profitability of a proposal in which investment has to be made. It uses present values of cash inflows on the basis of which, a proposal or a project is accepted or rejected. In other words, it is a simple accounting difference between the PV of cash inflow and PV of cash outflow. It can be positive, negative and zero. If NPV is positive which means PV of inflows is higher than PV of outflows. As a result, the project will be accepted. If it is negative, then the proposal is rejected because the PV of cash outflows is more than the PV of cash inflows. And if, NPV is equal to zero it means the present values of both inflow and outflow are equal and the project is accepted (Bierman Jr, Smidt, 2012). Advantages and Disadvantages Merits: The method helps in determining that whether the proposed project will increase the value of firm or not. NPV reveals that when the project will produce income and how important that income will be. It is used in calculating time value of money. Helps in comparing different projects. Evaluation of NPV always provide a correct decision regarding investments. Demerits: NPV is difficult to use. When the projects are of unequal life, NPV can provide incorrect decision. Appropriate discount rate cannot be calculated. The method is based on assumptions It is a very difficult task to determine the value of a project because there are many method to measure that. The time value of money factor is considered by the managers and for that they used NPV method. As this is based on predicted cash flows, the accounting practices like depreciation and many more does not affect the decision. So it is very important to use this method for knowing the profitability of a project. In the above table, NPV is evaluated at a discount rate of 10% and on the basis of the information provided in the scenario. The above table shows a negative NPV which means that the amount of present values of cash outflow is more than the cash inflow, so this project should be rejected. Calculation of Pay-Back Period Evaluation of Payback period Years Present Values Cumulative 0 -160000 1 -50909.09091 -210909.0909 2 46280.99174 -164628.0992 3 26296.01803 -138332.0811 4 48493.95533 -89838.12581 5 66438.58157 -23399.54424 Payback period Pay-Back period is the time taken by a project to recover the initial investment or outflow. In other words, it means how long a proposal will take to recoup the money invested in it. By knowing the payback period, investors can decide whether to invest in the desired proposal or not (Bierman Jr, Smidt, 2012). The above table shows that the project is not able to retrieve the amount invested in it during its life of 5 years. The amount gained from the project during the five years is not enough to meet the initial cash outlay. So it is suggested not to opt for this project. Analysis of the methods used The evaluation of both the methods shows that the proposal opted by DDC is not a desired one. Investing in it will not provide profits to the company. The NPV table shows that the project will not earn profits during its life span of five years. As the theory says that the investor should invest only in those projects that have a positive NPV. On the other hand, Payback period table represents that the project is not capable enough to recover the cash outlays incurred on it during its life span of 5 years. On the basis of above analysis, the proposal of purchasing two vans should not be accepted by DDC as it will result in creating loss for the company. So it is better for the company to avoid investing in this project. Budget DDC has prepared a budget for the production of range of vanilla ice-cream. It shows the consumption and cost of required ingredients per kilogram. Fixed and variable overheads along with the selling price per unit and quantity demanded for all three ranges is also mentioned in the budget. Contribution per unit, sales mix and analysis of limiting factor is done on the basis of provided budget. Calculation of contribution per Kilogram Contribution per kilogram ($) Single Whammy Double Whammy Triple Whammy Sales price per unit 2.00 2.50 3.00 less: variable cost per unit Material cost per unit 0.88 1.13 1.20 Sales commission@2% of sales 0.04 0.05 0.06 Outside carriers @4% of sales 0.08 0.10 0.12 Total variable cost 1.00 1.28 1.38 Contribution per kilogram 1.00 1.22 1.62 The above table shows contribution per kg calculated on the basis of data mentioned in the budget. Contribution per unit refers to the portion of total sales which is not consumed by variable costs and is used for covering fixed costs. It is Sales minus total variable costs. It is very important for the companies to calculate contribution margin because the amount left after deducting variable costs is used to cover fixed expenses or to add in the profit. The variable cost for DDC comprises of the material used in making of vanilla ice-cream, sales commission and outside carriers cost. Calculation of Material cost per Kg Material cost per unit Ingredients Single Whammy Cost Double Whammy Cost Triple Whammy Cost Cost per kg Milk 0.4 0.08 0.3 0.06 0.2 0.04 0.2 Cream 0.4 0.32 0.5 0.4 0.6 0.48 0.8 Castor sugar 0.1 0.1 0.09 0.09 0.08 0.08 1 Eggs 0.09 0.18 0.09 0.18 0.1 0.2 2 Vanilla pods 0.01 0.2 0.02 0.4 0.02 0.4 20 Total cost per Kg 0.88 1.13 1.2 This table shows the total material cost incurred in the production of ice-cream derived by multiplying cost per Kg with the consumption of each ingredient for each division. Material cost incurred for producing single whammy is $0.88 per Kg and for double and triple whammy, it is $1.13 per kg and $1.2 per kg respectively. Sales commission is calculated above is 2% of sales whereas outside carrier cost is 4% of sales. The total contribution per Kg for single, double and triple Whammy is $1.00, $1.22 and $1.62 respectively. Profit maximising Sales Mix Sales mix refers to the fraction of different products and services that covers the total sales of a company. In presence of a limiting factor, it is very important for an organization to make decision regarding an optimal sales mix which will derive higher profits. Companies should decide what product is to be produced and in what quantity. It should also evaluate that what quantity of limiting factor should be allocated to which product, so that profits can be maximised. In case of DDC, it has a short supply of vanilla pods from Madagascar because of the poor growing season. Considering it a limiting factor, company have to determine a sale mix which will maximise its profits. For this, following steps are been taken in order to calculate it. Required quantity of vanilla pods Calculation of quantity required of vanilla pods (limiting factor) Single whammy Double whammy Triple whammy Quantity Demanded 2000000 1350000 250000 Consumption of vanilla pods per kg 0.01 0.02 0.02 Total consumption of vanilla pods 20000 27000 5000 52000 The table shows the total consumption of vanilla pods required for the three divisions. It is calculated according to the quantity demand for each division. The total consumption is equal to 52000 kilos but the supply is limited to 45000 kilos. According to that, the sales mix will be obtained. Contribution of Vanilla Pods Contribution per unit of limiting factor (vanilla pods) Single whammy Double whammy Triple whammy Contribution per kilogram 1.00 1.22 1.62 Consumption of vanilla pods per kg 0.01 0.02 0.02 100.00 61.00 81.00 Rank I III II The next step involves the calculation of contribution per unit of the limiting factor that is vanilla pods. This is required to be calculated to attain an optimal sales mix. The above table shows that for producing the units of single whammy, 100% contribution of vanilla pods units is required as per the demand of the product. For double and triple whammy, it is 61% and 81%. On the basis of this, ranks are been given to the divisions in order of priority in production. This means that single whammy will be given first priority in production and triple whammy and double whammy will stand at second and third. Quantities to be produced Calculation of the production quantities Rank Vanilla units Vanilla units required Unit produced Single whammy I 20000 20000 2000000 Triple whammy II 5000 5000 250000 Double whammy III 20000 20000 1000000 Total 45000 3250000 Sales mix 61.54% 7.69% 30.77% After calculating the contribution per Kg, the next thing to do is to calculate how much quantity of what product is to be produced so that the total units of limiting factor can be used in a manner that the company can maximise its profits. The table presents that 20000 units of single whammy, 5000 units of triple whammy and 20000 units of double whammy is required to be produced with the consumption of vanilla pods. So the profit maximising sales mix is that single whammy has a weightage of 61.54%, triple whammy has 30.77% and the lowest weightage is given to double whammy that is 7.69% in a production plan. Limiting factor analysis Limiting factor basically means the constraints available in the resources which are used for production. They stop the business form maximizing its sales. Deficiency of labour, materials, machine hours and many more are considered as limiting factors in an organization. It is very important for the companies to perform an analysis of limiting factors, to increase its profits by making an optimal profit maximising sales mix. For DDC Company, vanilla pods which are used in production of vanilla ice-creams, are limiting factor. The option adopted by the company for its analysis is to calculate contribution per unit for different divisions, on the basis of which quantities of vanilla pods is allocated to the one who have higher preference as compare to others. The evaluation done above, shows that the total requirement of vanilla pods was 52000 Kilos but the company has the supply of 45000 kilos only. In regard to this, products quantity are calculated. 20000 units of single whammy can be produced using vanilla pods, satisfying the quantity demanded for that. Triple whammy production is on second priority and 5000 units are require to be produced. For that, 5000 vanilla pods units are used, meeting the demand of 250,000 Kg. For the production of double whammy, only 20000 units of vanilla pods are left to produce double whammy units. The units made, meet only the demand of 1000000 kilos, while initial demand for double whammy was 13500000 kilos. As this product has lowest contribution per unit, that is why it has given less priority and the demand is also reduced because there was not enough supply of vanilla pods to produce all the required units of double whammy which satisfies its initial demand. Accounting rules adopted by the treasurer Accounting rules are list of rules explain in detail and are required to be followed by accountants and treasurers in preparing final accounts of companies. Recording of transactions and creation of journal entries needed some rules that are known as three golden rules of accounting standards. These rules are classified according to the three different types of accounts named as Personal Account, Real Account and Nominal Account. The three golden rules are adopted by the treasures while preparing his report (Rajni, 2016). The three golden rules are: Debit the receiver, Credit the giver This rule is for personal account. It means that when an individual give some amount to the company, it is treated as an inflow and that individual becomes giver and his account is credited in the books of company. Similarly, if a person receives something form the company, then he is called a receiver and stands on the debit side of the books of business. Debit what comes in, Credit what goes out This rule is applicable for real account. Real account includes any property or goods which are either coming into the business or going out of the business. The rule states that if any property comes into the business, the account of that property will be debited in the books and similarly if any goods or property goes out of the business, the account of the same will be credited. The deposits done by the club for New Year and slide show are been credited in the books of accounts as per this rule. Debit all expenses and losses and Credit all incomes and gains This golden rule is for nominal account. This account generally includes business income, losses, expenses and gains. According to the rules, the account of expenses and losses incurred by the business will stand on the debit side of the accounts books. On the other hand, if business earns income and gains, the account of the same will have a credit balance. All the profit gained by the golf club from its activities have a credit balance and all the expenses incurred on the different events by the club are debited in its books of accounts Accounting rules should be adopted by treasurer The treasurer should use a proper format in presenting the financial statements of the club. The information presented by her in the balance sheet of accounts can be bifurcated into two accounts which are mandatory to be maintained as per accounting rules and standards. These accounts are Income and Expenditure account and Balance sheet. Income and Expenditure account includes balances of all the profits earned by the club and all the expenses incurred by it. All the capital expenditures are considered and then a surplus or a deficit is calculated, which is to be shown in the balance sheet on liabilities side. The balance sheet is the statement of balances of all the accounts which are maintained by the club. It represents the financial position give a clear view about the liquidity of the club. All the assets and liabilities of club are to be shown in this statement. This is also prepared according to the standards and rules of accounting. Preparing separate accounts will give a clear view of the financial position of the club. Financial accounts of the club Income and Expenditure Account for the year ending 2015-16 Expenditure Amount Income Amount Printing and Stationery 3300 Subscriptions 19500 Leader's expenses 160 Bus Cancelation fees 4060 Trainers expenses 10720 Private buses 1440 Postage/telephone charges 60 Christmas party 1730 Insurance 880 cheese and Wine 170 Hire of halls 2850 donations 50 General 420 Secretary 1310 Treasurer 360 General Expenses 420 surplus 6470 Total 26950 Total 26950 Balance Sheet Equity and Liabilities Amount Assets capital fund ( Mr Smith bequest) 960 Cash 52210 surplus 6470 Deposits 1780 Suspense account 46560 Total 53990 Total 53990 Conclusion The report concludes that for choosing an investment proposal, NPV and payback period method can be used as they gives a clear idea about the profitability of the project. DDC use these method to decide whether to invest in that proposal or not. CVP analysis tools are used to determine a sale mix which can increase companys profits. Calculation of contribution per unit and identification of a sales mix are the elements used to perform an analysis of a limiting factor. The report shows that how DDC have identified its profit maximising sales mix with the presence of limiting factors. It also concludes that proper accounting rules should be adopted in preparation of final accounts of the company. Treasurer must adopted three golden accounting rules and the standards of accounting while making the financial statements of Bespoke Golf Club. Using them will help the club to represent a fair and clear view of its position to the investors, its members and many other users. References Bierman Jr, H., Smidt, S. (2012).The capital budgeting decision: economic analysis of investment projects. Routledge. Rajni, S. (2016).Basic accounting. [S.l.]: Prentice-Hall Of India.