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Required: Critically discuss the benefits and limitations of using budgets for strategic management purposes, with exploring some potentially adverse consequences of the budget process

A real estate construction company currently sends out its doors for painting to specialist firms. During the last financial year, the number of doors painted was 1,826 at a cost of \$91,300. You are considering the possibility of this work being undertaken by the company in a workshop set up for this purpose. The following information relates to the project:

1-The paint shop can be set up in an existing warehouse that has not been used for some years and is estimated to be worth \$300,000.
2-Equipment costing \$160,000 needs to be purchased with a life expectancy of 6 years. The residual value is estimated as \$80,000 at the end of year 6.
3-The annual costs in today’s money of the operation are estimated to be:

 Rates and maintenance \$7,920 Management \$14,400 Labour \$18,400 Head office costs \$10,000*

4-Based on the number of doors painted last year, the cost of consumable materials and other variable costs is estimated at \$21,912.

5-Tax will be recoverable in year 2 and payable thereafter as shown below:

 Year 2 \$15,220 Recoverable Year 3 \$4,780 Payable Year 4 \$6,180 Payable Year 5 \$10,230 Payable Year 6 \$13,268 Payable Year 7 \$26,049 Payable

Required:

1-Calculate the following performance indicators relating to the proposal:
a-NPV based on a cost of capital of 11%.
b-IRR. (Hint use 5%)
c-Payback period in both nominal and present-value terms?

Do these indicators suggest that the project should be undertaken?

2-What other considerations should be taken into account by the company when establishing the new project?

3-Assume that the company typically adds or subtracts 3 percentage to the overall cost of capital to adjust for risk. Should the new project be accepted?

4-The company’s management is unsure of the reliability of the estimated figures for either the residual value of equipment or the unit variable cost. What is the maximum deviation allowed for the residual value of equipment if the change will affect the original decision to remain unchanged. Proof your answer.

Net present value

Budget is the tool and the blue print of the organization that depicts the transactions of the expenses and the revenue. The collective accumulation of all these things is represented by the budget.

Benefits of budgets

The benefits of the budgets for strategic management purposes have been outlined below.

• Planning orientation: The process of the preparation of the budget is one of the most important features which draw the attention of the management from the short term goals towards the long term goals. The idea to draw the attention is not to complete the goals rather even having a thinking of how well the company is aware about its financial position and the how they strategize to improve themselves (Accounting tools, 2017).
• Profitability review: during the scramble of the day to day activities the management loses the focus from the area which delivers most of the money to the company. A structured and the organised budget is one that presents the potential areas where the funds can be distributed and where the further money can be invested.
• Assumptions review: The main focus of the companies for the preparation of the budgets is that it allows the management to think about why the company is in business. A regular review of the assumptions results in altered assumptions which readily alters the business and the operations are settles in different manner (FEBMAT, 2016).
• Performance Evaluations: The work with the employees to set up new goals for the period where the budget is set out, possibly ties the bonuses or the other incentives on how to perform. The performance evaluation will give an insight of how the employees are performing with regards to the existing performance (Gallo, 2014).
• Bottleneck Analysis: Nearly every company has some kind of the bottlenecks and with the help of the budgets the bottlenecks can be eliminated on what can be done to expand the capacity or to shift the work around it (Strategic Management, 2017).

Limitations of budgets

• While budgeting performs so many issues there are many advantages that are core to the organization but there are several demerits attached while the preparation of the budget and hence it requires the careful consideration.
• Preparation of the budget is not a roller coaster science as it uses the approximations and the judgement which many not ne accurate to 100%. A budget is basically an estimate about the future which is unpredictable and unknown to anyone in the organization (Kandil, 2017).
• A budget is the only tool that neither eliminates nor takes over the concept of the management. A budget is such a proposal which is not used by the management except for the purpose of the managerial functions.  Executives feel circled in by the budget and its corresponding figures. The basic thing that they fail to understand is the budget that they are meant to provide the detailed information, goals and targets which may assist in achieving the company objectives (Safari, 2018).
• The most important part of the budgeting is its accuracy and there are huge amount of expectations involved from then budget and hence the budget is the most essential component and if the accuracy is not met with expectations than the entire blame shifts on the perpetrators of the budget (Karmakar, 2018).
• At last the biggest disadvantage of the budgets in the strategic management will also result in the utilization of the funds by the areas which required the least attention and therefore there may be a situation that would end up in sub optimal profits.
 Net present value Year Annual cash flows discounting factor @ 11% Present value 0 -160000 1.000 (\$160,000.000) 1 \$28,668 0.901 \$25,827.027 2 \$153,932 0.812 \$124,934.664 3 \$28,668 0.731 \$20,961.795 4 \$28,668 0.659 \$18,884.500 5 \$28,668 0.593 \$17,013.063 6 \$28,668 0.535 \$15,327.083 \$62,948.132

 Year Annual cash flows 0 -160000 1 \$28,668 2 \$153,932 3 \$28,668 4 \$28,668 5 \$28,668 6 \$28,668 IRR 26.52%

 Year Annual cash flows Cumulative cash flows 0 -160000 -160000 1 \$28,668 (\$131,332) 2 \$153,932 \$22,600 3 \$28,668 \$51,268 4 \$28,668 \$79,936 5 \$28,668 \$108,604 6 \$28,668 \$137,272 Payback Period 2.85

ii) As per the question there are three indicators namely the net present value, the payback period and the internal rate of return. These three are the normal indicators that are stated as the criteria for the company to decide whether the project shall be accepted or rejected.

Net present value is basically the value which is arrived after subtracting the cost of investment from the summation of the annual cash flows for the rest of the 6 years. The net present value of the real estate construction company is \$62948. The positive figure indicates that the investment that the company has made possess the grater present value than its future value.

Payback period is that kind of period which shows in how much time the company is able to recover the cost of the investment. The ability to recoup the funds is the measuring criteria in deciding whether the current proposal shall be accepted or rejected. The payback period is 2.85 which are considered as the great timing period. This can be ensured by the fact that from the period of the 6 years the company can recoup the funds in almost 2.85 years hence forth it is advised to the company that the project shall be accepted on account of the sound payback.

The internal rate of return is the other concept that is used to decide whether the project shall be accepted or in other words it can be described as whether the funds shall be invested or not. The internal rate of return is the discounting rate at which the net present value of all the cash flows from a particular project becomes to zero. The internal rate of return of the real estate company is 26.52%. This indicates that the rate of return is more than the cost of capital and it is beneficial for the company to invest in the project for the future growth (INTERNATIONAL FINANCIAL REPORTING TOO, 2018).

iii) The other consideration that needs to be taken by the company when establishing the new project is profitability index, policy of taxation followed by the company, the accounting methods for recording the sales and the other expenses. Beside this the external factors that are affecting are the inflation, ethical issues taking place within the company, the capital available and the managerial decisions. These are the factors that shall also be kept in mind while taking the final decision of whether the project shall be accepted or not apart from the net present value, internal rate of return and payback period (Money Matters, 2018).

iv)The new project can be accepted in both the situations if the net present value is the criteria for deciding whether the project shall be accepted or not. In case of less than 3% the net present value is \$79922 and in case of more than 3% the net present value fell down the \$47866. Hence the project shall be accepted in both the cases (Wall Street Mojo, 2017).

v) In case of the residual value the value remains unchanged as the depreciation is added back after deducting it from the profits. So overall from the point of view of the annual cash flows the residual value has no significance. In case of calculation of the net present value, payback period or IRR the value has no effect as the dual recording takes place.  The only affect will be in the life expectancy of the asset that is acquired by the company.

References

Accounting tools, (2017) the advantages of budgeting include [Online] Available from https://www.accountingtools.com/articles/what-are-the-advantages-of-budgeting.html [Accessed on 26th March 2019]

Gallo, A (2014) A Refresher on Net Present Value [Online] Available from https://hbr.org/2014/11/a-refresher-on-net-present-value [Accessed on 26th March 2019]

INTERNATIONAL FINANCIAL REPORTING TOO, (2018) Residual value [Online] Available from https://www.readyratios.com/reference/accounting/residual_value.html [Accessed on 26th March 2019]

Karmakar., R, (2018) Capital Budgeting: Meaning, Definition and Importance [Online] Available from https://www.yourarticlelibrary.com/accounting/capital-budgeting/capital-budgeting-meaning-definition-and-importance/66509 [Accessed on 26th March 2019]

Money Matters, (2018) Factors influencing capital expenditure decisions [Online] Available from https://accountlearning.com/factors-influencing-capital-expenditure-decisions/ [Accessed on 26th March 2019]

Strategic Management, (2017) Advantages and Disadvantages of Budget Control [Online] Available from https://www.strategic-control.24xls.com/en211 [Accessed on 26th March 2019]

Wall Street Mojo, (2017) INTERNAL RATE OF RETURN (IRR) [Online] Available from https://www.wallstreetmojo.com/internal-rate-of-return-irr/ [Accessed on 26th March 2019]

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[Accessed 04 August 2024].

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