FIN4001 Introduction To Finance

The proposal of acquisition of a new machine i.e. the robotics systems by Terra Nova Plc requires huge investment of funds amounting £4,150,000. These investments are generally irreversible in nature therefore requires the critical evaluation using different tools and techniques of capital budgeting. Since, such an investment is to be made before taking up the project; the company must evaluate the appropriateness of the project from the financial viewpoint. There are various techniques of capital investment appraisal under the financial management studies which can be used to evaluate the project’s risk and return potential.  Such techniques are Net Present value method, Payback method, Average annual accounting rate of return etc. (Baker and English, 2011)

Net present value method is the most common and easy method of capital investment appraisal. It determines the present value of net cash flows associated with the project. This technique helps the project manager to determine the return potential of the project over a period of time (Bierman Jr and Smidt, 2012). A project with positive NPV is favourable to be accepted by the firm as it shows that the proposed project has the potential of generating returns for its stakeholders. In the present case of Terra Nova Plc., the net present value of the proposed project is positive and hence it indicates that the company must accept the project as per the NPV technique (Bogsnes, 2016)

Payback period is also a key technique of capital budgeting as it determines the period within which the project will recover its initial investment. After achieving the payback period project starts generating returns in the form of cash inflows (Hise and Strawser, 2013). In the present case the director of the company wants to set the payback period of 2 years but when the payback technique is applied to the proposed project it has resulted in the payback period of 3.96 years which is quite higher than the budgeted standard and also it covers the substantial part of project’s life.  It signifies that the project will not be able to recover its initial costs within a reasonable time. Therefore, the project must not be accepted on the basis of Payback period.

Average annual rate of return takes into account the account the accounting profits of the project (Bogsnes, 2016). It is the rate of return of the project. In the present case the director has set a target of 50% of the ARR of the project. However, the ARR as determined by the application of ARR method is 87%. Higher ARR indicates higher project’s return and according to this method the project must be accepted.

Overall recommendation:

As two out of 3 techniques of capital budgeting are showing positive results towards the acceptance of project, the project must be accepted.

Before accepting the additional offer, the firm must consider both financial as well as non-financial factors to determine its feasibility in all the aspects. The non-financial factors that must be considered in the present case of AstraLens plc can be as follows:

• Political and legal relations with the new client:

As the additional order is placed by the overseas clients, the firm must consider whether it is legally permissible to maintain business relations with the potential clients. If the firm requires to hold any licence to deal with such overseas clients as per the regulations of the government of the country.

• Competitor’s policies and prices:

Before accepting the additional order, firm must take into account the competitive policies to achieve the competitive advantage over the rival firms in the market. If the competitors are also willing to take up the order, the firm must analyse the potential reasons lying behind the acceptance of overseas offers (Koller, Goedhart and Wessels, 2010).

• Availability of requisite resources:

Before accepting the order, the firm must take into account the considerations regarding the

availability of necessary resources to meet the demand of new customers. If the firm does not possess requisite resources such as required additional labour, machines, new techniques of production as required by the new clients etc., it must not accept the new order as it would lead to mismanagement of existing orders also.

Marginal costing analysis is undertaken when the firm wants to analyse the cost and benefits associated with the activity that is to be taken in addition to the original activities. Firms use this analysis to undertake informed decision making while accepting an additional order or activity. It facilitates them to determine the potential profitability of a new unit, order etc. The additional costs that are ascertained under the marginal costing analysis is known as marginal costs. Marginal costing analysis has various key advantages to be used by the managers of the firms. They are discussed below:

Advantages:

It is a simple approach to understand the variable cost and fixed cost associated with the product. As marginal costing analysis does not take into account the fixed costs, it gets easier for the firms to apply this technique.

Moreover, the marginal costing uses contribution as a key tool to undertake effective managerial decision making. Marginal costing analysis conveys more clearly the effect of changes in the levels of profits and sales volume. In this way it enables the managers to take informed decisions. Further, the problems of overhead’s under-absorption or over-absorption under marginal costing analysis do not occur. Furthermore, marginal cost analysis supports the firm to take short term decisions in the effective manner. It also provides the entity a competitive advantage over other firms operating in the same industry as the firms can use it to determine the profit potential of additional work. Marginal costing analysis also helps the firm to maximise its productivity and efficiency by utilising its maximum capacity.

Disadvantages:

The major drawback of marginal cost analysis is that it does not take into account the fixed cost. Fixed cost constitutes major portion of the overall cost and it must be not ignored while making crucial decisions. It is quite difficult to pre-anticipate the degree of variability of the costs that are of semi-variable in nature. Under marginal costing analysis, it is assumed that the fixed cost remains same and does not change over the period of time (Hillier, 2012). However, in practical word, it does not happen so. Even the fixed cost changes with the changing time and also marginal costing works on the assumption that the variable cost change in the proportion of changes in the sales volume. However, in reality this assumption proves to be unrealistic (Kinney, Raiborn and Poznanski, 2011).

Cash Conversion cycle is a metric that couriers the measurement of time, in days, that is taken by a firm to change the inputs of the resources into cash flows. The cash conversion cycle tries to evaluate the time every net input dollar is tied up in the procedure of sales and manufacture before it is transformed into cash by sales to consumers.

Significance of Cash Conversion Cycle:

Studying the cycle of cash conversion for a business is a stimulating technique to measure the competence of the operations of the company. What it evaluates is how rapidly a business converts its goods into cash, and fortunately, it is very simple to compute from the available information. It helps in maintaining the liquidity position of a company by managing its current assets and current liabilities effectively and efficiently. It helps in determining the operationally strategy to efficiently manage the inventories, accounts receivables and accounts payable of the firm (Raheman, et. al., 2010). Such strategies help the firm to manage its cash flows from the business.

A company may allow trade credit to its regular customers. But excessive amount of credit provision can affect the firm’s operating cycle because of non-availability of the adequate amount of funds to carry out basic business operations. Therefore, the firm must remain concerned about converting its trade receivables into cash as soon as possible. There are various effective ways that can actually help the firm to achieve the objective of collection of amount owed by the trade debtors. These methods are:

• Use of accounts receivable software: This can helps the firm to maintain appropriate records of its receivables. These software provides help to the firm by regularly reminding the customers from whom the amount is due so that they can make early payments (Vogel, 2014).
• Negotiation the payment terms: A firm could accelerate its receivables collection by allowing them various discounting schemes for the early payments ((Madura, 2011).
• Outsourcing the collection work: This can help the company to effectively keep a track of all its receivables without even indulging in such kind of collection work. They can hire professionals of the related field for this purpose so that they can make regular efforts to convert the accounts receivables of the firm into cash. This is done in return of certain commission or outsourcing fees (Miori and Russo, 2011).

Traditional budgeting is one of the common tools of cost management accounting. It is used to forecast the business of an entity through the use of budgets.  Under this type of budgeting, the budgets statements for the current year are prepared by taking the budgets of the last years as a basis of estimation of costs and income anticipation.(Vogel, 2014). In the current year, the budgets are prepared by incorporating changes in the budgets of last year for the adjustments that are required to be made because of changed situation in the current year. There occur various activities and events which demand the changes in the budgeted information and data of the last year such as effect of inflation, changes in the consumer demands, changed market situation etc. Not only external factors demands changes in the budgets but also budgeted incomes and costs are changed due to changes that occur in internal environment such as purchase of new machine that has increased the efficiency of company, increased number of employees etc. (Réka, ?tefan and Daniel, 2014)

Traditional budgeting had some limitations that required to be solved and due to this advanced method of budgeting is introduced under cost management accounting such as activity based budgeting. The data provided to the managers in not accurate enough to help the managers to undertake effective decision making (Abdel-Kader, M.G. ed., 2011). Therefore, traditional budgeting is often criticized because it leads to incorrect decisions for the business.  It is easy for the managers to manipulate the projected results so as to make the actual results more attractive. Also, there is a little room to incorporate the impact of new and unexpected events that occurs in between the budgeting period in the budgets that prepared using the traditional approach. Hence it amounts to provision of out-dated information to the managers. Also, in the modern world, traditional costing does not prove to be effective as the traditional budgeting processes fails to sort the wastages into normal and abnormal wastages. If the organisation cannot understand how much wastage can normally be accepted in business and what would amount to abnormal wastage, it would not operate appropriately and the valuable resources would be wasted. Further, it takes considerable time to prepare the traditional budgets as it requires referring to the previous year budgets. In large organisations, where there is large amount of data requires to be processed to produce budgets, traditional budgeting fails to serve the purpose and produces inaccurate and unrealistic results.

References

Abdel-Kader, M.G. ed., 2011. Review of management accounting research. Springer.

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Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.

Bogsnes, B., 2016. Implementing beyond budgeting: Unlocking the performance potential. John Wiley & Sons.

Brigham, E.F. and Houston, J.F., 2012. Fundamentals of financial management. Cengage Learning.

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Hillier, F.S., 2012. Introduction to operations research. Tata McGraw-Hill Education.

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Kinney, M.R., Raiborn, C.A. and Poznanski, P.J., 2011. Cost accounting: Foundations and evolutions. Issues in Accounting Education, 26(1), pp.257-258.

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Madura, J., 2011. International financial management. Cengage Learning.

Miori, V. and Russo, D., 2011. Integrating online and traditional involvement in participatory budgeting. Electronic Journal of e-Government, 9(1), p.41.

Nas, T.F., 2016. Cost-benefit analysis: Theory and application. Lexington Books.

Raheman, A., Afza, T., Qayyum, A. and Bodla, M.A., 2010. Working capital management and corporate performance of manufacturing sector in Pakistan. International Research Journal of Finance and Economics, 47(1), pp.156-169.

Réka, C.I., ?tefan, P. and Daniel, C.V., 2014. Traditional Budgeting Versus Beyond Budgeting: A Literature Review. Annals of the University of Oradea, Economic Science Series, 23(1).

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