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Importance Of Decision Making Of A Company

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Questions:

1.How much of the information which he had gathered was really relevant to the Decision? 
 
2.What was the best approach to assessing the Economic worth of the proposal?
 
3.Cash was particularly limited this year and acceptance of this project could mean that other projects would have to be deferred. How should this be taken into consideration?  
 
4.How should the Strategic factors be assessed?
 
 

Answers:

Introduction

George Panios is appointed as the finance manager of the Delphi Cones and Tubes Plc and has been entrusted with 24 hours to ascertain the profit projections of the accountant and needs to recommend a plan within 24 hours. Various discussions from the meeting needs to be taken into consideration for the purpose of decision making. Since, it is a machine it needs to be studied from the perspective of the life span and useful year. It is clearly mentioned that the machine can raise only £20,000 at the end of the period. Further, the opening stock in the initial year will be acquired at the same time with the machine.  The details says that the depreciation of the machine will be done over six years on the straight line basis.

1.The new machine namely Computer Numerically Controlled (CNC) milling machine has a capital cost of £ 2, 40,000. The company needs to consider a lot of important issues before making such a huge investment. The investment in this new machine and the project to be undertaken has a lot of factors that need to be considered such as the alternate use of machinery, its expected useful life, availability of parts of such machinery etc.

 


The information gathered by Mr. George is scattered although most of the information is relevant. The relevant information can be summed up in following points:

  1. The initial capital cost for purchasing the new machinery will be £ 2,40,000.
  2. The machinery is not useable for any other project.
  3. At the end of the project, it is estimated to realize only £ 20,000.
  4. The machine is to be depreciated as per straight line basis method in six years.
  5. Fixed overheads are known.
  6. The additional expenses on advertising and publicity are known if the new machinery is put to use in the new project (Porter & Norton, 2014).
  7. Further, the launch of the new project will reduce the sale of another project by £ 60,000 annually.

Apart from the information above, other information is also available which includes the rate of return, a recommendation from the chief manager, the margins expected for net profit and gross profit, etc.

The information available with Mr. George is material but at the same time, the projections given by the accountant seem unrealistic. The reason is that the flow of sales in the 4th year has been shown as falling drastically. Moreover, the expenses also are showing a dissimilar trend in the year after 1st year. Mr. George is advised to compile all the information himself in order to analyze the profitability and the production capacity of the new machine and new project. This will help in proving concrete information and aims to provide to provide better information that will aid in the process of decision making (Porter & Norton, 2014).

2.The company used discounted payback method to assess the economic worth of the proposal. Although, it is a good method to know that when the company will be able to recover the amount that has been invested by the company in the new proposal. The discounted payback period method does not include non-financial factors like employee’s honesty and punctuality. Such factors play an important role and hence, needs to be ascertained properly. But, there are few inherent limitations of payback methods due to which it cannot be solely taken as the only approach to economic worth assessment. These limitations should also be kept in mind by the management while assessing the product viability. The management should use these methods in combination with traditional methods of measuring project profitability (Davies & Crawford, 2012). Using the method in combination will provide a better result and deriving at a conclusion will be easier.

 


The limitations are that it does not take into consideration time value of money while taking into accounts the inflows and outflows of the upcoming years. Further, this method does not consider the cash inflows that are estimated after the payback period and hence this method does not accurately calculate the overall profitability of the proposal (Brigham & Daves, 2012).

Hence, the payback method should be used in combination with other methods of appraisal such as IRR, NPV, Profitability Index, etc. as also suggested by Mr. George. This method is more worthy and a modern day technique which gives us a new prospect at looking at the product. The product is to be analyzed at all prospects like profitability, break-even, the age of the product, scrap value and payback period (Peirson et. al, 2015).

The other discounted cash flow methods should also be used in combination with payback method due to its following merits

The discounted cash flow methods consider the time value of money while calculating the profitability of a proposal. This is a very important thing to consider because the inflows and outflows of cash during the tenure of the project cannot bear the same value of money as it bears today (Williams, 2012). Hence, the cash flows should be brought to the present value first so that they can be compared with the capital investments being done at the initial stage of the project. This can be done using the discounted cash flow techniques only (Petty et. al, 2012).

These methods help in making comparisons easy among the different projects which are dissimilar with regard to time period, cash inflows, initial investment, etc.

These methods help in quick and easy decision making.

These methods are important in analyzing the project and find out the project feasibility.

This method is latest and up to date techniques. These methods do not assume traditional methodology (Needles & Powers, 2013). Hence modern day managers prefer these over old methods.

 


3.The product has a 4-year life so we have to analyze whether the cash outflow on the machine is able to generate some profit over its lifespan. The accountant has not considered the scrap the product shall arise after the end of 4 years. The product life has been taken at 4 years and the depreciation calculation shall be revised and calculated as below:

New depreciation: 240-20 / 4   = 55 £

It will increase the depreciation by 15£ which has been incorporated in the chart shown below.

Also, fixed overheads have already been expensed and it shall in the case be incurred even if the product is not purchased, hence it shall be ignored i.e. 20% of total labor costs every year which has been included in other production expenses. This cost should not be included again in the product expenses as these are incurred for the new product (Northington, 2011). The accountant has also not considered the scrap value of 20,000 £ and annual benefits of 16000 £. Both the scrap value and the annual benefits have been included in the profit loss statement. We have below incorporated all the financial changes in the arrived profits of four years. These recommendations have been added or deducted as per its treatment.

Profit & Loss Statement (revised)

Particulars

2018

2019

2020

2021

Profit

(96)

(48)

72

(16)

Less: Depreciation

15

15

15

15

Add: Fixed Overheads 20%

16

24

24

16

Add: Scrap Sale

20

 

 

 

 

Add: Cash Benefits

16

16

16

16

Less: Rate of Return 10%

24

24

24

24

Total

(83)

(47)

73

(23)

The product figures have revealed that there are continuous losses even after the changes have been made the organization. The loss means that the management should not take up the project. The project is not able to produce profits even after reviewing and revising the figures. Hence it is clearly evident that project is loss making project (Brigham & Ehrhardt, 2011). The opportunity cost of losing sales of another product shall further increase the loss of the product, so the product should not be purchased. The company is also facing a cash crunch in their company financials so it is more important for the company to preserve its cash reserve. The company shall have to pay interest on the loan which is to be taken to purchase the product. The company can save on these interest payments, which shall not be paid if the loan is not taken. The suggestion to the company is that the product should not be purchased as it is a loss making venture. The cash availability can be increased by utilizing the available resources in the organization. The cash has been carefully spent and should be preserved. The tax payments also require cash so its availability should be kept well in advance. The management has to cut down its cash expenses and increase cash revenues in the company (Correia et. al, 2005). Cash has multi-dimensional users in the organization for entire payments and capital expenditure.

Before setting up the strategy of the organization, the goals, external environment, available resources, and organizational structure and history should be understood and accordingly be strategies should be developed. These are the most important factors to be kept in mind by the strategy makers. These factors are primarily important for the success of the organization in long term (Brealey et. al, 2011).

 


The strategic factors should be based on the whether the opportunity cost of product or project was undertaken is able to be covered by the product or project revenues. The strategy of the top management should be both short term and long term oriented so that both profits and break even may be achieved (Brealey et. al, 2015). Initially, the product/project should be able to cover its cost i.e. break even (cost= revenue) and gradually the product/project should gain profits. The strategy factors should be carefully able to judge the life of the product/project which afterward shall be scrapped. The organization should see whether taking up the new venture effects its existing capacity is utilized or whether existing capacity is to be released. Hence the strategy of the organization is to be maximizing its profits at lowest costs. The cost benefits analysis is also one of the strategy factors to be kept in mind (Parrino et. al, 2012). The organization shall be able to gain the minimum risk-free rate which is available in form of treasury or government bond rates. In case the project is able to earn risk-free rate, the project can be undertaken (Shah, 2013). The project is to be analyzed on the basis of NPV criteria which say that the yearly revenues can be discounted at a predetermined rate and it should be matched with probable initial outflow and in case the result is positive the project is viable and can be pursued further

Conclusion

From the above report, it is evident that the project needs to be evaluated on the basis of the NPV criteria because there are various advantages associated with the project. The major benefit that can be attained is that the yearly revenue can be discounted. Ratio analysis should also be done while considering strategic factors. Ratios such as current ratio, net profit ratio, gross profit ratio, interest coverage ratio, debt service ratio etc should be calculated and taken into consideration while assessing the profitability of the new venture in its entire tenure. Therefore, the decision making should not be done considering a single factor and must be done with the aid of various factors. In the above case, NPV is selected to attain the result and in this scenario, if the result is positive then the project is viable and can be pursued further.

 

References

Brealey, R. A, Myers, S. A & Marcus, A. J., 2015. Fundamentals of Corporate Finance, 8th ed. Australia: McGraw-Hill Irwin.

Brealey, R, Myers, S & Allen, F 2011, Principles of corporate finance, New York: McGraw-Hill/Irwin.

Brigham, E. & Daves, P 2012,  Intermediate Financial Management , USA: Cengage

Brigham, E.F. & Ehrhardt, M.C 2011, Financial Management: Theory and Practice, USA: Cengage Learning.

Correia, C, Mayall, P, O'Grady, B & Pang, J 2005, Corporate Financial Management, 2nd ed. Perth: Skystone Investments Pty Ltd.

Davies, T & Crawford, I 2012, Financial accounting, Harlow, England: Pearson.

Needles, B.E. &  Powers, M 2013, Principles of Financial Accounting, Financial Accounting Series: Cengage Learning.

Northington, S 2011, Finance, New York, NY: Ferguson's.

Parrino, R, Kidwell, D & Bates, T 2012, Fundamentals of corporate finance, Hoboken, NJ: Wiley

Peirson, G, Brown, R., Easton, S,   Howard, P & Pinder, S 2015, Business Finance, 12th ed., North Ryde: McGraw-Hill Australia.

Petty, J. W,  Titman, S., Keown, A. J., Martin, J. D., Burrow, M & Nguyen, H., 2012, Financial Management: Principles and Applications, 6th ed., Australia: Pearson Education Australia.

Porter, G & Norton, C 2014, Financial Accounting: The Impact on Decision Maker, Texas: Cengage Learning

Shah, P 2013, Financial Accounting, London: Oxford University Press

Williams, J 2012,  Financial accounting, New York: McGraw-Hill/Irwin.

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