BUS106 Accounting for Business : Net Present Value
Questions:
1.Delcom Chemicals is considering the purchase of a new industrial business for $800,000. The current owners have provided Delcom Chemicals with their financial information which has shown that they will expect a profit of $200,000 in year one, $210,000 in year two, $300,000 in year three, $320,000 in year four, and $340,000 in year five.
Using the information above, Calculate the net present value (assuming a discount rate of 13%), payback period and accounting rate of return (disregarding depreciation).
Net Present Value
200,000/(1+.13)+210,000/(1+.13)2+300,000/(1+.13)3+ 320,000/(1+.13)4+ 340,000/(1+.13)5- 800,000= $253,907.01 using the formula.
Using the table=
2.In your own words using appropriate references, provide a discussion about what these ratios calculate and whether they show that this investment should go ahead or not.
3.Delcom has also been provided with the opportunity to purchase an existing chemical plant for $800,000. Information to help them determine their future cash flow for the new business if they were to purchase it is shown below for the next 4 months starting in January. Assume that there is 4 weeks in every month.
Total monthly running costs:
- 14 staff members who will work 7.5 hours a day, 5 days a week at $26.50 per hour.
- Raw materials $300,000
- Electricity $100,000
- Administration $40,000
Delcom has been told by the current owners that they sell 400 tons of chemicals per month at a cost of $1600.00 per ton. If the business is purchased, Delcom intends to have $100,000 in the business bank account.
Using the information above, construct a sales budget and a labour budget for January, February, March and April.
4.In your own words using appropriate references, describe what each of these budgets are and state what they tell you about this business.
5.In your own words using appropriate references, critically analyse, describe and state which business should be purchased.
Answers:
1.Calculation of net present value
|
Year |
Cash inflow |
Disc @ 13% |
Discounted cash flow |
|
0 |
$ (800,000.00) |
1 |
$ (800,000.00) |
|
1 |
$ 200,000.00 |
0.885 |
$ 177,000.00 |
|
2 |
$ 210,000.00 |
0.783 |
$ 164,430.00 |
|
3 |
$ 300,000.00 |
0.693 |
$ 207,900.00 |
|
4 |
$ 320,000.00 |
0.613 |
$ 196,160.00 |
|
5 |
$ 340,000.00 |
0.543 |
$ 184,620.00 |
|
Total |
$ 130,110.00 | ||
Calculation of payback period
|
Year |
Cash inflow |
Cumulative cash flow |
|
0 |
$ (800,000.00) |
|
|
1 |
$ 200,000.00 |
$ 200,000.00 |
|
2 |
$ 210,000.00 |
$ 410,000.00 |
|
3 |
$ 300,000.00 |
$ 710,000.00 |
|
4 |
$ 320,000.00 |
$ 1,030,000.00 |
|
5 |
$ 340,000.00 |
$ 1,370,000.00 |
Payback period = 3 + ($ 800,000 - $ 710,000) / $ 320,000 = 3.28 years
Calculation of accounting rate of return
Accounting rate of return = Average net profit / Average investment
= ($ 13,70,000 / 5) / ($ 800,000 / 5)
= 1.7125 years.
2.Various methods are used for analysing the acceptability and feasibility of a project or investment. These methods includes the net present value (NPV) approach, accounting rate of return (ARR) approach, payback period and internal rate of return (IRR). Under the payback period method the project is considered as acceptable if the initial investment of the investor is recovered within the asset’s useful life or the time set by the company (Shaban, Al-Zubi & Abdallah, 2017). However, every company has different payback period. Various companies are there that prefer for the payback period that is shorter than the useful life of the asset. Therefore, the payback period is an important factor that must be taken into account while assessing the acceptability of any project (Rossi, 2015). In the given case, the project’s useful life is 5 years whereas the payback period of the project is calculated as 3.28 years. Therefore, if the payback period is taken into consideration to assess the acceptability of the project, the project shall be accepted as the payback period is less than the useful life of the project (Drury, 2013).
On the other hand, the net present value is the difference among the present value of cash outflows and the present value of cash inflows of any project. The NPV approach is used for analysing the profitability and feasibility of the project. If the PV of cash inflows is more than the PV of cash outflows that is if the NPV is positive then the project is considered as profitable and is accepted (Goyat & Nain, 2016). However, if the NPV of the project is negative then the project is not considered as feasible and is not accepted. In the given situation, the project has a useful life of 5 years and the required investment for the project is $ 800, 000. Further, the discounting rate is 13%. After considering the discounted cash inflows the net present value of the project comes to $ 130,110. Therefore, it can be identified that the project is generating positive cash inflows and can be considered as feasible and acceptable (Bora, 2015). However, the ARR of the project is only 1.7125 as against the required rate of return for 13%. Therefore, if only the ARR is considered then the project shall not be accepted. However, taking into consideration all the other method like payback period and NPV
3.Sales budget
|
Moths |
Sales |
|
January |
$ 640,000.00 |
|
February |
$ 640,000.00 |
|
March |
$ 640,000.00 |
|
April |
$ 640,000.00 |
The assumed sales levels per month were 400 tonne and the cost per ton was $ 1600. Therefore, per month sales amount will be = $ 1600 * 400 = $ 640,000.
Labour budget
|
Moths |
Labour cost |
|
January |
$ 55,650.00 |
|
February |
$ 55,650.00 |
|
March |
$ 55,650.00 |
|
April |
$ 55,650.00 |
The assumed cost of the labour was $ 26.50 per hour and the timings were 7.5 days per day and the weeks were considered as 4 weeks per month. Therefore, the labour cost comes to = 7.5 Hrs * 5 days * 4 Week * $26.50 per Hr *14 labours = $ 55,650
4.The companies use the saes budget for preparing the financial plan with the help of the projected sales volume and revenue amount (Whitecotton, Libby & Phillips 2013). The sales budget is used to assess the estimated sales levels along with the help of estimated sales price and estimated sales units. As per the given situation, the company is expected to sell 400 units tonne per month at the rate of $ 1600 per tonne all for the 4 months including January, February, March and April. The labour budget on the other hand, measures the amount of labour cost taking into account the total required labour hour, number of labours required, labour rate per hour and time required per month. As per the given situation and above calculation the required number of labour per month was 14, required labour hours were 7.5 hours per day where the working times were 5 days per week for 4 weeks per month (Braun et al., 2014). The labour rate was $ 26.50 per hour. Therefore, the total labour cost calculated as $ 55,650. As per the given information, there are no possibilities that the company is expecting any reduction or increase in the labour hours. Therefore, labour costs will also be stable over the period under concern (Klychova, Faskhutdinova & Sadrieva, 2014). Thus, the production levels are also expected to be the same.
5.Cash inflow calculation for the chemical plant
|
Particulars |
Amount per month |
|
Sales |
$ 640,000.00 |
|
Less |
|
|
Labour cost |
$ 55,650.00 |
|
Raw material |
$ 300,000.00 |
|
Electricity |
$ 100,000.00 |
|
Administration |
$ 40,000.00 |
|
Total expenses |
$ 495,650.00 |
|
Profit |
$ 144,350.00 |
|
Profit for 4 months |
$ 577,400.00 |
|
Less |
|
|
Purchase cost of machine |
$ 800,000.00 |
|
Requirement in bank account |
$ 100,000.00 |
|
Total requirement |
$ 900,000.00 |
|
Cash inflow |
$ (322,600.00) |
It is recognized from the above cash flow statement that if the company opts for purchasing the chemical plant then it will not be able to generate any positive cash inflow and the negative cash inflow will be amounted to $ 322,600. Thus, the company shall opt for purchasing the industrial business to get positive cash inflow.
References
Bora, B. (2015). Comparison between Net Present Value and Internal Rate of Return. International Journal of Research in Finance and Marketing, 5(12), 61-71.
Braun, K. W., Tietz, W. M., Harrison, W. T., Bamber, L. S., & Horngren, C. T. (2014). Managerial accounting. Pearson.
Drury, C. M. (2013). Management and cost accounting. Springer.
Goyat, S. & Nain, A, (2016). Methods of Evaluating Investment Proposals. International Journal of Engineering and Management Research (IJEMR), 6(5), pp.278-280.
Klychova, G. S., Faskhutdinova, ?. S., & Sadrieva, E. R. (2014). Budget efficiency for cost control purposes in management accounting system. Mediterranean journal of social sciences, 5(24), 79.
Rossi, M. (2015). The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), 43-56.
Shaban, O. S., Al-Zubi, Z., & Abdallah, A. A. (2017). The Extent of Using Capital Budgeting Techniques in Evaluating Manager’s Investments Projects Decisions (A Case Study on Jordanian Industrial Companies). International Journal of Economics and Finance, 9(12), 175.
Whitecotton, S., Libby, R., & Phillips, F. (2013). Managerial accounting. McGraw-Hill Higher Education.
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