Accounting For Business

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Questions:

Question 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).

Question 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.

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Question 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.

Question 4

In your own words using appropriate references, describe what each of these budgets are and state what they tell you about this business.

Question 5

In your own words using appropriate references, critically analyse, describe and state which business should be purchased.

Answers:

Question 1.

Calculation of Net Present Value

Discount rate = 13%

Evaluation of NPV
YearsCash flows ($000)pvf@13%Present values
0-8001-800
12000.884955752176.9911504
22100.783146683164.4608035
33000.693050162207.9150487
43200.613318728196.2619929
53400.542759936184.5383782
NPV130.1673737

Pay-Back Period

Evaluation of Pay-back period
YearsPresent valuesCumulative Present Values
0-800 
1176.9911504-623.0088496
2164.4608035-458.548046
3207.9150487-250.6329974
4196.2619929-54.37100451
5184.5383782130.1673737
Pay-back period4.294632504

Accounting Rate Of Return

Evaluation of ARR
YearsCash Inflows
0 
1200,000
2210,000
3300,000
4320,000
5340,000
Average accounting income274,000
ARR0.3425

Question 2.

In order to know about the financial viability of an investment proposal, various methods are used for its appraisal. Net Present Value is one of those methods which is used to determine the profitability of the project in which the money is invested. The method calculates the future present values of cash flows on the basis of which the project is accepted or rejected. It is basically known as a simple accounting difference between PV of cash inflow and PV of cash outflow. NPV can be positive, negative and Zero. If it is positive it means the project can be accepted and if it is negative than it is better to reject the project. If NPV is equal to zero, then proposal can be accepted or rejected because the PV of cash inflows will be equal to PV of cash outflows (Bierman and Smidt, 2012).

Pay-back period is used to calculate the duration of time taken by a project to recover the initial investment. In other words, it means how long a proposal will take to recoup the money invested in it. This method helps the investors in taking decision regarding the investment to be made in a particular proposal (Damodaran, 2010).

Accounting Rate of Return (ARR) also known as average rate of return and is calculated by dividing the average of cash inflows with the cash outflow. If ARR is equal to more than the required rate of return then the project is acceptable and if it is less than it should be rejected (Brealey, et al. 2012).

Delcom Chemicals is interested in purchasing a new industrial business which requires an initial outlay of $800,000. The NPV of this project is 130.16 and its payback period is 4.29 years. Although the project has a positive NPV but in its five years of life it will take 4.29 years to recover the initial investment. Also the ARR is 34% which is more than the required rate of return. This means that the project will earn more than the required rate of return. So, having a positive NPV and a high Accounting rate of return, the project should be accepted (Atrill and McLaney 2009).

Question 3.

Delcom sales budget for January-April
 JanuaryFebruaryMarchApril
Sales units (tons)400400400400
Sale price ($)1600160016001600
Total sales ($)640000640000640000640000
Delcom Labour budget for January-April
 JanuaryFebruaryMarchApril
No. of Labours14141414
Labour hours required7.57.57.57.5
Labour Rate per hour ($)26.526.526.526.5
No. of working days20202020
Total labour Cost ($)55650556505565055650

Question 4.

Sales budget is the first component of master project. It shows the sales units of a particular period and the sales price per unit and also their product as total sales. The other components of master budget like production budget and many more are prepared on the base figure given by sales budget (Weygandt, Kimmel and Kieso, 2009).

Labour budget shows the total labour cost and labour hours required for the production. It is a component of master budget and is prepared after the production budget, which gives the number of units to be produced (Marsh, 2013).

Delcom also has an opportunity of purchasing an existing chemical plant for $800,000. For this the company has prepared a sales budget and a labour budget for 4 months starting from January. The sales budget of the company shows that the company has sold 400 tons of chemical at the rate of $1600 per ton in every month. The total sales remains the same for each month that is $640,000. On the other side, labour budget shows that the labours of the company requires 7.5 hours per day at a rate of $26.50 per hour for producing specified units. The total labour cost for each month is $55650.

Question 5

As it is clear that, to evaluate first proposal, investment appraisal methods are used which are NPV, ARR and pay-back period. For the evaluation of second proposal, labour and sales budget are prepared. So it is not possible to compare between the two proposals because the evaluation methods which are used are not the same and cannot be comparable (Baker and English, 2011). However, considering the NPV of first project and profit of second, it can be seen that the more profit is earned by investing in second business that is purchase of an existing plant, although profit and NPV both are different and cannot be compared. Moreover, unlike first proposal, the company can cover its initial outlay and its labour cost within the four years if it invest in the second project. So it is better for the company to go for option second in order to earn profits and recover its costs. 

References

Atrill, P. and McLaney, E., 2009. Management accounting for decision makers. Pearson Education.

Baker, H.K. and English, P., 2011. Capital budgeting valuation: Financial analysis for today’s investment projects (Vol. 13). John Wiley & Sons.

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

Brealey, R.A., Myers, S.C., Allen, F. and Mohanty, P., 2012. Principles of corporate finance. Tata McGraw-Hill Education.

Damodaran, A., 2010. Applied corporate finance. John Wiley & Sons.

Marsh, C., 2013. Business and financial models. Kogan Page Publishers.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2009. Managerial accounting: Tools for business decision making. John Wiley & Sons.

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