Cost Management and Financial Accounting
Seminar Question:OJ Ltd is a medium size business operating in the home decoration sector. It produces wallpaper in bright contemporary colours for sale in the wholesale and retail markets. The product development director has identified two capital investment projects which she believes will help the company appeal to new markets and so improve its profitability. Project D concerns the development of a type of Shower panels, and Project G concerns a type of kitchen wall covering.Your line manager believes wonders if Project G is a better option if it has a higher Accounting Rate of Return (ARR).
The company’s cost of capital is currently 8%. The company only has the investment capital to undertake one of the two projects. Details of the investments required and the expected annual cashflows from the two projects over their five-year lives are as follows:
Project D Project G £ £ Initial capital expenditure 0 750,000 620,000Additional Cash-inflows per year 1 290,000 131,000 2 200,000 151,000 3 180,000 161,000 4 165,000 181,000 5 160,000 196,000Resale value of equipment 5 200,000 150,000 Required:
1) Determine the financial viability of each project by calculating each project’s:i. Payback period.ii. Accounting rate of Returniii. ii. Net Present Value.iv. Discuss your findings and make a recommendation to management on which project to undertake.
2) Critically appraise the use of the Net Present Value (NPV) method, The Payback period method and the Accounting Rate of Return for investment appraisal.
3) Explain to a non-accountant what is meant by the terms cost of capital and the hurdle rate.
Cost Management and Financial Accounting
Student name
Institution
Professor
Course
Date
Cost Management and Financial Accounting
The Total Cost of the New Car to be Treated as Part of the Business’s Property, Plant and Equipment
Particulars Cost (£)
New BMW 3 series 34,350
Delivery charge 280
Alloy wheels 860
Sunroof 600
Number plates 130
Road fund licence 150
Total Cost 36,370
Seminar Question
OJ Ltd Financial Viability of Projects D and G
* Payback Period
Year
Project D
Project G
Cash flows (£)
Cumulative cash flows (£)
Cash flows (£)
Cumulative cash flows (£)
0
(750,000)
(620,000)
1
290,000
290,000
131,000
131,000
2
200,000
490,000
151,000
282,000
3
180,000
670,000
161,000
443,000
4
165,000
835,000
181,000
624,000
5
160,000
196,000
Payback period for project D is 3 years and some months. Therefore, the remaining amount is initial capital expenditure - cumulative cash flows up to year 3 = £750,000 - £670,000 = £80,000. If £165,000 represents 12 months in year 4, therefore £80,000 represents (£80,000/ £165,000) X 12 months = 5.8 months. Hence, the payback period for project D is 3 years, 5 months and 24 days.
Payback period for project G is also 3 years and some months. Therefore, the remaining amount is initial capital expenditure - cumulative cash flows up to year 3 = £620,000 - £443,000 = £177,000. If £181,000 represents 12 months in year 4, therefore £177,000 represents (£177,000/ £181,000) X 12 months = 11.7 months. Hence, the payback period for project G is 3 years, 11 months and 21 days.
* Accounting Rate of Return
Accounting rate of return = average annual profit/ average investment
Annual profit = annual cash flows – annual depreciation
Assuming straight line method, annual depreciation = (cost – resale value)/useful life
Accounting Rate of Return for Project D
Annual depreciation for project D = (cost – resale value)/useful life
= (£750,000 - £200,000)/5 years = £110,000
Annual profits for project D are as follows.
Year
Cash flows (£)
Depreciation (£)
Profits (£)
1
290,000
(110,000)
180,000
2
200,000
(110,000)
90,000
3
180,000
(110,000)
70,000
4
165,000
(110,000)
55,000
5
160,000
(110,000)
50,000
Average annual profit = Total profit/ useful life
= (£180,000 + £90,000 + £70,000 + £55,000 + £50,000)/5 = £445,000/5= £89,000
Average investment = (initial capital expenditure + resale value of equipment)/2
= (£750,000 + £200,000)/2 = £475,000
Therefore, accounting rate of return for project D = £89...
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