Applied management accounting techniques: budgeting and investment appraisal

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Management Accounting

[Name of Student]

[Name of Institution]

Table of Contents

Solution No. 01:

Budgeting and Variance Analysis

Solution No. 02:

Solution No. 3:

Cash Flow

Payback Period

Accounting Rate of Return

Net Present Value (NPV)

Reference

Solution No. 01:

Budgeting and Variance Analysis

Budgetary control is said to be parallel with a thermostatic control. Firstly, a budgetary control is a structured mechanism of controlling and continuous monitoring of a firm’s operations via instituting standards and criteria to evaluate the performances, whereas the latter one is a structure that is designed to control, maintain and regulate the temperature of a system according to the desired level. Both the concepts are connected to each other as they act as regulating mechanism to attain anticipated results. Budgetary control is linked to a thermostatic control in such a manner than when the temperature of a system falls below the decided level, which is then indicated by a thermometer, a the thermostat comes into play to initiate the heating device to reinstate again to the preferred temperature. Similarly, a budgetary control monitors and takes action, if any, of the function deviates from the standards (Atrill & McLaney, 2009, pp. 472).

An organization cannot be effective without a budgetary control as it sets targets for the firm and guides it all through way to accomplish it. A budgetary control is an essential element for regulating the business, in the same way as a thermostatic control is mandatory for an air conditioner to run. Without a budgetary control, no business can proceed in the long run as the operations will have no force for observing, monitoring and rectifying the errors. A budgetary control provides the foundation for an organization to gain centralized empowerment. Bruns and Waterhouse (1975) in a study point out the responsibility of the management that it must ensure that all the departments are operating in a centralized manner, striving to attain the organizational goals and avoiding interdepartmental conflicts. Likewise, a thermostat has a centralized heating function to regulate and set the temperature.

The thermostat can be adjusted as per the requirements and we can change the desired level of temperature by amending the criteria. Therefore, just like a thermostat, changes can be brought into the budgetary control by analyzing the previous outcomes through comparing the budgeted and the actual outcomes called variance. A budgetary control has a responsibility to manage the innumerable variety of components of a business like controlling expenses, forming an optimal case in production, synchronizing different departments and their activities and reassuring performance to reap profitability. Like a budgetary control sets standards similar to a thermostat control as per the need and desire, so it would not be wrong to comment that both at corresponding to each other.

  1. Beyond Budgeting

Budgeting traditionally comprises of the process of controlling and managing performance. Traditional budgeting involves setting targets, arranging and allocating resources for future action plans. However, due to the advancement of operations, practices and technology, a new term has been tosses named “Beyond Budgeting”. Fraser and Hope (2003) in an article reviewing emphasize that the traditional budgeting is old-fashioned as very few of the management tools are required to create shareholder value, instead, intellectual capital and innovative ideas are being demanded more. To maintain a sustainable competitive advantage, organizations must ponder over to form creative model. Due to the dynamicity of the external factors, the internal activities and methods also have to change. Employees must be empowered to use their abilities and skills to come up with innovative mean which can be done through decentralization. Value-creating teams can be structured and they should be provided with a high-performance climate to function. As compared to the business two or three decades back, today’s operations have gained much complexity. Now, it’s not only manufacturing and selling, but creating value for the customers more that the competitors.

As the environment changes, flexibility is required in planning and budgeting. Instead of forecasting annually or for long term, managers can forecast on the continuous rolling basis by examining the fluctuating factors (Daum, 2002, pp. 3).

In the conventional manner of budgeting, the company is unable to cope up with the competitive environment. It is also very time consuming as it is observed that one-fourth of the financial managers and officials time is dedicated to budgeting, however, still it is irrelevant when it comes to providing helpful material for decision making in the current dynamic environment. So to cope up with this problem, the solution of ‘Beyond Budgeting’ evolved. It shifted the focus of the relevant planning to innovation and creativity by expanding people’s horizon. Beyond budgeting expand the boundary by motivating through goal and strategies, quick reaction, responsive customer service and a high performing and learning environment. Due to this, different supporting departments like human resource have high relevance as they must ensure the quality of the workforce because employees should have important qualities like decision making. Therefore, businesses in today’s world must be flexible; therefore, they are shifting their focus from traditional budgeting to beyond budgeting.

Solution No. 02:

  1. When the funds are arranged through debt financing, the projected income statement for Cottesbrooke Engineers at the end of Year 10 is shown below. Following are the assumptions and explanation of the figures considered.
  1. Sales for Year 10 are the same as of the previous year.
  2. Operating profit is increased by £6 million for Year 10 due to the savings.
  3. For a loan of £20 million, 7% interest is to be paid each year with first year interest 20,000,000 x 7% = £1.4 million, which adds to £5 million forming a total of £6.4 million.
  4. Taxation: 30% of Profit before Taxation i.e. £14,600,000 x 30% = 4.38 million
  5. Profit in year 10 is increased by £4.22 million
  6. Dividend paid is the same as the number of shares remains 80 million

Cottesbrooke Engineers

Income Statement

For the year ended 31st December Year 10

Year 9

Year 10 Debt Financing

(£) in million

(£) in million

Sales Revenue

145

145

PBIT

15

21

Interest Expenses

(5)

(6.4)

Profit before Taxation

10

14.6

Tax expenses

(4)

(4.38)

Profit after Taxation (PAT)

6

10.22

Dividends Paid during each year

4

4

When the funds are arranged through equity financing by issuing 20 million shares, the projected income statement for Cottesbrooke Engineers at the end of Year 10 is shown below. Following are the assumptions and explanation of the figures considered.

  1. Sales for Year 10 are the same as of the previous year.
  2. Operating profit is increased by £6 million for Year 10 due to the savings.
  3. Interest for Year 10 are the same as of the previous year
  4. Taxation: 30% of Profit before Taxation i.e. £6,000,000 x 30% = £4.8 million
  5. Profit in year 10 is increased by £5.2 million
  6. Dividend paid is the same per share, but now the amount of share increase from 80 to 100 million, dividend paid is calculated as 4/8*10= 5million

Cottesbrooke Engineers

Income Statement

For the year ended 31st December Year 10

Year 9

Year 10 Equity Financing

(£) in Millon

(£) in million

Sales Revenue

145

145

PBIT

15

21

Interest Expenses

(5)

(5)

Profit before Taxation (PBT)

10

16

Tax Expenses

(4)

(4.8)

Profit after Taxation (PAT)

6

11.2

Dividends Paid during each year

4

5

The following shows the state of firms' share capital, reserves and borrowing on 31st December Year 10 for both the cases of financing.

For debt financing, the fixed assets are increasing by £20 million by introducing robots. As a loan of £20 million is taken, the non-current liabilities increase from 30 to 50 million.

In the case of equity financing too, the fixed assets increase to £20 million with the introduction of robots. However, on the other side, the impact is on equity, which is increased to £83 million from £63million with the issuance of shares worth £20 million.

Year 9

Year 10 - Debt Financing

Year 10 - Equity Financing

ASSETS

(£) in million

(£) in million

Noncurrent assets

64

84

84

Current assets

55

55

55

Total assets

119

139

139

EQUITY AND LIABILITIES

Equity

63

63

83

Noncurrent Liabilities

30

50

30

Current Liabilities

26

26

26

Trade Payables

18

18

18

Short-term borrowings

8

8

8

Total equity and liabilities

145

139

139

For debt financing, the fixed assets are increasing by £20 million by introducing robots. As a loan of £20 million is taken, the non-current liabilities increase from 30 to 50 million.

In the case of equity financing too, the fixed assets increase to £20 million with the introduction of robots. However, on the other side, the impact is on equity, which is increased to £83 million from £63million with the issuance of shares worth £20 million.

b) The following table represents the earnings per share in both case and projects that debt financing offers higher EPS of 18.25p than that of equity financing i.e. 16p.

Year 9

Year 10 - Debt Financing

Year 10 - Equity Financing

Profit after Taxation

10

14.6

16

Dividends Paid

4

4

5

Retained Earnings

6

6.22

6.2

Number of Shares Outstanding

80

80

100

EPS

0.125

0.1825

0.16

EPS

12.5p

18.25p

16p

c) For a shareholder, the main objective is wealth maximization that is offered by higher EPS through debt financing rather than equity financing. However, the shareholder may seek higher dividend offered by equity financing. Benartzi (2002) in a study mentions that the shareholder do not well define their preferences. The projections of the Year 10 for both cases of financing depicts that equity financing earns more profit after taxation, however, if we see the EPS, debt financing has the higher one due to the tax shield. If we base our analysis to Year 10, then debt financing is a preferable one, however, the loan repayment will be made in Year 11 which will lessen the retained amount after which a much clearer picture will be seen.

d) As we look at Cottesbrooke past records, it has been profitable and quite efficient. A bank demands assurance from such companies which they doubt to operate, but lend to those with previous good performance, reliable credit ratings and decent liquidity (Blumenthal, 2009). Banks are reluctant to give loans to new businesses unless provided with security, however, the firm is generating high returns which is an advantage to the company. Also, the bank is pretty much concerned not only in the long term loan, but also the interest which is quite high and included worries of inflation, bankruptcy threat etc. This will bring impact on the company’s working capital. If the submission of interest to the bank is auto from the current account, this may endanger the overdraft facility which may be taken care of by setting system alerts.

Solution No. 3:

a) Following are the required figures of the two projects

Cash Flow

Cash flow is calculated by adding all the inflows (profit, salvage value) and subtracting all the outflows (initial investment and depreciation).

Project T

Year

Inflow

Outflow

Salvage

Depreciation

Net

0

70000

-70000

1

15000

12000

3000

2

18000

12000

6000

3

20000

12000

8000

4

32000

12000

20000

5

18000

10000

12000

16000

6

2000

2000

NET CF

-15000

Project R

Year

Inflow

Outflow

Salvage

Depreciation

Net

0

60000

-60000

1

20000

20000

0

2

25000

20000

5000

3

(50000.00)

75000

0

20000

-145000

4

10000

10000

5

3000

3000

6

NET CF

-187000

Payback Period

It is the time period to recover the initial investment. It is calculated by dividing the initial investment by the average cash inflow

Average Inflow

Initial Outlay

Payback period

Project T

19166.67

70000

3.65

Project R

1600

60000

37.5

Accounting Rate of Return

Accounting Rate of Return =

Average Profit

Initial Outlay

ROR

Project T

9166.667

70000

13.1%

Project R

-25400

60000

-42.3%

Net Present Value (NPV)

All the future cash flows are discounted at 14% and initial investment is subtracted.

Year

T

Present Value

R

Present Value

70000

60000

1

15000

13157.895

20000

17543.85965

2

18000

13850.416

25000

19236.68821

3

20000

13499.43

(50000.00)

(33748.58)

4

32000

18946.569

10000

5920.802774

5

18000

9348.636

3000

1558.105993

6

2000

911.1731

Salvage Value

10000

5193.6866

0

NPV

4907.80

-49489.12

Project T seems a far better prospect as it has positive NPV, Paying back the investment in less than 4 years and have a positive rate of return.

b) Armstrong (2012) discusses the advantages and disadvantages of all the methods. The flaw in payback method is that it does not discount back the cash flows displaying and unreal picture ignoring by ignoring the discount rate. Similarly, the Accounting Rate of Return does not consider the future value of the operating profits. Diacon (2004) suggests that this method involves trial and error in reaching the results, so for the same project, different returns can be calculated. In calculating NPV, all cash flows are discounted to their more relevant values and if compared to other methods, NPV shows a more realistic picture.

Reference

Armstrong, J. S. (2012). Illusions in regression analysis. International Journal of Forecasting, 28(3),689-694. Data retrieved from http://repository.upenn.edu/cgi/viewcontent.cgi?article=1190&context=marketing_papers

Benartzi, S. E. (2002). How much is investor autonomy worth? Journal of Finance, 57 (4), 1593- 1616. Data retrieved from http://www.blackwell-synergy.com/servlet/useragent?func=synergy&synergyAction=showTOC&journalCode=jofi&volume=57&issue=4&year=2002&part=null

Blumenthal, R. (May 5, 2009). Three credit rating agencies hold too much of the Power. Alaska. Data retrieved from juneauempire.com/stories/050509/opi_436594375.shtml

Bruns, W. J., & Waterhouse, J. H. (1975). Budgetary Control and Organization Structure. Journal of Accounting Research, 13 (2), 177-203. Data retrieved from www.jstor.org/stable/2490360

Daum, J. H. (2002). Beyond Budgeting: A Model for Performance Management and Controlling in the 21st Century. Controlling & Finance, July, 1-3. Data retrieved from http://www.juergendaum.de/articles/beyond_budgeting.en.pdf

Diacon, S. (2004). Investment risk perceptions. Do consumers and advisers agree? The International Journal of Bank Marketing, 22 (3), 180-199. Data retrieved from www.emeraldinsight.com/journals.htm?articleid=855109

Fraser, R., & Hope, J. (2003). Beyond Budgeting. Soundview Executives Book Summaries, 25 (9), Order 25-21. Data retrieved from http://www.businesstraining.com.mx/egaii/docs/Beyond%20Budgeting.pdf

McLaney, E. & Atrill, P. (2009). Accounting: An Introduction, 4th edn. Pearson Education, London. Data retrieved from ­­­­­http://web.kku.ac.th/chrira/050212/Text050212/Course%20Acct. %20Text%20-%20Ch.13.pdf

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