Capital budgeting and sources of capital

Published:

Answer 1

Investment in New Machine = £2,250,000

Ace Printer Owes = £120,000

The condition for production per annum is below

Maximum capacity = 180,000 units per annum

The criterion for sales volume

Sales volume

Variable cost (£)

till 89,999

4.5

90,000 to 99,999

4.4

100,000 to 109,999

4.3

110,000 to 119,999

4.2

120,000 to 129,999

4.1

130,000 to 139,999

4

140,000 to 149,999

3.9

Fixed cost for both the strategies

Year

Fixed cost

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Year 0

1,65,000

Year 1

171600

Year 2

178464

Year 3

185602.56

Year 4

193026.6624

Year 5

200747.7289

Now to calculate cost for Strategy 1

Year

Sales Volume

Sales volume (after replacing to nearest decimal place)

Year 1

80,000

80,000

Year 2

83,200

83,200

Year 3

86,528

86,528

Year 4

89,989.12

89,989

Year 5

93,588.68

93,589

Year 1

Cost = fixed cost + variable cost

= £171,600+ (80,000 * 4.635)

= £542,400

Year 2

Cost = fixed cost + variable cost

= £178,464 + (83,200 * 4.77)

= £575,328

Year 3

Cost = fixed cost + variable cost

= £185,602.6 + (86,528 * 4.92)

= £611,320.36

Year 4

Cost = fixed cost + variable cost

= £193,026.7 + (89,989 * 5.06)

= £648,371.04

Year 5

Cost = fixed cost + variable cost

= £200,747.73 + [(89,999 * 5.21) + (3590 * 5.1)]

= £687,951.52

Thus, the cost for Strategy 1

Year

Cost (£)

Year 1

£5,42,400.00

Year 2

£5,75,328.00

Year 3

£6,11,320.36

Year 4

£6,48,371.04

Year 5

£6,87,951.52

Similarly for strategy 2,

Year

Sales Volume

Sales volume (after replacing to nearest decimal place)

Year 1

95000

95000

Year 2

105450

105450

Year 3

117049.5

117050

Year 4

129924.945

129925

Year 5

144216.689

144217

Year 1

Cost = fixed cost + variable cost

= £171,600 + [(89,999 * 4.635) + (5,001 * 4.532)]

= £611,409.90

Year 2

Cost = fixed cost + variable cost

= £178,464 + [(89,999 * 4.77) + (10,000 * 4.67) + (5,451* 4.56)]

= £679,315.79

Year 3

Cost = fixed cost + variable cost

= £185,602.6 + [(89,999 * 4.92) + (10,000 * 4.81) + (10,000 * 4.70) + (7,051 * 4.59)]

= £755,861.77

Year 4

Cost = fixed cost + variable cost

= £193,026.7 + [(89,999 * 5.06) + (10,000 * 4.95) + (10,000 * 4.84) + (10,000 * 4.73) + (9926 * 4.61)]

= £839,380.5

Year 5

Cost = fixed cost + variable cost

= £200,747.73+ [(89,999 * 5.21) + (10,000* 5.1) + (10,000 * 4.99) + (10,000 * 4.87) + (10,000 * 4.75) + (10,000* 4.635) + (4,218 * 4.52)]

= £932,157.88

Thus, the cost for Strategy 2

Year

Cost (£)

Year 1

£ 6,11,409.90

Year 2

£ 6,79,315.79

Year 3

£ 7,55,861.77

Year 4

£ 8,39,380.50

Year 5

£ 9,32,157.88

Strategy 1

Year

Selling Price

Units produced

Total Cash inflows

Year 0

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12

Year 1

12.36

80,000

988800

Year 2

12.7308

83,200

1059203

Year 3

13.112724

86,528

1134618

Year 4

13.50610572

89,989

1215401

Year 5

13.91128889

93,589

1301944

Strategy 2

Year

Selling Price

Units produced

Total Cash inflows

Year 0

11.5

Year 1

11.845

95000

1125275

Year 2

12.20035

105450

1286527

Year 3

12.5663605

117050

1470892

Year 4

12.94335132

129925

1681665

Year 5

13.33165185

144217

1922651

Thus we have

Strategy 1

Year

Total Cash inflows

Total Cash outflows

Year 0

£ 22,50,000.00

Year 1

9,88,800.00

£ 5,42,400.00

Year 2

10,59,202.56

£ 5,75,328.00

Year 3

11,34,617.78

£ 6,11,320.36

Year 4

12,15,400.95

£ 6,48,371.04

Year 5

1301943.616

£ 6,87,951.52

Strategy 2

Year

Total Cash inflows

Total Cash outflows

Year 0

£ 22,50,000.00

Year 1

1125275

£ 6,11,409.90

Year 2

1286526.908

£ 6,79,315.79

Year 3

1470892.497

£ 7,55,861.77

Year 4

1681664.92

£ 8,39,380.50

Year 5

1922650.835

£ 9,32,157.88

So we have

Year

Strategy 1 (£)

Strategy 2 (£)

Year 0

-2250000

-2250000

Year 1

446400

513865.1

Year 2

483874.56

607211.1175

Year 3

523297.4223

715030.7265

Year 4

567029.9076

842284.4196

Year 5

613992.0961

990492.9555

NPV

- 1,84,664.52

5,21,386.19

IRR

5%

17%

Strategy 1

For accounting rate of return

Annual depreciation = -2,250,000 / 5

= £450,000

Average Accounting Income = £76,918.80

Thus, Accounting rate of return = 76,918.80 / 22,50,000

= 17.09%

Strategy 2

For accounting rate of return

Annual depreciation = -2,250,000 / 5

= £450,000

Average Accounting Income = £ 283,776.86

Thus, Accounting rate of return = 283,776.86 / 22,50,000

= 63.06%

As per Net Present Value

NPV for Strategy 1 < NPV for Strategy 2

Thus, it is clear that Strategy 2 is better one

As per Internal rate of Return

IRR for Strategy 1 < IRR for Strategy 2

So, it is clear that strategy 2 is better

As per Accounting rate of return, based on average investment

ARR for Strategy 1 < ARR for Strategy 2

Thus again Strategy 2 is better

In order to select the project, the NPV calculation can be viewed as a useful measure (Drury, 2007). For strategy 1, NPV is negative, which is enough to consider that it is not a suitable choice to go for this strategy. Instead, the strategy 2 is better as it constitutes of considerable positive value. The reason for choosing NPV is because of its usefulness in identifying the results. With the help of NPV, direct measure of GBP that is contributed to the shareholders is measured.

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However, the IRR is useful measure to identify the returns produced from the investment made in either of the strategies. Prior to beginning the project, the IRR method can be of immense help in estimating the rate of return that can be obtained from the investments made in the project (Davis and Davis, 2011). This measure can help in being used alone for the selection or rejection of project.

Although accounting rate of return is another commonly known technique to evaluate the project, this does not take into consideration the time value of money (Drury, 2006). This is the reason, it is better not to depend on this factor while selecting any project.

For the strategies here, since all the NPV, IRR and ARR are higher for strategy 2 as compared to strategy 1, it clearly shows strategy 2 as the preferable one to be followed, as it would yield better returns from the investments made in the project.

Answer 2

Diversification is viewed as a useful strategy to reduce risks (Drury, 2006). However, it is not possible to completely avoid the risks. Being an investor, one has to bear risk to get returns. The Capital Asset Pricing Model is quite well known technique for calculating risks and the expected rate of return from an investment. Based on this factor, investment decision in the project can be made. Here, beta is used for measuring risk associated with stocks. The volatility associated with stocks is measured using this technique. For an instance, it helps in determining the extent to which the stock market would grow in the future. If the beta is found to be 1, then it shows that there is no change in the share price. However, the increase in beta is expected to obtain profitability for shares.

On looking at the beta of two well known UK registered organisations

Beta of Severn Trent Plc = 0.77

Beta of Taylor Wimpey Plc = 1.23

Since the beta of Severn Trend Plc is less than 1, it shows the share value would fall by 23%. This illustrates incapability of the organisation to produce required returns from the investment made by them (Levy, 2011). There is the need for management to reconsider their strategies in order to produce profitability in their business. The fall in stock price is a serious issue of concern and need special attention.

However, the beta of Taylor Wimpey Plc shows an increase by 23% illustrating that the stock price would increase. The investors in this organisation had thus gained from their investments. The organisation thus seems to be a profitable option for investment (Graham and Smart, 2011). Although both the organisations belong to same industry, it does not necessitate that the stock price increase is also same. Instead, the stockholders need to depend on the organisation's beta to identify whether they are able to get returns from the investments made by them.

The beta can be helpful in identifying the risks associated with the market for particular asset in comparison to the market standards. The asset's volatility can be identified using this technique in the marketplace. This is calculated through comparison of historical return on assets in comparison to the returns obtained in the market (Graham and Smart, 2011). The usage of beta is commonly found to identify the risk/return associated with the mutual funds and stock value. The positive beta for Taylor Wimpey Plc shows that the organisation's stock price is moving in the direction similar to that of the marketplace. However, the negative beta of Severn Trent plc is an issue of concern (Pahl, 2009). The organisation should identify the key reason for such negative beta and thus introduce required strategies to avoid further issues in the future. The negative beta could result into considerable discouragement amongst the investors to invest in this organisation.

In order to calculate expected return

= Risk free return + beta * (Market return - Risk free return)

Here,

Risk free return = 8.5%

Beta = 1

Market return = 4%

Thus, we have expected return

= Risk free return + beta * (Market return - Risk free return)

= 0.085 + 1 * (0.04 - 0.085)

= 21%

Answer 3

The source of capital is quite important in the organisational operations to raise funds from the market. For the project, it is desirable to explore the means of financing that can be used. For the case here, Ace Printers plc is clearly working well with no long-term debt. The company has even been quoted on the stock exchange for the period of last 4 years. This illustrates well-set reputation of the organisation in the market. Since, it seems appropriate to choose strategy 2, there is the need to raise funds from the market. For the project, an investment of £2,250,000 is required to purchase new machine so as to manufacture new printer cartridge.

Since the company is already listed on stock exchange, they can issue more shares in the market. The board of directors however need to check for the shares that are held by them, so as to avoid any possibilities of ownership transfer in their business. The organisation also needs to reconsider the demand of their shares in the market four years back, when they were listed on stock exchange. In accordance with this and the current business worth, the share price can be fixed and the shares worth £2,250,000 should be issued into the market for sale.

Since the organisation does not have any long-term debt there is also an option to raise funds from sources of finance (Graham and Smart, 2011). The organisation can raise funds through long-term debt from the bank or any financial institution. The organisation can even repay the sum in the form of instalments, as the Strategy 2 clearly would yield returns right from first year. This would allow the organisation to get relieved from the debts taken from the market.

Increase of overdraft limit can also be an option, but that would demand the need of returns on an immediate basis. The organisation should take into consideration possible risks of business. So, it would be better to opt for the source of finance that allows them to establish their business and then only demand the need of paying off their debts. Other sources of fund include short/long term loan, trade credit, inventory financing. So, it is important to select the most appropriate option from the list of available sources of finance. This allows the organisation to reduce any risk against their successful operations during their production process.

The idea of Tom Sparkes to borrow money seems a perfect one for the given scenario. Since Ace Printers plc is not under the pressure of repaying any major liabilities, they can raise funds from the market through borrowing. This can be for long-term to allow the organisation to repay the sum gradually without any excessive pressure or demand. This would allow the organisation to carry out their operations with an ease. The management and production department can focus on their production process with an assurance that there is no shortage of funds at any stage. The organisation also needs to reconsider possible risks with sources of finance and then take decision appropriately. By using long-term sources of finance, the organisation would have enough time to set-up the project and start raising funds from that source.

Answer 4

The idea by Beverly Margerison to compare the Return on capital employed for the project with the industry standards. This can be a useful means to identify if the project falls under the standard returns produced in the industry. One can speculate if the project is worth investing or not. In order to expand further, the Peter Komakech is of the opinion to enter into new foreign market. As per him, the organisation should follow an aggressive expansion strategy by acquiring the French competitor. This would help them in obtaining synergy so as to run the business. The organisation is required to take an appropriate expansion decision as it may involve millions of GBP of investment. If the selection is not done appropriately, it can result into considerable failure of the project. According to Peter Komakech, the acquisition would help in obtaining synergy of the two organisations so as to perform even better in the market. This can also be useful to increase technical expertise of the organisation through offering wide array of products into the market.

Ace Printers plc is an expert in producing printer cartridges for computer industry. The organisation should therefore identify the product range that is produced by the French competitor. Through acquisition, the organisation may avoid the problem of price war into the market. The organisation would thus be able to maintain their profitability reasonably enough to operate successfully in the market (Davis and Davis, 2011). However, the marketing executive named Ms. Margerison is a bit reluctant in accepting quick growth. She perceives that instead of expanding the business scope, they should focus on specialisation.

The organisation is required to adopt the idea of Mr. Komakech who shows an aggressive expansion strategy. By restricting to the approach of the marketing executive, the organisation would not be able to increase their business scope in an instant manner. Instead, there is the need to wait for market demand to increase the business. Instead of this, the organisation can make use of the already existing business players within the industry. Through acquisition, the organisation can increase their scope of business and take control over their one major competitor. This would even help them to enter into new markets of Europe including France. Such a resistance to change by the marketing executive, and adherence to the pre-defined set of rules to run the business within their area of expertise involves less risk. As a result, the returns are also less. The organisation would grow at gradual rate through this strategy, suggesting that the efforts would not be able to yield enough returns (Davis and Davis, 2011). The acquisition would help the organisation to directly own the business of their French competitor without the need to do everything from scratch. Instead, the well-set organisation can be acquired to cover greater market share and obtain profitability in the business.

However, it is tough to state whether acquisition of French competitor would be an appropriate decision, because this depends on the other factors as well. For an instance, the current financial performance of the organisation should be evaluated to identify their key ratios including profitability and liquidity ratios (Jiambalvo, 2009). Once these ratios are identified, the management of Ace Printers plc would be in a better position to decide for the benefit involved with the purchase of this organisation. Following this, the right mix of steps can be taken to offer the pricing of acquisition. The assets carried out by the target organisation should be evaluated as well, so as to check for the worthiness of acquisition. This rather seems a daring step that can be of immense help to the growth of their business, or may even result into an overall loss. The organisation thus needs to further study this option so as to make a decision to acquire the French organisation.

References

Davis, C. E., & Davis, E. (2011), Managerial Accounting, John Wiley & Sons

Drury, C. (2007), Management and Cost Accounting, Cengage Learning EMEA

Drury, C. (2006), Cost and Management Accounting: An Introduction, Cengage Learning EMEA

Graham, J., & Smart, S. (2011), Introduction to Corporate Finance: What Companies Do, 3rd edn., Cengage Learning

Jiambalvo, J. (2009), Managerial Accounting, 4th edn., John Wiley & Sons

Levy, H. (2011), The Capital Asset Pricing Model in the 21st Century: Analytical, Empirical, and Behavioral Perspectives, Cambridge University Press

Pahl, N. (2009), Principles of the Capital Asset Pricing Model and the Importance in Firm Valuation, Books on Demand