Project Valuation - Rumpole Ltd - Essay Example

Rumpole Ltd Memo Directors Rumpole Ltd Accountant February 26, Subject: (1) Project Valuation (2) Analysis of Acquisition (3) Production Plan The purpose of this internal report is to present findings on three different tasks required by directors to be performed. These tasks are listed here, and under each section of the report different issues related to these tasks have been elaborated and discussed. 1) Valuation of a project for the production of new product involving costs of $2million. 2) Analysis of Genesis Ltd. that is under consideration for acquisition by Rumpole Ltd. 3) Investigation of a problem with supply of material in the manufacturing department. The above tasks have been supported by detailed calculations, which are attached to this report as Appendices and they have been referred to in the main report. Task 1: Project Valuation Rumpole Ltd. is considering launching a new product, which will require initial investment of £2 million to buy machinery outright and other alterations to the manufacturing process. This decision is evaluated on the basis of net present value and payback period that the company can expect from this investment. Net present value and payback period of this project The following table summarizes the revenues and costs that are predicted to incur during the five years course of the project. 　 Year1 Year2 Year3 Year4 Year5 Quantities sold (1,000 units) 5 15 22 15 5 Selling price £ per Unit 250 230 200 200 200 Revenues (£000) 1250 3450 4400 3000 1000 Less costs 　 　 　 　 　 Labour costs (£000) 200 630 924 630 210 Materials costs (£000) 400 1200 1936 1410 470 Other costs (£000) 125 375 550 375 125 Operating profits (£000) 525 1245 990 585 195 Notes: Labour costs in year1 are £40 per unit and £42 per unit in year2, year3, year4, and year5. Materials costs in year1 and year2 are £80 per unit, in year3 are £88 per unit, and in year4 and year5 are £94 per unit. Therefore, the statement of incremental cash flows should be displayed as follow: 　 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 5 　 £000 £000 £000 £000 £000 £000 £000 Sales revenue – 1250 3450 4400 3000 1000 Less Costs 　 　 　 　 　   Materials – (400) (1200) (1936) (1410) (470)   Labour – (200) (630) (924) (630) (210) Other costs – (125) (375) (550) (375) (125) Investment on equipment (2000) 　 　 　 　 　 Total costs (2000) (725) (2205) (3410) (2415) (805) Operating profit/(loss) 　 　 　 　 　 　 before depreciation (2000) 525 1245 990 585 195 Disposal proceeds 150 Then the Net Present Value is shown as bellow: 　 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 5 　 £000 £000 £000 £000 £000 £000 £000 Sales revenue – 1250 3450 4400 3000 1000 Less Costs 　 　 　 　 　   Materials – (400) (1200) (1936) (1410) (470)   Labour – (200) (630) (924) (630) (210) Other costs – (125) (375) (550) (375) (125) Investment on equipment (2000) - - - - - Total costs (2000) (725) (2205) (3410) (2415) (805) Operating profit/(loss) 　 　 　 　 　 　 before depreciation (2000) 525 1245 990 585 195 Disposal proceeds 150 Discount factor 6% 1 0.943 0.89 0.84 0.792 0.747 0.747 Present value -2000.0 495.1 1108.1 831.6 463.3 145.7 112.1 Net present value 1155.8 　 　 　 　 　 Therefore, the NPV is £1,155,800>0 Payback period is calculated as follow: Time 　 Net cash Cumulative flows cash flows £000 £000 Immediately (time=0) Cost of equipment and working capital (2000) (2000) 1 years time Operating profit before depreciation 525 (1475) 2 years time Operating profit before depreciation 1245 (230) 3 years time Operating profit before depreciation 990 760 4 years time Operating profit before depreciation 585 1,345 5 years time Operating profit before depreciation 195 1,540 5 years time Disposal proceeds 150 1,690 Therefore, the payback period is 2 years + (230/990) = 2 23/69 years The positive NPV indicates that the company will generate sufficient cash inflows, which will cover the initial investment and generate profits for the company. The payback period is also estimated at 2 23/69 years. The project has a positive NPV and the payback period appears to be reasonable (Kinney & Raiborn, 2008). On the basis of the project evaluation with positive NPV and reasonable payback period, it could be recommended to the company that it should go with the project. Since, the company is currently considering only one project therefore, it will be appropriate for the company to go ahead with the project. Otherwise, the company should consider other projects, which have higher positive NPV and short payback period (Maher et al., 2012). Equity and debt methods of raising capital The financing required for the project requires assessment of different types of funding sources available to the company. Since, Rumpole Ltd. is a private company, therefore it will not be possible for the company to acquire its funding from issuance of share capital or debt instrument in the secondary market. The company has two options from which it could raise capital for the net project. These include raising funds from internal equity and / or external debt financing. Internal equity comprises of retained earnings of the company. These earnings are accumulated over the year and disclosed on the face of the company’s balance sheet. These earnings are available to the company for investing into the company’s existing operations or investing in the new project, which the company is considering at the moment (Brigham, 2013). Managing retained earnings require time. In short run, the company will have to manage its working capital. Active recoveries will work a lot. Aging of the receivables should be monitored actively. Buffer levels of inventory should be lowered so that lesser amount is bound in stock. On the other hand, the company can also raise from external sources. The company can opt for loans from banks. However such loans will bring additional interest expense to the company. In intial stages of project, such costs will be difficult to manage but as the project progresses, theses costs will get easy to pay. The company will have to prepare a business plan and present to available financiers to acquire funding for the project. In return the company will have to pay interest charged on the amount borrowed and also repay the borrowed amount depending on the tenure of the loan and terms and condition set by the financier (Brigham & Ehrhardt, 2011). These two options are considered here for their merits and demerits for efficient decision-making by management. If the company arranges funding from its internal sources then it has to consider the opportunity cost associated with the company’s equity. The opportunity cost can be in terms of generating more business from the company’s existing business lines or making investment in debt instruments in the secondary market. This will require additional information for evaluation regarding possibilities of alternate investments by the company. The company may have to allocate its retained earnings to the new the project or inject fresh equity. In both cases, the use of funds needs to be evaluated for alternative options that the company may have. This option does not affect the company’s gearing position and no interest payments have to be made to debt financiers that could create leave more profits for distribution to the owners of the company. The cost of internal equity can be greater than the cost of external debt, which needs to be assessed in order to make a better decision. External financers will bring additional costs to the business. Their interest expense will be fixed. Whether company or project operated I profit or not, the company will have to pay them. However, this is not the case with retained earnings. Dividends can be compromised if profits are declining. For short-term financer sources, the company needs not to make strategic plans for financial management. They are easy to manage. Its better to take short-term loans at the time project starts generating cash flows. This will assist in paying them off appropriately. On the other hand, the company can also generate funds from borrowing. For this purpose, the company has the option of acquiring debt from financial institutions or investment companies. This could have a negative impact on the company’s profits as it will have to pay interest payments and repay loans before earnings can be distributed to the company’s owners. Moreover, the ownership of the company is diluted as external financiers have to be paid before anyone else. The company’s solvency position will be affected by external borrowing. Higher gearing ratio implies that the company will have to ensure that sufficient amount of its earnings is kept aside for the loan repayment and interest expense it has to bear. If the company is not able to generate enough cash / profits to pay off its debt obligations then it can have ramifications for it existing business operations. However, by acquiring debt the company can have tax advantage as it allows deduction of interest payments from the company’s income (Porter & Norton, 2010). Therefore, the company needs to be careful with planning its funding by considering advantages and disadvantages of both equity and debt financing methods of raising capital. Task 2: Analysis of Acquisition This section of the memo provides discussion and findings related to the company’s plan to go ahead with the acquisition of Genesis Ltd. Although, the company has achieved tremendous growth rates since its inception in 2009, but there are issues, which its current management is not able to manage. These issues are elaborated here in terms of overtrading. Overtrading The term overtrading refers to a situation involving a business not being able to generate sufficient liquidity to it meets business operations’ requirement (McLaney & Atrill, 2010). In such situations, the company faces problems, as it is not able to generate enough cash flow or capital to meet the raising demands of its business (Ogilvie, 2006). This does not mean that the company is not performing well in terms of its business growth, but it is not able to manage its capital to finance this growth (Homer, 2013). There are many reasons why overtrading may occur. These include inability of new or young businesses to plan out their operations in order to meet the rising demand for their products or services. Also, due to delays in realization of receivables and slow moving inventory, which can also result in delays in payment to suppliers. In addition, the company can face overtrading situation when the owners of the business are not able to inject more capital into the company and they have restricted access to external sources of funding. It is known that young companies in particular are not able to acquire external debt because of low credit rating and riskiness that financiers associate with their business (McLaney & Atrill, 2010). The outcome of wrong projections of the company’s sales result in incorrect estimations of costs and expenses by the business and thus, the company’s profit margins can shrink seriously. In case of slow movement of inventory, it is possible that the company will end up holding obsolete inventory, which will lead to its cash being hold up. Moreover, non-realization or delay in payments from receivables will hinder the company’s ability to meet its business requirements (Ogilvie, 2006). Another outcome of overtrading is that the company’s suppliers may stop their suppliers or delay shipments. This would put the company into a situation where it is not able to meet its order requirements and thus, it may face loss of its business. Delays in realization of cash can create problems for the company as it will run into liquidity problems. Moreover, the company’s inability to excess funding sources can limit its ability to meet demands of its customers and eventually this could negatively affect the company’s reputation and its overall business standing. The company in an overtrading situation will not be able to plan for long-term as it will be facing crisis related to its business arrangements and relationships. Non-shipment of goods can be overcome by having of suppliers. The company should not be dependent on one or two suppliers. In case of non-recovery, company can either get them insured or we can even sell the receivables to outsiders at discount. This will solve the problems of cash shortage. Low profit margins can also signal a situation of overtrading by the company. It can be noted in the case of Genesis Ltd that despite generating good sales is trading at low gross profit and net profit margins (Leach, 2010). This implies that the company is not able to work efficiently with its suppliers and they are charging company higher prices for its products. This is resulting in low gross profit margins of just 23.9%, which is very weak for a business that is experiencing high growth in its sales. Moreover, the company is incurring high selling and distribution expenses of £204,000, which are quite high in proportion to its sales. These reflect inefficiencies on behalf of the company’s management that it is not able to manage its supply chain effectively. In comparison to the company’ gross profit margin, its net profit margin is merely 2.2%. This is inappropriate for a business that has recently started and is recording higher demand for its products. Other ratios, which are indicators of overtrading, include those related with liquidity including current ratio and quick ratio. These ratios are calculated and provided in Appendix B of this report. Current ratio, which determines the proportion of current assets to current liabilities (Minaxi, 2011), indicates the company has poor liquidity situation. The ratio value is less than 1 that implies that the company can soon face major problems with meeting its short-term debt obligations. In current assets, there is a major proportion of inventory value held by Genesis Ltd. By excluding this from the current ratio, it can be noted that the company has significantly weak quick ratio. This reasserts that the company can have serious liquidity problems (Wood, 2010). Furthermore, the problem with overtrading is evaluated on the basis of the trade receivables period calculated in Appendix B. It clearly indicates that the company has issues with the collection of its receivables. The company is currently taking almost 23 days for collection. This has implications of its ability to have cash for funding its business requirements. Task 3: Production Plan Rumpole Ltd. is currently facing problems with the supply of the main input, which is used in the production of the company’s four different products. The company is faced with a decision to allocate this material to the production process keeping in view the limiting factor of constrained supply. The optimal production plan has been devised and included in Appendix C of this report. This has been achieved by calculating the contribution margin per kg of limiting factor of each of the four products that the company is currently manufacturing and then ranking each product according to the amount of the limiting factor required for producing one unit of each product. According to the table provided in Appendix C the ranking of four products is obtained as follows. Ranking Product 1 C 2 A 3 D 4 B By allocating limiting factor to each unit of four products the allocation is obtained as follows. Product Material   Available: 20,000 C 3,750 A 5,000 D 5,500 B 1,150 Furthermore, the expected profit £195, 500 from the allocation of the limiting factor is obtained as follows: Total Profit (£) Product A 80,000 Product B 23,000 Product C 67,500 Product D 55,000 Total Contribution 225,500 Fixed Costs (30,000) Total Profit 195,500 This table clearly shows that Product A is generating the highest profit and then it is Product C, which has the highest contribution margin, that is contributing significantly to the overall profit of the company. The allocation of fixed costs remains the same at £30,000 before deriving the profit for the company. The limiting factor is a factor that has implications for production of sales. It restricts a certain level of production or sales to be achieved by the company even if there is a demand for its products. This condition may exist at a point in time where the company is faced with a situation of limited supply of materials used in the production (Wickramasinghe & Alawattage, 2012). The limiting factor is also referred to as scarce factor. In addition to the materials required for production, there are other factors, which can also limit the ability of the entity to achieve a desired level of production. These inputs include machine hours or availability of skilled labor or capital required for the production (Debarshi, 2011). In such situations, the company has to decide between different products that are currently being produced by the company. There is, therefore, a trade off between the volumes produced for each product by the company. This decision is based on the profitability of each product or in other terms the company will allocate more of the limiting factor to that product, which have the highest level of contribution margin. Therefore, it could be stated that the allocation of limiting factor is done according to the ranking of products obtained on the basis of their contribution margin. The aim of this is to maximize the company’s contribution margin and eventually, this is to maximize the company’s profits (Drury, 2008; Pandikumar, 2009). The company can deal with this situation by working with different suppliers to ensure continuous supply of materials. Rumpole Ltd. can enter into agreements with suppliers that are offering competitive prices for the same material. Moreover, if the company can have storage space then it should plan out future requirements and acquire this material to complements its regular production process. Such inventory management will require defining the minimum buffer levels for each inventory items. Active co-ordination between sales, procurement and inventory will have to be introduced so that company does not run out of stock. For quick processing of inventory ins and outs, company can introduce Radio Frequency Identification tags. This will speed the inventory count process. The strategic aims of increasing sales should be drilled down to operational level. Adequate number of staff and machinery will have to maintained so that inventory is managed efficiently. Closing Remarks: From the above analysis presented in relation to three tasks the following can be summarized based on findings. 1.The company should go ahead with the new project of producing a new product as it is expected to yield positive net present value and it has a reasonable payback period. 2. The company must consider the overtrading situation that Genesis, Ltd. is currently facing before making decision to acquire this company. 3. The company must plan out for the limiting factor and select the production plan, which maximizes contribution and profits of the company. List of References Wickramasinghe, ‎. & Alawattage, C., 2012. Management Accounting Change: Approaches and Perspectives. Abingdon: Routledge. Wood, F., 2010. Business Accounting. New Delhi: Pearson Education India. Brigham, E.F., 2013. Financial Management: Theory & Practice. Mason, OH: Cengage Learning. Brigham, E.F. & Ehrhardt, M.C., 2011. Financial Management: Theory and Practice. Mason: Cengage Learning. Debarshi, B., 2011. Management Accounting. New Delhi: Pearson Education India. Drury, C., 2008. Management and Cost Accounting. Mason, OH: Cengage Learning EMEA. Homer, D., 2013. Accounting for Non-Accountants. London: Kogan Page Publishers. Kinney, ‎. & Raiborn, C., 2008. Cost Accounting: Foundations and Evolutions. Mason, OH: Cengage Learning.. Leach, R., 2010. Ratios Made Simple. Hampshire: Harriman House Limited. Needles, B., Powers, M. & Crosson, S., 2011. Principles of Accounting. Mason, OH: Cengage Learning. Maher, ‎., Stickney, C. & Weil, R., 2012. Managerial Accounting: An Introduction to Concepts, Methods and Uses. Mason, OH: Cengage Learning. McLaney, ‎.J. & Atrill, P., 2010. Accounting: An Introduction. Essex: Jean Morton. Minaxi, R.A., 2011. Introduction To Management Accounting. New Delhi: Pearson Education India. Ogilvie, J., 2006. Management Accounting - Financial Strategy. Burlington: Elsevier. Pandikumar, M.P., 2009. Management Accounting theory and practice. New Delhi: Excel Books India. Porter, ‎. & Norton, C., 2010. Financial Accounting: The Impact on Decision Makers. Mason, OH: Cengage Learning. Appendix A: Cost (2,000,000) Resale 150,000 5th Year Cost of Capital 6% Discount Factor             Year 0 1 2 3 4 5 Discount Factor 1.0000 0.9434 0.8900 0.8396 0.7921 0.7473 Year 0 1 2 3 4 5 Cash Flows             Cash Inflows             Revenue £   1,250,000 3,450,000 4,400,000 3,000,000 1,000,000 Resale of Machinery           150,000 Total Cash Inflows - 1,250,000 3,450,000 4,400,000 3,000,000 1,150,000               Cash Outflows             Purchase of Machinery 2,000,000           Labour Cost £   200,000 630,000 968,000 690,000 240,000 Material Cost £   400,000 1,200,000 1,936,000 1,410,000 500,000 Other Cost £ per Unit   125,000 375,000 550,000 375,000 125,000 Total Cash Outflows 2,000,000 725,000 2,205,000 3,454,000 2,475,000 865,000               Net Cash Flow (2,000,000) 525,000 1,245,000 946,000 525,000 285,000               PV of Cash Flows (2,000,000) 495,283 1,108,046 794,280 415,849 212,969               NPV 1,026,426           Payback Period 0 1 2 Sum of Cash Flows Balance of Investment   Initial Investment 2,000,000 525,000 1,245,000 1,770,000 230,000 0.24 Balance of Investment       230,000     Payback Period 2.24           Appendix B: Ratios Descriptions Calculations Values Current Ratio Current Assets / Current Liabilities 232/550 0.42 Quick Ratio Current Assets - Inventory / Current Liabilities (232-128)/550 0.19 Receivables Turnover Days 365/(Sales / Receivables) 365/(1640/104) 23.15 Gross Profit Margin Gross Profit / Sales 392/1640 23.9% Net Profit Margin Net Profit / Sales 36/1640 2.2% Appendix C: Product A B C D Maximum demand (units) 2,000 3,100 2,500 2,750   £ £ £ £ Sales 60 108 40 50 Variable costs         Materials 20 40 12 16 Labour 24 48 10 24 Contribution 16 20 18 10 Material Cost per kg (£) 8 Product A B C D Material Required per unit (Kgs) 2.5 5 1.5 2 Calculation of Contribution Margin per Unit Product A B C D   £ £ £ £ Sales 60 108 40 50 Variable costs 44 88 22 40 Contribution 16 20 18 10 Limiting Factor (Kgs required per unit) 2.5 5 1.5 2 Contribution Margin per kg of limiting factor 6.4 4 12 5 Ranking of Products 2 4 1 3 Optimal Production Plan   Ranking Material available for production (kgs)   20000           Total Material Left 1 C 2,500 x 1.5 kgs 3750 16250 2 A 2,000 x 2.5 kgs 5000 11250 3 D 2,750 x 2 kgs 5500 5750 4 B 5,750 / 5 kgs 1150   Total Profit Product A 80,000 Product B 23,000 Product C 67,500 Product D 55,000 Total Contribution 225,500 Fixed Costs (30,000) Total Profit 195,500 Read More