Accounting is a collection of processes and systems used to record, report and interpret the business transactions. It provides an account i.e. explanation or report in financial terms. Explanation or report regarding the transactions of an organisation can be viewed. A company named Flight high ventures plc is a producer/retailer of gliding equipment. The business would like to look into expanding their business abroad with an ambitious 20% export target in 2 years time. Company's sales turnover is growing at an impressive 10% yearly and they are looking at ways to improve their productivity even further. The company is planning to set up a new plant to cope with expansion plans. To set up a new plant company will require an initial outlay of £4m. The R&D team of Flight high ventures plc have developed two ways of manufacturing the new product. One method requires a lower initial cash outlay and a second method requires a higher initial outlay but would help in achieving better economies of scale. The methods are however mutually exclusive and a decision will have to be taken as to which method will be more appropriate. Based on the options A & B, Investment appraisal methods i.e. Accounting rate of return, Payback period, Net present value and Internal rate of return should be calculated to evaluate the R & D projects. A conclusion should be made on the results calculated and recommend the firm the best method of manufacturing the new product.
Background "Accounting is defined as a system for providing financial information to those who have to make decisions and control the implementation of those decisions" (Arnold and Turley, 1996). "Accounting can also be defined as the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information" (Collier, 2006). Accounting helps in knowing profit and financial position of the organisation and also it helps in planning for the expansion of business. "Management accounting is concerned with the provision of information to managers who make decisions about the ways in which an organisation's resources should be allocated" (Arnold and Turley, 1996). "Management accounting is concerned about providing information for management. It provides a wide range of internally used information much of also contributes to the creation of the financial accounts" (Ryan, 2004).
Uses of management accounting Comparison of accounts with original budgets or forecasts can be done Managing of resources will be better, Trends in the business can be identified and Variations in the income can be highlighted which requires attention. "Financial Accounting is the accountability which results in the production of financial statements, primarily for those integrated parties who are external to the business" (Collier, 2006). Through financial management and by using the investment appraisal methods a decision should be made on particular investment opportunity of company named Flight high ventures plc.
Accounting Rate of Return (ARR) "The ARR method takes the average accounting operating profit that the investment will generate and expresses it as a percentage of the average investment made over the life of the project" (Atrill and McLaney, 2008). For any project to be acceptable it must have a target ARR as a minimum. The Company's recent return on capital employed (ROCE) has been 20%. ARR and ROCE ratio takes the same approach to performance management. They both relate the profit to the cost of the assets invested to generate that profit. The minimum target would be based on the rate that previous investments have achieved. ARR has many advantages as a method of investment appraisal. Since ROCE is a widely used measure of business performance shareholders use this ratio to evaluate the management performance. In case of option A the ARR is 8.75% which is very low and does not reach the target. Whereas in case of option B the ARR is 14.87% which is nearly equal to the recent return on the capital employed. If the business is seeking through their investments to generate a percentage rate of return on investment, ARR would be more helpful. It gives a value in familiar percentage terms It can be compared with primary accounting ratios i.e. the company's required rate of return or cost of capital It is a relatively simple concept compared to Discounted Cash Flow methods, such as Net Present Value and Internal Rate of Return It can be used to compare mutually exclusive projects It considers the whole benefits of the project, unlike the payback method Disadvantages It uses accounting profit rather than cash The profit is not directly linked to the primary financial objective of shareholder wealth maximisation It uses average profits and hence it ignores the timing of profits It ignores the time value of money It is a relative measure and so it ignores the size of the initial investment
Payback Period (PP) "Payback period is the length of time it takes for an initial investment to be repaid out of the net cash inflows from a project" (Atrill and McLaney, 2008). Although it is simple concept to understand and easy to calculate, this technique fails to recognise the cash flows beyond the payback period. It only considers the less payback period and ignores the size of the investment and any cash flows that take place after the investment has been recovered. It ignores the size and timing of cash flows. Both the Accounting Rate of Return and Payback period does not consider the time value of money. The time value of the money should be recognised in investment appraisals in order to compare the investment alternatives with different cash flows over different time periods. The payback period of method A is 1 year 183 days and the payback period for method B is 2 years 183 days. We cannot consider the method A since it has less payback period. Method A has less initial investment of £968000 in the year 0 and the payback period is 1 year 183 days. After the payback period the cash flows of the Method A are declined year by year. Whereas in case of Method B it has initial investment of £1210000, more than Method A and its payback period is 2 years 183 days and the cash flows after the payback period are in increasing order year by year.
Net present value (NPV) "Net present value is the surplus value offered by an investment opportunity when the required capital investment is deducted from the present value of its future cash flows, discounted at the firms opportunity cost of capital" (Ryan, 2004). The NPV for Method A is 554.785 and NPV for Method B is 847.916.Using NPV method it is difficult to determine how much better Method B is than Method A because each has a different initial investment. By ranking the projects a decision can be taken on the methods. Ranking of projects with different NPVs is Cash value added= NPV Initial capital investment CVA for method A is 554.785 968 = 0.5731 CVA for method B is 847.916 1210 = 0.7007 Based on the profitability index or CVA the R & D team should choose method B. By discounting the various cash flows of every method, NPV takes account of the time value of the money.NPV takes account of all the relevant cash flows over the life of a project. NPV is the only method of appraisal in which the output the analysis has a direct bearing on the wealth of the owners of the business. If the choice has to be made between methods, the business should normally select the one with the higher or highest NPV. Method B has the highest NPV.
Internal Rate of Return (IRR) "The internal rate of return (IRR) of a particular investment is the discount rate that, when applied to its future cash flows, will produce an NPV of precisely zero" (Ryan, 2004). The IRR for method A is 42.92% and IRR for method B is 36.66%. If two (or more) competing projects exceed the minimum IRR, the one with the higher (or highest) IRR should be selected. Although if we accept the project with the higher percentage return which will often generate more wealth, this may not always be right because IRR completely ignores the scale of investment. There might be a future problem with the IRR method in handling the projects with unconventional cash flows. We cannot consider method A as it has highest IRR because method A has unconventional cash flows and it has less NPV. So method B can be considered as the best one because it has conventional cash flows and scale of investment is high.
Conclusion Method B would be the best choice for R & D team to develop the new product for Flight high ventures plc. In case of method B ARR is high whereas the payback period is more, where both the methods ignore the time value of money.NPV of method B is more when compared to method A. NPV takes account into time value of money and discount future cash flows to their present value. NPV is more reliable method of investment appraisal. A business usually selects the project with highest net present value. As the net profit of method B is increasing year by year and the sales turnover is growing at an impressive 10% yearly, it would be the best choice.