Managing Finance and Budgets

1
Managing Finance and Budgets

• Lecture 7
• Activities Solutions

2
Accounting Rate of Return Further Example

• PROJECT ONE PROJECT TWO
• Investment 300,000 500,000
• Cashflow Depn Net Profit
  Cashflow Depn Net Profit
• Year 1 90,000 60,000
  30,000 120,000 100,000 20,000
• Year 2 160,000 60,000 100,000
  140,000 100,000 40,000
• Year 3 120,000 60,000
  60,000 160,000 100,000 60,000
• Year 4 70,000 60,000
  10,000 240,000 100,000 140,000
• Year 5 70,000 60,000
  10,000 320,000 100,000 220,000
• Totals 510,000 300,000 210,000
  980,000 500,000 480,000
• ARR Average profit/Average
  investment
• (210,000/5)/ (300,000/2)
  28 (480,000/5)/(500,000)/2 38.4

In this case, the depreciation has been included
as part of the Net Profit calculation
3
Activity One

• A company is considering investing in either of
  two new machines which will help to increase its
  production. The first machine will cost 240,000,
  and the company estimates that it will have a
  working life of 5 years. The second machine will
  cost 360,000 and have a working life of 6 years.
  The net positive cash-flows as a result of cost
  savings from the new machine are shown below.
  Calculate the payback period and Accounting Rate
  of returns for each of the machines.
• Machine 1 Net Cash-flows 90,000/yr
  for first 3 years
• 50,000/yr for remaining 2 years
• Machine 2 Net Cash-flows 100,000 Year 1
• 110,000 Years 2
• 120,000 Years 3 and 4
• 90,000 Years 5 and 6

4
Activity One Solution Part 1

• Machine 1
• Cost 240K Life 5 years
• Net Cash-flows 90K /yr for first 3 years
• 50K /yr for remaining 2 years
• ARR
• Average Profit (3 x 90000) (2 x 50000) -
  240000 ? 5 26000
• Average Investment (240000 0) ? 5 48000
• ARR 26000/48000 54.2
• PP
• In the first two years, Total Cash flow
  180000,
• so the PP will occur sometime in year three
• Proportion of year three (240000-180000)/90000
  8 months
• PP 2 years and 8 months

5
Activity One Solution Part 2

• Machine 2
• Cost 360K Life 6 years
• Net Cash-flows 100K, 110K, 120K, 120K,
  90K, 90K
• ARR
• Average Profit (100000110000 120000x2
  90000x2) - 360000 ? 6 45000
• Average Investment (360000 0) ? 6 60000
• ARR 45000/60000 75
• PP
• In the first three years, Total Cash flow
  330000,
• so the PP will occur sometime in year four
• Proportion of year four (360000-330000)/120000
  3 months
• PP 3 years and 3 months

6
Activity One -Summary

• Machine 1 ARR 45.8 PP 2 years 8 months
• Machine 2 ARR 75 PP 3 years 3 months
• Analysis
• If we opt for the Machine 1, it will cost less,
  and we will recoup our initial expenditure 7
  months sooner. However the second machine
  promises greater return on our investment in the
  long run.
• Decision
• If the company can secure the finances (e.g.
  long term loan over 4 years ), then Machine 2
  represents a much better investment. If finances
  are a problem, then we may have to settle for
  Machine 1.

7
Activity Two

• For the scenario described in Activity One,
  calculate a Net Present Value for each of the two
  machines, using a Discount Rate of 10 and a
  Discount Rate of 20. The Discount Factors at the
  two rates are shown below
• 10 20
• Year 1 0.909 0.833
• Year 2 0.826 0.694
• Year 3 0.751 0.579
• Year 4 0.683 0.482
• Year 5 0.621 0.402
• Year 6 0.565 0.335

8
Activity Two Solution (1)

• MACHINE ONE MACHINE TWO
• Discount
  Discount
• Cashflow Factor DCF
  Cashflow Factor DCF
• Invmnt -240,000 1 -240,000
  360,000- 1 360,000-
• Year 1 90,000 0.909 81,810
  100,000 0.909 90,900
• Year 2 90,000 0.826 74,340
  110,000 0.826 90,860
• Year 3 90,000 0.751 67,590
  120,000 0.751 90,120
• Year 4 50,000 0.683 34,150
  120,000 0.683 81,960
• Year 5 50,000 0.621 31,050
  90,000 0.621 55,890
• Year 6
  90,000 0.565
  50,850
• Totals
  48,940
  100,580
• The above figures use a Discount Rate of 10

9
Activity Two Solution (2)

• MACHINE ONE MACHINE TWO
• Discount
  Discount
• Cashflow Factor DCF
  Cashflow Factor DCF
• Invmnt -240,000 1 -240,000
  360,000- 1 360,000-
• Year 1 90,000 0.833 74,970
  100,000 0.833 83,300
• Year 2 90,000 0.694 62,460
  110,000 0.694 76,340
• Year 3 90,000 0.579 52,110
  120,000 0.579 69,480
• Year 4 50,000 0.482 24,100
  120,000 0.482 57,840
• Year 5 50,000 0.402 20,100
  90,000 0.402 36,180
• Year 6
  90,000 0.335
  30,150
• Totals
  -6,260
  -6,710
• The above figures use a Discount Rate of 20

10
Activity Two Solution Summary

• DF 10 DF 20
• NPV of Machine 1 48,940 -6,260
• NPV of Machine 2 100,580 -6,710
• Analysis
• If the value of money is decreasing at 10 per
  annum (low risk, low inflation, low interest),
  then Machine 2 is a much better proposition,
  earning over 50K more.
• However, if the value of money is decreasing at
  20 per annum (high risk, high inflation, high
  interest) then Machine 1 is a slightly better
  proposition, as its loss is somewhat less.
  However, the value of purchasing any machine
  under these circumstances is questionable.