Managing Finance and Budgets Presentation 7 Financial Ratios.
Managing Finance and Budgets
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Transcript of Managing Finance and Budgets
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Managing Finance and Budgets
Lecture 7
Activities & Solutions
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Accounting Rate of Return – Further Example
PROJECT ONE PROJECT TWOInvestment £300,000 £ 500,000
Cashflow Dep’n Net Profit Cashflow Dep’n Net ProfitYear 1: 90,000 60,000 30,000 120,000 100,000 20,000Year 2: 160,000 60,000 100,000 140,000 100,000 40,000Year 3: 120,000 60,000 60,000 160,000 100,000 60,000Year 4: 70,000 60,000 10,000 240,000 100,000 140,000Year 5: 70,000 60,000 10,000 320,000 100,000 220,000Totals: 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
In this case, the depreciation has been included as part of the Net Profit calculation
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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
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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%
PPIn 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
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Activity One –Solution Part 2
Machine 2: Cost £360K Life 6 years Net Cash-flows: £100K, £110K, £120K, £120K, £90K, £90K
ARR Average Profit = [ (100000+110000+ 120000x2 +90000x2) - 360000 ]
6 = 45000Average Investment = (360000 + 0) 6 = 60000
ARR = 45000/60000 = 75%
PPIn the first three years, Total Cash flow = £330000,so the PP will occur sometime in year fourProportion of year four = (360000-330000)/120000 = 3 months
PP = 3 years and 3 months
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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.
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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
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Activity Two – Solution (1)
MACHINE ONE MACHINE TWO Discount Discount Cashflow Factor DCF Cashflow Factor DCF
Inv’mnt -240,000 1 -240,000 360,000- 1 360,000- Year 1: 90,000 0.909 81,810 100,000 0.909 90,900Year 2: 90,000 0.826 74,340 110,000 0.826 90,860Year 3: 90,000 0.751 67,590 120,000 0.751 90,120Year 4: 50,000 0.683 34,150 120,000 0.683 81,960Year 5: 50,000 0.621 31,050 90,000 0.621 55,890Year 6: 90,000 0.565 50,850 Totals: 48,940 100,580
The above figures use a Discount Rate of 10%
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Activity Two – Solution (2)
MACHINE ONE MACHINE TWO Discount Discount Cashflow Factor DCF Cashflow Factor DCF
Inv’mnt -240,000 1 -240,000 360,000- 1 360,000- Year 1: 90,000 0.833 74,970 100,000 0.833 83,300Year 2: 90,000 0.694 62,460 110,000 0.694 76,340Year 3: 90,000 0.579 52,110 120,000 0.579 69,480Year 4: 50,000 0.482 24,100 120,000 0.482 57,840Year 5: 50,000 0.402 20,100 90,000 0.402 36,180Year 6: 90,000 0.335 30,150 Totals: -6,260 -6,710
The above figures use a Discount Rate of 20%
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Activity Two – Solution Summary
DF = 10% DF = 20%NPV of Machine 1 £48,940 -£6,260NPV 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.