Financial Viability Of The Project
Discuss about the Theory Of Constraints And Implication For Management Accounting.
The company does when undertake a new project; they evaluate the financial viability of the new opportunity. There are capital budgeting tools which help the investors evaluate the financial viability of the project (Adelaja, 2015). There are certain rules which are required to be followed while applying capital budgeting tools. There are certain costs which are included in the evaluation and others which are to be excluded. Therefore, it is important that all these points are taken into consideration while taking the decision.
The pay-back period helps evaluate the investor the time in which the invested amount in the project will be recovered. The earnings after the pay-back period are all amount above the invested amount. (Atkinson, 2012)
The pay-back period of the said project for Booli Electronics is 2.02 years. The project period is for 5 years. This states that the amount invested initially in the project will be recovered within 2.02 years.
Profitability index helps determine the inflow per dollar (Berry, 2009). The profitability index for the project is 1.71. This indicates that the company will earn $ 1.71 for every $ spent. Since the company earns more than invested amount the project seems viable.
Internal rate of return in the hidden rate or the actual rate earned form the project (Bierman & Smidt, 2010). If the IRR is greater than the required rate, the project should be accepted. The IRR for given project is 37%. This indicates that the company earns 37% return on the invested amount. The IRR is greater than the required rate and based on IRR the project should be accepted.
Net present value is the difference between the cash inflows and outflows, in terms of the value of money today (Dayananda, Irons, Harrison, Herbohn, & Rowland, 2008). If the NPV is positive the project should be accepted. The NPV of the project is $40.2 million. The project has positive NPV and form NPV point of view the project should be accepted.
Sensitivity analysis is one of famous tools of capital budgeting which helps analyse the sensitivity of the NPV of the project with respect to other costs and amounts (Menifield, 2014). This analysis helps the investor evaluate the effect of change in independent variable on other dependent variables. In the following report we have discussed the effect of change in price and quantity on other financial viable of the project.
Non-Discounted Pay-Back Period
In the following we have analysed the effect of change of sales price of the products on other financial factors of the product.
We increased the sales price of the product by 1 percent, and noticed an increase of 4.35% in the NPV. The NPV of the project originally was $40.2 million with one percent increase in the sales price the NPV increased to $41.9 million. This means an increase of 1% in the sales price of the product will increase the net present value of the project by 4.35%.
Following was also analysed in the sensitivity analysis of the project with respect to change in price of the product:
- Change in IRR from 37% to 38%. With one percent increase in sales price of the product the IRR of the project increased by 2.67%
- Change in pay-back period from 2.02 years to 1.99 years. With one percent increase in the sales prices of the product the pay-back period of the project decreased by 1.75%
- Change in profitability index from 1.71 to 1.74. With one percent increase in the sales price of the product the profitability index of the project increased by 1.77%.
Therefore, from the above data we can see that the with respect to price of the product net present value is highest sensitive to any changes.
In the following we have analysed the effect of change of sales quantity of the products on other financial factors of the product.
We increased the sales quantity of the product by 1 percent, and noticed an increase of 2.23% in the NPV. The NPV of the project originally was $40.2 million with one percent increase in the sales price the NPV increased to $41.1 million. This means an increase of 1% in the sales price of the product will increase the net present value of the project by 2.23%.
Following was also analysed in the sensitivity analysis of the project with respect to change in price of the product:
- Change in IRR from 37.47% to 36.99%. With one percent increase in sales quantity of the product the IRR of the project increased by 1.30%
- Change in pay-back period from 2.02 years to 2 years. With one percent increase in the sales quantity of the product the pay-back period of the project decreased by 0.94%
- Change in profitability index from 1.71 to 1.73. With one percent increase in the sales quantity of the product the profitability index of the project increased by 0.89%.
Therefore, from the above data we can see that the with respect to price of the product net present value is highest sensitive to any changes.
The figures used in the capital budgeting decision are estimated based on various assumptions. They are forecasted based on the conditions of the economy and requirements of the investors (Noreen, 2015). There are various financial and non financial factors which are required to be taken into consideration in order to forecast the cash flows from the given project. These figures are subject to change. The economy is unpredictable and any a little change may affect the results in a vigorous manner. Sensitivity analysis helps us evaluate this effect. It gives us the idea of how the cash flows from the given project are likely to be affected.
The rate of return which is used to discount the cash flows of the project is also based on a lot of research and assumption (Peterson & Fabozzi, 2012). This rate also includes a risk percentage. This rate is very important in the capital budgeting decision making. The assumptions made during calculations of the estimates are to be made keeping in mind the requirements, the economy and the risk factors. These assumptions should be realistic. Any unrealistic assumption made while calculating the figures will lead to unreal results for the projects (Rivenbark, Vogt, & Marlowe, 2009). These results will be unreliable and will not be of any use to the project managers.
Profitability Index
As already discussed, while making the capital budgeting decisions there are various costs which are to be included and few others are to be excluded. These costs help the investor in taking the correct decision. (Seal, 2012)
For example in the given case we see that the company has already spent $1175000 on the development of the proto type for the new product and also the company has spent $ 650000 on marketing research for the new product. While making the capital decisions above, we have not includes these costs. These costs are also refers to as sunk costs (Seitz & Ellison, 2009). Sunk costs are those costs which have already been incurred and expended by the company. These are irrelevant cost, since acceptance or rejection of project will not affect these costs. They have already been spent irrespective of the decisions of the investor.
Similarly, if the company loses sale of the other products due to acceptance of this new project, the value of loss of sales are to be classified as relevant cost. Since the company will lose revenue due to acceptance of this new project, the loss of sales is referred to as opportunity cost. These costs are to be included in the capital budgeting decision (Shapiro, 2007). Therefore, these costs will affect the decision of the investor while evaluating the project and hence are to be included in calculations.
Conclusion And Recommendation
In our calculations above we have analysed the cash flows expected to generate from the new project of Booli electronics. We have calculated the factors such as net present value, internal rate of return, and profitability index and pay-back period of the project. We see that the company is expected to earn high positive net present value. Also, the internal rate of return of the project is higher than the required rate of return. The company will earn more than what is expected and will recover the invested amount in the initial two years itself.
Hence to conclude we can say that the project is expected to generate high returns for the company and the company should accept the project.
Adelaja, T. (2015). Capital Budgeting: Investment Appraisal Techniques Under Certainty. Chicago: CreateSpace Independent Publishing Platform .
Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.
Berry, L. E. (2009). Management accounting demystified. New York: McGraw-Hill.
Bierman, H., & Smidt, S. (2010). The Capital Budgeting Decision. Boston: Routledge.
Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. (2008). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press.
Menifield, C. E. (2014). The Basics of Public Budgeting and Financial Management: A Handbook for Academics and Practitioners. Lanham, Md.: University Press of America.
Noreen, E. (2015). The theory of constraints and its implications for management accounting. Great Barrington, MA: North River Press.
Peterson, P. P., & Fabozzi, F. J. (2012). Capital Budgeting. New York, NY: Wiley.
Rivenbark, W. C., Vogt, J., & Marlowe, J. (2009). Capital Budgeting and Finance: A Guide for Local Governments. Washington, D.C.: ICMA Press.
Seal, W. (2012). Management accounting. Maidenhead: McGraw-Hill Higher Education.
Seitz, N., & Ellison, M. (2009). Capital Budgeting and Long-Term Financing Decisions. New York: Thomson Learning.
Shapiro, A. C. (2007). Capital Budgeting and Investment Analysis. New Jersey: Wiley.
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