Case Study: CQU Printers

Case Study: CQU Printers   

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Table of Contents

Introduction. 3

a) Initial investment, operating cash inflows, and terminal cash flow.. 3

Initial Investment 3

Operating Cash Inflows. 4

Terminal Cash Flow.. 4

b) Cash Flow Stream.. 4

Proposal A.. 4

Proposal B.. 5

c) Application and explanation of Decision Techniques. 5

Payback Period. 5

Net Present Value (NPV) 6

Internal Rate of Return (IRR) 7

d) NPV vs. IRR.. 9

e) Conflicting Rankings (NPV vs. IRR) 10

e) Recommendation. 10

1. Unlimited funds. 11

2. Capital rationing. 11

f) Impact of risk factor on Recommendation. 12

Conclusion. 12

References. 13

 

Introduction

Managerial accounting is sometime termed as “internal accounting” as it is mainly used for internal purposes. The terms managerial accounting is also covered in managerial finance. Managerial accounting is used by managers or management to take decisions at organisational level (Besley, 2008). Overall, managerial accounting is consisted on process of preparation of management accounts and reports that provide timely and accurate statistical and financial information to management to support them in making short-term as well as long-term decisions. Basically, it assists in forecasting future; buy-or-make decisions; cash flow forecasting; understanding performance variances; analysing rate of return; as well as making mutually exclusive investment decisions like in case study of CQU Printers (Brewer, 2009). There are two mutually exclusive investment options for the firm. The two options have different purchase price, installation cost, as well as salvage value.

This report is divided into different sections. In the first section initial investment, operating cash inflows, and terminal cash flow for both investment options is given. Relevant cash flow stream of both options is given under second section while in the third section different decision techniques like; payback period, net present value (NPV), and internal rate of return (IRR) have been applied to both investment options in the third section. IRR and NPV profiles of the two options are graphed in next section while there is discussion about conflicting rankings, if any, of the two on the basis of NPV and IRR in next section, sixth section. It is followed by recommendations for investment on the basis of unlimited funds and capital rationing. There is also analysis of effect of risk on the recommendations. At the end of the report the analysis has been summarised under conclusion section.

a) Initial investment, operating cash inflows, and terminal cash flow

Initial Investment

Particulars Proposal A Proposal B
 Purchase price   $            830,000  $             640,000
 Installation cost  $              40,000  $                20,000
 Total Initial Investment   $            870,000  $             660,000

Operating Cash Inflows

Year Proposal A Proposal B
1  $                 250,000  $                210,000
2  $                 270,000  $                210,000
3  $                 300,000  $                210,000
4  $                 330,000  $                210,000
5  $                 370,000  $                210,000

Terminal Cash Flow

Particulars Proposal A Proposal B
 Terminal cash flow  $            400,000  $             330,000

b) Cash Flow Stream

Proposal A

S. No  Particulars Cash Outflow Cash Inflow Balance
1  Purchase Price  $               830,000    $     (830,000)
2  Installation cost  $                 40,000    $     (870,000)
3  PBDT Year 1    $       250,000  $     (620,000)
4  PBDT Year 2    $       270,000  $     (350,000)
5  PBDT Year 3    $       300,000  $       (50,000)
6  PBDT Year 4    $       330,000  $       280,000
7  PBDT Year 5    $       370,000  $       650,000
8  Terminal cash flow    $       400,000  $    1,050,000

Proposal B

S. No  Particulars Cash Outflow Cash Inflow Balance
1  Purchase Price  $               640,000    $     (640,000)
2  Installation cost  $                 20,000    $     (660,000)
3  PBDT Year 1    $       210,000  $     (450,000)
4  PBDT Year 2    $       210,000  $     (240,000)
5  PBDT Year 3    $       210,000  $       (30,000)
6  PBDT Year 4    $       210,000  $       180,000
7  PBDT Year 5    $       210,000  $       390,000
8  Terminal cash flow    $       400,000  $       790,000

c) Application and explanation of Decision Techniques

Payback Period

Payback Period is a useful technique in terms of deciding whether to accept an investment proposal or not. The technique measures how much time it would be required to cover initial investment (Berk, 2014). The investment proposal which has smallest payback period is accepted. Calculations for the two proposal of purchase of a printer have been given below:

Proposal A

S. No.  Year  Particulars Cash flow Balance/(Investment Recoverable)
1 0  Initial investment   $       870,000  $     (870,000)
2 1  PBDT Year 1  $       250,000  $     (620,000)
3 2  PBDT Year 2  $       270,000  $     (350,000)
4 3  PBDT Year 3  $       300,000  $       (50,000)
5 4  PBDT Year 4  $       330,000  
6 5  PBDT Year 5  $       370,000  

Proposal B

S. No.  Year  Particulars Cash flow Balance/(Investment Recoverable)
1 0  Initial investment   $       660,000  $     (660,000)
2 1  PBDT Year 1  $       210,000  $     (450,000)
3 2  PBDT Year 2  $       210,000  $     (240,000)
4 3  PBDT Year 3  $       210,000  $       (30,000)
5 4  PBDT Year 4  $       210,000  
6 5  PBDT Year 5  $       210,000  

According to above calculations both proposal would be able to recover initial investments in fourth year. If both projects are compared precisely then both proposals would take about 3 years and two months. However, proposal A would require 3 years and 2.03 months while proposal B would cover its initial investment in 3 years and 1.74 months which seems marginally less than the payback period of proposal A. If, recommendation is made on the basis of Payback period then Proposal B should be preferred (Brealey, 2012).

Net Present Value (NPV)

NPV helps in measuring present value of all present and future cash flows of an investment proposal. An NPV value of “Zero” reflects that a particular proposal would have no benefits for a firm (Brewer, 2009). NPV for both proposal for CQU Printers is given below:

Proposal A

Year Cash Outflow Cash Inflow Discounting factor           @ 14% Present Value
0  $    (870,000)  $             –   1.00  $ (870,000)
1  $                  –    $  250,000 1.14  $   219,298
2  $                  –    $  270,000 1.30  $   207,756
3  $                  –    $  300,000 1.48  $   202,491
4  $                  –    $  330,000 1.69  $   195,386
5  $                  –    $  770,000 1.93  $   399,914
NPV  $   354,846

Proposal B

Year Cash Outflow Cash Inflow Discounting factor           @ 14% Present Value
0  $   (660,000)  $              –   1.00  $ (660,000)
1  $                 –    $  210,000 1.14  $   184,211
2  $                 –    $  210,000 1.30  $   161,588
3  $                   0  $  210,000 1.48  $   141,744
4  $                 –    $  210,000 1.69  $   124,337
5  $                 –    $  540,000 1.93  $   280,459
NPV  $   232,339

The calculations given above clearly state that proposal A is much more beneficial for the firm as it would return a net cash inflow of over 0.3 million dollars while the proposal B would return only above 0.2 million dollars (Fischer, 2015).

Internal Rate of Return (IRR)

The IRR is used to measure profitability of a proposed investment. Technically, it is discount rate that makes all cash flows’ NPV equal to zero. If, IRR of an investment proposal is greater than cost of capital of a firm then it can be acceptable. A proposal with higher IRR is preferred (Garrison, 2004). IRR for CQU Printer’s proposals is calculated below:

Proposal A

Year Cash Flow
0  $           (870,000)
1  $              250,000
2  $              270,000
3  $              300,000
4  $              330,000
5  $              370,000

Following formula will be used to calculate IRR:

Where;
a is lower of two rates of return used
b is higher of two rates of return used
NPVa is NPV obtained using rate a
NPVb is NPV obtained using rate b (Besley, 2008)
Year Cash Flow DF (20%) Present value DF (21%) Present Value
0  $           (870,000) 1.0  $                    (870,000) 1.0  $           (870,000)
1  $              250,000 1.2  $                      208,333 1.2  $             206,612
2  $              270,000 1.4  $                      187,500 1.5  $             184,414
3  $              300,000 1.7  $                      173,611 1.8  $             169,342
4  $              330,000 2.1  $                      159,144 2.1  $             153,947
5  $              370,000 2.5  $                      148,695 2.6  $             142,651
NPV  $                           7,283  $             (13,034)
IRR= 20%  

Proposal B

Year Cash Flow
0  $           (660,000)
1  $              210,000
2  $              210,000
3  $              210,000
4  $              210,000
5  $              210,000
Year Cash Flow DF (20%) Present value DF (21%) Present Value
0  $           (660,000) 1.0  $                    (660,000) 1.0  $           (660,000)
1  $              210,000 1.2  $                      179,487 1.2  $             177,966
2  $              210,000 1.4  $                      153,408 1.4  $             150,819
3  $              210,000 1.6  $                      131,118 1.6  $             127,812
4  $              210,000 1.9  $                      112,067 1.9  $             108,316
5  $              210,000 2.2  $                         95,783 2.3  $                91,793
NPV  $                         11,863  $                (3,294)
IRR= 18%  

According to IRR both proposals have ability to cover cost of capital of the firm which is 14%. However, project A is more beneficial as it has IRR of 20% in comparison to 18% of proposal B (Berk, 2014).

d) NPV vs. IRR

It is very difficult to graph and compare figures with percentage. For comparison purpose there is need to standardize the variable like it is done in trend analysis, horizontal analysis and vertical analysis. For standardization purpose there are two options either to convert IRR to number or covert NPV to percentage (Brealey, 2012). The IRR has been converted to numbers by multiplying with initial investment of respective proposal.

e) Conflicting Rankings (NPV vs. IRR)

A graph comparing NPV and IRR has been given in previous section while its true figures are given below:

Proposal  NPV IRR
 A  $            354,846 20%
 B  $            232,339 18%

According to above analysis there is no difference in using two different techniques like NPV and IRR in order to make final decision about investment proposal. Both techniques NPV and IRR are in favour of proposal A as proposal A has NPV seriously greater than proposal B. Same is the case with IRR where proposal A has greater value than the B. However, IRR reflects that there is not much serious difference as NPV technique suggests. If there were any conflicting rankings then both techniques would have been compared in order to reach to a conclusion for selection of a particular proposal. However, both techniques are ranking proposal A higher than the proposal B therefore, it would be irrelevant and un-necessary to discuss their pros and cons (Berk, 2014).

e) Recommendation

There are three main techniques used for ranking purpose of the two proposals. Two of the techniques NPV and IRR are clearly in favour of proposal A. On the other hand, both are almost equal according to Payback Period as proposal B is marginally better than the A. Overall, it is recommended that CQU Printer must go with proposal A. However, factors like Unlimited Funds and Capital Rationing have ability to effect the recommendation. Let’s analyse how these can affect the recommendation (Brewer, 2009).

1. Unlimited funds

If, the firm has unlimited funds then the firm will prefer the project which has higher potential for profitability irrespective of initial investment or funds required for the proposal and the time period required to recover initial investment. From the previous analysis in this report it has been found that there are only two potential problems with proposal A that makes proposal B more attractive. One is higher initial investment and second one is payback period while on the basis of other factors whether it is NPV or IRR the proposal A is more attractive. If, the firm has unlimited funds then the two factors initial investment and payback period would become irrelevant and the firm clearly will have to go with proposal A (Garrison, 2004).

2. Capital rationing

Capital rationing has two implications. First, the firm would restrict amount of investment. Second, the firm will be looking for proposal that has greater potential profitability. Under first implications, proposal B should be preferred as proposal A requires significantly higher initial investment however, according to figures provided below proposal A will be able to increase net working capital that can offset negative implications of higher initial investment (Jeter, 2010).

Current Account Amount
Cash  $       25,400
Accounts Receivable  $    120,000
Inventories  $       20,000
Accounts payable  $    (35,000)
Effect on Net Working Capital  $    130,400

Under second implications the firm will be looking for investment proposal with higher profitability. It has been found through IRR that the proposal A has higher rate of return therefore, under this scenario also the firm should prefer and accept proposal A (Berk, 2014).

f) Impact of risk factor on Recommendation

Even though, operating cash inflows associated with printer A are riskier than of printer B the firm must go with printer A purchase if the firm is looking for higher profits. It is strongly stated that higher risks are linked with higher profits. In other words, an individual or corporate investor will have to bear higher risks if they have to earn higher profits. Yet in other words, as the level of profitability increases the level of risk also increases (Brealey, 2012). So, if the firm is looking for higher profits then the firm must go with printer A purchase. However, if CQU Printer does not want to face or bear riskier operating cash inflows and don’t want to invest higher amount initially then the firm must go with proposal B and purchase of printer B (Berk, 2014).

Conclusion

There are two mutually exclusive investment options for CQU Printer The two options have different purchase price, installation cost, as well as salvage value. If, recommendation is made on the basis of Payback period then Proposal B should be preferred. However, on the basis of NPV proposal A is much more beneficial for the firm. Moreover, project A is more beneficial on the basis of IRR as it has IRR of 20% in comparison to 18% of proposal B. Both techniques NPV and IRR are in favour of proposal A as proposal A has NPV seriously greater than proposal B. Same is the case with IRR where proposal A has greater value than the B.

If the firm has unlimited funds then the two drawbacks of proposal A, initial investment and payback period would become irrelevant and the firm clearly will have to go with proposal A. On the other hand, it has been found through IRR that the proposal A has higher rate of return therefore, under capital rationing scenario also the firm should prefer and accept proposal A.

If the firm is looking for higher profits then the firm must go with printer A purchase. However, if CQU Printer does not want to face or bear riskier operating cash inflows and don’t want to invest higher amount initially then the firm must go with proposal B and purchase of printer B.

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