Assignment : MAKING FINANCIAL DECISIONS

Task 1: On your first morning in early January 2008 the Directors present you with two budgets
prepared by the departed financial accountant. You are given the cash flow forecast for the
twelve months from January 2008 and the sales budget covering the twelve month period from
July 2007 to June 2008 – the first six months of which include actual sales figures and variances
between budgeted and actual sales.

The directors are concerned about the likely cash deficits shown in the cash flow forecast and the
sales performance from July to December 2007. They are also concerned that they are very
unlikely to meet their budgeted sales targets for January to June 2008.
With this in mind they ask you to:-

 Examination of the cash flow forecast and the sales budget:

The analysis of cash flow forecast and the sales budget shows that:

 There are positive variances during the duration of July-December 2007. For the time
being, it might seem favorable that actual expenses were less than the expected ones but
the major problems rise in the forecasted cash flows that seem to not able to maintain the
sales budget as before in the year of 2008 also.

 Cash flow forecast shows that sales increase up to April 2008 but decline in next two
months and then keep fluctuating till December 2008.

 Total income also will not remain constant and keep switching between increasing and
then decreasing for some time.

 The purchases will decrease, not remaining constant and ending will comparatively lesser
quantity then that it was in the beginning of the year.

 Total expenditure will decrease by the year ends.

 Monthly deficit will decrease a great till the year ends.

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 Assignment : MAKING FINANCIAL DECISIONS

 Accumulative deficit will also decrease but to a lesser extent as compared to that in
monthly surplus.

 Major problems faced by Northfield Components:

Above findings shows that Northfield is facing the following problems:

 There is flexible budgeting in the sales budget which is not favorable for forecasting
budget for the whole year.

 The company is facing positive variance but with lesser sales.

 The company is spending budget less than expected which means that it do have money
left behind making up the profit. Even though, due to fewer sales that money is not being
utilized in positive strategies.

 The sales and total income are fluctuating with no constant positive growth.

 There is no consistency in the sales due to which the directors’ salaries will not increase
the whole year.

 Insurance will be sought twice the year only.

 The company will spend relatively less amount on equipment in the latter months of
2008.

 The company is not going to spend any more amounts on advertising and will keep it
fixed on 2000 only.

 Causes of the problems:

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 Assignment : MAKING FINANCIAL DECISIONS

The possible causes of the above mentioned problems are stated below:
 The company is not thinking of any innovation in its business to enhance
sales.
 There is not strong strategy and planning for stabilizing the total sales and
income.
 There is no consistency in sales due to which the salaries cannot be
increased.
 The company is not spending any more money on equipment and is
merely concentrating on the already present ones to make sales.
 No money is being invested on advertisement and any other promotion
strategy.

 Remedy for problems to be avoided in future:

Following recommendations can work favorable for the Northfield to overcome

its shortcomings:
 The company must be innovative. Today’s world is advancing with rapid
pace. Customers are well aware of their preferences and want to see
innovation in the products. By introducing novelty in the products, the
sales can be enhanced.
 A strong guerilla strategy must be devised to focus on the sales and
income issues.
 Proper management must be employed to enhance the sales and thus
increase the salaries of the directors so that they remain connected to the
company and work more efficiently.
 More money must be spent on equipment. Up-to-dated items must be
purchased to make the production better and thus enhance sales.
 Promotion strategies must be employed and more money must be spent on
various sources such as advertisement, websites, banners, etc.

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 Assignment : MAKING FINANCIAL DECISIONS

 Recommendations for improving the cash flow situation:

The situation of cash flow can be best improved by minimizing the cash deficit or
generating a cash surplus. According to Evans (n.d.), this can be attained by:

 Accelerating cash inflows wherever possible.

 Delaying cash outflows until they come due.

 Investing surplus cash to earn a rate of return.

 Borrowing cash at the best possible terms.

 Maintaining an optimal level of cash that is neither excessive nor deficient.

 Preparing cash forecasts for shorter periods of time (weekly or daily) if cash
flows are tight.

 Using available data as much as possible to prepare cash flow forecasts.

 Preparing two forecasts: Early Warning Forecast for longer periods of time
(six months) and Targeted Forecast for shorter periods of time (weekly).

 Recommendations for resolving the issues highlighted in the sales budget:

In order to resolve the sales budget’s issues, it is needed to decide what approach
should be taken in relation to the January to June budget. The possible solutions are
stated here under:

 The budget should be kept as close as possible i.e. fixed throughout. Because
flexible budgeting can only preferred to be used as a tool to improve
management control information. In every scenario, the fixed budget is always
the target for the year.
 The monthly budget must be designed in such a way that it yields more
cumulative budget and thus high positive variance. This will be helpful in
earning more profit.

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 Assignment : MAKING FINANCIAL DECISIONS

Task 2: The Directors of Northfield Components Ltd are very concerned about the company’s
current costing and pricing policies. They are also anxious to find out which products are going
to be profitable or otherwise in the future. With this in mind the Directors ask you to carry out a
full costing and pricing review across the company’s product range.

Northfield components make plastic food storage boxes of various sizes in a factory made up of
a molding department and a finishing department. Each batch of 100 medium boxes uses 40 kg
plastic, which costs £0.60per kg. Labour time for the mounding process for each batch is 1.5hrs,
paid at a rate of £8.20 per hour. The hinges for the boxes, which cost £15 per packet of 50 pairs
(one pair per box) are a patented design and royalties are payable at £0.10 per pair of hinges used
in manufacture. Each batch takes 20 minutes to go through the finishing department, where
labour is paid at a rate of £9.60 per hour.

Total factory indirect costs for the forthcoming period are expected to be £8,500 during which
200 batches of medium boxes are expected to be made. 60% of these are attributable to the
molding department, and 40% to the finishing department.

Using the above information calculate the unit cost for plastic boxes, where each batch contains
100 boxes. Based upon the financial documents attached in the annex, your line manager also
wants you to recommend the most appropriate method of pricing.

Calculations:
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 Assignment : MAKING FINANCIAL DECISIONS

Number of boxes in each batch = 100

Plastic used by 100 boxes = 40kg
Plastic used by one box = 40/100 = 0.4
Cost of plastic per kg = £0.60per kg
Cost of plastic required for one box = 0.60 * 0.4 = £0.24

Labor time for the mounding process for each batch (100 boxes) = 1.5hrs
Labor time for the mounding process for one box = 1.5/100 = 0.015hrs
Pay given per hour for one box = 0.015 * 8.20 = £0.123

Cost of hinges for per packet of 50 pairs of boxes = £15

Cost of hinges for one pair per box = 15/50 = £0.3
Cost of hinges for per pairs of box (payable by royalties) = £0.10

Time taken by one batch (100 boxes) to go through finishing department = 20min
Time taken by one box to go through finishing department = 20/100 = 0.2
Payment given to labor at finishing department = £9.60 per hour
Cost for one box at finishing department = 0.2 * 9.60 = £1.92

Total cost of unit box = £ (0.24 + 0.123 + 0.10 + 1.92) = £2.383

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 Assignment : MAKING FINANCIAL DECISIONS

Task 3: The Directors of North Seaton Engineering Company are considering two alternative
business projects each of which involve an initial investment of ₤ 450,000. In your role as
financial consultant you are asked to advise the Directors which of the two projects would be the
more financially viable.

Project ‘A’ involves the introduction of modern, hi-tech machinery into the company’s main
production unit. This will result in significant increases in output and substantial savings in
production and maintenance costs. This in turn will result in a net increase in turnover to the
company of:-
Year 1 - ₤ 180,000
Year 2 - ₤ 230,000
Year 3 - ₤ 280,000
Year 4 - ₤ 120,000

Project ‘B’ involves an increase in the company’s marketing activities. The Directors would
employ one of the region’s most prestigious marketing companies to manage a massive national
campaign. They feel that business could be increased without, necessarily, updating production
processes. In is anticipated that the net effect of their campaign would bring in additional annual
turnovers of:-
Year 1 - ₤ 60,000
Year 2 - ₤ 120,000
Year 3 - ₤ 250,000
Year 4 - ₤ 250,000

As financial consultant, you are asked to carry out a full investment appraisal of the two projects.
In order to fully assess the pros and cons of the two alternatives you decide to employ a number
of appraisal techniques:-

• Payback:
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 Assignment : MAKING FINANCIAL DECISIONS

Project A:
Initial investment = ₤ 450,000
Life on investment = 4 years
Depreciation = ₤ 450,000 / 4 = ₤ 112,500

year Accounting profit Cash flows

1 ₤ 180,000 ₤ 180,000 + ₤ 112,500 = ₤ 292,500
2 ₤ 230,000 ₤ 230,000 + ₤ 112,500 = ₤ 342,500
3 ₤ 280,000 ₤ 280,000 + ₤ 112,500 = ₤ 672,500
4 ₤ 120,000 ₤ 120,000 + ₤ 112,500 = ₤ 232,500

Project B:
Payback period = 450,000 – 292,000 – 342,500 = 158,000
After one years and before the end of two years = 158,000/342,500 = 0.46
So, payback period = 3.46 years

year Accounting profit Cash flows

1 ₤ 60,000 ₤ 60,000 + ₤ 112,500 = ₤ 172,500

2 ₤ 120,000 ₤ 120,000 + ₤ 112,500 = ₤ 232,500

3 ₤ 250,000 ₤ 250,000 + ₤ 112,500 = ₤ 612,500
4 ₤ 250,000 ₤ 250,000 + ₤ 112,500 = ₤ 362,500

Payback period = 450,000 – 172,000 – 232,500 = 45,000

After two years and before the end of three years = 45,000/612,500 = 0.07
So, payback period = 2.07 years

Since, second investment plan has the shorter payback period, so it is more financially viable.

• Accounting rate of return:

Project A = ARR = [average net income (inclusive of profits and cash inflows) – depreciation] /
initial investment
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 Assignment : MAKING FINANCIAL DECISIONS

= [(450,000 + 180,000 + 230,000 + 280,000 + 120,000) – 45,000] / 450,000

= 2.078

Project B = ARR = [average net income (inclusive of profits and cash inflows) – depreciation] /
initial investment
= [(450,000 + 60,000 + 120,000 + 250,000 + 250,000) – 45,000] / 450,000
= 2.41

Since, second plan has higher ARR, so it is more financially viable.

• Net present value:

Project A:
Cash flows discounted at the project’s cost of capital:
Year 1 - ₤ 180,000 / (1 + 6%) ^1 = 180,000 / 1.06 = 169,811.32
Year 2 - ₤ 230,000 / (1 + 6%) ^2 = 230,000 / 1.06 = 216,981.13
Year 3 - ₤ 280,000 / (1 + 6%) ^3 = 280,000 / 1.06 = 264,150.94
Year 4 - ₤ 120,000 / (1 + 6%) ^4 = 120,000 / 1.06 = 113,207.55
NPV = 450,000 - 169,811.32 + 216,981.13 + 264,150.94 + 113,207.55 = ₤ 761,320.75

Project B:
Year 1 - ₤ 60,000 / (1 + 6%) ^1 = 60,000 / 1.06 = 56,603.77
Year 2 - ₤ 120,000 / (1 + 6%) ^2 = 113,207.55
Year 3 - ₤ 250,000 / (1 + 6%) ^3 = 250,000 / 1.06 = 235,849.06
Year 4 - ₤ 250,000 / (1 + 6%) ^4 = 235,849.06

NPV = 450,000 - 56,603.77 + 113,207.55 + 235,849.06 + 235,849.06 = ₤ 573,301.9

Here, project A has the higher NPV, so it is more favorable here.

• Internal rate of return:

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 Assignment : MAKING FINANCIAL DECISIONS

It is calculated in excel using function of IRR.

For project A = 29%
For project B = 15%
Project A here has higher IRR, so it seems favorable here.

 Summary of the conclusions:

Following results are drawn from above calculations:

 Project B has the shorter payback period comparatively.
 Project B has higher ARR.
 Project A has the higher NPV.
 Project A has higher IRR.

 Recommendations:

According to above findings, project A must be taken because of following

reasons:
 Pay back rule gives insufficient information.
 IRR rule is vital in choosing project.
 NPV gives the main answer. Higher NPV reflects higher value for
shareholders. It always leads to right decision.

Hence, since project A has higher NPV comparatively, the company must
consider it favorably feasible.

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 Assignment : MAKING FINANCIAL DECISIONS

Annexure

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