FINANCIAL MANAGEMENT

Financial Management - Assignment

Financial Management - Assignment

Part A - Investment Appraisal

A firm has made cumulative investment of amount $ 2, 200, 000 on a project with useful life of 8 years. For accounting purposes, the project is depreciated via double declining or reducing balance method and for tax purpose; the project is depreciated by straight line method. The firm has applied four different techniques to assess the feasibility of investment made in the project.

Project Investment

The total investment outlay was divided into beginning investment of value $ 1, 500, 000 and $ 700, 000 incurred as an up-gradation cost at the end of the third year. The project has a salvage value of $ 25, 000 with an estimated sales units of 0.5 million per annum.



Accounting Rate of Return (ARR)

The term 'ARR' refers to an estimated amount of return that a firm may expect from an investment decision. The rate is calculated by a formula that divides average income by the investment outlay. It is an investment appraisal method that has been calculated via incremental accounting profit approach with uneven cash flows (Investopedia, 2013, p. n.d.).

A three step method is used to calculate ARR for the firm. In the present case, the firm was using two different methods of depreciation for communicating and reporting accounting information (Armah, n.d., p. 2). Hence, ARR has been individually calculated for both approaches.

Using Straight Line Method - Using this approach, the firm will report an annual depreciation cost of amount $ 271, 875, which will result in an accounting loss of value $ 0.006875 million. Inserting these values in the formula provides a negative rate of 0.31%. It means that the project is not feasible because it is generating profit less than an expected return from the investment.

Incremental Accounting Approach with Uneven Cash Flows

Step 1: Annual Depreciation Expense

 

 

Depreciation (annual)=

Initial Investment - Salvage Value

 

Useful life of Project

Depreciation (annual)=

2175000

 

8

Depreciation (annual)=

271,875

Table 1: Annual Depreciation Expense

Step 2: Average Incremental Income per annum

 

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Cash inflows

0.275

0.275

0.275

0.275

0.275

0.4

0.4

0.4

Operating Expenses

0.055

0.055

0.055

0.055

0.055

0.06

0.06

0.06

Depreciation

0.27188 0.27188 0.27188 0.27188 0.27188 0.27188 0.27188 0.27188

Net income

(0.05)

(0.05)

(0.05)

(0.05)

(0.05)

0.07 0.07 0.07

 

 

Average Incremental Income=

(0.006875)

 

 

 

 

 

 

 

Table 2: Average Incremental Profit per Year

Step 3: ARR

 

 

 

Accounting Rate of Return=

-0.31%

Table 3: ARR under Straight Line Method

Using Reducing Balance Method - In this approach, the firm will record average incremental income of $ 0.093702 million over the defined period of time. With uneven cash stream and reducing balance approach to depreciation expense, the firm will produce an ARR of 4.26%.

Incremental Accounting Approach with Uneven Cash Flows

Step 1: Annual Depreciation Expense

 

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Reducing Balance Depreciation

375,000 281,250 217,188 162,891 122,168 91,626 68,719 51,540

Table 4: Annual Depreciation Expense

Step 2: Average Incremental Income per annum

 

 

 

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Cash inflows

0.275

0.275

0.275

0.275

0.275

0.4

0.4

0.4

Operating Expenses

0.055

0.055

0.055

0.055

0.055

0.06

0.06

0.06

Depreciation

0.37500 0.28125 0.21719 0.16289 0.12217 0.09163 0.06872 0.05154

Net income

(0.15500)

(0.06125)

0.00281 0.05711 0.09783 0.24837 0.27128 0.28846

 

 

Average Incremental Income=

0.093702

 

 

 

 

 

 

 

Table 5: Average Incremental Profit per Year

Step 3: ARR

 

 

 

Accounting Rate of ...