ACC701 Accounting For Managers and Residual Income Assignment

Equipment is depreciated over 5 years on a straight line basis and the cost of capital for Noothercompany Limited is 12.50%.
a. For each of the investment alternatives, calculate the
i. Net present value

ii. Internal Rate of Return
iii. Payback Period in years and days 
iv. Accounting rate of return (on an average basis, not per year), and
v. Recommend, with reasons, which of the investment proposals should be approved.

b. Discuss whether Noothercompany Limited should undertake sensitivity analysis as part of its capital investment decision making process and identify which variables should be sensitised in this case and explain why?

Answers:

The following are the answers given:

As per the NPV, Investment 1 should be chosen as it gives the positive NPV whereas Investment 2 gives negative returns (Alexander, 2016). Furthermore, as per Internal rate of return, investment 1 gives 13% returns whereas investment 2 gives 11.92%. Also, as per the payback period, both the investments are fairly comparable and investment 1 is recoverable in 3 years 78 days. Also, the accounting rate of return is more in case of investment 1. Therefore, considering all the perspectives and results, investment 1 should be given priority over investment 2. 

Sensitivity Analysis means what will be impact on the final decision or the dependent variables when both the positive and negative changes are made to the independent variable. It shows how the results may flicker and fluctuate changing one of the variables, others remaining constant (Knechel & Salterio, 2016). Therefore, Noothercompany Limite should definitely go ahead and do the sensitivity analysis to know the impact on the decision to invest in opportunity 1 or 2 and to see what impact it does create when the variables are changed and whether it changes the profits and the cost figures. The variables which can be sensitized in both the opportunities are time period of investment, the initial investement amount, the net income in each year, the cost of capital and the estimated depreciable life. It is widely done using cost of capital (Feger, C., Feger, C., Mermet, L. and Mermet, L., 2017). 

The performance of both the divisions using ROI and residual income approach is given below:

As per this, the return on income for QLD division is 22% which is much higher than 18% of NSW division. Therefore, as per ROI, QLD division is performing better. Furthermore, as per the residual income approach, the return in NSW is more than in QLD division (Yi, X., Liu, F., Li, Z. and Jin, H., 2016).

Considering the Board’s decision to invest more, the company should invest in QLD division for a clear cut reason that the return on investment is much more in investment 1 than in investment 2. Residual income is not a proper measure of comparison as it depends purely on the absolute amount and not the percentage of income earned. Hence, the decision and reason for investment stated above.

The strength of return on income is it gives the percentage of return being earned on a given investment irrespective of having an relation with the cost of capital (Gomez, J., Insua, D.R. and Alfaro, C., 2016). Its weakness is it does not reflect that wheter the profit has actually added to the business or having a increase in the value of the business. Therefore, it remains ambiguous whether to invest or not. One another measure of taking the decision is on basis of residual income. Its positive aspect is that it shows the amount of profit earned beyond the normal expectations of the shareholders, i.e., keeping aside the normal cost of capital. It negative side is the cost of capital has to be the same in order to have right decision. EVA or economic value added is the value added to the business besides the normal return as a part of the cost of capital (Gai, K., Qiu, M. and Hassan, H., 2017). Therefore, it is just like residual income approach and gives the wealth added to business post deducting the cost of capital from operating profit and adjusting for profits. 

1. Profit and loss statement for the 5 years is given below:
2. Cash Flow for each of the 5years is shown below
3. Given below is the NPV for the company for 5 years using discounted cash flow technique.

As per this, the company should not go ahead with the proposal as the net present value is negative as on date. This means that there will be negative cash flow for the company in case the company opts for this project (Feger, C., Feger, C., Mermet, L. and Mermet, L., 2017).

Budgeting is a technique of forecasting the future sales, costs, profits and losses for the company using a variety of budgeting measures. Further it shows how the company is allocating the targets and the measures ect for the upcoming years. It can be made for multiple years based on the company’s last year performance and future year targets. It has a number of strengths and limitations. The strengths include budgets are a part of management estimate, they are the measures of communication and coordination, they act as a guide of action for future courses of action (Soderstrom, K.M., Soderstrom, N.S. and Stewart, C.R., 2017). Also, they form a basis for evaluation for various people in the company and thus form an integral part of the review mechanism. Also, they help in saving the costs and the overheads. The limitations of budget are like it can be rigid at times, it can be coersive and lead to the decrease in performance due to undue pressure, it can be time consuming and costly affair at times. Finally, at times, budget can be bureaucratic (Bennett, M. and James, P. eds., 2017).

There can be many other techniques and variables which can still be used to get the exact picture and make the decision on the investment like the rate of growth will be same or not, the rate of depreciation needs to be revised or not, whether the cost and revenue streams will undergo a change in the future, whether the company will distribute the dividends or reinvest it in the future (Chohan, U.W., 2017).

References

Alexander, F., 2016. The Changing Face of Accountability. The Journal of Higher Education, 71(4), pp. 411-431.

Bennett, M. and James, P. eds., 2017. The Green bottom line: environmental accounting for management: current practice and future trends. Routledge.

Chohan, U.W., 2017. Legislative Budget Offices and Market Sentiment Impact: The Case of Trumpcare.

Feger, C., Feger, C., Mermet, L. and Mermet, L., 2017. A blueprint towards accounting for the management of ecosystems. Accounting, Auditing & Accountability Journal, 30(7), pp.1511-1536

Gai, K., Qiu, M. and Hassan, H., 2017. Secure cyber incident analytics framework using Monte Carlo simulations for financial cybersecurity insurance in cloud computing. Concurrency and Computation: Practice and Experience, 29(7).

Gomez, J., Insua, D.R. and Alfaro, C., 2016. A participatory budget model under uncertainty. European Journal of Operational Research, 249(1), pp.351-358

Knechel, W. & Salterio, S., 2016. Auditing:Assurance and Risk. fourth ed. New York: Routledge.

Soderstrom, K.M., Soderstrom, N.S. and Stewart, C.R., 2017. Sustainability/CSR research in management accounting: A review of the literature. In Advances in Management Accounting (pp. 59-85). Emerald Publishing Limited

Yi, X., Liu, F., Li, Z. and Jin, H., 2016, June. Flexible instance: Meeting deadlines of delay tolerant jobs in the cloud with dynamic pricing. In Distributed Computing Systems (ICDCS), 2016 IEEE 36th International Conference on (pp. 415-424). IEEE.