Critical Evaluation Of A Financial Planning Model Finance Essay

This study is intended to measure the strengths and failings of fiscal theoretical account ( Investment Appraisal ) applied to the instruction sector and besides reflect upon the public presentation of the theoretical accounts as an instrument of policy to help the companyaa‚¬a„?s decision-making procedure. The fanciful AJ College is continued to be used for illustrated intent as in Coursework 1.

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1.1 The Importance of Capital Investment Appraisal

All concerns require capital equipment ( fixed plus ) such as machinery, vehicles and premises to spread out the productive capacity of the concern. Most capital investing determinations will hold a direct consequence on future profitableness as they will either consequence in an addition in efficiency gross. Therefore, whatever degree of direction authorises a capital outgo, the proposed investing should be decently evaluated, and found to be worthwhile. ( Atrill & A ; McLaney 2007 )

Company has to choose appropriate and relevant fiscal information for usage in the procedure of doing strategic determinations on investing. Appraisal technique is the procedure of doing long term investing determinations. It enables a company to measure the viability of a long-run undertaking and whether it is deserving set abouting or no. Harmonizing to Meyers ( 2003 ) , there are two types of assessment techniques as given below:

1. Traditional method

a ) Payback Period ( PBP )

B ) Average Rate of Return ( ARR )

2. Discounted hard currency flow method

a ) Net Present Value ( NPV )

B ) Internal Rate of Return ( IRR )

degree Celsiuss ) Profitability Index ( PI )

1.2 Problem Statement

The AJ College has been losing gross due to its chief profitable accounting classs are confronting intense competition from other colleges in the bing instruction sector. With the aim of addition and maximising net income, the managers of AJ College have decided to present a new class in order to pull demand. The college needs to do a pick between two classs which are reciprocally sole as the college has merely sufficient financess to put in merely one new class. Both classs which are under consideration are E-Commerce and Applied Business Computing. The college has to buy new installations and equipments such as computing machines and machinery for the use of both classs.

1.2.1 Appraisal of Cash Flows

Both new classs would hold to be invested by RM 1 million in the equipment severally. The new class will get down from 1 January 2011 till terminal of 2014 for four old ages. The fees for E-Commerce will be RM 45000 per unit for four old ages and RM 60000 for 4 old ages class of Applied Business Computing. The variable cost of E-Commerce is RM26,400 per unit and RM 36,000 per unit for Applied Business Computing. Both classs are forecast to pull 150 and 100 pupils severally. The fees for both classs will be fixed while the variable cost rising prices is expected to be 5 % per twelvemonth. There is no addition in bing fixed costs as the AJ College has sufficient labor in footings of lector and administrative for the new demand and schoolrooms and talk halls for the expand scope of new class. Introducing and offering new class will name for increased investing in working capital. Analysis of historical degrees of working capital within AJ College indicates that at the start of each twelvemonth, investing in working capital for both classs will necessitate to be 5 % of gross for that twelvemonth. AJ College pays revenue enhancement of 30 % per twelvemonth in the twelvemonth in which the nonexempt net income occurs. Liability to revenue enhancement is reduced by capital allowances on equipments ( tax-allowable depreciation ) and the attendant decrease in a revenue enhancement is treated as hard currency salvaging originating from the credence of a undertaking. AJ College can claim on a straight-line footing over the four-year life of the proposed investing. The equipment does non hold residuary value at the terminal of 4th twelvemonth due to quickly alter of engineering. AJ College uses a nominal after-tax cost of capital which is besides discount rate of 12 % for investing assessment intent.

2.0 Analysis

2.1 the grounds of taking Discounted Cash Flow ( DCF ) Method in measuring

Harmonizing to Dyson ( 2007 ) , DCF is a capital assessment technique that is based on the construct of the clip value of money. For case, RM 1 at nowadays is deserving than RM 1 in the hereafter. The AJ College choose to use DCF method as the managers realize that the profitableness of the hereafter undertaking may be grossly optimistic if the clip value of money construct is ignored. Furthermore, the issue of rising prices is taken into history. By using the DCF method, the managers of AJ College are able to measure the investing by looking at the hard currency flows of the undertaking as hard currency flows shows the costs and benefits of a undertaking when they occur.

2.1.1 The NPV Method

NPV is the value obtained by dismissing all hard currency escapes and influxs of a capital investing undertaking at a chosen mark rate of return of return or cost of capital. Harmonizing to Birt, et Al ( 2008 ) , puting in capital undertakings that offer positive cyberspace

present values creates extra wealth for the concern and its proprietors.

Refer to the Appendix 1, the net present value obtained is RM 420,127 for the E-Commerce class. The positive NPV value indicates that investing in this class is potentially able to give a higher return which is RM 420,127 than the costs of investing which is RM 1,000,000. However, the NPV value in Appendix 2 is besides a positive value which is RM239,861 for Applied Business Computing class. The NPV of both classs indicate that the hard currency influxs will give a return in surplus of the cost of capital. In this instance, the AJ College has targeted the cost of capital of 12 % . However, the NPV value of E-Commerce is RM 180,266 higher than Applied Business Computing. Hence, E-Commerce is preferred.

Ehrhardt & A ; Brigham ( 2010 ) states that the advantages of NPV method is its usefulness in measuring a undertaking in which the needed rate of return varies over the life of the undertaking. Hence, the managers of AJ College can find and compare the entire present value of the hard currency influxs with the entire initial investing to measure the attraction of the undertaking which can ensue net income to the college.

2.1.2 The IRR Method

The IRR method calculates the exact rate of return which the undertaking is expected to accomplish, that is the price reduction rate at which the NPV is 0. ( Dylan pp 39, 2007 ) . For AJ College, a class can be considered if the expected rate of return exceeds the mark rate of return or cost of capital, which is 12 % . The consequences obtained in Appendix 3 show that the estimated IRR for both classs are higher than the cost of capital which is 12 % , which mean both proposed investing are financially acceptable for AJ College. However, the IRR for E-Commerce is 29.8 % which is higher than the 22.5 % of IRR of Applied Business Computing. Consequently, the E-Commerce is preferred to be invested.

Pogue ( 2004 ) claimed that the advantage of using IRR is that the accent is placed on liquidness. Besides, it is a per centum step and which gives a clearer thought to the managers of AJ College of how one undertaking compares with another in the rate at which it will add value to the college.

Harmonizing to Dyson ( 2007 pp 433 ) , in complex capital investing state of affairss, the IRR method can give some misleading consequence where there are reciprocally sole undertakings such as the current investings sing by AJ College. Hence, another method which is profitableness index may be helpful for determination doing procedure of the managers.

2.1.3 Profitability Index ( PI )

The PI method is helpful as the AJ College has the purpose of maximizing the net income and net present value. Wretman ( 2002 p. 747 ) stated that the profitableness index is the present value of hard currency flows discounted at the cost of capital divided by the present value of the investing. The undertaking with the highest profitableness index will give the highest net nowadays value for the sum of investing support available. Taking the information in Appendix 4, E-Commerce programme with profitableness index of 1.5 is preferred comparison with the 1.3 of Applied Business Computing programme at a cost of capital 12 % .

2.2 Failings of DCF method

From the consequences calculated in the excel spreadsheets, both NPV and IRR see the clip value of money and the initial hard currency investing. However, the methods rely on the usage of an appropriate price reduction factor for the fortunes. The existent return in footings of the per centum of the investing spending is non revealed. Besides, both methods have some dependability cautiousnesss as NPV is extremely dependable at the price reduction rate that is selected. Harmonizing to Drury ( 2006 ) , if an inappropriate and unrealistic price reduction rate is used in the investing assessment, erroneous determination could be made. Furthermore, determination should non be made entirely on the footing of a high IRR value but should look farther to measure if an chance to put hard currency flows at such a high IRR is realistic. Besides, IRR ignores the graduated table of undertakings, so it does non concentrate on the coevals of absolute wealth. ( Ismail & A ; Cline 2005 )

Ranking of undertakings in footings of highest NPVs and IRR may ensue struggle when there are reciprocally sole undertakings. ( Birt et al 2008 pp 438 ) Therefore, AJ College uses discounted payback method to find how long the investing would retrieve the original investing costs to guarantee the truth of determination devising.

2.3 Discounted payback method

The discounted payback method is another method which takes clip value of money into history. From Appendix 5, the consequence shows that investing in E-Commerce class will retrieve all of its original cost during twelvemonth 2013, which is the 3rd

twelvemonth of investing. Assuming that hard currency flows accrue equally, this would be about the terminal of 8th month at Year-2 because ( 220,038/323,259 ) x 12 months = 8.2 months, so the discounted payback period is about 2 old ages 8 months. On the other manus, the investing in Applied Business Computing class will retrieve all of its original cost during twelvemonth 2014, which is the 4th twelvemonth of investing and the discounted payback period would be 3 old ages 2 months. Again, the E-Commerce class is preferred.

3.0 mensurating hazard utilizing Sensitivity Analysis

Wilks & A ; Burke ( 2008 ) states that there are concern hazards and uncertainness in capital investing. Forecast gross has been used to foretell the figure of pupils by the AJ College and hence truth of the consequences may be wrong. A sensitiveness analysis has been conducted to supply a more informed image to the college of what would go on if the figure of pupils were lesser than predicted. The appendix 6 illustrates the consequences obtained if the demand of E-Commerce is merely 100 pupils. The NPV still shows positive consequence ; hence, E-Commerce class is extremely preferred to be invested.

4.0 Recommendation and Decision devising

AJ College has to take merely one class to put RM 1 million. From the consequences obtained in the four investing assessment methods, both classs are deserving sing. However, the E- Commerce class which has higher net present value, internal rate of return, profitableness index, and shorter discounted payback period than the Applied Business Computing class is extremely recommended. Therefore AJ College should put RM 1 million in E-Commerce class as the market value of the college would be increased. Besides, the college can raise financess through bank loans or trade recognition to put some short term undertakings in order to pull demand and increase net income. Entire gross can be increased by advancing the new class through advertisement and public dealingss so that more pupils will be attracted to inscribe the college. Furthermore, the E-Commerce class fees can be somewhat reduced as it is considered a new class in the current instruction sector. Lower fees would decidedly pull more demand in the current competitory instruction market.

Decision

In decision, capital investing assessment is really of import for determination devising map. It would be better for a company to follow a few capital appraisal methods as each method has its ain strengths and failings. However, discounted hard currency flow analysis is the most appropriate tool for determination devising. The lone thing that company should concern is to do the best possible appraisal of the hard currency flows.

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