A.C. 3.3 – Identify the strengths and weaknesses and give feedback on the financial proposal


Accounting Rate of Return Method

This method tests viability by establishing the average return on the proposed investment on the basis of a project estimated revenues and expenses. viability. In one of the projects that Tesco Plc was considering acquiring modern office equipment costing $25,000 with an expectation of generating profits of $2,000 annually over a period of ten years, the tool was used to evaluate its viability

The AAR identified which is 16% and identified through a division of the company average annual net profits of $2000 by average investment of $12,500 [($25,000+$0) ÷ 2] prompts the management of Tesco plc to identify its viability.

Payback Method

This is applied in computing the expected number of years in which a project would recover their initial investment through the future cash flows and making a decision of whether the payback period is acceptable.  For instance, at one point, Tesco Plc had to invest on a new line costing $25,000 to generate profits of $2,000 annually for a period of 10 years. Since the payback method adopt cash flows rather than profits, the net income needs to at first be converted to cash flow.

The strength of this approach is that it is applicable in organisations that are interested in sourcing a quick return on their investments in short-term projects where liquidity is the key concern.

Additionally, the Net Present Value can be used to complement the payback method as it exploits the discounting cash flows. Through this, it enables conversion of future expected cash flows to a current value amount. A positive amount of the business should lead to acceptance of the proposed investment while a negative one leading to rejection of the proposed investment. Considering the similar project of Tesco PLC investing $25,000 and the future after-tax flows estimated at $4,500 for each of the next 10 years, this tool is applicable. Tesco Plc has made a decision that the investment would produce a future cash flow return (after the taxes) of approximately 14% for it to be acceptable.

Year Description After-tax cash flow 14% Discount factor Discounted after-tax cash flow
0 Cost of investment $ (25,000) 1.000 $ (25,000)
1–10 Annual cash inflows 4,500 5.216 23,472
  Net present value     $ (1,528)

As it can be pointed out, the net present value of the future cash flows is a negative $1,528 which is an indication that the return is less than the 14% hurdle rate established by the company. As a consequence, it would tentatively reject this particular project. Nevertheless, the management must make a decision of whether to make a consideration of the non-quantitative reasons for accepting this project prior to coming up with the final decision. From the two analyses of the projects, it is evident that the first project is viable for the project while the second one is not viable.

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