Forecasting and Financial Appraisal Techniques
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Forecasting and Financial Appraisal Techniques
Case One: Forecasting
The Travel Company Ltd (AT) serves the Singapore clients who are going for holidays abroad. The company charter planes and book hotels for their clients. The aim of the case study is to justify the company's forecasting process. The company works with agents, hotels and the airline companies. The company recognizes the profits in the month in which the clients do the payments. It does not refund their clients on them cancelling the holidays either before the due date or after the due date. All the payment is done on the clients making a booking for their holidays. The Company's cash flow forecast and the profit and loss account are summarized as provided below.
From the schedule provided above, that is, the profit and loss account, and the cash flow forecast, that was developed following the AT company information concerning the expected orders and the expected expenditures of the company. The following features can be identified from the schedule with regard to forecasting.
The AT company will be realizing profits in the first four months of the year, and then afterward, it will be making losses till the month of December when it will realize again some profit. The failure for the company to realize profits during the months in which losses are incurred can be attributed to the number of orders that are expected during these months (Jordan, 1998, pp 14). The company experiences low volume of sales during the months, meaning that the company's profitability is heavily dependent on the volume of sales that it makes, where in this case, the number of sales implies the number of holidays booked by the clients. Therefore, the backbone for profit maximization for the company is through sales maximization (Cooper, 1988, pp101).
The company will be having surplus cash in the first nine months of the year, that is, in the months of January to September. The shortage of cash will be experienced in the months of October, November and December. The shortage of cash in the last three months can be attributed to the large expenditure that the company will incur in the month of October, that is, the purchase of premises that will cost the company $ 500000. The shortage of funds in the month of October, November and December are likely to affect the company's performance following the fact that the company will be requiring cash to settle its debts in the day to day's transactions. This situation provides the company with an incentive to seek external sources of funding that will enable it to meet its transactional needs (Lumby, 1981, pp102). The failure of the company to look for sources of external funding will paralyse the company's operational procedures.
There are a number of sources that the company can get finances from on avoiding the possibility of becoming bankrupt (Waletr, 1988, pp20. The possible sources include borrowing of the funds from the banking institutions, the issue of shares to the public or the extension of the company's creditors.
The borrowing of funds from the banking institution as one of the means that the AT company can finance its cash deficit, is the fastest way for raising the funds, because the only condition that they are supposed to meet is to show bank that they are worthy to be given a loans. The amount of loan to be awarded will however be limited to the credit worthiness of the company depending on the criteria of evaluation used by the lending bank (Adams, 1986, pp13). Despite the qualifications to meet the requirements of the lending bank, the company is expected to consider the terms and the conditions of attaining the loan. This is meant to rescue the company from an economic burden, following the fact that, other conditions and terms of loans might be uneconomical (Zhang, 2003, pp45). The evaluation of the terms and conditions of borrowing a loan should be based on the projected performance of the business and the period over which the loan will be repaid (Langdon, 2002, pp67). The performance of the business should be able to service the loan and at the same time enable the business to realize some profits to pay off the returns on the company's share holdings.
Another possible source for financing the company's deficit is through the issue of shares to the public. This form of business financing acts as a risk management strategy because the company's risk for making losses in the future is spread across many owners of the company in the form of shareholders (Chiang, 1990, pp12). This source of financing is also cost effective compared to other sources like loan, because the company will only be expected to pay of dividends only if profits are realized (McLaney, 2006, pp1440. However, this normally varies depending on the type of shares held by the shareholders. For the preference shareholders, they expect to be paid in a predetermined schedule and specified amount, unlike the common shareholders who only are paid when the company realizes profits (Martina, 2007, pp231). The company should encourage common shareholdings than the preferred shareholdings with an aim of reducing the possibly of their being cash shortages in the future, because the shareholders will only be paid if the company realizes profits or when there is surplus cash.
The extension of creditors is also another alternative under which the company can finance the cash deficits. This involves the purchasing of assets on credit, and the accessing of the airline and hotel services on credit. This will enable the company to finance its operation even though it does not involve the one on one handling of cash (Shim, 2000, pp198). It is a form of financing because the company's activities will be going as normal, that is the same way as if the company was spending on the expenses at the current times (Button, 1993, pp321). This however will heavily depend on the relationship that the company might have build in the initial interactions with the potential creditors. The initial interaction, that involve the promptness to pay a credit as scheduled will determine the possibility of the company getting funds through this means. The promptness to pay a credit determines the amount of trust that exists between the debtor and the creditor.
The company realizes profits at the time in which the orders are made regardless of whether the orders might be cancelled or taken as scheduled by the clients. This can be perceived as being inconsistent with the set accounting principles on the recognizing of revenue (James, 1997, pp44). Revenue is expected to be matched with the costs that were incurred to generate the revenue at a specified period of time (Bunz, 2002, pp57). That is, revenue should be matched with the costs in the month in which the costs are incurred for a particular order (Joseph, 2003, pp102). However, the practice of recognizing profits may vary from one industry to the other, depending on the nature of the industry and the policies that are adapted by specific companies in the industry (Geddes, 2002, pp140). The AT company does the contrary with regard to the revenue recognition as provided by the accounting standards. The company recognizes the profits in the month in which orders are made before the due date of the holidays. That is, it does not match the revenue and the costs at the same time, otherwise accounted for in different times. This situation makes it difficult to trace the marginal profit of a particular activity because the revenue and the cost are reflected in different times (Pettinger, 2000, pp21). It also eliminates the possibility of practicing comparability overtime, more especially on comparing the company's performance overtime.
The kind of policies adapted by companies also affects the revenue recognition. For instant, the AT company does not normally refund the cash that they receive from their clients on either the cancellation or not taking the holiday. This is a tradition that has been perfected on which is reinforced by price competence of the company (Hanke, 2004, pp302). This makes the company unique in recognizing revenue, unlike the companies that can refund the cash to the clients in case a holiday is cancelled. Therefore, the recognizing of profits in the month in which the orders are made is reinforced by the policy that is adapted by the company. The company is sure that the funds at hand will never be refunded to the customers (Dauten, 1987, pp302). The only challenge that the company is likely to face is the exact evaluation of the profits following the cancellation of some holidays, given the nature of the industry. The cancelling of holidays is not definite but rather an estimate, which might affect the profits that were recognized by the company in the later when the orders were made. The uncertainty of cancelling holidays in the future is what makes the recognizing of the profits in the month of making orders unreliable. The Hotels will require 60% if the holiday is cancelled before due date and they will require full amount if the holiday is cancelled after due date.
Case 2: Investment appraisal
This case is concerned with the making of appraisals over competing projects. The judgments are guided by the aim of ensuring high returns on capital. The analysis starts at providing a case summary and then an investment appraisal on the competing projects.
The public provided complaints to the regional authority of Toa Payos about the poor performance in clearing the local roads in the dry weather conditions. The complaints brought the concerns of the road department. The road department operates a fleet of 5 vehicles. The vehicles are operating beyond their optimal lifetime that increases the frequency of breakdowns. The second hand value of the each vehicle is $2000. The modern replacement of the vehicles will cost $50,000 each, where at the end of six years each vehicle will be expected to sell at $5000 after an overhaul and at $2000 as a scrap. Each vehicle will require an overhaul of $14000 after every two years.
The concern of the authority is to design the acceptable level of service that will have an impact of minimizing the future complaints. A consultant hired by the authority recommended that the company should purchase ten vehicles can suffice in all but exceptional weather conditions. The ten vehicles are only needed in six months, that is, from October to March. The vehicles can however be hired by a nearby quarry at a price of $200,000 per year, but expected to decline by $20,000 each year that is meant to reflect the ageing of the fleet. The risk that is associated with the authority choosing to lend their vehicles to the quarry is that, the quarry workings are approaching to exhaustion, and for a, reason the quarry workings are certain to close in the near future. The quarry is not ready to sign a contract of more than two years. During summer, the vehicles would be kept in a stand-by to be driven only when needed by the truck drivers.
Following the case provided, there are number of Investment decisions that the authority has to make. The decisions require the authority to make judgment on which Investment opportunity to invest in. This follows from a number of projects that are competing as provided in the case. The authority is expected to establish on whether it is significant to replace the vehicles with the new vehicles. The authority is also expected evaluate the contracting with the quarry on if it is economically sound (Anthony, 1975, pp57). The authority is also expected to evaluate the viability of using the vehicles in refuse managements.
The company can only solve the complaints from the public by doing a modern replacement of the vehicles. After the vehicles, serving for six years the authority should instead sale the vehicles as scrap than an overhaul. This follows from the fact the increase in value that is realized on selling the vehicle after an overhaul is lower than the cost of doing the overhauling (Gross, 1976, pp 111). The value only increases by $3000 compared to the cost of overhauling each vehicle of $14000, therefore, the vehicles should be sold as scrap.
The Cost for each vehicle is given as being $50,000. The scrap value after six years is $2000, meaning that each vehicle is depreciating at a value of $ 8000 per annum. On hiring the ten vehicles to the quarry, it means that each vehicle will be depreciating by 4000 every month, given that the depreciation is fixed at $40000 for the ten vehicles. The different between the two values of depreciation imply that the hiring the vehicles to the quarry will be enabling a greater return on capital than when used by the authority. The uncertainty of contracting with the quarry is that the quarry is likely to close in the near future, and the quarry cannot contract for more than two years (Ellis, 2005, pp98). The Authority should contract with the quarry because it will realize a capital gain in the two years compared to when the Authority would have used the vehicles in the collecting of refuse (Weetman, 2002, pp76). The vehicles should be used in the quarries because this is an ending opportunity compared to the collecting of refuse. Therefore, the authority will be maximizing the profits in the short-run (Atkinson, 2007, 125). This argument is based on the understanding that more risky investments are likely to have more returns. However, the authority in this context has been perceived as risk loving in the process of maximizing returns. If the authority is risk averse, then it should not choose to lend its vehicles to the quarry (Lucey, 2003, 126).
On average, that is, using the probability and the annual costs provided for different summer weather conditions, the average cost for collecting refuse is 0.79 Million. If the authority had contracted the Duplex plc for refuse management, it will cost the authority 1Million. This implies that contracting is expensive than when doing it by itself. Therefore, the authority should do it on its own than contracting Dumplex plc.
Dumplex plc case
The Dumplex plc is experiencing a fall in demand because of economic recession. The company opted to encounter this situation by taking an opportunity to produce designer ceramic tiles for home improvement market. The company has already invested $0.5 million in the development expenditure, market research and feasibility study. The company is expected to use $ 2M in redesigning and setting up the facilities. The income tax is at 33%. The Shareholders' returns are 14% per annum that includes an allowance for inflation of 5.5% per annum. The total variable costs per box of tiles are equal to $15. The cost involves the summation of Material costs, direct labor, variable overhead, fixed overhead and Distribution per box of tiles. The returns on shares, development expenditures and the redesigning of the facilities can be perceived as being fixed costs (Mowen, 2006, pp97).
The investing of the Dumplex plc in the project should be guided by the considering the profitability of the project. That is, the company should consider the costs that are involved in the production of a single box of tiles against the price of each box of tiles in the market. This will enable the company to establish a profit margin. The company should be able to sell the product above the breakeven price, at the point where the price of the product in the market is equal to the cost of producing one unit, if it was to realize profits (Scapens, 1985, 107).
Assuming that the fixed costs that include development expenditures and redesigning of facilities are spread across the products in the five years of operation, then the unit cost for the fixed costs can be established. The total fixed costs that are spread over the five years are equal to 2.5m, which is equivalent to 0.5m per year.
That is ; (2 + 0.5)M/ 5years.
=0.5m per year
Then divide the value by the total number of boxes per year to attain the per unit fixed costs of each box of tiles produced within a year.
The unit cost for producing each box is given by summing the total variable costs per unit and the fixed costs per unit, that is;
unit cost per box= 15 + 3.3
This cost implies the price at which the company can sell its product on making zero profits, that is, it represents a breakeven point.
On the assumption that Dumplex Company is a profit maximizing company, the company should sell each box of tiles at a price that is above $18.3 if it was to realize some profits. The company should be guided by profit margin that is desired by the company. However, at some stage, on the assumption that the company is operating in a competitive, the company might be forced to sell its products at some price as provided in the market. This is based on the assumption that, if the company is operating in a competitive market, then it is a price taker (Harper, 1965, pp45). The sale of the product above the market price will affect the demand for the company's product negatively, as it is likely to decline following the law of demand. When price of a commodity increases, the consumers are either likely to switch to the substitute of product or consume less of the product (Nelson, 2001, pp34). In such situations, the company should redesign its production and distribution channels, with an aim of reducing the cost of production and distribution, in the process of making adjustments to attain the desired profit margin (Garrison, 2000, pp12).
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