Limitations and Applications of Capital Budgeting Methods

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The article discusses the limitations of capital budgeting techniques used by firms to evaluate and select projects. It highlights that NPV (Net Present Value) has a main limitation in that it relies on the concept of discount rate, which is difficult to identify accurately. This may lead to wrong project selection if incorrect assumptions are made. Payback period is another method that does not consider present value and can be misleading as business conditions are dynamic. The article concludes that firms must conduct ratio analysis regularly to monitor their performance and make informed decisions. While there are limitations to these techniques, they can still be used effectively with caution.

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ACCOUNTING

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TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................3
Question 1........................................................................................................................................3
1Ratio analysis............................................................................................................................3
(2) Explanation on company performance in last five years.......................................................5
2(3) Recommendations for improving company performance...................................................7
Question 2........................................................................................................................................7
1(1) Project evaluation techniques for project evaluation...........................................................7
2Limitations of investment appraisal technique.........................................................................8
CONCLUSION................................................................................................................................9
REFRENCES...................................................................................................................................9
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INDEX OF TABLES
Table 1: Calculation of current ratio................................................................................................4
Table 2: Calculation of asset turnover ratio.....................................................................................5
Table 3: Calculation of inventory turnover ratio.............................................................................5
Table 4: Calculation of days of inventory........................................................................................6
Table 5: Calculation of receivable turnover ratio............................................................................6
Table 6: Calculation of gross profit margin.....................................................................................6
Table 7: Calculation of operating profit margin..............................................................................7
Table 8: Calculation of free cash flow per share.............................................................................7
Table 9: Calculation of COGS as percentage of revenue................................................................8
Table 10: Calculation of revenue as a proportion of employee.......................................................8
Table 11: Summary of firms performance.......................................................................................9
Table 12: Staff turnover ratio of Next plc........................................................................................9
Table 13: Staff turnover ratio of H&M............................................................................................9
Table 14: Estimated working days lost of Next plc.......................................................................10
Table 15: Estimated working days lost of H&M...........................................................................10
Table 16: Poor performance of Next plc on COGS.......................................................................14
Table 17: Poor performance of Next plc on Assets utilization......................................................14
Table 18: Poor performance of Next plc on liquidity....................................................................14
Table 19: Calculation of payback period.......................................................................................15
Table 20: Calculation of ARR.......................................................................................................16
Table 21: Calculation of NPV........................................................................................................16
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ILLUSTRATION INDEX
Illustration 1: Companies comparison of COGS/ revenue ratio....................................................11
Illustration 2: Comparison of firms on the basis of gross margin ratio........................................11
Illustration 3: Staff turnover ratio..................................................................................................12
Illustration 4: Estimated working days lost...................................................................................12

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INTRODUCTION
Accounting is a discipline that helps business firms in evaluating their business
performance. In the present report, ratio analysis of Next plc and H&M is done and comments
are made on their performance of five years. Along with this, recommendations are also made in
the report regarding improvements in company’s performance. Further, in the second section of
report, project evaluation techniques are applied on the firm’s cash flows and the best project is
selected for the further expansion. At the end of report, limitations of these techniques are also
discussed in detail.
QUESTION 1
1. Ratio analysis
1. Current ratio- It refers to liquidity position of the company for given financial year
(Karande and Chakraborty, 2012). This ratio is chosen because it reflects the amount of
current asset that firm is having relative to current liability. Thus, if supplier wants to
give loan to any firm he can make better decision by looking at the company current
liquidity position. In case of Next plc Current ratio is declining consistently which
indicates that its liquidity position is decreasing consistently. This also reflects that firm
ability to pay its current liability by using current assets declining. On the other hand, in
case of H&M, current ratio is increasing consistently. This means that proportion of
current assets is enhancing in the company’s balance sheet relative to current liabilities.
Firm, current payment capability increases due to elevation in current assets. Thus, it can
be said that H&M has good liquidity position than Next plc.
Table 1: Calculation of current ratio
Next plc Current Ratio 1.82 1.76 1.48 1.54 1.28
H & M Hennes &
Mauritz AB Current Ratio 2.11 2.25 2.66 2.71 2.96
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2. Asset turnover ratio- This ratio is selected because it reflects the number of times assets
are used in order to generate sales (Kumbirai and Webb, 2013). Thus, higher value of
asset turnover reflects that firm is making best use of asset. This ratio is selected to
measure the efficiency level of both firms that are taken for analysis. Increase in sales
turnover ratio indicates that firm assets are used for generating sales in a perfect way.
There is stability in value of this turnover ratio in case of Next plc which means that at
same rate, assets are used every year for generating sales. Hence, there is no
improvement in performance of Next plc. In case of H&M, this ratio is declining and this
means that firm assets are not used properly for generating sales. Hence, it can be said
that Next plc is efficiently using its assets for generating sales.
Table 2: Calculation of asset turnover ratio
Next plc Asset Turnover 1.81 1.85 1.89 1.89 1.89
H & M Hennes &
Mauritz AB Asset Turnover 2.14 2.04 2.01 1.84 1.91
Current Ratio Current Ratio
Next plc H & M Hennes & Mauritz AB
0
0.5
1
1.5
2
2.5
3
3.5
1.82
2.11
1.76
2.25
1.48
2.66
1.54
2.71
1.28
2.96
Column C
Column D
Column E
Column F
Column G
Illustration 1: Calculation of current ratio
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3. Inventory turnover ratio- This ratio is selected because it reflects number of times in a
year inventory of firm is converted into sales (Petzke, Fuller and Metges, 2010). This
ratio helps in assessing the speed with which firm is successfully converting its stock of
finished goods in to sales. Hence, in order to measure firm sales generating capability and
inventory control strategy effectiveness this ratio is selected. This ratio is revolving in
range of 6-7 in case of Next. But in case of H&M, value of this ratio is in range of 3-4.
This means that Next plc is converting its inventory into sales at a rapid rate than H&M.
This further reflects that Next plc is keeping low amount of inventory at its place. Hence,
as per the comparison, it can be said that Next plc performs well than H&M and lots of
cash of latter firm is blocked in unsold inventory.
Table 3: Calculation of inventory turnover ratio
Next plc Inventory Turnover 6.62 6.97 6.91 6.47 6.89
H & M Hennes & Inventory Turnover 3.46 3.29 3.37 3.47 3.7
Asset Turnover Asset Turnover
Next plc H & M Hennes & Mauritz AB
1.6
1.7
1.8
1.9
2
2.1
2.2
1.81
2.14
1.85
2.04
1.89
2.01
1.89
1.84
1.89 1.91 Column C
Column D
Column E
Column F
Column G
Illustration 2: Calculation of asset turnover ratio

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Mauritz AB
Inventory Turnover Inventory Turnover
Next plc H & M Hennes & Mauritz AB
0
1
2
3
4
5
6
7
8
6.62
3.46
6.97
3.29
6.91
3.37
6.47
3.47
6.89
3.7
Column C
Column D
Column E
Column F
Column G
Illustration 3: Calculation of inventory turnover ratio
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4. Days in inventory – This ratio is being chosen to measure the number of days inventory
remain unsold for the firm. If inventory days are higher than storage cost of the firm get
increased which lead to erosion of firm profit. Hence, in order to judge speed with which
firm is generating sales this ratio is selected for the firm. It indicates number of times
unsold goods remain in company stock. Number of inventory days is low for Next. But in
case of H&M, these days are in range of 100. It means that latter firm is taking double
time in converting its inventory into sales. Thus, on the basis of this figure, it can be said
that Next plc is performing better than H&M.
Table 4: Calculation of days of inventory
Next plc Days In Inventory 55.13 52.37 52.83 56.38 52.99
H & M Hennes &
Mauritz AB Days In Inventory 105.63 110.84 108.29 105.32 98.6
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5. Receivable turnover ratio- This ratio is selected to identify the level up to which both
firms are dependent on credit sales in order to earn revenue in the business. This ratio
helps in identifying the contribution of account receivables in generating sales for the
firm (Guo and et.al., 2010). In case of Next, this ratio is very low and remains nearby to 5
times in a year. While, in case of H&M, value of this ratio is very high and at least 30%
of its sales is generated by selling goods on credit basis to the customers. Hence, it can be
said that Next plc is on safe zone because there are less chances of conversion of
receivables amount into bad debt. Thus, it can be said that Next plc is performing well
than H&M.
Table 5: Calculation of receivable turnover ratio
Next plc Receivables Turnover 5.45 5.56 5.72 5.97 6.14
H & M Hennes &
Mauritz AB Receivables Turnover 33.12 33.16 32.42 29.64 32.92
Days In Inventory Days In Inventory
Next plc H & M Hennes & Mauritz AB
0
20
40
60
80
100
120
55.13
105.63
52.37
110.84
52.83
108.29
56.38
105.32
52.99
98.6
Column C
Column D
Column E
Column F
Column G
Illustration 4: Calculation of days turnover ratio

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6. Gross profit margin- This ratio is selected in order to identify the percentage of sales that
is covered by profit. This ratio is also selected in order to judge firm cost control
capability (Drivelos. and Georgiou, 2012). Gross profit ratio of H&M is increasing
consistently but in case of Next, same is declining. This may happen due to selling
products at low price by Next plc. Gross profit ratio of H&M is high and it means that
firm has good control on its direct expenses or its sales increase may be another one
reason responsible for increase in gross profit ratio. Thus, it can be said that H&M has
good control on its direct expenses than Next plc.
Table 6: Calculation of gross profit margin
Next plc Gross Margin 33.59% 33.16% 31.48% 30.38% 29.27%
H & M Hennes &
Mauritz AB Gross Margin 58.81% 59.13% 59.50% 60.13% 62.93%
Receivables Turnover Receivables Turnover
Next plc H & M Hennes & Mauritz AB
0
5
10
15
20
25
30
35
5.45
33.12
5.56
33.16
5.72
32.42
5.97
29.64
6.14
32.92
Column C
Column D
Column E
Column F
Column G
Illustration 5: Calculation of receivable turnover ratio
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7. Operating margin- This ratio is selected in order to judge firm capability to control its
operating expenses. By comparing both firms on the basis of this ratio their efficiency
level is determined. It indicates the part of sales revenue that is covered by operating
profit of the firm (Cui and Ryan, 2011). This margin is increasing in case of H&M which
means that it has strict control on its operating expenses. In case of Next, it is declining
steadily and it is a matter of concern. Low gross and operating margins are clearly
indicating that sales of the firm are declining or it does not have control on its expenses.
Hence, on the basis of this ratio, it can be assumed that H & M is at better condition than
Next plc.
Table 7: Calculation of operating profit margin
Next plc Operating Margin 20.62% 19.33% 19.59% 17.67% 17.19%
Gross Margin Gross Margin
Next plc H & M Hennes & Mauritz AB
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
33.59%
58.81%
33.16%
59.13%
31.48%
59.50%
30.38%
60.13%
29.27%
62.93%
Column C
Column D
Column E
Column F
Column G
Illustration 6: Calculation of gross profit ratio

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H & M Hennes &
Mauritz AB Operating Margin 16.90% 17.18% 18.01% 18.53% 22.73%
Operating Margin Operating Margin
Next plc H & M Hennes & Mauritz AB
0
0.05
0.1
0.15
0.2
0.25
20.62%
16.90%
19.33%
17.18%
19.59%
18.01%17.67% 18.53%
17.19%
22.73%
Column C
Column D
Column E
Column F
Column G
Illustration 7: Calculation of operating margin ratio
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8. Free cash flow per shares- This ratio is selected in order to measure value of actual cash
flow of the firm that is received by the shareholder on each share. This ratio is helping in
judging management efficiency level and their capability to generate cash flow on the
basis of capital which was taken from the shareholders. In order to understand this ratio,
it is necessary to identify free cash flow (Brand and et.al., 2014). It is a term that reflects
actual cash flows that are happening in the business. Under this, expenses are added back
to revenue and incomes are deducted from cash inflow. By doing so, managers identify
actual cash flow in the business. In case of H&M, free cash flow per share is less than
one which means that each shareholder is receiving less amount of cash flow on per
share. This also means that shareholders of the firm will receive less amount of dividend .
In case of Next, free cash flow per share has declined in last two years. Hence, it can be
said that on the basis of this ratio, H&M is performing well than Next plc.
Table 8: Calculation of free cash flow per share
Next plc Free Cash Flow/Share 4.14 3.29 3.58 2.37 1.83
H & M Hennes &
Mauritz AB Free Cash Flow/Share 0.76 0.89 0.68 0.7 0.93
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9. COGS/ Revenue- This ratio is taken because it helps in identifying proportion of revenue
that is covered by actual cost of produced goods. If this proportion is high then it will
mean that firm is earning low amount of profit on per unit sales. Hence, this ratio show
actual image of the profit earned by the firm after deducting actual cost of product from
earned revenue. From this ratio, it is clear that in case of H&M, cost of produced goods is
declining sharply (Cranmer-Sargison and et.al., 2011). This reflects that firm adopt cost
control stratgy at the workplace. But in case of Next plc, this percentage is increasing
sharply. This may happen due to loose control of the firm on the expenses incurred by the
managers. Hence, as per the estimation, increase in cost is the main reason behind low
gross and net profit of the firm.
Table 9: Calculation of COGS as percentage of revenue
Next plc COGS/Revenue 66.41% 66.84% 68.52% 69.62% 70.73%
H & M Hennes &
Mauritz AB COGS/Revenue 41.19% 40.87% 40.50% 39.87% 37.07%
Free Cash Flow/Share Free Cash Flow/Share
Next plc H & M Hennes & Mauritz AB
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5 4.14
0.76
3.29
0.89
3.58
0.68
2.37
0.7
1.83
0.93
Column C
Column D
Column E
Column F
Column G
Illustration 8: Calculation of free cash flow per share

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10. Revenue/ employee- This ratio is selected because it indicates revenue per employee. It
can be said that by using this ratio firm measure how much amount of revenue is earned
on each employee. In case of H&M, this ratio is increasing (Osorio and et.al., 2011).
Whereas, in case of Next, it is declining which means that firm is increasing its
workforce but its revenue is declining sharply. This is absolutely wrong business strategy
because by doing so firm is reducing its profitability. Hence, it can be said that H&M is
performing well than Next plc.
Table 10: Calculation of revenue as a proportion of employee
Next plc Revenue/Employee 135729 130916 125360 119962 114727
H & M Hennes &
Mauritz AB Revenue/Employee 138467 147942 156151 159858 166639
COGS/Revenue COGS/Revenue
Next plc H & M Hennes & Mauritz AB
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
66.41%
41.19%
66.84%
40.87%
68.52%
40.50%
69.62%
39.87%
70.73%
37.07%
Column C
Column D
Column E
Column F
Column G
Illustration 9: Calculation of COGS as percentage of revenue
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Table 11: Summary of firm’s performance
Basis Next plc H&M
Current ratio Worst Good
Asset turnover ratio Good Worst
Inventory turnover ratio Good Worst
Days in inventory Good Worst
Receivable turnover ratio Good Worst
Gross profit margin Worst Good
Operating margin Worst Good
Free cash flow per share Worst Good
EBITDA margin Worst Good
COGS/revenue Worst Good
Revenue/ employee Worst Good
Revenue/Employee Revenue/Employee
Next plc H & M Hennes & Mauritz AB
0
20000
40000
60000
80000
100000
120000
140000
160000
180000
135729 138467
130916
147942
125360
156151
119962
159858
114727
166639
Column C
Column D
Column E
Column F
Column G
Illustration 10: Calculation of revenue as a proportion of employee
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Table 12: Summary of performance of both ratios
2015 2014 2013 2012 2011
Next plc Current Ratio 1.82 1.76 1.48 1.54 1.28
H & M Hennes &
Mauritz AB Current Ratio 2.11 2.25 2.66 2.71 2.96
Next plc Asset Turnover 1.81 1.85 1.89 1.89 1.89
H & M Hennes &
Mauritz AB Asset Turnover 2.14 2.04 2.01 1.84 1.91
Next plc Inventory Turnover 6.62 6.97 6.91 6.47 6.89
H & M Hennes &
Mauritz AB Inventory Turnover 3.46 3.29 3.37 3.47 3.7
Next plc Days In Inventory 55.13 52.37 52.83 56.38 52.99
H & M Hennes &
Mauritz AB Days In Inventory 105.63 110.84 108.29 105.32 98.6
Next plc Revenue/Employee 135729 130916 125360 119962 114727
H & M Hennes &
Mauritz AB Revenue/Employee 138467 147942 156151 159858 166639
Next plc Gross Margin 33.59% 33.16% 31.48% 30.38% 29.27%
H & M Hennes &
Mauritz AB Gross Margin 58.81% 59.13% 59.50% 60.13% 62.93%
Next plc Operating Margin 20.62% 19.33% 19.59% 17.67% 17.19%
H & M Hennes &
Mauritz AB Operating Margin 16.90% 17.18% 18.01% 18.53% 22.73%

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Next plc COGS/Revenue 66.41% 66.84% 68.52% 69.62% 70.73%
H & M Hennes &
Mauritz AB COGS/Revenue 41.19% 40.87% 40.50% 39.87% 37.07%
Next plc Receivables Turnover 5.45 5.56 5.72 5.97 6.14
H & M Hennes &
Mauritz AB Receivables Turnover 33.12 33.16 32.42 29.64 32.92
Next plc Free Cash Flow/Share 4.14 3.29 3.58 2.37 1.83
H & M Hennes &
Mauritz AB Free Cash Flow/Share 0.76 0.89 0.68 0.7 0.93
Non financial ratios
Next plc H&M
Staff turnover ratio Best Worst
Estimated working days lost Best Worst
Table 13: Staff turnover ratio of Next plc
1 2 3 4 5
Total staff 44287 46133 48055 50057 47562
Absenteeism 7300 9125 8030 8760 9855
Staff turnover ratio 0.16 0.20 0.17 0.18 0.21
Table 14: Staff turnover ratio of H&M
1 2 3 4 5
Total staff 47524 50026 50026 52659 55430
Absenteeism 8030 9855 10950 11680 12045
Staff turnover ratio 0.17 0.20 0.22 0.22 0.22
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Interpretation
This ratio is selected because by using this ratio the extent to which firm is making
optimum use of its workforce is identified. On analysis of figures it can be said that staff
turnover ratio is high in case of H&M in comparison to Next plc. Bad working conditions or
dissatisfaction among the employees may be one of the main reason for higher employee
turnover. This may also happen due to liberal control of HR on the employees or health issues
may be another reason responsible for high employee turnover at H&M. Hence, this is big
concern for the H&M.
Table 15: Estimated working days lost of Next plc
1 2 3 4 5
Usual hours worked per week 70 70 70 70 70
Average hours worked per 56 56 56 56 56
Next plc H&M
Staff turnover ratio
0
0.05
0.1
0.15
0.2
0.25
0.16 0.17
0.2 0.2
0.17
0.22
0.18
0.22
0.21 0.22
Column C
Column D
Column E
Column F
Column G
Illustration 11: Calculation of Staff turnover ratio
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week
Working days lost 6 8 10 9 8
Estimated working days lost 7.5 10 12.5 11.25 10
Table 16: Estimated working days lost of H&M
1 2 3 4 5
Usual hours worked per week 70 70 70 70 70
Average hours worked per
week 63 63 63 63 63
Working days lost 10 11 15 14 13
Estimated working days lost 11.1 12.2 16.7 15.6 14.4

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Interpretation
This ratio is selected because by using same working days for which firm do not get
productivity from the employee is identified. On yearly basis it can be seen that estimated
working days lost is higher in case of H&M then Next plc. Hence, firm needs to pay attention on
this weak point. Wrong treatment to the employees from managers side and dissatisfaction
among the employee may be one of the main reason due to which estimated working days lost
increased in case of H&M.
2. (2) Explanation on company performance in last five years
Next plc H&M
Estimated working days lost
0
2
4
6
8
10
12
14
16
18
7.5
11.1
10
12.212.5
16.7
11.25
15.6
10
14.4
Column C
Column D
Column E
Column F
Column G
Illustration 12: Calculation of estimated working days lost
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On analysis of chart, it can be seen that cost of goods sold to revenue is higher in case of
Next plc relative to H&M. Hence, it can be said that COGS is very high relative to revenue in
case of Next plc and it needs to take some steps in order to improve its performance.
Illustration 13: Companies comparison of COGS/ revenue ratio
Illustration 14: Comparison of firms on the basis of gross margin ratio
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From the above figure, it can be observed that gross margin is higher in case of H&M
relative to Next plc. This reflects that H&M have a good control on its direct expenses. Thus,
Next plc needs to adopt an effective cost control strategy in order to keep control on its direct
expenses.
From chart, it can be seen that staff turnover ratio is very high in case of H&M in
comparison to Next plc. Hence, it can be said that firm is not making maximum use of its
employees and it needs to formulate strict HR leave policy.
Illustration 15: Staff turnover ratio

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Estimated working days lost is also high in case of H&M relative to Tesco and this
reflects that H&M needs to make many improvements in its HR policy in order to reduce lost
working days in a year.
33) Recommendations for improving company’s performance
Table 17: Poor performance of Next plc on COGS
Next plc COGS/Revenue 66.41% 66.84% 68.52% 69.62% 70.73%
Table 18: Poor performance of Next plc on Assets utilization
Next plc Asset Turnover 1.81 1.85 1.89 1.89 1.89
Table 19: Poor performance of Next plc on liquidity
Next plc Current Ratio 1.82 1.76 1.48 1.54 1.28
In order to improve its performance and liquidity position, Next plc needs to adopt strict
cost control strategy. By applying such kind of strategy, firm will be able to generate economies
of scale. It also needs to review its product selling strategy (Bartal and et.al., 2010). It must
Illustration 16: Estimated working days lost
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abstain from using discount strategy for selling its product because selling more and more goods
at discount rate is also reducing the firm’s profit. Firm must enter in to contract with firms and
must directly purchase finished goods from them in order to control its cost and this will result in
decline in COGS as a percentage of revenue. Instead to this, firm can launch loyalty schemes to
retain their customers. By doing so, organization will be able to control its cost and increase its
profit. Next plc can increase its assets turnover ratio by determining the way in which asset must
be used for performing each activity. Maangers must make sure that its each asset is used fully to
maximum capacity. Gross margin ratio of Next plc is also low and in order to increase this firm
can adopt cost control strategy at the workplace. Receivable turnover ratio is very low in case of
Next plc,. Firm must make sales on credit basis to some extent in order to increase its products
sale.
In case of H&M efforts needs to be made to purchase less products from the suppliers
and by doing so inventory turnover ratio can be increased. Firm mangers must bring change in
their leadership style and employees must be paid for their work. By doing so revenue employee
ratio can be reduced by the managers. Cash flow per share is low for H&M and in order to
improve performance on this ratio firm can give more discount to buyers. This may boost sale of
the firm product in the market and by doing so value of ratio can be improved. Firm operating
margin ratio is also low and in order to enhance its value firm must keep control on its operating
expenses. For this it can analyze its operations and can eliminate wasteful steps from procedures
that an organization follow to perform its operations.
(4) Limitations of ratio analysis
The main limitation of ratio analysis is that if standards are already determined then firm
compares its performance with the standards of ratio like 2:1 for current ratio. Sometimes,
business conditions are very poor and it is not possible to reach the standard value (Brand and
et.al., 2014). If this happens then manager assumes that they are not performing well. Thus, it
can be said that sometimes by using this technique, manager can wrongly interpret the firm’s
performance. This is main limitation of ratio analysis. Inflation rate get changed with passage of
time and it is possible that in present year inflation rate increased in comparison to previous year.
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If this happens then current year’s performance may become low relative to previous year. If
performance will be compared on the basis of both year ratios then it will reflect that firm does
not perform well. Actual result behind poor performance is elevation in inflation rate. In
calculation of ratio analysis impact of inflation is not considered. Hence, by using this method
firm performance cannot be measured in a proper way.
QUESTION 2
1(1) Project evaluation techniques for project evaluation
Calculation of Net cash flow (NCF)
NCF can be determined through adding depreciation in the net profit.
Table 20: Depreciation on machines
Year 2016 2017 2018 2019 2020 2021 Total
Net profit 40000 40000 40000 30000 30000 20000 200000
Depreciation 33000 33000 33000 10000 10000 10000
Machine
sold
21000
Machine
purchase
-50000
NCF 73000 73000 44000 40000 40000 30000 300000
Depreciation on 1st Machine = (120000-21000/3) = 33000
Depreciation on 2nd Machine = (50000/5) = 10000
Table 21: Depreciation on machines
Year 2016 2017 2018 2019 2020 2021 Total
Net profit 10000 20000 30000 60000 70000 55000 245000
Depreciati
on
20000 20000 20000 20000 20000 20000 120000

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NCF 30000 40000 50000 80000 90000 75000
Depreciation = 120000/6 = 20000
Table 22: Calculation of payback period
Year Project A CCF Project B CCF
0 (120000) (120000) (120000) (120000)
2016 73000 (47000) 30000 (90000)
2017 73000 26000 40000 (50000)
2018 44000 70000 50000 0
2019 40000 110000 80000 80000
2020 40000 150000 90000 170000
2021 30000 180000 75000 245000
Project A = 1 year + (47000£/73000£) = 1.64 years
Project B = 3 year
Interpretation
This ratio indicates the time period within which project can recover invested amount.
Form calculation, it can be seen that project A is covering the invested corpus in one year and six
months. However, project B is recovering the invested amount in three years. Thus, project A is
assumed to be viable for the firm then project B.
Average rate of return method
Table 23: Cash flow for calculation of average rate of return
Year 2016 2017 2018 2019 2020 2021 Total
Net profit 40000 40000 40000 30000 30000 20000 200000
Depreciation 33000 33000 33000 10000 10000 10000
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Machine
sold
21000
Machine
purchase
-50000
NCF 73000 73000 44000 40000 40000 30000 300000
Depreciation on 1st Machine = (120000-21000/3) = 33000
Depreciation on 2nd Machine = (50000/5) = 10000
Year 2016 2017 2018 2019 2020 2021 Total
Net profit 10000 20000 30000 60000 70000 55000 245000
Depreciati
on
20000 20000 20000 20000 20000 20000 120000
NCF 30000 40000 50000 80000 90000 75000
Depreciation = 120000/6 = 20000
Table 24: Calculation of ARR
Project A Project B
Initial
investment 120000 120000
1 73000 30000
2 73000 40000
3 44000 50000
4 40000 80000
5 40000 90000
6 30000 75000
Total 300000 365000
Average 50000 60833
ARR 41.67% 50.69%
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Interpretation
ARR indicates the average rate of return that a project can earn on the invested amount
(Sinha, and Labi, 2011). ARR of project A is 41.67% and of project B is 50.69%. Hence, it can
be said that project B is viable for Hilltop ltd.
Net present value method
Table 25: Calculation of NPV
Year Project A
Discounted
value of 1£
@20% DCF Project B DCF
0 -120000 1 -120000 -120000 -120000
2016 73000 0.833 60809 30000 24990
2017 73000 0.694 50662 40000 27760
2018 44000 0.579 25476 50000 28950
2019 40000 0.482 19280 80000 38560
2020 40000 0.402 16080 90000 36180
2021 30000 0.335 10050 75000 25125
62357 61565
Interpretation
NPV indicates net present value of the project that remains after deducting initial;
investment from the present value of cash flows. On the basis of comparison of values of both
projects it can be said that project A is more viable than project B. Hence, it is recommended to
the management that it must select project A because it has higher NPV and is recovering the
invested amount in a short duration.

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2. Limitations of investment appraisal technique
There are many limitations of investment appraisal technique and one of the main weak
points is that in this method, discount rate is used. Following are the limitations of various
project evaluation techniques: ARR- The main limitation of this method is that for identification of project viability,
accounting figures are used (Jacobsen and et.al., 2010). These figures do not reflect
actual cash flow occurred in the project. Hence, on the basis of this method, if project is
evaluated then it is not necessary that viable project will be selected by the firm at every
time. NPV- Main limitation of NPV is that in this method, concept of discount rate is used. It is
very difficult to identify actual discount rate as for this, concept of WACC is used. In
calculation of WACC, risk premium and market return in future are estimated for
computing weight of equity on total capital (What are the limitations of capital budgeting.
2016). Hence, if wrong estimations are made then wrong discount rate will be selected by
the mangers for project evaluation. Hence, by using this method, Hilltop may select
enviable project. This is the main limitation of NPV method.
Payback period- The main limitation of this method is that in this concept, present values
are not used. Business conditions are dynamic in nature and this affects the cash flow of
project. It is not necessary that project will be completed exactly in a time period which is
reflected by the result of payback period. Thus, this method does not reflect the payback
period of project by considering its present value.
CONCLUSION
On the basis of above discussion, it has been concluded that firms must conduct ratio
analysis on time to time in order to monitor their performance. By using this method, managers
can take business decisions on right time. It is also concluded that instead of selecting project on
the random basis, managers must use project evaluation methods in order to select the most
viable project for the firm. There are some limitations of these techniques but if cautious
approach is followed then these methods can be used in an effective way by the managers.
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