Investment Appraisal Techniques and Approaches to Pricing - Management Accounting

This report discusses various investment appraisal techniques and approaches to pricing in management accounting. It includes calculation of NPV and IRR, comparison of capital budgeting decisions, methods of investment appraisals, and approaches to pricing.

MANAGEMENT
ACCOUNTING

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
MAIN BODY...................................................................................................................................1
A) Calculation of Net present value.......................................................................................1
B) Calculation of IRR.............................................................................................................1
C) Limitation of various techniques of proposed investments...............................................1
D) Comparison of two approaches to making capital budgeting decisions by means of
discounted cash flow..............................................................................................................2
E) Another two methods of investment appraisals.................................................................2
F) Can non-monetary aspects are useful to make various decisions related to the investment
projects...................................................................................................................................3
G) Four methods used in investment appraisals are...............................................................3
H) Various approaches to pricing...........................................................................................4
CONCLUSION................................................................................................................................5
REFERENCES................................................................................................................................6
APPENDIX......................................................................................................................................7

INTRODUCTION
Management accounting is the process of preparing various financial accounts and
reports in order to analyze the accurate and timely based financial and statistics data which are
required by managers to make day-to-day decisions in order to achieve the short term and long
term objectives of the company. Investment appraisal is a collection of various techniques that
are used to identify the attractiveness of investment. In this report, case study of KingtonTech
Ltd. has being used in order to calculate the NPV and IRR. In this report, two approaches are
compared to make various capital budgeting decisions. In this, methods of investment appraisals
are also discussed.
MAIN BODY
A) Calculation of Net present value
[Enclosed in appendix]
B) Calculation of IRR
[Enclosed in appendix]
C) Limitation of various techniques of proposed investments
The acceptability of proposed investment is that NPV is positive, thus it can be suggested
as a proposed investment in financial terms. In the above calculation, IRR is 16% and discounted
rate of return is only 12% which indicate that IRR is more as compared to discounted rate that is
used. Thus, proposed investment can be financially accepted (Carmichael, 2011). It can be said
that cash flow of the proposed investment in terms of Alpha is inevitable as there is only one
IRR. Therefore, limitation of investment in Alpha is that evaluation of IRR and NPV is highly
reliant on the production and sales volume. Thus, Kingston Tech Ltd. should analyze and
investigate the assumption that is underlying the production and sales volume. Thus one of the
main limitations of NPV is that it requires an estimated cost of capital in order to calculate Net
present Value and at the same time, cash flows should be in terms of dollars not in the term of
percentage. Likewise, the method of IRR cannot be used in a situation in which sign of the cash
flows of a project changes continuously.
1

D) Comparison of two approaches to making capital budgeting decisions by means of discounted
cash flow
The two approaches to make capital budgeting decisions by the means of discounted cash
flow are NPV and IRR. Company should make an efforts to select/accept the investment
proposal that gives positive NPV as it can increase the market value of company to the great
extent as per the increment in NPV. In order to increase the wealth of shareholders, companies
should always make effects to investment in the proposal which gives the positive NPV
(Garleanu and Pedersen, 2011). At the same time, in order to increase the wealth of shareholders,
Kingston Tech Ltd. can also accept the projects that have profitability IRR. The condition of
profitability IRR arises when IRR is higher than the uniform discounted rate. Technique of IRR
is used for making various necessary decisions for the management.
NPV at 20% -£92,387
NPV at 12% £91,154
IRR 15.97 16%
By taking into consideration, it could be concluded that Kingston Tech Ltd. should move
on with the NPV at 12% because it is given positive cash flow which in turn will aid company to
increase the shareholder’s wealth. At the same time, IRR at 16% should be selected in order to
achieve the profitability IRR.
E) Another two methods of investment appraisals
Another two methods of investment appraisals which management accountant can use are
payback period method and Accounting rate of return.
Pay Back Period Method is the method of analyzing the time period after that investment
made will be recovered back (Irani, 2010). This method will provide the manager of Kingston
Tech Ltd. an indication that how many year will take place in order to recover the original
investment cost. This method makes an allowance for the risk by focusing attention on the near
future term. The advantage of this method is that it helps to identify the project which is having
fastest return on investment made. This method is especially beneficial for the newly opened
firm in order to know the actual time frame for recovering the amount invested. However,
drawback of this method is that it does not consider the time value of money which in turn could
lead to wrong decision making. Furthermore, it ignores cash flows that occur after the payback
2

period which indicates that there is the possibility of ignoring the complete return which a
project can generate.
Likewise, on the other hand Average Rate of Return is the percentage of average
accounting profit that is earned over the average accounting value of investment earned (Kaplan
and Atkinson, 2015). This method normally focuses on the accounting profit generated than that
of cash flows. The approach of this method is to estimate revenues that will be generated by a
proposed investment and then, deducting all the projected operating expenses that are associated
with the project. Advantage of this method is that it uses the entire streams of net operating
income which in turn assists investors and creditors to evaluate the performance of business.
Moreover, there is also a drawback of this method. This method ignores the time value of money
which is a major decision factor which aids company in taking various financial decisions
F) Can non-monetary aspects are useful to make various decisions related to the investment
projects
It is true that all monetary aspects are important and beneficial in order to find out the
best investment proposal/ project. There is no doubt that these methods aid investors to analyze
the time period after which they are able to recover the particular amount of money invested.
But, all the time, decisions taken on these basis are not correct (Lukka and Modell, 2010).
Meanwhile, it could also be concluded that only by using various monetary aspects for making
investment decision is not a right way. Investment decisions should be made by taking into
consideration both the monetary and non-monetary aspects. Monetary aspects include various
methods of capital budgeting like Payback period, IRR, NPV, ARR and many more. Similarly,
non-monetary aspects includes various internal and external factors that are available in the
environment. These factors could be identified by conducting SWOT or PESTLE analysis or by
using various relevant models. Thus, at last, it suggests that in order to take correct decisions,
Kingston Tech Ltd. should undertake both the monetary and non-monetary aspects. This in turn
will aid company to properly found the time period after which they are able to recover the
invested amount.
G) Four methods used in investment appraisals are
Out of the four investment appraisal methods, company can use more than one method at
a time. These four methods (i.e. NPV, IRR, ARR and Pay Back period) contribute towards the
broader understanding of the investment projects. These methods also assist company to rank
3

various investment that can be made according to their optimality and efficiency of return in
order to select the best investment proposal.
But, at the same time, it cannot be ignored that each of the methods has its own risk
factors and different methods are suitable for the different type of business organization. Features
of different types of methods are as follow:- Net Present Value: - NPV takes into account the size, risk factor and timing of the future
cash flow which in turn aid managers to determine the viability on the cost of capital of
the company based on the selected project (Maharjan, Zhang and Gjessing, 2011). Internal Rate of Return: - IRR takes the cash flows of investment projects into account
along with the time value of money (Otley, 1999). This method will aid manager to
decide and analyze whether the selected investment proposal/ project is profitable from
the company’s point of view or it will increase the cost of company. Moreover, this
method can be considered as one of the best methods for ranking projects. Pay Back period: - This method reduces the cost of company due to its simplicity. At the
same time, this method will aid company to analyze the number of years when it is able
to recover the amount of money investment (Willcocks, 2013).
 Average Rate of Return: - ARR does not take into account the concept of time value of
money. This method is used by company in order to calculate the return earned out of the
net income generated from the proposed capital investment (Zimmerman and Yahya-
Zadeh, 2011).
 Furthermore, it is analyzed that using more than one method of investment appraisals
reduces the risk involved and at the same time, decreases the chance of discrepancy
between actual and budgeted revenue. Sum of methods also reduces the cost of project.
Henceforth, after analyzing all the four methods of investment appraisals, it could be
concluded that NPV is one of the suitable methods for the long term investment. Thus, on the
other hand, it could be concluded that Pay Back period is suitable for analyzing the short term
investment.
H) Various approaches to pricing
There are three main approaches which Kingston Tech Ltd. can consider (i.e. competitor
based approach, economist approach and cost plus pricing approach).
4

 Competitor based pricing approach: - It is one of the effective pricing methods in which
seller considers the price of competitors as a benchmark for setting its own prices. Main
advantage of this method is that it helps company to set their prices in a competitive
manner (Andor, Mohanty and Toth, 2011). But, on the other hand, drawbacks of the
approach cannot be ignored, this is a very time consuming approach and competitors are
also able to change its price easily.
 Cost plus pricing approach: - In this method, markup is applied to the base cost in order
to determine the targeted selling price. This method will assist Kingston Tech Ltd. to
easily identify the amount of expenditure that is incurred by the company at the time of
manufacturing goods.
According to me, most suitable pricing method for Kingston Tech Ltd. is the cost plus
pricing approach because this method will reduce the risk as well as uncertainty and at the same
time, it assures company to make profit since its cost are reimbursed so it will initially make
profit and there is no risk of losses.
CONCLUSION
From the following report, it could be concluded that Net Present value is one of the best
methods for analyzing the long term investment and payback period method will be beneficial
for meeting the short term investments. At last, it can also be said that out of the three selected
approaches, Cost plus approach is one of the best approaches for the Kingston Tech Ltd.
5

REFERENCES
Books and Journals
Carmichael, D. G., 2011. An alternative approach to capital investment appraisal. The
Engineering Economist. 56(2). pp.123-139.
Garleanu, N. and Pedersen, L. H., 2011. Margin-based asset pricing and deviations from the law
of one price. Review of Financial Studies, p.hhr027.
Irani, Z., 2010. Investment evaluation within project management: an information systems
perspective. Journal of the Operational Research Society. 61(6). pp.917-928.
Kaplan, R. S. and Atkinson, A. A., 2015. Advanced management accounting. PHI Learning.
Lukka, K. and Modell, S., 2010. Validation in interpretive management accounting research.
Accounting, Organizations and Society. 35(4). pp.462-477.
Maharjan, S., Zhang, Y. and Gjessing, S., 2011. Economic approaches for cognitive radio
networks: A survey. Wireless Personal Communications. 57(1). pp.33-51.
Otley, D., 1999. Performance management: a framework for management control systems
research. Management accounting research. 10(4). pp.363-382.
Willcocks, L., 2013. Information management: the evaluation of information systems
investments. Springer.
Zimmerman, J. L. and Yahya-Zadeh, M., 2011. Accounting for decision making and control.
Issues in Accounting Education. 26(1). pp.258-259.
Online
Andor, G., Mohanty, S.K. and Toth, T., 2011. Capital Budgeting Practices: A Survey of Central
and Eastern European Firms. Available
through:<http://www.efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL
%20MEETINGS/2011-Braga/papers/0118.pdf>[Assessed on 30th December, 2015].
6

APPENDIX
1)
Sales Revenue
workings (W1)
Year 1 2 3 4
Selling price per
unit with inflation
of 4%per year (£) 20.80 21.63 22.50 23.40
Production and
Sales (units) 35,000 53,000 75,000 36,000
Sales Revenue (£) 7,28,000 11,46,390 16,87,500 8,42,400
Variable cost (W2)
Year 1 2 3 4
Variable cost per unit with
inflation of 5% per year (£) 12.60 13.23 13.89 14.59
Production and Sales (units) 35,000 53,000 75,000 36,000
Total Variable cost (£) 4,41,000 7,01,190 10,41,750 5,24,880
Total Investment in working
capital (W3)
7

Year 0 1 2 3
Sales Revenue (£) 7,28,000 11,46,390 16,87,500 8,42,400
Investment in working capital
(7%) 0.07 0.07 0.07 0.07
Total Investment in working
capital (£) 50,960 80,247 1,18,125 58,968
Year 0 Investment: £50,960
Year 1 Investment: £29,287
Year 2 Investment: £37,878
Year 3 Investment: -£59,157 Recovery
Year 4 Investment: £58,968 Recovery
Depreciation workings (W4)
Plant cost £10,00,000
Four year life 4
Depreciation across 4 years £2,50,000
N
ot
es Year 0 Year 1 Year 2 Year 3 Year 4
£ £ £ £
Sales
Revenue 1
7,28,00
0 11,46,390
16,87,50
0 8,42,400
Costs:
Variable 2 (4,41,0 (7,01,190) (10,41, (5,24,8
8

cost 00) 750) 80)
Total
Contribut
ion 3
2,87,00
0 4,45,200 6,45,750 3,17,520
Capital
allowanc
es
(Deprecia
tion) 4
(2,50,0
00) (2,50,000)
(2,50,0
00)
(2,50,0
00)
Taxable
profit 5 37,000 1,95,200 3,95,750 67,520
Taxation
(30% per
year) 6
(11,10
0) (58,560)
(1,18,7
25)
(20,256
)
After tax
profit 7 25,900 1,36,640
2,77,02
5 47,264
Capital
allowanc
es
(Deprecia
tion) 8
2,50,00
0 2,50,000 2,50,000 2,50,000
After-tax
cashflow 9
2,75,90
0 3,86,640
5,27,02
5
2,97,26
4
Initial
investme
nt- Plant
cost
1
0
(10,00,
000)
Working 1 (50,96 (29,28 (37,878) 59,157 58,968
9

capital 1 0) 7)
Net
Cashflow
s
1
2
(10,50,
960)
2,46,61
3 3,48,762
5,86,18
2
3,56,23
2
Discount
at 12%
1
3 1.000 0.893 0.797 0.712 0.636
Present
values
1
4
(10,50,
960)
2,20,22
5 2,77,964
4,17,36
2
2,26,56
4
NPV
1
5 £91,154
2)
IRR
Estimati
on
Year 0 1 2 3 4
£ £ £ £ £
Net
Cashflow
s
1
6
(10,50,
960)
2,46,61
3 3,48,762
5,86,18
2
3,56,23
2
Discount
at 20%
1
7 1.000 0.833 0.694 0.579 0.482
Present
Values
1
8
(10,50,
960)
2,05,42
8 2,42,041
3,39,39
9
1,71,70
4
NPV at -
10

20% £92,387
NPV at
12% £91,154
IRR 15.97
1
6
%
11