• Apply decision analysis to the decision problem facing Mexton Machines and advise the company on their outcome options. Clearly state any assumptions you have made.
• Discuss in detail the strengths and limitations of your analysis in the context of the problem faced by Mexton Machines. What other information would you need to improve your analysis?
Mexton Machine limited is known as one of the largest industry manufacturing the various ranges of small machines and tools. Company was establish in 1950 and is known for its high brand quality in England. Since 70’s company has been growing extensively and company has been diversifying its products range (Goodwin and Wright, 2014). For instance company has established paint business in order to gain the large customer base of England. Company has also extensively opened its business in all over the England places like Bristol, Leicestershire and Yorkshire. In recent times company is very much facing trouble because of recession in 1980. Company has closed down its paint business because of huge loss (Williams, 2002). After 1996 company has been looking open a new form of business in order to attract the customer base. A range of products that has been looking to produce by the Mexton is very much consumer goods such as electric drill and car engine turner in order to increase its sales which by far not been possible.
Since, then Mexton new management is been toying with various ideas like coming up with new gardening instrument which will help the company to standalone in the business and beat the existing competitors (Zeleny, 1982). For which company has to spend more than £ 16 million in their R&D to gain the large customer base. In spite of that, company has also made investment in opening of the new plant at Wiltham site in an old textile mill. The price of the site would be more than 6 million. However, company has another major option to manage and control the business by renovating the Eastoak existing plant for which company has to spend more than 24 million (Patterson et al. 2002).
The decision making process comprises of five major process:
Figure 1: Decision making process
(Source: Courtney et al. 2009, pp-123)
Identification of the problem: The decision making for these investments are being one of the major reasons for delaying the project. Besides that, company has already been invested more than millions in inventing the prototype to get in order to build the new machinery for gardening. In order to build the prototype the company is very much facing tough to manage the cost of the R&D (Yaniv et al. 2009). In order to build the prototype of lawnmower, company has to spend more than 6.4 million. The decision to continue to build the lawnmower in a new area at Wiltham or to manufacture at Eastoaks is one of the toughest decision making for the Mexton currently (Schlingemann et al. 2009).
Information sereach: as per the information given by Mr. castle that, 75% of the chances of the prototype will be completed within the December 2003. In order to understand whether to invest in new plant or to invest within the existing plant, information like initial investment of the two projects, cash flow of the tow project and the cost of the capital of two major project must be identified (Davenport, 2009). The company has already been given the information such as the total initial investment and total outflow and assuming the total cost of capital is 10% for both of the project is been part of the information’s (Ang and Geert, 2009). Besides that some of the assumption has been made such as:
-No taxation factors will be considered
– Depreciation cost is not been considered
-Development of grant should be ignored
Evaluation of the alternatives: With the help of analysing the two mega project requires the various investment appraisals techniques. In order to calculate the tow project both NPV and payback period is been considered as an alternative techniques. While evaluating the alternative understanding the major strength and weakness of the both of method will help to choose which method to follow (Blenko et al. 2010). With two major methods and two major initial investment against the Wiltham is 24 million and for Eastoaks is 40.9 million. There has been ample evidence which shows that, both of the method. By evaluating the various method that best suitable alternatives will be chosen for the analysing the both of suitable options (Davenport 2013). Another major investment is made in terms of the R&D in prototyping are some of the examples for the Mexton business (Schlingemann et al. 2009).
Production at WIITHAM
|
Year |
Cash Flow |
Discounting Factor(10%) |
Present Value |
|
(£) |
(£) |
||
|
1st year |
16 |
0.909091 |
14.54545455 |
|
2nd year |
16 |
0.826446 |
13.2231405 |
|
3rd year |
16 |
0.751315 |
12.02103681 |
|
4th year |
16 |
0.683013 |
10.92821529 |
|
Total |
50.71784714 |
||
|
Less: Outflow |
24 |
||
|
NPV |
26.71784714 |
|
(£ million) |
|||
|
Year |
Cash Flow |
Discounting Factor(10%) |
Present Value |
|
(£) |
(£) |
||
|
1st year |
24 |
0.909091 |
21.81818 |
|
2nd year |
24 |
0.826446 |
19.83471 |
|
3rdyear |
24 |
0.751315 |
18.03156 |
|
4th year |
24 |
0.683013 |
16.39232 |
|
Total |
76.07677 |
||
|
Less: Outflow |
40.9 |
||
|
NPV |
35.17677 |
From the above , it has been found that from both of the projects , the chosen would be production in Eastoaks because of the higher NPV. The Higher the NPV the higher would be chances of taking the project (Von Winterfeldt and Fasola, 2009). Company need to focus on to investment would be fruitful for the company because it considers the present value of money.
1.Production at WITHAM
|
Year |
Cash Flow |
Cumulative cash flow |
|
0 |
(24) |
(24) |
|
1st year |
16 |
(8) |
|
2nd year |
16 |
8 |
|
3rd year |
16 |
|
|
4th year |
16 |
=2+ (8 m/16m)
=2 + 0.5
=2.5 years
Production within Eastoaks
|
Year |
Cash Flow |
Cumulative Cash flow |
|
0 |
(40.9) |
(40.9) |
|
1st year |
24 |
(16.9) |
|
2nd year |
24 |
7.1 |
|
3rdyear |
24 |
|
|
4th year |
24 |
|
Payback period
= 2 + (7.1/ 24)
=2+ 0.29
=2.29 years
From the above payback period, it has been found that , company need to invest in the Wiltham because of the investment is taking less years in compare to the East oaks. Payback period of the project Wiltham project is 2.5 years which is less than the 2.29 years. The payback period will give the Mexton measure the liquidity positions (Valerie et al. 2010).
Investment: As per the investment appraisal system, Mexton need to choose the suitable options to get over the decision making right. In order to do so appraisal system is been one of the major part of helping to gain the actual information which will help to manage the right kind of investment areas (Marić et al. 2011). After the choosing the both method NPV and Payback period. It has been found that as per NPV best suitable options for the business would be investing in East oaks is better NPV with return of 35 million in compare to 24 million from the Wiltham (Lee et al. 2011).
However, while choosing the payback period , it suggest that Wiltham has better option with the lower payback period with 2.5 years. Finally company will be following the NPV selection because of the NPV consist of the time value of money and is very much useful to analyse the present value of the money (Amihud and Mendelson, 2010). on the other hand , payback period decision making is also one of the most prominent way to appraise the business but the techniques is very fails to carry the time value of money which is one of the major problems in payback period (Faulkender and Petersen, 2009).
Post purchase evaluations: After making the decision to invest in EastOaks, Mexton needs to look to understand the decision making made by the company is been right for the company or not. In order to manage the post purchase evaluations, company need to manage the focus on the actual cost and standard cost that has been kept by the company (Easley and O’Hara, 2009). Pots purchase strategy gives the company enough scope to judge whether the decision making was fruitful enough or not as the company used loss of opportunity cost. Opening of new plant would be least costly but investment existing company give increase the in the production with more than 166,000 lawnmower (La Porta et al. 2009). This is one of the finest achievement made by the company after able to achieve their target. Post purchase decision gives the company to make the future reference for the company expansion plan of the diversifying the projects (Carlson et al. 2008).
Mexton need to understand that , company has to spending huge funding, therefore company also need to consider the another major investment appraisal method process which will help in decision making more of suitable like IRR (Internal rate of return) and ARR (Accounting rate of return) (Cooper, 2010). Both of the method will also help the Mexton to make better decision making in term of high investment.
It is known that investment decision technique is effective for any business to take identify the project that can ensure high return. Therefore, in order to analyse the decision two capital budgeting techniques has been used that are discounting method which relate with the Net Present Value and the non-discounting method which relate to Pay Back period. Both the methods has provided extreme support base to analyse the problem of Mexton Machines The discounted method is effective in determining the stock value and the also provide details that how much company can accumulate cash after meeting all financial obligations (Bierman and Smidt, 2012). Apart from that, non-discounted method can be too effective in analysing the project decisions and the company can be able to know the expected time period to recover the invested amount. On the other hand, both the capital budgeting methods comprises some strengths and weakness that can be related with the investment decision. Therefore, the company may need to consider the major weakness before making up any decision so that higher benefit can be received and increasing cost can be controlled (Chiang, Cheng and Lam, 2010). Thus, the strength and limitation of the payback will be discussed along with the strength and restriction of net present value so that extracted analysis can be improved.
The variation between the cash inflow and the cash outflow of the present value in the whole life period of a project is known as NPV. NPV is also known as the Net Present Value. The research analyst uses the Net Present Value factor in above part because Net Present Value always focuses on the gain made in the whole period of a project. The total gain in Net Present Value is calculated by the difference between the cash inflow and the cash outflow of the present value in the whole life period of a project (Connor, 2006).
The financial analyst uses the NPV (Net Present Value) in the above part to find out the financial profit from the project. The Net Present Value helps the financial analyst to take the decision whether to invest in the new project or not. The Net Present Value helps the financial analyst to find out the whether the cash inflow is greater than the cash outflow in the whole life of the project. If the present value of the total cash inflow is greater than the present value of the total cash outflow of the project, then the financial analyst will invest in that particular project (Djursaa Clausen, 2012). If the present value of the cash outflow is greater than the present value of the cash inflow of the project, then the financial analyst will not allow to invest in that particular project. The main purpose of using the Net Present Value is to find out whether the company will earn profit from the project or not.
The strength of the Net Present Value is NPV always gives importance to the value of money in respect to time. NPV always calculate the cash inflow of the present value. In Net Present Value, it calculates both the cash flow to find out whether to invest in the project or not. The Net Present Value always gives high priority to the profitability. If the financial analyst calculate and found that the project return is less, the financial analyst will not allow investing in that project (Pfeiffer, n.d.). It also gives high priority to the risk factor of the project.
The use of Net Present Value is very difficult. In the Net Present Value, it is very difficult to find the accurate discount rate. The Net Present Value sometimes does not give the correct calculation, when the life of the project is unequal.
It can be understood that Net Present Value from the production of Witham is lower than NPV of Eastoaks. On the other hand, from the payback period it can be understood that investment recovering period is almost same but still Witham requires slightly more time. Apart from that, it is seen that there are certain limitation with the decision analysis; therefore, Internal Rate of Return can be effective in offsetting the weakness that has been acknowledged. It is known that IRR make effective use of time value of money and it will help in accounting high interest rate that may have been expected by the company, Mexton Machine. Furthermore, a relation can be created with the various rates and thus the company can be able to account the value, at which the cash inflow present value and cash outflow present value (Schönbohm and Zahn, 2012). Therefore, a uniform ranking can be extracted for the proposed projects. Apart from saying that, IRR can be a useful base in selecting the project that can ensure higher profitability for the company and their shareholders. The value that may be accumulated from the IRR evaluation, then it can be assumed that if the IRR is more than the cut off rate then the company can be able to gain high profit from the particular project (Shim, Siegel and Shim, 2012).
Payback period is calculated to find out the length of time required to recover the cost of investment. According to that the decision is taken whether to undertake the project or not. Longer the payback period is not suitable for investment (Baker and English, 2011).
When two or more projects are considered in capital budgeting, the project having shortest payback period is accepted because it can recover the initial investment of project quickly
1. According to Payback period approach, all the cash flows are forecasted from the project which it will earn in future. The period of recovering the cost of project is calculated. This method is usually applied by the business to set a limit of time within which the cost should be recovered.
2. The one of the important advantage of Payback period is that it is simple to calculate. Under this method, it is not required like other methods of capital budgeting to convert all the expected cash flows into present value adjusting the discounting factor. The calculation is straightforward. All the expected cash flows are added and then the initial cost of the project is subtracted from that.
3. The payback period method is associated with the short time prospect. This approach implies that the project will generate cash shortly and the initial cost will recovered within the shortest time. So, the risk is lower.
1. Payback period method does not consider time value of money. The expected cash flows are not adjusted with discounting factor. But, in real economy, the value money is affected by the time. The cash flows are expected to earn but the value is expected for future may be less in present time. Also, the inflation is not adjusted in this approach. But, the inflation has greater impact on economy (Kalyebara and Islam, 2013).The risk of recovering cost is minimized by this method.
2. The risk is less for short-term oriented project. But, the risk is more for long-term oriented project. The organization may earn more return from a high risky project.
3. According to Payback period method, the better investment is that one which has the shorter payback period. But it ignores the any benefits that occur after the payback period (Wyatt, 2012). So, it does not measure profitability. If the organization a short time limit, it may miss the future benefits of the project.
On the other hand, it is known that IRR can be employed if the company knows the investment cost and annual cash flows. Therefore, the company can determine the accurate rate of earnings that can deliver the expected return at some point of time that is four years. The company, Mexton Machine by using the internal rate of return can disclose the high rate of return that can be generated from the project. Apart from that, the company need to study the market condition to whether the market feasible for the production of proposed project or not (Talbot, 2012). The market will let know about the cost of raw materials, labour cost, numbers of competitors, etc. Therefore, it will help the company to take effective decision and gain much expected higher benefit from the project. On the other side, in order to improve the analysis, the company may need to acknowledge all the cost related to building cost, installation cost, raw material cost, manufacturing cost, etc so that exact return can be evaluated in order to be sure that production of the machines can ensure expected return (Bierman and Smidt, 2012).
Moreover, in accounting IRR methods, the company need to determine the value of cash flow after tax so that exact valuation can be identified and ensuring effective return rate. Apart from that, cash flow analysis can be useful in analysing decision. The company may need to estimate the cash outflow that is expenditure and also the cash inflows that is revenue which will help in analysing the net cash that may be available in the project. Therefore, the company can be able to take decision on accounting cash for the production of machine. Moreover, it will let know the whether the company is financially sound or not and also the position of company in clearing debt (Djursaa Clausen, 2012). On the other hand, determining the expected sales from the production will be valuable for the Mexton Machine to take decision. Therefore, company can use break even analysis as it will help the company to know amount of sales they may required to cover up their costs and also they can be able to ascertain the point at which, the company can gain profit. Thus, the company may need to understand their expected sales from the proposed project.
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