Cash Budget, Break-Even Analysis, And Equipment Decision For A Landscaping Business

Monthly cash budget for three months ending 30 September 2018

1.(a)

(b) While the company purchase the equipment, the bank balance of the company goes negative and therefore, a borrowing was made equivalent to that amount(Bruner, Eades and Schill, 2017). But, if the company goes for the rental arrangement of $10000 per month, the bank balance remains positive in all the three months. Also, the balance as on 30.09.2018 is $9000 more in case of lease arrangement than in case of purchase.

 However, an equipment usually have a life span of more than 5-6 years, therefore, the cost of the equipment today would be equal to rent paid for 1 year consistently that is, the cost of the equipment $120000 would be equal to 12 months and so, if the equipment is being used for more than one year, the rental expense would be more than the original cost. Therefore, assuming that the equipment is for more than one year at least, it is hitherto purchase the equipment so as to bear the cost for once rather than bearing it for months and months.

2.(a)

(c) By altering the sales mix ratio, the company would be incurring an additional $50000 fixed costs. However, considering the revenue earned after bearing the fixed costs, the company is making a profit of $4,50,000 more. Thus, it is clear from the calculations that the company should consider this initiative as it would be yielding more income than the initial sales mix revenue (Clarke and Clarke, 1990).

3.(a) Decision – making is one of the most crucial step of any business and therefore, a careful analysis is to be done before making any investments or taking any loan. Similarly, in the present case, the landscaping business is considering thr purchase of an equipment for which it has two alternatives. While the office manager has calculated accounting rate of return (ARR), the assistant office manager has calculated the internal rate of return (IRR).

However, the decision couldn’t be taken only on the basis of ARR and IRR. There are other financial information that the company has to consider before making a decision  (Fairhurst, 2015):

• The time value of money should be considered so as to know whether the amount invested today will be worth more than the same amount in the future, thus, considering the earning capacity of the business and therefore, the efficiency of the two equipments.
• The future value of the cash inflows are to be taken into account because there are a number of limitations related to ARR and IRR which completely makes the cash inflows per annum out of picture.

(b) As an owner of the company, the given information is not sufficient for the decision making purpose due to the following information (Hassani, 2016) :

• ARR doesn’t include cash flows and shows an average profits which isn’t appropriate for decision purpose. It excludes the various other costs such as opportunity costs & savings. In a similar way, the costs such as sunk cost or other fixed costs are considered in accounting profits which is actually not relevant for decision purpose (Galbraith, Downey and Kates, 2002).
• No matter IRR considers the time value of money, the decisions cannot be taken on this basis as a high IRR may not always yield high NPV. In a similar way, a low IRR may yield high NPV. Therefore, taking up a project with high IRR cannot always be a profitable investment for the business. It ignores the actual dollar value of benefits because of this. For example, a project value of $20, 00,000 with 18% rate of return is obviously going to be chosen over the project value of $20,000 with 50% rate of return. This can be understood simply by seeing and no comparison or calculations are to be made. However, the IRR concept will rank the latter project first simply because the latter one yields a return of 50% over former rate of return of 18%.
• IRR is calculated on the basis of trial and error method, which is again an inappropriate factor for decison purpose. Also, multiple IRR problems arises when the cash flows during the lifetime of the project comes out to be negative.

(c) If the calculated returns all exceed the entity’s required minimum rate, the design to be recommended to the owner is equipment B. Making decison on the basis of mere ARR isn’t a good idea as ARR doesn’t consider the time value of money and therefore, excludes the concept of cash flows which is the most vital part of any investment (Khan and Jain, 2014). The average profits aren’t the true reflection of cash flows as where it includes the sunk costs and other fixed costs; it excludes the opportunity costs and savings, which are the actual key factors relevant for a decision making. Also, the more the IRR is, the more profitable is the investment and vice versa.

References:

Bruner, R., Eades, K. and Schill, M. (2017). Case studies in finance. Dubuque, IA: McGraw-Hill Education.

Clarke, R. and Clarke, R. (1990). Strategic financial management. Homewood, Ill.: R.D. Irwin.

Fairhurst, D. (2015). Using Excel for Business Analysis A Guide to Financial Modelling Fundamenta. John Wiley & Sons.

Galbraith, J., Downey, D. and Kates, A. (2002). Designing dynamic organizations. New York: AMACOM.

Hassani, B. (2016). Scenario analysis in risk management. Cham: Springer International Publishing.

Khan, M. and Jain, P. (2014). Financial management. New Delhi: McGraw Hill Education.