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Homework answers / question archive / The IT Manager of Moriarty Marketing company is considering purchasing some new audio visual equipment
The IT Manager of Moriarty Marketing company is considering purchasing some new audio visual equipment. Initial research has identified two possible suppliers that can provide different equipment that will satisfy the requirements and has given the following budget outlines on a cash basis: The equipment will cost £50,000 to purchase and at the end of the period will have zero residual value. If the project geos ahead, it is predicted that the company will gain increased revenue that has been projected as that shown in Table Q3a. Year Revenue generated- Revenue generated Supplier A (£) Supplier B (£) 1 5,000 20,000 2 17,000 30,000 3 42,000 20,000 4 30,000 20.000 5 10,000 20,000 Table Q3a You are required to determine for each supplier option: The Payback Period The ARR (Average rate of Return) Produce tables showing the relative cash flows that are relevant to each year that can be used to determine these answers. It is assumed that the annual cash flows shown in the table arise evenly throughout the year and that there are no tax, depreciation or interest aspects to be considered. Analyse your findings and make recommendations as to which supplier Moriarty Marketing should choose from a financial perspective, using the answers from above to support your argument (Maximum 150 words). (6 marks) b) Discuss the various limitations of the simple payback period method and the ARR in the context of overall capital investment appraisal. Explain what you believe the advantages and disadvantages may be of using discounted cash flow methods for capital investment appraisal. (Maximum 600 words). (14 marks) c) The Lestrade & Metropolitan Manufacturing company produce aluminium die cast models of famous fictional characters. On the 1st of September they carried out a stock check and found that they held in their company stores a quantity of 1.100 tonnes of aluminium alloy, which is valued at £5.10 per tonne (as shown in Table Q3c). The goods received notes and materials requisitions (from production
(A) pay back period- is the year in which total revenues will cover the initial cost
* supplier A
Year 1 - revenue =5000
Year 2 revenue =17000, cumulative revenue= 5000+17000=22000
Year 3 revenue =42000, cumulative revenue =22000+42000=64000
So the payback occur in between year 2 and 3
Payback = 2 years+ (50000-22000)/42000
=2+0.67 = 2.67 years
* Supplier B
Year 1 revenue=20000
Year 2 revenue =30000, cumulative revenue=20000+30000=50000
Payback period = 2 years
*Average rate of return
=average return/initial investment
Supppier A average return=(5000+17000+42000+30000+10000)/5
=104000/5=20800
Average rate of return=20800/50000=41.6%
Supplier B
Average return=(20000+30000+20000+20000+20000)/5
=110000/5=22000
Average rate of return=22000/50000=44%
** based on both payback period and average rate of return measures, it is advisable to go for supplier B as it has less payback period and more average rate of return compared to supplier A
(B) DRAWBACKS
** Pay back period
1.it doesn't consider time value money
Due to inflation value of money is decreasing as the time passes. So to adjust this we will discount the cash flows. But in payback period computation time value of money is not at all considered
2.not account for cash flows after payback years
The another biggest drawback is that this method doesn't consider or values cash flows after the payback year. Cash flows till break even only considered
** Average rate of return
1. ARR ignores the time value of money.
2. ARR method ignores the cash flow from investment
3. ARR method does not consider terminal value of the project.
