The assignment requires appraisal of a project involving production of plugs. The specific requirements are computation of the net profit value (NPV), Internal Rate of Return (IRR), Profitability Index (PI) and an opinion whether the project should be undertaken or not. Here below are the responses.
In computing the Net Present Value, all the incomes accruing to the project for the five years are considered. They are discounted at the rate of the costs of funds, which is given at 10.8% per year. To get the periodic amount earned per year, the difference between the sale price and the cost of production is calculated.
The realized difference gives the income for a year. When this amount is discounted for five years, it gives the present value of the income that accrues. There is however the issue of taxes, which is taken as a cost. Depreciation must also be has accounted for, since it reduces the amount of tax to be paid to the relevant authorities (Graham & David, 1951). Depreciation is not taxable and its computation is done on a straight-line basis meaning the initial costs of acquiring the machine is divided by the lifetime of the machine (Khan, 1993). The amount of depreciation per year is also discounted for five years at the same rate of the costs of capital. Based on the calculation, we are able to attain the present value of depreciation. The obtained amount is then deducted from the present value of the earnings and the costs of acquisition and installation in order to obtain the Net Present Value of the project.
To calculate the Internal Rate of Return, two rates are chosen. Of the two rates, one should be slightly lower than the rate of return sought by the investor, and the other should be higher than the rate of return that is used. Their present values are computed by use of the two rates that are chosen. The present values are then substituted in the above formula to pave way for the realization of the sought Internal Rate of Return for the project.
Where the Internal Rate of Return is higher than the return sought from the project, it is recommended that the project should go on (Hoang, 2007). On the other hand, when the Internal Rate of Return is lower than the project should be discarded. This is because the return sought cannot be obtained and thereby no need to invest in such a project.
Payback Period is the time it takes for the investment to recoup the costs that have been incurred by the project. It is arrived at by dividing the costs of the project with the net income accruing to the project per year. This is an indicator to the investors on how long it would take them before their costs are earned back. It should be noted that the aspect of time is of critical value in investments since the interest earned must have a time value for it to qualify as being worthwhile. Payback period divided by the initial cost/income per year gives the Payback Period. 3,000,000/1,200,000 = 2.5 Years The Profitability Index is obtained by dividing the present value of the project by the initial costs of starting the project. It is therefore a multiplier that indicates the scale of the return by the investment. Profitability index divided by present value/initial investment should yield the profitability index. 1,214,574/3,000,000 = 0.4
The project should be accepted. This is because it has a positive Net Present Value, meaning it gives a return for the investment. The sign of the payback period is critical in investment decisions as already pointed above. Projects with positive Net Present Values imply that a return would be earned from the project while those with negative Net Present Values means no return would be earned. Since, investors have a primary goal of enhancing profitability they should opt for those investments that guarantee a positive Net Present Value. Similarly, such calculations would help investors to avoid investments that are likely to lead to losses.
It is therefore important to emphasize the value of these accounting calculations in the implementation of projects. In every business undertaking, decision-making is important. This would depend on the data and information available to support whatever deliberations are taken, therefore, the need to maintain the records (Eugene, 1996). An accounting system on the other hand is a set of methods of accounting. Accounting systems contain procedures and measures of control established with an aim to collect and maintain financial data for management decisions. Reasons for maintaining such a system include easy retrieval when required. Additionally, future reference or evidence in case of need for confirmation or some proof presents the other vale of financial accounting. It is also important to keep the system since it is useful in computing cash flows within the organization or concerning some business enterprise. This is important since the concept of time value of money must be considered.