It’s possible that the company saw a decline in sales due to increased competition or were marketing a product inappropriate for the marketplace and decided to invest heavily on marketing in an effort to increase sales revenue. The marketing strategy and decisions adopted in practice could also have been inappropriate for the product as it failed to respond to “needs or created wants”. The board clearly need to devise more appropriate means of marketing and have a clear understanding of consumer behaviour.
Overall, overheads have increased significantly and sales have dropped, which clearly states that the product being manufactured has little significance to consumer tastes or that there are significant inefficiencies within staff/management operations. Cost-Plus Pricing: This is a simple method of pricing adopted by Slingshot which uses the calculation of total cost per unit + mark up (15%). Total fixed costs are divided by expected output to calculate cost per unit. Variable costs are then added and the 15% mark- up profit to give selling price.
Of course, in the case of Slingshot, where cost-plus is too high a price, it means that their business model is not appropriate for the marketplace and they should – either re-design their product or process to reduce costs in the business or find another opportunity. Slingshot’s cost-plus pricing method fails to take market factors or customer value into account. Their level of mark-up needs to take into account market circumstances, rather than to simply set a target mark-up of 15%, thus, a more market based pricing strategy would clearly be more appropriate.
Capital investments are vital for any firm. They are usually expensive, often long tern and, given the limited nature of a firm’s resources, likely to be irreversible. These three factors alone demonstrate how important it is for a firm to do everything it possibly can to make the right decision when faced with potential investments. To make a financial assessment of a capital investment, the first step is to estimate the expected cash flows associated with it. The cost of the investment is calculated, and set against the expected returns.
This shows the profit over the lifetime of the investment. At Slingshots Ltd the Board are considering the purchase of new computer aided manufacturing machinery. They need to choose between the following two machines. Both machines have a useful life of five years and a scrap value of zero. The payback on machine A is one year less than machine B. The investment on machine A was fully recouped in two years compared to three years on machine B. Machine A indicates a quick payback further indicating a reduction in risk as forecast cash flows become more unreliable over time.
It can be said that an early payback eliminates some of the concerns management might have over the later cash flow projections. Purely on payback criteria, machine A is therefore more attractive and, thus more likely to be invested in. Machine A also nets i?? 41,000 over its 5 year life period while machine B nets only i?? 38,000. Assuming the later year cash flows to be reasonably reliable, machine A clearly looks to be the better opportunity, bringing an extra i?? 3,000 over machine B. Payback is a simple calculation to make. It gives some indication on the level of risk associated with a potential investment.
The longer the payback period, the longer your money is at risk and the greater the likelihood that something unexpected may spoil your plans. However, payback fails to take into account the overall profitability of the potential project, as it ignores cash flows that occur after payback isachieved. As a result, in business it should only be used as a minimum, or screening, criterion. Payback should not be used by itself in making an investment decision. Discounted Cash Flows: The main problem with the appraisal techniques described so far is that they fail to account fully for the timing of cash flows.
DCF measures (Net Present Value (NPV) and Internal Rate of Return (IRR)) use cash flows and make due allowance for the time value of money. The DCF methods use cash flows and not accounting profits. The time value of money is represented by a composite annual percentage rate. The time value of money is considered by appraisal techniques that discount project cash flows. The technique of discounting future cash flows provides a valuable tool for valuing receipts and payments that occur at different times over the life of a project.
By reducing all future cash flows to a common measure, comparisons can be made between projects. The total of all cash flows restated in today’s money terms is called the Net Present Value (NPV). The NPV of a future cash flow is found by multiplying it by a discount factor. The size of the factor depends on the discount rate used and the number of years involved. The discount factor used in the net present value calculations is often based of a firm’s weighted average cost of capital. Each element of capital – equity, long-term loans and debt – is weighted to the capital employed.
The weighted average cost of capital is the most frequently used discount factor, because funds available for investment cannot usually be identified specifically to just one source of capital: the money comes from the total capital available. Therefore it is logical to weight all the elements to arrive at an average figure. If funds to finance a particular project can, however, be identified specifically with the project, then the cost of capital will be the cost of financing those funds. Another method sometimes used, is when the weighted average cost percentage is lower than, say prevailing market interest rates.