Financial Reporting

Assignment Report

Unit Title: Financial Reporting

Unit Reference Number: J/650/1919

Level: 5

Credits: 20

i
Table of Contents
1 Task 1 ................................................................................................................................. 1

1.1 Task 1 - Part A: Report on Financial Reporting and Budget Setting .......................... 1

1.1.1 Purpose of Financial Reporting ........................................................................... 1

1.1.2 Budgeting and Monitoring Performance ............................................................. 1

1.1.3 Advantages and Disadvantages of Budget-Setting Types ................................... 1

1.2 Task 1 - Part B: Variance Analysis Report for Makhani Ltd ...................................... 2

1.2.1 Variance Analysis Calculation ............................................................................. 2

1.2.2 Variance Analysis and Potential Reasons ............................................................ 2

1.3 Recommendations for Makhani Ltd ............................................................................ 4

2 Task 2: Instructions for Preparing Control Accounts ........................................................ 6

2.1 Introduction ................................................................................................................. 6

2.2 1. Purpose and Functions of Control Accounts ........................................................... 6

2.3 2. Preparing Control Accounts: Worked Examples .................................................... 6

2.4 3. Types of Errors in Control Accounts ...................................................................... 8

2.5 4. Amending Errors in Control Accounts ................................................................... 8

2.6 5. Impact of Errors in Control Accounts ..................................................................... 9

2.7 6. Formatting Management Reports on Control Accounts ......................................... 9

3 Task 3 ............................................................................................................................... 11

3.1 Investment Appraisal Report ..................................................................................... 11

3.1.1 Investment Details ............................................................................................. 11

3.2 Method 1: Payback Period ........................................................................................ 11

3.3 Method 2: Net Present Value (NPV)......................................................................... 12

3.4 Method 3: Internal Rate of Return (IRR) .................................................................. 12

3.4.1 Step 1: Calculate NPV at 10% ........................................................................... 12

3.4.2 Step 2: Calculate IRR Using Linear Interpolation Formula .............................. 13

3.5 Evaluation of Investment Appraisal Methods ........................................................... 13

ii
 3.5.1 Payback Period................................................................................................... 13

3.5.2 3.5.2 Net Present Value (NPV) .......................................................................... 15

3.5.3 Internal Rate of Return (IRR) ............................................................................ 16

3.6 Recommendation ....................................................................................................... 17

4 References ........................................................................................................................ 18

iii
List of Tables

Table 1: Variance Analysis Calculation .................................................................................... 2

Table 2: Accounts Receivable Control Account ........................................................................ 7
Table 3: Accounts Payable Control Account ............................................................................. 8
Table 4: Formatting Management Reports on Control Accounts ............................................ 10
Table 5: Method 1: Payback Period ......................................................................................... 11
Table 6: Method 2: Net Present Value ..................................................................................... 12
Table 7: NPV at 10% ............................................................................................................... 12

iv
1 Task 1

1.1 Task 1 - Part A: Report on Financial Reporting and Budget Setting

1.1.1 Purpose of Financial Reporting

Financial reporting is crucial to organizational objectives and activities for growth and
development, through which accurate and comprehensive finance information is provided to
stakeholders like managers, investors, and regulatory bodies(planful 2024). It supports
decision-making, presents financial health, and is prepared according to the normative
conditions laid by the International Financial Reporting Standards or Generally Accepted
Accounting Principles, since their observance ensures that an organization pursues its standards
of compliance. These reports afford strategic planning and needed transparency to develop trust
among its stakeholders, which can also enable investors and entrepreneurs to make informed
decisions on investments and expansions.

1.1.2 Budgeting and Monitoring Performance

Budgeting means the process of apportioning resources to attain organizational objectives, and
it involves setting financial targets for revenues, expenses, and profits. Business performance
monitoring through budgets is very significant, as it would allow managers to understand or
know what actual performances are posted against expectations, thereby providing an avenue
to institute necessary adjustments. Effective budgetary control also ensures cost management,
resource optimization, and financial stability, thereby contributing to overall business success.

1.1.3 Advantages and Disadvantages of Budget-Setting Types

1. Incremental Budgeting:

o Advantages: Simple, requires minimal data, and is suitable for stable industries.

o Disadvantages: Can encourage inefficiency and ignore changing market

dynamics.

2. Zero-Based Budgeting (ZBB):

o Advantages: Promotes efficiency by requiring justification for all expenditures.

o Disadvantages: Time-consuming and may strain resources.

1
 3. Flexible Budgeting:

o Advantages: Adjusts to changes in activity levels, offering better control.

o Disadvantages: Complexity in preparation and requires constant monitoring.

1.2 Task 1 - Part B: Variance Analysis Report for Makhani Ltd

In this report, I’ll calculate the variances between budgeted and actual figures, identify them as
favorable or adverse, analyze the reasons for these variances, and recommend actions.

1.2.1 Variance Analysis Calculation

Budget Area Budget (£) Actual (£) Variance (£) Type of Variance
Sales Volume 25,000 35,000 10,000 Favourable
Direct 6,000 10,000 -4,000 Adverse
Materials
Labour Rate 4,000 8,000 -4,000 Adverse
Labour 3,000 1,000 -2,000 Adverse
Efficiency
Fixed 4,000 5,000 -1,000 Adverse
Overheads
T ABLE 1: VARIANCE ANALYSIS CALCULATION
1.2.2 Variance Analysis and Potential Reasons

A variance analysis will help in determining the difference between budgeted and actual figures
to enable Makhani Ltd to analyze performances for which strategies need to be adapted. The
succeeding analysis looks at variances from sales volume, direct materials, labor rate, labor
efficiency, and fixed overheads. Possible causes as to why this outcome occurred are discussed
here, and recommendations are made accordingly.

1. Sales Volume (Favourable)

The sales volume variance is favorable because actual sales of £35,000 exceeded the budgeted
amount of £25,000 by £10,000. This can be due to increased demand in the market or effective
marketing strategies that attracted more than anticipated. Seasonal factors or promotions might

2
have also contributed to the increase in sales. The greater sales volume not only lifts revenue
but is advantageous to profitability because fixed costs are spread over a larger volume of sales.

To capitalize on this, Makhani Ltd. could probe into the exact factors that trigger the growth in
demand. For instance, it would likely be a seasonal factor. Preparing for strategic marketing
around this period of the year in the coming years could help maintain favorable sales levels.
It also allows for capturing customer preference and purchasing behavior to facilitate informed
product choices in future production.

2. Direct Materials (Adverse)

The variance for direct material is adverse, having the actual cost £ 4,000 over and above the
budget. This could be explained by an increase in raw material prices, poor usage of material,
or a price increase by the supplier (Humai 2020). Inflationary pressures could also lead to the
variance by impacting raw material prices that directly affect the profitability at Makhani Ltd.

For this, the company must try to negotiate with the suppliers for bulk discounts or fixed
contracts that can stabilize the prices over time. Alternatively, Makhani Ltd. may look at
alternative suppliers or explore resource-efficient methods of production that minimize wastes,
hence lowering the material cost. Periodic cost review with suppliers would further ensure
competitive pricing.

3. Labour Rate (Adverse)

An adverse labor rate variance, when actual labor costs are £4,000 above budget, tends to
indicate higher wage rates or increased overtime payments. This may also be due to necessary
use of better-qualified workers, who must be paid at higher wage rates to meet production
requirements, or simply that wage awards have forced up the wage structure. The increased
cost of labor indicates that wage structures, staffing, and scheduling need to be reviewed.

Makhani Ltd. should also re-evaluate the workforce management strategy, including offering
incentives with productivity instead of increasing wages. Productivity incentives can enhance
efficiency of employees without inflating the normal labor rate, which puts labour costs closer
to budget expectations. Other strategies may be changing the scheduling of staff to minimize
overtime and ensure adequate staffing on busy days.

4. Labour Efficiency (Adverse)

3
Efficiency variance shows an adverse variance of £2,000 because actual efficiency levels are
below that set by the budget. This is usually due to a number of reasons such as inefficient
labor force composition, machine breakdowns, or incorrect staffing levels. A poorly trained
workforce may take longer over a specific task, which ultimately leads to low productivity and
thus gives rise to this variance (indeed 2024).

Regarding enhancing labor efficiency, Makhani Ltd. may make focused investments in
employee training programs that emphasize very new or relatively less experienced employees.
Training increases productivity while reducing the likelihood of costly mistakes. Additionally,
Makhani Ltd. could automate or upgrade machinery to minimize human errors and ensure
uniformity of output. Regular machinery and equipment maintenance may decrease the
likelihood of their sitting idle and help maintain more productive processes.

5. Fixed Overheads (Adverse)

On fixed overheads, the adverse variance is actually £1,000 over and above the budget.
Increased expenses likely due to rent, utilities, maintenance, and others Other instances may
be higher utility costs or increased repairs leading to an increase in the level of overheads,
distortion of overall cost structure, and reduction of profitability levels.

To control fixed overheads, Makhani Ltd. should continually look at its overhead expenditure
and find unnecessary spending that it could cut or reduce. For example, negotiations of lease
terms or facility consolidation can be put in place to keep such costs low. Similarly, replacing
energy-intensive equipment with their energy-efficient versions helps reduce utility costs little
by little, and timely maintenance of machinery and facilities prevents sudden repairs that dent
the company's budget.

1.3 Recommendations for Makhani Ltd

The following recommendations align with the identified variances, supporting cost efficiency
and operational improvements.

1. Sales Volume

The company Makhani Ltd should continue with the existing marketing activities and
provide incentives, if feasible to customers like loyalty programmes or discounts for
maintaining the high volume of sales. The trend of the customer's preference can also
be judged and the marketing activities can be aligned accordingly for further

4
 improvement in sales. Alternatively, the company may assess whether the sale for some
product lines was greater compared to the rest and sell only product lines in the future.

2. Direct Materials

To offset the upward trend of direct material costs, Makhani Ltd. is recommended to
negotiate long-term contracts with suppliers, thereby obtaining a preferential rate to
reduce the price volatility of its raw materials. After all, identifying discounts on bulk
buys, exploring alternative suppliers, or finding resource-efficient means of production
may continue to help alleviate material costs. Tight inventory control will also reduce
waste, thus saving on some material costs (linkedin 2023).

3. Labour Rate

Makhani Ltd. would want to reassess its labour structure for alternatives to the
increasing wages. Therefore, what the workers will want is some form of performance-
based incentives that keep them more productive rather than increasing base rates.
Optimization of staff scheduling to minimize overtime and use of part-time or
temporary workers during peak periods could also cut labor costs. In this way, Makhani
Ltd. can maintain efficient levels of production but without the additional costs of
unnecessary labor.

4. Labour Efficiency

It is also very relevant in this context to state that employee training, particularly for
the less experienced employees, may largely increase productivity and reduce errors.
Training programs shall be focused on those areas where maximum time consumption
or most frequent mistakes are found. Makhani Ltd. may further consider upgrading or
automation of machinery in order to lessen its dependency on manual labor for
improving production efficiency and consistency.

5. Fixed Overheads

Operational expenses should be re-looked at from time to time by Makhani Ltd. and
clearly segregate the non-essential expenses that could be minimized or nil in order to
keep the fixed overheads under control.

5
2 Task 2: Instructions for Preparing Control Accounts

2.1 Introduction

These directions ensure the preparation and control accounts in Makhani Ltd. not only maintain
accuracy but also consistency to uphold the integrity of the financial statements and help in
accounting for any errors that may be identified. Without going into the problems caused by
the reduced staffing levels, accurate control accounts are, therefore, vital for reconciliation of
financial transactions and to provide management with an accurate picture of the company's
financial health (AccountingInsights Team 2024).

2.2 1. Purpose and Functions of Control Accounts

Definition and Purpose

Control accounts are those accounts in the general ledger that summarize and therefore allow
the management and verification of transactions affecting the account. The major types include
Accounts Receivable Control Account and Accounts Payable Control Account. In summary,
these accounts derive their transaction summaries from individual accounts; hence, they reduce
the complexities in the general ledger.

Functions of Control Accounts

• Verification: This ensures that the subsidiary ledgers are accurate and agree with the
balances in the control accounts.

• Error Detection: Identifies the differences at an earlier stage due to time-to-time

changes.

• Streamlining: The general ledger is simplified because the details of debtors and
creditors are summarized.

• Financial Control: It provides better control through the division of labor and
summarizes the activities related to the accounts, assisting in clear vision.

2.3 2. Preparing Control Accounts: Worked Examples

Example 1: Accounts Receivable Control Account

Suppose Makhani Ltd. has the following transactions in a month for accounts receivable:

6
 • Opening Balance: £10,000

• Credit Sales: £15,000

• Receipts from Customers: £8,000

• Returns: £1,000

• Bad Debts: £500

The Accounts Receivable Control Account would be prepared as follows:

Date Details Debit Credit Balance (£)

(£) (£)
Opening Balance b/f 10,000 10,000
Credit Sales 15,000 25,000
Receipts 8,000 17,000
Returns 1,000 16,000
Bad Debts 500 15,500
Closing Balance c/f 15,500
TABLE 2: ACCOUNTS R ECEIVABLE C ONTROL ACCOUNT
Example 2: Accounts Payable Control Account

For accounts payable, let’s assume the following monthly transactions:

• Opening Balance: £5,000

• Credit Purchases: £12,000

• Payments to Suppliers: £7,000

• Purchase Returns: £1,500

The Accounts Payable Control Account would look like this:

Date Details Debit (£) Credit (£) Balance (£)

Opening Balance b/f 5,000 5,000
Credit Purchases 12,000 17,000
Payments to 7,000 10,000
Suppliers
Purchase Returns 1,500 8,500

7
 Closing Balance c/f 8,500
TABLE 3: ACCOUNTS P AYABLE C ONTROL ACCOUNT
2.4 3. Types of Errors in Control Accounts

Errors are common in control accounts, but identifying and addressing them promptly is crucial
for financial accuracy.

Common Errors

1. Errors of Omission: One transaction is completely omitted; for example, sales recorded
but not entered.

2. Errors of Commission: Inclusion of incorrect amounts, or entering the transactions in

wrong accounts.

3. Errors of Principle: Entries made that are in contravention of accounting principles,

such as booking an income expenditure as capital.

4. Transposition Errors: Reversal of digits in numbers; for example, typing in £3200

instead of £2300.

5. Duplication: Recording of a transaction more than once.

2.5 4. Amending Errors in Control Accounts

Errors in control accounts can be corrected through journal entries, reversal entries, or
adjustments in the subsidiary ledgers.

• Omission Error - The transaction that has been omitted should be recorded in the
subsidiary ledger and control account

• Commission and Principle - Rectify through correcting journal entries - reverse the
wrong entry and post the correct one.

• Transposition Errors - locate them and rectify them by replacing the incorrect values
with correct amounts.

• Duplicates: Reverse the duplicate entry to bring the control account balance to its
correct amount.

8
2.6 5. Impact of Errors in Control Accounts

Errors in control accounts affect financial reporting accuracy and can lead to incorrect financial
decisions. For instance:

• Misstated Assets and Liabilities: Inaccurate balance sheets results in problems

pertaining to investor confidence.

• Delayed Payments: A control account error in accounts payable may result in delayed
payments, affecting supplier relationships.

• Misleading Financial Performance: Accounts receivable may inaccurately show

business growth or decline, which can skew strategic decisions.

By detecting and correcting these, the financial statements would remain reliable and in
conformance with the requirements of the regulators.

2.7 6. Formatting Management Reports on Control Accounts

Control account reports should be clear, concise, and structured to support informed
management decisions. Below is a recommended format:

1. Title and Date: The period covered should be clearly stated on the report.

2. Summary Section: Provide an overview regarding the major findings and variances,
and major adjustments made.

3. Detailed Analysis:

o Opening and Closing Balances: Starting and closing balances for the period
under report.

o Transaction Breakdown: Specify all significant transaction categories, such as

sales, payments, and returns.

o Error Corrections: All accounting corrections due to errors should be listed with
explanations.

4. Comments and Recommendations: Comments regarding any identified trend or

issues and recommendations for future courses of actions.

9
 5. Supporting Figures and Tables: Tables and charts are to be used wherever possible
for clarity and visual ease.

Section Details
Title Accounts Receivable Control Account Report for [Month/Year]
Summary Key findings, such as significant increases in sales, detected errors, or
adjustments
Transaction Detailed entries for each transaction category
Breakdown
Error Corrections Explanation and details of corrections made to amend errors
Recommendations Actions suggested for improving controls or managing specific
accounts
TABLE 4: FORMATTING M ANAGEMENT R EPORTS ON C ONTROL ACCOUNTS

10
3 Task 3

3.1 Investment Appraisal Report

3.1.1 Investment Details

• Initial Cost: $100,000

• Useful Life: 5 years

• Salvage Value at End of Life: $20,000

• Cash Inflows: Provided in each year as follows

• Discount Rate: 5%

3.2 Method 1: Payback Period

Payback Period: This is the time needed to recoup initial investment through cash inflows
generated. We will use the cumulative cash flows to determine the payback period in years
(Kim 2024).

Year Cash Flow ($) Cumulative Cash Flow ($)

0 -100,000 -100,000
1 20,000 -80,000
2 40,000 -40,000
3 60,000 20,000
4 60,000 80,000
5 20,000 + 20,000 (disposal) = 40,000 120,000
TABLE 5: M ETHOD 1: PAYBACK P ERIOD
Payback Period Calculation: At the end of Year 2, the cumulative cash flow is -$40,000. At the
end of Year 3, the cumulative cash flow becomes positive at $20,000. Thus, the payback period
lies within Year 3. Now, using interpolation to find out exactly when within Year 3:

Payback Period = 2 years + (40,000 / 60,000) = 2 + 0.67 = 2.67 years

Payback Period: 2.67 years

11
3.3 Method 2: Net Present Value (NPV)

The NPV method calculates the present value of future cash inflows minus the initial
investment, using the discount rate of 5%.

Year Cash Flow ($) Discount Factor Present Value ($)

(5%)
0 -100,000 1 -100,000
1 20,000 0.9524 19,048
2 40,000 0.907 36,280
3 60,000 0.8638 51,828
4 60,000 0.8227 49,362
5 40,000 0.7835 31,340
TABLE 6: M ETHOD 2: NET PRESENT VALUE
The NPV is calculated by summing these present values:

NPV = -100,000 + 19,048 + 36,280 + 51,828 + 49,362 + 31,340 = $87,858

Net Present Value (NPV): $87,858

3.4 Method 3: Internal Rate of Return (IRR)

The IRR is calculated using linear interpolation between two discount rates, one lower and one
higher, to approximate the rate at which NPV equals zero (Higher Logic, LLC 2024).

3.4.1 Step 1: Calculate NPV at 10%

Year Cash Flow ($) Discount Factor (10%) Present Value ($)
0 -100,000 1 -100,000
1 20,000 0.9091 18,182
2 40,000 0.8264 33,056
3 60,000 0.7513 45,078
4 60,000 0.683 40,980
5 40,000 0.6209 24,836
TABLE 7: NPV AT 10%
The NPV at a 10% discount rate is calculated as:

NPV at 10% = -100,000 + 18,182 + 33,056 + 45,078 + 40,980 + 24,836 = $62,132

12
3.4.2 Step 2: Calculate IRR Using Linear Interpolation Formula

Using the IRR formula:

IRR = Lower Rate + [(NPV at Lower Rate) / (NPV at Lower Rate - NPV at Higher Rate)] ×
(Higher Rate - Lower Rate)

Where:

• Lower Rate (L) = 5%

• Higher Rate (H) = 10%

• NPV at Lower Rate (5%) = $87,858

• NPV at Higher Rate (10%) = $62,132

Substituting the values into the formula:

IRR = 5 + [(87,858) / (87,858 - 62,132)] × (10 - 5)

IRR = 5 + [87,858 / 25,726] × 5

IRR = 5 + 3.41 = 8.41%

Internal Rate of Return (IRR): 8.41%

3.5 Evaluation of Investment Appraisal Methods

Different investment appraisal methods bring different dimensions concerning the feasibility
and profitability of the projects. The payback period, the NPV, and the IRR give an all-round
view of the financial implications of the purchase of the fabrication machine by Makhani Ltd.
Each of these methods is analyzed below in detail, with its strong points and weaknesses, to
determine whether it is relevant to the project.

3.5.1 Payback Period

Payback period is a simple calculation method that gives the time required by the project to
pay back its investment cost through cash inflow. Makhani Ltd with the payback period of 2.67
years indicates that the $100,000 investment amount is quite recoverable in a rather short
period.

1. Advantages of Payback Period

13
 o Simplicity: The payback period is intuitive and thus easy to explain to
stakeholders. It provides a clear timeline as to when the investment will start
yielding net benefits, and it is most useful for non-financially oriented
stakeholders.

o Insight into liquidity: This technique is useful in viewing the short-term

liquidity effects of the investment. The companies like Makhani Ltd. which may
be facing the problem of short liquidity, the time when cash may come back
would help in arranging working capital.

o Risk Mitigation: By focusing on quicker returns of investment, the payback

period inherently supports projects that are less risky. In industries where
market conditions or operational costs tend to be highly volatile, this short-term
view decreases exposure to risks across time.

2. Limitations of Payback Period

o No Time Value of Money: No time value of money is considered in the payback

period method. The $100,000 initial outlay or cash inflows in later years is
equally valued, while obviously the latter has less purchasing power due to the
inflationary and opportunity cost elements.

o Ignores Cash Flows Beyond Payback: This technique looks at the time required
to recover the investment. Any cash flows beyond that are ignored. Hence, any
more cash inflows of Makhani Ltd's machine over the period beyond its payback
period will not be considered in payback.

o Limited Profitability Insight: The payback period does not indicate the
aggregate profitability of the project. If projects have a longer useful life, then
an attractive payback period may be given misleading indications if cash flows
drop off after this perio.

Suitability for Makhani Ltd.

Despite its deficiencies, the payback period can assist Makhani Ltd. supplemental methods at
least the company expects balanced insight into investment liquidity. On the contrary, relying
on a payback period exclusively, would be insufficient as it does not take into consideration
the machine's extended contribution to profitability beyond the time the machine is recovered.

14
3.5.2 3.5.2 Net Present Value (NPV)

NPV is an extended investment appraisal technique that outlines the present value of
anticipated cash inflows, discounted at a given rate in this case, 5%, and then deducting the
cost of investment. The Makhani Ltd positive NPV of $87,858 means the project will yield net
cash inflows in excess of the capital cost and hence viable from a financial point of view (Team
2024).

1. Advantages of NPV

o Considers Time Value of Money: NPV considers the time value of money, by
discounting future cash flows using 5%, an interest rate presumed prevailing
currently. This adjustment makes NPV more accurate, reflecting the true value
of cash over time.

o All-Inclusive Profitability Measure: NPV gives a straightforward indication of

the absolute profitability of the project. A positive NPV, as in this project,
reflects that the investment will increase Makhani Ltd.'s wealth and, therefore,
meet the financial goals of the company.

o Inclusion of Capital Cost: NPV allows the project by Makhani Ltd. to consider
the cost of capital, that will further check whether the project earns more than
the returns required by investors and/or lenders. This will also ensure that
projects adding value over and above their cost of capital are focused on, which
helps in better capital allocation.

o Alignment with shareholder value: NPV is directly related to the maximization

of shareholders' value. Positive NPV investments increase the market value of
a company, thereby aligning the project with wider financial objectives.

2. Limitations of NPV

o Complexity: NPV is more complicated compared to the payback period since it

involves an exact estimation of future flows of money, adding the relevant
discount rate. Poor judgment in this respect may lead to having a fallacious
answer, especially where cash flow is not certain.

o Dependent on Discount Rate Accuracy: The estimation of a suitable discount

rate is very important since it might affect the present value of cash flows. In

15
 cases where the discount rate applied fails to reflect Makhani Ltd.'s cost of
capital or the risk profile accurately, the results derived through NPV could be
misleading.

o May ignore liquidity: Although the NPV comprehensively covers the project's
profitability, it does not cover the liquidity or speed of recovering the cost of
investment. Companies that do need fast returns on cash may find the NPV on
its own unsuitable to their short-run cash exigencies.

Suitability for Makhani Ltd.

NPV would be sufficient for investment analysis at Makhani Ltd. because it gives the general
idea of the profitability generated by a project, taking into consideration the time value feature
of money. This would be ideal in long-term projects because it maximises value. This,
however, needs to be supplemented with other techniques, such as payback period, if liquidity
is a major concer.

3.5.3 Internal Rate of Return (IRR)

The discount rate at which NPV of the project is zero is called IRR. It represents the expected
rate of return on the project. Hence, Makhani Ltd. has an IRR of 8.41%, which is above the
discount rate of 5%, hence making the project attractive as it is over the minimum required
rate.

1. Advantages of IRR

o Spontaneous Benchmark: IRR delivers a distinct benchmark against which

comparisons can be made. If the IRR is greater than the cost of capital, then it
indicates that the project will meet the return demanded by the firm. In the case
of Makhani Ltd., this IRR of 8.41% indicates that the machine project is viable
financially.

o IRR Simplifies decision-making: Because IRR converts an investment project's

profitability into a percentage, that may be easier to understand, especially when
comparing projects of different sizes and/or length. It enables decision-makers
to assess expectations of return without having to consider complicated dollar
values.

2. Limitations of IRR

16
 o Sensitivity to Cash Flow Patterns: The IRR may give misleading results for
projects with unconventional cash flow patterns, such as those exhibiting
alternating inflows and outflows. Such a pattern may yield more than one IRR,
deciding very cumbersome.

o Less Reliable for Mutually Exclusive Projects: In mutually exclusive projects,

IRR may favor a high percentage return but overall has a lower NPV. For
example, those projects that have a high percentage IRR but low dollar returns
will not be favored as compared to the other projects having a low IRR with
overall high NP.

Suitability for Makhani Ltd.

IRR is a good measure in consolidating the project return rate in relation to Makhani Ltd.'s cost
of capital. However, for detailed analysis, it is best used with NPV because it may be
misleading in situations where future cash flows are not certain.

3.6 Recommendation

Based on a thorough evaluation of the payback period, NPV, and IRR, I recommend Makhani
Ltd. proceed with the purchase of the fabrication machine for the following reasons:

1. The positive NPV, at $ 87,858, represents reasonable cash inflows well over and above
the initial investment in the project. The positive NPV simply assures that the project
is profitable and adds financial value to Makhani Ltd.

2. IRR outstrips the cost of capital: With the project IRR standing at 8.41%, it's also well
above the Company's discount rate of 5%, hence supporting the fact that the project
return is on top of Makhani Ltd.'s cost of capital. This will ensure that the project is not
only rewarding but will also ensure the accomplishment of the long-term financial
objectives.

3. Quick Payback Period: With a payback period of only 2.67 years, which is relatively
short, Makhani Ltd. will be able to recover its initial investment in this project rather
quickly. This will reduce the possibility of sustaining a financial risk and give it the
needed liquidity flexibility for further investments or operational requirements.

17
4 References

1. AccountingInsights Team. 2024. Enhancing efficiency and accuracy in accounts

preparation - accounting insights. Available at: https://accountinginsights.org/enhancing-
efficiency-and-accuracy-in-accounts-preparation/ [Accessed: 26 October 2024].
2. Higher Logic, LLC. 2024. Internal Rate of Return (IRR) | CMA Study Group. Available at:
https://myimanetwork.imanet.org/communities/community-
home/digestviewer/viewthread?GroupId=1573&MessageKey=70443b7b-fd3f-463a-
badd-84ac102bef3c&CommunityKey=538b6443-38cb-4957-9a03-
9d7acca007f1&tab=digestviewer&hlmlt=VT&ssopc=1 [Accessed: 26 October 2024].
3. Humai. 2020. Variance mcq on material usage variance. Available at:
https://opentuition.com/topic/variance-mcq-on-material-usage-variance/.
4. indeed. 2024. Complete Guide to Efficiency Variance (With examples). Available at:
https://www.indeed.com/career-advice/career-development/efficiency-variance
[Accessed: 26 October 2024].
5. Kim, J. 2024. Payback period. Available at:
https://www.wallstreetprep.com/knowledge/payback-period/.
6. inkedin. 2023. How do you negotiate cost reduction with suppliers without compromising
quality? Available at: https://www.linkedin.com/advice/3/how-do-you-negotiate-cost-
reduction-suppliers [Accessed: 26 October 2024].
7. planful. 2024. What is financial reporting and why is it important to the business?
Available at: https://planful.com/blog/what-is-financial-reporting/ [Accessed: 26 October
2024].
8. Team, C. 2024. Net Present Value (NPV). Available at:
https://corporatefinanceinstitute.com/resources/valuation/net-present-value-npv/.

18