Grott Video should sell their VCR’s and use the money to help pay for the substantial capital spend envisaged with the introduction of computerisation.
They should also introduce new ranges, utilising the space left by the removal of the VCR’s. They needn’t try anything unique or drastic, just keep in line with competitors. They should introduce the latest films on DVD format, they should sell DVD players, they should have the latest console games for hire at the same price as the videos, they should sell the consoles and they should also have a substantial selection of refreshments including ice-cream, confectionary and crisps.
By storing the Band Rate List in a computer system it can be used to attach ‘payments due’ automatically to each video when a member returns it late. The system can also be efficiently updated. The use of a computer system would also enable Jean to generate a daily report for each shop detailing unreturned tapes and their subsequent charges. By having all member details on account no report would need to be written to County Court as Jean could simply e-mail all relevant information in a matter of seconds. Saving both time and money.
By implementing a scanning device/system on the drop box, linked to a computer, staff will immediately be notified when videos are returned preventing any more lost sales. Introduction of a computer system network will mean any number of staff can access the member files at the same time (as long as there are sufficient servers). It will also put an end to anyone’s struggle to decipher handwriting.
To solve the problem of parking Jean could purchase extra space if possible, alternatively he could use the less busy shop 3 to pilot an innovative scheme where customers can choose to get a drive-thru video. This would cut down on the number requiring parking spaces if successful. Two windows could be formed at the side, one to take the order, receive payment and swipe the membership card, while the other is used to give the video to the member. If the idea catches on Jean could patent it and introduce it to his other shops before retiring with a large sum in the bank as a result (or maybe I should do that).
A computer system would allow Jean access to all files from wherever he desired. It would also allow him to organise members easily, e.g. by postcode for mailing, and he would no longer have to start from scratch every time he wanted to update it.
Security could also be improved as the shops can efficiently communicate using the computer network. In future a gang member who has stolen from one shop would be expected in the other shops on the same day so relevant actions can be taken before they arrive.
Information relevant to Jean in terms of financing any forthcoming I.T. installation is detailed in the section entitled ‘costs’.
Costs:
Jean-Luc Picard, the owner, has decided to investigate the possibility of installing a computer system to be used within the company. Using my expert knowledge on options which could be beneficial to Jean:
Option A: Costs of £1,500 Hardware (for a single PC) + £500 (Software and one-off training session), this would enable an increase of 2.5% additional sales per year (based on the current sales figure).
Option B: £4,500 Hardware (1 PC for each section) + £1,500 (Software & training) + £650 per year (Support cost). The anticipated increase in revenue would be 10%.
Option C: £7,000 Hardware (1 PC for each section – networked together) + £2,250 (Software & training) + £950 per year (Support cost). The anticipated increase in revenue would be 15%.
Using this information I can apply my knowledge of investment appraisal to show if the capital investment project is worthwhile.
The information can be processed in a number of different ways to highlight different areas.
Payback Period:
An investment's payback period in years (and months, weeks or even days) is equal to the net investment amount divided by the average annual cash flow from the investment. It basically means: How long will it take to get my money back?
This refers to the time it takes for an investment to repay the initial outlay. In calculating the payback period, it is usual to work to the nearest month. This month can be obtained using the following formula:
Month of Payback = (Income Required / Contribution per Month)
Or to find the day of payback:
Day of Payback = (Income Required / Contribution per Day)
When using this method to choose between projects, the shortest payback period will be chosen.
For a business, payback is a simple calculation to make. It gives a good indication of the level of risk associated with potential investments because the longer the payback period, the longer the firm’s money is at risk, and the greater the likelihood that something unexpected may negatively affect the business.
The payback period also takes into account the timing of cash flows. Firms might adopt this method if they have cash flow problems. This is because the project chosen will ‘payback’ the investment more quickly than others.
Strengths of the Payback method are: It's easy to compute, easy to understand and provides some indication of risk by separating long-term projects from short-term projects. It is particularly useful for firms with difficult cash flow positions as it helps them to identify how long it will take for the cash to be restored. Also, the further ahead a forecast looks, the less likely it is to be accurate due to uncertainty increasing over time. For this reason payback is advantageous as it only focuses on the short-term.
Weaknesses: It doesn't measure profitability, doesn't account for the time value of money and ignores financial performance after the break-even period. Using this method may also encourage a short-termist attitude within the business.
Payback period is the most widely used measure for evaluating potential investments.
Payback Period for Option A:
Initial information: Number of videos hired per day in all 3 shops = 250.
250 x 6 (days open per week) =1500 videos hired per week.
1500 x 52 (weeks in a year) = 78000 videos hired per year.
Total Cost: Hardware + Software = (£1500 + £500) £2000
Training support: £0
Annual sales increase: 2.5%
Year Revenue Cumulative Total
Year 0 (£2000) (£2000)
Year 1 £3900 £1900
Here we can see the payback occurs in the first year. We use the formula …
Day of Payback = (Income Required / Contribution per Day)
… to gain a precise day when payback will be made.
£2000/£10.69=187.09 therefore option A will take 188 days to payback
Payback Period for Option B:
Total Cost: Hardware + Software = (£4500 + £1500) £6000
Training support: £650
Annual sales increase: 10%
Year Revenue Training & support Cumulative Total
Year 0 (£6000) (£6000)
Year 1 £15600 (£650) £8950
Here we can see the payback occurs in the first year. We use the formula to gain a precise day when payback will be made.
£6000/£40.96=146.48 therefore option B will take 147 days to payback.
Payback Period for Option C:
Total Cost: Hardware + Software = (£7000 + £2250) £9250
Training support: £950
Annual sales increase: 15%
Year Revenue Training & support Cumulative Total
Year 0 (£9250) (£9250)
Year 1 £23400 (£950) £13200
Here we can see the payback occurs in the first year. We use the formula to gain a precise day when payback will be made.
£9250/£61.50=150.40 therefore option C will take 151 days to payback.
Using the Payback Period the shortest project is always deemed to be the best option for the firm. Due to this fact I am able to conclude that Grott Video should choose option B when deciding on which I.T. facilities to install.
Average Rate of Return (ARR):
The ARR is a calculation of the average annual profit on an investment as a percentage of the sum invested.
The formula to calculate ARR is as follows:
(Total Additional Net Cash Flows/No. of years) / (Initial capital cost–Residual value)
The resultant figure is then multiplied by 100 to give the percentage value of ARR.
The percentage calculated gives the average annual rate of return. There are three steps to calculating ARR, first of all calculate the total profit over the lifetime of the investment (net cash inflows minus the investment). Next, divide by the number of years of the investment project (this gives the average annual profit. The final step is to apply the formula: (average annual profit / initial outlay) x 100
The ARR method takes account of the cash flows throughout the life of a project and focuses on the key decision making factor: profitability. However, it ignores when the cash flows occur, which can have a great impact on the risks of the project. One advantage of this technique is that it is simple to calculate. The ARR is also easy to communicate as well as being an easy and effective technique to compare results with other potential investments. When comparing results, the higher the figure, the better. Also, because the result is a percentage return, the answer can be compared with alternative options for investment other than the specified project. Another advantage of the ARR is that all the net cash flows are used from the projects lifetime; however, a disadvantage is that because later years are included, the results will not prove as accurate as payback. Other disadvantages of the ARR include the fact this technique ignores the timing of the ‘net cash flow’. Also it is an average percentage figure so it disguises the impact of high and low additional profit in individual years. ARR also ignores the time value (opportunity cost) of the money invested.
ARR for Option A:
For this calculation I will presume the new I.T. system will last for 6 years.
Year Revenue Cumulative Revenue
Year 0 (£2000) (£2000)
Year 1 £3900 £1900
Year 2 £3900 £5800
Year 3 £3900 £9700
Year 4 £3900 £13600
Year 5 £3900 £17500
Year 6 £3900 £21400
The lifetime profit of option A is £21400
Divide this by the number of years: £21400 / 6 = £3566.667
Calculate this annual profit as a % of the initial outlay: £3566.667 / £2000 = 1.7833
Multiply by 100 to give percentage figure:
Then we discover there is a 178.33% average rate of return on option A.
ARR for Option B:
For this calculation I will presume the new I.T. system will last for 6 years.
Year Revenue Training support Cumulative Revenue
Year 0 (£6000) (£6000)
Year 1 £15600 £650 £8950
Year 2 £15600 £650 £23900
Year 3 £15600 £650 £38850
Year 4 £15600 £650 £53800
Year 5 £15600 £650 £68750
Year 6 £15600 £650 £83700
The lifetime profit of option B is £83700
Divide this by the number of years: £83700 / 6 = £13950
Calculate this annual profit as a % of the initial outlay: £13950 / £6000 = 2.325
Multiply by 100 to give percentage figure:
Then we discover there is a 232.50% average rate of return on option B.
ARR for Option C:
For this calculation I will presume the new I.T. system will last for 6 years.
Year Revenue Training support Cumulative Revenue
Year 0 (£9250) (£9250)
Year 1 £23400 £950 £13200
Year 2 £23400 £950 £35650
Year 3 £23400 £950 £58100
Year 4 £23400 £950 £80550
Year 5 £23400 £950 £103000
Year 6 £23400 £950 £125450
The lifetime profit of option C is £125450
Divide this by the number of years: £125450 / 6 = £20908.33
Calculate this annual profit as a % of the initial outlay: £20908.33 / £9250 = 2.2603
Multiply by 100 to give percentage figure:
Finally we discover there is a 226.03% average rate of return on option C.
The higher the ARR given by a project, the better. Bearing this in mind it is clear to see in this instance option B would be best for Grott Video as it will give an Average Rate of Return of 232.50%.
Net Present Value:
This method calculates the present values of all the money coming in from the project in the future. Then sets these against the money being spent on the project today. The result is known as the net present value of the project. It can be compared with other projects to find which has the highest return in real terms, and should therefore be the one chosen by the firm.
The technique can also be used to see if any of the projects are worth undertaking at all. All the investments provided may have a negative net present value (money spent exceeds that being recouped). If this is the case, the firm will be better off putting the money in a bank to earn the current rate of interest. Projects are only worth carrying out if the resultant net present value is positive.
An advantage of NPV is that it takes the opportunity cost of money into account. Also, this method pays close attention to the timing of cash flows and their values in relation to the value of money today. NPV also allows you to consider different scenarios for your firm because different calculations can be made to see what returns would be obtained at different interest rates or with different cash flows to reflect different expectations.
A disadvantage of NPV is that the calculation is not easy, particularly compared to some other appraisals such as ARR and Payback. Another disadvantage is that it can be very difficult to obtain the ‘cost of capital’, especially over a long time period, and communication of the technique is also a problem as the meaning of the result is often misunderstood.
Net Present Value for Option A:
For the purpose of this section I will presume there will be an interest rate increase of 10%.
Year Detail Amount £ Discountfactor Presentvalue £
0 Initial capital cost -2000 1 (2000)
1 Net cash flow 3900 0.9091 3545.49
2 Net cash flow 3900 0.8264 3222.96
3 Net cash flow 3900 0.7513 2930.07
4 Net cash flow 3900 0.6830 2663.70
5 Net cash flow 3900 0.6209 2421.51
Total 19500 14783.73
Minus - 2000 - 2000
Net value £17500
Present Value £12783.73
This table shows that the firm gains £17500 from the investment after everything has been paid for, this is the net value. However because money loses value over time that £17500 will only be worth £12783.73 in today’s money terms, this is the net present value.
Net Present Value for Option B:
For the purpose of this section I will presume there will be an interest rate increase of 10%.
Also, 14950 is gained from subtracting the annual training support costs (650) from the annual revenue (15600).
Year Detail Amount £ Discountfactor Presentvalue £
0 Initial capital cost -6000 1 (6000)
1 Net cash flow 14950 0.9091 13591.05
2 Net cash flow 14950 0.8264 12354.68
3 Net cash flow 14950 0.7513 11231.94
4 Net cash flow 14950 0.6830 10210.85
5 Net cash flow 14950 0.6209 9282.46
Total 74750 56670.98
Minus - 6000 - 6000
Net value £68750
Present Value £50670.98
This table shows that the firm gains £68750 from the investment after everything has been paid for, this is the net value. However because money loses value over time that £68750 will only be worth £50670.98 in today’s money terms, this is the net present value.
Net Present Value for Option C:
For the purpose of this section I will presume there will be an interest rate increase of 10%.
Also, 22450 is gained from subtracting the annual training support costs (950) from the annual revenue (23400).
Year Detail Amount £ Discountfactor Presentvalue £
0 Initial capital cost -9250 1 (9250)
1 Net cash flow 22450 0.9091 20409.30
2 Net cash flow 22450 0.8264 18552.68
3 Net cash flow 22450 0.7513 16866.69
4 Net cash flow 22450 0.6830 15333.35
5 Net cash flow 22450 0.6209 13939.21
Total 112250 85101.23
Minus - 9250 - 9250
Net value £103000
Present Value £75851.23
This table shows that the firm gains £103000 from the investment after everything has been paid for, this is the net value. However because money loses value over time that £103000 will only be worth £75851.23 in today’s money terms, this is the net present value.
When comparing NPV between different projects a firm looks for the option that offers the best cash return on their investment. From the figures shown above we can clearly identify that option B is the best option for Grott Video to pursue.
Project Planning:
A project is a temporary organisational device that brings resources to achieve a desired end, to time and within budget. It also always has a start, a middle and an end.
The characteristics of a project are:
Purpose – a single, definable end product.
Complexity – traditional organisational lines become blurred as projects utilise skills and talents from other areas.
Uniqueness – Each project requires something different doing than before.
Unfamiliarity & Stake – new technology may cause uncertainty, failure could jeopardise the organisation and its goals.
Impermanence – once a goal is achieved the organisation often disbands.
Life Cycle – the process of working to achieve a goal.
Recommendations:
Based on all this information I would advise Jean to immediately install a computer system before areas as important as customer relations suffer anymore. The computer system seems the ideal answer to so many of his current problems. However, there are some problems explained above that cannot be solved by I.T. (at least not alone), these solutions should also be heeded as it is my considered opinion that they would only improve the business.
By using three different methods of investment appraisal we can see the same figures highlighting different areas and providing us with new information. The most interesting thing found out was that in all three instances option B was the best project for Grott Video. It is worth bearing in mind though that methods such as Break-even Point Analysis and Internal Rate of Return have been overlooked on this occasion. Having said that, using the information that has been obtained I can confidently advise Grott Video to pursue the installation of the I.T. facilities detailed in option B as they came out top in all three methods, Payback, ARR and NPV.
Please find herewith James Heavey’s Feasibility report on Grott Video.
All the information asked for is provided and I very much hope it is of the desired use to you.
If there are any queries or comments you wish to make on any of the following areas, please do not hesitate to contact me at Floor 2, Crewe Building (01270-001270).
Thank you for taking the time to read this feasibility report.
Signed ……………………