kist-fin 3420-course syllabus final april 2013

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Year 2012-2013, KIST. FIN 3420 Engineering Economics and Finance COURSE SYLLABUS prepared by I-kabod M. & Ally M.

KIGALI INSTITUTE OF SCIENCE AND TECHNOLOGY INSTITUT DES SCIENCES ET TECHNOLOGIE DE KIGALI

Avenue de l’armée, B.P.3900 Kigali, Rwanda Website: www.kist.ac.rw

ENGINEERING FACULTY

FIN 3420 ENGINEERING ECONOMICS AND FINANCE

Year 4 CE, Year 4 WEE, Year 4 CEIT, Year 4 MEE

COURSE SYLLABUS

Jan 14-, July 2013

Lecturer’s name, Qualification & Rank:

I-kabod MWITENDE, MBA. Contacts: 0788-543-527, [email protected]

Ally MUNDERERE, MBA Contacts: 0788-466-821, [email protected]

Contact Hours: Three (3) hours per week/class; 15 weeks in a semester= 45 Hours

Tutorial Hours:

Timing and Location:

Mode of Delivery: Lectures, Class Presentations, Discussions.

Mode of Assessment: Assignments (Reading Reports and Oral Presentations), CAT & Final Exam

Consultation Time: Immediately after lectures, E-mail.

http://www.kist.ac.rw/

mailto:[email protected]

mailto:[email protected]

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Prerequisites: Engineering Experience OR Review of Engineering Practice. Engineering Communication. Design and Innovation Fundamentals. Entrepreneurship Development skills. Engineering Ethics.

Text: Paul Milgron & John Roberts, Economics organization and management,

Hall International Editions, 1992. Financial Management by I.M Pandey Prentice Hall of India Financial Management and Policy J .Van Horne Prentice Hall Managerial Finance J. Fred and Thomas E. Copeland CBS College Publishing NY

Grades: Assignment I: 10%, Assignment II: 10%, Class Test: 20%, Examination: 60% Course Outlines:

WEEK/DAY AND DATE TOPICS OBSERVATIONS

1/ Tue’ 29 Jan 2013 - Introduction, nature of business and financial planning - Assignment I

Introduction of Lecturer-Students and the Course

2/ Tue’ 05 Feb 2013 -Presentation of Assignment I

Submit the Assignment I to the Lecturer’s e-mail one day before the presentation

3/ Tue’ 12 Feb 2013 Introduction, nature of business and financial planning

4/ Tue’ 19 Feb 2013 External sources 5/ Tue’ 26 Feb 2013 Uses of Business finance 6/ Tue’ 05 Mar 2013 CAT 7/ Tue’12 Mar 2013 Working capital decisions 8/ Tue’ 19 Mar 2013 -Analysis of costs

-Assignment II Submit the Assignment II to the Lecturer’s e-mail before 25th March 2013

9/ Tue’ 26 Mar 2013 Measuring Business Performance 10/ Tue’ 02 Apr 2013 Budgets and Budgetary Control

11/ Tue’ 16/4/13 Revision 12/Mon’ 22/4/13-Fri 3/5/13

Semester 2 exams

13/ Fri’ 7/6/13 Release of exam results 14/ Thu’ 13/6-Wed’ 26/6/13 Supp exam 15/ Thu’ 11/7-Fri’ 12/7/13 Release of supp exam results

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CHAP I. INTRODUCTION, NATURE OF BUSINESS AND FINANCIAL PLANNING

1.1. Need for Economics

Present day engineers are commonly faced with no technological, in addition to technological, barriers that limit what can be done to solve a problem or meet a need. Technological barriers limit what engineers can do because required to solve a problem. However, engineers commonly encounter barriers that are not technological, that is, in addition to designing and building systems, they must meet other constraints, such as budgets and regulations. For example, natural resources necessary to build systems are becoming scarcer and more expensive than ever before. This trend is expected to continue. Also, engineers and economist are aware of the potential negative side effects of engineering innovations, such as air pollution from automobiles. For these reasons, they are often asked to place their project ideas within the larger framework of the environment of a specific planet, country, or region. They must ask themselves if a particular project would offer some net benefit to individuals or society as a whole. The net benefit assessment requires considering the inherent benefits of the project, plus any negative side effects, including severities associated with failure consequences due to hazards, plus the cost of consuming natural resources, considering both the price that must be paid for them and the realization that once they are used for that project they will no longer be available for other projects. Risk analysis requires engineers and economists to work closely together to develop new systems, solve problems that face society, and meet societal needs. They must decide if the benefits of a project exceed its costs and must make this comparison in a unified, systems framework. Results from the risk assessment, therefore, should feed into economic models, and economic models might drive technological innovations and solutions. 1.2. What is economy?

a. Definition and history

Economics is the science that deals with the production, allocation, and use of goods and services, it is important to study how resources can best be distributed to meet the needs of the greatest number of people. As we are more connected globally to one another, the study of economics becomes an extremely important one. While there are many subdivisions in the study of economics, two major ones are macroeconomics and microeconomics. Macroeconomics is the study of the entire systems of economics. Microeconomics is the study of how the system affects one business or parts of the economic system.

An economy consists of the economic system of a country or other area; the labor, capital, and land resources; and the manufacturing, production, trade, distribution, and consumption of goods and services of that area.

http://en.wikipedia.org/wiki/Economic_system

http://en.wikipedia.org/wiki/Wage_labor

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http://en.wikipedia.org/wiki/Resources

http://en.wikipedia.org/wiki/Manufacturing

http://en.wikipedia.org/wiki/Production_%28economics%29

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A given economy is the result of a process that involves its technological evolution, history and social organization, as well as its geography, natural resource endowment, and ecology, as main factors. These factors give context, content, and set the conditions and parameters in which an economy functions.

History of Economics The first writings on the subject of economics occurred in early Greek times as Plato, in The Republic, and Aristotle wrote on the topic. Later such Romans as Cicero and Virgil also wrote about economics.

In medieval times the system of feudalism dominated. With feudalism, there was a strict class system consisting of nobles, clergy and the peasants. In the system, the king owned almost all the land and under him were a series of nobles that had land holdings of various sizes. On these landholdings were series of manors. These were akin to large farming tracts in which the peasants or serfs worked the land in exchange for protection by the nobles.

Later the system of mercantilism predominated. It was an economic system of the major trading nations during the 16th, 17th, and 18th cent., based on the idea that national wealth and power were best served by increasing exports and collecting precious metals in return. Manufacturing and commerce became more important in this system.

In the mid eighteenth century, the Industrial Revolution ushered in an era in which machines rather than tools were used in the factory system. More workers were employed in factories in urban areas rather than on farms. The Industrial Revolution was fueled by great gains in technology and invention. This also made farms more efficient, although fewer people were working the farms. During this time the idea of "laissez faire" became popular. This means that economies work best without lots of rules and regulations from the government. This philosophy of economics is a strong factor in capitalism, which favors private ownership.

In the nineteenth century, there was reaction to the "laissez-faire" thinking of the eighteenth century due to the writings of Thomas Malthus. He felt that population would always advance faster than the science and technology needed to support such population growth. David Ricardo later stated that wages tend to settle at a poor or subsistence level for most workers. John Stuart Mill provided the backdrop for socialism with his theories that supported farm cooperatives and labor unions, less competition. These theories were brought to a high point by Karl Marx who attacked the capitalistic, "laissez-faire" theories of competition and instead favored socialisms, marked more government control and state rather than private ownership of property.

Another important idea at this time was the change in how items are valued. While formerly and item's value stayed the same according to what the item was, now worth of an item is determined by how many people want the item and how great the supply of the item was. This was the beginning of the laws of supply and demand.

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In the first half of the twentieth century, John Maynard Keynes wrote about business cycles - when the economy is doing well and when it is in a slump. His theories led to governments seeking to put more controls on the economy to prevent wide swings.

After World War II, emphasis was placed on the analysis of economic growth and development using more sophisticated technological tools.

In recent years, economic theory has been broadly separated into two major fields: macroeconomics, which studies entire economic systems; and microeconomics, which observes the workings of the market on an individual or group within an economic system. In the later twentieth century such ideas as supply side economics which states that a healthy economy is very necessary for the health of the nation and Milton Friedman's ideas that the money supply is the most important influence on the economy.

In the twenty-first century, the rapid changes and growth in technology have spawned the term "Information Age" in which knowledge and information have become important commodities.

b. Microeconomics-Macroeconomics How do companies decide what price to charge for their sleek new gadgets? Why are some people willing to pay more for a product than others? How do your decisions play into how corporations price their products? The answer to all of these questions and many more is microeconomics. Microeconomics focuses on the role consumers and businesses play in the economy, with specific attention paid to how these two groups make decisions. These decisions include when a consumer purchases a good and for how much, or how a business determines the price it will charge for its product. Microeconomics examines smaller units of the overall economy; it is different than macroeconomics, which focuses primarily on the effects of interest rates, employment, output and exchange rates on governments and economies as a whole. Both microeconomics and macroeconomics examine the effects of actions in terms of supply and demand. Microeconomics is generally the study of individuals and business decisions; macroeconomics looks at higher up country and government decisions. Macroeconomics and microeconomics, and their wide array of underlying concepts, have been the subject of a great deal of writings. The field of study is vast; here is a brief summary of what each covers: b.1. Microeconomics Microeconomics is the study of decisions that people and businesses make regarding the allocation of resources and prices of goods and services. This means also taking into account taxes and regulations created by governments. Microeconomics focuses on supply and demand and other forces that determine the price levels seen in the economy. For example, microeconomics would look at how a specific company could maximize its production and capacity so it could lower prices and better compete in its industry.

http://www.investopedia.com/terms/m/microeconomics.asp

http://www.investopedia.com/terms/m/macroeconomics.asp

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Microeconomics focuses on the role consumers and businesses play in the economy, with specific attention paid to how these two groups make decisions. These decisions include when a consumer purchases a good and for how much, or how a business determines the price it will charge for its product. Microeconomics examines smaller units of the overall economy; it is different than macroeconomics, which focuses primarily on the effects of interest rates, employment, output and exchange rates on governments and economies as a whole. Both microeconomics and macroeconomics examine the effects of actions in terms of supply and demand.

Cost Cost is an amount that has to be paid or given up in order to get something. In business, cost is usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good or service. All expenses are costs, but not all costs (such as those incurred in acquisition of an income-generating asset) are expenses. Profit Profit is a very important concept for any business – particularly a start-up. Profit is the financial return or reward that entrepreneurs aim to achieve to reflect the risk that they take. Given that most entrepreneurs invest in order to make a return, the profit earned by a business can be used to measure the success of that investment.

Profit is an important signal to other providers of finance to a business. Banks, suppliers and other lenders are more likely to provide finance to a business that can demonstrate that it makes a profit (or is very likely to do so in the near future) and that it can pay debts as they fall due. Profit is also an important source of finance for a business. Profits earned which are kept in the business (i.e. not distributed to the owners via dividends or other payments) are known as retained profits.

Retained profits are an important source of finance for any business, but especially start-up or small businesses. The moment a product is sold for more than it cost to produce, then a profit is earned which can be reinvested. Profit can be measured and calculated. So here is the formula: PROFIT = TOTAL SALES less TOTAL COSTS Profit is reflected in reduction in liabilities, increase in assets, and/or increase in owners' equity. It furnishes resources for investing in future operations, and its absence may result in the extinction of a company. As an indicator of comparative performance, however, it is less valuable than return on investment (ROI). Also called earnings, gain or income. b.2. Macroeconomics Macroeconomics, on the other hand, is the field of economics that studies the behavior of the economy as a whole and not just on specific companies, but entire industries and economies. This looks at economy-wide phenomena, such as Gross Domestic Product (GDP) and how it is affected




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http://www.businessdictionary.com/definition/utility.html

http://www.businessdictionary.com/definition/risk.html

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http://www.investorguide.com/definition/acquisition.html

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http://www.investorguide.com/definition/profit.html

http://www.investorguide.com/definition/liability.html

http://www.investorguide.com/definition/increase.html


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http://www.investorguide.com/definition/earnings.html

http://www.investorguide.com/definition/gain.html

http://www.businessdictionary.com/definition/income.html


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by changes in unemployment, national income, rate of growth, and price levels. For example, macroeconomics would look at how an increase/decrease in net exports would affect a nation's capital account or how GDP would be affected by unemployment rate. While these two studies of economics appear to be different, they are actually interdependent and complement one another since there are many overlapping issues between the two fields. For example, increased inflation (macro effect) would cause the price of raw materials to increase for companies and in turn affect the end product's price charged to the public. The bottom line is that microeconomics takes a bottoms-up approach to analyzing the economy while macroeconomics takes a top-down approach. Regardless, both micro- and macroeconomics provide fundamental tools for any finance professional and should be studied together in order to fully understand how companies operate and earn revenues and thus, how an entire economy is managed and sustained.

Definition of 'Gross Domestic Product - GDP'

The monetary value of all the finished goods and services produced within a country's borders in

a specific time period, though GDP is usually calculated on an annual basis. It includes all of

private and public consumption, government outlays, investments and exports less imports that

occur within a defined territory.

GDP = C + G + I + NX

Where:

"C" is equal to all private consumption, or consumer spending, in a nation's economy "G" is the sum of government spending "I" is the sum of all the country's businesses spending on capital "NX" is the nation's total net exports, calculated as total exports minus total imports. (NX = Exports - Imports) Inflation

Inflation means a sustained increase in the aggregate or general price level in an economy. Inflation means there is an increase in the cost of living. “Inflation means that your money won’t buy as much today as you could yesterday.”

Unemployment

The amount of unemployment in an economy is measured by the unemployment rate, the percentage of workers without jobs in the labor force. The labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded from the labor force.

http://www.investopedia.com/terms/c/capitalaccount.asp

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http://www.investopedia.com/terms/b/bottomupinvesting.asp

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http://www.investopedia.com/terms/r/revenue.asp

http://en.wikipedia.org/wiki/Labor_force

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Who is unemployed?

The unemployed are people able, available and willing to work at the going wage rate but cannot find a job despite an active search for work

Unemployment means that scarce human resources are not being used to produce goods and services to meet people’s needs and wants

Persistently high levels of joblessness have damaging consequences for an economy causing both economic and social costs

Problems caused by unemployment occur across a country but are often very bad and deep-rooted in local and regional communities and within particular groups of society.

1.3. What is finance?

a. Definition, relationship between business and financial planning, Goals of the firm, agency theory

Finance is the application of economic principles and concepts to business decision making and problem solving. It is simply applied economics. Finance is broken into three main topics:

a. Financial management – deals with the management of finances of a business enterprise

b. Investments – deals with financial markets and security pricing c. Financial institutions – deals with financial firms such as banks

There are a number of different financial decisions made within the firm. Investment decisions concern the use of funds for future benefits such as extending credit to customers or purchasing a new processing plant. Consider these two examples of financial decisions

– Starting a new business

– Investing in cash

Starting a new business You need to consider

– How much the equipments will cost

– How much money should be tied to working capital – cash on hand, inventory etc

– What cash flows do you expect – cash expected in from sales and cash expected out in form of expenses

– Difference between expected future cash flow and actual future cash flows

– How much credit to extend to customers and for how long?

– What else you can do with the money – opportunity cost

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Investing in cash You have to consider

– How large a cash balance is needed

– How much cash is needed in future

– Where the cash balance will be held – in bank, under the mattress, in treasury bills, in stocks

– Should cash balance be constant throughout the year

– What else can you do with the money

– Opportunity cost

Financial planning is the process of wisely managing both your personal and business finances so

that you can achieve your goals and dreams. You can do financial planning on your own or with

the assistance of a financial planner. In other word, Financial Planning is the process of estimating

the capital required and determining its competition. It is the process of framing financial policies

in relation to procurement, investment and administration of funds of an enterprise.

Financial planners help their individual clients to achieve their lifetime dreams by identifying and

planning for short and long-term financial goals. This includes covering all elements of a client’s

financial plan, encompassing planning for retirement, transferring of wealth to future generations,

funding education, minimizing taxes, risk management (including proper insurance coverage) and

general investment decisions. Some planners eventually choose to leave the tax work behind and

focus solely on financial planning, particularly in smaller firms.

Either way, it makes sense to follow a financial planning process that includes:

•Setting realistic financial and personal goals

•Evaluating where you are now financially

•Developing a plan to reach your goals

•Putting your plan into action

•Monitoring your plan to stay on track with changing goals and circumstances Can a firm maximize the shareholders’ and stakeholders’ wealth at the same time?

• Maximizing the stakeholders wealth succeeds only if costs include the costs to stakeholders

• The firm has a responsibility to assist employees and other stakeholders failure to which they could tarnish their reputation, erode their ability to attract new stakeholder groups to new investments and ultimately act to the detriment of shareholders

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Goals of the firms: I. Profit Maximization II. Maximization of the Shareholders Wealth

I. Profit Maximization:

Profit maximization stresses the efficient use of capital resources, but it is not specific (or ignore)

with respect to the time frame over which the profits are to be measured.

In short- term executives may used different assets to sell-off and turn the cash to increase

liquidity on corporate balance sheets and then could easily increase profits. But this short run

profit taking strategy is not in the best long-term objective and interest of the owners of the public

corporation.

In microeconomics, profit maximization functions largely as a theoretical goal, with economist using

different models, charts and tables to prove the case that in free market economy firms behave

rationally if they increase or maximize profit based on information.

In this world of economics two (2) distinctive elements of business are ignored:

1. Uncertainty 2. Timing

In reality, different investment projects differ a great deal with respect to risk characteristics, and

to ignore these differences in the practice of corporate financing can result in poor management

decisions. In business life there is a very definite relationship between risk and expected return -

that is, private investors demand a higher expected return for taking on the investment projects

additional risk. To ignore this relationship leads to improper decision making to allocate the

capital which could lead to long-term conflict between existing investors and management.

II. Maximization of Shareholders Wealth

Means maximization of the market value of the existing shareholders common stock price –

because the effects of all financial decisions are included.

-Private Investors react to poor investment or dividend decisions by selling stocks and causing the total market value of the public shares to fall.

-Investors can react to good decisions by pushing up the price of stocks and create wealth for the shareholder. If the owners of the corporation are to base financial decisions on a single goal, that goal must be precise, not allow for misinterpretation, and deal with all the complexities of the

real business world, including but not limited to:

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1. legal issues 2. environmental standards 3. ethical and cultural considerations 4. international dimensions 5. labor demand and rights 6. tax

The market price of the public corporation reflects the value of the public corporations seen by its

owners (investors = shareholders = equity holders) and takes into account the complexity and

complications of the real-business risks. The unifying objective in corporate finance is to maximize

the share value of the public firm.

Investment projects, financing structure and dividend decisions must be directed by management toward share value maximization objective. The objective is narrowed from maximizing firm value to maximizing stockholder value or stockholder wealth.

How do we measure stockholder wealth?

1. In a publicly traded company, the stock price is an observable and real measure of stockholder wealth

2. The objective of maximizing stockholder wealth can be narrowed to maximizing stock price

3. The stock prices possess unique value of measuring stockholder wealth at any time, not limited to corporate annual report or financial reports.

Why private investors focuses on Stock Price Maximization:

1. The stock prices are the most observable of all measures that can be used to judge the performance of the publicly traded corporation.

2. The stock price, in a market with rational investors, reflects the long-term effects of the firm’s decisions

3. The stock price is a real measure of stockholders wealth, since the stockholders can sell stock

and receive the price now.

Two mechanisms designed to provide power to stockholders:

I. The Annual Meeting, where the shareholders of publicly traded firms are called to gather

once every year at annual meeting and decide directly on selection of the board of directors. The

shareholders who cannot attend the meeting can still exercise their voting power by filling out a

proxy. A Proxy enables shareholders to vote in absentia for boards of directors and resolution

that will come to a vote at the shareholders meeting.

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II. The Boards of Directors is the body that oversees the management of a public

corporation. The Board of Directors as elected representatives of the shareholders, the directors

are obligated to ensure that managers are looking out for stockholders interests. They have the

power to change the top management of the firm and have a substantial influence on how the

corporation is run and how the dividends are distributed.

b. Financial management Overview of financial management

Financial management is the management of cash flows to make profits for the firm’s owners. It requires the coordination of all areas of a business to effectively benefit the owners. Financial decision making are usually managed by the financial controller or treasure. Financial Management can be defined as the management of the finances of a business/ organisation in order to achieve financial objectives.

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There are three key elements to the process of financial management:

• (1) Financial Planning

• (2) Financial Control

• (3) Financial Decision-making (1) Financial Planning Management need to ensure that enough funding is available at the right time to meet the needs of the business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit. In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions. (2) Financial Control Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. Financial control addresses questions such as:

Are assets being used efficiently?

Are the businesses assets secure?

Do management act in the best interest of shareholders and in accordance with business rules?

(3) Financial Decision-making The key aspects of financial decision-making relate to investment, financing and dividends:

a. Investments must be financed in some way – however there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers

b. A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further.

Who is involved? Departments that typically perform financial management tasks include

– Accounts payable - deal with payment to suppliers

– Capital budgeting –investment in ling term assets

– Accounts receivables – collection of customer credit accounts

– Financial Planning – planning for cash inflow and outflows Usually the functions of financial management are integrated with accounting and economic functions

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Financial analysis

• This is a tool that involves evaluating the financial condition and operating performance of a business enterprise

• Financial analysis requires the evaluation of the firm, the firm’s industry and the economy

• Within the firm, financial analysis may be used to evaluate the performance of the firm as well as its divisions or departments and its product lines

• The analysis may be done periodically or as needed in order to ensure informed investment and financing decisions and also aid in implementing personnel policies and rewards systems

• Outside the firm, financial analysis may be used

• to determine the credit worthiness of a new customer,

• to evaluate the ability of a supplier to hold to the conditions of a long term contract and

• To evaluate the market performance of competitors Objectives of financial management Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to:

Create wealth for the business

Generate cash, and

Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested

• A firm should seek to maximize the value of the firm

• For a corporation, this goal translates to maximizing shareholder’s wealth as represented by the market value of equity

• The market value of the shareholder’s equity is the value of all owners’ interest in the corporation and is calculated as the product of the market value of a share of stock and the number of shares of stock outstanding

Market value of equity = Market price x No. of shares

• To maximize the economic well being of the corporation’s owners, managers must maximize the market price of the stock

• Therefore, market price is a measure of owners’ economic well being.

• The goal of the firm is to maximize shareholders’ wealth as measured by the market price of the firm’s shares

The agency relationship

• This is the relationship between the principal and the agent, in which the agency acts for the principal.

• In a corporation, the principals are the shareholders and the agents are the managers

• The managers are hired by the owners of the firm (shareholders) to manage the firm and make decisions for the owners’ benefit

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• In practice, managers also consider their own personal wealth, job security, lifestyle and prestige and seek to receive perquisites (perks) such as country club memberships, limousines, corporate jet usage, posh offices

• Such concerns often motivate managers to pursue objectives other than shareholders wealth maximization

• Some problems associated with this differing interests between principals agents include

• Agents may consume excessive perquisites

• Agents may shirk – not expend their best efforts

• Agents may act in their own self-interest instead of that of the principal Examples

• Managers fighting a take over that would be in the best interest of shareholders

• Managers adopt golden parachutes – lucrative compensation packages that take effect if a manager loses his or her job in a takeover

Associated costs

• Monitoring costs – costs incurred by the principal to monitor the actions of the agents e.g. annual report to shareholders

• Bonding costs – costs incurred by the agent to ensure they will act in the best interests of the principals e.g. binding employment contract

• Residual loss – implicit cost when management and shareholders’ interests cannot be aligned even when bonding and monitoring casts are incurred

Solutions to agency problems

• Using market forces to exert managerial discipline – e.g. pressure underperforming managers and even replacing them, hostile takeover

• Monitoring and bonding expenditures e.g. delayed compensation which must be forfeited in the event of poor performance – bonuses – audits and controls that alert shareholders of impending problems

• Executive remuneration packages (compensation) Executive compensation The goal is to provide incentives for management to work in the owner’s best interests. There are many ways of compensating managers which include:

– Salary – a fixed cash payment per period. This must be enough to attract talented executives

– Bonus – based on some measure of operating performance such as earnings or gain in market share

– Stock appreciation rights – compensation corresponding to changes in the firm’s share price

– Performance shares – shares given as rewards based on operating performance

– Stock options – options to buy shares of stock at a specified price within a specified period of time

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– Restricted stock grant – options to buy stock where the stock must be owned for a period of time

– Stock options and grants are aimed at making managers also owners in which case they also benefit financially when they maximize owners’ wealth

– Threat of firing – removal of poor performing managers

Social responsibilities

• The managers have a responsibility to the firm’s stakeholders

• These are various groups of persons that depend on a firm because they all have a stake in the outcomes of the firm – employees, community, customers, suppliers

• A firm’s decision to invest or disinvest may affect all these groups of people Stakeholders

• Stakeholders are Groups / individuals that are affected by and/or have an interest in the operations and objectives of the business

• Most businesses have a variety of stakeholder groups who vary both in terms of their interest in the business activities and also their power to influence business decisions.

• They can be broadly categorized as follows:

• Shareholders

Main Interest - Profit growth, Share price growth, dividends Power and influence - Election of directors

• Banks & other Lenders Main Interest - Interest and principal to be repaid, maintain credit rating Power and influence - Can enforce loan covenants Can withdraw banking facilities

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• Directors and managers Main Interest - Salary ,share options, job satisfaction, status Power and influence - Make decisions, have detailed information

• Employees Main Interest - Salaries & wages, job security, job satisfaction & motivation Power and influence - Staff turnover, industrial action, service quality

• Suppliers Main Interest - Long term contracts, prompt payment, growth of purchasing Power and influence - Pricing, quality, product availability

• Customers Main Interest - Reliable quality, value for money, product availability, customer service Power and influence - Revenue / repeat business Word of mouth recommendation

• Community Main Interest - Environment, local jobs, local impact Power and influence - Indirect via local planning and opinion leaders

• Government Main Interest - Operate legally, tax receipts, jobs Power and influence - Regulation, subsidies, taxation, planning Managing the power of stakeholders

• The relationship between a business and its stakeholders lays the power and influence that a stakeholder has over the business objectives.

• For stakeholders to have power and influence, their desire to exert influence must be combined with their ability to exert influence on the business.

• The power a stakeholder can exert will reflect the extent to which:

• The stakeholder can disrupt the business’ plans

• The stakeholder causes uncertainty in the plans

• The business needs and relies on the stakeholder

• The reality is that stakeholders do not have equality in terms of their power and influence Examples

• Senior managers have more influence than environmental activists

• A venture capitalist with 40% of the company’s share capital will have a greater influence that a small shareholder

• Banks have a considerable impact on firms facing cash flow problems but can be ignored by a cash rich firm

• A customer that provides 50% of a business’ revenues exerts significantly more influence than several smaller customer accounts

Businesses that operate from many locations across the country will be less relevant to the local community than a business which is the dominant employer in a town or village

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Governments exercise relatively little influence on many well-established and competitive business-to-business markets. However their power is much stronger over businesses in markets which are regulated (e.g. water, gas & electricity) or where the public sector has a direct stake (e.g. retail banking) Employees have traditionally sought to increase their power as stakeholders by grouping together in trade unions and exercising that power through industrial action. However, in the last two decades the level of union membership has declined significantly as has the total time lost to industrial action

How should a business handle stakeholders?

• How should a business respond to these variations in stakeholder power and influence?

• The matrix below provides some guidance on the approaches often taken

High level of interest Low level of interest

High level of power Key players Take notice of them

Keep them satisfied

Low level of power Communicate regularly with them

Can usually be ignored

• In handling its stakeholders, a business has to accept that it will have to make choices. It is rare that “win-win” solutions can be found for key business decisions. Almost certainly the business cannot meet the needs of every stakeholder group and most decisions will end up being “win-lose”: i.e. supporting one stakeholder means another misses out.

• There are often areas where stakeholder interests are aligned (in agreement) – where a decision can benefit more than one stakeholder group.

• In other cases, there is a clear conflict of interest. Where Stakeholder Interests are Aligned

• Shareholders and employees have a common interest in the success and growth of the business

• High profits lead not only lead to good dividends but also greater investment (retained) in the business

• Suppliers have an interest in the growth and prosperity of the business

• Local community, employees and shareholders benefit from business involvement in the community

Where Stakeholder Interests Conflict

• Wage rises might be at the expense of lower profits and dividends

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• Managers have an interest in organisational growth but this might be at the expense of short term profits

• Expansion of production activity might cause extra noise and disruption in local community Handling Conflicts – Shareholder’s approach

• This is the traditional approach

• Business (management) acts in best interest of shareholders/owners

• Principal aim is to maximize shareholder returns. Main focus is on growth & profit

• This is becoming increasingly popular

• Business takes much more account of wider stakeholder interests

• Approach based on consultation, agreement, cooperation E.g. social and environmental concerns become more important

Five M’s of management

Managing business organizations has always been a challenge to man since it became scientific. The earliest known accounts of business management in man's existence tended to be crude, brutish and short. Anything, and anyone, found to be an impediment to any growth in entrepreneurship was either pilloried or guillotined off for 'progress' to be made. Then came the industrial revolution. Welcome to machines and goodbye to servitude. Slavery became abolished as people had causes to be more 'humane' in business. Man's overuse had become juxtaposed with gears and belts of machines. Welcome to mass production. Things became manufactured at the touch of a button. Materials were optimally utilised. Time became shorter and physical exertion of force required to create utility became a thing of the past.

Since man became victorious in the industrial revolution, every business has been using these five M's: man, materials, machines, minutes and money; to operate with, or without, success. It will also be disastrous for organizations not to properly and effectively organise the M's for business success. That, in itself is a different kettle of fish. None of the M's is useless no matter the perspective it is viewed from. A meta-analysis of organizations that have survived over time showed that careless regard to any of the five resulted in economic fiascos, with some even affecting global business. When man took time off work to fight two major wars, there was economic downturn as precious time was expended to right perceived wrongs.

In business it pays to have the right innovations, but even when you have innovations you still need a follow through plan. In management the 5 M’s are money, manpower, minutes, materials, and machinery. Each of these 5 M’s is important to the overall production for innovations.

Man: Man, the first of the five M's is the most important. The right personnel for the right position is a sure bet for organizational effectiveness and efficiency. No two ways about that. Thus, lateness and absenteeism, unsafe acts, alcoholism, poor training, incompetence are just some of the attributes of man at work that could upturn the apple cart of business ventures. Human resources determine the workings of the other four basic business resources. People make sure materials,

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machines, minutes and money are utilised in a productive manner to achieve goals or aims and objectives of organizations and enterprises. Poor employment practices are inimical to the sustenance of such ventures. With the right man in the right job, a large portion of effective business management will have been achieved. No doubts about that. Materials: Without materials, human resource is made redundant. Thus every right thinking and right planning organization knows that materials needed for any business or service mist be in place before 'man' can be of use in any business activity. A supply chain department grew out of this thinking and has been a very useful and effective aspect of business management. A group of cement factory workers waiting for supply of limestone may have nothing much to do for as long as the supply does not arrive. Even if it arrives, but in poor quality, the production is certainly doomed for a loss. Quality compromised is business pauperized. Poor quality of materials potentially ruins entrepreneurship. This is an indisputable fact. Machines: The metal contraptions called machines have made man fulfil almost effortlessly various dreams of creating things that make a existence more worthwhile. Machines have replaced man in tilling, planting, and harvesting. Man has been replaced with looms in cotton and fabric processing. Countless other ventures requiring physical exertions of force has been taken over by things fixed with gears, bolts and nuts and conveyor belts. Recently, computers joined in the fray of increasing production and reduction in time spent by man for manufacturing and general production of goods and services. However, without man and materials, machines will be useless. They need to be operated by man and fed with materials. That again is a doubtless fact. Minutes: Time management is one contemporary aspect of business that has been employed in use by effective and successful business ventures to optimize delivery. As earlier noted, lateness and absenteeism of man at work is a large chunk of time off production. Poor time management is as ineffectual as a broken down machine, an indisposed employee or lack of adequate materials for production of goods or services. Various schemes have been used by successful enterprises to ensure proper and efficient use of time by man and machine, including timely delivery of materials, to ensure business sustainability. Compromising time is tantamount to a business venture shooting itself in the foot. There are umpteen instances to ascertain this truism. Money: Without money, no venture or enterprise can motivate workers, get quality and sufficient materials, get the right machines and maintain them or even ensure that time is properly managed. Money management, when not properly organized has been the most known factor involved in collapse of enterprises in history. The quantity and quality of money expended in ventures have a direct bearing on the fruitfulness of same over time. Accounts department have been revolutionarized over the years, by man, to ensure maximum operations of surviving business organizations. Where there is not enough money, no good workers, materials, or machines can be employed or purchased or acquired. In other words, such a venture will be wasting its time existing in the first place.

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Time or minutes is the most important of the 5 M’s in management because it offers an appropriate method. The method has to create a product in the allotted time frame in order to earn money. The 5 M’s of management work together to supply the product. From the materials and the machinery used the time allotted for a project will be determined. It is also important to have the right manpower.

c. Financial accounting ] Financial accountancy (or financial accounting) is the field of accountancy/accounting that treats money as a means of measuring economic performance instead of as a factor of production. It encompasses the entire system of monitoring and control of money as it flows in and out of an organization as assets and liabilities, and revenues and expenses. This is to mean that it is concerned with the preparation of financial statements for decision makers, such as stockholders, suppliers, banks, employees, government agencies, owners, and other stakeholders. The fundamental need for financial accounting is to reduce principal–agent problem by measuring and monitoring agents' performance and reporting the results to interested users. Financial accountancy is used to prepare accounting information for people outside the organization or not involved in the day-to-day running of the company. Management accounting provides accounting information to help managers make decisions to manage the business. In short, financial accounting is the process of summarizing financial data taken from an organization's accounting records and publishing in the form of annual (or more frequent) reports for the benefit of people outside the organization. Financial accounting gathers and summarizes financial data to prepare financial reports such as balance sheet and income statement for the organization's management, investors, lenders, suppliers, tax authorities, and other stakeholders. Financial accountancy is governed by both local and international accounting standards.

d. Management accounting Management accounting or managerial accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control functions. In contrast to financial accountancy information, management accounting information is:

primarily forward-looking, instead of historical; model based with a degree of abstraction to support decision making generically, instead

of case based;

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designed and intended for use by managers within the organization, instead of being intended for use by shareholders, creditors, and public regulators;

usually confidential and used by management, instead of publicly reported; Computed by reference to the needs of managers, often using management information

systems, instead of by reference to general financial accounting standards.

1.4. Basic inputs

One topic of study in economics is how and why different amounts of different goods are produced in an economy. Economists who study why one area produces more lumber while another produces computers, or why one country has more small businesses while another has only state-run corporations, will look at the four factors of production to help guide their inquiry. The four factors of production in economics are land, labor, capital and organisation.

a. Land Land refers to the natural resources that are available and used in the production of goods. For example, a heavy mining industry could not exist without the natural deposits of valuable minerals in the ground, while a thriving farming community would have a hard time surviving with poor soil and no rainfall.

b. Labor

Labor refers to the human inputs of work to produce the goods and services. For example, the training required for employees to successfully operate machines to produce cars would be considered as part of labor. In addition, the mental capacity to perform tasks and invent new products is also part of labor. The only human element not included in labor is entrepreneurship.

c. Capital

Capital refers to the tools and machines that are required for the production of the product. For example, when making cars, the capital would include the factory and all the machinery in the factory used in making the car. On a farm, the capital would include the tractors, harvesters and other equipment used to grow crops or raise livestock.

d. Organization Basically, an organization in its simplest form (and not necessarily a legal entity, is a person or group of people intentionally organized to accomplish an overall, common goal or set of goals. Business organizations can range in size from one person to tens of thousands. There are several important aspects to consider about the goal of the business organization. These features are explicit (deliberate and recognized) or implicit (operating unrecognized, "behind the scenes"). Ideally, these features are carefully considered and established, usually during the strategic planning process.

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1.5. Time value of money Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities.

TVM is based on the concept that 100 Rwf that you have today is worth more than the promise or expectation that you will receive 100 Rwf in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest 1000rwf for one year at a 6% annual interest rate and accumulate 1060Rwf at the end of the year. You can say that the future value of 1000Rwf is 1060Rwf given a 6% interest rate and a one-year period. It follows that the present value of the 1060Rwf you expect to receive in one year is only 1000Rwf. A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. Applications:

• Loan amortization

• Deposits needed to accumulate a future sum

Formulae and Examples: 1. Future value of a lump sum

• FV = PV x (1+r)n

Where FV is future value of an investment PV is present value of an investment r is annual rate of interest n is number of years

2. Present value of a lump sum

• PV = FV (1+r)n

3. Future value of an ordinary annuity

• FV = PMT x (1+r)n – 1 r

Where PMT is annuity’s annual payment 4. Present value of an ordinary annuity

• PV = PMT x [1- 1/ (1+r)n ] r

5. Future value of an annuity due

• FV = PMT x (1+r)n – 1 x (1 + r) r

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Where PMT is annuity’s annual payment

6. Present value of an annuity due

• PV = PMT x [1- 1/ (1+r)n ] x (1 + r) r

7. Future value of an annuity due

• FV = PMT x (1+r)n – 1 x (1 + r) r

Where PMT is annuity’s annual payment 8. Present value of a perpetuity

• PV = PMT x 1 = PMT/r r

Where PMT is annuity’s annual payment

9. Compounding more frequently than annually

• FV = PV x [1+ (r/m))m x n Where m is number of compounding per year

In finance theory, A lump-Sum Payment is a one-time payment for the total or partial value of an asset. A lump-sum payment is usually taken in lieu of recurring payments that would otherwise be received over a period of time. The value of a lump-sum payment is generally less than the sum of all payments that the party would otherwise receive, since the party paying the lump-sum payment is being asked to provide more funds up front than it otherwise would have been required to

An annuity,is a terminating "stream" of fixed payments, i.e., a collection of payments to be

periodically received over a specified period of time. The valuation of such a stream of payments

entails concepts such as the time value of money, interest rate, and future value.

Examples of annuities are regular deposits to a savings account, monthly home mortgage payments and monthly insurance payments. Annuities are classified by the frequency of payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other interval of time. Loan Amortization Example Suppose you borrow 25,000 at 8% annual interest rate for five years to purchase a new car. How much do you pay annually? To find the size of the annual payments you determine a 5 year annual annuity discounted at 8% that has a present value of 25,000. It is the inverse of finding the present value of an annuity.

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Present value of an ordinary annuity

• PMT = PV/{ 1 x [1- 1/ (1+r)n ]} r =25,000 / { 1 x [1- 1/ (1+0.08)5 ]} = 25000/3.9875 = 6269.59 0.08

Alternatively read from the PV table the amount in brackets PV (n = 5; r = 8%) = 3.993x25,000/3.993 = 6261.14 Loan Amortization Schedule

Year Principal Interest Principal end of year P 1 25,000 2000 4261 20,738.5 2 20,738 1659 4602 16136

Deposit needed to accumulate a future sum

• Assume that you want to buy a house five years from now and estimate that an initial down payment of 20,000 will be required. You want to make equal end of year deposits into an account paying annual interest of 6%. You must decide what size of annuity results to a lumpsum of 20,000 at the end of 5 years.

• You use the equation of finding the future value of an ordinary annuity

• PMT = FV/{ (1+r)n – 1} = 20,000/{(1+0.06)5 – 1} = 3547.93 r 0.06 Alternatively read from the FV table the amount in brackets FV (n = 5; r = 6%) = 5.637x20,000/5.637 = 3547.93 Time Value of Money Problems

1. You are planning to retire in twenty years. You'll live ten years after retirement. You want to be able to draw out of your savings at the rate of $10,000 per year. How much would you have to pay in equal annual deposits until retirement to meet your objectives? Assume interest remains at 9%.(FV of annuity formulae)

2. You can deposit $4000 per year into an account that pays 12% interest. If you deposit such amounts for 15 years and start drawing money out of the account in equal annual installments, how much could you draw out each year for 20 years? (FV of annuity formulae)

3. What is the value of a $100 perpetuity if interest is 7%? 4. You deposit $13,000 at the beginning of every year for 10 years. If interest is being

paid at 8%, how much will you have in 10 years? 5. You are getting payments of $8000 at the beginning of every year and they are to last

another five years. At 6%, what is the present value of this annuity? 6. How much would you have to deposit today to have $10,000 in five years at 6% interest

compounded semiannually? 7. Construct an amortization schedule for a 3-year loan of $20,000 if interest is 9%. 8. If you deposit $45,000 into an account earning 4% interest compounded quarterly, how

much would you have in 5 years? (future value of lumpsum – compounded quarterly)

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9. How much would you pay for an investment which will be worth $16,000 in three years? Assume interest is 5%. (PV of lumpsum)

10. You have $100,000 to invest at 4% interest. If you wish to withdraw equal annual payments for 4 years, how much could you withdraw each year and leave $0 in the investment account? (FV of lumpsum)

11. You are considering the purchase of two different insurance annuities. Annuity A will pay you $16,000 at the beginning of each year for 8 years.(FV annuity due)

12. Annuity B will pay you $12,000 at the end of each year for 12 years. .(FV ordinary annuity) Assuming your money is worth 7%, and each costs you $75,000 today, which would you prefer?

13. If your company borrows $300,000 at 8% interest and agrees to repay the loan in 10 equal semiannual payments to include principal plus interest, how much would those payments be? (PV of annuity compounded semiannually)

1.6. Interest rates Interest rate is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). The assets borrowed could include, cash, consumer goods, large assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to the borrower, for the asset's use. In the case of a large asset, like a vehicle or building, the interest rate is sometimes known as the “lease rate”. When the borrower is a low-risk party, they will usually be charged a low interest rate; if the borrower is considered high risk, the interest rate that they are charged will be higher.

When someone lends money to someone else, the borrower usually pays a fee to the lender. This fee is called 'interest'. 'Simple' interest or 'flat rate' interest. The amount of simple interest paid each year is a fixed percentage of the amount borrowed or lent at the start.

The simple interest formula is as follows:

Interest = Principal × Rate × Time

Where: 'Interest' is the total amount of interest paid, 'Principal' is the amount lent or borrowed, 'Rate' is the percentage of the principal charged as interest each year. The rate is expressed as a decimal fraction, so percentages must be divided by 100. For example, if the rate is 15%, then use 15/100 or 0.15 in the formula. 'Time' is the time in years of the loan.

The simple interest formula is often abbreviated in this form:

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I = P R T

Three other variations of this formula are used to find P, R and T:

Simple interest problems can involve lending or borrowing. In both cases the same formulas are used.

Whenever money is borrowed, the total amount to be paid back equals the principal borrowed plus the interest charge:

Total repayments = (principal + interest)

Usually the money is paid back in regular installments, either monthly or weekly. To calculate the regular payment amount, you divide the total amount to be repaid by the number of months ( or weeks ) of the loan. Like this:

OR:

To convert the loan period, 'T', from years to months, you multiply it by 12, since there are 12 months in a year. Or, to convert 'T' to weeks, you multiply by 52, because there are 52 weeks in a year.

The example problem below shows you how to use these formulas:

Example: A student purchases a computer by obtaining a simple interest loan. The computer costs $1500, and the interest rate on the loan is 12%. If the loan is to be paid back in weekly installments over 2 years, calculate: 1. The amount of interest paid over the 2 years, 2. The total amount to be paid back, 3. The weekly payment amount.

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Given: principal: 'P' = $1500, Interest rate: 'R' = 12% = 0.12, Repayment time: 'T' = 2 years Part 1: Find the amount of interest paid. Interest: 'I' = PRT = 1500 × 0.12 × 2 = $360

Part 2: Find the total amount to be paid back. Total repayments = principal + interest = $1500 + $360 = $1860

Part 3: Calculate the weekly payment amount Total repayments Weekly payment amount = --------------------------- Loan period, T, in weeks $1860 = ------------------- 2 × 52 = $17.88 per week 1.7. Cash flows

Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Cash flow can also be defined by the below definition:

- A revenue or expense stream that changes a cash account over a given period. Cash inflows usually arise from one of three activities - financing, operations or investing - although this also occurs as a result of donations or gifts in the case of personal finance. Cash outflows result from expenses or investments. This holds true for both business and personal finance.

- An accounting statement called the "statement of cash flows", which shows the amount of cash generated and used by a company in a given period. It is calculated by adding noncash charges (such as depreciation) to net income after taxes. Cash flow can be attributed to a specific project, or to a business as a whole. Cash flow can be used as an indication of a company's financial strength.

Cash inflows from operations include cash received from sale of goods or services, collection of receivables from customers, cash interest and cash dividends received.

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Cash outflows from operations include cash payments for goods purchased, cash payments for notes to suppliers, cash payments to employees, cash paid for taxes, fees, and fines, and interest paid to creditors.

Using the indirect method of cash flow from operations will reflect net income and increase or changes in assets and liabilities such as inventory, receivables, and payables, and less depreciation and amortization

In business as in personal finance, cash flows are essential to solvency. They can be presented as a record of something that has happened in the past, such as the sale of a particular product, or forecasted into the future, representing what a business or a person expects to take in and to spend. Cash flow is crucial to an entity's survival. Having ample cash on hand will ensure that creditors, employees and others can be paid on time.

Formats of cash flow statements This can be done by direct method – where major classes of gross cash receipts and gross cash payments are disclosed for the operating activities. This method is encouraged for enterprises. The (total) net cash flow of a company over a period (typically a quarter or a full year) is equal to the change in cash balance over this period: positive if the cash balance increases (more cash

becomes available), negative if the cash balance decreases. The cash flow statement should

show amounts of cash flow from the following in the given order:

1. Operational cash flows: Cash received or expended as a result of the company's internal

business activities. It includes cash earnings plus changes to working capital. Over the

medium term this must be net positive if the company is to remain solvent.

2. Investment cash flows: Cash received from the sale of long-life assets, or spent on capital

expenditure (investments, acquisitions and long-life assets).

3. Financing cash flows: Cash received from the issue of debt and equity, or paid out as

dividends, share repurchases or debt repayments.

4. Reconciliation with cash movement

Format is as follows: XYZ business Cash flow statement for the year ended xxxxxxx $ $

Cash flows from operating activities Cash receipts from customers XX Cash paid to suppliers and employees (XX)

Cash generated from operations XX Interest paid (XX) Income taxes paid (XX)

Net cash from operating activities XXX

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Cash flows from investing activities Purchase of property, plant and equipment (XX) Proceeds from sale of equipment XX Interest received XX Dividend received XX

Net cash used in investing activities XXX Cash flows from financing activities

Proceeds from issue of shares XX Proceeds from long term borrowing XX Dividends paid (XX)

Net cash used in financing activities XXX

Net increase/(decrease) in cash and cash equivalents

XXX

Cash and cash equivalents at start of period XXX

Cash and cash equivalents at end of period XXX

Example 1 Prepare a cash flow statement for FIN 3420 Intake 2013 Ltd for the year ended 31 December 2012 using the direct method. The balance sheet for the years 20011 and 2012 and profit and loss account and cash account for 2012 are given as follows.

Balance sheet as at 31 December

2012 2011 $ $ $ $ Non-current assets 4,500 3,800 Accumulated depreciation 2,300 1,800

2,200 2,000 Current assets Stock 400 500

Profit and loss account for the year ending 31 December 2012

$ $ Sales 6,500 Less Cost of goods sold 3,000

3,500 Less expenses Wages 2,000 Other costs 600 Depreciation 500 Interest 100

3,200

Profit for the year 300 Proposed dividend 40

Retained profit 260

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Trade debtors 150 200 Cash 200 750 100 800

2,950 2,800

Ordinary share capital 1,000 1,000 Retained profits 710 450

1,710 1,450 Non-current liabilities Debentures 900 1,000 Current liabilities Trade creditors 275 250 Accrued wages 25 50 Proposed dividends 40 340 50 350

2,950 2,800

Dr Cash account

Cr

$ $ Balance b/f 100 Wages 2,025 Cash from customers 6,550 Other expenses 600 Cash paid to suppliers 2,875 Interest paid 100 Non-current assets 700 Debenture holders 100

Dividends paid 50 Balance c/f 200 6,650 6,650

The cash flow statement according to direct method is as follows:

FIN 3420 Intake 2013 Ltd

Cash flow statement for the year ended 31 December 2012

$ $ Cash flows from operating activities Cash receipts from customers 6,550 Cash paid to suppliers (2,875) Cash paid to employees (2,025) Other cash payments (600)

Cash generated from operations 1,050 Interest paid (100) Income taxes paid -

Net cash from operating activities 950 Cash flows from investing activities

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Purchase of non-current assets (700) Proceeds from sale of equipment - Interest received - Dividend received -

Net cash used in investing activities

(700)

Cash flows from financing activities

Repurchase/redeeming debentures (100) Proceeds from long term borrowing - Dividends paid (50)

Net cash used in financing activities (150)

Net increase/(decrease) in cash and cash equivalents

100

Cash and cash equivalents at start of period 100

Cash and cash equivalents at end of period 200

This method has merely used the information from the cash account. The emphasis is to show the cash flow from operations using the gross sales proceeds and payments to suppliers and other payments for the trading activity. 1.8. Introduction to the concept of risk and returns

There are different motives for investment. The most prominent among all is to earn a return on investment, however selecting investments on the basis of return in not good enough. The fact is that most investors invest their funds in more than one security suggest that there are other factors, besides return, and they must be considered. The investors not only like return but also dislike risk. So, what is required is a Clear understanding of what risk and return are, what creates them, and how can they be measured?

a. Definition of Return: The return is the basic motivating force and the principal reward in the investment process. The return may be defined in terms of (i) realized return, i.e., the return which has been earned, and (ii) expected return, i.e., the return which the investor anticipates to earn over some future investment period. The expected return is a predicted or estimated return and may or may not occur. The realized returns in the past allow an investor to estimate cash inflows in terms of dividends, interest, bonus, capital gains, etc, available to the holder of the investment. The return can be measured as the total gain or loss to the holder over a given period of time and may be defined as a percentage return on the initial amount invested. With reference to investment inequity shares, return is consisting of the dividends and the capital gain or loss at the time of sale of these shares.

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We can use the following equation to calculate the expected rate of return of individual asset:

Expected Rate of Return: Example

b. Definition of Risk: Risk in investment analysis means the expected future returns from an investment is unpredictable. The concept of risk may be defined as the possibility that the actual return may not be same as expected. In other words, risk refers to the chance that the actual outcome (return) from an investment will differ from an expected outcome. With reference to a firm, risk may be defined as the possibility that the actual outcome of a financial decision may not be same as estimated. The risk may be considered as a chance of variation in return. Investments having g rea te r chan ce s o f va r i a t i o n s a re con s i de red more r i s ky t han t ho se w i t h l e s se r chanc e s o f variations. Between equity shares and corporate bonds, the former is riskier than latter. If the corporate bonds are held till maturity, then the annual interest inflows and maturity repayment are fixed. However, in case of equity investment, neith er the dividend inflow nor the terminal price is fixed. Risk should be differentiated with uncertainty: Risk is defined as a situation where the possibility of happening or non happening of an event can be quantified and measured: while uncertainty is defined as a situation where this possibility cannot be measured. Thus, risk is a situation when probabilities can be

Possible Outcomes of two Assets, X and Y

Return (%)

State of Economy Probability X Y

A 0.10 – 8 14

B 0.20 10 – 4

C 0.40 8 6

D 0.20 5 15

E 0.10 – 4 20

The expected rate of return of X is the sum of the product of outcomes and their respective

probability. That is:

( ) ( 8 0.1) (10 0.2) (8 0.4) (5 0.2)

( 4 0.1) 5%

xE R = - ´ + ´ + ´ + ´

+ - ´ =

Similarly, the expected rate of return of Y is:

( ) (14 0.1) ( 4 0.2) (6 0.4) (15 0.2)

(20 0.1) 8%

yE R = ´ + - ´ + ´ + ´

+ ´ =

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assigned to an event on the basis of facts and figures available regarding the decision. Uncertainty, on the other hand, is a situation where either the facts and figures are not available, or the probabilities cannot be assigned.

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CHAP II. EXTERNAL SOURCES

1. EQUITY AND LOAN CAPITAL 1.a. EQUITY CAPITAL

Capital is simply the funds you have to invest in growing your business and buying assets for use

in long-term business operations.

Equity is one of two common sources you may use to acquire funds for your business. The other is long-term financing. Equity capital is raised by offering investors a percentage of ownership in the business in exchange for their investment.

Equity capital is money that is invested into a company in exchange for an ownership interest in that company. Traditionally, equity capital unlike debt is not intended to be repaid according to a specific schedule and is not secured (or guaranteed) by the company's assets. Instead, an equity investor (i.e., the individual or entity that supplies the company with the money) expects that, within a certain time frame, the ownership percentage she holds will be worth more than the original amount she invested. Equity capital is also referred as:

a. Your Equity is your ownership interest in the Business.

b. It is capital in nature.

c. It is an asset that you can buy and sell.

d. It should be the primary focus of the Asset Strategy in a Succession Plan.

e. The Asset Strategy needs to buy and sell the Proprietor's Equity in the Business.

f. Equity capital is financing made available for investment in promising with a

greater risk of loss than what is normally acceptable to traditional lending

institutions .Equity capital can fill a vital role in the growth of a company.

The advantages and disadvantages of equity capital.

Repayment Obligations

One significant advantage of equity capital versus financing is that you have no obligation to

make regular payments to investors.

Shared Risks

Investors typically take on the risks of the business in exchange for access to its profits or the

opportunity to earn money from an increase in their ownership value.

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Diluted Ownership

The counter-effect of sharing the risks of ownership is that you also give up some of the

opportunity to profit. Each investor and new round of investment means you give up more

ownership. In a partnership or corporation, your share of current and future earnings is dependent

on the number of shares, or percentage of the business, you own. In some instances, the costs of

giving up some of the profit may outweigh the money you save on loan interest.

Loss of Control

Relying on a small amount of equity capital usually means you get to retain most of the ownership and authority in the business. However, when you take on significant equity investment, you may have to turn over some level of control. 1.b. LOAN CAPITAL

The money that a business borrows from banks and other organizations for an agreed period and

on which it pays interest. It is the money that people borrow to help them to start a business.

On the other hand, many Proprietors also have Loan Capital tied up in a Business. This means

funds that they have lent to the Business (or funds that otherwise owe by the Business to the

Proprietors). It is short term or long term liabilities, which have end date and annul interest

payments funds, are raised by issuing for example debentures against these funds company has

to pay the amount of the interest annually to debenture holders and principle amount at maturity

date. Here they are not the owner of the company but the creditors.

Loan capital may be obtained from a bank or finance company as long-term loans, or from debt-

equity investors in the form of debentures or preferred stock (preference shares), and is usually

secured by a fixed and/or floating charge on the company's assets. Unlike debt capital, it does

not include short-term loans (such as overdraft). Also called borrowed capital.

Loan Capital is often required in order to meet the capital requirements of the Business, when the Business is established. The Proprietors might structure their investment in the Business partly as a capital investment (e.g., shares in a Company) and partly as a Loan. Normally, they would expect that the Loan would be repaid in the short to medium term. The need for Loan Capital can also occur during the life of the Business, in order to:

meet cash flow requirements; or Allow the Business to reduce an external Loan (e.g., from a Bank).

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The advantages of loan capital

Loans are a relatively fast way to obtain funds for a special purchase or project, and even large

amounts can be borrowed for almost any purpose. They are suitable for expensive purchases that

require immediate payment, allowing you to spread the cost of the purchase and manage your

short term finances more easily, especially if your loan has a fixed interest rate.

The disadvantages of loan capital

Loans constitute a long-term financial agreement and used in the right way can be a useful financial tool. However, anyone considering applying for a loan should analyses their personal finances carefully, and calculate exactly how much they can afford to borrow based on how much money they can spend on repayments each month, once their other financial commitments have been honored.

2. HIRE PURCHASE

Hire purchase (abbreviated HP) is the legal term for a contract, in which persons usually agree to

pay for goods in parts or a percentage at a time.

It is buying on credit, without paying the full amount straight away. It is often used to buy household appliances, furniture and cars. You take the goods home and pay for them over time

but the finance company has a security interest in them until you have made the final payment

Anyone can buy goods on hire purchase if they meet the finance company’s credit conditions.

These conditions should be based on your ability to repay. Often the finance company will do a

credit check to make sure you have not defaulted on any credit contracts in the past. Hire

purchase will almost always cost more than the price on the price tag. You will also pay interest

and administrative costs. Even an interest free deal usually has extra charges like booking fees or

insurance.

Some of the ‘buy now, pay nothing for a year’ deals offered by stores and catalogue companies may seem good value. Many offer ‘interest-free credit’ for six or twelve months, so the monthly payments quoted may be quite low. However, these ‘deals’ usually have conditions attached. For example, the payment must be made by a set date. Sometimes the last monthly payment due is much higher than the other payments. If you cannot pay it on time or in full by that date, you can find yourself ‘locked in’ to a three, four or even five-year hire purchase agreement. By that time, you may have paid off nearly double the price of the goods.

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An example of a car hire purchase

A car hire purchase agreement is one of the most popular ways to buy a car. This guide to hire

purchase explains the key features and benefits of this type of car finance agreement.

Remember that before taking out any type of car finance it is a good idea to compare all car

finance products available: car finance options. Our car finance decider tool will help you to

decide if hire purchase is the best option for you.

What is hire purchase?

Hire purchase means you pay for the hire of goods over a set period of time, with a view to owning them eventually. Many hire purchase agreements work in a similar way to a fixed rate loan. You pay back a set amount of money at a fixed rate of interest. You pay this by installments of a set amount each month. You cannot usually pay more than your installment amount. Unlike a loan, however:

a. You are the hirer of the goods. You do not actually own them until you pay off all the installments due;

b. the lender of the finance is the owner of the goods; c. the owner can take back (or re-possess) the goods in certain circumstances; and d. You can use the goods during the agreement, but you cannot sell them without the consent

of the owner. The owner is a bank or a finance company.

A hire purchase agreement, also referred to as HP, is a hire agreement which gives you an option

to purchase at the end of the agreement. HP is normally a fixed cost, fixed period loan (typically,

2-3 years) of money to purchase goods, which is secured against the car being bought.

You are the registered keeper of the car and are responsible for insuring and maintaining it, but

the finance company providing the HP agreement remains the legal owner (‘has title’) of the car

until the amount you have borrowed has been fully repaid and you have decided to pay the

‘Option to Purchase’ fee. However, this is completely optional.

How hire purchase works:

The customer chooses a car from a motor dealer and completes a finance application to borrow

money to ‘buy’ the car.

The motor dealer sends the application to the finance company/bank. If accepted, the finance

company then pays the dealer for the car. It is the finance company which buys the car (and

becomes the legal owner) and the customer who uses it (known as the registered keeper on the car

log-book).

The finance company allows the customer to use the car for an agreed period of time, subject to the receipt of agreed repayments. When all the repayments have been made the customer will be given the option to purchase the car and gain outright ownership. The customer can do this by

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paying the ‘Option to Purchase’ fee, which is usually a nominal fee of around Rwf 5000-Rwf 10000 to cover the finance company’s administrative costs of transferring ownership (title) of the car to the customer. End of agreement: What happens next? There are several ways to conclude a Hire Purchase Agreement:

Early Settlement – You can settle a Hire Purchase agreement at any point in the agreement by

paying the outstanding balance and the Option to Purchase fee to the lender. There may be a

charge for settling the agreement early.

End of Agreement / Contract - At the natural end of a Hire Purchase contract, once all the

contracted payments have been made, you can pay the Option to Purchase fee and take legal

title to the car. Alternatively, you can choose not to pay this fee and simply return the car to the

finance company.

Fees/Charges - Finance companies will disclose all fees and charges in the terms and conditions

of the Hire Purchase agreement.

Hire purchase is calculated using the simple interest formula, and interest is only calculated on the amount owing. A = S (1 + i.n)

Where:

A = Total amount after interest

S = Starting amount after deposit has been subtracted (no interest)

i = Interest rate (divide the % by 100, and then again by 12, 4, or 6 depending on the number

of times interest will be calculated)

n = number of time periods that the purchase agreement states to pay over (24 months, etc)

Substituting the given values into the formula will give you the total amount to be paid after

interest has been accrued.

To calculate the repayments, you divide the answer derived as a (total amount) by the number of

repayments (n) you have to make.

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Example

Who offers hire purchase agreements? Car dealers and retail shops that sell furniture or electrical goods often offer hire purchase agreements. These agreements are also sometimes offered by catalogue companies that sell products either by post or online. The store, catalogue company or car dealer is not actually providing the finance. It is acting on behalf of the finance company or bank that lends you the money and usually gets a commission from the finance company. 2 Hire purchase at a glance Pays commission Provide finance

Sells goods and arranges finance

See 13 What does a hire purchase agreement contain? A hire purchase agreement must be given to you in writing. The words ‘Hire purchase agreement’ must be contained in a prominent position, and the agreement itself must include the following information:

a. the cash price of the goods (the cost if you paid in full by cash); b. the deposit required, if any; c. the number of installments you have to pay, the frequency (e.g. monthly) and the amount

of each installment; d. the hire purchase price (the total of all installments plus fees) that you must pay to own the

goods;

Bank or Finance Company

Owns the goods until the final payment is made

Dealership

Car dealer, shop or Catalogue Company

Consumer Hire the goods

Pays installments and fees

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e. the amount (usually half the hire purchase price) that you would owe if you end the agreement early;

f. information about the ‘cooling-off’ period; and g. the costs and penalties you are liable to pay if you cannot meet your repayments.

You will note that you are referred to as ‘the hirer’ throughout this agreement, and not as the ‘borrower’ or ‘buyer’. What costs are involved? The costs vary depending on the type of goods you are hiring and on the company offering the finance. The following is an example of the typical costs for hire purchase car finance. 4 Yusuf picks a car costing €13,300 from a motor dealer. The dealer arranges a 5 years hire purchase plan for Yusuf, and asks for an initial deposit of €400. Example: Yusuf’s hire purchase plan over 5 years (60 Months) Example: Joe’s hire purchase plan over 5 years (60 months)plan over 5 years (60 months) €

Cash price 13,300.00 This is the cost of the car if Yusuf was paying cash.

(1) Less: deposit/part exchange – 400.00

Amount for finance 12,900.00

Plus: interest charge + 3,972.60

(2) Total 16,872.60

Plus: Fees (3) Documentation fee + 63.45 This is the fee for setting up the agreement. (4) Completion fee + 63.45 This is a fee charged to end the agreement.

Hire purchase price (1)+(2)+(3)+(4) 17,399.50

The amount for finance plus the interest (€16,872) is repayable by 61 installments of €276.60

The real cost of Yusuf’s car is the hire purchase price of €17,399.50. Note: With any form of credit, try to choose the shortest repayment plan you can afford. The longer you take to pay off what you owe, the more costly the finance will be. You may have a lower monthly installment, but the total cost over the life of the agreement will usually be higher.

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Can I afford it?

It is tempting to decide this based on the amount of your monthly or weekly installment. However,

you also need to look at the total number of installments, plus any fees. This lets you see the total

cost. Also, with some hire purchase agreements, your last installment may be bigger than all the

others. This is called a balloon payment. It means your payments are not evenly spread out. You

pay less each month but then you owe more at the end of the agreement. The finance may

appear more affordable than it really is.

The size of any final installment is very important because:

a. the larger the final payment the longer it takes you to pay half the hire purchase price –

the point when you could end the agreement; and

b. a large final payment could be more than the value of the goods at the end of the

agreement.

7

Can I change my mind after signing a hire purchase agreement?

You are permitted to a ten-day ‘cooling off’ period in which you can change your mind. This gives

you time to consider the terms and conditions of the agreement, and to seek advice if you want

to. If you decide not to go ahead with the agreement, you must give notice in writing to this effect.

As with a personal loan, most hire purchase agreements have a section called a Waiver. If you

sign the Waiver it means that you give up your right to the ten-day cooling-off period and you

would not then be able to change your mind about the agreement. You do not have to sign this

Waiver in order for your application to be processed. Don’t be pushed into making a quick

decision. You will have to wait 10 days to receive the goods, but this gives you time to consider

the terms and conditions and to shop around. Remember that once you sign the agreement and

take home the goods, it is usually not possible to change your mind without being liable for

certain costs.

Can I end a hire purchase agreement once it’s up and running?

If you no longer want to keep the goods, or find that you cannot afford the repayments, you can

end a hire purchase agreement at any time. However, there are certain conditions and costs

involved. These are:

a. you must give notice in writing and agree to return the goods;

b. You are legally liable to pay half the hire purchase price, less the total of your payments

to date. This is sometimes called the half rule;

c. you are also liable for repair costs if you have not taken reasonable care of the goods

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Let’s look at how this might affect Yusuf if he ends his hire purchase agreement after two years. Month 25: Yusuf sends a letter of notice to his lender and arranges to give back the car. Example: Cost to Yusuf of ending agreement in Months 25 Example: Joe’s hire purchase plan over 5 years (60 months)plan over 5 years (60 months)

€

Half the hire purchase price of €17,399.50 8,699.75

Less: amounts paid off to date:

25 payments of €276.60 6,915.00

deposit 400.00

documentation (or set-up) fee 63.45

7,378.45

Plus: interest charge + 3,972.60

Amount due (€8,699.75 less €7,378.45): 1,321.30

If he ends the agreement at month 25, Yusuf will have to give back the car. He will owe an extra

€1,321.30 to bring his payments up to half the hire purchase price.

If Yusuf had already paid half the hire purchase price or more, he would only owe any

installments that were in arrears at the date he ended the agreement.

How do I return the goods?

Banks and finance companies will usually arrange collection of the goods and charge you a

collection fee.

To avoid this you can suggest returning the goods yourself, or agree on a convenient collection

point such as a local garage.

Example: Cost to Joe of ending agreement in month 25

Am I responsible for damage to the goods?

Yes, under a hire purchase plan you have a duty to take reasonable care of the goods you hire.

You can usually expect to receive a bill for repairs if the goods are returned damaged. In the

case of car repairs, consider getting your own mechanical report and paying for any necessary

repairs before you return it to the bank or finance company. Depending on the value of the car,

consider getting comprehensive motor insurance cover for any car you hire under a hire purchase

agreement.

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The owner is entitled to know where the goods are being kept at any given time. You must notify

the owner if the goods are moved to a new location. This might happen, for example, if you

changed address. It is important to be aware that if the goods are deliberately destroyed or

damaged the owner is entitled to charge you for replacement costs.

Can I decide to pay off a hire purchase agreement early and own the goods?

If you can afford it, you can decide at any time to pay off the full hire purchase price and

become the owner of the goods.

11

How much could it cost to do this? Let’s look at what it could cost Yusuf to buy the car outright after two years. Example: Yusuf’s bill to buy the car (Months 25) mple: Joe’s bill to buy the car (month 25)

€

Hire purchase price 17,399.50

Less: Amounts Yusuf has paid to date

Deposit – 400.00

25 payments of €276.60 – 6,915.00

Documentation fee – 63.45

Total paid 7,378.45

Amount Yusuf still owes (17,399.50 less 7,378.45) 10,021.05

Plus: completion fee 63.45 Less: interest rebate* – 746.14*

Total Yusuf must pay to own car 9,338.36

* Yusuf will get back some of the interest that would be due in years 3, 4 and 5. The amount can vary depending on the formula that is used by the finance company.

Note: Yusuf cannot decide to sell the car to raise some of the money due because he is not the owner of the goods. This means he may find it hard to pay off his hire purchase agreement early. 12 What should I do if I cannot afford to keep up payments? If you find it difficult to keep up your payments or you have already missed payments, contact the bank or finance company as soon as you can. They will often agree to postpone your agreement. If this is agreed:

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a. the owner may be entitled to charge a postponement fee; b. the term will be extended so extra interest will apply to cover the longer period; and c. Monthly installments may be reduced, but because the agreement is extended it will take

you longer to own the goods.

Despite this, postponement is usually less costly for you than ignoring the problem and possibly

facing repossession. Postponement also means you can continue to use the goods.

Can the goods be repossessed?

Yes. The owner is entitled to know where the goods are kept at all times and can, in certain

circumstances, take the goods back from you, or ‘repossess’ them. If you have paid off less than

one-third of the hire purchase price, a lender can take back the goods without taking a legal

action against you. In practice a lender could do this only if you broke the terms of the

agreement, for example if you had missed repayments or had caused damage to the goods.

The lender must give you notice in writing and must give you 21 days’ notice to resolve the

problem. Once you have paid one-third or more of the hire purchase price, a lender cannot

repossess the goods without taking legal action against you. In calculating one third of the hire

purchase price, any deposit you paid or the value of any trade-in will be taken into account.

Note:

As with a loan or mortgage, if you cannot pay back what you owe on a hire purchase agreement,

your credit rating will be affected. This is likely to make it more difficult for you to get a loan or

mortgage at a later date.

14 How much could repossession cost me? If goods are repossessed you will usually face many extra costs on top of what you already owe. These costs may include some or all of the following:

a. repossession fee, which could be around €300; b. additional interest penalty, which varies from about 0.5% to 2% per month of the

installments you missed; c. unpaid fees, which are charged each time a cheque bounces or a direct debit fails; and d. towing or trace fees would apply if the owner had to tow or locate a vehicle; If you are

buying a second hand car, it is important to make sure that it is not already owned by a finance company.

Questions to ask

a. What is the total amount I have to pay to own the goods - the hire purchase price? b. Is the final installment larger than the rest, or are there extra installments at the end of the

agreement? c. What amount would I have to pay back if I need to break the agreement?

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Do’s

a. Do make sure you understand the terms and conditions before signing the agreement. b. Do look at the type of agreement you are signing – make sure that it is a Hire Purchase

agreement, and not a Consumer Hire agreement. c. Do match the term of the agreement to the purpose of the borrowing and the expected

lifespan of the goods. d. Do look at the number of installments and the amount of the final installment. The larger

the final installment, the more difficult it may be for you to own the goods. e. Do ensure when offered car finance that the car dealer is authorized to offer you credit –

a credit intermediary.

Dont’s

a. Don’t borrow more than you can afford to repay – consider saving part or all of the cost of what you want first.

b. Don’t be tempted into buying goods simply because you are offered a convenient finance plan.

c. Don’t choose long, fixed-repayment agreements if you can get a more flexible personal loan from a credit union or bank.

d. Don’t be influenced by lower monthly or weekly payments – look at the total hire purchase price as this is what you must pay to own the goods.

e. Don’t sign the Waiver of your right to the cooling-off period unless you are satisfied that you understand the terms and conditions.

f. Don’t sign any voluntary surrender document if you have already given notice to return the goods and end the agreement under the half rule. Always ask for an explanation of how this will affect you.

www.itsyourmoney.ie S lo-call 1890 77e regulate financial services firms in Irela 3. LEASE AND TRADE CREDIT

3.1. LEASE A lease is a legal agreement under which someone pays money to another person in exchange for the use of a building or piece of land for a specified period of time.

For example, if you lease property or something such as a car, or if someone leases it to you,

they allow you to use it in return for regular payments of money. Leasing is like renting a piece of

equipment or machinery. The business pays a regular amount for a period of time, but the item

belongs to the leasing company. Most company cars are leased to businesses. The business pays a

monthly fee for the car and at the end of the period (normally about two years); the business

swaps the car for a newer model.

The advantages of leasing are:

Cheaper in the short run than buying a piece of equipment outright.

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If technology is changing quickly or equipment wears out quickly it can be regularly

updated or replaced.

Cash flow management easier because of regular payments.

The disadvantages of leasing are:

More expensive in the long run, because the leasing company charges fees which make

the total cost greater than the original cost.

Some questions and answers about “Lease”

Q. 1 Define a lease. How does it differ from a hire purchase and installment sale? What are

the cash flow consequences of a lease? Illustrate.

A.1 A lease is an agreement for the use of the asset for a specified rental . The owner of the

asset is called the lessor and the user the lessee. The leases are of two types, i.e., (1)

operating leases which are short term and cancellable, and (2) financial leases which are

long term non-cancellable. The most compelling reason for leasing equipment rather than

buying it is the tax advantage of depreciation which can mutually benefit both the lessee

and lessor. In India, lease can prove handy to those firms which cannot obtain loan capital

from normal sources. In the case of lease, the company can acquire the asset without

immediately paying for I; depreciation is a deductible expenses; and lease rentals are

also deductible expenses, so it saves taxes.

Under a higher price arrangement, like in a lease, the hire purchaser is able to avoid

the payment for the purchase of the asset now, and instead pays higher purchase

installments over a specified period and time as per agreement. The hire purchaser

becomes the owner of the asset once he has paid all installments. Unlike the lease, he is

entitled to claim depreciation as well as the salvage value of the acquired asset.

Hire purchase arrangements differ from installment sale arrangement in terms of the

timing of ownership. Under hire purchase, ownership passes to the hire purchaser on the

payment of the last installment, while under installment sale ownership is transferred

once the agreement has been made between the buyer and the seller.

Q.2 What are the myths and advantages of a lease?

A.2 A number of advantages, which really are myths, are claimed for a lease.

a) It is misconception about leasing that it provides 100% financing for the assets. Most

lease agreement requires lease rentals in the beginning of the period. In leasing,

the firm acquires the asset and incurs the liability to make fixed payments in

future.

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b) It is also myth that leasing provides off-the balance sheet financing. Leasing affects

the firm's debt capacity; that is, its debt-servicing ability. Practically, the contractual

obligations of any form reduce the debt-servicing capacity of a firm.

c) It is a myth that leasing absolves a firm from capital investment evaluation. It also requires the screening of investments decision since a long term financial commitments are to be made.

If a firm is incurring losses or making low profits, it cannot take the full advantage of the depreciation tax shield on purchase of assets. It is, therefore, sensible for it to let the leasing company (lessor) own the assets, take full advantage of tax benefits, and expect that the lessor passes on at least some part of the benefits in the form of low lease rentals. So, both parties, i.e., lessee and lessor, may stand to gain financially (of course at the cost of government which

will lose tax revenues!).

Lease is suitable, if an asset is needed for a short period. It provides the flexibility to tailor lease payments to the lessee's cash flow. Q.4 What is net advantage of a lease? How is it calculated? A.4 The net advantage of leasing is equal to the purchase price of the asset (avoided) less

present value of lease flows. The formula given above (see answer to Q 3) is used to calculate net advantage of leasing. It denotes the incremental advantage over the net present value of buying the asset through normal financing channels. A positive net advantage of leasing does not imply that the assets should be acquired, it implies advantage to leasing. So, before taking decision, net present value of asset should be assessed as an investment. It is possible that leasing may make a financially unattractive asset investment worthwhile.

Q.5 what is the difference between equivalent loan and net advantage of lease methods

of the lease evaluation? A.5 Financial lease involves fixed obligations in the form of lease rentals. Thus, it is like a debt

and can be evaluated that way. Given the lease rentals and tax shields, one can find the amount of debt which this cash flow can service. This is equivalent loan. If equivalent loan is more than the cost of the asset, it is not worth leasing the equipment. Lease evaluation can be done by calculating the net advantage of lease. After-tax lease rentals and tax shields may be discounted at the after tax borrowing rate while operating costs and salvage value at the firm's cost of capital to find out NAL.

Q.6 "It makes sense for companies that pay no taxes to lease from companies that do". Explain. A.6 A firm that is incurring losses or making low profits, it cannot take full advantage of the

depreciation tax shield on purchase of assets. It is, therefore, sensible for it to let the leasing company (lessor) own the asset, take full advantage of two benefits, and passes on some benefits in the form of reduced lease rentals to the lessee. Both the lessor and lessee will gain financially.

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Q.7 What is a leveraged lease? What are its merits and demerits?

A.7 Under a leveraged lease, four parties are involved: the manufacturer of the asset, the

lender from whom the lessor borrows a substantial portion of the assets purchase price,

the lessor and the lessee. In a leveraged lease, the lessor makes substantial borrowing,

e.g., 80% of the asset's purchase price, and provides remaining amount. The lessor

claims all tax benefits related to the ownership of the asset. Lenders, generally the large

financial institutions, provide loans on a non-recourse basis to the lessor. Their debt is

serviced exclusively out of the lease proceeds. The lessor mortgages the asset to the

lenders.

The leveraged lease creates a high degree of leverage. It is quite useful for large capital

equipment with long economic life, say, 20 years or more.

Q.8 What is the hire purchase financing? How does it differ from the lease financing?

A.8 In hire purchase financing, there are three parties: the manufacturer, the hiree and the

hirer. The hiree may be a manufacturer, or a finance company. The

manufacturer sells asset to the hiree who sells it to the hirer in exchange for the

payment to be made over a specified period of time. The hire purchase financing have

three distinctive features:

- The owner of the asset (hiree or manufacturer) gives the possession of the asset to the hirer on

agreement.

- The ownership will transfer to the hirer on the payment of all installments.

- The hirer will have the option to terminate the agreement before the transfer of

ownership of the asset.

In the case of hire purchaser, hirer is entitled to claim depreciation, while in case of lease, lessee

is not entitled to claim depreciation. Hirer can charge only interest portion of HP payments as

expenses for tax computation, while in case of lease financing, lessee can charge the entire lease

payments as expenses for tax computation. On payment of all installments as agreed, the hirer

become owner of the asset and can claim its salvage value. Lessee does not become the owner

of the asset. Therefore, he has no claim over the asset's salvage value. In case of lease, the

asset reverts back to the lessor at the end of lease period.

3.2 TRADE CREDIT

It is a general known source of finance that does not prepare the cash available but with use of it,

purchases possible with later payment. This type of short-term fund relies on credit from producers

and different companies as suppliers of current assets (raw materials, finished goods, components,

etc.). This means that supplies are given but payments are at the end of credit time.

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A business does not always have to pay their bills as soon as they receive them. They are given period of credit, normally around 30-60 days. By trying to extend this period they can improve their short-term finance position. Trade credit is an important source of finance for nearly all businesses – since it is effectively a free source of finance.

4. RETAINED EARNINGS

Retained earnings are an easy source of internal financing to use because they are liquid assets.

Retained earnings are the portion of net income that you have retained in your company and not

paid out. In a small business, retained earnings are usually paid out to the owners, who often do

not draw a budgeted salary. Instead of paying out retained earnings, you can reinvest them into

the company.

Retained earnings means that part of trading profits which is not distributed in the form of

dividends but retained by directors for future expansion of the company. Retained earnings

ultimately come back to the equity shares in the form of enhanced dividend or capital gains.

Retained earnings are an internal source of finance available to the company. In other words, it is a sacrifice made by equity shareholders also referred to as internal equity. Companies normally retain 30 per cent to 80 percent of profit after tax for financing growth. How to Calculate Retained Earnings? Calculating retained earnings is an essential activity in any organization which is keen on growing and increasing its profitabilities. These earnings are the summation of all the profits a company has made since it came into existence. In a balance sheet of a company, this comes under the equities section where it is stated as the cumulative account of all the earnings of a company since its inception sans the dividends. * For making any calculation regarding investments, profits and dividends, one must have all the relevant information concerning the financial statements of the company. So gather the sales, costs, depreciation, interest expense, dividends and tax rate related information. * With the information in hand, determine the net income which can be obtained by deducting the costs, depreciation and interest from the gross sales. * Calculate the tax rate and deduct the tax rate from the net income. * Now subtract the dividends from the net income to get the retained earnings. Besides, there are a few more points to be kept in mind when doing calculations. We know that the retained earnings are sum of the net profits made by the company and the net income sans the dividends. However if the earnings reflect a negative amount, it will be termed as deficit in the stockholders' equity section of the balance sheet. Hence the balance sheet must have an entry for the modified earnings whenever losses are incurred.

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Example

Gross Sales $800,000

Total Costs $200,000

Depreciation $35,000

Interest expenses $15,000

Tax rate 24%

Dividends $100,000

Calculating net income Net Income (NI) = Gross Sales (GS) - (Costs + Depreciation + Interest) NI = $800,000 - ($200,000 + $35,000 + $15,000) = $800,000 - $250,000 = $550,000 Removing tax rate amount from the NI NI - (NI * Tax rate) = $550,000 - ($550,000 * 0.24) = $418,000 Retained earnings calculation Retained Earnings (RE) = NI – Dividends RE = $418,000 - $100,000 = $318,000 After deducting all expenses, taxes, and payment of dividends to shareholders, the retained earnings sum to $318,000. This calculation was for the first financial year of the company. For cumulative calculations, the earnings of the previous years are also added to the net income. RE (t) = RE (t-1) + NI - Dividends (where ’t’ is the year for which the retained earnings are being calculated.) Retained earnings calculation is a beneficial aspect for any company when it plans its business growth strategies. Many a time these earnings are used for accumulating assets which become means of income generation for the company. With this extra income, the company has a scope to invest the earnings in research and development, which further assists in the growth of the company. At times, these earnings are also used in clearing debts and liabilities. Hence, calculating earnings is an integral part of every balance sheet maintained by a company. After all, it helps in improving the financial status of an organization and sustaining the good will of its shareholders Advantages of Retained Earnings: (i)Ready Availability. Being an internal source, these earnings are readily available to the management and directors don't have to ask outsiders for finance. (ii) Cheaper than External Equity. Retained earnings are cheaper than external equity because the floatation costs, brokerage costs, underwriting commission are other issue expenses are eliminated.

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(iii) No Ownership Dilution. Relying on retained earnings eliminates the fear of ownership

dilution and loss of control by the existing shareholders.

(iv)Positive Connotation. Retained earnings carry positive connotation as compared to equity issue as far as stock market is concerned. Disadvantages of Retained Earnings: The unfavorable views of retained earnings are as follows: (i) Limited Finance. The amount which can be raised by way of retained earnings will be limited to an extent only. Keeping in view a stable dividend policy, the directors can't exhaust the whole balance retained. As a result, the variability of profit after tax is substantially transmitted to retained earnings. (ii)High Opportunity Cost. The retained earnings are nothing but sacrifice of profits made by equity shareholders. In other words, retained earnings are dividend foregone by equity shareholders. This sacrifice increases the opportunity cost of retained earnings

5. PROVISIONS AND RESERVES

5.1 RESERVES

In asset-based lending, the difference between the value of the collateral and the amount lent.

Also, funds set aside for emergencies or other future needs. In an auction, the minimum amount a

seller is willing to sell at, known to the auction house but not the bidders. From the point of view of

financial statements, reserves are provided as an estimate of liabilities that have a good

probability of arising, such as bad debt reserve attempts to estimate what percentage of the

firm's creditors will not pay (based on previous records and practical experience). Reserves are

always a subjective estimate (since they reflect contingent liabilities).

5.2 PROVISION

In general words provision means system to complete any work. But accounting provides very technical definition of provision. In small business like shop, general store, there is no need to make any provision, so you will find minimum reference in basic accounting books but from time to time business expands and reaches at corporate level. It needs to understand the real meaning of provision and what is its importance and how can it implement in business accounting. In very simple accounting term, “Provision is that action of business in which business organization reserves his money for future losses for safeguarding business.

Now from this definition we get idea that it is the part of profit or money which we receive from sale or from debtors because money of sale, money of debtor and even money of other fixed asset which is saved and reserve for fulfilling losses due to bad debts, depreciation, income tax

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and other losses which we cannot forecast. But for any loss we make different provision accounts like provision for doubtful debts, provision for depreciation, provision for income tax. The following are the main differences between reserve and provision:

a. Mode Of Creation

Reserve is created against the charge of the profit and loss appropriation account.

Provision is created against the charge of the profit and loss account.

b. Objective

Main objective of reserve is to strengthen the financial position and to meet future unknown losses

and liabilities.

Objective of provision is to meet known losses and liabilities the amount of which is not certain.

c. Accounting Treatment

Reserve is shown on debit side of profit and loss appropriation account and liabilities side of

balance sheet.

Provision is shown on debit side of profit and loss account and assets side of balance sheet as

deduction from the concerned asset

d. Relation with Profit

Reserve is created when there is enough profit in the business.

Provision is created even if there is loss in the business.

e. Distribution

Reserve can be distributed to shareholders as dividend.

Provision cannot be distributed as dividend to shareholders.

f. Future Requirement

Reserve is created without considering the future requirement of the business.

Provision is created by estimating the future requirement of the business.

g. Impact

Impact of reserve will be on financial position.

Impact of provision will be on profit or loss of the business.

6. SOURCES OF FUNDS FOR SMALL AND MEDIUM ENTERPRISES( SMESes of business finance)

Sources of funds for Small and Medium Enterprises (SMESes of business finance) are

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6.1 Loans

Small and mid-size organizations finance their operations by applying for fixed-term bank loans, overdraft agreements or lines of credit. Such types of borrowing are facilitated by financial institutions such as banks, private equity firms and asset managers. Entities pay monthly installments to lenders in accordance with debt agreements. Organizations listed in securities exchanges raise funds by selling debt products--also called bonds or debentures--to investors. These investors receive monthly interest payments and loan amounts at maturity. 6.2 Equity Insurance

Organizations also raise funds by selling equity shares--or stocks--to investors. Listed entities may

do so on securities exchanges. Non-listed firms acquire funding through private stock placements

to institutional investors such as banks or insurance companies. Stockholders--or shareholders--

receive periodic dividends and have voting rights. They also gain from increases in share prices.

For example, a small non-listed jewelry store might sell equity shares totaling 20 percent of

ownership to investors, and use proceeds to open seven new stores.

6.3 Hybrid Financing

Entities also may issue hybrid finance products to fund operations. Such products are also called

quasi-debt because they hold equity and debt features. Convertible bonds and preferred shares

are examples of quasi-debt. Convertible bondholders receive periodic interest payments and

initial loan amounts at maturity. Preferred shareholders receive regular dividends and also make

profits when share prices increase.

6.4 Internal Finance Sources

Entities may use internal funds to finance expansion needs or short- and long-term initiatives. They use retained earnings--portions of income not distributed as dividends--to finance such initiatives. Corporate finance analysts help small and mid-size entities appraise financial data and gauge adequate capital structure levels. For instance, a corporate financial analyst might advise management to use internal funds, instead of external financing, to buy a new truck because the internal cost of funds--12 percent, for example is lower than the market interest rate of 15 percent.

6.5 Government Subsidies

Public officials may provide subsidies, grants or fiscal benefits to investors who meet specific criteria and follow some guidelines. Such guidelines may include investing in economically disadvantaged zones, hiring local job seekers and paying employment taxes. For instance, a Georgia-based medium-sized farming company might get environmental tax breaks from the U.S. government by investing in alternative energy sources such as wind or solar.

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CHAP III- USES OF BUSINESS FINANCE

3.1. CAPITAL INVESTMENT DECISIONS- CAPITAL BUDGETING TECHNIQUES

Learning Goals LG1: Understand the key elements of the capital budgeting process. LG2: Calculate, interpret, and evaluate the payback period. LG3: Calculate, interpret, and evaluate the net present value (NPV) and economic value added

(EVA) LG4: Calculate, interpret, and evaluate the internal rate of return (IRR). LG5: Use net present value profiles to compare NPV and IRR techniques. LG6: Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical

strengths of each approach.

Overview of capital budgeting

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth. Capital budgeting decisions are the firm’s decisions to invest its current funds most efficiently in long-term assets in anticipation of expected flow of benefits over several years. These decisions generally include:

a. Expansion b. Acquisitions c. Modernization d. Replacement of long-term assets

Other activities that may be evaluated in as investment decisions include:

a. Changing method of distribution b. Undertaking advertising campaign c. Research and development programs.

- A capital expenditure is an outlay of funds by the firm that is expected to produce benefits

over a period of time greater than 1 year. - An operating expenditure is an outlay of funds by the firm resulting in benefits received

within 1 year. - The fund are invested in long-term assets - The decisions involve exchange of current funds for future benefits - The future benefits occur to the firm over a series of years - Expenditures and benefits are measured in cash. In investment decisions it is cash flow, which is

important, and not accounting profit - The decisions are irreversible.

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Importance of Investment decisions

1- They affect the value of the firm. Decisions resulting in profitable ventures increase the value of the firm and add to the shareholders wealth.

2- These decisions expose the companies funds to risk and if not well made can lead the company in liquidation.

3- They involve commitment large amount of funds and can result in heavy losses to the company if not carefully planned.

4- Investment decisions are among the company’s most difficult decisions. They are an assessment of future events, which are difficult to predict i.e. it is a complex problem to correctly estimate future cash flows of an investment. Economic, political, social and technological forces cause the cash flow uncertainty.

Overview of capital budgeting: Steps in the process

The capital budgeting process consists of five steps:

1. Proposal generation. Proposals for new investment projects are made at all levels within a business organization and are reviewed by finance personnel.

2. Review and analysis. Financial managers perform formal review and analysis to assess the merits of investment proposals

3. Decision making. Firms typically delegate capital expenditure decision making on the basis of dollar limits.

4. Implementation. Following approval, expenditures are made and projects implemented. Expenditures for a large project often occur in phases.

5. Follow-up. Results are monitored and actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones.

Types of investment

1. Mutually exclusive investment These are alternative options, which serve the same purpose and compete with one another. If one investment is undertaken others will have to be excluded.

2. Independent investment These serve different purpose and do not compete with each other e.g. a company may be considering expanding its business and at the same time introducing a new product line. Depending on the profitability of the two projects both can be undertaken subject to availability of funds.

3. Contingent investment These are dependent projects. The choice of one investment necessitates that one or more projects should also be undertaken e.g. if a company decides to build a factory in a remote and backward area, it will be necessary to invest in houses, roads, hospitals, schools, etc. for

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employees to attract workforce. The total expenditure of building the factory and investment in facilities for employees is treated as one single investment. Qualities of sound investment decisions

a. It should maximize shareholders wealth b. It should consider cash flows of the entire life of the project to determine true profitability. c. It should help ranking projects according to their true profitability d. It should recognize the fact that the bigger cash flows are preferable to smaller ones and

earlier cash flows are preferable to later ones. e. The criterion should provide for an objective and an ambiguous way of separating bad

projects from good ones. CAPITAL BUDGETING TECHNIQUES/INVESTMENT APPRAISAL TECHNIQUES

1. Techniques under Certainty There is perfect knowledge about the cash flows their timings and magnitude.

a. Payback period b. Accounting rate of return c. Net present value d. Internal rate of return e. Profitability index

2. Techniques under uncertainty and risk

The decision maker does not have perfect knowledge about future outcomes but is able to predict the outcomes and their associated probabilities.

a. Decision trees/Theory models b. Sensitivity analysis c. Scenario analysis d. Simulation analysis e. Portfolio theory analysis f. Capital asset pricing model g. Arbitrage pricing model

In the narrow sense capital budgeting techniques can be divided into two:

a. Non-Discounted cash flow techniques: These techniques do not take into account the time value for money. They include:

(I)- Payback Period, PB (II)- Accounting Rate of Return, ARR

b. Discounted cash flow techniques

These techniques take into account the time value of money. They include: (I)- Net Present Value, NPV (II)- Internal Rate of Return, IRR (III)Profitability Index, PI

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Overview of capital budgeting: Basic terminology Independent versus Mutually Exclusive Projects

– Independent projects are projects whose cash flows are unrelated to (or independent of) one another; the acceptance of one does not eliminate the others from further consideration.

– Mutually exclusive projects are projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

Unlimited Funds versus Capital Rationing

– An unlimited fund is the financial situation in which a firm is able to accept all independent projects that provide an acceptable return.

– Capital rationing is the financial situation in which a firm has only a fixed number of dollars available for capital expenditures, and numerous projects compete for these dollars.

Accept-Reject versus Ranking Approaches

– An accept–reject approach is the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion.

– A ranking approach is the ranking of capital expenditure projects on the basis of some predetermined measure, such as the rate of return.

Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 10.1 and depicted on the time lines in Figure 10.1.

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3.2. PAYBACK PERIOD The payback method is the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows. Decision criteria:

– The length of the maximum acceptable payback period is determined by management.

– If the payback period is less than the maximum acceptable payback period, accept the project.

– If the payback period is greater than the maximum acceptable payback period, reject the project.

We can calculate the payback period for Bennett Company’s projects A and B using the data in Table 10.1.

– For project A, which is an annuity, the payback period is 3.0 years ($42,000 initial

investment ÷ $14,000 annual cash inflow).

– Because project B generates a mixed stream of cash inflows, the calculation of its payback period is not as clear-cut.

• In year 1, the firm will recover $28,000 of its $45,000 initial investment.

• By the end of year 2, $40,000 ($28,000 from year 1 + $12,000 from year 2) will have been recovered.

• At the end of year 3, $50,000 will have been recovered.

• Only 50% of the year-3 cash inflow of $10,000 is needed to complete the payback of the initial $45,000.

– The payback period for project B is therefore 2.5 years (2 years + 50% of year 3).

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Payback period: Pros and Cons of payback analysis

• The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects.

• Its popularity results from its computational simplicity and intuitive appeal.

• By measuring how quickly the firm recovers its initial investment, the payback period also gives implicit consideration to the timing of cash flows and therefore to the time value of money.

• Because it can be viewed as a measure of risk exposure, many firms use the payback period as a decision criterion or as a supplement to other decision techniques.

• The major weakness of the payback period is that the appropriate payback period is merely a subjectively determined number.

– It cannot be specified in light of the wealth maximization goal because it is not based on discounting cash flows to determine whether they add to the firm’s value.

• A second weakness is that this approach fails to take fully into account the time factor in the value of money.

• A third weakness of payback is its failure to recognize cash flows that occur after the payback period.

Focus on practice Limits on Payback Analysis

– While easy to compute and easy to understand, the payback period simplicity brings with it some drawbacks.

– Whatever the weaknesses of the payback period method of evaluating capital projects, the simplicity of the method does allow it to be used in conjunction with other, more sophisticated measures.

In your view, if the payback period method is used in conjunction with the NPV method, should it be used before or after the NPV evaluation? Personal finance example Seema Mehdi is considering investing $20,000 to obtain a 5% interest in a rental property. Seema is in the 25% tax bracket.

– Her real estate agent conservatively estimates that Seema should receive between $4,000 and $6,000 per year in cash from her 5% interest in the property.

– Seema’s calculation of the payback period on this deal begins with calculation of the range of annual after-tax cash flow:

– After-tax cash flow = (1 – tax rate) Pre-tax cash flow

= (1 – 0.25) $4,000 = $3,000

= (1 – 0.25) $6,000 = $4,500

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Seema Mehdi is considering investing $20,000 to obtain a 5% interest in a rental property. Seema is in the 25% tax bracket.

– Dividing the $20,000 initial investment by each of the estimated after-tax cash flows, we get the payback period:

– Payback period = Initial investment ÷ After-tax cash flow

= $20,000 ÷ $3,000 = 6.67 years

= $20,000 ÷ $4,500 = 4.44 years

3.2. ACCOUNTING RATE OF RETURN (ARR) It is also known as return on investment. This technique uses accounting information as revealed by financial statements i.e profit and loss and balance sheet to measure the profitability of an investment.

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ARR= Average income x 100 Average investment The method divides the average income after taxes by average investment. Illustration A project is estimating to cost 80 Million. Its string of earnings before depreciation interest and taxes during the first year through 5 years is expected to be 20 million, 24 million, 28 million, 32 million and 40 million. Assume 50% tax rate and depreciation on straight basis line. Compute the project accounting rate of return.

Year 1 (000)

2 (000)

3 (000)

4 (000)

5 (000)

Average (000)

Earnings Before Depreciation, Interest and Taxes(EBDT)

20,000 24,000 28,000 32,000 40,000 28,800

Less depreciation 16,000 16,000 16,000 16,000 16,000 16,000

EAD 4,000 8,000 12,000 16,000 24,000 12,800

Tax 50% 2,000 4,000 6,000 8,000 12,000 6,400

EAT 2,000 4,000 6,000 8,000 12,000 6,400

Investment

Beginning 80,000 64,000 48,000 32,000 16,000 48,000

End 64,000 48,000 32,000 16,000 0 32,000

Average 72,000 56,000 40,000 24,000 8,000 40,000

ARR= Average income x 100 = 6,400 x 100= 16% Average investment 40,000 NB: When the investment is written down at a constant rate (straight-line method of depreciation), Average investment is equal to = Initial investment=80 million=40,000 million 2 Depreciation= 80 million=16, 000 5 Acceptance rule This method would accept all those projects whose accounting rate of return is higher than the minimum rate established by management and reject those projects which have accounting rate of return which is less than the minimum rate. Rate method would rank project as NO 1 if it has the highest rate of return and lowest rank would be assigned to the project with lowest accounting rate of return.

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Advantages a- It is simple to understand and use b- It uses returns of the entire life of the project in calculating project

profitability c- It is calculated from accounting data, which is readily available from

financial statements of business organization Disadvantages

a. It uses accounting profits and not cash flows in appraising the projects. Profits are based on arbitrary assumptions and choices and also include non-cash items.

b. It ignores time value of money as income is averaged without due regards to its timings. c. There is no universally acceptable way of computing accounting rate of return and this

means that different parties can come up with different rates depending on the formula used.

3.3. NET PRESENT VALUE (NPV)

Net present value (NPV) is a sophisticated capital budgeting technique; found by subtracting a project’s initial investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital.

NPV = Present value of cash inflows – Initial investment

Decision criteria:

– If the NPV is greater than $0, accept the project.

– If the NPV is less than $0, reject the project. If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV.

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3.4. NET PRESENT VALUE (NPV) AND THE PROFITABILITY INDEX For a project that has an initial cash outflow followed by cash inflows, the profitability index (PI) is simply equal to the present value of cash inflows divided by the initial cash outflow:

When companies evaluate investment opportunities using the PI, the decision rule they follow is to invest in the project when the index is greater than 1.0. We can refer back to Figure 10.2, which shows the present value of cash inflows for projects A and B, to calculate the PI for each of Bennett’s investment options: PIA = $53,071 ÷ $42,000 = 1.26 PIB = $55,924 ÷ $45,000 = 1.24

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Net Present Value (NPV): NPV and Economic Value Added

• Economic Value Added (or EVA), a registered trademark of the consulting firm, Stern Stewart & Co., is another close cousin of the NPV method.

• The EVA method begins the same way that NPV does—by calculating a project’s net cash flows.

• However, the EVA approach subtracts from those cash flows a charge that is designed to capture the return that the firm’s investors demand on the project.

• EVA determines whether a project earns a pure economic profit–a profit above and beyond the normal competitive rate of return in a line of business.

Suppose a certain project costs $1,000,000 up front, but after that it will generate net cash inflows each year (in perpetuity) of $120,000. If the firm’s cost of capital is 10%, then the project’s NPV and EVA are:

NPV = –$1,000,000 + ($120,000 ÷ 0.10) = $200,000

EVA = $120,000 – $100,000 = $20,000

3.5. INTERNAL RATE OF RETURN (IRR) The Internal Rate of Return (IRR) is a sophisticated capital budgeting technique; the discount rate that equates the NPV of an investment opportunity with $0 (because the present value of cash inflows equals the initial investment); it is the rate of return that the firm will earn if it invests in the project and receives the given cash inflows.

Decision criteria:

– If the IRR is greater than the cost of capital, accept the project.

– If the IRR is less than the cost of capital, reject the project. These criteria guarantee that the firm will earn at least its required return. Such an outcome should increase the market value of the firm and, therefore, the wealth of its owners.

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Internal Rate of Return (IRR): Calculating the IRR

• To find the IRR using the preprogrammed function in a financial calculator, the keystrokes for each project are the same as those for the NPV calculation, except that the last two NPV keystrokes (punching I and then NPV) are replaced by a single IRR keystroke.

• Comparing the IRRs of projects A and B given in Figure 10.3 to Bennett Company’s 10% cost of capital, we can see that both projects are acceptable because

– IRRA = 19.9% > 10.0% cost of capital

– IRRB = 21.7% > 10.0% cost of capital

• Comparing the two projects’ IRRs, we would prefer project B over project A because IRRB = 21.7% > IRRA = 19.9%.

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• It is interesting to note in the preceding example that the IRR suggests that project B, which has an IRR of 21.7%, is preferable to project A, which has an IRR of 19.9%.

• This conflicts with the NPV rankings obtained in an earlier example.

• Such conflicts are not unusual.

• There is no guarantee that NPV and IRR will rank projects in the same order. However, both methods should reach the same conclusion about the acceptability or nonacceptability of projects

Personal Finance Example Tony DiLorenzo is evaluating an investment opportunity. He feels that this investment must earn a minimum compound annual after-tax return of 9% in order to be acceptable. Tony’s initial investment would be $7,500, and he expects to receive annual after-tax cash flows of $500 per year in each of the first 4 years, followed by $700 per year at the end of years 5 through 8. He plans to sell the investment at the end of year 8 and net $9,000, after taxes.

– Tony finds the investment’s IRR of 9.54%.

– Given that the expected IRR of 9.54% exceeds Tony’s required minimum IRR of 9%, the investment is acceptable.

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Comparing NPV and IRR Techniques: Net Present Value Profiles Net present value profiles are graphs that depict a project’s NPVs for various discount rates. To prepare NPV profiles for Bennett Company’s projects A and B, the first step is to develop a number of discount rate-NPV coordinates and then graph them as shown in the following table and figure.

Comparing NPV and IRR Techniques: Conflicting Rankings

• Conflicting rankings are conflicts in the ranking given a project by NPV and IRR, resulting from differences in the magnitude and timing of cash flows.

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• One underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project.

• NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.

A project requiring a $170,000 initial investment is expected to provide cash inflows of $52,000, $78,000 and $100,000. The NPV of the project at 10% is $16,867 and its IRR is 15%. The following table 10.5 demonstrates the calculation of the project’s future value at the end of its 3-year life, assuming both a 10% (cost of capital) and 15% (IRR) interest rate.

If the future value in each case in Table 10.5 were viewed as the return received 3 years from today from the $170,000 investment, then the cash flows would be those given in the following Table 10.6.

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Comparing NPV and IRR Techniques: Timing of the Cash Flow Another reason why the IRR and NPV methods may provide different rankings for investment options has to do with differences in the timing of cash flows.

– When much of a project’s cash flows arrive early in its life, the project’s NPV will not be particularly sensitive to the discount rate.

– On the other hand, the NPV of projects with cash flows that arrive later will fluctuate more as the discount rate changes.

– The difference in the timing of cash flows between the two projects does not affect the ranking provided by the IRR method.

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Comparing NPV and IRR Techniques: Magnitude of the Initial Investment The scale problem occurs when two projects are very different in terms of how much money is required to invest in each project.

– In these cases, the IRR and NPV methods may rank projects differently.

– The IRR approach (and the PI method) may favor small projects with high returns (like the $2 loan that turns into $3).

– The NPV approach favors the investment that makes the investor the most money (like the $1,000 investment that yields $1,100 in one day).

Comparing NPV and IRR Techniques: Which Approach is better? On a purely theoretical basis, NPV is the better approach because:

– NPV measures how much wealth a project creates (or destroys if the NPV is negative) for shareholders.

– Certain mathematical properties may cause a project to have multiple IRRs more than one IRR resulting from a capital budgeting project with a nonconventional cash flow pattern; the maximum number of IRRs for a project is equal to the number of sign changes in its cash flows.

Despite its theoretical superiority, however, financial managers prefer to use the IRR approach just as often as the NPV method because of the preference for rates of return. Matter of Fact Which Methods Do Companies Actually Use?

– A recent survey asked Chief Financial Officers (CFOs) what methods they used to evaluate capital investment projects.

– The most popular approaches by far were IRR and NPV, used by 76% and 75% (respectively) of the CFOs responding to the survey.

– These techniques enjoy wider use in larger firms, with the payback approach being more common in smaller firms.

Focus on Ethics Nonfinancial Considerations in Project Selection

– For most companies ethical considerations are primarily concerned with the reduction of potential risks associated with a project.

– However, The Kuwait Fund was established as the first institution in the Middle East that took an active role in international development efforts. The fund finances development projects and their feasibility studies in developing countries.

– One of the major objectives of the Kuwait Fund is to build a solid bridge of friendship and solidarity between the state of Kuwait and the developing nations.

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– The success of the Kuwait Fund in achieving this objective helped the state of Kuwait to get the necessary votes in the United Nations and the U.N. Security Council for the war against Iraq to liberate Kuwait in 1991.

– The Kuwait Fund offers many forms of assistance, including direct loans or the provision of guarantees, and grants-in-aid to finance technical, economic, and financial studies.

– What are the potential benefits to the state of Kuwait of the ethical behavior of the Kuwait Fund?

Review of Learning Goals LG1 Understand the key elements of the capital budgeting process.

– Capital budgeting techniques are the tools used to assess project acceptability and ranking. Applied to each project’s relevant cash flows, they indicate which capital expenditures are consistent with the firm’s goal of maximizing owners’ wealth.

LG2 Calculate, interpret, and evaluate the payback period.

– The payback period is the amount of time required for the firm to recover its initial investment, as calculated from cash inflows. Shorter payback periods are preferred. The payback period is relatively easy to calculate, has simple intuitive appeal, considers cash flows, and measures risk exposure. Its weaknesses include lack of linkage to the wealth maximization goal, failure to consider time value explicitly, and the fact that it ignores cash flows that occur after the payback period.

LG3 Calculate, interpret, and evaluate the net present value (NPV) and economic value added (EVA).

– NPV measures the amount of value created by a given project; only positive NPV projects are acceptable. The rate at which cash flows are discounted in calculating NPV is called the discount rate, required return, cost of capital, or opportunity cost. By whatever name, this rate represents the minimum return that must be earned on a project to leave the firm’s market value unchanged.

– The EVA method begins the same way that NPV does—by calculating a project’s net cash flows. However, the EVA approach subtracts from those cash flows a charge that is designed to capture the return that the firm’s investors demand on the project. That is, the EVA calculation asks whether a project generates positive cash flows above and beyond what investors demand. If so, then the project is worth undertaking.

LG4 Calculate, interpret, and evaluate the internal rate of return (IRR).

– Like NPV, IRR is a sophisticated capital budgeting technique. IRR is the compound annual rate of return that the firm will earn by investing in a project and receiving the given cash inflows. By accepting only those projects with IRRs in excess of the firm’s cost of capital, the firm should enhance its market value and the wealth of its owners.

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LG5 Use net present value profiles to compare NPV and IRR techniques.

– A net present value profile is a graph that depicts projects’ NPVs for various discount rates. The NPV profile is prepared by developing a number of “discount rate–net present value” coordinates (including discount rates of 0 percent, the cost of capital, and the IRR for each project) and then plotting them on the same set of discount rate–NPV axes.

LG6 Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach.

– Conflicting rankings of projects frequently emerge from NPV and IRR as a result of differences in the reinvestment rate assumption, as well as the magnitude and timing of cash flows. NPV assumes reinvestment of intermediate cash inflows at the more conservative cost of capital; IRR assumes reinvestment at the project’s IRR. On a purely theoretical basis, NPV is preferred over IRR because NPV assumes the more conservative reinvestment rate and does not exhibit the mathematical problem of multiple IRRs that often occurs when IRRs are calculated for nonconventional cash flows. In practice, the IRR is more commonly used because it is consistent with the general preference of business professionals for rates of return, and corporate financial analysts can identify and resolve problems with the IRR before decision makers use it.

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CHAP IV. WORKING CAPITAL DECISIONS

GENERAL INTRODUCTION

Major capital decisions tangibly shape the future of a company. However, this critical skill is often the most difficult to teach. To improve the return on capital employed, learning departments must

master the art of capital decision making.

Of all the missions a learning organization might tackle, educating executives to make effective capital decisions might prove the most consequential over the long term. Major capital decisions tangibly shape the future of a company. Further, as the ultimate objective of this learning mission is improved return on capital employed (ROCE), it is sure to be valued at the uppermost levels of

the corporation.

The executives who make capital decisions tend to be very self-confident. They have already proven to themselves and others that they are smart, thorough and insightful decision-makers. That is why they now have authority over millions and often billions of dollars.

Can the quality of capital decisions be demonstrably improved through executive education and coaching? And can a corporate learning experience be made valuable and enjoyable even to the self-assured, high-powered executives who make major capital decisions?

The answer to both questions is a resounding yes. That is based on direct experience. The approaches recommended here were developed and proven by hundreds of executives who make major capital decisions.

4.1. DETERMINANTS OF WORKING CAPITAL

What is working capital?

Definition

The cash available for day-to-day operations of an organization. Strictly speaking, one borrows cash (and not working capital) to be able to buy assets or to pay for obligations. It is also called current capital.

A measure of both a company's efficiency and its short-term financial health. The working capital ratio is calculated as:

Positive working capital means that the company is able to pay off its short-term liabilities.

Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).

Calculation formula: Working Capital = Current Assets − Current Liabilities

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1.1 Five (5) use of working capital

Working capital is used to finance the following:

• Construction, renovation or improvements to the leasehold.

• To buy furniture, fixtures, machinery, or equipment.

• To replenish inventory.

• For day-to-day operations of a business and payroll (except owners’salary).

• For down payment assistance on the purchase of real estate for the business.

There are no set rules or formulate to determine the working capital requirements of a firm. The level of working capital is influenced by a number of factors. In this section let us examine the influencing factors. There are lots of factor of determinants of working capital:

1) Nature of business

2) Market and demand condition

3) Technology and manufacturing policy

4) Credit policy of the firm

5) Conditions of supply

6) The Availability of Credit from banks and financial institutions also influences the working capital requirement of a firm.

1.2. Sources of Finance for Working Capital Working capital refers to the funds needed by a business to conduct its daily operations, such as payment of wages, purchase of raw material, covering overhead costs and offering credit services. Working capital can be subdivided into two areas: regular working capital that provides a steady base for overall business objectives; and short-term working capital used to facilitate the day-to-day business operations. Sources of finance for working capital include bank loans, retained earnings, credit from suppliers, long-term loans from financial institutions, or proceeds from sale of assets.

4.2. Costs of Business funds

Definition of 'Cost of business Funds'

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The amount of money paid in interest on a loan. The cost of funds is an expense for both personal and business loans. It also refers to the interest rate in addition to the absolute amount in interest.

The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one of the most important input costs for a financial institution, since a lower cost will generate better returns when the funds are deployed in the form of short-term and long-term loans to borrowers. The spread between the cost of funds and the interest rate charged to borrowers represents one of the main sources of profit for

most financial institutions.

For lenders such as banks and credit unions, cost of funds is determined by the interest rate paid to depositors on financial products including savings accounts and time deposits. Although the term cost of funds usually refers to financial institutions, most corporations that rely on borrowing are impacted by the costs they must incur to gain access to capital.

4.3. Specific costs of capital 4.3.1.1. Cost of debt 4.3.1.2. Cost of equity 4.3.1.3. Cost of retained earnings and Weighted Average Cost of Capital

(WACC) Cost of capital is the minimum required rate of return a project must earn in order to cover the cost of raising fund being used by the firm in financing of the proposal. It may be defined in two phase i.e. operational term and economic term. In the first, it refers to the discount rate that would be used in determining the present value of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not. Economic term further divided into two categories. In the first cost of capital is the cost of acquiring the fund required to finance the proposed project i.e. the borrowing rate of the firm. In term of lending rate it refers to the opportunity cost of the funds to the firm i.e. what the firm could have earned by investing fund elsewhere. In both cases cost of capital connotes rate of return prevailing in the market and anybody seeking capital from the market will have to promise to pay this rate to the suppliers or anyone investing funds will receive return at the same rate. Specific cost of capital – It is the cost associated with particular component of capital structure FACTORS AFFECTING COST OF CAPITAL The elements in the business environment that cause a company's cost of capital to be high or low determine the cost of capital of any firm. These factors are: General Economic Conditions: The general economic conditions determine the demand for and supply of capital within the economy as well as the level of expected inflation. This economic variable is reflected in the risk less rate of return. This rate represents the rate of return on risk

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free investments such as the interest rate on short-term government securities. In principle as the demand for money in the economy changes relative to the supply investors change their required rate of return. Risk and Cost of Capital High-risk investments only make the investors attractive to purchase the security. The risk elements are composed of five aspects that are closely intertwined. These are : (a) Financial Risk- refers to the proportion of debt and equity with which a firm is financed. (b) Business Risk- refers to the variability in return of assets and is affected by the company's investment decision. (c) Purchasing Power Risk- refers to the change in purchasing power of money measured by price level changes. (d) Money Rate Risk- refers to the premium in the yield demanded by suppliers of capital to cover the risk of an increase in future interest rate. (e) Market/Liquidity Risk- refers to the ability of a supplier of fund to sell his holding quickly.

1. COST OF DEBT

Definition- Cost of debt is the interest rate that the organization pays for the debts it have. The debts includes loan, bonds etc. The cost of debt is calculated both before tax calculation as well as after tax calculation this is called cost of debt before tax and cost of debt after tax. The cost of debt calculated after tax is given more preference by the investor whereas the cost of debt calculated before tax is given more preference by the firm.

The Cost of Debt

- The cost of debt is the rate of return the firm’s lenders demand when they loan money to the firm.

- Note, the rate of return is not the same as coupon rate, which is the rate contractually set at the time of issue.

- We can estimate the market’s required rate of return by examining the yield to maturity on the firm’s debt.

- After-tax cost of debt = Yield (1-tax rate)

The investor can identify how much risk the organization is taking, because higher the debt rate higher is the risk. If the debt rate is high the organization has to pay a higher amount for debt from profit, therefore there is higher cash out flow.

From an organization point of view the debt rate can be used to get tax exemption, thus organization uses this debt rate to get tax exemption. The organization can use cost of debt to get the best interest rate that is available for its financial needs. The organization can also make decision on whether to continue with the existing fund raising method or should it have to change

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the method completely. The organization can also make decision whether to continue with the current creditor or find new one.

Organization must take care that cost of debt does not go beyond certain level; it is not good for business and improving investor confidence as well. It is therefore the duty of the organization to keep the cost of debt as low as possible. The formula used for calculating cost of debt is

Cost of Debt (before calculation of tax) = (C + (M-N)/n) / (M + N) / 2

Where C is the money returned, M is the maturity value, n is the number of years, N is the net proceeds issue.

Another formula to calculate cost of debt

Cost of Debt (after calculation of tax) = (I (1-t) +(R-S) /n) / (R+S) /2

Where R is the realizable value, S is the net proceeds issue, n is no of years, and tax rate.

Thus the cost of debt before taxing and after taxing are useful for the organization and the investor respectively to find the exact source of funds raising and to determine the risk in investing in the particular stock respectively.

Example

What will be the yield to maturity on a debt that has par value of $1,000, a coupon interest rate of 5%, time to maturity of 10 years and is currently trading at $900? What will be the cost of debt if the tax rate is 30%?

We can calculate yield to maturity of the bond using a financial calculator or excel: YTM=6.38%. After-tax cost of debt = YTM(1-Tax Rate)=6.38%(1-.3)=4.47%

It is not easy to find the market price of a specific bond as most bonds do not trade in the public market.

Because of this, it is a standard practice to estimate the cost of debt using the average yield to maturity on a portfolio of bonds with similar credit rating and maturity as the firm’s outstanding debt.

The average yield to maturity for a specific rating class varies over time. It can also differ across different industry groups.

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2. COST OF EQUITY It is generally argued that the equity capital is free of cost. But it is not true: The reason behind this argument is that there is no legal binding on company to pay dividend to equity shareholders. The return to the equity shareholders solely depends upon the discretion of the company management. Apart from the absence of any definite commitment to receive dividend, the equity shareholders rank at the bottom as claimants on the assets of the company at the time of liquidation. But apart from all this argument like other sources equity share capital certainly involves a loss. The objective of management is to maximize shareholders wealth and the maximization of market price of share is the operational substitute of wealth maximization. Therefore the required rate of return, which equates the present value of the expected dividends with the market value of shares, is the equity capital. The cost of equity capital may be defined as "The minimum, rate of return that a firm must earn on the equity-finance portion of an investment project in order to leave unchanged the market price of the shares". Thus the expected rate of return in equity share is just equal to the required rate of return of investors. The measurement of this expected rate of return is the measurement of cost of equity share capital. This can be calculated as follows:

; Where Ke=cost of capital of equity

MP= market price per share

DP= dividend per share

In case of Dividend Growth Rate it is ; where: G= annual growth

rate of dividend

The Cost of Preferred Equity

The cost of preferred equity is the rate of return investors require of the firm when they purchase its preferred stock.

The cost is not adjusted for taxes since dividends are paid to preferred stockholders out of

after-tax income.

The cost of preferred stock can be inferred from its trading price and the fixed dividend:

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Example

Consider the preferred shares of Relay Company that are trading at $25 per share. What will be the cost of preferred equity if these stocks have a par value of $35 and pay annual dividend of 4%? Dividend =$35x4%=$1.4 Cost of preferred equity = Dividend/price=1.4/25=5.6%.

3. COST OF RETAINED EARNINGS The cost of existing common stock, or retained earnings, is one of four possible direct sources of capital for the business firm.

If the entire earning is not distributed and the firm retains a part then these retained earnings are available within the firm. Companies are not required to pay any dividend on retained earnings, so it is generally observed that this source of finance is cost-free, but it is not true. If earnings were not retained, they would have been paid out to the ordinary shareholders as dividend. This dividend forgone by the equity shareholders is opportunity cost. The firm has required to earn on retained earnings at least equal to the rate that would have been earned by the shareholders if they were distributed to them. So the cost of retained earnings may be defined as opportunity cost in term of dividends forgone by withholding from the equity shareholders. This cost can be calculated as under:

; Where: Kr = Cost of capital of retained earning

T = Shareholders personal tax rate B = Brokerage cost

4. WEIGHTED AVERAGE COST OF CAPITAL(WACC) The Cost of Capital: An Overview In order to evaluate a capital expenditure project, overall or average cost of capital is required. The overall cost of capital is the rate of return that must be earned by the firm in order to satisfy the requirements of different investors. It is the minimum rate of return on the asset of the firm, so it is preferably calculated as weighted average rather than the simple average. Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

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A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Cost of capital is the weighted average of the required returns of the securities that are used to finance the firm. We refer to this as the firm’s Weighted Average Cost of Capital, or WACC. Most firms raise capital with a combination of debt, equity, and hybrid securities. WACC incorporates the required rates of return of the firm’s lenders and investors and the particular mix of financing sources that the firm uses How does riskiness of firm affect WACC?

Required rate of return on securities will be higher if the firm is riskier.

Risk will influence how the firm chooses to finance, i.e., the proportion of debt and equity.

WACC is useful in a number of settings:

- WACC is used to value the firm.

- WACC is used as a starting point for determining the discount rate for investment projects the firm might undertake.

- WACC is the appropriate rate to use when evaluating performance, specifically whether or not the firm has created value for its shareholders

The WACC equation The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

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Tc = corporate tax rate

Businesses often discount cash flows at WACC to determine the Net Present Value (NPV) of a

project, using the formula:

NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Or,

If there is a preferred stock, there will be a third component on the cost of preferred stock. A Three-Step Procedure for Estimating Firm WACC

1. Define the firm’s capital structure by determining the weight of each source of capital. 2. Estimate the opportunity cost of each source of financing. We will use the current market

value of each source of capital based on its current, not historical, costs. 3. Calculate a weighted average of the costs of each source of financing.

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Determining the Firm’s Capital Structure Weights

The weights are based on the following sources of capital: debt (short-term and long-term), preferred stock, and common equity.

Liabilities such as accounts payable and accrued expenses are not included in capital structure.

Ideally, the weights should be based on observed market values. However, not all market values may be readily available. Hence, we generally use book values for debt and market values for equity.

Exemple: Calculating the WACC for Templeton Extended Care Facilities, Inc. In the spring of 2010, Templeton was considering the acquisition of a chain of extended care facilities and wanted to estimate its own WACC as a guide to the cost of capital for the acquisition. Templeton’s capital structure consists of the following:

Templeton contacted the firm’s investment banker to get estimates of the firm’s current cost of financing and was told that if the firm were to borrow the same amount of money today, it would have to pay lenders 8%; however, given the firm’s 25% tax rate, the after-tax cost of borrowing would only be 6% = 8%(1-.25). Preferred stockholders currently demand a 10% rate of return, and common stockholders demand 15%. Templeton’s CFO knew that the WACC would be somewhere between 6% and 15% since the firm’s capital structure is a blend of the three sources of capital whose costs are bounded by this range.

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Check Yourself After completing her estimate of Templeton’s WACC, the CFO decided to explore the possibility of adding more low-cost debt to the capital structure. With the help of the firm’s investment banker, the CFO learned that Templeton could probably push its use of debt to 37.5% of the firm’s capital structure by issuing more debt and retiring (purchasing) the firm’s preferred shares. This could be done without increasing the firm’s costs of borrowing or the required rate of return demanded by the firm’s common stockholders. What is your estimate of the WACC for Templeton under this new capital structure proposal? WACC=w_cs k_cs + w_d k_d (1-T) =.625x15%+.375x6%=11.625%.

4.4. Financial Leverage

Meaning and definition of financial leverage

Financial Leverage -- The use of fixed financing costs by the firm. The British expression is gearing

Financial leverage can be aptly described as the extent to which a business or investor is using the borrowed money. Business companies with high leverage are considered to be at risk of bankruptcy if, in case, they are not able to repay the debts, it might lead to difficulties in getting new lenders in future. It is not that financial leverage is always bad. However, it can lead to an increased shareholders’ return on investment. Also, very often, there are tax advantages related with borrowing, also known as leverage.

Financial leverage is acquired by choice. Is used as a means of increasing the return to common shareholders. Formula: The most well-known financial leverage ratio is the debt-to-equity ratio . It is calculated as:

Calculating financial leverage

Financial leverage indicates the reliability of a business on its debts in order to operate. Knowing about the method and technique of calculating financial leverage can help you determine a business’ financial solvency and its dependency upon its borrowings. The key steps involved in the calculation of Financial Leverage are:

Total debt / Shareholders Equity

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Compute the total debt owed by the company. This counts both short term as well as long term debt, also including commodities like mortgages and money due for services provided.

Estimate the total equity held by the shareholders in the company. This requires multiplying the number of outstanding shares by the stock price. The total amount thus obtained represents the shareholder equity.

Divide the total debt by total equity. The quotient thus obtained represents the financial leverage ratio.

Norms and Limits

If the financial leverage ratio of a company is higher than 2-to-1, it indicates financial weakness. If the company is leveraged highly, it is considered to be near bankruptcy. Also, it might not be able to secure new capital if it is incapable of meeting its current obligations.

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CHAP V. ANALYSIS OF COSTS Main issues:

Cost classification CVP Analysis and interpretation

5.1. Cost classification CLASSIFICATION OF COSTS, PROFITS, CONTRIBUTION Costs, Profit, Contribution and Break-Even Analysis Cost Classification and Cost Allocation In order to make meaningful decisions a manager must have cost data for each product, department and function of the business. The problem with this is how to accurately define the costs and how to allocate the costs to the various products and departments. The management accountant classifies costs into fixed and variable costs or direct and indirect costs. These costs are then allocated as accurately as possible to the cost centres that generate them. In this way centres are made aware of their responsibility to control costs Fixed, Variable and Semi- Variable Costs Variable Costs – expenses that alter in the short run to changes in output e.g. raw materials, packaging and components. They are payments for the use of inputs Fixed Costs – expenses that do not alter in the short run in relation to changes in output e.g. rent, insurance and depreciation. These costs are linked to time rather the level of business activity Semi Variable Costs – expenses that vary with output but not in direct proportion e.g. maintenance costs. They often comprise a fixed element and a variable element Direct and Indirect Costs Indirect Costs – costs that cannot be allocated accurately to a cost centre or product e.g. administration costs, management salaries or maintenance costs. Another term for this is overheads Direct Costs – costs that can be directly identified with a product or cost centre. They are mainly variable costs but can include some fixed costs e.g. the rent of a building solely used for one product. They are also referred to as prime costs. Total Cost Total Cost – this is the addition of all fixed and variable costs (plus any semi-variable costs)

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Where fixed costs form a significant part of total costs it is important for a business to maximise sales so that the fixed cost element is spread across as many units as possible. The total cost is used by the business to see how much finance is required for each level of output Average Cost / Selling Price Per Unit Average Cost – this is the cost per unit of production and is found by dividing total cost by total output. Average cost can be used to establish the basic price level by adding on a suitable mark-up For example: Variable costs are £10 per unit of production Costs for 1,000 units are: Fixed Costs £20,000 (These do not increase with production) Variable Costs £10,000 Total Costs £30,000 Average Cost per unit = £30,000 / 1,000 units = £30 per unit Average Cost Per Unit + Percentage Mark-up = Selling Price £30 + 50% = £45 Total Revenue / Contribution Per Unit Total Revenue – This is the amount of money a business receives from selling its products. It is calculated by multiplying the number of units sold by the the unit price Contribution Per Unit – This is the difference between the selling price per unit and the variable cost per unit For example: Selling Price Per Unit £20 Variable Cost Per Unit £10 Contribution Per Unit £10 Contribution is used to pay the fixed costs and generate a profit Break-Even Analysis / Margin of Safety / Profit Break-even provides the firm with its first target i.e. covering all of its costs. Any sales beyond the break-even point (BEP) will then generate a profit For example: A firm has fixed costs of £100,000, variable costs (VC) of £10 per unit and a selling price (SP) of £20 per unit. BEP = Fixed Costs / Contribution per unit (i.e. SP – VC)

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BEP = £100,000 / £20 - £10 = 10,000 units The Margin of Safety (MOS) is the difference between the planned level of sales and the BEP. If the firm planned to sell 12,000 units. The MOS would be 12,000 – 10,000 = 2,000 units Thus the profit for the firm would be 2,000 units x £10 contribution per unit = £20,000 Quick Quiz Q1 Which of the following fixed costs does not affect cash flow? Rent Insurance Depreciation To make 1 unit of product X the following are required: Material Costs: 2 kg of raw materials at £5 per kg Packing costs at £4 per unit Labour Costs: 2.0 hours of machining time at £10 per hour 1.5 hours of finishing time at £8 per hour What is the total variable cost of making 1 unit of product X? What is the total variable cost of making 1,000 units of product X? Q2 A firm has the following fixed costs: Rent £5,000 Rates £4,000 Insurance £3,000 Depreciation £8,000 It makes and sells product X – the variable costs are £10 per unit. What is the total cost of making 1,000 units? What is the total cost of making: 2,000 units 5,000 units 10,000 units 20,000 units Q3 What will be the selling price per unit if production is increased from 1,000 to 2,000 units and the mark-up is increased to 75%? Q4 Using the information from the previous quiz – calculate the total revenue generated from the sale of 1,000 units and 2,000 units. Q5 A firm has fixed costs of £200,000 – variable costs of £20 per unit and a selling price of £40 per unit. It plans to make and sell 15,000 units.

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What is the contribution per unit? What is the margin of safety? How much sales revenue will be generated by selling 15,000 units? What is the break-even point? What is the total cost of making 15,000 units? How much profit will be generated if the firm achieves its sales target? Draw a break-even chart showing the above information Repeat the exercise – assuming one change – the firm plans to make and sell 20,000 units. Cost centres and profit centres The Changing Nature of Business – Globalisation of business, a higher rate of product obsolescence (due to rapid technological developments) and the increased sophistication of consumers has led to increased competitive pressures within all markets The Impact of Increased Competition – The major impact of this development has been the drive for all firms to reduce their costs. The most effective way to achieve this objective is through economies of scale Mergers and Takeovers – In all industries there has been increased activity with regard to takeovers and mergers. This means that there are fewer firms but now they operate on a global basis thus generating large economies of scale and reduced costs The Disadvantages of Becoming A Global Operator:

Decision making becomes centralised

As the company grows the decision makers become isolated and lose touch with the customers

Increased size makes communications and decision making much more complex

The company loses touch with the market place and becomes de-sensitised to changes occurring within the external environment

The company becomes complacent and loses its innovative drive Delegated Decision Making - this provides the means to overcome the problems caused by becoming a global operator How? – Proctor and Gamble plc is a global operator. However, it is not simply one company. It is actually a large number of companies (100+) which make up the Proctor and Gamble group Autonomous business units – this simply means that each company within the Proctor and Gamble group is allowed to operate as an independent company

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The directors of each company must comply with corporate standards and supply reports on their performance (e.g. costs, sales and profits) on a periodic basis (e.g. quarterly, annually) to the main board of directors The principle of delegated decision making can then be applied to each company. This is achieved by subdividing each company into profit centres and cost centres A profit centre could be a retail outlet, a brand, a sales force operating in a geographical location e.g. the North East of England etc. Each profit centre will have a manager who is responsible for ensuring that sales and profit targets are achieved. He must also ensure that costs are kept within the stated budget limits The manager of a cost centre is only responsible for keeping costs within stated budget limits. He has no responsibility for sales or profits Cost Centres are sections of a business to which costs can be charged. A cost centre in a manufacturing business, for example, is a department of a factory, a particular stage in the production process, or even a whole factory. In a college, examples of cost centres are the teaching departments, or particular sections of departments, e.g. the administrative office. In a hospital, examples of cost centres are the hospital wards, operating theatres, and specialist sections such as the X-ray department, pathology department. A Profit Centre represents a segment of a business to which separate activities can be analysed It generates revenues and incur costs and is a convenient business unit for the analysis of profit which are generated by various activities A designated manager will be responsible for the successful running of the profit centre The manager will be given the authority to make decisions within specified limits (delegated decision making) Delegated budget is the amount of money the manager can spend without having to refer to a higher level manager for approval. e.g. for a 12-month period, a manager could have a £200,000 budget and could spend a maximum of £20,000 on any item without having to seek prior approval Case Study THE SITUATION – Your name is Edward West and you are the Managing Director of West Perfumes Ltd (WPL). This is a family business and produces scented perfumes, which are sold to a wide range of different retailers e.g. John Lewis, Marks and Spencers etc.

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The company has recently been taken over by Proctor and Gamble (P&G). However, the current board of directors are being allowed to remain in control. P&G are investing £5m in West Ltd to finance the development of new products and upgrade its manufacturing equipment. However, P&G want sales and profits to increase by 30% within the next 12 months. You have also been told to reduce the workforce by 20%. From the viewpoint of West Perfumes Ltd, what are the advantages and disadvantages of the P&G takeover? Management Accounting is concerned with providing the management of a business with financial recommendations, based on costing information, e.g. the cost of materials, labour, overheads etc, in order to enable day-to-day and longer-term plans to be made Management accounting uses information from past transactions as an aid to financial decision making, planning and control for the future The management of a business needs information from which to work. It needs to know accurate costs of individual products or services, together with the total costs of running the business WPL’s labour costs are 20% higher than the average for a P&G company. Why is this figure of significance? What action can be taken to reduce this figure? What will happen if nothing is done to reduce labour costs? A complex of machines may act as a cost centre, and in turn the factory departments in which the machines operate can also be cost centres But the factory itself may be a profit centre, its manager being responsible for sales as well as production Explain why WPL is a profit centre for P&G? Explain how P&G’s organisational structure overcomes the disadvantages of being a global operator?

5.2. CVP ANALYSIS AND INTERPRETATION

Learning Objective 1

Understand the assumptions underlying cost-volume-profit (CVP) analysis. Cost-Volume-Profit Assumptions and Terminology 1-Changes in the level of revenues and costs arise only because of changes in the number of

product (or service) units produced and sold.

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2-Total costs can be divided into a fixed component and a component that is variable with

respect to the level of output.

3-When graphed, the behavior of total revenues and total costs is linear (straight-line) in relation

to output units within the relevant range (and time period).

4-The unit selling price, unit variable costs, and fixed costs are known and constant.

5-The analysis either covers a single product or assumes that the sales mix when multiple products

are sold will remain constant as the level of total units sold changes.

6-All revenues and costs can be added and compared without taking into account the time value of money. Operating income = Total revenues from operations – Cost of goods sold and operating costs (excluding income taxes) Net income = Operating income – Income taxes

Learning Objective 2 Explain the features of CVP analysis.

Essentials of Cost-Volume-Profit (CVP) Analysis Example Assume that the Pants Shop can purchase pants for $32 from a local factory; other variable costs amount to $10 per unit. The local factory allows the Pants Shop to return all unsold pants and receive a full $32 refund per pair of pants within one year. The average selling price per pair of pants is $70 and total fixed costs amount to $84,000. How much revenue will the business receive if 2,500 units are sold?

2,500 × $70 = $175,000 How much variable costs will the business incur?

2,500 × $42 = $105,000

$175,000 – 105,000 – 84,000 = ($14,000) What is the contribution margin per unit? $70 – $42 = $28 contribution margin per unit What is the total contribution margin when 2,500 pairs of pants are sold? 2,500 × $28 = $70,000 Contribution margin percentage (contribution margin ratio) is the contribution margin per unit divided by the selling price. What is the contribution margin percentage? $28 ÷ $70 = 40%

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If the business sells 3,000 pairs of pants, revenues will be $210,000 and contribution margin would equal 40% × $210,000 = $84,000.


Determine the breakeven point and output level needed to achieve a target operating income using the equation, contribution margin, and graph methods.

Breakeven Point Sales-Variable expenses= Fixed expenses

Total revenues = Total costs Abbreviations SP = Selling price

VCU = Variable cost per unit

CMU = Contribution margin per unit

CM% = Contribution margin percentage

FC = Fixed costs

Q = Quantity of output units sold (and manufactured)

OI = Operating income

TOI = Target operating income

TNI = Target net income Equation Method (Selling price × Quantity sold) – (Variable unit cost × Quantity sold) – Fixed costs = Operating income

Let Q = number of units to be sold to break even

$70Q – $42Q – $84,000 = 0

$28Q = $84,000

Q = $84,000 ÷ $28 = 3,000 units

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Contribution Margin Method

$84,000 ÷ $28 = 3,000 units

$84,000 ÷ 40% = $210,000 Target Operating Income (Fixed costs + Target operating income) divided either by Contribution margin percentage or Contribution margin per unit Assume that management wants to have an operating income of $14,000.

How many pairs of pants must be sold?

($84,000 + $14,000) ÷ $28 = 3,500 What dollar sales are needed to achieve this income? ($84,000 + $14,000) ÷ 40% = $245,000


Understand how income taxes affect CVP analysis

Target Net Income and Income Taxes Example

Management would like to earn an after tax income of $35,711. The tax rate is 30%. What is the target operating income?

Target operating income = Target net income ÷ (1 – tax rate)

TOI = $35,711 ÷ (1 – 0.30) = $51,016 How many units must be sold?

Revenues – Variable costs – Fixed costs = Target net income ÷ (1 – tax rate)

$70Q – $42Q – $84,000 = $35,711 ÷ 0.70

$28Q = $51,016 + $84,000

Q = $135,016 ÷ $28 = 4,822 pairs of pants Proof:

Revenues: 4,822 × $70 $337,540

Variable costs: 4,822 × $42 202,524

Contribution margin $135,016

Fixed costs 84,000

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Operating income 51,016

Income taxes: $51,016 × 30% 15,305

Net income $ 35,711

Learning Objective 5 Explain CVP analysis in decision making and how sensitivity analysis helps managers cope

with uncertainty Using CVP Analysis Example Suppose the management anticipates selling 3,200 pairs of pants. Management is considering an advertising campaign that would cost $10,000. It is anticipated that the advertising will increase sales to 4,000 units. Should the business advertise? 3,200 pairs of pants sold with no advertising: Contribution margin $89,600 Fixed costs 84,000 Operating income $ 5,600 4,000 pairs of pants sold with advertising: Contribution margin $112,000 Fixed costs 94,000 Operating income $ 18,000

Instead of advertising, management is considering reducing the selling price to $61 per pair of pants. It is anticipated that this will increase sales to 4,500 units. Should management decrease the selling price per pair of pants to $61? Instead of advertising, management is considering reducing the selling price to $61 per pair of pants. It is anticipated that this will increase sales to 4,500 units. Should management decrease the selling price per pair of pants to $61?

3,200 pairs of pants sold with no change in the selling price:

Operating income = $5,600 4,500 pairs of pants sold at a reduced selling price: Contribution margin: (4,500 × $19) $85,500 Fixed costs 84,000 Operating income $ 1,500

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Sensitivity Analysis and Uncertainty Example

Assume that the Pants Shop can sell 4,000 pairs of pants. Fixed costs are $84,000. Contribution margin ratio is 40%. At the present time the business cannot handle more than 3,500 pairs of pants. To satisfy a demand for 4,000 pairs, management must acquire additional space for $6,000. Should the additional space be acquired? Revenues at breakeven with existing space are $84,000 ÷ .40 = $210,000.

Revenues at breakeven with additional space are $90,000 ÷ .40 = $225,000

Operating income at $245,000 revenues with existing space = ($245,000 × .40)– $84,000 = $14,000. (3,500 pairs of pants × $28) – $84,000 = $14,000 Operating income at $280,000 revenues with additional space = ($280,000 × .40) – $90,000= $22,000. (4,000 pairs of pants × $28 contribution margin) – $90,000 = $22,000

Learning Objective 6 Use CVP analysis to plan fixed and variable costs

Alternative Fixed/Variable Cost Structures Example Suppose that the factory the Pants Shop is using to obtain the merchandise offers the following: Decrease the price they charge from $32 to $25 and charge an annual administrative fee of $30,000. What is the new contribution margin? $70 – ($25 + $10) = $35 Contribution margin increases from $28 to $35. What is the contribution margin percentage? $35 ÷ $70 = 50% What are the new fixed costs?

$84,000 + $30,000 = $114,000

Management questions what sales volume would yield an identical operating income regardless

of the arrangement.

28x – 84,000 = 35x – 114,000

114,000 – 84,000 = 35x – 28x

7x = 30,000

x = 4,286 pairs of pants

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Cost with existing arrangement = Cost with new arrangement 60x + 84,000 = .50x + 114,000

10x = $30,000 x = $300,000 ($300,000 × .40) – $ 84,000 = $36,000 ($300,000 × .50) – $114,000 = $36,000 OPERATING LEVERAGE

Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold. Organizations with a high proportion of fixed costs have high operating leverage. Operating Leverage Example Degree of operating leverage = Contribution margin ÷ Operating income What is the degree of operating leverage of the Pants Shop at the 3,500 sales level under both arrangements?

Existing arrangement: 3,500 × $28 = $98,000 contribution margin

$98,000 contribution margin – $84,000 fixed costs = $14,000 operating income New arrangement: 3,500 × $35 = $122,500 contribution margin $122,500 contribution margin – $114,000 fixed costs = $8,500 $122,500 ÷ $8,500 = 14.4 The degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating income.

Learning Objective 7 Apply CVP analysis to a company producing different products.

Effects of Sales Mix on Income Pants Shop Example Management expects to sell 2 shirts at $20 each for every pair of pants it sells. This will not require any additional fixed costs. Contribution margin per shirt: $20 – $9 = $11 What is the contribution margin of the mix? $28 + (2 × $11) = $28 + $22 = $50 $84,000 fixed costs ÷ $50 = 1,680 packages 1,680 × 2 = 3,360 shirt 1,680 × 1 = 1,680 pairs of pants

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Total units = 5,040 What is the breakeven in dollars? 3,360 shirts × $20= $ 67,200 1,680 pairs of pants × $70= 117,600

$184,800 What is the weighted-average budgeted contribution margin? Pants: 1 × $28 + Shirts: 2 × $11 = $50 ÷ 3 = $16.667 The breakeven point for the two products is: $84,000 ÷ $16.667 = 5,040 units 5,040 × 1/3 = 1,680 pairs of pants 5,040 × 2/3 = 3,360 shirts Sales mix can be stated in sales dollars: Pants Shirts Sales price $70 $40 Variable costs 42 18 Contribution margin $28 $22 Contribution margin ratio 40% 55% Assume the sales mix in dollars is 63.6% pants and 36.4% shirts. Weighted contribution would be: 40% × 63.6% = 25.44% pants 55% × 36.4% = 20.02% shirts 45.46% Breakeven sales dollars is $84,000 ÷ 45.46% = $184,778 (rounding). $184,778 × 63.6% = $117,519 pants sales $184,778 × 36.4% = $ 67,259 shirt sales


Adapt CVP analysis to situations in which a product has more than one cost driver Multiple Cost Drivers Example Suppose that the business will incur an additional cost of $10 for preparing documents associated with the sale of pants to various customers. Assume that the business sells 3,500 pants to 100 different customers. What is the operating income from this sale? Revenues: 3,500 × $70 $245,000 Variable costs:

Pants: 3,500 × $42 147,000 Documents: 100 × $10 1,000

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Total 148,000 Contribution margin 97,000 Fixed costs 84,000 Operating income $ 13,000 Multiple Cost Drivers Would the operating income of the Pants Shop be lower or higher if the business sells pants to more customers? The cost structure depends on two cost drivers: 1-Number of units 2-Number of customers

Learning Objective 9 Distinguish between contribution margin and gross margin

Contribution Margin versus Gross Margin Contribution income statement emphasizes contribution margin. Financial accounting income statement emphasizes gross margin

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CHAP VI. MEASURING BUSINESS PERFORMANCE 5.1. Understanding financial statements income statement and balance sheet

a. Business performance measurement (BPM)

Business Performance Measurements is the Way to Increase Production, Profit and Morale. A BPM is also a system which enables an enterprise to plan, measure, and control its performance and helps ensure that sales and marketing initiatives, operating practices, information technology resources, business decision, and people’s activities are aligned with business strategies to achieve desired business results and create shareholder value.

b. Financial statements Financial statements are records that provide an indication of an individual’s, organizations, or business’ financial status. There are four basic types of financial statements: balance sheets, income statements, cash-flow statements, and statements of retained earnings. Typically, financial statements are used in relation to business endeavors.

c. Income financial statement

Income financial statements present information concerning the revenue earned by a company in a specified time period. Income statements also show the company’s expenses in attaining the income and shareholder earnings per share. At the bottom of the income statement, a total of the amount earned or lost is included. Often, income statements provide a record of revenue over a year’s time.

d. Balance sheet financial statement Balance sheet financial statements are used to provide insight into a company’s assets and debts at a particular point in time. Information about the company’s shareholder equity is included as well. Typically, a company lists its assets on the left side of the balance sheet and its debts and liabilities on the right. Sometimes, however, a balance sheet has assets listed at the top, debts in the middle, and shareholders’ equity at the bottom. 5.2. Why Measure Business Performance (BPM)?

Business performance measurement has a variety of uses:

To monitor and control

To drive improvement

To maximize the effectiveness of the improvement effort

To achieve alignment with organizational goals and objectives

To reward and to discipline Simmons (2000) looks at business performance measurement as a tool to balance five major tensions within a firm:

1- Balancing profit, growth and control 2- Balancing short term results against long-term capabilities and growth opportunities

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3- Balancing performance expectations of different constituencies 4- Balancing opportunities and attention 5- Balancing the motives of human behavior

5.3. What are the issues with BPM?

Commentary on performance measurement can be placed along a continuum ranging from views supporting conventional approaches based on a rational view of decision-making at one end to unconventional approaches that derive from a view based on ambiguity, irrationality or bounded-rationality. In addition, commentaries cover a wide range of topics from data integration and quality, best practices to cognitive psychology that address multiple levels of analysis including the individual, the workgroup and team, the firm and cultures.

a. Diversity Perhaps the first and most important issue with BPM is its diversity. Neely (2002) cites tremendous diversity in the academic field as well, with experts in accounting, economics, human resource management, marketing, operations management, psychology and sociology all exploring the subject independent of each other. More importantly, neely argues that there is little agreement on what are the most important themes and theories in performance measurement.

b. Adoption rates Performance measurement may be following similar diffusion patters as other productivity improvements, which can take a generation to achieve widespread acceptance. Wide variation in the use of information technology may be part of the problem as well. Performance measurement efforts may have more success in measuring activities and outputs, versus outcomes. Outcomes require stakeholder or customer perceptions of timeliness, quality and usefulness of services, which involve data not widely gathered (Berman, 2002).

c. Data quality BPM systems typically draw their data from data warehouses that in turn draw their data from source enterprise systems and numerous ancillary software and data sources throughout an enterprise. Bad data quality is affecting the usefulness for data warehouses in general. 5.4. Financial Ratio analysis

5.4.1. Profitability ratios

Closely linked with income ratios are profitability ratios, which shed light upon the overall effectiveness of management regarding the returns generated on sales and investment. Gross Profit on Net Sales Net Sales - Cost of Goods Sold = Gross Profit on Net Sales Ratio Net Sales

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Note: This percentage rate can and will vary greatly from business to business, even those within the same industry. Sales, location, size of operations, and intensity of competition are all factors that can affect the gross profit rate.

5.4.2. Liquidity Ratios or Solvency Ratios While liquidity ratios are most helpful for short-term creditors/suppliers and bankers, they are also important to financial managers who must meet obligations to suppliers of credit and various government agencies. A complete liquidity ratio analysis can help uncover weaknesses in the financial position of your business.

Current Ratio Current Assets *= Current Ratio Current Liabilities* Popular since the turn of the century, this test of solvency balances your current assets against your current liabilities. The current ratio will disclose balance sheet changes that net working capital will not. *Current Assets = net of contingent liabilities on notes receivable *Current Liabilities = all debt due within one year of statement data Note: The current ratio reveals your business's ability to meet its current obligations. It should be supplemented with the other ratios listed below, however.

Quick Ratio Cash + Marketable Securities + Accounts Receivable (net) = Quick Ratio Current Liabilities Also known as the "acid test," this ratio specifies whether your current assets that could be quickly converted into cash are sufficient to cover current liabilities. Until recently, a Current Ratio of 2:1 was considered standard. A firm that had additional sufficient quick assets available to creditors was believed to be in sound financial condition. Note: The Quick Ratio assumes that all assets are of equal liquidity. Receivables are one step closer to liquidity than inventory. However, sales are not complete until the money is in hand.

Absolute Liquidity Ratio Cash + Marketable Securities= Absolute Liquidity Ratio Current Liabilities A subsequent innovation in ratio analysis, the Absolute Liquidity Ratio eliminates any unknowns surrounding receivables.

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Note: The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and marketable securities.

Basic Defense Interval (Cash + Receivables + Marketable Securities) .= Basic Defense Interval (Operating Expenses + Interest + Income Taxes) / 365 If for some reason all of your revenues were to suddenly cease, the Basic Defense Interval would help determine the number of days your company can cover its cash expenses without the aid of additional financing.

Receivables Turnover Total Credit Sales .= Receivables Turnover Ratio Average Receivables Owing Another indicator of liquidity, Receivables Turnover Ratio can also indicate management's efficiency in employing those funds invested in receivables. Net credit sales, while preferable, may be replaced in the formula with net total sales for an industry-wide comparison. Note: Closely monitoring this ratio on a monthly or quarterly basis can quickly underscore any change in collections.

Average Collection Period (Accounts + Notes Receivable)= Average Collection Period (Annual Net Credit Sales) / 365 The Average Collection Period (ACP) is another litmus test for the quality of your receivables business, giving you the average length of the collection period. As a rule, outstanding receivables should not exceed credit terms by 10-15 days. If you allow various types of credit transactions, such as a retail outlet selling both on open credit and installment, then the ACP must be calculated separately for each category. Note: Discounted notes which create contingent liabilities must be added back into receivables.

Inventory Turnover Cost of Goods Sold= Inventory Turnover Ratio Average Inventory Rule of Thumb: Multiply your inventory turnover by your gross margin percentage. If the result is 100 percent or greater, your average inventory is not too high. 5.4.3. Market Ratios When a stock analyst wants to understand how other investors value a company, they look at market ratios. These measures all have one factor in common; they're evaluating the current market price of a share of common stock versus an indicator of the company's ability to generate profits or assets held by the company. The following are the common market ratios:

http://www.money-zine.com/Investing/Investing/Market-Ratios/

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Stock Prices and Market Value

Since each of these market ratios contains the price per share of common stock, they provide the analyst with a sense of investor sentiment towards a particular company.

Price to Earnings Also known as the P/E ratio, this first metric tells the analyst the cost to acquire $1.00 of the company's earnings. For example, if a company is reporting $1.00 in annual earnings and the stock's current market price is $20.00, then the price to earnings ratio is 20.0. Formula

Price to Earnings = Market Value per Share / Annual Earnings per Share

Forward and Trailing P/E (ttm) While the typical convention is to report the P/E in terms of past earnings, it's important for an analyst to understand the exact calculation behind this value. To clarify this point, the ratio is often reported as: Trailing P/E (ttm): the trailing twelve months (ttm) of earnings; therefore, is a historical account of this ratio. Forward P/E: a forecast of earnings over the next twelve months, thereby providing the analyst with a forward-looking metric.

The price to earnings growth ratio or PEG Ratio As just mentioned, when an analyst finds a company with a relatively high P/E ratio, that value is typically justified by a high earnings growth rate. The price to earnings growth ratio, or PEG ratio, corrects the P/E for this growth rate. In doing so, it "normalizes" the data and allows the analyst to make more accurate value judgments. Formula

PEG Ratio = Price to Earnings / Annual EPS Growth

Where:

Annual EPS Growth is stated as % x 100

Dividend Yield

While dividend payments are extremely important to some shareholders, they are of secondary consideration for others. Some investors seek a regular stream of income from a stock, while others invest with the hope of securing capital gains. The dividend yield allows the analyst to quickly compare the merits of these alternative investment opportunities.

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Formula

Dividend Yield (%) = (Market Price per Share / Dividends per Share) x 100

Price to Book or Market to Book This next metric can be calculated two ways, both with the same result. The measure is used to understand the price, or market value, of a company relative to its worth (assets). For example, if a company's market capitalization was $10B and its assets were equal to $10B, its market to book would be 1.0. Formula

Price to Book = Market Price per Share / Book Value per Share

Where:

Book Value per Share = (Total Shareholder Equity - Preferred Equity) / Common Shares Outstanding

Alternatively:

Market to Book = Total Market Capitalization / Total Book Value

Where: Total Book Value = Total Shareholder Equity - Preferred Equity

Pros and Cons

Market ratios allow the analyst to understand how other investors feel about owning a share of a company's stock. They demonstrate the relationship between the price per share and its earnings, growth and assets. As such it's a good indicator of the relative value of a company.

While some investors might feel an undervalued business represents an opportunity to buy a stock at bargain prices, others feel it's a warning sign the company may not perform well in the future relative to expectations (it will disappoint). As is the case with nearly all financial ratios, benchmarks and comparisons should be made relative to companies in the same industry. 5.4.4. Activity ratio Activity ratios are the accounting ratios that measure a firm's ability to convert different accounts within its balance sheets into cash or sales. Activity ratios are used to measure the relative efficiency of a firm based on its use of its assets, leverage or other such balance sheet items. These ratios are important in determining whether a company's management is doing a good enough job of generating revenues, cash, etc. from its resources. The most formulas used in Activity ratios are:

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Inventory turnover= Cost of goods sale / inventory

Accounts receivable turnover= Sales on credit / Accounts receivable

Total asset turnover= Sales / Total assets

Fixed asset turnover= Sales / Fixed assets 5.5. Vertical and Horizontal analysis

a. Horizontal analysis

In business, horizontal analysis refers to a type of fundamental analysis in which a financial analyst uses certain financial data to assess a company’s performance over time.

The analyst compares the same items or ratios for a particular company over a period of time in order to assess the company’s growth during that time.

Horizontal analysis can also be performed on multiple companies in the same industry, to assess a company’s performance relative to its competitors.

The data used in horizontal analysis is found in a company’s financial statements, which include the balance sheet, income statement, and statement of cash flows. It can be line items, such as expense items, or it can be a ratio.

b. Vertical analysis Vertical analysis is a method of analyzing financial statements in which each item in the statement is represented as a percentage of a single larger item.

This method of analysis may be used with both balance sheets and income statements as a way of coherently comparing large monetary amounts and making sense of the data.

One of the advantages of vertical analysis is that it makes comparisons between companies of different sizes within the same industry easier to prepare.

It also allows a company to weigh its current reports against reports from its past, revealing possible trends or areas that need improvement

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CHAP VII. BUDGETS AND BUDGETARY CONTROL There are two types of control, namely budgetary and financial. This chapter concentrates on budgetary control only. Chapter objectives This chapter is intended to provide:

An indication and explanation of the importance of budgetary control in marketing as a key marketing control technique

An overview of the advantages and disadvantages of budgeting

An introduction to the methods for preparing budgets

An appreciation of the uses of budgets. Structure of the chapter Of all business activities, budgeting is one of the most important and, therefore, requires detailed attention. The chapter looks at the concept of responsibility centres, and the advantages and disadvantages of budgetary control. It then goes on to look at the detail of budget construction and the use to which budgets can be put. Like all management tools, the chapter highlights the need for detailed information, if the technique is to be used to its fullest advantage.

7.1. Meaning, Objectives and Limitations of Budgetary control

7.1.1. Definition of budget

1. According to the Institute of Cost & Management (ICMA), London, a BUDGET is ‘a financial and / or quantitative statement, prepared and approved prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. It may include income, expenditure and the employment of

capital’.

Or as: "The establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy, or to provide a basis for its revision". 2. According to Brown and Howard of Management Accountant "a budget is a

predetermined statement of managerial policy during the given period which provides a standard for comparison with the results actually achieved."

7.1.2. Definition of budgetary control

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1. Budgetary Control is the process of establishment of budgets relating to various activities and comparing the budgeted figures with the actual performance for arriving at deviations, if any. Accordingly, there cannot be budgetary control without budgets.

2. Budgetary Control is a system which uses budgets as a means of planning and controlling.

3. According to I.C.M.A. England Budgetary control is defined by Terminology as the

establishment of budgets relating to the responsibilities of executives to the requirements of a policy and the continuous comparison of actual with the budgeted results, either to secure by individual actions the objectives of that policy or to provide a basis for its revision.

7.1.3. Objectives and limitation of budgetary control

Objectives of budgetary control

Budgetary Control is planned to assist the management for policy formulation. It is planned for the following objectives:

1. To plan and measure the performance. 2. To co-ordinate and communicate. 3. To improve the efficiency and economy in operations (cost control and cost reduction). 4. To increase the profitability of operations. 5. To anticipate the future capital expenditure. 6. To exercise control. 7. To locate deviations and correct them. 8. To establish a system of control. 9. To motivate employees.

Limitations of budgetary control The main limitations of budgetary control are:

1. It used the estimates as a basis for the budget plan.

2. In order to fit with the changing circumstances the budgetary programme must be continually adapted. Normally for attaining a reasonably good budgetary programme, it takes several years.

3. A budget plan cannot be executed automatically. Enthusiastic participation is required by all levels of management in the programme.

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4. The necessity of having a management & administration will not be eliminated by any budgetary control system. The place of the management is not taken by it; rather it is a tool of the management.

5. It involves predicting the future which is highly uncertain.

6. Market is dynamic and continuously evolving. Hence budgets based on past data may not be relevant. 7. Too much reliance on budget will result in complacence on the part of the employees. 8. In reality, gaining full co-ordination of all the employees may be difficult. 9. There may be conflict among different departments. 10. Preparation of a budget is very difficult. 11. Resistance in accepting also will not result in achieving the set goals.

Budgetary control methods

a) Budget:

o A formal statement of the financial resources set aside for carrying out specific activities in a given period of time.

o It helps to co-ordinate the activities of the organisation.

An example would be an advertising budget or sales force budget. b) Budgetary control:

- A control technique whereby actual results are compared with budgets.

- Any differences (variances) are made the responsibility of key individuals who can either exercise control action or revise the original budgets.

Budgetary control and responsibility centres;

These enable managers to monitor organisational functions.

A responsibility centre can be defined as any functional unit headed by a manager who is responsible for the activities of that unit. There are four types of responsibility centres: a) Revenue centres: Organisational units in which outputs are measured in monetary terms but are not directly compared to input costs.

b) Expense centres: Units where inputs are measured in monetary terms but outputs are not.

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c) Profit centres: Where performance is measured by the difference between revenues (outputs) and expenditure (inputs). Inter-departmental sales are often made using "transfer prices".

d) Investment centre: Where outputs are compared with the assets employed in producing them, i.e. ROI. Advantages of budgeting and budgetary control

There are a number of advantages to budgeting and budgetary control:

- Compels management to think about the future, which is probably the most important feature of a budgetary planning and control system. Forces management to look ahead, to set out detailed plans for achieving the targets for each department, operation and (ideally) each manager, to anticipate and give the organisation purpose and direction.

- Promotes coordination and communication.

- Clearly defines areas of responsibility. Requires managers of budget centres to be made responsible for the achievement of budget targets for the operations under their personal control.

- Provides a basis for performance appraisal (variance analysis). A budget is basically a yardstick against which actual performance is measured and assessed. Control is provided by comparisons of actual results against budget plan. Departures from budget can then be investigated and the reasons for the differences can be divided into controllable and non-controllable factors.

- Enables remedial action to be taken as variances emerge.

- Motivates employees by participating in the setting of budgets.

- Improves the allocation of scarce resources.

- Economises management time by using the management by exception principle. Problems in budgeting

Whilst budgets may be an essential part of any marketing activity they do have a number of disadvantages, particularly in perception terms.

- Budgets can be seen as pressure devices imposed by management, thus resulting in: a) bad labour relations

b) inaccurate record-keeping.

- Departmental conflict arises due to:

a) disputes over resource allocation

b) departments blaming each other if targets are not attained.

- It is difficult to reconcile personal/individual and corporate goals.

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- Waste may arise as managers adopt the view, "we had better spend it or we will lose it". This is often coupled with "empire building" in order to enhance the prestige of a department.

Responsibility versus controlling, i.e. some costs are under the influence of more than one person, e.g. power costs.

- Managers may overestimate costs so that they will not be blamed in the future should they overspend.

Characteristics of a budget

A good budget is characterised by the following:

- Participation: involve as many people as possible in drawing up a budget.

- Comprehensiveness: embrace the whole organisation.

- Standards: base it on established standards of performance.

- Flexibility: allow for changing circumstances.

- Feedback: constantly monitor performance.

- Analysis of costs and revenues: this can be done on the basis of product lines, departments or cost centres.

Budget organisation and administration:

In organising and administering a budget system the following characteristics may apply:

a) Budget centres: Units responsible for the preparation of budgets. A budget centre may encompass several cost centres.

b) Budget committee: This may consist of senior members of the organisation, e.g. departmental heads and executives (with the managing director as chairman). Every part of the organisation should be represented on the committee, so there should be a representative from sales, production, marketing and so on. Functions of the budget committee include:

- Coordination of the preparation of budgets, including the issue of a manual

- Issuing of timetables for preparation of budgets

- Provision of information to assist budget preparations

- Comparison of actual results with budget and investigation of variances.

c) Budget Officer: Controls the budget administration The job involves:

- liaising between the budget committee and managers responsible for budget preparation

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- dealing with budgetary control problems

- ensuring that deadlines are met

- educating people about budgetary control.

d) Budget manual:

This document:

- charts the organization

- details the budget procedures

- contains account codes for items of expenditure and revenue

- timetables the process

- clearly defines the responsibility of persons involved in the budgeting system.

7.2. Types of Budget

As budgets serve different purposes, different types of budgets have been developed. The following are the different classification of budgets developed on the basis of time, functions, and flexibility or capacity. A .Classification on the Basis of Time

1. Long-Term Budgets: Long-term budgets are prepared for a longer period varies between five to ten years. It is usually developed by the top level management. These budgets summarise the general plan of operations and its expected consequences. Long-Term Budgets are prepared for important activities like composition of its capital expenditure, new product development and research, long-term finance etc.

2. Short-Term Budgets: These budgets are usually prepared for a period of one year.

Sometimes they may be prepared for shorter period as for quarterly or half yearly. The scope of budgeting activity may vary considerably among different organization.

3. Current Budgets: Current budgets are prepared for the current operations of the

business. The planning period of a budget generally in months or weeks. As per ICMA London, "Current budget is a budget which is established for use over a short period of time and related to current conditions."

B. Classification on the Basis of Function

1. Functional Budget: The functional budget is one which relates to any of the functions of an organization. The number of functional budgets depend upon the size and nature of business. The following are the commonly used:

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a) Sales Budget b) Purchase Budget c) Production Budget d) Selling and Distribution Cost Budget e) Labour Cost Budget f) Cash Budget g) Capital Expenditure Budget

2. Master Budget: The Master Budget is a summary budget. This budget encompasses all

the functional activities into one harmonious unit. The ICMA England defines a Master Budget as the summary budget incorporating its functional budgets, which is finally approved, adopted and employed.

C. Classification on the Basis of Capacity 1. Fixed Budget: A fixed budget is designed to remain unchanged irrespective of the level of activity actually attained. 2. Flexible Budget: A flexible budget is a budget which is designed to change in accordance with the various level of activity actually attained. The flexible budget also called as Variable Budget or Sliding Scale Budget, takes both fixed, variable and semi fixed manufacturing costs into account.

Budget preparation

Firstly, determine the principal budget factor. This is also known as the key budget factor or limiting budget factor and is the factor which will limit the activities of an undertaking. This limits output, e.g. sales, material or labour.

a) Sales budget: this involves a realistic sales forecast. This is prepared in units of each product and also in sales value. Methods of sales forecasting include:

- Sales force opinions

- Market research

- Statistical methods (correlation analysis and examination of trends)

- Mathematical models.

In using these techniques consider:

- company's pricing policy

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- general economic and political conditions

- changes in the population

- competition

- consumers' income and tastes

- advertising and other sales promotion techniques

- after sales service

- Credit terms offered.

b) Production budget: expressed in quantitative terms only and is geared to the sales budget. The production manager's duties include:

- Analysis of plant utilization

Work-in-progress budgets.

If requirements exceed capacity he may:

- subcontract

- plan for overtime

- introduce shift work

- hire or buy additional machinery

- The materials purchases budget's both quantitative and financial.

c) Raw materials and purchasing budget:

- The materials usage budget is in quantities.

- The materials purchases budget is both quantitative and financial.

Factors influencing a) and b) include:

- production requirements

- planning stock levels

- storage space

- trends of material prices.

d) Labour budget: is both quantitative and financial. This is influenced by:

- production requirements

- man-hours available

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- grades of labour required

- wage rates (union agreements)

- the need for incentives.

e) Cash budget: a cash plan for a defined period of time. It summarises monthly receipts and payments. Hence, it highlights monthly surpluses and deficits of actual cash. Its main uses are:

- to maintain control over a firm's cash requirements, e.g. stock and debtors

- to enable a firm to take precautionary measures and arrange in advance for investment and loan facilities whenever cash surpluses or deficits arises

- to show the feasibility of management's plans in cash terms

- to illustrate the financial impact of changes in management policy, e.g. change of credit terms offered to customers.

Receipts of cash may come from one of the following:

- cash sales

- - payments by debtors

- the sale of fixed assets

- the issue of new shares

- the receipt of interest and dividends from investments.

Payments of cash may be for one or more of the following:

- purchase of stocks

- payments of wages or other expenses

- purchase of capital items

- payment of interest, dividends or taxation.

Steps in preparing a cash budget

i) Step 1: set out a pro forma cash budget month by month. Below is a suggested layout.

Month 1 Month 2 Month 3

$ $ $

Cash receipts

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Receipts from debtors

Sales of capital items

Loans received

Proceeds from share issues

Any other cash receipts

Cash payments

Payments to creditors

Wages and salaries

Loan repayments

Capital expenditure

Taxation

Dividends

Any other cash expenditure

Receipts less payments

Opening cash balance b/f W X Y

Closing cash balance c/f X Y Z

ii) Step 2: sort out cash receipts from debtors

iii) Step 3: other income

iv) Step 4: sort out cash payments to suppliers

v) Step 5: establish other cash payments in the month

Figure 4.1 shows the composition of a master budget analysis.

Figure 4.1 Composition of a master budget

OPERATING BUDGET FINANCIAL BUDGET

consists of:- consists of

Budget P/L acc: get: Cash budget

Production budget Balance sheet

Materials budget Funds statement

Labour budget

Admin. budget

Stocks budget

f) Other budgets:

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These include budgets for:

- administration

- research and development

- selling and distribution expenses

- capital expenditures

- working capital (debtors and creditors).

The master budget (figure 4.1) illustrates this. Now attempt exercise 4.1.

Exercise 4.1 Budgeting I

Draw up a cash budget for D. Sithole showing the balance at the end of each month, from the following information provided by her for the six months ended 31 December 19X2.

a) Opening Cash $ 1,200.

19X2 19X3

Sales at $20 per unit MAR APR MAY JUN JUL AUG SEP OCT NOV DEC JAN FEB

260 200 320 290 400 300 350 400 390 400 260 250

Cash is received for sales after 3 months following the sales.

c) Production in units: 240 270 300 320 350 370 380 340 310 260 250

d) Raw materials cost $5/unit. Of this 80% is paid in the month of production and 20% after production.

e) Direct labour costs of $8/unit are payable in the month of production.

f) Variable expenses are $2/unit. Of this 50% is paid in the same month as production and 50% in the month following production.

g) Fixed expenses are $400/month payable each month.

h) Machinery costing $2,000 to be paid for in October 19X2.

i) Will receive a legacy of $ 2,500 in December 19X2.

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j) Drawings to be $300/month.

An example

A sugar cane farm in the Lowveld district may devise an operating budget as follows:

- Cultivation

- Irrigation

- Field maintenance

- Harvesting

- Transportation.

With each operation, there will be costs for labour, materials and machinery usage. Therefore, for e.g. harvesting, these may include four resources, namely:

- Labour: -cutting

-sundry

- Tractors

- Cane trailers

- Implements and sundries.

Having identified cost centres, the next step will be to make a quantitative calculation of the resources to be used, and to further break this down to shorter periods, say, one month or three months. The length of period chosen is important in that the shorter it is, the greater the control that can be exercised by the budget but the greater the expense in preparation of the budget and reporting of any variances.

The quantitative budget for harvesting may be calculated as shown in figure 4.2.

Figure 4.2 Quantitative harvesting budget

Harvesting 1st quarter 2nd quarter 3rd quarter 4th quarter

Labour

Cutting nil 9,000 tonnes 16,000 tonnes 10,000 tonnes

Sundry nil 300 man days 450 man days 450 man days

Tractors nil 630 hours 1,100 hours 700 hours

Cane trailers nil 9,000 tonnes 16,000 tonnes 10,000 tonnes

Imp, & sundries nil 9,000 tonnes 16,000 tonnes 10,000 tonnes

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Each item is measured in different quantitative units - tonnes of cane, man days etc.-and depends on individual judgement of which is the best unit to use.

Once the budget in quantitative terms has been prepared, unit costs can then be allocated to the individual items to arrive at a budget for harvesting in financial terms as shown in table 4.2.

Charge out costs

In table 4.2 tractors have a unit cost of $7.50 per hour - machines like tractors have a whole range of costs like fuel and oil, repairs and maintenance, driver, licence, road tax and insurance and depreciation. Some of the costs are fixed, e.g. depreciation and insurance, whereas some vary directly with use of the tractor, e.g. fuel and oil. Other costs such as repairs are unpredictable and may be very high or low - an estimated figure based on past experience.

Figure 4.3 Harvesting cost budget

Item harvesting Unit cost 1st quarter 2nd quarter 3rd quarter 4th quarter Total

Labour

Cutting $0.75 per tonne - 6,750 12,000 7,500 26,250

Sundry $2.50 per day - 750 1,125 1,125 3,000

Tractors $7.50 per hour - 4,725 8,250 5,250 18,225

Cane Trailers $0.15 per tonne - 1,350 2,400 1,500 5,250

Imp. & sundries $0.25 per tonne - 2,250 4,000 2,500 8,750

- $15,825 $27,775 $17,875 $61,475

So, overall operating cost of the tractor for the year may be budgeted as shown in figure 4.4.

If the tractor is used for more than 1,000 hours then there will be an over-recovery on its operational costs and if used for less than 1,000 hours there will be under-recovery, i.e. in the first instance making an internal 'profit' and in the second a 'loss'.

Figure 4.4 Tractor costs

Unit rate Cost per annum (1,000 hours)

($) ($)

Fixed costs Depreciation 2,000.00 2,000.00

Licence and insurance 200.00 200.00

Driver 100.00 per month 1,200.00

Repairs 600.00 per annum 600.00

Variable costs Fuel and oil 2.00 per hour 2,000.00

Maintenance 3.00 per 200 hours 1,500.00

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7,500.00

No. of hours used 1,000.00

Cost per hour 7.50

Master budget

The master budget for the sugar cane farm may be as shown in figure 4.5. The budget represents an overall objective for the farm for the whole year ahead, expressed in financial terms.

Table 4.5 Operating budget for sugar cane farm 19X4

1st quarter 2nd quarter 3rd quarter 4th quarter Total $

Revenue from cane 130,000 250,000 120,000 500,000

Less: Costs

Cultivation 37,261 48,268 42,368 55,416 183,313

Irrigation 7,278 15,297 18,473 11,329 52,377

Field maintenance 4,826 12,923 15,991 7,262 41,002

Harvesting - 15,825 27,775 17,875 61,475

Transportation - 14,100 24,750 15,750 54,600

49,365 106,413 129,357 107,632 392,767

Add: Opening valuation 85,800 135,165 112,240 94,260 85,800

135,165 241,578 241,597 201,892 478,567

Less: Closing valuation 135,165 112,240 94,260 90,290 90,290

Net crop cost - 129,338 147,337 111,602 388,277

Gross surplus - 66,200 102,663 8,398 111,723

Less: Overheads 5,876 7,361 7,486 5,321 26,044

Net profitless) (5,876) (6,699) 95,177 3,077 85,679

Once the operating budget has been prepared, two further budgets can be done, namely:

i. Balance sheet at the end of the year. ii. Cash flow budget which shows the amount of cash necessary to support the operating budget. It is of great importance that the business has sufficient funds to support the planned operational budget. Reporting back

During the year the management accountant will prepare statements, as quickly as possible after each operating period, in our example, each quarter, setting out the actual operating costs

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against the budgeted costs. This statement will calculate the difference between the 'budgeted' and the 'actual' cost, which is called the 'variance'.

There are many ways in which management accounts can be prepared. To continue with our example of harvesting on the sugar cane farm, management accounts at the end of the third quarter can be presented as shown in figure 4.6. Figure 4.6 Management accounts - actual costs against budget costs Management accounts for sugar cane farm 3rd quarter 19X4

Item Harvesting

3rd quarter Year to date

Actual Budget Variance Actual Budget Variance

Labour

- Cutting 12,200 12,000 (200) 19,060 18,750 (310)

- Sundry 742 1,125 383 1,584 1,875 291

Tractors 9,375 8,250 (1,125) 13,500 12,975 (525)

Cane trailers 1,678 2,400 722 2,505 3,750 1,245

Imp & sundries 4,270 4,000 (270) 6,513 6,250 (263)

28,265 27,775 (490) 43,162 43,600 438

Here, actual harvesting costs for the 3rd quarter are $28,265 against a budget of $27,775 indicating an increase of $490 whilst the cumulative figure for the year to date shows an overall saving of $438. It appears that actual costs are less than budgeted costs, so the harvesting operations are proceeding within the budget set and satisfactory. However, a further look may reveal that this may not be the case. The budget was based on a cane tonnage cut of 16,000 tonnes in the 3rd quarter and a cumulative tonnage of 25,000. If these tonnages have been achieved then the statement will be satisfactory. If the actual production was much higher than budgeted then these costs represent a very considerable saving, even though only a marginal saving is shown by the variance. Similarly, if the actual tonnage was significantly less than budgeted, then what is indicated as a marginal saving in the variance may, in fact, be a considerable overspending.

7.3. Production quantity and cost budget

Production Budget Production budget is usually prepared on the basis of sales budget. But it also takes into account the stock levels desired to be maintained. The estimated output of business firm during a budget period will be forecast in production budget. The production budget determines the level of activity of the produce business and facilities planning of production so as to maximum efficiency. The production budget is prepared by the chief executives of the production department. While

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preparing the production budget, the factors like estimated sales, availability of raw materials, plant capacity, availability of labour, budgeted stock requirements etc. are carefully considered. Cost of Production Budget After Preparation of production budget, this budget is prepared. Production Cost Budgets show the cost of the production determined in the production budget. Cost of Production Budget is grouped in to Material Cost Budget, Labour Cost Budget and Overhead Cost Budget. Because it breaks up the cost of each product into three main elements material, labour and overheads. Overheads may be further subdivided in to fixed, variable and semi-fixed overheads. Therefore separate budgets required for each item. Price and quantity variances Just to state that there is a variance on a particular item of expenditure does not really mean a lot. Most costs are composed of two elements - the quantity used and the price per unit. A variance between the actual cost of an item and its budgeted cost may be due to one or both of these factors. Apparent similarity between budgeted and actual costs may hide significant compensating variances between price and usage. For example, say it is budgeted to take 300 man days at $3.00 per man day - giving a total budgeted cost of $900.00. The actual cost on completion was $875.00, showing a saving of $25.00. Further investigations may reveal that the job took 250 man days at a daily rate of $3.50 - a favourable usage variance but a very unfavourable price variance. Management may therefore need to investigate some significant variances revealed by further analysis, which a comparison of the total costs would not have revealed. Price and usage variances for major items of expense are discussed below. Labour

The difference between actual labour costs and budgeted or standard labour costs is known as direct wages variance. This variance may arise due to a difference in the amount of labour used or the price per unit of labour, i.e. the wage rate. The direct wages variance can be split into:

i) Wage rate variance: the wage rate was higher or lower than budgeted, e.g. using more unskilled labour, or working overtime at a higher rate. ii) Labour efficiency variance: arises when the actual time spent on a particular job is higher or lower than the standard labour hours specified, e.g. breakdown of a machine. Materials

The variance for materials cost could also be split into price and usage elements:

i) Material price variance: arises when the actual unit price is greater or lower than budgeted. Could be due to inflation, discounts, alternative suppliers etc. ii) Material quantity variance: arises when the actual amount of material used is greater or lower than the amount specified in the budget, e.g. a budgeted fertiliser at 350 kg per hectare may be increased or decreased when the actual fertiliser is applied, giving rise to a usage variance.

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Overheads

Again, overhead variance can be split into:

i) Overhead volume variance: where overheads are taken into the cost centres, a production higher or lower than budgeted will cause an over-or under-absorption of overheads. ii) Overhead expenditure variance: where the actual overhead expenditure is higher or lower than that budgeted for the level of output actually produced. Calculation of price and usage variances The price and usage variance are calculated as follows: Price variance = (budgeted price - actual price) X actual quantity Usage variance = (budgeted quantity - actual quantity) X budgeted price

Now attempt exercise 4.2. Exercise 4.2 Computation of labour variances

It was budgeted that it would take 200 man days at $10.00 per day to complete the task costing $2,000.00 when the actual cost was $1,875.00, being 150 man days at $12.50 per day. Calculate:

i) Price variance

ii) Usage variance

Comment briefly on the results of your calculation. Management action and cost control Producing information in management accounting form is expensive in terms of the time and effort involved. It will be very wasteful if the information once produced is not put into effective use. There are five parts to an effective cost control system. These are: a) preparation of budgets

b) communicating and agreeing budgets with all concerned

c) having an accounting system that will record all actual costs

d) preparing statements that will compare actual costs with budgets, showing any variances and disclosing the reasons for them, and

e) taking any appropriate action based on the analysis of the variances in d) above.

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Action(s) that can be taken when a significant variance has been revealed will depend on the nature of the variance itself. Some variances can be identified to a specific department and it is within that department's control to take corrective action. Other variances might prove to be much more difficult, and sometimes impossible, to control. Variances revealed are historic. They show what happened last month or last quarter and no amount of analysis and discussion can alter that. However, they can be used to influence managerial action in future periods. Zero base budgeting (ZBB) After a budgeting system has been in operation for some time, there is a tendency for next year's budget to be justified by reference to the actual levels being achieved at present. In fact this is part of the financial analysis discussed so far, but the proper analysis process takes into account all the changes which should affect the future activities of the company. Even using such an analytical base, some businesses find that historical comparisons, and particularly the current level of constraints on resources, can inhibit really innovative changes in budgets. This can cause a severe handicap for the business because the budget should be the first year of the long range plan. Thus, if changes are not started in the budget period, it will be difficult for the business to make the progress necessary to achieve longer term objectives. One way of breaking out of this cyclical budgeting problem is to go back to basics and develop the budget from an assumption of no existing resources (that is, a zero base). This means all resources will have to be justified and the chosen way of achieving any specified objectives will have to be compared with the alternatives. For example, in the sales area, the current existing field sales force will be ignored, and the optimum way of achieving the sales objectives in that particular market for the particular goods or services should be developed. This might not include any field sales force, or a different-sized team, and the company then has to plan how to implement this new strategy. The obvious problem of this zero-base budgeting process is the massive amount of managerial time needed to carry out the exercise. Hence, some companies carry out the full process every five years, but in that year the business can almost grind to a halt. Thus, an alternative way is to look in depth at one area of the business each year on a rolling basis, so that each sector does a zero base budget every five years or so.

7.4. Raw Materials quantity and Cost Budget

The different level of material stock are based on planned out. Once the production budget is prepared, it is necessary to consider the requirement of materials to carry out the production activities. Material cost Budget is concerned with purchase and requirement of direct materials to be made during the budget period. While preparing the materials purchase budget, the following factors to be considered carefully:

a. Estimated sales and production.

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b. Requirement of materials during budget period. c. Expected changes in the prices of raw materials. d. Different stock levels e. Availability of raw materials, i.e., seasonal or otherwise. f. Availability of financial resources. g. Price trend in the market. h. Company's stock policy etc

7.5. Flexible budget and Cash Budget. (Receipts and Payments Method A flexible budget is defined as “a budget which, by recognizing the difference between fixed, semi variable and variable costs is designed to change in relation to the level of activity attained”. A fixed budget, on the other hand is a budget which is designed to remain unchanged irrespective of the level of activity actually attained. In a fixed budgetary control, budgets are prepared for one level of activity whereas in a flexible budgetary control system, a series of budgets are prepared one for each of a number of alternative production levels or volumes. Flexible budgets represent the amount of expenses that is reasonably necessary to achieve each level of output specified. In other words, the allowances given under flexible budgetary control system serve as standards of what costs should be at each level of output. Cash Budget This budget represent the anticipated receipts and payment of cash during the budget period. The cash budget also called as Functional Budget. Cash budget is the most important of all the functional budget because, cash is required for the purpose to meeting its current cash obligations. If at any time, a concern fails to meet its obligations, it will be technically insolvent. Therefore, this budget is prepared on the basis of detailed cash receipts and cash payments. The estimated Cash Receipts include:

a. Cash Sales b. Credit Sales c. Collection from Sundry Debtors d. Bills Receivable e. Interest Received f. Income from Sale of Investment g. Commission Received

h. Dividend Received

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SUMMARY NOTES AND EXAMPLES ON THIS CHAPTER: PROFIT PLANNING (BUDGETING)

A. Purposes and overview of budgeting. B. Building a master budget.

1. Sales budget

2. Production budget

3. Direct materials budget

4. Direct labor budget

5. Manufacturing overhead budget

6. Ending finished goods inventory budget

7. Selling and administrative expenses budget

8. Cash budget

9. Budgeted income statement

10. Budgeted balance sheet OVERVIEW OF BUDGETING A budget is a detailed plan for acquiring and using financial and other resources over a specified period. Budgeting involves two stages:

• Planning: Developing objectives and preparing various detailed budgets to achieve those objectives.

• Control: The steps taken by management to attain the objectives set down at the planning stage.

PURPOSES OF BUDGETING

• Budgets communicate management’s plans throughout the organization. • Budgeting forces managers to give planning top priority.

• Budgets provide a means of allocating resources to their most effective uses.

• Budgeting uncovers potential bottlenecks.

• Budgeting coordinates the activities of the entire organization.

• Budgeting provides goals that serve as benchmarks for evaluating subsequent performance.

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MASTER BUDGET INTERRELATIONSHIPS

COMPREHENSIVE BUDGETING EXAMPLE Royal Company is preparing budgets for the second quarter ending June 30.

• Budgeted sales of the company’s only product for the next five months are:

April ............ 20,000 units May ............. 50,000 units June ............. 30,000 units July .............. 25,000 units August ......... 15,000 units

• The selling price is $10 per unit.

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• The following elements of the master budget will be prepared in this example:

1. Sales budget (with a schedule of expected cash collections).

2. Production budget.

3. Direct materials budget (with a schedule of expected cash disbursements for materials).

4. Direct labor budget.

5. Manufacturing overhead budget.

6. Ending finished goods inventory budget.

7. Selling and administrative expense budget.

8. Cash budget.

9. Budgeted income statement.

10. Budgeted balance sheet. SALES BUDGET April May June Quarter Budgeted sales (units) ................... 20,000 50,000 30,000 100,000 Selling price per unit ..................... × $10 × $10 × $10 × $10 Total sales ....................................... $200,000 $500,000 $300,000 $1,000,000

SCHEDULE OF EXPECTED CASH COLLECTIONS Additional data: • All sales are on account.

• The company collects 70% of these credit sales in the month of the sale; 25% are collected in the month following sale; and the remaining 5% are uncollectible.

• The accounts receivable balance on March 31 was $30,000. All of this balance was collectible.

April May June Quarter Accounts receivable beginning

balance ............................................. $ 30,000 $ 30,000 April sales

70% × $200,000 .......................... 140,000 140,000 25% × $200,000 .......................... $ 50,000 50,000

May sales 70% × $500,000 .......................... 350,000 350,000 25% × $500,000 .......................... $125,000 125,000

June sales 70% × $300,000 .......................... 210,000 210,000

Total cash collections .......................... $170,000 $400,000 $335,000 $905,000

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PRODUCTION BUDGET Additional data:

• The company desires to have inventory on hand at the end of each month equal to 20% of the following month’s budgeted unit sales.

• On March 31, 4,000 units were on hand.

April May June July Budgeted sales [TM 9-4] ........................... 20,000 50,000 30,000 25,000 Add desired ending inventory .................. 10,000 6,000 5,000 3,000* Total needs ................................................... 30,000 56,000 35,000 28,000 Less beginning inventory ............................ 4,000 10,000 6,000 5,000 Required production ................................... 26,000 46,000 29,000 23,000

* Budgeted sales in August = 15,000 units.

Desired ending inventory in July = 15,000 units × 20% = 3,000 units. DIRECT MATERIALS BUDGET

Additional data:

• 5 pounds of material are required per unit of product.

• Management desires to have materials on hand at the end of each month equal to 10% of the following month’s production needs.

• The beginning materials inventory was 13,000 pounds.

• The material costs $0.40 per pound.

April May June Quarter Required production in units

[TM 9-6] ....................................................... 26,000 46,000 29,000 101,000 Raw materials per unit (pounds) .................. × 5 × 5 × 5 × 5 Production needs (pounds) ............................ 130,000 230,000 145,000 505,000 Add desired ending inventory (pounds)* ... 23,000 14,500 11,500 11,500 Total needs (pounds) ...................................... 153,000 244,500 156,500 516,500 Less beginning inventory (pounds) ............... 13,000 23,000 14,500 13,000 Raw materials to be purchased (pounds) .. 140,000 221,500 142,000 503,500 Cost of raw materials to be purchased at

$0.40 per pound ........................................ $56,000 $88,600 $56,800 $201,400 * For June: 23,000 units produced in July [TM 9-6] × 5 pounds per unit = 115,000 pounds;

115,000 pounds × 10% = 11,500 pounds

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SCHEDULE OF EXPECTED CASH DISBURSEMENTS FOR MATERIAL Additional data: • Half of a month’s purchases are paid for in the month of purchase; the other half is paid for in

the following month.

• No discounts are given for early payment.

• The accounts payable balance on March 31 was $12,000.

April May June Quarter Accounts payable beginning

balance ................................................ $12,000 $ 12,000 April purchases:

50% × $56,000 ................................. 28,000 28,000 50% × $56,000 ................................. $28,000 28,000

May purchases: 50% × $88,600 ................................. 44,300 44,300 50% × $88,600 ................................. $44,300 44,300

June purchases: 50% × $56,800 ................................. 28,400 28,400

Total cash disbursements for materials .............................................. $40,000 $72,300 $72,700 $185,000

DIRECT LABOR BUDGET Additional data: • Each unit produced requires 0.05 hour of direct labor.

• Each hour of direct labor costs the company $10.

• Management fully adjusts the workforce to the workload each month.

April May June Quarter Required production

[TM 9-6] ............................................ 26,000 46,000 29,000 101,000 Direct labor-hours per unit ................. × 0.05 × 0.05 × 0.05 × 0.05 Total direct labor–hours needed ...... 1,300 2,300 1,450 5,050 Direct labor cost per hour .................. × $10 × $10 × $10 × $10 Total direct labor cost ......................... $13,000 $23,000 $14,500 $50,500 Note: Many companies do not fully adjust their direct labor workforce every month and in such companies direct labor behaves more like a fixed cost, with additional cost if overtime is necessary.

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MANUFACTURING OVERHEAD BUDGET

Additional data:

• Variable manufacturing overhead is $20 per direct labor-hour.

• Fixed manufacturing overhead is $50,500 per month. This includes $20,500 in depreciation, which is not a cash outflow.

April May June Quarter Budgeted direct labor-hours [TM 9-9] ..... 1,300 2,300 1,450 5,050 Variable manufacturing overhead rate .. × $20 × $20 × $20 × $20 Variable manufacturing overhead ........... $26,000 $46,000 $29,000 $101,000 Fixed manufacturing overhead ................. 50,500 50,500 50,500 151,500 Total manufacturing overhead .................. 76,500 96,500 79,500 252,500 Less depreciation ......................................... 20,500 20,500 20,500 61,500 Cash disbursements for manufacturing

overhead ................................................... $56,000 $76,000 $59,000 $191,000

ENDING FINISHED GOODS INVENTORY BUDGET Additional data: • Royal Company uses absorption costing in its budgeted income statement and balance sheet.

• Manufacturing overhead is applied to units of product on the basis of direct labor-hours.

• The company has no work in process inventories. Computation of absorption unit product cost:

Quantity Cost Total Direct materials .............................. 5 pounds $0.40 per pound $2.00 Direct labor ..................................... 0.05 hours $10.00 per hour 0.50 Manufacturing overhead .............. 0.05 hours $50.00 per hour* 2.50 Unit product cost ............................ $5.00

* Total manufacturing overheadPredetermined =

overhead rate Total direct labor hours

$252,500= = $50.00 per hour

5,050 hours

Budgeted ending finished goods inventory:

Ending finished goods inventory in units [TM 9-6] ............................... 5,000 Unit product cost [see above] .................................................................. × $5 Ending finished goods inventory in dollars ........................................... $25,000

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SELLING AND ADMINISTRATIVE EXPENSE BUDGET Additional data: • Variable selling and administrative expenses are $0.50 per unit sold.

• Fixed selling and administrative expenses are $70,000 per month and include $10,000 in depreciation.

April May June Quarter Budgeted sales in units

[TM 9-4] ............................................... 20,000 50,000 30,000 100,000 Variable selling and administrative

expense per unit ................................................. × $0.50 × $0.50 × $0.50 × $0.50

Variable selling and administrative expense ................................................ $10,000 $25,000 $15,000 $ 50,000

Fixed selling and administrative expense ................................................ 70,000 70,000 70,000 210,000

Total selling and administrative expense ................................................ 80,000 95,000 85,000 260,000

Less depreciation .................................... 10,000 10,000 10,000 30,000 Cash disbursements for selling and

administrative expenses .................... $70,000 $85,000 $75,000 $230,000 CASH BUDGET

Additional data:

1. A line of credit is available at a local bank that allows the company to borrow up to $75,000.

a. All borrowing occurs at the beginning of the month, and all repayments occur at the end of the month.

b. The interest rate is 1% per month.

c. The company does not have to make any payments until the end of the quarter.

2. Royal Company desires a cash balance of at least $30,000 at the end of each month. The cash balance at the beginning of April was $40,000.

3. Cash dividends of $51,000 are to be paid to stockholders in April.

4. Equipment purchases of $143,700 are scheduled for May and $48,800 for June. This equipment will be installed and tested during the second quarter and will not become operational until July, when depreciation charges will commence.

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CASH BUDGET Royal Company Cash Budget For the Quarter Ending June 30 April May June Quarter Cash balance, beginning......................... $ 40,000 $ 30,000 $ 30,000 $ 40,000 Add receipts:

Cash collections [TM 9-5] .................... 170,000 400,000 335,000 905,000 Total cash available................................. 210,000 430,000 365,000 945,000 Less disbursements:

Direct materials [TM 9-8] .................... 40,000 72,300 72,700 185,000 Direct labor [TM 9-9] .......................... 13,000 23,000 14,500 50,500 Manufacturing overhead

[TM 9-10] ........................................... 56,000 76,000 59,000 191,000 Selling & administrative

[TM 9-12] ........................................... 70,000 85,000 75,000 230,000 Equipment purchases ............................ 0 143,700 48,800 192,500 Dividends ............................................... 51,000 0 0 51,000

Total disbursements .................................. 230,000 400,000 270,000 900,000 Excess (deficiency) of cash available

over disbursements ............................... (20,000) 30,000 95,000 45,000 Financing:

Borrowings ............................................. 50,000 0 0 50,000 Repayments ........................................... 0 0 (50,000) (50,000) Interest* .................................................. 0 0 ( 2,000) ( 2,000)

Total financing ........................................... 50,000 0 (52,000) ( 2,000) Cash balance, ending .............................. $ 30,000 $ 30,000 $ 43,000 $ 43,000 * $50,000 × 1% × 3 = $2,000. BUDGETED INCOME STATEMENT

Royal Company Budgeted Income Statement For the Quarter Ending June 30 Net sales [see below] ................................................................................ $950,000 Cost of goods sold [see below] ............................................................... 500,000 Gross margin .............................................................................................. 450,000 Selling & administrative expenses [TM 9-12] ...................................... 260,000

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Net operating income ............................................................................... 190,000 Interest expense [TM 9-14] ...................................................................... 2,000 Net income .................................................................................................. $188,000

Computation of net sales:

Sales ............................................................................ $1,000,000 Less uncollectible amounts (5%) .............................. 50,000 Net sales ..................................................................... $ 950,000

Computation of cost of goods sold:

Budgeted sales (units) ............................................... 100,000 Unit product cost ........................................................ × $5 Cost of goods sold ..................................................... $500,000

BEGINNING BALANCE SHEET Royal Company Balance Sheet March 31 Current assets:

Cash .............................................................................. $ 40,000 (a) Accounts receivable .................................................... 30,000 (b) Raw materials inventory ............................................ 5,200 (c) Finished goods inventory ........................................... 20,000 (d) $ 95,200

Plant and equipment: Land .............................................................................. 400,000 (e) Buildings and equipment ........................................... 1,610,000 (f) Accumulated depreciation ........................................ (750,000) (g) 1,260,000

Total assets ...................................................................... $1,355,200 Liabilities:

Accounts payable ....................................................... $ 12,000 (h) Stockholders’ equity:

Common stock .............................................................. $ 200,000 (i) Retained earnings ....................................................... 1,143,200 (j) 1,343,200

Total liabilities and stockholders’ equity .................... $1,355,200

(a) See TM 9-13 (f) Given (b) See TM 9-5 (g) Given (c) Given (h) See TM 9-8 (d) Given (i) Given

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(e) Given (j) Given

BUDGETED BALANCE SHEET Royal Company Budgeted Balance Sheet June 30 Current assets:

Cash .............................................................................. $ 43,000 (a) Accounts receivable .................................................... 75,000 (b) Raw materials inventory ............................................ 4,600 (c) Finished goods inventory ........................................... 25,000 (d) $ 147,600

Plant and equipment: Land .............................................................................. 400,000 (e) Buildings and equipment ........................................... 1,802,500 (f) Accumulated depreciation ........................................ (841,500) (g) 1,361,000

Total assets ...................................................................... $1,508,600 Liabilities:

Accounts payable ....................................................... $ 28,400 (h) Stockholders’ equity:

Common stock .............................................................. $ 200,000 (i) Retained earnings ....................................................... 1,280,200 (j) 1,480,200

Total liabilities and stockholders’ equity .................... $1,508,600

(a) See TM 9-14 (f) $1,610,000+ $143,700+ $48,800 (b) $300,000 sales × 25% (g) $750,000 + $61,500 + $30,000 (c) 11,500 pounds × $0.40 per

pound (h) $56,800 purchases × 50%

(d) See TM 9-11 (i) See TM 9-16 (e) See TM 9-16 (j) $1,143,200 + $188,000 – $51,000