The Components of Financial Management - Coursework Example

? PART A Section I Net Present Value (NPV) is defined as the present value of cash flows less the initial outflow. When making decisions on the viability of a project using NPV, the project is accepted whenever the NPV is positive and rejected when NPV is negative. A finance manager should be indifferent to projects with a zero NPV and use other methods to help in the decision making concerning that project. (Horngren, Foster, and Datar, 2001) The NPV for the project that Peng intends to venture into can be calculated as follows. Year Cash flow Discount factor Present value 0 (? 2m) 1 (? 2m) 1 (? 1.5m) 0.909 (? 1.3635m) 2 ? 1.0m 0.826 ? 0.826m 3 ? 1.3m 0.751 ? 0.9763m 4 ? 1.8m 0.683 ? 1.2294m 5 ? 1.3m 0.621 ? 0.8073m 6 ? 0.6m 0.564 ? 0.3384m ? 0.8139m The NPV of the project is ? 0.8139m. This is a positive amount and therefore is an indicator that the project can be carried on. Section II Associated risks of the project The risk associated with a project may be defined as the variability that is likely to occur in the future returns from the project. Risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty and consequently, cannot make any correct prediction about the cash flow sequence. In the context of capital budgeting projects, risk results almost entirely from the uncertainty about future cash inflows, because the initial cash outflow is generally known. These risks result from a variety of factors including uncertainty about future revenues, expenditures and taxes. Therefore, to assess the risk of a potential project, the analyst needs to evaluate the riskiness of the cash inflows. There are three possible attitudes towards risk that can be identified. These are: (a) Risk aversion (b) Desire for risk (c) Indifference to risk A risk averter is an individual who prefers less risky investment. The basic assumption in financial theory is that most investors and managers are risk averse. Risk seekers on the other hand are individuals who prefer risk. Given a choice between more and less risky investments with identical expected monetary returns, they would prefer the riskier investment. The person who is indifferent to risk would not care which investment he or she received. There are various risks involved in the project that have different degrees of consequences. Such risks may be categorized into technical risks, environmental risks, economic risks, political risks and project completion risks. (Horngren, Foster, & Datar, 2001) The risks that any project is predisposed can be avoidable or unavoidable and therefore a firm has to minimize the risks that face the projects it undertakes as much as possible. The project that is intended to be carried out can face the risk of errors in estimation. Such errors could disrupt the schedule of the whole project as a whole if the business and development teams do not work closely to curb such cases of errors. There is also the possibility that there can be a requirements overload whereby the requirements for the project are not well established and are therefore constantly being added later on during the development phases of the project. This disrupts the laid down schedule and delays the events of each step of the project. Lack of proper documentation of the project at the same time as the project progresses is also a risk that most projects face since critical information related to the project may be lost. PART B Section I Beck Bag Year Expected cash flows Accumulated cash flows 1 60,000 60,000 2 70,000 130,000 3 70,000 200,000 4 40,000 240,000 5 20,000 260,000 The project costs 200,000 and the amount is recouped in the third year, therefore the payback period is 3 years. Roo Bag Year Expected cash flows Accumulated cash flows 1 70,000 70,000 2 70,000 140,000 3 60,000 200,000 4 60,000 260,000 5 60,000 320,000 The project costs 260,000 and it takes 4 years to recoup this amount. Therefore the payback period is 4 years. Section II Accounting rate of return = Average Income x 100 (ARR) Average Investment Beck Bag, ARR = (60,000 + 70,000 + 70,000 + 40,000 + 20,000)/ 5 x 100 = 26% 200,000 Roo Bag, ARR = (70,000 + 70,000 + 60,000 + 60,000 + 60,000)/ 5 x 100 = 24.6% 260,000 Section III Drawbacks of using payback in investment appraisal: Does not take into account time value of money and assumes that a shilling received in the 1st year and in the Nth year have the same value so as to rank them together to ascertain the PBP which is unrealistic given that a shilling now is valuable than a shilling N years from now. PBP method does not measure the profitability of a venture but rather measures the period of time a venture takes to pay back the cost. The method is outside looking (lender oriented rather than owner oriented). (Kaplan & Atkinson, 2004) Section IV Drawbacks of using accounting rate of return in investment appraisal: It ignores time value of money. This method does not take into account the present value of money neither its future value, therefore leading to an incorrect decision being made since the time value of money was not considered. It does not consider how soon the investment should recover the cost (it is owner looking than creditor oriented approach). It uses accounting profits instead of cash inflows some of which may not be realizable. The accounting rate of return uses the net profit obtained from financial statements rather than the cash inflows or outflows that the company underwent during a given financial period. (Kaplan & Atkinson, 2004) Section V When using net present value, costs such as market research incurred before a product decision is made are ignored in investment appraisal calculations. Why is this? This is because NPV ignores implicit costs even though in its calculation the cost of finance is used which considers both implicit and explicit costs. Implicit costs are incurred regardless of the project therefore they do not affect the decision that is expected to be made on the viability of the project. Therefore, implicit costs are irrelevant costs since they do not have a basis on the decision to be made hence the reason why they are ignored in investment appraisal calculations. PART C Section I Various Types of Costs There are various types of costs that can be classified according to cost behavior. Cost behavior refers to the change in costs (increase or decrease) as the output level changes, i.e. as we increase output, are the costs rising, dropping or remaining the same. 1) Variable costs These are costs that increase or decrease proportionately with the level of activity, i.e. that portion of the cost of an activity that change with the level of output. With variable costs, the cost level is zero when production is zero. The cost increases in proportion to the increase in the activity level, thus a variable cost function is represented by a straight line from the origin and the gradient of the function indicates the variable cost per unit. (Brealey & Myers, 2008) 2) Semi variable costs These are costs with both a fixed and variable cost component. The fixed component is that portion which is constant irrespective of the level of activity. They are variable within certain activity levels but are fixed within other activity levels. (Van Horne & Wachowizc, 2008) 3) Fixed Costs These are costs that do not change with of the level of output. It is also called autonomous cost, as it remains the same irrespective of the activity level. The classification of cost into fixed and variable costs would only hold within a relevant range beyond which all costs are variable. The relevant range is the activity limits within which the cost behavior can be predicted. (Van Horne & Wachowizc, 2008) 4) Semi Fixed Costs These are costs with both a fixed and variable cost component. The fixed component is that portion which is constant irrespective of the level of activity. They are variable within certain activity levels but are fixed within other activity levels. (Van Horne & Wachowizc, 2008) Importance of cost classification Analysis of cost behavior is important to all organizations for effective management. This is because many organizations have a unique cost structure. For example, fixed costs account for 60 – 80% of all hospital costs. However, unlike many organizations of this type, labor costs largely comprise the hospital’s fixed costs. (Drury, 2008) Labor costs unlike depreciation require a cash outflow. This is characteristic of labor intensive organizations. Capital-intensive organizations, on the other hand, have low labor costs, e.g. computerized manufacturing organizations. Some organizations e.g. hospitals allocate 10 –15% of their space for standby emergency events giving them built in idle capacity. This prevents them from enjoying advantages of higher profits that a capital-intensive organization realizes at higher volumes beyond the break-even volume. Thus the cost structure of healthcare institutions presents challenges to accountants because of their labor intensive and capital-intensive characteristics. Section II Reason why classification of costs is not always appropriate Such classification of costs does not provide all the necessary data concerning cost. It is therefore paramount for organizations to implement an adequate cost system whereby the bulk of cost planning and control data can be provided. This is important so that supervisors, executives and department heads can be held accountable to the respective costs in which they are responsible for. Rather than use such classifications of costs, it is fundamental that a cost system be tailored to the structure of an organization in order to suit its needs. PART D Section 1 Product 1 2 3 Labour cost per unit 56 48 40 Labour hours per unit 7 6 5 Demand 10,000 8,000 6,000 Labour hours required 70,000 48,000 30,000 Selling price 350 240 220 Material cost per unit (98) (72) (60) Labour cost per unit (56) (48) (40) Contribution per unit 196 120 120 Contribution per hour 28 20 24 Product rank 1 3 2 Labour hours utilized 70,000 6,000 30,000 Units to produce 10,000 1,000 6,000 Section II Profit Statement Product 1 2 3 Total Units to produce 10,000 1,000 6,000 Contribution earned 1,960,000 120,000 720,000 2,800,000 Less fixed cost 800,000 Net Profit 2,000,000 Section III The D&P Two should be subcontracted since it is ranked least given the limited number of labour hours which stands at 106,000 labour hours. The contribution per hour for this product is 20 which is the least amongst all products. Therefore this product should not be produced but rather subcontracted to another who would issue the product at a lower cost than our company would make it for. The contribution per unit for D&P Two if subcontracted will be equal to ?240 - ?170 = ?70. If the annual demand for this product is 8,000 units per annum then the contribution earned for this product will be ?70 * 8,000 = ?560,000. This is more compared to only 1,000 units that the company can be able to produce given its production capacity hence increasing the profits of the company. The contribution earned by the company when it produces this product is ?120,000. The profits of the company will therefore rise by ?560,000 - ?120,000 = ?440,000 PART E Section I Break even occurs when a company’s total costs are equal to its total revenue. Separating the semi variable costs into fixed and variable components: Y = a + bx b = 8,500 – 6,000 = 93 84 -57 8,500 = a + (93 * 84) a = 8,500 – 7,812 = 688 Therefore, for the semi-variable costs the variable cost per unit is ? 93 and the fixed cost is ? 688. Total costs per week = 2,000 + 750 + 900 + 600 + (100 * N) + 688 + (93 * N) Total revenue = 218 * N Where N is the number of guests per week At break even, 2,000 + 750 + 900 + 600 + (100 * N) + 688 + (93 * N) = 218 * N 4,938 + 193N = 218N 25N = 4,938 N = 198 guests per week Section II Occupancy level of 40% Total revenue = 218 * 40% * 150 = 13,080 Total costs = 4,938 + (193 * 40% * 150) = 16,518 Weekly loss 3,438 Occupancy level of 70% Total revenue = 218 * 70% * 150 = 22,890 Total costs = 4,938 + (193 * 70% * 150) = 25,203 Weekly loss 2,313 Occupancy level of 90% Total revenue = 218 * 90% * 150 = 29,430 Total costs = 4,938 + (193 * 90% * 150) = 30,993 Weekly loss 1,563 Section III To: The Board of Global Oil Inc. From: Lin Subject: Importance of the Components of Financial Management Date: 5th January, 2013 Purpose The purpose of this memo is to address the components of financial management specifically outlining the importance of these components to our company. Discussion Financial management entails managing the finances of an enterprise or business with an aim of achieving the financial objectives of the organization. The key financial objectives for most businesses are creation of wealth for the firm, generating cash and providing a sufficient return on the organization’s investment taking into account the risks involved. (Brealey & Myers, 2008) Financial management involves three key elements: financial planning; financial control; and financial decision-making. Financial planning is the measure that the management of a business takes to ensure that adequate funding is available at the appropriate time to meet the firm’s needs. Funding may be of essence in acquiring equipment and inventory in the short term, as well as to remunerate employees and fund credit sales. (Lawrence & Addison-Wesley, 2003) Funds also have to be allocated to make the required additions to the organization’s productive capacity and to also make acquisitions in the medium term and long term. Financial control is necessary to an organization so as to ensure that the business is diligent in the fulfillment of its objectives. Financial control ensures that assets are efficiently utilized, the assets are also secure and that the management is acting in the best interests of the company’s shareholders as well as in line with the set business rules. (Drury, 2008) Financial decision making relates to financing, investment and dividends. The business’ investments must be adequately financed and alternatives of the various ways to finance such investments must be taken into consideration. (Lawrence & Addison-Wesley, 2003) The management of any organization is also faced with the critical financial decision of whether profits earned should be retained by the firm or distributed as dividends to the company’s shareholders. Conclusion As has been outlined, the components of financial management are crucial in the achievement of the financial objectives of any company. Therefore, for a business to be successful in its endeavors, it has to put in place adequate measures to ensure that these components are emphasized and implemented fully. References Brealey, R. & Myers,S. (2008). Principles of Corporate Finance, 6th Edition. Longman Drury C., (2008). Management and Cost Accounting, 7th Edition. Chapman and Hall. Horngren, C. T., Foster, G. and Datar S.M. (2001). Cost Accounting: A Managerial Emphasis, 10th Edition. Prentice Hall India; New Delhi. Kaplan R. & Atkinson A. (2004). Advanced Management Accounting, 2nd Edition. Prentice-Hall Lawrence J. Gitman & Addison-Wesley (2003). Principles of Managerial Finance, 11th Edition Van Horne, J. & Wachowizc, J.M. (2008). Fundamentals of Financial Management, 13th Edition. Prentice Hall Read More