Financial Management and Control - Assignment Example

Finаnсiаl Маnаgеmеnt аnd Соntrоl Name Lecturer Course Institution Finаnсiаl Маnаgеmеnt аnd Соntrоl Part A (a) Advice the management of Thomson Ltd Pay Back Period (PBP) The method measures the span of time necessary to recoupr the amount of money invested in a project. The PBP is determined by adding up the cash inflows from year one until the sum cash inflow is equal to the amount invested. Pay back period = Initial investment Annual cash flow income = 300,000 80,000 =3 years 9 months A PBP of less than 4 years indicates that the project will pay itself at the end of its lifespan. Therefore the project should be adopted. Net Present Value (NPV) This method is a discounted cash flow to capital budgeting whereby all expected future cash flows/incomes are discounted to their present values using a minimum desired. NPV is the excess of the present value of cash inflows generated by the project over the amount invested in the project, expressed by PV-I=NPV, where PV is the Present Value and I is the Investment Net present Value (NPV) = Annual cash inflows x Present value annuity factor PV = 80,000 x 3.1699 = 253,592 NPV = PV-I = 253,592 -300,000 = (46,408) The NPV is negative; hence the project should be rejected. Project is accepted if the PV of future cash flows exceeds the amount invested giving a positive net present value. Accounting Rate of Return (ARR) ARR measures the profitability of a project from the conventional accounting point of view. ARR is found by dividing the after tax profit/income by average investment. Average investment is equivalent to a half of the original investment. If depreciated constantly ARR is found by dividing the total of investment book value after depreciation by the life of the project. ARR = Average Income x 100 Average Investment Average Income = Total revenues expected + amount realized after disposal of asset = (80,000 x 4) + 60,000) = 380,000 Average Investment = 300,000 + (10/100 x 300,000) =330,000 ARR = 380,000 x 100 330,000 =115.15 % The results using this method indicate an average rate of return above 100%, therefore the project should be undertaken. Internal Rate of Return (IRR) IRR method takes into account the discount rate taking into account the adjustment in time at a discount rate of 15% Year PV factor Cash inflow PV of project 0 1.0000 (380,000) 380,000 1 0.8700 80,000 69,600 2 0.756 80,000 60,480 3 0.658 80,000 52,640 4 0.572 80,000 45,760 228,480 Discounted cash inflow = 228,480 + (60,000 x 0.572) = 268,800 Discounted Investment = 330,000 x 1.0000 = 330,000 IRR = Discounted average income Discounted average investment =268,800/330,000 x 100 =81.45% The results here indicate an internal rate of return of less than 100%; therefore the project should be rejected. (b) Critically comment on the results you obtained in (a) above referring to the pros and cons of each evaluation method. Despite the fact that the PBP handles investment risk effectively and costs less in terms of time and may not involve sophisticated techniques, it has the disadvantage of not recognizing the time value of money. The method does not take into account the interest rate of 10% regarding the cost of capital and the amounts to be realized after disposal. PBP also ignores cash flows arising after the PBP and any accountant knows that it is the cash flows after PBP which determines the profitability of an investment. A project should be accepted in this approach if its NPV is positive and rejected if it is negative. In case of ranking projects, the NPV method gives the highest ranking to a project with the highest Net present value. The method however fails to take into account the cash inflows realized from disposing the machine which is 20% of the initial cost of capital. Failure to do this leads to an inaccurate evaluation of the viability of the project since it may change the balance. ARR gives a rate that is slightly misleading as even though it takes consideration of book values it fails to consider the time factor which is essential due to inflationary factors. The management should adopt IRR as it gives a rate that takes into account the value of money with time as this follows the prudent concept of accounting which supposes that income should be understated while costs should be overstated. Part B (a) For the year just ended, prepare the income statement, calculate the breakeven quantity and value, and determine the units and the value of the safety margin. Income Statement of El-Domyati Co Sales (100,000 units @ 15) 1,500,000 Variable costs Direct material (100,000 @ 6) 600,000 Others (100,000 @ 3) 300,000 (900,000) Contribution 600,000 Less fixed costs (100,000 @ 3) 300,000 Net Profit 300,000 Contribution Ratio =Sales – Variable Cost Sales =1,500,000 – 900,000 1,500,000 =0.4 Break-even point: BEP units = Fixed Costs (Unit price – Unit variable cost) = 300,000 = 300,000 (15 – 9) 6 = 50,000 B.E.P sales = Fixed costs Contribution ratio =300,000 0.4 =750,000 Safety margin = Actual sales – Break even Sales = 1,500,000 - 750,000 = 750,000 (b) What selling price per unit must “El-Domyati Co.” charge in the coming year to cover an expected increase of 5% in the cost of milk and still maintain the last year’s contribution margin ratio? Given: Contribution Ratio (C.R) = Sales(S) – Variable Cost(V.C) Sales(S) Expected 5% increase in cost of milk: V.C. 900,000 = 100% w = 105% w = 105 x 900,000 100 =945,000 Let the selling price be y Contribution Ratio (C.R) = Sales(S) – Variable Cost(V.C) Sales(S) 0.4 = 1,00,000y – 945,000 1,00,000y 60,000y = 945,000, y= 945,000/60,000 Selling price = 15.75 Prepare the expected income statement assuming that the company is planning to achieve a net profit of £300,000. (5%) Desired sales be k = 300,000 + fixed cost (15 -9) 6k =300,000 + 300,000 k = 100,000 Income Statement of El-Domyati Co Sales (100,000 units @ 15) 1,500,000 Variable costs Direct material (100,000 @ 6) 600,000 Others (100,000 @ 3) 300,000 (900,000) Contribution 600,000 Less fixed costs (100,000 @ 3) 300,000 Net Profit 300,000 (c) What increase in net income must the company achieve in the coming year assuming that the company expects an increase of £300,000 in sales revenue next year and still maintain the last year’s contribution margin ratio without changing last year’s selling price per unit? Discuss the results you may achieve. 300,000 increase in sales revenue implies 20,000 more units sales = (300,000/15 per unit) and hence total sales increase will be 1,500,000 + 300,000 = 1,800,000 Sales – Variable Cost – Fixed Cost = Profit S (1,800,000) – VC (9 x 120,000) – FC(120,000 x3) =Z Z = 1,800,000 -1,440,000 = 340,000 NB: The figure of 340,000 increase in net income may be inaccurate in regard to the unit variable cost of production may vary due to increased production units. The assumptions underlying are that fixed costs will remain constant and will not change with the level of activity which might not necessary be true (Blocher & Cokins, 2008). (d) Analyze and criticize the assumptions of the breakeven analysis in the light of the reality of today’s business environments. (10%) Break even analysis assumes that costs can be reliably divided into two categories namely variable costs, fixed costs, and semi-variable costs are ignored or separated into fixed and variable component, which is very difficult in practice. BEP analysis also assumes that all units produced are sold leaving no consideration of closing or opening stock in addition to the assumption that there is only one product produced and in case of several products the product mix remains unchanged. The most undeniable factor is maybe the assumption that variable costs fluctuate in the same proportion in which the level of activity fluctuates for example factors such as wages and direct materials will remain the same. Limitations of break-even analysis can be summarized into the difficulty in separating costs into fixed and variable components only, the inability to use break-even analysis to determine the Break-even points of a multi-product firm, the fact that an assumption that total fixed costs would remain constant over the entire range of activity and the market unpractical realities of fixing a constant selling price per unit and a constant unit variable cost per unit. It is therefore recommended for a company to use other capital management theories in planning for their capital management endeavours (Folt & Wilson, 2008). Part C (a) The main sources of finance available to business and the advantages and disadvantages of each source Several sources of finance are available to businesses depending on the nature of needs necessitating them. Business finance sources can be classified into long-term, medium-term and short-term, among other classifications depending on cost of finance source, tenure, leverage and risk profile of each source. Long-term finance sources refer to those that provide repayment options of periods longer than 5-50 years and include share/equity capital, debentures and bonds, long-term loans, venture capital and asset financing. Medium-term financing sources refer to those that are available for business needs not exceeding five years and include some form of share capital, bonds and loans, lease financing and commercial borrowings. Short-term sources of finance are those that do not exceed the financial accounting period and arise from finance using current assets to meet working capital requirements. They include trade credit, deferred incomes and accrued expenses, commercial bank loans, annual fixed deposits and customer advances (Paramasivan & Subramanian, 2009, p. 28). Owners or Equity Capital By issuing of ordinary shares, a public limited company may access financing from the public investors and promoters. Owners/equity capital is a long-term source of permanent capital from equity/ordinary shareholders who practically constitute the owners of the company. These investors undertake the largest investment risk in the business and are entitled to dividends paid from appropriation of profits. The cost of equity financing to a business is usually the highest since shareholders expect a higher rate of return on their investment compared to other sources of longer-term financing. Advantages of this form of financing are related to its long-term and permanent nature since these shares are not redeemable and place no liability on the part of the business for cash outflows relating to its redemption. Equity share financing increase the capital, and asset, base of the business, thereby increasing its net worth and placing the company in a better position to access other sources of borrowed financing. Another advantage is that the company is not obligated to make payments to the holders of these shares in times of uncertainty and loss because dividend payments for ordinary shares may be reduced, suspended or increased according to the financial outlook of the company and the earnings in the financial period. A disadvantage of this method of financing is that the cost of accessing equity shares financing is higher given the cost of floating the shares in the capital market. The dividends payable by the business to the shareholders are not tax-deductible and thus add an extra taxation cost to the business while making the payouts. The uncertainty of the dividend payments owing to their being pegged on the profitability and capital gains of the company make potential investors of ordinary shares to shy away. Floating new equity shares to the capital market adds to the number of shares with claims on the company profits, thereby reducing the amount of profits available to the business for ploughing back/reinvestment while reducing the amount of dividend earnings available per share. New equity capital also reduces the ownership and controlling power of the existing owners and shareholders by bringing on board an added number of owners with further voting rights which may compound further the decision making process for management (Paramasivan & Subramanian, 2009, p. 28). Preference Share capital This is a form of business finance where the business floats a special kind of shares which enjoy priority in regards to fixed dividend payment and repayment of capital during the winding up of the company. The funds from preference shares are raised through floating by public issue. The dividend payable may be accumulated to the next year if it is not payable in the current year. Dividend on these shares is usually higher than interest on loan and debentures. Mostly, the funds have to be repaid after a given period. Cumulative convertible preference shares may be converted to equity shares after a fixed period of non-payment of dividends, usually three years. The share capital in preference shares may be withdrawn at a pre-decided future date. Advantages of these shares are that they do not constitute ownership capital, thus do not dilute earnings per share for ordinary shares, and thus does not affect the market price for shares of the company. These shares have a leveraging advantage as they bear a fixed charge which cannot force the company into liquidity over non-payment. The holders of preference shares do not hold any voting rights, therefore pose no risk of take over of decision making and ownership. The dividends payable are fixed and predetermined, thus holders cannot participate in sharing of surplus profits. The disadvantage of preference shares is that, in the case of dividend arrears, the holders gain voting right in the company and may influence decision making. Preference dividends are not tax-deductible and thus are more costly than debenture capital. Their cumulative nature forces the company to part with huge cash outflow in future payment of the accumulated dividends. Further, ordinary shares may not receive any dividends until preference shares’ dividends have been paid in full, which may impact on the reputation of the company. Debentures and Corporate Bonds The public limited company may opt to raise long-term loans from the public by the issuing of corporate bonds or debentures. Corporate bonds or debentures are issued to the public in different and set denominations ranging from 100 to 1000 through floating in the capital market. They may be secured or unsecured, carry different interest rates and are based on a debenture trust deed listing the terms and conditions of issue. Non-convertible debentures pay higher returns to investors but cannot be converted before maturity, unlike partly and fully convertible debentures which can be converted to equity shares, which can then be sold, before maturity depending on the terms of issue. The advantage of this form of financing to the issuing company is that management can raise equity capital without immediately diluting the present equity holding. Bonds/debentures can be issued even when the equity market is suffering low prices. The unsecured nature of convertible bonds does not reduce future borrowing power of the company by tying assets as collateral. The cost of issuing and paying interest on debentures is much lower compared to equity or preference capital since the interest is tax deductible and the issuing process is not as cumbersome. Investors are more attracted to debentures as an investments, thus require a lower return and lesser claim on business profits. Issuing debentures does not change the control and ownership of the company. In periods of inflation, the fixed amount paid to debentures decreases in real terms with increased inflation compared to the value of the investment at issue. To the investor, debentures have an advantage over preference or ordinary shares in that dividends are payable to them irrespective of whether the business makes profit or not. Disadvantages of debentures to the business are that capital and interest repayment due to them is mandatory irrespective of the business’s profit conditions, and enormous amounts of cash outflow would be required to pay them off when they mature. Protective covenants for debentures may be quite restrictive for businesses, requiring the approval of credit rating companies, while the added payments increase the business operating risk owing to the mandatory nature of the payments. A disadvantage of debentures to the investor is that the amount of revenue raised from the capital loaned may be quite low given that interest on them is charged as an expense before tax, therefore being subjected to tax. Venture Capital Financing This type of financing refers to financing provided to business entrepreneurs for new and high-risk ventures by providing the funds and expertise required to bring their ideas to fruition. The venture capitalists providing the funding undertake to make investment by purchasing equity or debt security in the new or existing enterprises to undertake those high-risk ventures with a promising chance of success. Venture capital is essentially long-term equity finance in new companies and growth oriented small and medium enterprises. Venture, seed or private capital is provided to companies which may not have sufficient experience, operating history and track-record to qualify for bank loans. The venture capitalists undertake to provide funding and expertise in the form of sales and marketing expertise and managerial assistance for the new start-ups. Advantages of venture capital include the associated business and management consultation that comes with it which can help companies in avoiding market pitfalls. The company gets human resource assistance and other resources including legal assistance that put it at a better chance of realizing success in the venture. Disadvantage of venture capital include giving up a large part of management to the owners of the capital and their management decisions, and the sharing of the equity position of the firm. The firm seeking the financing ends up disclosing their business plan and market advantage to the venture capitalists which puts them at risk of loosing their business edge to unscrupulous financiers, while the funding plan may not be in the control of the firms owners and may not be paid in whole upfront. Venture capital brings in too much outside control to the business decisions and operations (Martel & Scheid, 2011). Retained Earnings Retained earnings or deferred income are a form of short-term financing where businesses may invest part of their accumulated cash reserves and profits in capital assets as opposed to appropriating them for the payment of dividends to shareholders. The surplus on contractual payments and working capital is utilized for financing new operations and capital goods. Plugging back of profits is prescribed by the government usually not to exceed 10% of net profits after tax before declaring dividends. Advantage of retained earnings are that they are internally generated and are least costly to the business owing to the fact that they do not attract floatation costs and create no fixed obligation on the business. They allow the capital structure of the business to remain intact and flexible. Retained earnings directly increase the share capital value by increasing the value of capital. Disadvantages of this method of finance include potential misuse by management by manipulating the value of shares in the stock market, which indicate a rising capital value where no actual reinvestment has taken lace. More and more retained earnings may lead to overcapitalization in the business which artificially raises the value of shares in the books of account. Retained earnings lead to tax evasion, and further, the retained earnings suddenly become due to shareholders in subsequent accounting periods, drawing larger cash outflow from the business in future. (b) The importance of budgets as a means of planning and controlling the various business activities as well as the advantages and disadvantages of budgets A budget is a quantitative accounting statement describing the planned revenue appropriation, assets acquisition, liabilities obligations and cash flows for the business for a defined period of time. The budget is a comprehensive written plan outlining the expected monetary consequences of the management’s financial plans and strategies for the coming period in line with the overall objectives and mission of the organization. It is a master financial document or blueprint for action setting out the expected consequences of operation and managerial control in terms of the anticipated revenues and expenditures over a given period. The budget serves as a tool for providing decision-making focus for an organization and aids in coordinating the operational activities while facilitating the control of expenses in the firm. The budget is important for the business as it forms part of the effective management process for the organization by enabling management to systematically think ahead about the future of the business. The budget is a device for planning/forecasting, controlling and coordinating the varied and complex operations of a firm by providing a communication medium for the financial goals of an organization. If properly executed, the budgeting process provides valuable managerial information about the direction, resource optimization and financial expectations of the organization for the particular planning period. The budget provides a benchmarking framework for performance evaluation of the various aspects and departments while motivating managers and employees towards attaining the various set goals for the department and the organization. As a planning tool, the budget enables the forecasting of unforeseen and otherwise uncontrollable events in the business environment, thus providing the management with a tool for analysing alternative courses of action in shaping the future of the firm. The budget serves as a system of authorization and allocation of responsibility to the various management branches by allocating resources and setting action results to be achieved by each. It is an optimization tool in ensuring the optimal allocation of resources towards achievement of specific organizational goals (Paramasivan & Subramanian, 2009). (c) What is the relevance – if any – of the company’s committed fixed costs to the decision of determining the optimal mix of products? Managerial finance accounting provides the cost-volume-profit (CVP) analysis method for evaluating the viability in growing or scaling production mix for a business. The methods look into the fixed and variable costs behavior of production in determining the optimal mix and volumes of production for various products of a firm. Fixed costs do not fluctuate with variation of production volumes of the various products. Some businesses, for example airlines and electronics producers, have very little variation in fixed production costs tied to the volume of production, while others find ways to avoid some fixed costs altogether. The economic concept of economies of scale stipulates that certain efficiencies are achievable by increasing the overall production run sizes, minimizing the per-unit fixed costs of production. This method evaluates the relevant range on a production possibility frontier in determining optimal production level given fixed costs, and determines that increasing production beyond a certain level causes fixed costs to rise (Walther, 2012). A better approach has been proposed in Activity-Based Costing (ABC) which seeks to determine profitable and non-profitable by systematically analyzing variable and fixed costs by identifying activities that do not add value to production processes and should not constitute fixed costs (Masood, 1995). However, this method has been criticized as being ignorant of resource constraints in making this consideration, resulting in product mixes that are irrational by maintaining low-margin products at the expense of high-margin ones (Martel, & Scheid, 2011). The theory of constraints solves this problem by adopting an approach that views production processes as being independent and removing the slowest of them, referred to as production bottle-neck processes. The Total Cost Theory (TOC) approach treats both variable and fixed costs as being given, and identifies certain costs believed to be fixed as depending on certain cost drivers. References Martel, D., & Scheid, J., (2011), Learn the Ins and Outs of Venture Capital Investments, Retrieved from http://www.brighthub.com/office/entrepreneurs/articles/77501.aspx Paramasivan, C., & Subramanian, T., (2009), Financial Management, New Age International Publishers, New Delhi. Masood, Y., (1995), Product-Mix Decisions Under Activity-Based Costing With Resource Constraints and Non-Proportional Activity Costing, Journal of Applied Business research, Vol. 14, No. 4, Goergetown University: Georgetown. Tioanda, P., Whitman, L., & Malzhan, D., (1999), Determine Product Mix using ABC and TOC, Wichita State University: Kansas. Folt J., & Wilson C., (2008), Using Break-even Analysis in Business Decisions, Webpage: Retrieved From http://www.feedandgrain.com/article/10229961/using-break-even-analysis-in-business-decisions Sullivan, W., Killough, L., & Van Aken, E., (1999), An Activity- Based Costing and Theory of Constraints Model for Product- Mix Decisions, Virginia Polytechnic Institute and State University: Virhinia. Walther, L. (2012), Chapter 18: Cost-Volume –Profit and Business Scalability, Principles of Accounting, Webpage, Retrieved from: http://www.principlesofaccounting.com/chapter18/chapter18.html Blocher, S., Cokins, C., (2008), Chapter 9: Decision Making with Relevant Costs and a Strategic Emphasis, Cost Management, The McGraw-Hill Companies, Inc.: New York. Read More