Financial Management for Decision Making - Assignment Example

Financial Management for Decision Making (Authors Name) (Institutional Affiliation) Question 1 The purchasing manager understands the value of cost reduction to the company. Cost reduction is important to a company because it enables the company to increase its profits, to improve its competitive advantage, to preserve the scarce company resources and to improve on the company’s productivity (Steve 2010). The manager acknowledges the fact that successful cost reduction is dependent on reduction of the company’s overall operating costs. The manager thus recommended that the company stops its manufacturing activities and get the products directly from Stirling Company. The current cost of producing the product is 95p per piece however Stirling is offering to supply the product at 83p to the company. This implies that the company has a potential of saving 96,000 pounds over a period of 8 years. The production manager however is against the move to stop the manufacturing of the product. The production manager is concerned about quality control and the security of the supply side. Quality control is defined as the activities a company undertakes to ensure that its products are dependable satisfactory and fiscally sound. Quality control is important because it enables the company to produce convenient products that meet their customers’ needs (Larry 2011). If the quality of the product is compromised the product will not meet the customers’ expectations and thus have a negative effect on the products brand. Customers who have purchased the company’s product will expect a certain level of quality and if not met will consider other options in the market. This in the long run will affect the overall profits of the firm. The production manager was concerned that transactions with Stirling Company will compromise its quality control measures. Stirling Company produced a product that varied by 2mm from the product produced by the company. This greatly affects the quality of the product and would also cost the company an extra 8,000 pounds to purchase a variable dimensions sensor to fit on one of its assembly machines. The production manager cited several other areas where the company would have to incur extra costs and also experience loses. The sale of the newly acquired machine would see the company lose 40,000 pounds. The company will also incur an extra cost of 1,000 pounds every year as additional pay to the chief operator amounting to 8,000 over the eight years. The company will also in the future incur warehousing costs. This is because Stirling would not deliver batches of less than 30,000 items. The company in four years would have to extend its warehouse and this would cost it 50,000 pounds. Over the period of eight years, through its partnership with Stirling Company, Menstrie and Co’s would save up to 96,000 pounds but lose 106,000 not included are the reduced profits arising from the changing quality of the product. The lose is attributed to the loss of the sale of the new machine 40,000, the extra salary of the operations manager 8,000, the variable dimensions sensor 8,000 and the cost of extending the warehouse which is 50,000 pounds. The productions manager's argument is correct assuming that the company will also experience a reduction of profits due to a decreasing customer base that is affected by the quality of the product. Question 2 Financial analysis Financial analysis can be described as the activities a company undertakes in evaluating its finance related objectives such as projects and budgets with an aim of determining investment suitability. Companies perform financial analysis to determine whether the entity they plan to invest in is sound and stable. Financial analysis focuses on income statements, balance sheets and cash flow statements (Bodie 2004). Income statements are used to provide insight on a company’s earnings over a period of time. They show the company’s profits and losses over a certain period of time. Income statements are used to assess how effective a company’s management is in controlling its expenses. Balance sheets are used to analyze the assets, liabilities and the equity of accompany. Balance sheets are used to determine the profitability of investing in a company (Ronald 2004). Cash flows are used to highlight the changes that are taking place in the balance sheet of a company. It identifies the amount of cash that is flowing in and out of the company. Cash flows are used by investors to determine whether a company is financially sound (Timothy 2012). The important issues to Menstrie & Co are whether Stirling Company can be able to constantly and conveniently supply the product to them and also the quality of the product being delivered. It is therefore important for Menstrie & Co to analyze the balance sheet statements and cash flow statements of Stirling Company. The balance sheet statement will provide insight on Stirling’s assets and liabilities. This will enable Menstrie & Co to determine whether Stirling is able to soundly operate its business for a long period of time. The cash flow statements will enable Menstrie & Co to determine whether Stirling is capable of compensation. Cash flow moreover provides insight on Stirling’s operating activities such as production, sales and delivery of its products. It also provides Menstrie & Co with knowledge of Stirling’s investing activities such as payments resulting from acquisitions and the purchase of an asset for example land or a warehouse. Question three Financial Appraisal Financial appraisal is an essential part in every company. It a method used by financial analysts to evaluate whether an investment undertaken by the company is commercially profitable. Financial appraisal techniques evaluate the viability of an investment by carefully assessing the net cash flows that will result from the investment (Uwe 2007). The objective of financial appraisal includes; estimation and identification of financial cash flows, evaluating financial sustainability of a project and calculation of performance indicators such as the Net Present Value (NPV) and the Internal Rate of Return (IRR). Determining the viability and profitability of an investment is very difficult because of the time value of money. This simply means that a dollar today will not have the same value as a dollar in the future. A simple way of assessing the profitability of a project is through calculation of the Net Present Value. Net present value can be defined as the difference between the present value of cash inflows and the present value of cash outflows. This measure of profitability is efficient because the discount rate accounts for the time value of money. The disadvantage to using net present value is that it estimates the future cash flows of an investment and these estimates may be wrong (Harry 2003). The first step of calculating net present value is by calculating the present value. The present value is the sum of the periodic payments each discounted at a given rate of interest to reflect the time value of money. The formula for calculating Present Value is: PV = R ×1 − (1 + i)-n /i Where R is the fixed periodic payment n is the number of compounding periods i is the interest rate per compounding period Therefore the Present Value for buying the product from Stirling Company is: 7,000 × 1- (1+0.12) -8 / 0.12 7,000 × 1- (1.12) -8 / 0.12 7,000 × 1- 0.40388323 / 0.12 = 34,773.4782 The Net Present Value for buying the product is calculated as P.V- Initial investment. Due to the fact that there is no initial investment in buying, the Net present value is $34,773.48 (to the nearest cent) The Present value for manufacturing the product is 7,000 × 1- (1+0.8) -8 / 0.8 7,000 × 1- (1.8) -8 / 0.8 7,000 × 1- 0.009074443 / 0.8 7,000 ×1.23865695= 8,670.59865 The Net Present value of manufacturing the product is therefore Present value minus the initial investment which is 8,670.59865- 135,000 = -126,329.4 (to the nearest cent) A negative Net Present Value suggests that manufacturing the components by Menstrie & Co. will not be a profitable investment in the future. Using the Net Present Value as a deterministic approach suggests that Menstrie & Co should buy the product from Stirling Company. Question 4 Menstrie & Co faces a risk of a loss $35,000 from the resale of their newly acquired machine and an additional cost of $1,000 every month as additional payment for the Chief operator who had signed a contract with the family. The other risk that Menstrie faces is in quality control. Purchasing the product limits the control of Menstrie & Co over the quality of the product. This might cause considerable changes in customer relations with the company. The alternative that Menstrie & Co has is to conduct a risk analysis to guide them through their investment decision. There are two measures that Menstrie & Co can employ to summaries the overall risk that will occur due to its partnership with Stirling Company. They include; the expected-loss ratio and the risk-exposure coefficient. The expected-loss ratio is defined as the absolute value of expected loss as a proportion of total expected value of all possible outcomes. It is basically a ratio of losses to gains (David 2008). The risk-exposure coefficient on the other hand is a combination of the standard deviation of possible outcomes and the proportion by which the possible outcome is on left of the Net Present Value i.e. the loss side of the outcome distribution. Advantages of risk analysis are that it helps solve the problems associated with deterministic benefit-cost analysis such as unresolved uncertainties in important variables. Risk analysis also identifies where action to reduce risk may be most effective. Risk analysis more importantly bridges the communication gap between the production manager and the purchasing manager about decisions making by carefully emphasizing on risk variables and using available information on ranges and probabilities to enrich the benefit-cost data (John 2004). References Bodie, Zane, Alex Kane and Alan J. Marcus (2004) Essentials of Investments, 5th ed, McGraw-Hill Irwin  Steve M. Bragg (2010) Costs Reduction Analysis: Tools and Strategies. John Wiley & Sons Larry Weber, Michael Wallace (2011) Quality Control for Dummies. Wiley Publishers Eugene Brigham, Michael Ehrhardt (2013) Financial Management: Theory and Practice, Cengage Learning David Vose (2008) Risk Analysis: A Quantitative Guide, Wiley Publishers John Bartlett (2004) Project Risk Analysis and Management Guide, APM Publishers Limited Harry F. Campbell (2003) Benefit Cost Analysis: Financial and Economic Appraisal Using Spreadsheets, Cambridge University Press Uwe Gotze, Deryl Northcott (2007) Financial Appraisal: Methods and Models, Springer. Ronald C. Spurga (2004) Balance Sheet Basics: Financial Management for Nonfinancial Managers, Penguin. Timothy Jury (2012) Cash Flow Analysis and Forecasting: The Definitive Guide to Understanding and Using Published Cash Flow Data, Wiley Publishers Read More