Fundamentals of Financial Management - Essay Example

Question Part The concept of net present values can be used in this situation to advise Harriet on the most appropriate action to take. Harriet has been presented two options to pay off the cost of TV i.e. either to pay in the lump sum 899 today or pay 50 in the beginning and 40 for the next 24 months. The NPV can be used to compare the cost of TV to be paid today and discount back the payment in instalments with the help of the rate of return on alternative investment or the opportunity cost of capital i.e. 3% annually and 0.2466% per month. The two options can be compared so as to determine which one would be the most beneficial for Harriet. Part 2 The most suitable payment option of the two can be chosen with the help of present value concept. Harriet should choose the option which provides the lowest cost to be paid for the purchase of TV. The first option involving a complete payment of 899 today is to be compared with the second option suggesting payment of 50 in the beginning with 40 to be paid every month for the next 2 years. The present value of 899 to be paid today is simply 899. However, the present value of 50 today + 40 monthly for 24 months needs to be calculated. For this purpose the values of monthly payment needs to be discounted back at the rate of return Harriet expects to earn on an alternative investment. This would provide the present value of that series of payment that the purchase of TV requires. Because of the fact that there is equal monthly outflow, the NPV can be calculated with the help of the following formula: PVFA = A ( 1 - 1 (1+i)n ) + 50 i PVFA= Present Value Factor of Annuity A = Amount of annuity = 40 n = Number of periods = 24 i = Discount rate = 0.2466% PVFA = 40 ( 1 - 1 (1+0.2466%)24 ) + 50 0.2466% = 931 + 50 = 981 The above calculation suggest that Harriet will actually be paying 981 as the total cost of purchasing the TV if she decides to accept the second option i.e. 50 plus equal monthly payment for the next 2 years. However, if Harriet decides to pay the cost of TV today, she would only be paying 899. This illustrate that Harriet will have to pay 80 in excess of the cost of TV if she agrees to pay in future instalments. Hence, on the basis of the above calculations, it is advised that Harriet should pay the cost of TV today i.e. 899 because of the fact that she will have to bear higher cost if she pays in instalments. Part 3: Limitations of NPV as a Method of Investment Appraisal Despite the fact that Net Present Value or NPV serves to be the most important of all the available investment appraisal techniques, there happen to be several limitations of this method. The first drawback of using NPV as investment appraisal is this method's reliance on discount rates which should represent the opportunity cost of capital. This opportunity cost of capital might be the cost of funds employed in the investment, rate of return on alternate investment and inflation etc. The determination of a correct discount rate is very important in the calculation of NPV as it is the rate which is used to discount back the value of future cash inflows to their present values. An inaccurate estimation of discount rate will lead to acceptance of a wrong project or rejection of a right one. Another important point to be considered in calculation of NPV is that the method does not consider risk involved in accepting a project. It just evaluates a project on the basis of time value of money. However, there are several risks that are involved in starting a new project other than the time value of money such as business risk, financial risk, market risk, industry risk etc. A high NPV project might be having huge risk as compared to a low NPV project. The decision criteria made solely on the basis of NPV with no consideration for project risk can be misleading. Even if a risk premium is added to the discount rate, NPV will assume that the risk rate will remain constant over the life of a project. An important drawback of using NPV as a method of investment appraisal is that it is calculated on estimated cash flows. These cash flows are calculated on the basis of expected demand, revenues and expenses. These variables, however, are uncertain and can vary with changes in economic conditions etc. The variables in cash flows can go wrong which in turn will mislead decision making on the basis of NPV. Therefore, the above mentioned limitations cause NPV to be ineffective in providing the right decision criteria. Question 2: Part 1 Jarred Limited Cash Flow Statement For the year ended 31 December 2006 Cash Flow from Operations: '000 Net Profit 28,000 Add: Depreciation Expense 26,000 Increase in accrued income tax payable 4,000 58,000 Less: Increase in trade receivables 17,800 Increase in inventory 9,800 Decrease in trade payables 4,200 (31,800) Net cash flow from operating activities 26,200 Cash Flow from Investment: Cash paid to acquire plant assets (36,000) Cash Flow from Financing: Proceeds from short-term bank overdraft 2,600 Proceeds from 8% loan notes 4,000 Proceeds from Issuing share capital 28,000 Dividends Paid (8,000) Net Increase in cash 16,800 Part 2 As evident from the cash flow statement presented above, the net cash flow from operations figure is different from net income. Jarred Limited's net profit was 28,000 for the year 2006, whereas the net cash flow from operations was calculated to be 26,200. The net difference in both the amounts is 2200. It is because of several reasons: Non-cash Expenses: Non cash expenditures, for instance, depreciation in the case of Jarred Limited decrease the company's net income. However such expenditures do not require a cash outlay for the current period. The depreciation expense for the current period is added back to net income to provide a correct estimation of cash inflow and outflows. Accrual and Cash differences: Net income is obtained from Profit and loss statement which is prepared on accrual basis, whereas net cash flow from operations is calculated on cash basis. It suggests that in calculation of net cash flows, expenses and revenues of related cash flows may be recognised in different accounting periods. Therefore, the figures of net profit and net cash flow are different because of differences in accounting treatment. Changes in Trade Receivables: Trade receivables increase due to increase in sales revenues and decrease as the cash is collected from customers. In order to correctly estimate the cash inflow from operations, an increase in trade receivables is subtracted from net income. This provides correct information as to the company's real cash inflows. In the case of net income, however, sales revenues are taken regardless of real cash inflows. This is why net income is different from net cash flow. Changes in Inventory: An increase in inventory represents additional purchases of stock by the company, whereas a decrease represents that goods have been sold. Net income in the above example is different from net cash flow because of the fact that an increase in inventory has been deducted from operating cash flows, suggesting a cash outflow. Changes in Trade Payables: Increase in trade payables suggests purchases of merchandise, whereas a decrease signifies cash payment to suppliers. A decrease in trade payable reduces net cash flow from operations so as to obtain real cash outflow against purchases. Because net income is obtained on accrual basis, it includes purchases amount regardless of actual cash paid against these purchases. In the example of Jarred Limited cash flow statement, it is evident that a decrease in trade payables reduces the net cash flow from operations by 4,200. Changes in accrued expense payable: In the above cash flow statement, tax payable represents the only accrued expense payable. An increase in accrued expense payable represents recognition of expenses to be paid at some point in future and a decrease in accrued expense payable suggests that a cash payment has been made. Tax expenses payable reduce net income but they are no actual cash outflow, therefore this item is added back to net income in order to calculate net cash flow from operations. This also contributes to the difference between net income and net cash flow amounts. Question 3: Part 1: Verdame Gardening Monthly Cash Flow Budget- Six Months Jan Feb March April May June I. Cash Receipts: Revenue from the contract 40,000 120,000 80,000 80,000 80,000 400,000 Collections from Debtors 4,800 Refundable Deposits 5,000 Payment received on car sell. 6,000 Total collections 44,800 125,000 80,000 86,000 80,000 400,000 II. Cash Disbursements: Purchases: Soil 25,200 Sand 4,400 Cement 6,200 Bricks/stone 170,000 Turf 96,000 Shrubs 33,400 Other materials 4000 4000 4000 4000 4000 4000 Payment to creditors: Materials 13,200 Misc 5,140 Payment for Diggers: (5*2400) 12,000 Advance for Diggers 5,000 Payment for waste disposal 17,000 Salaries and Bonuses: Salaries (43,200/12) * 5 18,000 18,000 18,000 18,000 18,000 18,000 Bonus (3000*5) 15,000 Lease payments 1,980 1,980 1,980 1,980 1,980 1,980 Car payments 18,500 Total Payments 101,520 23,980 34,580 42,480 227,380 134,980 Borrowings: 28,400 Cash at start of the month (28,320) 101,020 45420 43420 (147,380) 265,020 Less: Interest on borrowings 284 284 284 284 284 Part 2: Main Purpose of Cash Flow Forecast Cash flow forecasting serves to be an important tool for analysing a company's future cash flow position. It can be used for determining the company's future credit position i.e. the extent to which the company will be or will not be able to meet its liabilities and expenditures. Cash is considered to be the life blood of any organization and cash flow forecast helps a firm to determine its liquidity position. It tells whether or not enough cash is available to carry out business operations in future. Cash budgets provide information on whether the company needs to borrow additional short-term funds to generate more cash, if needed. Cash flow forecasts help a company to determine its future borrowing needs before they actually arise. Cash flow forecasting is very important in this regard because of the need of continuous availability of cash to maintain a company's solvency. Thus, the main purpose of cash flow forecasting is to proactively gain information about a company's future cash needs as well as its ability to meet these needs. Furthermore, it provides important insight into impending problems with respect to a company's cash liquidity. Bibliography Brigham, E.F. and Houston, J.F. (2004). Fundamentals of Financial Management. 10th ed. Thomson South-Western: Ohio Garrision, R.H. and Noreen, E.W. (2003). Managerial Accounting, 10th ed., McGraw Hill: New York Meigs, W.B. and Meigs, R.F. (1993). Accounting: The Basis For Business Decision Making. McGraw Hill: New York Read More