You must read all the textbooks I uploaded before starting to write.
You need to strictly follow the assignment requirements.
I will request unlimited revisions if the assignment does not meet the requirements.
I will request a refund if the assignment does not pass.
If you cannot accept these terms, please do not quote me.
The "AS2" is a scoring sheet that needs to cover all the sub-items.
"7029- Assessment2 Brief" contains the assignment requirements. The analysis and completion of the assignment need to be based on the content provided in this WORD document.
"Sample+case-study_tech-innovations-ltd" is a sample case study provided by the teacher.
"MN7029 Assessment 2" contains the writing process provided by the teacher.
Kindly note that the submission of your AS2 is to be presented in ppt. slides.
- Slides submission: 15 slides excluding references and appendix (maximum 20 slides); to include the student’s name and number for your AS2.
- Word documents: a complete filled up Assessment Submission Form.
In other words, 2 sets of documents are required:
ppt slides
word documents

MN7029 Assessment 2

The assessment consists of

The written PowerPoint document answering the questions and containing your calculations in the body of the document or Appendices

You may want to use more than one slide to explain a particular aspect.

Please feel free to use pictures, graphs or other illustrations to explain your point

a) Title

b) Name

c) Student number

d) Executive Summary

e) Introduction-Content Page

f) Calculation of WACC and explanation (Detailed calculations should be included as an appendix)

a) Projected cash flow statement

b) Calculation of NPV and Payback period using the WACC Calculation should here or appendix

c) Calculation of NPV using a 20% Cost of Capital Calculation should be here or in appendix

d) Your decision regarding proceeding with the project and justification. (Calculation should be here or in appendix)

e) Critical evaluation of 4 main capital investment appraisal techniques

f) Types of Finance available

g) Conclusion

h) Appendix 1 Detailed calculations or further information. Include any additional information that might be helpful. E.g. back up to financial projections or calculations.

i) Any other additional slides you wish to include

j) In text citations

k) Harvard Referencing.

Guildhall School of Business and Law

Feedback/Feedforward Coversheet

MN7029SR Financial Decision Making	Academic Year 2024/25 Assessment 2 Individual Assignment
First Marker:
Second Marker:
Title of presentation:
Assessment criteria	Level of achievement	Marks to be awarded	First Marker	Second Marker
Calculation and explanation of WACC for the company	15 m
A projected cash flow for the project	15 m
Calculation of NPV and Payback Period using the WACC you have calculated	15 m
Calculation of NPV and Payback Period using a 20% cost of capital	15 m
A decision as to whether the project should go ahead and your justification for this decision	5 m
An explanation of the benefits and limitations of the 4 main investment appraisal techniques	10 m
An explanation of the different types of funding available to a companies (Long term, short term, equity and debt and others), the advantages and disadvantages of each and a detailed explanation of what a bank might look at in deciding whether to make a loan to a company and the steps they might take for extra protection on the loan repayment.	15 m
Your report and presentation: executive summary, professionalism, summary recording, logical flow and conclusion	10 m
Total	100 m

Areas for Improvements
From First Marker
Knowledge and understanding
Analysis and evaluation
From Second Marker
Knowledge and understanding
Analysis and evaluation
Agreed Marks First Marker’s marks /date Second Marker’s marks/date

Please upload the Turnitin Report

Appendix 2

Assessment 2

Assessment Brief

Introduction

The assessment assesses learning outcomes 2 and 3 of the 3 module learning outcomes of this module, which are that on successful completion of the module students will be able to:

· Demonstrate an understanding and use of the appropriate analytical techniques to be applied to business case development and Investment appraisal; the raising of finance and the distribution of funds to investors;

· Communicate financial information, analysis, issues and recommendations clearly and concisely.

The Question

Background information

Smart Home Plc (a fictional company) is a UK incorporated and UK tax resident technology company focussing on the manufacture and retail of internet enabling devices for homes.

The business has been conducting Research and Development on a new smart watch and now needs to make a decision whether to go ahead with launching the product and determining what is an appropriate price for it.

You are the Business Manager responsible for the product launch and the CEO has asked you to prepare a report on the investment in the new product. With the Finance Manager on leave for the next 3 weeks, you are on your own for the presentation.

You have been given the following information from various teams in the organisation.

R&D Team

“We’ve spent quite a lot on developing this project – £450,000 – and it would be a shame if we didn’t get it to market. I would estimate that we would need to spend around and other £60,000 on research costs to get it to a position where it is ready to launch”.

The production department:

“I’ve looked into the production of the smart watch and we will need to purchase a new machine to manufacture at the scale we want which will which will cost us £1,500,000. We have spare capacity in current staff to run the machine, but we will need to hire a “Specialist Supervisor” for the machine – I asked the HR team to let me know what the salary for that person would be, but they haven’t got back to me yet. The machine will last for around 5 years – you need that for your depreciation calculations right?”

The Marketing director

“I’ve done some research on the potential pricing of the watch and likely customer targets and worked with someone in the finance team to look at pricing. I think our wholesale sales price should be £150 per watch over the course of the whole 5 years. The cost of the raw materials makes up 40% of the sales price. My team have estimated that sales for the first 5 years should be as follows:

Year 1	10,000 watches
Year 2	12,500 watches
Year 3	15,750 watches
Year 4	15,750 watches
Year 5	12,350 watches

After 5 years we think that the tech will have advanced beyond this and the product will no longer be attractive so we are assuming that the life of this project will probably only be until then before we need to make a new investment, and we are constantly innovating other projects. The machine will not have any scrap value at this stage.

We’re planning an advertising and marketing campaign costing £545k in year 1 to get started and these costs will the same in in year 2 and 3, and fall to £190k in years 4 and 5. Oh, and HR have just confirmed that the Supervisor salary and benefits will start at £36k in year 1 but we expect inflationary rises to be 3% year on year. That includes our National Insurance costs”

You have investigated how to calculate an appropriate cost of capital (WACC) and gathered the following information:

· The market value of the shares is £2.75 per share and there are 5.5 million ordinary shares in issue. Dividends are expected to continue at 30p per share for the foreseeable future

· The company has £10m in irredeemable loan capital with an interest rate of 7% and it is currently quoted at £95 per £100. The tax rate is 20%.

The business has previously been using an estimated Weighted Average Cost of Capital of 20% and the management team would like to see your calculations using the WACC you have calculated and the original estimate of 20%.

Your task

In the absence of the Finance Manager the CEO wants you to make a presentation to the Board about whether the project should go ahead. The Board are not finance people but are very interested in the techniques that are used to appraise investments and so would like a comprehensive explanation of how you came to your conclusion. In particular they would like you to include the following:

1. Executive summary

2. A projected cash flow for the project over its 5 year life

3. An explanation of cost of capital including:

a. What is Weighted Average Cost of Capital (WACC)?

b. What do we use WACC for?

c. Your calculations of the WACC of capital for the business showing each of the individual components.

4. A financial evaluation of the project using the NPV and Payback Period Methods including:

a. Your calculations of NPV and Payback period for the project using WACC (the detail should be in the Appendix of the report and should be calculated in Excel)

b. Your calculations of NPV and Payback period for the project using the previous business cost of capital of 20% (the detail should be in the Appendix of the report and should be calculated in Excel)

c. A decision as to whether the project should go ahead and your justification for this decisions

5. An explanation of the benefits and limitations of the 4 main investment appraisal techniques.

6. An explanation of the different types of funding available to a company (Long term, short term, equity and debt and others), the advantages and disadvantages of each and a detailed explanation of what a bank might look at in deciding whether to make a loan to a company and the steps they might take for extra protection on the loan repayment.

7. Conclusion

Your report should have an executive summary at the start and a conclusion at the end and you should conclude on the viability of the project at the current cost of capital and the situation if cost of capital were 20%.

Structure of the report

The report should be prepared in PowerPoint and should contain the following slides:

· Executive summary ( A summary of your proposal in a page)

· Introduction

· Calculation and critical evaluation of WACC (detailed calculation may be shown in an Appendix)

· Projected cash flow

· Calculation of NPV and PP (detailed calculation may be shown in an Appendix) using the WACC

· Calculation of NPV and PP (detailed calculation may be shown in an Appendix) using a cost of capital of 20%

· Explanation of and critical evaluation of the 4 main capital investment appraisal techniques

· Critical explanation of different forms of funding for companies

· Conclusion

· Appendices – detailed calculations and references

The Powerpoint file should be uploaded to Turnitin. A template is provided but you should feel free to adapt and personalise this.

Assessment Marking Scheme

The assessment is marked out of 100.

Case Study: Investment Appraisal for Tech Innovations Ltd.

Introduction

This assessment evaluates the learning outcomes of this module. Upon successful completion, students will be able to:

· Demonstrate an understanding and use of the appropriate analytical techniques for business case development, investment appraisal, raising finance, and distribution of funds to investors.

· Communicate financial information, analysis, issues, and recommendations clearly and concisely.

Background Information

Tech Innovations Ltd (a fictional company) is a UK-incorporated and UK tax resident technology company specializing in manufacturing and retailing internet-enabled home devices. The company has been conducting Research and Development (R&D) on a new smart thermostat and now needs to decide whether to launch the product and determine an appropriate price.

As the Business Manager responsible for the product launch, the CEO has tasked you with preparing a report on the investment in the new product. With the Finance Manager on leave for the next three weeks, the responsibility lies solely with you.

You have received the following information from various departments within the organization:

R&D Team

“We’ve spent quite a lot on developing this project – £520,000 – and it would be a shame if we didn’t bring it to market. We estimate that we need to spend another £80,000 on research costs to get it ready for launch.”

Production Department

“I’ve analyzed the production of the smart thermostat. We will need to purchase a new machine for large-scale manufacturing, costing £1,800,000. Our current staff has spare capacity to run the machine, but we will need to hire a ‘Specialist Supervisor’ for the machine. The HR team estimates the salary for this position to be £40,000 per year with a 3% annual inflationary increase. The machine will have a useful life of five years, and we should sell it for spares at about £420,000.”

Marketing Director

“I’ve researched potential pricing and customer targets, collaborating with the finance team to determine a wholesale price of £280 per thermostat over five years. The raw materials cost 30% of the sales price. We estimate the following sales for the first five years:

· Year 1: 20,000 thermostats

· Year 2: 22,000 thermostats

· Year 3: 28,000 thermostats

· Year 4: 34,000 thermostats

· Year 5: 18,000 thermostats

After five years, the technology will likely be outdated. The initial advertising and marketing campaign will cost £400,000 in year one, £600,000 in year two, and £200,000 in years three to five. HR confirmed the Supervisor’s salary and benefits start at £40,000 in year one, increasing by 3% annually.”

Financial Information for WACC Calculation

You have investigated the appropriate cost of capital (WACC) and gathered the following information:

· The market value of the shares is £3.00 per share, with 6 million ordinary shares issued. Dividends are expected to remain at 35p per share indefinitely.

· The company has £12m in irredeemable loan capital with an interest rate of 8%, currently quoted at £90 per £100. The effective tax rate is 20%.

The company has been using an estimated WACC of 18%, and the management team would like to see your calculations using this WACC. In the absence of the Finance Manager, the CEO wants you to present to the Board whether the project should proceed. The Board is interested in the techniques used to appraise investments, so provide a comprehensive explanation of your conclusion, including:

Rubrics

1. Executive Summary

2. Projected Cash Flow for the Project Over Its 5-Year Life

3. Explanation of Cost of Capital

· What is the Weighted Average Cost of Capital (WACC)?

· What is WACC used for?

· Your calculations of the WACC for the business show each component.

4. Financial Evaluation of the Project Using NPV and Payback Period Methods

· Calculations of NPV and Payback period using the WACC (detailed in the Appendix and calculated in Excel)

· Calculations of NPV and Payback period using the previous business cost of capital of 18% (detailed in the Appendix and calculated in Excel)

· A decision on whether the project should proceed, with justification.

5. Explanation of the Benefits and Limitations of the Four Main Investment Appraisal Techniques

6. Explanation of the Different Types of Funding Available to a Company

· Long-term, short-term, equity, debt, and others.

· Advantages and disadvantages of each.

· A detailed explanation of what a bank might consider when deciding whether to make a loan to a company and the steps they might take for extra protection on the loan repayment.

7. Conclusion

8. Reference List of at least 10 scholarly articles in Havard Referencing style.

Module Handbook

Module Title:

Financial Decision Making

Module Code:

MN7029SR

Module Leader:

Prof KOH Kee Lee

Dr Suresh Kumar

Session: 2024/25

Teaching period: Spring, March 2024tumn

Pre-requisites: None

Canvas URL: https://stanfort.instructure.com

Teaching team

Details of staff teaching on the module
Name	Role	Office	Email
Prof Koh Kee Lee	Dean, EDP	Level 11, Stanfort Academy	[email protected]
Dr Suresh Kumar	Senior Lecturer	Level 11, Stanfort Academy	[email protected]

Module Summary and Description

This module aims to provide practical methods and approaches to enable business managers and entrepreneurs to understand and use financial information to make effective business decisions. The financial decision-making process demands the understanding of key financial management issues, performance indicators and methodologies to critically analyse accounting and financial information. Strong financial literacy is essential in business.

The module also aims to introduce and examine the preparation and use of accounting and information to inform financial decisions. It provides the understanding of key performance indicators, cashflow management, full costing, working capital management techniques and the budgeting process to manage finances and support management decisions on investment projects and making capital investment decisions. The module concludes with a practice of developing business plan, capital investment decisions and aspects of financing businesses.

The module aims to enable students to be able to:

· ask insightful questions of their financial advisors, to challenge their analysis and to specify their financial information needs

· quickly assess accounting information to evaluate business performance

· create financial forecasts, plans and models, particularly in relation to business planning and investment appraisal.

Module Learning Outcomes

On successful completion of this module students should be able to:

LO1: Critically evaluate company financial performance and make recommendations for improvement;

LO2: Demonstrate an understanding and use of the appropriate analytical techniques to be applied to business case development and Investment appraisal; the raising of finance and the distribution of funds to investors;

LO3: Communicate financial information, analysis, issues and recommendations clearly and concisely.

Module Syllabus/Content

1. Introduction to accounting and finance LO1

2. Measuring and reporting financial position LO1, 2

3. Understanding the income statement LO1, 2

4. Cashflow management LO1, 2,

5. Analysing and interpreting financial statements LO1, 2, 3

6. Managing Working Capital LO1, 2

7. The relevance and behaviour of costs LO1, 2

8. Full costing LO1, 2

9. Budgeting LO1, 2

10. Creating a Business Plan LO2, 3

11. Making Capital Investment Decisions LO2, 3

12. Financing a business LO2, 3

Indicative weekly teaching programme

The indicative weekly programme shows the topic likely to be covered in each teaching week, please note that the precise order can change. Please see Weblearn for more detailed timetable.

Lesson	Topic
1.	· Introduction to accounting and Financial Management
2.	· Reviewing Financial Statements
3.	· Financial Planning
4.	· Analysing and Interpreting Financial Statements
5.	· Cost behaviour, pricing and budgets
6.	· Working Capital Management
7.	· Making Capital Investment Decisions
8.	· Financing a Business
9.	· Financing a Business & Cost of Capital
10.	· Group Presentations
11.	· Group Presentations
12.	· Preparing a Business Plan

To pass the module you must achieve an overall minimum mark of 50%. If you pass the module on re-assessment, the component you resit will be capped at a pass mark level of 50%

Assessment

All assessments are designed to support your learning and help you develop a deeper understanding of the topics covered in your module.

· Formative assessments provide an opportunity to learn and do not contribute to your grade.

· Summative assessment contributes to your overall mark and grades.

Module Assessments (Summative)

Assessment Method	Description of Item	% weighting	Week Due
Group Coursework	Simulation company investor briefing	30	6 May 2024
Coursework	Investment Appraisal	70	25 June 2024

Module Assessment Cycle

Assessment 1: Students need to prepare business model of a company , part way through the business simulation, the student teams will prepare a briefing for their shareholders on the latest round of the business simulation explaining their financial performance and positions and plans for the future. They will have 20 minutes to present, with an emphasis on clear and concise communication of the financial issues and proposed actions, group cohesion, and professional behaviour. This assessment covers LO1 and LO3 in the context of the simulation.

Assessment 2: Working individually, students will prepare an investment appraisal of a business project or major sale. They will submit a presentation and a supporting spreadsheet analysis. This address LO2 and LO3.

The module assessment cycle shows all assessment related activities of the module.

How is your work marked?

To pass the module you must achieve an overall minimum mark of 50%. If you pass the module on re-assessment, the component you resit will be capped at a pass mark level of 50%.

The marking process makes sure that our marking of your work is fair and transparent. There is a first marker responsibility for giving your formal feedback and making an initial assessment of the standard of your work by giving it a provisional mark. After this there are two further layers of checking and assurance. It is worth noting that this process means that you are unable to appeal your final marks and/or grades on the grounds of academic judgement.

You will be marked, graded and assessed according to the following PG criteria :

Class

Mark %

Characteristics

Distinction

70 +

Excellent in every way. Knowledgeable, incisively analytical, conceptually sound, widelyresearched and well-structured. Displays a critical and sophisticated understanding of ideas, debates, methodologies and principles. Comprehensively cited and referenced. A degree of flair apparent in the work.

Merit

60 – 69

Very good, well-researched, solid. Addresses question. Sensibly structured and well presented. Evidence of analysis, reasoning and evaluation. May have some errors in emphasis but not in fact, and may be limited in terms of supporting material and breadth of coverage. Appropriately cited and referenced.

Pass

50 – 59

Average to good. Reasonable bibliography. Signs of effort, though more descriptive than analytical. May have some errors but balanced by sound work. May not fully address the question with deficiencies in knowledge and understanding or directness and organisation.

Fail

40 – 49

Fail. Descriptive narrative. May be partly irrelevant. Indiscriminate. Lacks structure. Could be more direct and explicit. Little independent research evident. Short bibliography.

May be confused or irrelevant. Heavily based on lecture notes, but a minimum of understanding to justify a pass. Answers by inference.

Fail

0 – 39

Poor. Does not answer question directly. Little evidence of independent reading or lecture notes. Major errors or too brief. Unstructured.

Very poor indeed. Fails in every respect to answer the question effectively. No evidence of learning, reading or knowledge. Largely irrelevant. Very brief.

Appendix 1

Assessment 1

Assessment Brief

Forming Groups

The presentation group is the same group that you are working with in the business simulation. It is important that you develop into a high performing team, which requires investment of time and commitment. At the outset it is important to agree when you will meet, for how long and who will arrange each session and keep the group log (attached). All group members should contribute to the decision-making process. You will have one hour available in lesson time for each round of the simulation but you may need to work together outside of this time.

The group must made up of 4 members (maximum).

The Assessment

Your Task

You are required to give a 10-minute presentation to the investors in your business on the strategic financial decisions you made, the financial position of the company. Following the presentation there will be 10 minutes available for Question and Answers.

Each student is required to complete an Individual and Group Work Evaluation log (see appendix) and submit to Turnitin with their PowerPoint presentation.

Presentation structure

Using an appropriate template, you should structure your presentation as follows:

· Title page

· Group member list including student IDs

· Presentation Agenda

· Summary Slide

· Financial performance and analysis

· Key decisions taken

· Appendix – Detailed financial information and calculations

· Appendix – Group Contribution Log

All members of the group should present and each presenter should take ownership of a specific section and a sub-heading slide should be included with the presenter’s name showing the content that they presented.

Assessment Marking Scheme

General Assessment criteria:

The presentation should meet the following criteria:

· It should be clear, concise and professional;

· It should consist of PowerPoint slides and live presentation.

· All members of the group should take part in the presentation;

· It should be no more than 10 minutes long with 5 minutes available at the end for questions.

The assignment is marked out of 100.

Group Log

The group meeting log should be submitted as an appendix slide or slides to your presentation. You do not need to present it.

Describe how you went about tackling the simulation (e.g. did you assign roles, take decisions collectively)

Did anyone take responsibility for making sure that the group submitted the decisions on time for each round?

Did you need to work outside of the time allotted in class and if so how did you organise the group to get together?

How did you resolve conflict in the group?

Do you feel everyone in the group contributed equally to the task?

Is there anything that you would do differently next time?

Appendix 2

Assessment 2

Assessment Brief

Introduction

The assessment assesses learning outcomes 2 and 3 of the 3 module learning outcomes of this module, which are that on successful completion of the module students will be able to:

· Demonstrate an understanding and use of the appropriate analytical techniques to be applied to business case development and Investment appraisal; the raising of finance and the distribution of funds to investors;

· Communicate financial information, analysis, issues and recommendations clearly and concisely.

The Question

Background information

Smart Home Plc (a fictional company) is a UK incorporated and UK tax resident technology company focussing on the manufacture and retail of internet enabling devices for homes.

The business has been conducting Research and Development on a new smart watch and now needs to make a decision whether to go ahead with launching the product and determining what is an appropriate price for it.

You are the Business Manager responsible for the product launch and the CEO has asked you to prepare a report on the investment in the new product. With the Finance Manager on leave for the next 3 weeks, you are on your own for the presentation.

You have been given the following information from various teams in the organisation.

R&D Team

“We’ve spent quite a lot on developing this project – £450,000 – and it would be a shame if we didn’t get it to market. I would estimate that we would need to spend around and other £60,000 on research costs to get it to a position where it is ready to launch”.

The production department:

“I’ve looked into the production of the smart watch and we will need to purchase a new machine to manufacture at the scale we want which will which will cost us £1,500,000. We have spare capacity in current staff to run the machine, but we will need to hire a “Specialist Supervisor” for the machine – I asked the HR team to let me know what the salary for that person would be, but they haven’t got back to me yet. The machine will last for around 5 years – you need that for your depreciation calculations right?”

The Marketing director

“I’ve done some research on the potential pricing of the watch and likely customer targets and worked with someone in the finance team to look at pricing. I think our wholesale sales price should be £150 per watch over the course of the whole 5 years. The cost of the raw materials makes up 40% of the sales price. My team have estimated that sales for the first 5 years should be as follows:

Year 1

10,000 watches

Year 2

12,500 watches

Year 3

15,750 watches

Year 4

15,750 watches

Year 5

12,350 watches

After 5 years we think that the tech will have advanced beyond this and the product will no longer be attractive so we are assuming that the life of this project will probably only be until then before we need to make a new investment, and we are constantly innovating other projects. The machine will not have any scrap value at this stage.

We’re planning an advertising and marketing campaign costing £545k in year 1 to get started and these costs will the same in in year 2 and 3, and fall to £190k in years 4 and 5. Oh, and HR have just confirmed that the Supervisor salary and benefits will start at £36k in year 1 but we expect inflationary rises to be 3% year on year. That includes our National Insurance costs”

You have investigated how to calculate an appropriate cost of capital (WACC) and gathered the following information:

· The market value of the shares is £2.75 per share and there are 5.5 million ordinary shares in issue. Dividends are expected to continue at 30p per share for the foreseeable future

· The company has £10m in irredeemable loan capital with an interest rate of 7% and it is currently quoted at £95 per £100. The tax rate is 20%.

The business has previously been using an estimated Weighted Average Cost of Capital of 20% and the management team would like to see your calculations using the WACC you have calculated and the original estimate of 20%.

Your task

In the absence of the Finance Manager the CEO wants you to make a presentation to the Board about whether the project should go ahead. The Board are not finance people but are very interested in the techniques that are used to appraise investments and so would like a comprehensive explanation of how you came to your conclusion. In particular they would like you to include the following:

1. Executive summary

2. A projected cash flow for the project over its 5 year life

3. An explanation of cost of capital including:

a. What is Weighted Average Cost of Capital (WACC)?

b. What do we use WACC for?

c. Your calculations of the WACC of capital for the business showing each of the individual components.

4. A financial evaluation of the project using the NPV and Payback Period Methods including:

a. Your calculations of NPV and Payback period for the project using WACC (the detail should be in the Appendix of the report and should be calculated in Excel)

b. Your calculations of NPV and Payback period for the project using the previous business cost of capital of 20% (the detail should be in the Appendix of the report and should be calculated in Excel)

c. A decision as to whether the project should go ahead and your justification for this decisions

5. An explanation of the benefits and limitations of the 4 main investment appraisal techniques.

6. An explanation of the different types of funding available to a company (Long term, short term, equity and debt and others), the advantages and disadvantages of each and a detailed explanation of what a bank might look at in deciding whether to make a loan to a company and the steps they might take for extra protection on the loan repayment.

7. Conclusion

Your report should have an executive summary at the start and a conclusion at the end and you should conclude on the viability of the project at the current cost of capital and the situation if cost of capital were 20%.

Structure of the report

The report should be prepared in PowerPoint and should contain the following slides:

· Executive summary ( A summary of your proposal in a page)

· Introduction

· Calculation and critical evaluation of WACC (detailed calculation may be shown in an Appendix)

· Projected cash flow

· Calculation of NPV and PP (detailed calculation may be shown in an Appendix) using the WACC

· Calculation of NPV and PP (detailed calculation may be shown in an Appendix) using a cost of capital of 20%

· Explanation of and critical evaluation of the 4 main capital investment appraisal techniques

· Critical explanation of different forms of funding for companies

· Conclusion

· Appendices – detailed calculations and references

The Powerpoint file should be uploaded to Turnitin. A template is provided but you should feel free to adapt and personalise this.

Assessment Marking Scheme

The assessment is marked out of 100.

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MN7029 Week 4.3

M&A & International Business

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Week 4.3 – Learning Objects

Identify the main reasons why a company will undertake M&A;

Discuss the legal forms of a takeover;

Consider methods for valuing shares;

Discuss what a business needs to consider when expanding overseas

Identify the key components of a business plan;

Understand what help is available.

Why did Facebook buy Instagram

https://www.youtube.com/watch?v=3MxNsE7kCT4

https://youtu.be/WYsaedx4KaQ

Two videos to introduce M&A – ten years ago but still very relevant. Key issues to draw out:

$1bn acquisition – before Instagram made any profit, only 8 employees and had only raised $7.5m previously from angel investors and VC

Strategic – Instagram made no money – Facebook was lagging behind in mobile engagement

Facebook going public – money for investment for growing the business, Facebook shares could be used as currency to buy the business

Acquisition of customers

“Acquisition” of the Instagram team

Backdoor into Twitter

Eliminate the threat of Instagram, but kept as a separate brand

Reputation – did customers like this? Facebook had a different profile to Instagram users.

The acquisition was a mixture of cash and stock – i.e. owners of Instagram received Facebook shares

What is a Merger/Acquisition

“Where two businesses combine this can take the form of either a merger or takeover”

Merger usually describes where two businesses are a similar size, takeover tends to refer a larger company acquiring control of a smaller business.

Structurally this involves one company acquiring the shares (ownership) of another business, but that is just the start as the businesses will need to integrate to make the merger a success

Explanation of the terms

Figure 12.2 The rationale for mergers

The economic rational for a merger:

A business has a current present value (we might use different techniques to calculate this)

It’s target also has a value

Combining the two gives a gain which means that the value of the combined business is greater than the sum of its parts (therefore it creates an increase in shareholder wealth)

Figure 12.3 Motives for mergers that enhance shareholder wealth

These are some of the wealth enhancing motives that can create an enhances business value following a merger

Benefits of scale – possibly better negotiation of deals with suppliers as the company becomes larger and more powerful. Also opportunity to reduce costs by combining back office functions, for example one HR team, one finance team

Eliminate competition – does this mean opportunity to charge higher prices, or if competition looks like it might take market share in future e.g. Instagram

Inefficient management – a company may not be performing to its full potential because of inefficient management. Therefore when the acquiring company buys it there may be a chance to fulfil untapped potential

Protect sources of supply – if a company relies on another for its supply e.g. a mobile phone company acquiring the company that supplies microchips

Complementary resources – e.g. combined goods or services that could be sold together to make a more valuable product

Other motives for mergers

Management interests and goals

Other motives for mergers

Diversification

Undervalued shares

Some other motives are diversification of the business e.g. to reduce risk of concentrating on one industry or product, management desire to build a larger business and if the company feels that the shares are undervalued

Who benefits?

The main players are:

Shareholders in the bidding business

Managers

Shareholders in the target business

Advisers

Assuming the economic calculations are correct then both sets of shareholders can benefit from a combined business as the value of the combined entity will be higher than the sum of the individual entities. The managers may now be the management team of a larger entity which can mean more responsibility or personal satisfaction – they are also often given a successful merger completion bonus or shares in the new entity. The whole process also needs a large set of advisers – accountants, tax advisers, lawyers which can be very lucrative for the adviser team

Why do mergers fail?

Integration problems

Management neglect

Overpayment

Hidden problems

However not all mergers are successful – some reasons for failure include:

Overpayment – have the entities miscalculated their respective value or the value of the combined benefits? A miscalculation or incorrect cost of capital may mean that a merger could reduce rather than increase shareholder value.

Integration may not be successful – if the teams have different cultures or values or redundancies are required to achieve merger benefits this can lead to staff dissatisfaction and an impact on company trading. It may also be costly to integrate large computer systems.

A merger can take a huge amount of time and respouirces – there is a danger managers will take their eye of normal trading operations

There may be hidden problems in the company that were not picked up during the process of reviewing the company.

Do Acquiring Shareholders Benefit??

Wealth Destruction on a Massive Scale? A Study of Acquiring-Firm Returns in the Recent Merger Wave, MOELLER, SCHLINGEMANN, STULZ, JOURNAL OF FINANCE • VOL. LX, NO. 2 • APRIL 2005

Yearly aggregate dollar return of acquiring-firm shareholders

A video about Kraft takeover of Cadbury and some of the issues around it

Write down of acquisitions

When companies acquire another company they may be able to account for intangibles such as goodwill. However, they also need to review that value each year

Inflation, poor performance and weakened demand may mean that companies write down their acquisition value and take a hit to their accounts

2021 European Goodwill Impairment Study, Kroll

Source: 2021 European Goodwill Impairment Study| Kroll

Successfully implementing a merger

Rapid integration

Incentivising managers

Early planning

Ensuring sales force fully engaged throughout

Retaining talented employees

Awareness of cultural issues

Here are some tips for successful mergers

Due diligence

May cover an examination of:

Legal obligations

Assets owned

Financial health

Strategic fit

During the merger planning process companies will undertake a due diligence. This is a review of the target to determine its financial health etc etc

Due diligence (Continued)

May cover an examination of:

Key relationships

Marketing and production

Market prospects

Other issues

The valuation of shares

Methods based on stock market information

Methods based on future cash flows

Methods based on the value of the business’s assets

The main methods include:

How do we value a target to decide how much to pay for it? If it is a listed company then the stock exchange provides a price for the company’s shares. However, it is more complicated if it is not listed. We might look at the company’s assets, but the accounts will show the assets at the price they were purchased at minus depreciation so this may not be accurate. It also does not take account of assets that cannot appear in accounts such as internally generated goodwill. Another way is to find a similar company listed on the stock exchange and use their ratios (e.g. earnings per share) to determine the value of a similar but unlisted company. Finally we can use methods based on the present value of future cash flows, just as we learned during the session on NPV of capital asset investments.

One of the most talked about acquisitions of last year was Elon Musk’s takeover of Twitter.

How does Twitter make money?

It can be interesting to consider his reasons for the takeover, but first it’s helpful to consider how Twitter makes money – does anyone know?

Answer – advertising and sales of data

The takeover of Twitter

https://www.youtube.com/watch?v=hIcHfneWEeU

Video explaining the timeline of the Twitter acqusition

Twitter performance and accounts

Source Twitter accounts 2021

Twitter has had only 2 years where it made profits – so why would Elon Musk want to buy it?

It’s revenue comes from advertising and data licencing

Some interesting points…

How was it funded? https://www.reuters.com/markets/us/how-will-elon-musk-pay-twitter-2022-10-07/

The price was $44bn and this was funded party via debt and equity with other investors and his cash from the sale of his Tesla shares

Can he come up with a business model to make Twitter more profitable? Paying for blue ticks?

I don’t know who this will help, but I feel its my duty to add to the business school syllabus the importance of price negotiation with the famous horror author Stephen King

Practical Aspects of a Takeover

Company A

Company B

Shareholders of A

Shareholders of B

Company A pays cash to the shareholders of company B in exchange for their shares.

Company A

Company B

Shareholders of A

Practically for accountants there are three ways a takeover or merger can take place

Firstly Company A pays cash for the shares of company B – therefore the shareholders of B are no longer involved and walk away with cash

Practical Aspects of a Takeover

Company A

Company B

Shareholders of A

Shareholders of B

2. Company A issues shares to the shareholders of company B in exchange for their shares.

Company A

Company B

Shareholders of A

Shareholders of B

Secondly Company A gives shares in Company A to the shareholders in Company B in exchange for their shares in Company B, so now both groups of shareholders own the merged companies. This is what happened when Facebook acquired Instagram

Practical Aspects of a Takeover

Company A

Company B

Shareholders of A

Shareholders of B

3. Company A issues loan stock to the shareholders of company B in exchange for their shares.

Company A

Company B

Shareholders of A

Shareholders of B

Loan stock

Thirdly, if the company does not have enough cash to buy the shares it can issue a loan note to the original shareholders of company B, so they become lenders rather than owners

Protections

City Code on Takeovers and Mergers

Competition and Markets Authority

UK sales revenue>£70m

Combined business has 25% of market

One of the risk of mergers in that they can damage competition in the market. Theerfore many countries have mechanism that mergers over acertain size need to be approved by a regulatory body. In the UK the CMA need to approve mergers over this size.

Valuation for Seed Stage Startups (3 Rules You Need to Know) – YouTube

Video on how a VC fund values seed investment if you have time to show the first few minutes

International Business

International Trade and Supply Chains – YouTube

I wanted to finish the module with some thought about how the scale of global business can impact on financial decision making

The Suez Canal

https://www.youtube.com/watch?v=hIcHfneWEeU

Video about the Suez canal being blocked – ask the class how they think this impacts supply chain and decisions about where to build factories and distribution centres in relation to customers

When does a business need to consider international issues?

Overseas customer

Payment in a foreign currency

An overseas investor e.g. VC fund

Overseas supplier

Overseas employee

Planned market expansion

Acquisition of an overseas business

Sale to an overseas buyer

These days a business may need to consider international implications from Day 1. These are some of the areas that might be relevant:

An overseas customer – how will the product be delivered? What customs duties are there? Can the customer pay in local currency (if so exchange risk) or do you want them to pay in the company’s home currency (less attractive to customer)

If the business is trying to raise seed funding the first investor may be a foreign VC fund or investor. How does this impact how the business communicates its financial statements? Some US VC funds like to invest in a US company and so will require a change in structure of the company

Overseas supplier – same issues with currency transactions and the supply chain issues e.g. Suez

An employee might live overseas (or want to work overseas e.g. during the pandemic). This has local tax reporting requirements which can be costly and complicated.

Expansion – when you expand into a new territory there can be local complications e.g. it is very difficult to set up a business in China with foreign investors, there can be a lot of red tape, what registrations do you need to make, do you need local sales people, distribution centre. There can be cultural differences e.g. cultural customs in Japan can be unfamiliar to a UK or a US business

Over seas acquisitions or sale – how do you know you can rely on the financial statements? Currency and exchange control issues

International considerations

Raw materials may only be available from overseas – how am I processing/transporting/storing

Manufacturing close to market reduces transport costs

Time/language differences with local market e.g. customer support

Different costs of resources e.g. overseas call centres

Diversification of risk

Cheaper finance

Managing supply chains

Local rules about doing business e.g. China

Local taxes, currency restrictions, import and export charges

There may be some compelling reasons to undertaking international operations –

Your Export Journey: The Financial Side of Exporting – YouTube

This is a video about how some small businesses dealt with the issues of exporting to overseas customers

Financial Decision Making and International Markets

Do I need a local entity?

How much does this cost to set up?

Managing foreign currency transactions

Do I need local input?

Local employees or contractors?

Management structure and controls

Computer systems

These are the kind of questions companies consider when setting up in an international market

What’s next?

MN7P13 for those who have completed all six modules – Steve Hills will be in touch about the classes

MN7030 for those still on the carousel, starting week commencing 30 January 2023

Edumundo results for London (Group 1)

In third place…

WatchIT (Team 5)

In second place…

The winners…

Voraus (Team 4)

Schweitzer (Team 3)

Edumundo results for Birmingham (Group 1 & 2)

In third place…

Metawatch (Team 10)

In second place…

The winners…

Bling (Team 14)

World of Watches (Team 8)

Edumundo results for Manchester (Group 2)

In third place…

ADAMS (Team 15)

In second place…

The winners…

Richard Mille (Team 16)

TITAN (Team 17)

Edumundo results for Liverpool (Group 3)

In third place…

PERFECT (Team 23)

In second place…

The winners…

Aara (Team 28)

Loisfoeribari (Team 22)

Edumundo results for Leeds (Group 4)

In third place…

Leec (Team 31)

In second place…

The winners…

Leef (Team 34)

The Better Catch (Team 35)

Edumundo results for Cardiff (Group 4 & 5)

In third place…

Carf (Team 41)

In second place…

The winners…

Cara (Team 36)

& Time (Team 43)

Edumundo results for Edinburgh (Group 5)

In third place…

Joobe (Allie)

In second place…

The winners…

Alpha (Team 46)

LEGENDS (Team 47)

Edumundo overall results

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MN7029 – Financial Decision Making

3.2 Making Capital Investment Decisions (2)/ Financing a business

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

Learning Outcomes

Explain the modifications needed to the simple NPV decision rules where investment funds are limited or where there are competing projects with unequal lives

Discuss the nature of risk and explain why it is important in the context of investment decisions

Describe the main approaches to the measurement of risk and discuss their limitations

Divisible projects

Earlier we considered projects that could not be divided up i.e. the decision was whether to go ahead with a project or not go ahead. We did not consider whether it was possible to do half a project.

The rules for NPV were:

If NPV is positive, accept the project

If you have competing projects accept the one with the higher NPV.

However, we might have a situation where we have one project that will cost £7m, another than will cost £5m but only £10m to spend. If we use the decision rule above we choose the project with the higher NPV and discard the other.

What if we could divide them up?

Example

I have £12m available to spend on a capital investment project. Three potential projects have been identified and the NPV calculated. Which should I choose if the product cannot be divided?

Ask students – hopefully they will identify that project Z gives the highest NPV and so if the project cannot be divided up, the £12m should be spend on the one with the highest NPV.

What about if we can do a “bit” of another project?

If we rank according to NPV we might decide to do all of Project Z with £11m (generating NPV of £3.6m) and then use the remaining £1m for Project Y (NPV would be 1/9 of the total NPV of £3.2m = £0.4m) so total NPV is £4m. Is this the best outcome?

Where projects are divisible, managers should seek to maximise the present value per £ of scarce resource

PI =

PV of future cash flows Initial outlay

Profitability index (PI)

A better way of calculating how much to do of divisible project is using the Profitability Index. This calculates how much PV of future cash flows is generated per £ of initial investment.

Example

I have £12m available to spend on a capital investment project. Three potential projects have been identified and the NPV calculated. Which should I choose if the product cannot be divided?

Ask students – hopefully they will identify that project Z gives the highest NPV and so if the project cannot be divided up, the £12m should be spend on the one with the highest NPV.

Example

Profitability Index = £10.8m/£8m =1.35

Profitability Index = £12.2m/£9m =1.36

Profitability Index = £14.6m/£11m =1.33

We calculate the Profitibiility Index (PI) by dividing the total future PV cash flows by the original outlay. As project Y has the highest PI we should use the funds here, then Project X and finally project Z.

Example

(2) Use remaining £3m on Project X = 3/8 x £2.8m = £1.05m

(1) Use £9m on Project Y = NPV of £3.2m

(3) Total NPV generated = £3.2m+£1.05m = £4.25m

By prioritising Project Y then project X as a result of calculating the profitability index the company can generate a better result of £4.25m

Comparing projects with unequal lives

Equivalent-annual-annuity approach

Shortest-common-period-of-time approach

Two possible approaches

Both methods should provide the same solution

A further complication might be where we need to compare projects with unequal lives. There are two methods we can use here that should give the same result.

Example

	Cash flow	Discount at 10%	Present Value
Machine A:
Initial outlay (Year 0)	(100)	1.00	(100)
Year 1	50	0.91	45.5
Year 2	70	0.83	58.1
NPV			3.6
Machine B:
Initial outlay (Year 0)	(140)	1.00	(140)
Year 1	60	0.91	54.6
Year 2	80	0.83	66.4
Year 3	32	0.75	24.0
NPV			5.0

The company has to make a decision between these two machines. Machine B produces a higher NPV, but over a longer period. Machine A will need to be replaced after Year 2. How do we decide which option to choose?

Figure 5.3 NPV for Machine a using a common period of time

Years	NPV	Discount factor	Adjusted NPV at Year 0
Cycle 1 at Year 0	£3.6m	1	£3.6m
Cycle 2 at Year 2	£3.6m	0.83	£3m
Cycle 3 at Year 4	£3.6m	0.68	£2.5m
Total			£9.1m

The first way to consider this is to calculate the NPV over a common period of time. Machine A runs from Year 0 to Year 2 and produced an NPV of £3.6m when we discount it back to Year 0. Assuming this pattern in repeated, the machine would be replaced for Year 2 to 4 and generate a further NPV of £3.6m when we discount it back to the start of the cycle in Year 2, then replaced again for years 4-6 to generate an NPV of £3.6m when we discount it back to the start of the machine cycle in year 4. We then need to discount these two cycles back to year 0 and that gives us a total NPV of £9.1 for 6 years use of the machines.

Figure 5.3 NPV for Machine a using a common period of time

Years	NPV	Discount factor	Adjusted NPV at Year 0
Cycle 1 at Year 0	£5m	1	£5m
Cycle 2 at Year 3	£5m	0.75	£3.8m
Total			£8.8m

£5m

£3.8m

£8.8m

Doing the same for Machine 2, this has a 3 year cycle so we go through this twice in order to get to the common period of 6 years. For years 0-3 the NPV discounted back to year 0 is £5m. For periods 3-6 the NPV discounted back to Year 3 is £5m, an therefore we discount it again back tot Year 0 to give us £3.8m. Overall this project has an NPV of £8.8m over a six year life. Given the choice between the projects we should therefore choose Machine A as the equivalent NPV over a six year period is £9.1m

Equivalent-annual-annuity approach

For machine A: £3.6m x = £2.07m

Equivalent Annual Annuity = NPV x

For machine B: £5m x = £2.01m

Therefore Machine A has the higher Equivalent Annual Annuity and should be chosen

An alternative way to approach this question is to calculate what the equivalent annual annuity would be relating to the project or what does it represent in terms of constant annual cash flows. To do this we use this formula shown on the slide. Using a discount rate of 10% (represented by i), again Machine A represents the higher EAA and should therefore be chosen.

Investment appraisal and risk

The size of the investment made

The long timescales involved

Risk is important because of:

Another aspect of investment appraisal is risk. We need to consider the risk of things not working out as they have in our prjections and we need to understand the risk profile because of the long timescales and the size of the investment.

Methods of dealing with risk in investment appraisal

Scenario analysis

Risk-adjusted discount rate

Simulations

Portfolio approach

Sensitivity analysis

Expected values

These are some of the methods we can use to assess risk in an investment

Sensitivity analysis involves changing one variable at a time (e.g. change in sales by 10%) to see the effect on NPV

Scenario analysis involves changing all variables and having usually three scenarios – best case, worst case and most likely (we did these two in our session on projections)

We may adjust the discount rate we use according to the risk profile e.g. an inherently more risky project might have a higher discount rate to reflect that risk

We can apply percentage likelihood of each outcome occurring to calculate an Expected Nep Present Value

We can use more complicated software simulations to determine outcome

We can consider diversification of our investment projects into a portfolio to reduce overall risk in the company.

Figure 5.11 Relationship between risk and return

Generally as the risk of a project increases the required return of that project also increases.

What types or sources of finance are available to companies to fund capital investment?

Capital Investment projects often need large sums of money to finance them, so alongside considering the viability of the investment project we also need to think about where the company can raise this finance and what form it might take. Ask the students to give ideas about what sources of finance are available to companies when considering capital investment projects. Hopefully they will be able to identify debt and equity, although they may also talk about the entity providing the finance (e.g. venture capital, crowdfunding etc)

This section moves onto types of finace – you may not be able to get through all of this section but that’s not a problem as we continue on the same topic in session 4.1.

Figure 6.1 The major external sources of finance

The main sources of finance can first be divided into external and internal sources. We are going to look at external first. This is finance that involves going outside of the company to a third party. It can be divided into long term (over 1 year) and short term (less than one year) and into two key types of finance – debt and equity and we will look at each one in turn.

The structure of a company

Company X

Management

Employees

Banks

Customers

Suppliers

General Public

Shareholders

A quick reminder – a company is a sperate legal entity. It is not the same as it’s management team – they have a contract to provide services to the company. It is also not the same as it’s shareholders – they own the shares of slices that the company is divided up into. It is also not the banks – this is a completely separate third party who has agreed to provide the company with money for a stated period of time under a contractual arrangement.

Ordinary shares

Looking first at share ownership, the most common type of shares are ordinary shares. There are a number of properties of ordinary shares, explained above.

No fixed right to a dividend

More volatile market price

“Residual”

High risk, therefore relatively high rate of return expected

High upside potential

Control/owners of the business

Preference shares

An alternative to ordinary shares in preference shares. These are much less common nowadays but the key difference is that they had a fixed right to a dividend but usually not voting rights and little upside (this residual goes to the ordinary shareholders who are bearing more risk).

Fixed right to a dividend & “first slice”

Less volatile market price

Rights documented in constitution documents

Lower risk than ord shares, therefore lower return

Little upside potential

Usually no voting rights.

Borrowing/Loan Capital

The other key long term finance option is a bank loan. This is completely different to shares as it is a contractual rather than an ownership relationship. It is low risk from the perspective of the bank as there is a right to interest and if the company is in trouble the bank loans take priority over the shareholders. There is little upside if the company does well and no voting rights.

Contractual right to interest

May be traded

Contractual obligation

Lower risk than shares, therefore lower return

No upside potential beyond more security

May use loan covenants or securities

Figure 6.2 The risk/return characteristics of sources of long-term finance

From the perspective of the person providing the finance this is the risk profile – loans have the lower risk going up to ordinary shares which carry the highest risk because they have no fixed or contractual right to a return and are the lowest priority if the company fails. They do however get the benefit of all of the upside if the company performs well.

Public v Private Companies

Company X

Management

Employees

Banks

Customers

Suppliers

General Public?

Shareholders

General Public

It is worth clarifying the difference between public and private companies. Both public and private companies are owned by shareholders, but in the case of public companies those shares can be traded freely among the general publiuc.

Public or Private Company

A private company (in the UK a Ltd) is held privately, usually by founders or other private individual investors.

The general public cannot buy or sell shares in Limited

May invite specific people to invest (e.g. a Private Equity Fund or Business Angel)

Does not appear on a Stock Exchange

A public company (in the UK a Plc) has sold some or all of its shares to the general public by way of an Initial Public Offering (IPO).

Listed on a stock exchange

Public can buy and sell shares on investment platforms

Has a higher level of scrutiny

Explanation of the terms

Public or Private Company

Public companies tend to be larger and have more access to funding, but there are some very large private companies

What is the function of a stock market?

The Stock Exchange

Secondary market

Primary market

Two important roles

A publicly traded company is listed on a stock market. The market has two functions – firstly for the company to raise new capital (the first time it does this on the stock market is known as an Initial public Offering or IPO). The second function is then to provide liquidity for the shares – shareholders can buy and sell their shares as they wish, without involvement of the company. It is worth clarifying that when individuals buy and sell shares among themselves this does not generate new finance for the company. It does however indicate the share price – if shares are in demand the price rises and therefore the value of the company increases.

What is an IPO (video)? https://www.youtube.com/watch?v =l4HMCr5roAM

What is an IPO (video)?

Stock Exchange listing

Advantages for a business

Enables other businesses to be acquired by shares rather than cash

Shares valued in an efficient manner

Broadens investor base/exit for founders

Raises profile

Funds acquired at lower cost

Easier to raise funds

Can help attract and retain employees (share incentives)

Self explanatory advantages – I like to use the example of Facebook which was listing at the same time as buying Instagram so the listing gave a valuation to Facebook and allowed it to use its shares as currency in the acquisition of Instagram

Stock Exchange listing (Continued)

Increased vulnerability to takeover

Close monitoring of actions and decisions

Increased regulatory burden

Cost (including management time)

Disadvantages for a business

UK IPO Journey (https://pwc.blogs.com/deals/2015/07/ipo_journey.html)

This is a PwC flier that explain the stages of a company’s IPO journey

What’s Next…

7.30pm 8.30pm – Business Simulation Round 5

8.30pm – Finish!

For Thursday (Groups 1 & 2) & Friday (Groups 3, 4 & 5) …

GROUP PRESENTATIONS!!

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MN7029: Financial Decision Making

2.2 Cost behaviour, pricing and budgets

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Learning Outcomes

Define and distinguish different categories of cost

Understand how a fixed cost and a variable cost behave and deduce the break even point

Understand the benefits and limitations of using marginal contribution analysis and break even point

Discuss the impact for managers in decision making

Describe operation of full absorption costing and Activity Based Costing

Define a budget and show how budgets and strategy are related.

The Decision Making Process

4. Develop short term plans/budgets

3. Select option and consider long term plans

5. Implement the decisions

6. Review and monitor outcomes of decision

7. Act on differences from plan

2. Consider options available

1. Set aims and objective

What is the purpose of management accounting?

Allocate costs between costs of goods sold and inventory for reporting

Provide date for management decision making

Information for planning and performance review

Definition of cost

The amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective

For example:

A hotel uses resources such as food to make breakfast, labour to clean rooms and electricity to provide light to achieve the objective of providing a comfortable place to stay for customers

Examples of costs

Fixed and variable – we will discuss next

Direct and indirect – can it be exclusively identified with a cost object or is it an overhead?

Sunk Costs – costs incurred as a result of a past decision that cannot be reversed

Opportunity cost – benefit that is lost as a result of a choice of one course of action rather than another

Behaviour of costs

Helps managers to determine:

How many units to break even point – the number of items sold where costs are equivalent to revenue and therefore there is no profit or loss

Effect of reducing/increasing sales price

Effect of an increase or reduction in volume of sales

Effect of a incurring an additional cost of a marketing campaign or

How best to pay people

Two types of cost

The value of an opportunity forgone

Opportunity cost

A cost already incurred

Historic cost

Figure 7.1 Decision flow diagram for identifying relevant costs

Relevant cost

Irrelevant cost

Does the cost relate to the objectives of the business?

Does the cost vary with the decision?

Does the cost relate to the future?

Yes

The behaviour of costs

Remain constant (fixed) when changes occur to the volume of activity

Vary according to the volume of activity

Costs may be classified as:

Fixed

Variable

The value of costs incurred in producing one unit.

Fixed Costs

Fixed cost: total remains constant in proportion to the level of activity, within a relevant range (per unit decreases)

For example: Rent

Salaries

Advertising

Example: I have rented a factory for £5,000 per month to make my cupcakes. If cake production goes up 10%, rent does not change.

Production

Cost

Figure 7.3 Graph of rent cost against the volume of activity

Rent cost (£)

Volume of activity

Variable Costs

Variable cost: total changes in proportion to the level of activity (unit cost remains constant)

For example: Number of units produced

Hours worked

Rooms occupied

Example: If I am making cake and each cake needs 200g of flour then if cake production goes up 10%, so does the quantity and total cost of flour.

Cost

Production

Figure 7.5 Graph of total cost against the volume of activity

Graph of total sales revenue against the volume of activity

Total sales £

Volume of activity

Figure 7.5 Graph of total cost against the volume of activity

Figure 7.6 Break-even chart

Break even point:

Figure 7.7 Break-even and load factors at Ryanair

Load factor

Break-even point

100

Per cent

2013

2014

2015

2016

2017

Source: Based on information contained in Ryanair Holdings plc, Annual Report 2017.

Why does a manager need to know which costs are variable and which are fixed?

Prediction of costs

Traditional accounts separate costs on a functional rather than behavioural basis

The Contribution Approach

Start with sales

Deduct variable costs

Contribution margin

Example CVP

	Total	Per unit
Sales (1,000 cakes)	£10,000	£10
Variable costs	£4,000	£4
Contribution margin	£6,000	£6
Fixed costs	£3,600
Profit	£2,400

Contribution margin shows the amount available to cover fixed costs and then provide profits.

If Contribution margin does not cover fixed costs the company makes a loss

CVP and Break even

	Total	Per unit
Sales (600 cakes)	£6,000	£10
Variable costs	£2,400	£4
Contribution margin	£3,600	£6
Fixed costs	£3,600
Profit	£0

To reach break even point, the company must make enough contribution margin to cover fixed costs

Since our cakes have a contribution margin of £6 per unit and fixed costs of £3,600 we can calculate that the break even point is 600 cakes (£3,600/£6)

CVP Chart

Revenue 0 100 200 300 400 500 600 700 800 900 1000 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 Variable costs 0 100 200 300 400 500 600 700 800 900 1000 0 400 800 1200 1600 2000 2400 2800 3200 3600 4000 Fixed costs 0 100 200 300 400 500 600 700 800 900 1000 3600 3600 3600 3600 3600 3600 3600 3600 3600 3600 3600 Total costs 0 100 200 300 400 500 600 700 800 900 1000 3600 4000 4400 4800 5200 5600 6000 6400 6800 7200 7600

Units sold

£ Costs and Revenue

Example CVP

	Total	Per unit
Sales (601 cakes)	£6,010	£10
Variable costs	£2,404	£4
Contribution margin	£3,606	£6
Fixed costs	£3,600
Profit	£6

Above break even, each sale will increase profit by the contribution margin – so if we sell 601 cakes: profit = contribution margin = £6

Managers use this to work out budgets simply at different levels of activity – you just need to multiply the units over break even point by the contribution margin per unit to give the profit

Cost Volume Profit Analysis recap

Total cost (or full cost) = Fixed costs + variable costs

Contribution margin = Sales revenue per unit – variable costs per unit

Break Even Units =

Examples of how to use CVP

Break even point = = = 600 cakes

No of cakes sold to achieve profit of £5,000 = = = 1,433 cakes

Additional profit from sale of an extra 100 cakes above break even = 100 × £6 = £600

What price do we sell cake at if we want to make a profit of £5,000 at 600 cakes? Total revenue to get £5,000 profit would be Fixed costs (£3,600) plus variable costs (600 × £4 = £2,400) plus required profit (£5,000) = £11,000. Divided by number of cakes (600) gives a selling price of £18

Contribution Margin Ratio

	Total	Percentage of sales
Sales (1,000 cakes)	£10,000	100
Variable costs	£4,000	40
Contribution margin	£6,000	60
Fixed costs	£3,600
Profit	£2,400

Contribution margin can also be calculated as a % of sales:

Profit = (Sales Revenue x contribution margin) – Fixed costs

Application of CVP

Once we know contribution margin, managers can use this in decision making, for example modelling the impact on profit of:

A change in fixed costs and sales volume (e.g. an advertising campaign)

A change in variable costs and sales volume (e.g. using higher quality raw materials)

A change in fixed cost, sales price and sales volume

A change in variable costs, fixed costs and sales volume

A change in sales price

You can also use it for target profit analysis

Margin of safety = Budgeted or actual sales – Break even sales

Margin of safety % =

Practice question

Question 1: You decide to reduce variable costs by using a lower quality ingredients with a per unit cost of £2 but this will cause sales to fall to 700 cakes – should you do it?

Question 2: You decide to undertake an advertising campaign which will cost £1,000 but will increase sales to 1,200 units. Should you do it?

	Total	Per unit
Sales (1,000 cakes)	£10,000	£10
Variable costs	£4,000	£4
Contribution margin	£6,000	£6
Fixed costs	£3,600
Profit	£2,400

Practice question

Q1: You decide to reduce variable costs by using a lower quality ingredients with a per unit cost of £2 but this will cause sales to fall to 700 cakes – should you do it?

New contribution margin = 700 x £8 = £5,600

Present contribution margin = 1,000 x £6 = £6,000

Decrease in total contribution margin = £400

Q2: You decide to undertake an advertising campaign which will cost £1,000 but will increase sales to 1,200 units. Should you do it?

Incremental contribution margin = £6 x 200 = £1,200

Increase in fixed costs = £1,000

Increase in profit = £200

Figure 7.10 The effect of operating gearing

Volume of output

Profit

Cost Structure/Operating Gearing

What is the best trade off between fixed and variable costs

E.g. buying in components rather than making yourself, automating by machinery rather than labour costs

In my cupcake factory I have the choice of using a individuals to make the cakes (high variable cost, lower fixed cost) or a machine to (low variable cost, high fixed cost)

As you can see at sales of 1,000 I get the same profit whatever I choose.

	Total	Per unit	Total	Per Unit
Sales (1,000 cakes)	£10,000	£10	£10,000	£10
Variable costs	£4,000	£4	£2,000	£2
Contribution margin	£6,000	£6	£8,000	£8
Fixed costs	£3,600		£5,600
Profit	£2,400		£2,400

Cost Structure/Operating Gearing

What happens if there is a 10% increase in sales?

	Total	Per unit	Total	Per Unit
Sales (1,100 cakes)	£11,000	£10	£11,000	£10
Variable costs	£4,400	£4	£2,200	£2
Contribution margin	£6,600	£6	£8,800	£8
Fixed costs	£3,600		£5,600
Profit	£3,000		£3,200

For a 10% increase in sales, option 1 gives a 25% increase in profit, option 2 gives a 33% increase in profit.

Cost Structure/Operating Gearing

What about a 10% decrease in sales?

	Total	Per unit	Total	Per Unit
Sales (900 cakes)	£9,000	£10	£9,000	£10
Variable costs	£3,600	£4	£1,800	£2
Contribution margin	£5,400	£6	£7,200	£8
Fixed costs	£3,600		£5,600
Profit	£1,800		£1,600

For a 10% decrease in sales, option 1 gives a 25% decrease in profit, option 2 gives a 33% decrease in profit.

Higher proportion of fixed costs mean a higher break even point and more profit volatility – more upside when things go well but also more downside…

Operating leverage

The degree of operating leverage shows how profit moves when sales move.

If leverage is high, profit will move proportionately more than if it is low

Operating leverage =

Option A – operating leverage at 1,000 sales = 2.5

Option B – operating leverage at 1,000 sales = 3.33

Figure 7.8a Break-even chart – low gearing

Figure 7.8b Break-even chart – high gearing

Revenue/Cost (£000)

Fixed cost

Volume of activity (number of baskets)

100

400

300

200

500

Total costs

Break-even point

Total revenue

LOSS

PROFIT

600

Margin of Safety

How “safe” is a business in relation to changes in sales volume?

Margin of safety in £revenue = estimated sales revenue – breakeven sales revenue

Margin of safety % = x 100

Figure 7.9 Ryanair’s margin of safety

Margin of safety

Operating profit

Margin of safety (as a percentage of BEP)

1000

600

400

200

1600

Operating profit (in millions of euros)

2013

718

2014

659

2015

1043

800

1200

1400

2016

1460

2017

1534

Source: Derived from information contained in Ryanair Holdings plc 2013 Annual Report.

Examples of business with different gearing

Jones, T. (2012) Strategic managerial accounting: hospitality, tourism and events applications. Oxford, U.K.: Goodfellow p42

Weaknesses of break-even analysis

Three general problems

Non-linear relationships

Stepped fixed cost

Multi-product businesses

Decision making

Marginal cost – the cost of producing one more unit

Marginal analysis – only costs and revenues that vary with decision are considered, so fixed costs excluded.

Uses

Deciding whether to apply a discount to a particular order

Scare resources – calculate the contribution per unit

Deciding whether to buy a component or make in house

Considering whether to close departments

Why do we need to know the full cost of a product?

Figure 8.1 Uses of full cost by managers

Assessing relative efficiency

Uses of full cost

Exercising control

Pricing and output decisions

Assessing performance

Full costing

Earlier we looked top down:

Sales	X
Variable costs	(X)
Contribution to fixed costs	X

Now we look bottom up:

Direct costs	X
Allocation of indirect costs	X
Total cost of one unit	X

Direct and indirect cost

All other elements of cost, that is, those that cannot be directly measured in respect of each particular unit of output

Categories of cost

Direct cost

Cost that can be identified with specific cost units – the effect of the cost can be measured in respect of each particular output

Indirect cost or overheads

Figure 8.2 Percentage of full cost contributed by direct and indirect cost

Indirect cost

Direct cost

Percentage of full cost

All 176 businesses

Manufacturing businesses (91)

Service and retail businesses (85)

Source: Al-Omiri, M. and Drury, C. (2007) ‘A survey of factors influencing the choice of product costing systems in UK organizations’, Management Accounting Research, December, pp. 399–424.

Figure 8.3 The relationship between direct cost and indirect cost

Full cost of the job

Direct cost of the job

Appropriate share of indirect cost (overheads)

Why is this a problem?

If we produce one homogenous product (e.g. identical cupcakes) we could just split the overhead over units produced

E.g In my cupcake factory the overhead is £20,000 and I produce 10,000 cakes I could allocate £2 to every cake to determine price.

But if my factory produces cupcakes and cars and I produce 10,000 cakes and 500 cars with a total overhead of £500,000, is it fair to allocate £48 to each cupcake and each car?

Figure 8.5 The relationship between direct, indirect, variable and fixed costs of a particular job

Total (or full) cost of a particular job

Fixed cost

Indirect cost (overheads)

Direct cost

Variable cost

VARIABLE

FIXED

DIRECT (Traced to a product)

INDIRECT

Raw materials; commissions

Electricity for a whole factory

Some labour; rent for a production plant

Head office rent and salaries

Insert footer / references if needed

Traditional full costing process

How do we assign an indirect cost to individual differing units?

Full costing sees overheads as a service to the end cost unit (e.g. factory overhead provides a service to the end product of keeping the machine operating, housing the product etc).

We need to choose something measurable on which to apportion the overhead

This could be

Labour hours

Machine hours

Physical space

Number of employees

And so on…

Budgeting

Figure 9.1 The planning and control process

Identify and assess strategic options

Revise plans (and budgets) if necessary

Undertake a position analysis

Establish mission and objectives

Select strategic options and formulate long-term (strategic) plans

Prepare budgets

Perform and collect information on actual performance

Respond to variances and exercise control

Identify variances between planned (budgeted) and actual performance

Budgeting

Plan the operations for the year – takes an organisational objective and quantifies it.

Measure performance against targets (control)

Coordination of different parts of the business

Communicates expectations to unit managers

Helps efficient allocation of resources

Motivation to achieve organization’s goals

Helps to control and authorize the ongoing activities

Evaluate performance of individual managers

Figure 9.3 The interrelationship of operating budgets

Finished inventories budget

Production budget

Raw materials inventories budget

Overheads budget

Trade receivables budget

Trade payables budget

Capital expenditure budget

Raw materials purchases budget

Sales budget

Direct labour budget

Cash budget

An example of a budget – the cash budget

Jan Feb Mar Apr May June

£000 £000 £000 £000 £000 £000

Receipts

Receivables 60 52 55 55 60 55

Payments

Payables (30) (30) (31) (26) (35) (31)

Salaries and wages (10) (10) (10) (10) (10) (10)

Electricity (14) (9)

Other overheads (2) (2) (2) (2) (2) (2)

Van purchase (11)

Total payments (42) (42) (68) (38) (47) (52)

Cash surplus 18 10 (13) 17 13 3

Cash balance 30 40 27 44 57 60

Opening balance 12 30 40 27 44 57

An example of the inventories budget

	Jan £000	Feb £000	Mar £000	Apr £000	May £000	June £000
Opening balance	30	30	30	25	25	25
Purchases	30	31	26	35	31	32
Inventories used	(30)	(31)	(31)	(35)	(31)	(32)
Closing balance	30	30	25	25	25	25

Budget variances

	Original budget	Actual
Output (production and sales)	1,000 units	900 units
	£	£
Sales revenue	100,000	92,000
Direct materials	(40,000)	(36,900) (37,000m)
Direct labour	(20,000)	(17,500) (2,150 hr)
Fixed overheads	(20,000)	(20,700)
Operating profit	20,000	16,900

Flexible budgets

A more valid comparison can be made between the budget (using the flexed figures) and the actual results.

	Original budget	Flexed budget	Actual
Output (production and sales)	1,000 units	900 units	900 units
	£	£	£
Sales revenue	100,000	90,000	92,000
Direct materials	(40,000)	(36,000) (36,000m)	(36,900) (37,000m)
Direct labour	(20,000)	(18,000) (2,250 hr)	(17,500) (2,150 hr)
Fixed overheads	(20,000)	(20,000)	(20,700)
Operating profit	20,000	16,000	16,900

Figure 9.6 Relationship between the budgeted and actual profit

equals

minus

Actual profit

plus

All adverse variances

All favourable variances

Budgeted profit

Behavioural issues of budgetary control

Demanding, yet achievable, budget targets can motivate more than less demanding ones

Unrealistically demanding targets can adversely effect managers’ performance

Budgets can improve job satisfaction and performance

Participation of managers in setting their targets can improve motivation and performance

Making Budgetary Control Effective

A serious attitude taken to the system.

Clear demarcation between areas of managerial responsibility.

Budget targets that are challenging yet achievable.

Established data collection, analysis and reporting routines.

Reports aimed at individual managers, rather than general-purpose documents.

Fairly short reporting periods.

Timely variance reports.

Action being taken to get operations back under control if they are shown to be out of control.

What’s Next…

7.30pm to 8.30pm – Review round 1 and prepare round 2.

8.30pm – Finish!

Next time:

Business Simulation round 2 submitted by 3pm Wednesday 14th December

Review Weblearn for extended learning questions

Read Atrill Ch 10

Consider: You run a business producing health food bars and selling them to supermarkets wholesale and customers online. What are the key elements of working capital management that you are concerned with?

"Buying goods on credit can be a good source of finance so it is good financial management practice to delay payment for as long as possible." Do you agree with this statement?

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MN7029 – Financial Decision Making for Managers

Session 3.1

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Learning Outcomes

Explain the nature and importance of investment decision making

Identify and evaluate the four main investment appraisal methods

Use each of the four methods to reach a decision on a particular investment opportunity

Explain the key steps in the investment decision-making process

Maximising Shareholder Wealth

£1m funds available

Bank – interest rate ?%

Investment – return ??%

Dividend – shareholders decide where to invest… ??%

A reminder – the role of the management is to maximise shareholder wealth. In order to do so excess funds either need to be invested in the bank, re-invested in the business in profitable opportunities or returned to the shareholders via dividend so they can make the decision where to invest for maximum return. To day we are looking at the second of these – investigating whether reinvestment in capital projects is going to achieve the aim of maximising the wealth of the shareholders so that the management team can decide whether to proceed.

What is a capital investment project?

Ask the class to see if any have ideas about what we are talking about

What is a capital investment?

Using money to buy fixed assets, or otherwise expand the business

Not day to day operational expenses (working capital)

Capital investment is using money to buy fixed assets or expand the business in some way (e.g. undertake research in to a new product). It is not the working capital or every day expenses of the business

Sources: https://www.bbc.co.uk/news/uk-england-somerset-55823575

https://www.insidermedia.com/news/midlands/new-1.7m-starbucks-site-sold

Some capital investment projects take years and years and cost huge amounts of money – building this nuclear plant is a capital investment project and will take 10 years and cost between £22 and £23bn. Starbucks opening a new coffee shop is also a capital investment project but only takes 6 months and costs £2.7m which is being funded from the company’s own available cash.

The nature & importance of investment decisions

Large amounts of resources are often involved

Relatively long timescales are involved

Often difficult or expensive to bale out of an investment once undertaken

Why are these decisions important?

Figure 4.1 Annual and cumulative cash flows over time for the development of a successful therapeutic drug

Source: Adapted from: ‘Biotech Economics and Valuation’ Massachusetts Biotechnology Council and L.E.K. Consulting, August 2009, p. 3. Reprinted with permission from L.E.K. Consulting. L.E.K. Consulting is a registered trademark of L.E.K. Consulting, LLC. All other products and brands mentioned in this document are properties of their respective owners.

Research into new drugs is another example of a capital investment project which takes years. This example shows expenditure on drug research over 6 years before product launch and then another 4-5 years after the before the drug breaks even

Capital Budgeting

https://www.investopedia.com/terms/c/capitalbudgeting.asp

Investopedia video on capital budgeting

Figure 4.8 Managing the investment decision

How does this fit into decision making? Companies will go through this process:

Determine how much cash is available

Identify projects that could be undertaken

Get more detail on each of the potential projects

Figure 4.8 Managing the investment decision (Continued)

4. Use the tools we are about to look at to evaluate and rate the projects

5. Make a decision on which one(s) to proceed

6. Monitor the budget and control the project

Investment appraisal methods

Four methods of evaluation

Accounting rate of return (ARR)

Payback period (PP)

Net present value (NPV)

Internal rate of return (IRR)

These are the 4 methods we use to evaluate the projects – we will look at each one in turn

Accounting rate of return (ARR)

Average annual operating profit Average investment to earn that profit

ARR =

× 100%

Average annual operating profit Average investment to earn that profit

ARR =

× 100%

The first is a traditional accounting method of project evaluation. This is the Accounting Rate of Return – it takes the average operating profit for each year of the project and divides by the average investment. This is then multiplied to give a percentage return. It is very similar to Return on Capital Employed which we looked at in financial ratios

ARR example

Year	Cost	Operating profit
Now (Year 0)	(160,000)
Year 1		20,000
Year 2		40,000
Year 3		60,000
Year 4		60,000
Total		180,000

I am deciding whether to buy a new machine for £160,000

In years 1 to 4 it generates the profit to the left totalling £180,000. On average this is £45,000 per year

Average investment is (Cost of machine + any disposal value )/2 which is £80,000

x 100 = 56.25%

A machine costs £160k. If I buy it now (which we refer to as Year 0) I will be able to generate profits for the next four years as per this table. The total profits generated are £180k and if we divide by 4 we get an average profit per year of £45k. The average investment is calculated by the value of the machine at the start (£160k) and the value at the end (in this case there is no scrap value so 0) and finding the average i.e. add together and divide by 2 (£80k). Finally the ARR is calculated by dividing the average profit by the average investment and multiplying it by 100. This project has an ARR of 56.25%, meaning a return of £56 earned on the average capital. This in itself does not tell us however whether we should proceed with the project.

ARR decision rule

Where competing projects exceed the minimum rate, the one with the highest ARR should be selected

For a project to be acceptable, it must achieve at least a minimum target ARR

In order to decide whether to proceed we need a decision rule. In the case of ARR, companies need to set a target. If the project ARR exceeds the target it can go ahead. In the case of 2 projects, you would choose the one with the largest ARR.

Problems with ARR

Ignores the timing of cash flows

Use of average investment

Use of accounting profit

Competing investments

Problems:

Uses accounting profit rather than cash (which is more subjective) and ignores the timing – we will talk much more on timing issues later

It also has uses average investment which is not a real cash flow and doesn’t necessarily help us choose between competing investmnets

Payback period (PP)

Time taken for initial investment to be repaid out of project net cash inflows

Payback period is even more simple – it calculates how long it takes for the cash spent on the project to be repaid by the cash flows coming in on the project.

Example 4.1 (Atrill p150)

Time		£’000	Cumulative
Immediately	Cost of machine	(100)
In 1 year	Net cash inflow	20
In 2 years	Net cash inflow	40
In 3 years	Net cash inflow	60
In 4 Years	Net cash inflow	60
In 5 years	Net cash inflow	20

The easiest way to calculate this is to present it like this. In Year 0 we have a cash outflow as we have purchased a machine for £100k. We then get cash coming in from the project over the next 5 years. We add a cumulative column to see how long it takes tp offset the cash out.

Ask class to fill in a couple of cumulatives

Example 4.1 (Atrill p150)

Time		£’000	Cumulative
Immediately	Cost of machine	(100)	(100)
In 1 year	Net cash inflow	20	(80)
In 2 years	Net cash inflow	40	(40)
In 3 years	Net cash inflow	60	20
In 4 Years	Net cash inflow	60	80
In 5 years	Net cash inflow	20	100

Payback Period is 3 years. If we received the £60k evenly over year 3 (i.e. £5k per month) it would take 8 months to receive £40k and PP is therefore more accurately 2 years and 8 months

PP decision rule

If competing projects have payback periods shorter than maximum payback period, the one with the shortest payback period is selected

Project should have a shorter payback period than the required maximum payback period

As with ARR the payback period itself doesn't give us an answer whether tp proceed with the project. We need a decision rule. Companies need to get a target payback period and provided the project payback period is shorter we can proceed. If we have two competing projects we would choose the one with the shorter period.

Problems with PP

Does not take timing of cash flows fully into account

Ignores cash flows after PP

Does not take risk fully into account

Not related to wealth maximisation objective

Arbitrarily determined target payback period

This also has problems.

The first two are illustrated over the next slides

It is subjective because the company chooses the target and it doesn’t take into account risk – e.g. one project may have a shorter PP but be riskier.

It is not directly related to wealth maixmisation

Time		Project 1 £’000	Project 2 £’000	Project 3 £’000
Immediately	Cost of machine	(200)	(200)	(200)
In 1 years time	Cash inflow	70	20	70
In 2 years time	Cash inflow	60	20	100
In 3 years time	Cash inflow	70	160	30
In 4 years time	Cash inflow	80	30	200
In 5 Years time	Cash inflow	90	30	460

Comparing 3 projects with Payback Period (p158)

Take these three projects as an example. All have an initial outlay of £200k and generate cash flows as shown in the table

Time		Project 1 £’000	Cumulative	Project 2 £’000	Cumulative	Project 3 £’000	Cumulative
Immediately	Cost of machine	(200)	(200)	(200)	(200)	(200)	(200)
In 1 years time	Cash inflow	70	(130)	20	(180)	70	(130)
In 2 years time	Cash inflow	60	(70)	20	(160)	100	(30)
In 3 years time	Cash inflow	70	0	160	0	30	0
In 4 years time	Cash inflow	80		30		200
In 5 Years time	Cash inflow	90		30		460

Comparing 3 projects with Payback Period (p158)

If we do the payback period calculation, all have a payback period of 3 years so we are indifferent as to which one we would chose.

Figure 4.2 Cumulative cash flows for each project in Activity 4.6

Source: Adapted from Atrill, P. and McLaney E. (2009) Accounting: An Introduction, 5th edn, Pearson Education.

However if we present the payback like this we can see that project 3 has a much larger payout after the payback period – this is effectively ignored by the payback period method. Also Project 2 has most of the back in period 3, whereas project 1 and 3 have a more even spread. This problem with the payback period method leads us to consider the time value of money.

Both methods assume that £100 received in Year 4 is the same as £100 received in Year 1.

But is it?

The methods we have looked at until now assume that £100 received in year 4 is the same as £100 received now. Is this the case.

As the class – If I offer you either £100 now or £100 in 4 years, which would you choose? Why?

Video about time value of money

NPV investment appraisal method

Makes a logical allowance for the timing of those cash flows

Considers all of the cash flows for each investment opportunity

The next methods we will consider is Net Present Value and this has an advantage over payback period as it takes into account all the cash flows and when they are received.

Figure 4.3 Factors influencing the return required by investors from a project

Source: Atrill, P. and McLaney, E. (2009) Accounting an Introduction, 5th edn, Pearson Education.

What causes us to place different values on cash depending on when it is received? The three elements to the time value of money are as above (explained on next slide)

Time value of money

Interest lost – an investment return must exceed the opportunity cost of doing something else with the money e.g. if a company could get a return of 5% simply by putting it in the bank, they should only make the investment if the return exceeds that.

Risk – All investments have risk – there could be risks that the projections do not work out as planned, or that a piece of machine could break down, or a pandemic could hit… When making an investment the manger must consider the risk and will expect a higher return the higher the risk.

Inflation – the loss in the purchasing power of money means that £100 in one year will not be able to buy the same amount as £100 now, therefore returns must compensate for this.

Explanation of time value

Maximising Shareholder Wealth

£1m funds available

Bank – interest rate 1%

Investment – return ??%

Dividend – shareholders decide where to invest… ??%

Rate of return > Pure Time Value + Inflation+ Risk Premium

Going back to our decision making, the investment return must compensate for the opportunity cost, inflation and risk

The present value of a cash flow

PV of the cash flow of year n = actual cash flow of year n divided by (1 + r) n

The NPV method looks at each cash flow and when it arises in the future and assigns a present value to it.

For example receiving £105 in Year 1, might only be equivalent to receiving £100 today. We then add up all those cash flows to give a total value of the project today

NPV applies time value by examining each future cash flow and assigning a value to it to represent what it is worth today (i.e. the present value). For example receiving £105 in a year’s time might be equivalent to receiving £100 today – we need to receive more in the future to equate to the same value. The equation for calculating today’s value of a future cash amount is shown here. r represents an appropriate discounting rate to take account of inflation, opportunity cost and risk

The future value of a deposit

FV of a deposit of £100 at 5%= £100(1+0.05)n

In year 1 (n=1) the FV is £105, in year 2 the FV is £110.25 and so on

It can sometimes help to look at this in the other direction. If I deposit £100 today (Year 0) at a rate of 5% in one year the future value is £105, in 2 years £110.25. This is compounding forwards. Discounting works the other way – if I expect to receive £105 in one year at a rate of 5% how much do I need to deposit (or spend in the case of our capital investment) today to get that £105

Ways to calculate Present Value

Using discount tables

Using the formula

Using calculations in Excel

Using Excel formulas

I am going to show you 4 ways to calculate the net present value of the future cash flows of an investment. All give the same answers so you can use whichever method you are most comfortable with.

Using discount tables

Prepare the cash flow for each year of the project

Select the column representing the discount rate (cost of capital) you will use in the table

For each period find the multiplier and multiply the cash flow for that period by it

Add up all of the present values to give you the Net Present Value (NPV)

Apply rule – If NPV is positive, it increases shareholder wealth therefore accept project.

Steps to calculate NPV using discount tables

Example of NPV using 20%

Time

Project 1 £’000

Project 2 £’000

Project 3 £’000

Time	Cash flow £’000	Multiplier (from the discount table)	Present value
Immediately (year 0)	(100)	1	(100)
1 Years time	20	0.833	16.66
2 Years time	40	0.694	27.76
3 Years time	60	0.579	34.74
4 Years time	60	0.482	28.92
5 Years time	40	0.402	16.08
Total – NPV			24.16

Investing in the machine will increase wealth of business and owners by £24,160 therefore accept.

Walk through the example making sure students can identify where each multiplier is coming from on the discount table. Make the point that to finalise this NPV calc you need to add up the Present Value and deduct the original cost of the machine – students seem to forget the final step.

Figure 4.4 Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent

This demonstrates that the discount rates are really just a short cut to the formula that we look at next.

Using mathematical equation

Prepare the cash flow for each year of the project

Calculate the PV of each

Add up all of the present values to give you the Net Present Value (NPV)

Apply rule – If NPV is positive, it increases shareholder wealth therefore accept project.

If you prefer, rather than using the discount rates, you can take a step even further back and use the equation that the discount rates are derived from. Again you still need to prepare a cash flow and then you calculate the PV for each year and then add them all up

Investing in the machine will increase wealth of business and owners by £24,190 therefore accept.

If NPV is positive, project should be accepted.

If comparing two projects with positive NPV accept the higher.

Time	Cash flow £’000	Formula	Present value
Immediately (year 0)	(100)		(100.00)
1 Years time	20	20/	16.67
2 Years time	40	40/	27.78
3 Years time	60	60/	34.72
4 Years time	60	60/	28.94
5 Years time	40	40/	16.08
Total – NPV			24.19

You will get the same answer as using the discount tables – the tables are really just a short cut from this method.

Mathematical equation in excel


	A			B
Time	Cash flow	1 + discount rate	To the power of	Equals	Present value (A/B)
Year 0	-100	1.2	0	1.00	-100.00
Year 1	20	1.2	1	1.20	16.67
Year 2	40	1.2	2	1.44	27.78
Year 3	60	1.2	3	1.73	34.72
Year 4	60	1.2	4	2.07	28.94
Year 5	40	1.2	5	2.49	16.08

Total					24.18

=POWER(1.2,1)

If you like Excel you can calculate the present values using the POWER formula

PV Function in Excel

Even more easily you can use the function Present Value or PV in Excel. Once you have brough up the function box you fill in the rate, the year in Nper and the future value (i.e. the future cash flow) and the formula will calculate the PV for you.

There is a detailed step by step video on Weblearn showing you how to use this function in Excel.

NPV decision rule

If competing projects are positive, the one with the highest NPV is selected

If NPV is positive, it increases shareholder wealth therefore accept.

NPV shows whether the future cash flows from a project will increase the value of a company at today’s values. Therefore, any project that has a positive NPV will increase the value of the company and increase shareholder wealth and should therefore be accepted. If there are competing projects you should choose the one with the higher NPV as that increases wealth more than the other.

Why NPV is better than ARR and PP

The whole of the relevant cash flows

The objectives of the business

The timing of the cash flows

NPV fully addresses each of the following:

NPV has a number of advantages over the other methods so far

Internal rate of return (IRR)

The discount rate, which, when applied to the future project cash flows, produces a zero NPV

The final tool we use is linked to NPV. Internal Rate of Return shows the discount rate that would give a NPV of zero

On a particular project, the higher the discount rate used, the lower the NPV, until it will eventually move into a loss

Time	Cash flow	Present Value at 20%	Present Value at 25%	Present Value at 30%	Present Value at 35%

Year 0	-100	-£100.00	-£100.00	-£100.00	-£100.00
Year 1	20	£16.67	£16.00	£15.38	£14.81
Year 2	40	£27.78	£25.60	£23.67	£21.95
Year 3	60	£34.72	£30.72	£27.31	£24.39
Year 4	60	£28.94	£24.58	£21.01	£18.06
Year 5	40	£16.08	£13.11	£10.77	£8.92

Total		£24.18	£10.00	-£1.86	-£11.87

This si easiest to see in an example. When we calculated the NPV of the project we calculated that at a rate of 20% the project had an NPV of £24,180. If we increased the discount rate then the NPV starts to fall, so at 25% it is £10,000 and eventually it becomes negative – at 30% it is negative £1,860. Therefore, there must be a discount rate that will give an NPV of Zero – i.e. the barrier between accepting and rejecting the project. This either needs to be done by trial and error – as above – we can guess that the IRR will be slightly lower that 30%, probably around 29% based on those figures, or we can use Excel and there is a video that shows you how to do this on Weblearn.

Figure 4.5 The relationship between the NPV and IRR methods

Source: Adapted from Atrill, P. and McLaney E. (2009) Accounting: An Introduction, 5th edn, Pearson Education.

If we wre to plot NPV and rate of return on a graph we can see where it crosses the X axis is the IRR

IRR decision rule

If competing projects exceed minimum IRR requirement, the one with the highest IRR is selected

Project must meet a minimum IRR requirement (The opportunity cost of finance)

Again we need a decision rule and again in this case it is a target set by the company.

On this project, IRR is about 30% – if this is higher than the minimum target the project should go ahead

If competing projects, the one with the highest IRR should be selected.

Present Value at 30%

-£100.00
£15.38
£23.67
£27.31
£21.01
£10.77

-£1.86

IRR decision Making

Explanation of decision making

An example of where companies use IRR in decision making e.g. Legoland owned by Merlin have a target IRR of 14% on their capital investments. Rentokill use IRR hurdles in different departments to reflect different risk profiles

Problems with IRR

Does not directly address wealth maximisation

Ignores the scale of investment

Has difficulty with unconventional cash flows

Problems with IRR

Unconventional cash flows have two or more changes of sign in the cash flows

Some practical points related to investment appraisal

Year-end assumption

Cash flows not profit flows

Interest payments

Other factors

Past costs

Common future costs

Opportunity costs

Taxation

Practical points:

Do not include past costs – these are gone. Only include future costs

Do not include common future costs e.g. if you have a worker on the project who you would need to pay anyway this does not get included in the calculation.

Do include opportunity costs. If buying a new machine means you can sell the old one, that is additional revenue you can include

Tax is something to consider in real life, but too complicated to go into here.

Remember NPV and IRR and PP use cash flows, not accounting profit

Year end assumptions relate to things like additional working capital needed, we have-not gone into this here

Interest payments again have not been looked at here

Remember that finance is just one element – there may be other factors you need to consider

Figure 4.7 The main investment appraisal methods

Source: Adapted from Atrill, P. and McLaney, E. (2013) Accounting and Finance for Non-Specialists, 8th edn, Pearson Education.

A summary of methods

Summary of the key features

Investment appraisal in practice

Many surveys have shown the following features:

NPV and IRR have become increasingly popular

Continued popularity of the PP and ARR methods

Businesses tend to use more than one method

Larger businesses rely more heavily on NPV and IRR than smaller businesses

In practice…

Response scale

IRR

NPV

1 – never

5 – always

USA

Germany

Canada

Japan

Average

3.88

3.46

4.00

3.89

4.16

3.50

3.33

4.08

4.09

3.57

4.15

3.57

3.52

3.29

3.80

3.55

3.93

Frequency of use of investment appraisal techniques

Source: Based on information in G. Cohen and J. Yagil (2007) ‘A multinational survey of corporate financial policies’, Journal of Applied Finance. vol 17(1).

In practice…

What’s Next…

Today

5.30 – 7.30 Capital Investment Decision Making continued

7.30 – 8.30 Business Simulation Round 5

8.30pm – Finish!

For next time:

Business Simulation round 5 submitted by 3pm Wednesday 11th January

Assessment 1 – Thursday 12th January 2022 for groups 1 & 2 and Friday 13th January for groups 3,4 & 5

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MN7029: Financial Decision Making

2.2 Cost behaviour, pricing and budgets

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Learning Outcomes

Define and distinguish different categories of cost

Understand how a fixed cost and a variable cost behave and deduce the break even point

Understand the benefits and limitations of using marginal contribution analysis and break even point

Discuss the impact for managers in decision making

Describe operation of full absorption costing and Activity Based Costing

Define a budget and show how budgets and strategy are related.

The Decision Making Process

4. Develop short term plans/budgets

3. Select option and consider long term plans

5. Implement the decisions

6. Review and monitor outcomes of decision

7. Act on differences from plan

2. Consider options available

1. Set aims and objective

What is the purpose of management accounting?

Allocate costs between costs of goods sold and inventory for reporting

Provide date for management decision making

Information for planning and performance review

Definition of cost

The amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective

For example:

A hotel uses resources such as food to make breakfast, labour to clean rooms and electricity to provide light to achieve the objective of providing a comfortable place to stay for customers

Examples of costs

Fixed and variable – we will discuss next

Direct and indirect – can it be exclusively identified with a cost object or is it an overhead?

Sunk Costs – costs incurred as a result of a past decision that cannot be reversed

Opportunity cost – benefit that is lost as a result of a choice of one course of action rather than another

Behaviour of costs

Helps managers to determine:

How many units to break even point – the number of items sold where costs are equivalent to revenue and therefore there is no profit or loss

Effect of reducing/increasing sales price

Effect of an increase or reduction in volume of sales

Effect of a incurring an additional cost of a marketing campaign or

How best to pay people

Two types of cost

The value of an opportunity forgone

Opportunity cost

A cost already incurred

Historic cost

Figure 7.1 Decision flow diagram for identifying relevant costs

Relevant cost

Irrelevant cost

Does the cost relate to the objectives of the business?

Does the cost vary with the decision?

Does the cost relate to the future?

Yes

The behaviour of costs

Remain constant (fixed) when changes occur to the volume of activity

Vary according to the volume of activity

Costs may be classified as:

Fixed

Variable

The value of costs incurred in producing one unit.

Fixed Costs

Fixed cost: total remains constant in proportion to the level of activity, within a relevant range (per unit decreases)

For example: Rent

Salaries

Advertising

Example: I have rented a factory for £5,000 per month to make my cupcakes. If cake production goes up 10%, rent does not change.

Production

Cost

Figure 7.3 Graph of rent cost against the volume of activity

Rent cost (£)

Volume of activity

Variable Costs

Variable cost: total changes in proportion to the level of activity (unit cost remains constant)

For example: Number of units produced

Hours worked

Rooms occupied

Example: If I am making cake and each cake needs 200g of flour then if cake production goes up 10%, so does the quantity and total cost of flour.

Cost

Production

Figure 7.5 Graph of total cost against the volume of activity

Graph of total sales revenue against the volume of activity

Total sales £

Volume of activity

Figure 7.5 Graph of total cost against the volume of activity

Figure 7.6 Break-even chart

Break even point:

Figure 7.7 Break-even and load factors at Ryanair

Load factor

Break-even point

100

Per cent

2013

2014

2015

2016

2017

Source: Based on information contained in Ryanair Holdings plc, Annual Report 2017.

Why does a manager need to know which costs are variable and which are fixed?

Prediction of costs

Traditional accounts separate costs on a functional rather than behavioural basis

The Contribution Approach

Start with sales

Deduct variable costs

Contribution margin

Example CVP

	Total	Per unit
Sales (1,000 cakes)	£10,000	£10
Variable costs	£4,000	£4
Contribution margin	£6,000	£6
Fixed costs	£3,600
Profit	£2,400

Contribution margin shows the amount available to cover fixed costs and then provide profits.

If Contribution margin does not cover fixed costs the company makes a loss

CVP and Break even

	Total	Per unit
Sales (600 cakes)	£6,000	£10
Variable costs	£2,400	£4
Contribution margin	£3,600	£6
Fixed costs	£3,600
Profit	£0

To reach break even point, the company must make enough contribution margin to cover fixed costs

Since our cakes have a contribution margin of £6 per unit and fixed costs of £3,600 we can calculate that the break even point is 600 cakes (£3,600/£6)

CVP Chart

Units sold

£ Costs and Revenue

Example CVP

	Total	Per unit
Sales (601 cakes)	£6,010	£10
Variable costs	£2,404	£4
Contribution margin	£3,606	£6
Fixed costs	£3,600
Profit	£6

Above break even, each sale will increase profit by the contribution margin – so if we sell 601 cakes: profit = contribution margin = £6

Managers use this to work out budgets simply at different levels of activity – you just need to multiply the units over break even point by the contribution margin per unit to give the profit

Cost Volume Profit Analysis recap

Total cost (or full cost) = Fixed costs + variable costs

Contribution margin = Sales revenue per unit – variable costs per unit

Break Even Units =

Examples of how to use CVP

Break even point = = = 600 cakes

No of cakes sold to achieve profit of £5,000 = = = 1,433 cakes

Additional profit from sale of an extra 100 cakes above break even = 100 × £6 = £600

Contribution Margin Ratio

	Total	Percentage of sales
Sales (1,000 cakes)	£10,000	100
Variable costs	£4,000	40
Contribution margin	£6,000	60
Fixed costs	£3,600
Profit	£2,400

Contribution margin can also be calculated as a % of sales:

Profit = (Sales Revenue x contribution margin) – Fixed costs

Application of CVP

Once we know contribution margin, managers can use this in decision making, for example modelling the impact on profit of:

A change in fixed costs and sales volume (e.g. an advertising campaign)

A change in variable costs and sales volume (e.g. using higher quality raw materials)

A change in fixed cost, sales price and sales volume

A change in variable costs, fixed costs and sales volume

A change in sales price

You can also use it for target profit analysis

Margin of safety = Budgeted or actual sales – Break even sales

Margin of safety % =

Practice question

Question 1: You decide to reduce variable costs by using a lower quality ingredients with a per unit cost of £2 but this will cause sales to fall to 700 cakes – should you do it?

Question 2: You decide to undertake an advertising campaign which will cost £1,000 but will increase sales to 1,200 units. Should you do it?

	Total	Per unit
Sales (1,000 cakes)	£10,000	£10
Variable costs	£4,000	£4
Contribution margin	£6,000	£6
Fixed costs	£3,600
Profit	£2,400

Practice question

Q1: You decide to reduce variable costs by using a lower quality ingredients with a per unit cost of £2 but this will cause sales to fall to 700 cakes – should you do it?

New contribution margin = 700 x £8 = £5,600

Present contribution margin = 1,000 x £6 = £6,000

Decrease in total contribution margin = £400

Q2: You decide to undertake an advertising campaign which will cost £1,000 but will increase sales to 1,200 units. Should you do it?

Incremental contribution margin = £6 x 200 = £1,200

Increase in fixed costs = £1,000

Increase in profit = £200

Figure 7.10 The effect of operating gearing

Volume of output

Profit

Cost Structure/Operating Gearing

What is the best trade off between fixed and variable costs

E.g. buying in components rather than making yourself, automating by machinery rather than labour costs

In my cupcake factory I have the choice of using a individuals to make the cakes (high variable cost, lower fixed cost) or a machine to (low variable cost, high fixed cost)

As you can see at sales of 1,000 I get the same profit whatever I choose.

	Total	Per unit	Total	Per Unit
Sales (1,000 cakes)	£10,000	£10	£10,000	£10
Variable costs	£4,000	£4	£2,000	£2
Contribution margin	£6,000	£6	£8,000	£8
Fixed costs	£3,600		£5,600
Profit	£2,400		£2,400

Cost Structure/Operating Gearing

What happens if there is a 10% increase in sales?

	Total	Per unit	Total	Per Unit
Sales (1,100 cakes)	£11,000	£10	£11,000	£10
Variable costs	£4,400	£4	£2,200	£2
Contribution margin	£6,600	£6	£8,800	£8
Fixed costs	£3,600		£5,600
Profit	£3,000		£3,200

For a 10% increase in sales, option 1 gives a 25% increase in profit, option 2 gives a 33% increase in profit.

Cost Structure/Operating Gearing

What about a 10% decrease in sales?

	Total	Per unit	Total	Per Unit
Sales (900 cakes)	£9,000	£10	£9,000	£10
Variable costs	£3,600	£4	£1,800	£2
Contribution margin	£5,400	£6	£7,200	£8
Fixed costs	£3,600		£5,600
Profit	£1,800		£1,600

For a 10% decrease in sales, option 1 gives a 25% decrease in profit, option 2 gives a 33% decrease in profit.

Higher proportion of fixed costs mean a higher break even point and more profit volatility – more upside when things go well but also more downside…

Operating leverage

The degree of operating leverage shows how profit moves when sales move.

If leverage is high, profit will move proportionately more than if it is low

Operating leverage =

Option A – operating leverage at 1,000 sales = 2.5

Option B – operating leverage at 1,000 sales = 3.33

Figure 7.8a Break-even chart – low gearing

Figure 7.8b Break-even chart – high gearing

Revenue/Cost (£000)

Fixed cost

Volume of activity (number of baskets)

100

400

300

200

500

Total costs

Break-even point

Total revenue

LOSS

PROFIT

600

Margin of Safety

How “safe” is a business in relation to changes in sales volume?

Margin of safety in £revenue = estimated sales revenue – breakeven sales revenue

Margin of safety % = x 100

Figure 7.9 Ryanair’s margin of safety

Margin of safety

Operating profit

Margin of safety (as a percentage of BEP)

1000

600

400

200

1600

Operating profit (in millions of euros)

2013

718

2014

659

2015

1043

800

1200

1400

2016

1460

2017

1534

Source: Derived from information contained in Ryanair Holdings plc 2013 Annual Report.

Examples of business with different gearing

Jones, T. (2012) Strategic managerial accounting: hospitality, tourism and events applications. Oxford, U.K.: Goodfellow p42

Weaknesses of break-even analysis

Three general problems

Non-linear relationships

Stepped fixed cost

Multi-product businesses

Decision making

Marginal cost – the cost of producing one more unit

Marginal analysis – only costs and revenues that vary with decision are considered, so fixed costs excluded.

Uses

Deciding whether to apply a discount to a particular order

Scare resources – calculate the contribution per unit

Deciding whether to buy a component or make in house

Considering whether to close departments

Why do we need to know the full cost of a product?

Figure 8.1 Uses of full cost by managers

Assessing relative efficiency

Uses of full cost

Exercising control

Pricing and output decisions

Assessing performance

Full costing

Earlier we looked top down:

Sales	X
Variable costs	(X)
Contribution to fixed costs	X

Now we look bottom up:

Direct costs	X
Allocation of indirect costs	X
Total cost of one unit	X

Direct and indirect cost

All other elements of cost, that is, those that cannot be directly measured in respect of each particular unit of output

Categories of cost

Direct cost

Cost that can be identified with specific cost units – the effect of the cost can be measured in respect of each particular output

Indirect cost or overheads

Figure 8.2 Percentage of full cost contributed by direct and indirect cost

Indirect cost

Direct cost

Percentage of full cost

All 176 businesses

Manufacturing businesses (91)

Service and retail businesses (85)

Source: Al-Omiri, M. and Drury, C. (2007) ‘A survey of factors influencing the choice of product costing systems in UK organizations’, Management Accounting Research, December, pp. 399–424.

Figure 8.3 The relationship between direct cost and indirect cost

Full cost of the job

Direct cost of the job

Appropriate share of indirect cost (overheads)

Why is this a problem?

If we produce one homogenous product (e.g. identical cupcakes) we could just split the overhead over units produced

E.g In my cupcake factory the overhead is £20,000 and I produce 10,000 cakes I could allocate £2 to every cake to determine price.

But if my factory produces cupcakes and cars and I produce 10,000 cakes and 500 cars with a total overhead of £500,000, is it fair to allocate £48 to each cupcake and each car?

Figure 8.5 The relationship between direct, indirect, variable and fixed costs of a particular job

Total (or full) cost of a particular job

Fixed cost

Indirect cost (overheads)

Direct cost

Variable cost

VARIABLE

FIXED

DIRECT (Traced to a product)

INDIRECT

Raw materials; commissions

Electricity for a whole factory

Some labour; rent for a production plant

Head office rent and salaries

Insert footer / references if needed

Traditional full costing process

How do we assign an indirect cost to individual differing units?

Full costing sees overheads as a service to the end cost unit (e.g. factory overhead provides a service to the end product of keeping the machine operating, housing the product etc).

We need to choose something measurable on which to apportion the overhead

This could be

Labour hours

Machine hours

Physical space

Number of employees

And so on…

Budgeting

Figure 9.1 The planning and control process

Identify and assess strategic options

Revise plans (and budgets) if necessary

Undertake a position analysis

Establish mission and objectives

Select strategic options and formulate long-term (strategic) plans

Prepare budgets

Perform and collect information on actual performance

Respond to variances and exercise control

Identify variances between planned (budgeted) and actual performance

Budgeting

Plan the operations for the year – takes an organisational objective and quantifies it.

Measure performance against targets (control)

Coordination of different parts of the business

Communicates expectations to unit managers

Helps efficient allocation of resources

Motivation to achieve organization’s goals

Helps to control and authorize the ongoing activities

Evaluate performance of individual managers

Figure 9.3 The interrelationship of operating budgets

Finished inventories budget

Production budget

Raw materials inventories budget

Overheads budget

Trade receivables budget

Trade payables budget

Capital expenditure budget

Raw materials purchases budget

Sales budget

Direct labour budget

Cash budget

An example of a budget – the cash budget

Jan Feb Mar Apr May June

£000 £000 £000 £000 £000 £000

Receipts

Receivables 60 52 55 55 60 55

Payments

Payables (30) (30) (31) (26) (35) (31)

Salaries and wages (10) (10) (10) (10) (10) (10)

Electricity (14) (9)

Other overheads (2) (2) (2) (2) (2) (2)

Van purchase (11)

Total payments (42) (42) (68) (38) (47) (52)

Cash surplus 18 10 (13) 17 13 3

Cash balance 30 40 27 44 57 60

Opening balance 12 30 40 27 44 57

An example of the inventories budget

	Jan £000	Feb £000	Mar £000	Apr £000	May £000	June £000
Opening balance	30	30	30	25	25	25
Purchases	30	31	26	35	31	32
Inventories used	(30)	(31)	(31)	(35)	(31)	(32)
Closing balance	30	30	25	25	25	25

Budget variances

	Original budget	Actual
Output (production and sales)	1,000 units	900 units
	£	£
Sales revenue	100,000	92,000
Direct materials	(40,000)	(36,900) (37,000m)
Direct labour	(20,000)	(17,500) (2,150 hr)
Fixed overheads	(20,000)	(20,700)
Operating profit	20,000	16,900

Flexible budgets

A more valid comparison can be made between the budget (using the flexed figures) and the actual results.

	Original budget	Flexed budget	Actual
Output (production and sales)	1,000 units	900 units	900 units
	£	£	£
Sales revenue	100,000	90,000	92,000
Direct materials	(40,000)	(36,000) (36,000m)	(36,900) (37,000m)
Direct labour	(20,000)	(18,000) (2,250 hr)	(17,500) (2,150 hr)
Fixed overheads	(20,000)	(20,000)	(20,700)
Operating profit	20,000	16,000	16,900

Figure 9.6 Relationship between the budgeted and actual profit

equals

minus

Actual profit

plus

All adverse variances

All favourable variances

Budgeted profit

Behavioural issues of budgetary control

Demanding, yet achievable, budget targets can motivate more than less demanding ones

Unrealistically demanding targets can adversely effect managers’ performance

Budgets can improve job satisfaction and performance

Participation of managers in setting their targets can improve motivation and performance

Making Budgetary Control Effective

A serious attitude taken to the system.

Clear demarcation between areas of managerial responsibility.

Budget targets that are challenging yet achievable.

Established data collection, analysis and reporting routines.

Reports aimed at individual managers, rather than general-purpose documents.

Fairly short reporting periods.

Timely variance reports.

Action being taken to get operations back under control if they are shown to be out of control.

What’s Next…

7.30pm to 8.30pm – Review round 1 and prepare round 2.

8.30pm – Finish!

Next time:

Business Simulation round 2 submitted by 3pm Wednesday 14th December

Review Weblearn for extended learning questions

Read Atrill Ch 10

"Buying goods on credit can be a good source of finance so it is good financial management practice to delay payment for as long as possible." Do you agree with this statement?

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MN7029 – Financial Decision Making

Welcome to Week 2.1!

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Learning Outcomes

Look for clues in a company's financial statements about performance

Identify and calculate major ratios used for assessing financial performance

Discuss the use and limitations of such financial ratios.

Interpreting financial performance

	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6
Sales	50,000	100,000	120,000	150,000	180,000	210,000
Cost of sales	25,000	40,000	55,000	82,000	100,000	120,000
Profit	25,000	60,000	65,000	68,000	80,000	90,000

What can you tell me about this company’s performance?

Consider the following….

In 2022 Marks & Spencer made £10.9bn in revenue and £391.7m in profit before tax

In 2021 Boden made £256m in revenue and £14m in profit

Which company is performing better?

Consider the following….

How about if I told you in 2-21 M&S made £9.2bn in revenue and a loss of £209m and 2019 Boden made £295m in revenue and a profit of £14m?

Or showed you this graph of M&S share price over the last year?

We learned in Session 2 that different groups of people use financial information for different reasons…

Interpreting financial performance

	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6
Sales	50,000	80,000	120,000	150,000	180,000	210,000
		60%	50%	25%	20%	17%
Cost of sales	25,000	40,000	55,000	82,000	100,000	120,000
		60%	37.5%	49%	22%	20%
Profit	25,000	40,000	65,000	68,000	80,000	90,000
		60%	62.5%	5%	18%	12.5%

What can you tell me about this company’s performance now?

Types of financial analysis

Scanning

Trend analysis

Common sized statements

Financial ratios

Financial Ratios

A ratio relates one figure in the financial statements to another (e.g. operating profit compared to sales revenue).

Means of assessing health of the company.

Comparison tools e.g. between periods or companies.

Eliminate the problem of scale.

Identify strength/weaknesses but do not explain them.

Ensure they are meaningful relationships.

Variations in choice and calculation.

Figure 3.1 The key aspects of financial health

Categories of Ratio

Profitability – indication of how well company is generating profit or wealth for shareholders.

Efficiency (or activity) – how well the particular resources e.g. inventory have been used in the business.

Liquidity – relationship between liquid resources and what is due to be paid.

Financial gearing – relationship between shareholder capital and borrowing.

Investment – measuring return and performance of shares

Historical and Projected Financial Statement Users

Current/potential investors

Employees

Lenders

Suppliers

Customers

Government and regulators

The public

Management

Profitability – indication of how well company is generating profit or wealth for shareholders.

Efficiency (or activity) – how well the particular resources e.g. inventory have been used in the business.

Liquidity – relationship between liquid resources and what is due to be paid.

Financial gearing – relationship between shareholder capital and borrowing.

Investment – measuring return and performance of shares

Ratios

Comparison with what?

Past periods

Improvement/deterioration in performance;

Long term trends;

But may not expose inefficiencies in comparison to other businesses;

Does not consider trading conditions.

Similar businesses

Compare efficiency to competitors;

But may be differences in accounting policies;

May not be able to get the information or sufficiently useful breakdown.

Planned performance

Helps to set budgets and track achievement.

Calculating the ratios

Please have p94 Financial Management for Decision Making (9th edn) open (p87 in 8th edn).

Financial statements relating to Alexis Plc.

Profitability ratios

Profit for the year less any preference dividend Ordinary share capital + Reserves

Return on ordinary shareholders’ funds (ROSF)

Operating profit Share capital + Reserves + Non-current liabilities

Return on capital employed (ROCE)

Operating profit Sales revenue

Operating profit margin

Gross profit Sales revenue

Gross profit margin

× 100

Operating/Gross profit margin

Operating profit margin relates the profit to the sales revenue (notice that this ratio compares two income statement items).

Operating profit is used as it excludes financing costs but includes all general costs of running the business.

This ratio varies according to type of business e.g. supermarket versus jeweller.

Businesses often use target operating margins in budgets.

Gross profit margin relates the gross profit to the sales revenue (again this ratio compares two income statement items).

Measures profitability in producing goods before other general expenses.

2018

Gross profit margin =

= 22.1%

Op profit margin = 100%

=10.8%

2019

Gross profit margin =

= 15.3%

Op profit margin = 100%

=1.8%

Return on Ordinary Shareholders’ Funds

Return on ordinary shareholders funds ratio (ROSF) compares the profit for the year with the owners’ average stake in the business.

An average figure is used for shareholder funds as it should be more representative but you may need to rely on year end if that is not available;

Business seek to generate as high as possible value for ROSF.

ROSF for 2019

×100

= 2.0%

ROSF for 2018

×100

= 33.0%

Return on Capital Employed

Return on Capital Employed (ROCE) compares the operating profit for the year with the average long term capital (so shareholder funds and long term loans).

We use Profit Before Interest and Tax as the top figure as this ratio is looking at the return to everyone before deductions of financing interest.

Again, an average figure is used for shareholder funds as it should be more representative but you may need to rely on year end if that is not available;

An important ratio as it compares inputs through capital with outputs (operating profit).

ROCE for 2018

×100

= 34.7%

ROCE for 2018

×100

= 5.9%

Profitability Summary

Overall profitability indicators have declined quite severely

Both gross and operating profits declined, but operating profit declined proportionately more – what has caused increase in operating expenses? Could it be due to increasing employee numbers?

Revenue has increased, but cost of sales proportionately more – again what has caused this?

	2018	2019
ROSF	33%	2%
ROCE	34.7%	5.9%
Gross Profit Margin	22.1%	15.3%
Operating Profit Margin	10.8%	1.8%

Efficiency ratios

Formula

Average inventories turnover period

Average settlement period for trade receivables

Average settlement period for trade payables

Sales revenue to capital employed

Sales revenue per employee

Average inventories held Cost of sales

Average trade receivables Credit sales revenue

Average trade payables Credit purchases

Sales revenue Number of employees

Sales revenue________________ Share capital + Reserves + Non-current liabilities

× 365

Average inventories turnover:

2018: ×365 = 56.6 days

2019: ×365 = 56.7 days

Average receivables settlement:

2018: ×365 = 37.7 days

2019: ×365 = 34.9 days

Average payables turnover:

2018: × 365 = 44.9 days

2019: × 365 = 47.2 days

Sales Revenue to Capital Employed (2019): =3.36

Sales Revenue to Capital Employed (2018): =3.2

Summary of Efficiency Ratios

	2018	2019
Average inventories turnover period	56.6 days	56.7 days
Average settlement period for trade receivables	37.7 days	34.9 days
Average settlement period for trade payables	44.9 days	47.2 days
Sales revenue to capital employed (net asset turnover)	3.20 times	3.36 times
Sales revenue per employee	£160,057	£143,962

Figure 3.6 The main elements of the ROCE ratio

Source: Atrill, P. and McLaney, E. (2010) Accounting and Finance for Non-specialists, 7th edn, Pearson Education.

Operating profit margin ratio

Sales revenue to capital employed

Operating profit/Long term capital

Liquidity ratios

Current ratio

Acid test ratio

Formula

Current assets Current liabilities

Current assets (excluding inventories) Current liabilities

Acid Test ratio:

2018: = 0.8 times

2019: = 0.6 times

Current ratio:

2018: = 1.9 times

2019: = 1.6 times

Gearing ratios

Long-term (non-current) liabilities Share capital + Reserves + Long-term (non-current) liabilities

Gearing ratio

Formula

Interest cover ratio

Operating profit Interest payable

× 100

Gearing ratio:

2018: 100 = 26.2%

2019: 100 = 36%

Interest cover

2018: = 13.5 times

2019: 1.5 times

Investment ratios

Formula

Dividend payout ratio

Dividend cover ratio

Dividend yield ratio

Earnings for the year available for dividends Dividends announced for the year

Dividends announced for the year Earnings for the year available for dividends

× 100

Dividend per share Market value per share

× 100

Investment ratios (Continued)

Formula

Price/earnings ratio (P/E)

Earnings per share

Earnings available to ordinary shareholders Number of ordinary shares in issue

Market value per share Earnings per share

What is a dividend?

Company X

Management

Employees

Shareholders

A payment to shareholders out of retained profit

Decided by directors

Directors may choose to keep profit in the business for growth

Dividend payout ratio:

2018: × 100% = 24.2%

2019: × 100% = 363%

Dividend payout ratio:

2018: = 4.1 times

2019: = 0.3 times

Dividend yield ratio:

2018: × 100% = 2.7%

2019: × 100% = 4.5%

Earnings per share:

2018: = 27.5p

2019: = 1.8p

Price/Earnings Ratio:

2018: = 9.1 times

2019: = 83.3 times

Earnings Ratios

EPS relates the earnings for a period to the number of shares in issue;

This is a key ratio for investment analysts and they will track this over time to assess a business;

P/E ratio then relates the EPS to the market value of the share – the higher the ratio the greater the confidence in the future earnings and the more the investors are willing to pay in relation to its current earnings.

Figure 3.10 Tesco: The Leahy years

1.0

2.0

5.0

4.0

3.0

1.60

1.87

2.04

2.62

1.74

1.56

2.10

6.52

4.37

3.06

2.51

Dividend yield (%)

6.0

1.64

Aerospace/Defence

Auto parts

Beverage (Soft)

Coal & Related Energy

Drugs (Pharmaceutical)

Entertainment

Healthcare products

Household products

Oil/Gas Distribution

Total market

Utility (Water)

Publishing & Newspapers

7.0

Figure 3.11 Average dividend yield ratios for business in a range of industries

Source: Charts compiled from data in Damodaran, A., ‘Useful data sets’, www.stern.nyu.edu/~adamodar/New_Home_Page/data.html, accessed 9 January 2019.

Figure 3.12 Average price/earnings ratios for businesses in a range of industries

11.39

26.73

74.89

29.61

88.72

52.05

29.16

105.67

12.66

32.81

46.52

30.91

Aerospace/Defence

Auto parts

Beverage (Soft)

Drugs (Pharmaceutical)

Entertainment

Healthcare products

Household products

Oil/Gas Distribution

Total market

Utility (Water)

Publishing & Newspapers

Current PE (times)

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

100.00

Coal & Related Energy

Source: Charts compiled from data in Damodaran, A., ‘Useful data sets’, www.stern.nyu.edu/~adamodar/New_ Home_Page/data.html, accessed 9 January 2019.

Figure 3.14 Current ratio of three leading businesses

Current ratio

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

2018

2010

2009

2008

2011

2012

2013

2014

2015

2016

2017

Tesco plc

J. Sainsbury plc

William Morrison

Source: Ratios calculated from information in the annual reports of the three businesses for each of the years 2008 to 2018.

Which ratios will be important for different industries?

Overtrading

Overtrading occurs where a business is operating at an unsustainable level

May be due to expanding businesses that have not prepared, misjudgement on sales or costs levels, lack of access to further finance

Can cause liquidity problems and company may run out of cash

Can be spotted in low current ratios; low inventory turnover ratio, high settlement ratio for payables

Company must ensure that finance available is consistent with level of operations.

Overtrading and financial ratios

Current ratio

Acid test ratio

Average settlement period for trade receivables

Average inventories turnover period

Overtrading may lead to a lower than expected:

Average settlement period for trade payables

Sales to capital employed ratio

Overtrading may lead to a higher than expected:

Using Ratios to Predict Failure

An analyst will look at a combination of ratios to judge the health of a business.

Is it possible to develop a mathematical formula for failure?

Beaver’s research showed that some ratios exhibited differences between businesses that subsequently failed and this that didn’t.

Zmijewski found connection between failure and rates of return and gearing, but not liquidity in his study.

The Z-score model

where:

a = Working capital/Total assets

b = Accumulated retained profits/Total assets

c = Operating profit/Total assets

d = Book (statement of financial position) value of ordinary and preference shares/Total liabilities at book (statement of financial position) value

e = Sales revenue/Total assets

1.2a + 1.4b + 3.3c + 0.6d + 1.0e

Z =

Limitations of ratio analysis

Over-reliance on ratios

Basis for comparison

Quality of financial statements

Statement of financial position ratios

Inflation

Creative accounting

What’s Next…

5.30pm to 7.30pm – Cost behaviour, pricing and budgets (incl 10 minutes break).

7.30pm to 8.30pm – Review round 1 and prepare round 2.

8.30pm – Finish!

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MN7029 – Financial Decision Making Week 1.1

Welcome!

Purpose of Module and Learning Objects

Understand and use financial information to make effective business decisions;

Understand key financial management issues, performance indicators and methodologies;

Understand the preparation of and use of accounting;

Assess accounting information to evaluate business performance

Learning Objects

LO1: Critically evaluate company financial performance and make recommendations for improvement;

LO2: Demonstrate an understanding and use of the appropriate analytical techniques to be applied to business case development and investment appraisal; the raising of finance and the distribution of funds to investors;

LO3: Communicate financial information, analysis, issues and recommendations clearly and concisely.

Weblearn

Please make use of Weblearn.

For each session you will see:

Introduction and learning objectives;

Lecture slides;

Additional reading.

You can also share ideas on the Discussion Board

Key Points

Please make sure you are familiar with the module handbook and timetable;

Please watch out for Announcements & Emails

If you have any questions about the course, please consider posting them on the discussion board

If you can’t make a class please let me know beforehand

The group assessment requires you to work in teams. Please be respectful of your teammates time and arrange sessions that work for you all

Any Questions?

Week 1 – Learning Outcomes

Consider the role of the finance function

Compare and contrast the differences between financial accounting and financial management;

Examine how a finance team will support managerial decisions;

Consider your interaction as a manager with the finance function in a business;

Identify and discuss possible objectives for a business;

Introduce the main purpose of corporate governance rules.

What do companies do?

They produce good or services

They use inputs (which need to be paid for) to produce outputs

They need money to pay for inputs (costs) and they receive money (revenue) for their outputs

Paying for inputs or receiving revenue is an economic transaction

Difference between costs and revenue is profit

Managers need to decide what to produce, what price, which supplier, how many workers, contracts, production technique

https://www.bbc.co.uk/news/business-58340082

Financial decision making in the real world – how does a CEO improve share price?

Demonstrating the importance of financial decisions – this manager will have the opportunity to take home a big bonus if he can increase the share price of the company. But how do managers do this? Later we will look at the link between making decisions that increase the wealth of the company in relation to the wealth of the shareholders and therefore share price, but this will involve making pricing/investment decisions

What is accounting?

A process of identifying, recording summarizing and reporting economic information or transactions to decision makers and stakeholders in the form of financial statements

There is a difference between financial accounting and management accounting

The accounting system is the steps performed to analyze, record, quantify and report economic events and their effects on an organization. It must be designed to meet the needs of the users

Insert footer / references if needed

Emphasis on financial management as the ability to take possibly millions of economic transactions in a company and present them in a way that allows interpretation and decision making

The Finance Function

Managers understand, plan, control and make decisions

The finance function helps managers to manage

They do this through managerial activities in the organisation namely

The Finance Function

Strategic management – which requires the setting of long-term objectives and setting out how these objectives will be achieved

Operations management – which requires that things go to plan and putting in place the day to day control of activities in each functional area.

Risk management – which requires the managers to identify the risks faced by the entity and how to manage them.

Figure 1.1 The role of managers

The three management activities can be depicted as shown. The figure shows clearly that they are not distinct and separate.

The Finance Function

To carry out the aforementioned functions requires managers to undertake a number of tasks namely:

Financial Planning

Investment Project Appraisal

Financing Decisions

Capital Market Operations

Financial Control

Financial Planning (Week 1.2)

This requires managers to assess the potential impact of their future investment projects on future financial performance and position using budgeted information to prepare key financial statements for the intended projects.

Investment Project Appraisal (Week 3.1)

Appraising the financial viability of each long term investment projects throws some light on whether or not the project should be undertaken. This will assist the manager to make informed decisions about whether to reject or accept the investment proposal.

Financing Decisions (Week 4.1)

These require managers to decide how projects will be financed. Will they be financed through internally or externally generated funds? What are the costs of each source? Which is most beneficial to the company? These are a few of the questions managers will ask.

Capital Markets Operations (Weeks 4.2)

Companies, especially Public Limited Companies (Plc), raise long term finance through the capital markets which invariably means that managers need to understand how these markets operate.

Financial Control (Week 2.2)

Once managers have taken the decision to implement a plan, they must ensure that things go according to plan. They this by asking subordinates to provide regular reports to them as things get under way. This will enable them to put in place control activities.

The Finance Function Contd.

The five areas looked at above can be depicted in pictorial form in the figure on the next slide. This should hopefully allow you to see the interrelationship of them all and the finance function.

They are all part of the three roles of managers we looked at above – Strategic, Operations and Risk Management.

Figure 1.2 The tasks of the finance function

Financial planning and analysis

Treasury manager

Risk management

Corporate strategy

Who might form part of a finance function?

Financial Controller

Financial accountant

General ledger accountants

Cash book

REPORTING/HISTORICAL

FORECASTING/FUTURE

CFO

CFO is known as Csuite – part of the Board of Directors,

Financial controller – oversees the accounts reporting team, responsible for budgets, analysis

Ginance/accounts manager – day to day running of the finance requirements

May also have general ledger accounts responsible for specific areas e.g. cash book

Strategic finance function:

FP&A:

What is the objective of a company?

Question for the class – can they come up with ideas about what a company’s objective or goal should be? Leading into the theories of Friedman and Freeman about only objective to be to maximise wealth or take account of stakeholder interests

The structure of a company

Company X

Management

Employees

Banks

Customers

Suppliers

General Public

Shareholders

For students to help emphasis the relationships:

Company is a separate legal entity – it can contract in its own right and has its own transactions. A company is not its employees or managers – they have a contractual relationship with the company to perform duties or services

Shareholders are owners of the company – this might include some members of the management team but they can wear different hats whether they are acting as owner or manager – possibly conflicts of interest

Other people are stakeholders- they have an interest – it might be contractual e.g. a bank or more nebulous – how does your company affect the general public

Milton Friedman’s Shareholder Theory

The management team are responsible for the business. They are employees of the owner of the business. The management’s prime responsibility is to the owners.

The goal of the owners (shareholders) is “to make as much money as possible while conforming to the basic rules of society, both those embodied in law and those embodied in ethical custom”

Therefore, the objective of the business is to use the resources of the company to increase or maximize the wealth of the shareholders.

If the managers account do not use the resources to maximize the wealth of the shareholders they will invest their money elsewhere.

How do we maximize value? By making economic decisions within the business that maximize the value of the business.

Primary objective

To achieve wealth maximisation the needs of other stakeholders must be considered

Not the same as profit maximisation

The primary objective of a business is shareholder wealth maximisation:

High ethical standards may be needed to maximise shareholder wealth

Shareholder wealth maximisation

Shareholders:

Have a residual claim and bear the risk

Are incentivised to increase their residual claim through entrepreneurial activity

Are the effective owners

However, pursuit of this objective:

May undermine the status of other stakeholders

May encourage excessive cost cutting

May encourage unethical behaviour

Profit maximisation problems

Profit cannot be objectively determined

Profit takes no account of risk

Profit is an imprecise term

Period over which profit should be maximised is unclear

Profit takes no account of opportunity cost

Video – R Edward Freeman on Stakeholder Theory

Does not offer clear-cut objectives

Increases problems of accountability

Raises difficult questions concerning who the stakeholders are and how they should be treated

Stakeholder approach – problems

Case study

Consider this article about the profits drug companies expect to make from the COVID vaccine (https://www.bbc.co.uk/news/business-55170756)

AstraZeneca has promised not to make a profit until the pandemic is over

Each group takes on the role of a stakeholder in AstraZeneca (shareholder, manager, government) spend 10 minutes discussing your view on the decision

One person report back to the group

If time get the groups to discuss and report back or can do as a class discussion

The agency problem

In a company the owners (shareholders) are not the management (directors).

Directors are agents of the shareholders.

How can we protect shareholders if there is a difference of interests?

Align interests/link reward

Rules (UK governance code)

Increasing shareholder involvement

Figure 1.4 Principles underpinning a framework of rules

Rules are set by individual jurisdictions, but generally will be underpinned by these principles

Disclosure of relevant information to parties who need to understand it

Fairness across different businesses (i.e. not unnecessary rules)

A mechanism to hold those responsible as accountable for their actions

The UK Corporate Governance Code

Aims to ensure that:

Powers and responsibilities of directors are clearly delineated

Appropriate checks and balances are in place

Source: Based on information in The UK Corporate Governance Code, July 2018, Financial reporting Council. www.frc.org.uk

Covers five main areas

Board leadership and company purpose

Division of responsibilities

Audit, risk and internal control

Composition succession and evaluation

Remuneration

The UK Corporate Governance Code

Source: Based on information in The UK Corporate Governance Code, July 2018, Financial reporting Council. www.frc.org.uk

Figure 1.5 Ownership of UK listed shares, end of 2016

Source: Ownership of UK Quoted Shares 2016, Table 4, Office for National Statistics, 29 November 2017. Office for National Statistics licensed under the Open Government Licence v3.0.

Exerting control over directors

Two main approaches available to shareholders:

Linking directors remuneration to share performance

Monitoring directors actions and controlling their use of business resources

Figure 1.6 The main forms of shareholder activism

UK Stewardship Code

establishing policies relating to stewardship and voting procedures, along with their periodic reporting

checking on investee businesses

deciding when stewardship activities should be intensified and when to act in concert with other shareholders

disclosing conflicts of interest arising from stewardship activities and how they are resolved

Relates to financial institutions:

Coming Next…

4pm to 5pm – Introduction to the business simulation

5pm to 5.30pm – Break (Read the Enron article if you have not already done so)

5.30pm to 7.00pm – Financial Statements

7.00pm to 8.00pm – Simulation practice round in groups

8pm to 8.30pm – Live Q&A and feedback on simulation

8.30pm – Finish!

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MN7029 – Financial Decision Making

Welcome to Week 1.3!

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

What are the three main financial statements?

Ask the class to see if they remember

Financial Statements

Statement of Financial Position

A summary at a fixed point in time;

Assets, liabilities and equity.

Statement of Profit or Loss

Data for a period of time (accounting period);

Shows income and expenditure for that period.

Cash Flow

Data for a period of time (accounting period);

Shows cash in and outflows for that period.

Not profit

Learning Outcomes

Consider how management make business decisions

Look at the role of financial statements in decision making

Prepare projected financial statements

Consider how they can be adapted for uncertainty

Start to investigate how gearing impacts risks and return.

Natalie’s Restaurant

I set up a restaurant club.

On Thursday I spend £60 on ingredients.

I also spend £20 on new tablecloths which I can use for the foreseeable future.

On Friday I cook a meal with ¾ of the ingredients and charge 10 people £15 each for dinner.

An example of putting together a simple set of financial statements

What are my cash flows?

My initial funding	£80
Money from the customers (£15×10)	£150
Cash inflow		£230
Money spent on ingredients	£60
Money spent on tablecloths	£20
Cash outflow		£(80)
Net Cash		£150

Cash balance at start		£0
Net cash inflow		£150
Cash balance at end		£150

What is my profit?

Sales revenue (£15 x 10)	£150
Cost of goods sold (3/4 of ingredients)	£(45)
Profit		£105

What is my financial position?

Tablecloths	£20
Cash	£150
Stock (unused food)	£15
Assets		£185
Equity (initial funding of £80 + profit £105)		£185

The Finance Function Contd.

To carry out the aforementioned functions requires managers to undertake a number of tasks namely:

This session we are focussed on the first of the main finance functions – planning

Financial Planning

Investment Project Appraisal

Financing Decisions

Capital Market Operations

Financial Control

Why does a business need to plan?

Ask the class – why does a business need to plan? Some ideas

So that it knows where it should be going

To decide what prices to charge so it can make a profit

So it doesn’t run out of money

To make sure all the different bits of the business are aligned

The Decision Making Process

5. Develop short term plans

4. Select option and consider long term plans

6. Implement the decisions

7. Review and monitor outcomes of decision

8. Act on differences from plan

2. Determine options available

1. Set aims and objective

3. Gather data and information on options

Examples of how a businesses mission (or overarching aim and objective) needs to be taken account of when financial planning

For example, compare easyjet strategy (low cost affordable) with Virgin (most loved travel company) in the context of a management team deciding whether to invest in more luxurious seats on the plane, or whether to charge travellers for inflight meals. They are both airlines, but their different strategy means that they would have different answers to these questions.

Can also link in theories or competitive advantage – Virgin would not be competing with easyjet on price

Walt Disney company strategy is around creative minds and innovative technologies, so it’s financial decisions on how much to pay staff, who to recruit and spending money on R&D will also be influenced by this

Today…

In the discussion today we are focussed on these two steps

4. Develop short term plans

3. Select option and consider long term plans

Projected financial statements

Projected income statement

Projected statement of financial position (balance sheet)

Projected cash flow statement

The projected financial statements normally comprise:

Projected financial statements look into the future and help a business to plan

Preparing projected financial statements

External variables:

Rate of taxation

Interest rates for borrowings

Rate of inflation

Look at external info to identify rates;

Consider inflation rates for different items.

To prepare projections we need to start by looking at different variables, external and internal (next slide)

Preparing projected financial statements (Continued)

Capital expenditure commitments

Financing agreements

Inventories holding policies

Payment policies for trade payables

Credit period allowed to customers

Dividend policy

Accounting policies

Internal variables:

Steps in preparing projected financial statements

Step 1

Step 2

Step 3

Step 4

Identify the key variables affecting performance

Prepare sales forecasts

Prepare forecasts for remaining elements of financial statements

Prepare projected financial statements

Specific steps to prepare projections – after variables we start with sales and then go on from there

Why do we look at sales first?

Question for class

Answer – because sales drives most of the other elements of the statements – in determines how much we need to spend on stock, staff, how much tax we eill pay etc

Preparing sales forecasts

Two main approaches:

Qualitative

Quantitative

Sales forecasts approaches

A qualitative approach uses subjective judgement to estimate forecasts, using for example:

Information and predictions from the sales teams

Managers opinions

Consumer surveys

A quantitative approach uses a numerical analysis based on past performance, for example:

Trend analysis

Regression analysis

Econometric models

Preparing projected financial statements

Short-term

Usually involves detailed forecasts of income, cash flows and financial position

Long-term

Usually involves making simplifying assumptions

Projected financial statements may cover a short-term or long-term horizon:

Projected Cash Flow Statement

What would we use a projected cash flow for?

Monitor changes in liquidity;

Help management to manage the impact of events on cash;

Indicate when business may need to raise more funds;

Indicate when funds will be available for projects;

Make sure it doesn't run out of cash!

Figure 2.2 Sources of cash inflows and outflows

Remember this statements is about cash not profit – these are some of the main sources of cash in and out flows

	Jan £000	Feb £000	Mar £000	Apr £000	May £000	June £000
Cash inflows
Issue of shares
Credit sales	____	____	____	____	____	____
	____	____	____	____	____	____
Cash outflows
Credit purchases
Other costs
Rent and rates	____	____	____	____	____	____
	____	____	____	____	____	____
Net cash flow
Opening balance	____	____	____	____	____	____
Closing balance	____	____	____	____	____	____

Projected cash flow statement for the six months to 30 June

Example proforma of a cash flow statement – note that this is on a monthly basis. Some businesses might even do this on a weekly or daily basis as cash management is so important. Cannot just do it on an annual basis

Cash flow items

Example of how cash might not necessarily occur in the same month as the sale or the purchase

January

Buy raw materials on 30 days credit

February

Pay supplier for raw materials

CASH OUTLOW

March

Sell product on 30 days credit

April

Recive cash for product

CASH INFLOW

	£000	£000
Credit sales revenue
Less Cost of sales
Opening inventories
Add Purchases	____
Less Closing inventories	____	____
Gross profit
Less
Credit card discounts
Rent and rates
Other costs
Depreciation of fittings		____
Profit for the period		____

Projected income statement for the six months to 30 June

Example of projected income statement

	£000
ASSETS
Non-current assets
Fittings
Less Accumulated depreciation	_____
	_____
Current assets
Inventories
Trade receivables	_____
	_____
Total assets	_____
EQUITY AND LIABILITIES
Equity
Share capital
Retained earnings	_____
	_____
Current liabilities
Trade payables
Bank overdraft	_____
	_____
Total equity and liabilities	_____

Projected statement of financial position as at 30 June

Figure 2.4 Variance between actual performance and forecast performance

Source: KPMG (2016) Forecasting with confidence, KPMG, p. 41 Reprinted with permission from Parker Scott.

Just to illustrate that very few companies get projections spot on – all kinds of things could happen that means there is a divergence from projections.

Forecast financial statements and decision making

What underlying assumptions have been made and are they valid?

Have all relevant items been included?

How were the projections developed?

As a manager if we are presented with a set of projections, what questions should we ask our team to determine the reliability of the statements and what questions do we ask to see what kind of decisions would flow from these?

Forecast financial statements and decision making (Continued)

Is there a need for additional financing? Is it feasible to obtain the amount required?

Can any surplus funds be profitably reinvested?

Are the cash flows satisfactory? Can they be improved by changing policies or plans?

Is the level of projected profit satisfactory in relation to the risks involved? If not, what could be done to improve matters?

Forecast financial statements and decision making (Continued)

Are the sales and individual expense items at a satisfactory level?

Is the financial position at the end of the period acceptable?

Is the level of borrowing acceptable? Is the business too dependent on borrowing?

Projected financial statements and risk

Scenario analysis

Sensitivity analysis

Risk assessment may be undertaken using

As financial projections are forward looking we might want to test out how much it would affect the business if they are wrong – this can be done with these methods

Sensitivity Analysis

Take a single variable and examine the effect of changes in that variable on overall performance

Shows how sensitive changes are for the projected outcome.

What happens if sales are 5% lower/higher?

What if sales price could be increased by 20%?

BUT – does not assign probability or consider changes to more than one variable at a time.

Scenario Analysis

Prepare projected statements according to different states of the world:

Optimistic view

Pessimistic view

"Most likely" view

Can change more than one variable

Does not identify likelihood of each occurring.

Practice Question

If we have time this is an example that can be done in class or students can practice and home and the answer will be posted on weblearn

What’s Next…

Today

7.30pm 8.30pm – Business Simulation Round 1

8.30pm – Finish!

For next week:

Review Weblearn for additional reading and exercises

Read Atrill Ch 3

Consider: One advantage of using financial ratios is that the eliminate problems in comparing businesses of different sizes. Why might this be helpful to an investor?

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MN7029 – Financial Decision Making

2.3 Working Capital Management

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Learning Outcomes

Identify the main elements of working capital

Discuss the purpose of working capital and the nature of the working capital cycle

Explain the importance of establishing policies for the control of working capital

Explain the factors that have to be taken into account when managing each element of working capital

What are the components of working capital?

The nature and purpose of working capital

Major elements

Inventories

Trade receivables

Cash (in hand and at bank)

Trade payables

less

equals

Current liabilities

Working capital

Current assets

Bank overdrafts

Figure 10.1 The working capital cycle

Cash is used to pay trade payables for raw materials, or raw materials are bought for immediate cash settlement. Cash is also spent on labour and other items that turn raw materials into work in progress and, finally, into finished goods. The finished goods are sold to customers either for cash or on credit. In the case of credit customers, there will be a delay before the cash is received from the sales. Receipt of cash completes the cycle.

What can change amount or split of working capital?

Seasonality of business

Market demand

External economic factors

Changes in manufacturing technique

Interest rates

Change in attitude towards risk

Figure 10.2 Average investment (in days) for the main working capital elements

Trade receivables settlement period

Inventories turnover period

Trade payables settlement period

Days

47.9

48.1

41.0

51.9

2013

2014

2015

2016

2017

51.8

54.0

56.4

58.9

53.1

2013

2014

2015

2016

2017

58.2

58.8

60.4

62.9

68.0

2013

2014

2015

2016

2017

67.7

Source: Compiled from information in ‘Navigating uncertainty: PwC's annual global working capital study’, 2018/19, www.pwc.com.

Inventories

Opportunity cost

Finance cost

Storage and handling

Order costs

Obsolescence

Lost sales

Goodwill

Lost production

Inventories financing cost


Business	Type of operations	Cost of capital	Average inventories held	Financing cost of holding inventories	Operating profit/ (loss)	Financing cost as % of operating profit/(loss)
		(a)	(b)	(a) × (b)
		%				%

Associated British Foods	Food producer	14.2	£2,144m	£304.4m	£1,404m	21.7
BT Group	Telecoms	8.4	£233m	£19.5m	£20,342m	0.1
Go-Ahead	Transport	5.2	£17m	£0.9m	£161m	0.6
Kingfisher	DIY	10.1	£2,437m	£246.1m	£685m	35.9
Tesco	Supermarket	9.5	£2,282m	£216.8m	£1,837m	11.8

Source: Annual reports of the businesses for the years ended during 2018.

Managing inventories

Forecasting future demand

Financial ratios

Recording and reordering systems

Inventories management models

Enterprise resource planning (ERP) system

Levels of control

Just-in-time (JIT) inventories management

Procedures and techniques that can be used to ensure the proper management of inventories

1. Forecasting future demand

2. Financial ratios

Average inventories turnover period

Average inventories held Cost of sales

× 365

3. Recording and reordering systems

Checks and procedures

Authorisation

Buffers

Lead time

4. Levels of Control

Figure 10.4 ABC method of analysing and controlling inventories

Category A contains inventories that, though relatively few in quantity, account for a large proportion of the total value. Category B inventories consist of those items that are less valuable but more numerous. Category C comprises those inventories items that are very numerous but relatively low in value. Different inventories’ control rules would be applied to each category. For example, only Category A inventories would attract the more expensive and sophisticated

controls.

5. Inventories Management Models

Figure 10.5 Patterns of inventories movements over time

Here, we assume that there is a constant rate of usage of the inventories item and that inventories are reduced to 0 just as new inventories arrive. At time 0, there is a full level of inventories. This is steadily used as time passes and just as it falls to 0 it is replaced. This pattern is then repeated.

5. Inventories Management Models

Figure 10.6 Inventories holding and order costs

Small inventories levels imply frequent reordering and high annual ordering costs. Small inventories levels also imply relatively low inventories holding costs. High inventories levels imply exactly the opposite. There is, in theory, an optimum order size that will lead to the sum of ordering and holding costs (total costs) being at a minimum.

The economic order quantity (EOQ) model

Where:

D = the annual demand for the inventories item (expressed in units of the inventory item);

C = the cost of placing an order;

H = the cost of holding one unit of the inventories item for one year

EOQ

2DC

6. Enterprise Resource Planning Systems

Integrated software systems

Can manage inventory, logistics, pricing

Can be very expensive

7. Just-in-time inventories management

May result in hidden costs (taking advantage of cheap sources of supply)

Requires close relationship with suppliers

May require re-engineering production process

Can be seen as part of TQM approach

Toyota Production System ( https://www.youtube.com/watch?v=nFu4FFgbMY4&t=1s)

Demand (units)

Jan

Feb

Mar

Apr

May

June

July

Aug

Sept

Oct

Nov

Dec

Category Z

Category Y

Category X

Figure 10.7 Patterns of inventories demand

Managing trade receivables

Which customers should receive credit

Questions to ask

How much credit should be offered

What length of credit it is prepared to offer

Whether discounts will be offered for prompt payment

What collection policies should be adopted

How the risk of non-payment can be reduced

What might you look at to determine whether you will offer credit to a particular customer?

Managing trade receivables

Which customers should receive credit

Questions to ask

How much credit should be offered

What length of credit it is prepared to offer

Whether discounts will be offered for prompt payment

What collection policies should be adopted

How the risk of non-payment can be reduced

The five Cs of credit

Capital

Capacity

Collateral

Conditions

Character

Which customers should receive credit?

Sources of credit information

Bank references

Published financial statements

Trade references

Credit agencies

The customer

Other suppliers

Length of credit period

The typical credit terms operating within the industry

The degree of competition within the industry

The bargaining power of particular customers

The risk of non-payment

The capacity of the business to offer credit

The marketing strategy of the business

May be influenced by:

Collection policies

Publicise credit terms

Issue invoices promptly

Develop customer relationships

Produce an ageing schedule of receivables

Answer queries quickly

Monitor outstanding debts

Deal with slow payers

Financial ratios

Average settlement period for trade receivables

Average trade receivables Credit sales

× 365

Financial ratios (Continued)

Trade receivables to sales

Trade receivables outstanding Sales revenue for period

× 365

Ageing schedule of trade receivables at 31 December

Customer		Days	outstanding		Total
	1 to 30 days	31 to 60 days	61 to 90 days	More than 90 days
	£	£	£	£	£
A Ltd	12,000	13,000	14,000	18,000	57,000
B Ltd	20,000	10,000	–	–	30,000
C Ltd	–	24,000	–	–	24,000
Total	32,000	47,000	14,000	18,000	111,000

Figure 10.9 Comparison of actual and expected (target) receipts over time for Example 10.5

It can be seen that 30 per cent of the sales income for June is received in that month; the remainder is received in the following three months. The expected (target) pattern of cash receipts for June sales, which has been assumed, is also depicted. By comparing the actual and expected pattern of receipts, it is possible to see whether credit sales are being properly controlled and to decide whether corrective action is required.

Why does a business hold cash?

Should it hold as much cash as possible?

Why hold cash?

There are three reasons:

To meet day-to-day commitments

To deal with uncertain cash flows

To exploit profitable opportunities

Factors influencing the amount of cash held

The opportunity cost of holding cash

The level of inflation

The nature of the business

The cost of borrowing

Economic conditions

The availability of near-liquid assets

Relationships with suppliers

The availability of borrowing

Possible factors may include:

Managing cash

Main techniques

Preparing projected cash flow statements

Controlling the cash balance (using control limits)

Managing the operating cash cycle

Figure 10.10 Controlling the cash balance

Management sets the upper and lower limits for the business’s cash balance. When the balance goes beyond either of these limits, unless it is clear that the balance will return fairly quickly to within the limit, action will need to be taken. If the upper limit is breached, some cash will be placed on deposit or used to buy some marketable securities. If the lower limit is breached, the business will need to borrow some cash or sell some securities.

Figure 10.11 The operating cash cycle

The OCC is the time lapse between paying for goods and receiving the cash from the sale of those goods. The length of the OCC has a significant impact on the amount of funds that the business needs to apply to working capital.

Figure 10.12 Calculating the operating cash cycle

For businesses that buy and sell on credit, three ratios are required to calculate the OCC.

Figure 10.13 The average OCC of businesses categorised according to size

Revenues <€500m

Revenues between €500m and €1bn

Revenues >€1bn

Net working capital days

2013

2015

2016

2014

100

2017

Source: Compiled from information in ‘Navigating uncertainty: PwC's annual global working capital study’, 2018/19, www.wpc.com, p. 17.

Managing Trade Payables

Remember – one business’s trade receivable is another business’s trade payable…

Admin expenses of tracking payables dates;

Goodwill;

Prompt payments discounts – the other side;

Monitor through average settlement period for trade payables.

Discussion question

How might each of these affect levels of inventory held by a business?

Increase in number of production bottlenecks

Rise in business cost of capital

Decision to offer a narrower range of products

A switch of suppliers from overseas to local

Deterioration in quality and reliability of bought in components.

What’s Next…

7.30pm 8.30pm – Business Simulation Round 3

8.30pm – Finish!

For next time:

Business Simulation round 3 submitted by 3pm Friday 16th December

Business Simulation round 4 submitted by 3pm Sunday 8th January 2023

Assessment 1 – Thursday 12th January 2022

Review Weblearn for extended learning questions

Read Atrill Ch 4&5

Consider: In respect of a business you have worked in or know well, can you think of significant capital investment decisions that company has had to make?

Have a lovely break!

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MN7029 – Financial Decision Making

3.3 Financing a business (continued)

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

What sources or types of finance are available to a company?

Insert footer / references if needed

Reminder from last week – what can the students remember about sources/types of finance?

Figure 6.1 The major external sources of finance

A reminder

What might a bank consider before lending money to a company?

Question for class – what would a bank look at in a potential loan?

Bank lending

Attitude of lenders influenced by:

Cash-generating ability

Security for the loan

Profitability

Fixed cost commitments

Lender will look at the profitability of the company, cash flows and whether there is any security available for the loan.

What can banks do to reduce risk?

Loan covenants may deal with such matters as:

Other borrowings

Dividend payments

Financial statements

Liquidity

Requiring security (fixed or floating charge on assets)

Including covenants in the loan contract

Lenders may reduce the risk of lending by

Examples of how bank reduce risk. They can take a security over a specific asset or assets in general (floating) like a mortgage, or they can put covenants into the loan agreement. Covenants tend to put restrictions on how a company will behave in order to protect the bank’s interests e.g. they need to provide the financial statements to the bank immediately after year end or they need to keep liquidity at a certain level, or they have restrictions on the dividend payments that can be made. If a company breaks covenants the bank can ask for the loan to be repaid immediately.

Figure 6.3 Factors influencing the attitude of owners towards borrowing

These are some of the factors that can influence how the company feels about borrowing as a source of finance. It tends to have a lower return requirement than more risky equity finance and means that the existing owners do not need to give up ownership of the company (dilution of shareholdings). It can also be flexible (often loans have a draw down facility so that company’s only need to take the loan when they need it) and having a third party involved can encourage better financial discipline in the company. However, the company needs to be aware of how much capacity they have to take on extra debt – is the company already very highly geared and therefore lenders may be less disposed to lending more money due to risk?

Figure 6.1 The major external sources of finance

There are other external sources of finance that a company can tap into. The next is finance leases, HP and securitisation

Figure 6.5 Benefits of finance leasing

If a company for example wants to buy a fixed asset it could take out a loan and buy the asset. A finance lease on the other hand is where the financial institution buys the asset and rents it to the company, so the company never owns it. Often this can be easier than arranging a loan, it improves the company cash flows as the cost of the machine is spread across it’s life rather than all paid out to acquire the machine, and it gives flexibility e.g. if the company wants to upgrade to a better machine they don’t have to go through the bother of selling the original.

Figure 6.6 The hire purchase process

HP is very similar – the financial institution buys the machine and the customer makes regular payments to the financial institution over the life of the asset. However, generally an HP agreements has a clause such that the company ends up owning the asset after a final payment is made.

Figure 6.7 The securitisation process

Securitisation is where a company creates a special purpose vehicle (SPV) which is usually a trust or a company, bundles up some assets and transfers them into the SPV and then issues bonds from the SPV to third parties. The assets in the SPV generate income which is then used to pay the interest on the bonds. It is a way generating capital from a bundle of assets and can be sued for example with a bunch of intangible assets such as licenses or IP. However this is similar to what happened during the financial crisis in 2008 when banks were bundling up bad mortgages and then selling bonds off the back of these bundles.

Figure 6.1 The major external sources of finance

We can also consider short term external finance. A bank overdraft is fairly self explanatory – it is a short term loan which can be very flexible but may also be more expansive than properly arranging a loan facility with the bank. Bills of exchange are short term IOUs.

Figure 6.8 The factoring process

Debt factoring is particularly popular with small businesses. Where a company supplies goods to customers on credit, it can enter into an arrangement with a financial institution or factor. The factor is responsible for invoicing the customer and pays 80% of the value of the invoice to the company immediately. Therefore the company does not need to wait until the credit period is up to get payment from customers. The factor then chases the customer for payment and when they pay the factor transfer the remaining 20% to the company less its factoring fees. This can be really useful for small companies who do not have a debt chasing department as it takes away all of that administrative work. However, it may also to signal to customers that the company is short of funding.

Debt factoring

Two types

Recourse factoring – where the business assumes responsibility for bad debts

Non-recourse factoring – where the factor assumes responsibility for bad debts

Debt factoring can also be recourse – so if the debt factor does not get paid by the customer they can reclaim the money from the original company or non recourse where the debt factor bears the risk of an unpaid invoice – this is obviously preferable to the company but tends to be more expensive.

Invoice discounting

Charges are lower

It is confidential

Invoice discounting is often preferred to debt factoring because:

Control over all aspects of customer relationship is retained

Invoice discounting is similar but the factor does not take over responsibility for issuing the invoice and chasing the debt – that remains with the original company, but the debt factor advances the money to the original company. This can be used when companies want to maintain control over their debt chasing

Long-term versus short-term borrowing

Considerations

Flexibility

Refunding risk

Matching borrowing with assets held

Interest rates

Companies clearly have a choice between different methods of funding, some of which are long term and some short term. In deciding which is the most appropriate they might consider matching to borrowing with the asset – e.g. if it is for a long term capital investment project it might be best to look at a long term loan, rather than a bank overdraft. However if it is for a short term boost in stock they might go for a short term method such as bank overdraft. Short term finance can often be more flexible – the ability to repay an overdraft which you cannot necessarily do with a loan until it becomes due. Refunding risk occurs if a lender calls back the loan before maturity and the borrower cannot find a loan with a similar rate of interest and interest rates themselves might determine whether to do for short or long term, or equity v debt

Figure 6.10 Short-term and long-term financing requirements

A typical; example of how short and long term financing might look might be to have a level of long term finance that covers both fixed assets and the permanent level of current assets e.g, the amount of stock that usually needs to be held. Short term finance is then used to finance any fluctuations in current assets.

Figure 6.11 The major internal sources of finance

We have looked so far only at external finance. However there are ways of generating finance without needing to go to third parties. On a short term basis reducing stock, collecting receivables and extending the period for trade payables will provide some financing. Ona long term kevel companies can choose to re-invest retained profits, however, always considering the impact of reinvestment on shareholder wealth.

Pecking order theory and long-term financing

Retained profits will be used to finance the business if possible

Where retained profits are insufficient, or unavailable, loan capital will be used

Where loan capital is insufficient, or unavailable, share capital will be used

One final theory about how business use finance is Pecking order Theory. This states that businesses when requiring finding will first use retained profits as they are quick and easy to access, the loan capital as it is again relatively quick and more certain and finally share capital as this is the hardest and most costly to raise.

The funding journey

In the next section e are going to look specially at funding for start up and early stage companies and where they might go to raise finance.

Start ups

How does a start up raise initial funding – can you guess from the pictures. Answers clockwise from top left:

Friend and family

Seed money/venture capital

Bank loans

Grants or government incentives

Crowdfunding

Business angels

Figure 7.5 Long-term finance for smaller businesses

Business angels

Financing smaller businesses

Crowdfunding

Government

Alternative investment market

Venture capital

Hotel Chocolat (Video) https://www.youtube.com/watch?v=TOcxf7kL8VQ

Video about how Hotel Chocolat raised initial funding – in particular I like to discuss with the class the innovation behind the Chocolate Bond and how they effectively self financed market research through the Chocolate club. You don’t need to watch the whole video – I generally stop it around 3:52.

Private equity – types of investment

Expansion capital

Venture capital

Replacement capital

Buy-out and buy-in capital

Rescue capital

One course of funding for early stage, particularly tech companies is private equity. Private Equity refers to funds put together by financial institutions and generally funded by High Net Worth Individuals who invest in private companies. Private Equity covers a lot of different capital at different stages, but the most relevant for small companies is venture capital. This is private investment in early stage businesses who have the potential to grow. It can range from hundreds of thousands to millions and the fund will take a reasonable large slide of shares for the funding as it tends to be high risk. As businesses grow there are other forms of private equity available e.g expansion if the company is trying to grow or expand into a new jurisdiction, replacement capital where one fund buys out another, buy out capital which is provided if a management team want to buy the company from the existing owners or rescue capital for businesses in trouble.

This is a flier prepared by PwC to help companies understand what Venture capital firms are looking for when they consider an investment.

Problems of smaller businesses in raising finance

Lack of financial management skills

Lack of knowledge concerning the availability of finance

Inability to meet assessment criteria of lenders

Bureaucratic screening processes

Inability to provide security

To sum up, some of the issues around smaller businesses raising capital – there is generally a lack of time and specific finance skills to understand where and how to raise capital as it can take a lot of time to secure a venture capital investment or a bank loan. Small business, particularly tech companies do not tend to have fixed assets they can offer as security and may not have much of track record or prior financial statements to convince lenders or inventors and for years many banks had quite bureaucratic screening processes which put small companies at a disadvantage.

Figure 7.9: External financing of small businesses (2017/18)

Bank loan/ commercial mortgage

Credit cards

Loans from other third parties

Grants

Invoice finance

Bank overdraft

Leasing or hire purchase

Loans/equity from directors, family, friends

Per cent

Source: British Business Bank 2017/18 (2018), ‘Small business finance markets (February)'. Figure B.16, p. 25, Used with permission.

Overall, small businesses tend to rely on credit cards and bank overdrafts to get the business operational, but for those who have the potential for growth, seed funding, crowd funding or business angels may be available.

Cost of Capital

In the next section we are going to look at the cost of the capital we have been discussing in the financing section.

What is cost of capital?

The cost to the business to of the finance needed.

Businesses tend to be financed through a mixture of equity (shareholder funds) or debt (bonds or borrowings from a bank, financial institution).

Shareholders will only invest if the business is likely to generate the return required by them. This is linked to the risk they perceive in the business and the opportunity cost of investing elsewhere. Therefore the cost of equity is the shareholders required return.

Banks or financial institutions require return in the form of interest on borrowings

The combined cost of these required returns is a company’s Cost of Capital

Video

Investopedia Cost of Capital explained

https://www.investopedia.com/terms/c/costofcapital.asp

Why do we need to know cost of capital?

It indicates the return required by shareholders and banks in order to provide funding

The cost of capital is therefore used as the discount rate for NPV;

If understated, may accept projects which decrease shareholder wealth;

If overstated may reject projects that would increase wealth.

What is cost of capital? Ultimately it is the cost of all the company’s funding, both debt and equity as all types of funding carries a cost. However, it can be easier to think about it from the other angle – it is the return that a company needs to generate in order to satisfy the requirements of its debt and equity funders. If it cannot generate this return then they will not provide the funding to the company, therefore it doesn’t represent a cost in cash terms, but a return that the company needs to achieve

Practically speaking the cost of capital is the discount rate we use when we are calculating the Net present Value of a project. If we get it wrong we might make an incorrect decision. If we pick a rate that is too low we may go ahead with project that do not achieve the required return and therefore decrease shareholder value. If we get it too high we may reject projects that would otherwise have been wealth enhancing.

So far you have been given the discount rate or cost of capital but now we are going ton work out how to calculate it ourselves. The steps we take are to look at each form of long term capital, work out the cost of that particular type of capita and then calculate an overall cost for the business.

Steps to calculate cost of capital

Identify each form of long term capital

Deduce the cost of each form of capital

Determine value of each form of long term capital;

Calculate an overall cost of capital.

The steps we take are to look at each form of long term capital, work out the cost of that particular type of capita and then calculate an overall cost for the business.

Cost of capital

The major forms of external long-term capital

Ordinary shares

Loan capital

Retained earnings

In addition an important form of internal long-term capital is:

These are the 3 types of capital which we can calculate the cost of capital on. Next week we will look at how you deduce the cost of capital for each of these elements of long term finance

What’s Next…

Next week:

Session 4.1: Assessment 1 presentations

Session 4.2: Weighted Average Cost of Capital & Business simulation round 6

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MN7029 – Financial Decision Making

1.2 Reviewing financial statements

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Week 1.2 – Learning Outcomes

Explain the key statements within a company’s Financial Statements;

Describe the main users of financial statements and why they would use them;

Debate the limitations of financial statements

Agency & Stakeholder Theory – Enron

Who is responsible for the collapse of Enron?

What steps could be, or have been, taken to prevent this sort of failure in the future?

I asked the students to read the Enron article as part of pre course reading. This discussion is a general discussion on what went wrong and what mechanism should have, and have now been put in place to stop this happening again. Get thoughts from students before moving onto suggested answers

Who is to blame?

The business environment – rapid growth

The CFO/CEO – set up the structure to enable fraudulent accounting (hiding debts/losses), failed to maintain control of operations

Executives – exercised share options at inflated share prices

The Board – pursued rapid growth and lost strategic focus

Audit committee – did not understand or question the complexity of the business

Auditors – close relationship, income from consultancy, failure to interrogate management

Stock analysts – had conflict of interest with investment banking side of their firm

What steps could be taken to prevent this happening?

Accounting for the substance not the form of the transaction (changes to accounting standards)

Stricter rules around audits

Independence of audit firms and investment banks

Independence of regulatory bodies – harsher penalties?

Stricter rules on director duties

More protection for whistleblowers

Embedding a culture of ethics

Independent audit committees and appointment of those with relevant skills

Types of business

Main types of business

Sole trader

Partnership

Company/corporation

In the UK we have

Sole trader

Partnership

Limited Liability Partnership (LLP)

Private company (Ltd)

Public Company (Plc)

We also have special designations e.g.:

Charities

Place of business

B Corp

Community Amateur Sports Club (CASC)

Introduction to types of business structures in the UK

Example Ownership Structure

Nat’s International Company Ltd

Investment Company Plc

70 shares = 70%

20 shares = 20%

10 shares = 10%

This is to break down in simple terms how a company issues shares to owners.

I set up Nat’s company with £20 and issue myself 20 shares of £1 each. At that stage I own 100% of the 20 shares in issue so I am the sole shareholder.

A friend offers to invest £70 in exchange for 70 shares and a separate investment company invests £10 in exchange for 10 shares. Now the ownership structure consist of 100 shares, of which I own 70 so I own 70% of the company.

I use the analogy of a pizza to describe this – the pizza is the whole company, but I can divide it up into as many slices as I like. People take a slice in exchange for putting money into the business. A pizza could have 4 slices (or shares) or 1 million slices and the amount of slices you hold indicates the level of influence you may have over the company.

Public v Private Companies

Company X

Management

Employees

Banks

Customers

Suppliers

General Public?

Shareholders

General Public

Introducing the concept of private companies – companies where shares can be issued to and traded by members of the general public

Public or Private Company

A private company (in the UK a Ltd) is held privately, usually by founders or other private individual investors.

The general public cannot buy or sell shares in Limited

May invite specific people to invest (e.g. a Private Equity Fund or Business Angel)

Does not appear on a Stock Exchange

A public company (in the UK a Plc) has sold some or all of its shares to the general public by way of an Initial Public Offering (IPO).

Listed on a stock exchange

Public can buy and sell shares on investment platforms

Has a higher level of scrutiny

Public or Private Company

Public companies tend to be larger and have more access to funding, but there are some very large private companies

Examples of large private companies – private companies does not necessarily correlate to small company

What is accounting?

A process of identifying, recording summarizing and reporting economic information or transactions to decision makers and stakeholders in the form of financial statements

There is a difference between financial accounting and management accounting

The accounting system is the steps performed to analyze, record, quantify and report economic events and their effects on an organization. It must be designed to meet the needs of the users

Insert footer / references if needed

Reiterating the role of accounting as taking many economic transactions in a business and presenting them in a way that is understandable, allowing management to make decisions and allowing interested parties to compare different businesses in the understanding that the companies will have applied standard principles to organising their transactions into this format.

What are Financial Statements?

Record of the company’s performance (in the form of economic information or transactions);

Key statements

Statement of financial position (balance sheet);

Profit or loss (income) statement;

Statement of cash flows.

A historical record of past events;

Numerical data and explanatory notes;

Publicly available in the UK

Video – what are financial statements?

Video is halfway down the linked page – you can show in class or the students can review later

Financial Statements: List of Types and How to Read Them (investopedia.com)

The Annual Report and Accounts

All UK companies are required to prepare accounts and file with UK Companies House ( https://www.gov.uk/government/organisations/companies-house);

If a business is not a company they will still draw up financial statements;

Companies must draw up accounts based on UK GAAP or IFRS;

All UK companies require an audit unless subject to exemption (e.g. certain small co’s);

Additional publication requirements for public companies.

Emphasise just how much information is publicly available in the UK – all UK company must prepare accounts and submit to Companies House and anyone can view – different in other jurisdictions – the US does not require private companies to make these publicly available.

Financial Statements

Statement of Financial Position

A summary at a fixed point in time;

Assets, liabilities and equity.

Statement of Profit or Loss

Data for a period of time (accounting period);

Shows income and expenditure for that period.

Cash Flow

Data for a period of time (accounting period);

Shows cash in and outflows for that period.

Not profit

Financial Statements Cycle

12 month period

Income Statement

Cash Flow

Income Statement

Cash Flow

Income Statement

Cash Flow

Statement of Financial Position

Emphasising that the Statement of financial position bookends the period

Who might use financial statements?

Question for the class – get their ideas on who might use them

Users of financial statements

This page can be used if you want to write up the students ideas on who the users might be or you can do it as a discussion

Pick a user – what might they use the financial statements for?

Class input – why might people use the statements – this might have been discussed in the previous slide

Who uses financial statements and why?

Current/potential investors

Employees

Lenders

Suppliers

Customers

Government and regulators

The public

Will I get paid?

Is the company meeting its company law and regulatory requirements?

What is the environmental and social impact of the company?

What level of profit did the company make?

Will the company be able to repay borrowings?

How much tax should the company pay?

Is the company in danger of insolvency?

Can the company continue to supply my goods?

Should I invest more/sell shares?

Is the company managed effectively?

Is the company growing?

Some ideas of users and what they use them for

Some key terms…

Revenue: Sales made to customers

Cost of goods sold: the cost of making the sales

Operating expenses: the cost of marketing the product or administering the business

Profit: Excess of revenue (sales, turnover) over expenditure (costs of good sold and operating expenses)

Assets: Business resources that the company owns or has use of

Equity: the investment or “stake” of the owner, the owner’s value in the business (initial investment in shares, retailed profits)

Inventory: Stock, goods for resale, raw materials

Receivables: money owed to the business

Payables: money the business owes to others

Statement of Financial Position (Balance Sheet)

Purpose of the balance sheet

The purpose of the balance sheet is to set out the financial position of a business at a particular point in time, the economic resources (assets) it controls and where its finance comes from (liabilities and equity).

It sets out the assets of the business and the claims against it (liabilities and owners’ equity) at a particular point in time.

What types of assets might you find in a business?

Ask the class to see if they can guess the assets that the pictures are clues to:

Cash

Property

Machinery

Inventory/stock/raw materials

Brand names or intangible assets

Merlin Entertainments Ltd – statement of financial position

An example of a statement of financial position – Merlin owns and operates theme parks around the world – I usually highlight the property, intangible assets, inventories etc

Types of assets

Current

Held for sale or consumption

Lifespan of a year of less

Held principally for trading

Cash or liquid short term investments

Non Current

Held for longer term

Business may be done in or with them (i.e. not consumed)

Tangible and intangible

Figure 2.3 The circulating nature of current assets

Cash

Trade receivables

Inventories

Circular nature of current assets – business uses cash to buy stock which it then sells for cash immediately (or cash to be received in the future – trade receivable)

Intangible assets

Goodwill:

Represents for example brand name, strong management team, business contacts, staff relations

Not possible to identify created goodwill separately from the business – subjective so cannot be recorded.

Purchased goodwill = price paid – (fair value of the assets – liabilities) – objective so can be recorded.

Subject to annual impairment review

Other intangibles:

For example, trademarks, patents.

Stated at cost and amortised over useful economic life

Typical assets

Land and buildings,

Machinery and equipment,

Fixtures and fittings,

Debtors (receivables),

Investments

Cash

Inventory

What is depreciation?

Depreciation

Depreciation is the allowance for wear and tear on some fixed assets like, plant and machinery. It is an allowance for:

Wearing out,

Consumption or

other reductions in the useful economic life of a fixed asset,

NOT A CASH FLOW!!!!

Accumulated depreciation shows amount that the asset has lost in value since its purchase

You can depreciate on a straight line or a reducing balance (%) method.

Claims

Equity

The owner’s claim against the business.

Ordinary shares plus reserves

Capital.

Separate legal identity

Liabilities

Other parties

For example, money owed for raw materials, upfront customer prepayments

Types of claim

Current

Settled in a year or less

Arise from trading

Non Current

Held for longer term

May not arise from trading

(e.g. long term bank loan)

Typical claims

Long term loans

Wages payable

Deposits received

Trade creditors

Loans and debentures

Bank overdraft

The accounting equation

Liabilities

Assets

Equity

The beauty of double entry accounting! The statement of financial position will always balance = assets must equal equity + liabilitirs

The effect of trading transactions on the accounting equation

The accounting equation can be extended as follows:

Profit (Loss)

Assets

Equity

Liabilities

+ (−)

The income statement (profit & loss account)

Profit (or loss) for the period = Total revenue for the period – Total expenses incurred in generating that revenue

What types of income might we have in a business?

Ask the class if they can guess the types of revenue a business might have:

Sales of goods (e.g. a supermarket)

Sales of subscriptions (Netflix, a gym)

Financial income (e.g. bank interest, or income from share investments)

Income from licencing (e.g. Disney might allow someone to use the image of Mickey Mouse on a pencil case and they pay to use that right)

Sales of services (e.g. an accountant or lawyers)

Rent (e.g. hotels renting rooms, or a landlord renting a property)

I like to compare how businesses have evolved their sales models e.g. Blockbuster video (sale/rental or physical product and late fees) v Netflix (subscriptions to view licecnced content)

Expenses

Ask the class if they can guess the types of revenue a business might have:

People, wages, salaries

Light and heat

Phone

Computing or cloud services (AWS)

Delivery costs

Rent of property or office

Raw materials

Figure 3.2

The layout of the income statement

How does Twitter make money?

This made me laugh – when Elon Musk bought Twitter he had to figure out how to make money from it and introduced the idea of paying for the blue tick. Lots of people complained, including the esteemed author Stephen King and Elon replied to that seemingly negotiating the price. I’m not sure how much product pricing is determined live online with Stephen King, but clearly some is!

How does Twitter make money?

How does Twitter make money though? It is free to users, so they are not asking for payment from users. Most of its money is made through advertising. Other companies pay Twitter to promote ads. Some money is also made by selling or licencing the data it collects to other companies who are interested in that data

How does Twitter make money?

In 2021 Twitter received revenue or sales of $4.5bn from advertising and $0.5bn from licencing data. Ask students to consider how business they use actually generate cash from sales? Will Twitter need to find a new model e.g. payment for users? Even though it made that money in sales in 2020 and 2021 it made a loss – revenue is not profit. Can a business survive if it continually makes a loss? Yes provided that people are willing to invest money, but when they are not and the cash runs out the business will fail. Lack of profits is not the ultimate killer of businesses it is lack of cash.

The cash flow statement

Figure 5.3

Standard presentation for the statement of cash flows

Cash is not profit!!!

Operating examples

	Profit	Cash
Receiving a loan from the bank
Profitable sale for cash
Profitable sale on credit
Buying a machine for cash
Depreciation of the machine
Buying inventory (stock) for cash
Issuing shares to investors for cash

Operating examples

	Profit	Cash
Receiving a loan from the bank	None	Increase
Profitable sale for cash	Increase	Increase
Profitable sale on credit	Increase	None
Buying a machine for cash	None	Increase
Depreciation of the machine	Decrease	None
Buying inventory (stock) for cash	None	Decrease
Issuing shares to investors for cash	None	Increase

Financial Management

Also called cost and management accounting;

Using financial data to help make business decisions;

Fundamental qualities of financial information:

Relevant

Timely

Understandable

Comparable

Verifiable

We’ve so far looked at financial accounting – how do businesses present their annual economic transactions. Financial management or management accounting is using financial data to help the management team make decisions

Differences between financial management and financial accounting

Financial accounting and management accounting can differ in lots of ways – the crucial element is that the financial accounting tends to be historic and summarised and subject to rules about accounting standards and disclosure. Management need timely and often detailed and forward looking information to aid the decision making process. This may mean they want it to be presented in different ways.

Financial Statements

Users?

Rules?

Features?

Type?

Frequency?

Uses?

Whole company?

Timing?

Detail?

Financial planning and analysis

Treasury manager

Risk management

Corporate strategy

Who might form part of a finance function?

Financial Controller

Financial accountant

General ledger accountants

Cash book

REPORTING/HISTORICAL

FORECASTING/FUTURE

CFO

CFO is known as Csuite – part of the Board of Directors,

Financial controller – oversees the accounts reporting team, responsible for budgets, analysis

Ginance/accounts manager – day to day running of the finance requirements

May also have general ledger accounts responsible for specific areas e.g. cash book

Strategic finance function:

FP&A:

What’s Next…

Today to 8.30pm: Practice round business simulation and Q&A

Thursday/Friday

5.30pm to 7.30pm (10-12pm) – Financial Planning (including break)

7.30pm 8.30pm (12-1pm) – Business Simulation Round 1

8.30pm (1pm) – Finish!

For Thursday:

Review Weblearn for additional reading and exercises.

Read Atrill Ch 2

Consider: Should a manager take everything in a set of financial projections as fact? Why might the projections be incorrect?

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Click to edit Master title style Click to edit Master text styles Second level Third level Fourth level Fifth level Click to edit Master text styles

ppt/slideLayouts/slideLayout101.xml

Click to edit Master title style Click to edit Master text styles

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Click to edit Master title style Click to edit Master text styles Second level Third level Fourth level Fifth level

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Click to edit Master title style Click to edit Master text styles Second level Third level Fourth level Fifth level

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Click to edit Master title style Click to edit Master text styles Click to edit Master text styles Click to edit Master text styles

ppt/slideMasters/slideMaster10.xml

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MN7029 – Financial Decision Making 1.2 Reviewing financial statements

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Week 1.2 – Learning Outcomes Explain the key statements within a company’s Financial Statements; Describe the main users of financial statements and why they would use them; Debate the limitations of financial statements

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Agency & Stakeholder Theory – Enron Who is responsible for the collapse of Enron? What steps could be, or have been, taken to prevent this sort of failure in the future?

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Who is to blame? The business environment – rapid growth The CFO/CEO – set up the structure to enable fraudulent accounting (hiding debts/losses), failed to maintain control of operations Executives – exercised share options at inflated share prices The Board – pursued rapid growth and lost strategic focus Audit committee – did not understand or question the complexity of the business Auditors – close relationship, income from consultancy, failure to interrogate management Stock analysts – had conflict of interest with investment banking side of their firm

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What steps could be taken to prevent this happening? Accounting for the substance not the form of the transaction (changes to accounting standards) Stricter rules around audits Independence of audit firms and investment banks Independence of regulatory bodies – harsher penalties? Stricter rules on director duties More protection for whistleblowers Embedding a culture of ethics Independent audit committees and appointment of those with relevant skills

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Types of business Main types of business Sole trader Partnership Company/corporation In the UK we have Sole trader Partnership Limited Liability Partnership (LLP) Private company (Ltd) Public Company (Plc) We also have special designations e.g.: Charities Place of business B Corp Community Amateur Sports Club (CASC)

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Introduction to types of business structures in the UK

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Example Ownership Structure Nat’s International Company Ltd Investment Company Plc 70 shares = 70% 20 shares = 20% 10 shares = 10%

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This is to break down in simple terms how a company issues shares to owners. I set up Nat’s company with £20 and issue myself 20 shares of £1 each. At that stage I own 100% of the 20 shares in issue so I am the sole shareholder. A friend offers to invest £70 in exchange for 70 shares and a separate investment company invests £10 in exchange for 10 shares. Now the ownership structure consist of 100 shares, of which I own 70 so I own 70% of the company. I use the analogy of a pizza to describe this – the pizza is the whole company, but I can divide it up into as many slices as I like. People take a slice in exchange for putting money into the business. A pizza could have 4 slices (or shares) or 1 million slices and the amount of slices you hold indicates the level of influence you may have over the company.

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Public v Private Companies Company X Management Employees Banks Customers Suppliers General Public? Shareholders General Public

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Introducing the concept of private companies – companies where shares can be issued to and traded by members of the general public

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Public or Private Company A private company (in the UK a Ltd) is held privately, usually by founders or other private individual investors. The general public cannot buy or sell shares in Limited May invite specific people to invest (e.g. a Private Equity Fund or Business Angel) Does not appear on a Stock Exchange A public company (in the UK a Plc) has sold some or all of its shares to the general public by way of an Initial Public Offering (IPO). Listed on a stock exchange Public can buy and sell shares on investment platforms Has a higher level of scrutiny

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Public or Private Company Public companies tend to be larger and have more access to funding, but there are some very large private companies

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Examples of large private companies – private companies does not necessarily correlate to small company

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What is accounting? A process of identifying, recording summarizing and reporting economic information or transactions to decision makers and stakeholders in the form of financial statements There is a difference between financial accounting and management accounting The accounting system is the steps performed to analyze, record, quantify and report economic events and their effects on an organization. It must be designed to meet the needs of the users

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What are Financial Statements? Record of the company’s performance (in the form of economic information or transactions); Key statements Statement of financial position (balance sheet); Profit or loss (income) statement; Statement of cash flows. A historical record of past events; Numerical data and explanatory notes; Publicly available in the UK Video – what are financial statements?

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Video is halfway down the linked page – you can show in class or the students can review later Financial Statements: List of Types and How to Read Them (investopedia.com)

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The Annual Report and Accounts All UK companies are required to prepare accounts and file with UK Companies House ( https://www.gov.uk/government/organisations/companies-house ); If a business is not a company they will still draw up financial statements; Companies must draw up accounts based on UK GAAP or IFRS; All UK companies require an audit unless subject to exemption (e.g. certain small co’s ); Additional publication requirements for public companies.

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Financial Statements Statement of Financial Position A summary at a fixed point in time; Assets, liabilities and equity. Statement of Profit or Loss Data for a period of time (accounting period); Shows income and expenditure for that period. Cash Flow Data for a period of time (accounting period); Shows cash in and outflows for that period. Not profit

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Financial Statements Cycle 12 month period 12 month period 12 month period Income Statement Cash Flow Income Statement Cash Flow Income Statement Cash Flow Statement of Financial Position Statement of Financial Position Statement of Financial Position Statement of Financial Position

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Emphasising that the Statement of financial position bookends the period

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Who might use financial statements?

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Question for the class – get their ideas on who might use them

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Users of financial statements

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This page can be used if you want to write up the students ideas on who the users might be or you can do it as a discussion

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Pick a user – what might they use the financial statements for?

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Class input – why might people use the statements – this might have been discussed in the previous slide

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Who uses financial statements and why? Current/potential investors Employees Lenders Suppliers Customers Government and regulators The public Will I get paid? Is the company meeting its company law and regulatory requirements? What is the environmental and social impact of the company? What level of profit did the company make? Will the company be able to repay borrowings? How much tax should the company pay? Is the company in danger of insolvency? Can the company continue to supply my goods? Should I invest more/sell shares? Is the company managed effectively? Is the company growing?

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Some ideas of users and what they use them for

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Some key terms… Revenue: Sales made to customers Cost of goods sold: the cost of making the sales Operating expenses: the cost of marketing the product or administering the business Profit: Excess of revenue (sales, turnover) over expenditure (costs of good sold and operating expenses) Assets: Business resources that the company owns or has use of Equity: the investment or “stake” of the owner, the owner’s value in the business (initial investment in shares, retailed profits) Inventory: Stock, goods for resale, raw materials Receivables: money owed to the business Payables: money the business owes to others

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Statement of Financial Position (Balance Sheet)

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Purpose of the balance sheet The purpose of the balance sheet is to set out the financial position of a business at a particular point in time, the economic resources ( assets ) it controls and where its finance comes from ( liabilities and equity ). It sets out the assets of the business and the claims against it (liabilities and owners’ equity) at a particular point in time.

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What types of assets might you find in a business?

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Ask the class to see if they can guess the assets that the pictures are clues to: Cash Property Machinery Inventory/stock/raw materials Brand names or intangible assets

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Merlin Entertainments Ltd – statement of financial position

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An example of a statement of financial position – Merlin owns and operates theme parks around the world – I usually highlight the property, intangible assets, inventories etc

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Types of assets Current Held for sale or consumption Lifespan of a year of less Held principally for trading Cash or liquid short term investments Non Current Held for longer term Business may be done in or with them (i.e. not consumed) Tangible and intangible

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Figure 2.3 The circulating nature of current assets Cash Trade receivables Inventories

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Circular nature of current assets – business uses cash to buy stock which it then sells for cash immediately (or cash to be received in the future – trade receivable)

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Intangible assets Goodwill: Represents for example brand name, strong management team, business contacts, staff relations Not possible to identify created goodwill separately from the business – subjective so cannot be recorded. Purchased goodwill = price paid – (fair value of the assets – liabilities) – objective so can be recorded. Subject to annual impairment review Other intangibles: For example, trademarks, patents. Stated at cost and amortised over useful economic life

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Typical assets

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What is depreciation?

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Depreciation Depreciation is the allowance for wear and tear on some fixed assets like, plant and machinery. It is an allowance for: Wearing out, Consumption or other reductions in the useful economic life of a fixed asset, NOT A CASH FLOW!!!! Accumulated depreciation shows amount that the asset has lost in value since its purchase You can depreciate on a straight line or a reducing balance (%) method.

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Claims Equity The owner’s claim against the business. Ordinary shares plus reserves Capital. Separate legal identity Liabilities Other parties For example, money owed for raw materials, upfront customer prepayments

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Types of claim Current Settled in a year or less Arise from trading Non Current Held for longer term May not arise from trading (e.g. long term bank loan)

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Typical claims

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The accounting equation Liabilities Assets Equity = +

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The beauty of double entry accounting! The statement of financial position will always balance = assets must equal equity + liabilitirs

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The effect of trading transactions on the accounting equation The accounting equation can be extended as follows: Profit (Loss) Assets Equity Liabilities = + + ( − )

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The income statement (profit & loss account)

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Profit (or loss) for the period = Total revenue for the period – Total expenses incurred in generating that revenue

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What types of income might we have in a business?

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Ask the class if they can guess the types of revenue a business might have: Sales of goods (e.g. a supermarket) Sales of subscriptions (Netflix, a gym) Financial income (e.g. bank interest, or income from share investments) Income from licencing (e.g. Disney might allow someone to use the image of Mickey Mouse on a pencil case and they pay to use that right) Sales of services (e.g. an accountant or lawyers) Rent (e.g. hotels renting rooms, or a landlord renting a property) I like to compare how businesses have evolved their sales models e.g. Blockbuster video (sale/rental or physical product and late fees) v Netflix (subscriptions to view licecnced content)

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Expenses

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Ask the class if they can guess the types of revenue a business might have: People, wages, salaries Light and heat Phone Computing or cloud services (AWS) Delivery costs Rent of property or office Raw materials

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Figure 3.2 The layout of the income statement

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How does Twitter make money?

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How does Twitter make money?

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How does Twitter make money?

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The cash flow statement

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Figure 5.3 Standard presentation for the statement of cash flows

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Cash is not profit!!!

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Operating examples {073A0DAA-6AF3-43AB-8588-CEC1D06C72B9} Profit Cash Receiving a loan from the bank Profitable sale for cash Profitable sale on credit Buying a machine for cash Depreciation of the machine Buying inventory (stock) for cash Issuing shares to investors for cash

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Operating examples {073A0DAA-6AF3-43AB-8588-CEC1D06C72B9} Profit Cash Receiving a loan from the bank None Increase Profitable sale for cash Increase Increase Profitable sale on credit Increase None Buying a machine for cash None Increase Depreciation of the machine Decrease None Buying inventory (stock) for cash None Decrease Issuing shares to investors for cash None Increase

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Financial Management Also called cost and management accounting; Using financial data to help make business decisions; Fundamental qualities of financial information: Relevant Timely Understandable Comparable Verifiable

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Differences between financial management and financial accounting

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Financial planning and analysis Treasury manager Risk management Corporate strategy Who might form part of a finance function? Financial Controller Financial accountant General ledger accountants Cash book REPORTING/HISTORICAL FORECASTING/FUTURE CFO FD

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CFO is known as Csuite – part of the Board of Directors, Financial controller – oversees the accounts reporting team, responsible for budgets, analysis Ginance /accounts manager – day to day running of the finance requirements May also have general ledger accounts responsible for specific areas e.g. cash book Strategic finance function: FP&A:

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Click to edit Master text styles Second level Third level Fourth level Fifth level

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Land and buildings, Machinery and equipment, Fixtures and fittings, Debtors (receivables), Investments Cash Inventory

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Land and buildings, Machinery and equipment, Fixtures and fittings, Debtors (receivables), Investments Cash Inventory

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Long term loans Wages payable Deposits received Trade creditors Loans and debentures Bank overdraft

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Long term loans Wages payable Deposits received Trade creditors Loans and debentures Bank overdraft

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Financial Statements Users? Rules? Features? Type? Frequency? Uses? Whole company? Timing? Detail?

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Financial Statements Users? Rules? Features? Type? Frequency? Uses? Whole company? Timing? Detail?

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Office Theme 0 9740 WPS 演示 Widescreen 454 50 27 0 0 false 已用的字体 15 主题 10 幻灯片标题 50 Arial 宋体 Wingdings Arial Verdana Times New Roman Times MS PGothic Calibri 微软雅黑 Arial Unicode MS 等线 MS UI Gothic Calibri Light 黑体 Default Design 2_Content slides – basic Office Theme Content slides – basic 3_Content slides – basic 1_Content slides – basic 4_Content slides – basic 5_Content slides – basic 1_Default Design 3_Default Design MN7029 – Financial Decision Making Week 1.2 – Learning Outcomes Agency & Stakeholder Theory – Enron Who is to blame? What steps could be taken to prevent this happening? Types of business Example Ownership Structure Public v Private Companies Public or Private Company Public or Private Company What is accounting? What are Financial Statements? The Annual Report and Accounts Financial Statements Financial Statements Cycle Who might use financial statements? PowerPoint 演示文稿 Pick a user – what might they use the financial statements for? Who uses financial statements and why? Some key terms… Statement of Financial Position (Balance Sheet) Purpose of the balance sheet What types of assets might you find in a business? Merlin Entertainments Ltd – statement of financial position Types of assets PowerPoint 演示文稿 Intangible assets Typical assets What is depreciation? Depreciation Claims Types of claim Typical claims PowerPoint 演示文稿 PowerPoint 演示文稿 The income statement (profit & loss account) Profit (or loss) for the period = Total revenue for the period – Total expenses incurred in generating that revenue What types of income might we have in a business? Expenses PowerPoint 演示文稿 How does Twitter make money? How does Twitter make money? How does Twitter make money? The cash flow statement PowerPoint 演示文稿 Operating examples Operating examples Financial Management Differences between financial management and financial accounting Who might form part of a finance function? false false false 14.0000

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MN6068 – Financial Decision Making for Managers Natalie Langley Jyyy 13 2021-05-17T13:25:00Z 2024-04-12T12:46:58Z

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Class	Mark %	Characteristics
Distinction	70 +	Excellent in every way. Knowledgeable, incisively analytical, conceptually sound, widelyresearched and well-structured. Displays a critical and sophisticated understanding of ideas, debates, methodologies and principles. Comprehensively cited and referenced. A degree of flair apparent in the work.
Merit	60 – 69	Very good, well-researched, solid. Addresses question. Sensibly structured and well presented. Evidence of analysis, reasoning and evaluation. May have some errors in emphasis but not in fact, and may be limited in terms of supporting material and breadth of coverage. Appropriately cited and referenced.
Pass	50 – 59	Average to good. Reasonable bibliography. Signs of effort, though more descriptive than analytical. May have some errors but balanced by sound work. May not fully address the question with deficiencies in knowledge and understanding or directness and organisation.
Fail	40 – 49	Fail. Descriptive narrative. May be partly irrelevant. Indiscriminate. Lacks structure. Could be more direct and explicit. Little independent research evident. Short bibliography. May be confused or irrelevant. Heavily based on lecture notes, but a minimum of understanding to justify a pass. Answers by inference.
Fail	0 – 39	Poor. Does not answer question directly. Little evidence of independent reading or lecture notes. Major errors or too brief. Unstructured.
		Very poor indeed. Fails in every respect to answer the question effectively. No evidence of learning, reading or knowledge. Largely irrelevant. Very brief.

Describe how you went about tackling the simulation (e.g. did you assign roles, take decisions collectively)
Did anyone take responsibility for making sure that the group submitted the decisions on time for each round?
Did you need to work outside of the time allotted in class and if so how did you organise the group to get together?
How did you resolve conflict in the group?
Do you feel everyone in the group contributed equally to the task?
Is there anything that you would do differently next time?

Financial Decision Making-6

Case Study: Investment Appraisal for Tech Innovations Ltd.

Introduction

Background Information

R&D Team

Rubrics

Teaching team

Module Summary and Description

Module Learning Outcomes

Module Syllabus/Content

Indicative weekly teaching programme

Assessment

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