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If you cannot accept these terms, please do not quote me.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

Appendix 2

Assessment 2

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.

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

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

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

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

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

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.

16

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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 ba

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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-2

Case Study: Investment Appraisal for Tech Innovations Ltd.

Introduction

Background Information

R&D Team

Rubrics

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Teaching team

Module Summary and Description

Module Learning Outcomes

Module Syllabus/Content

Indicative weekly teaching programme

Assessment

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