Managing finances
| by Ann Irons 20 Aug 2004 Diploma in Financial Management Relevant to Subject Area 3 |
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By now you should all be familiar with the broad theme of subject area 3. It is to develop an understanding of the role of financial strategy in the investing, financing, and resource allocation decisions within an organisation. So understanding how businesses and other organisations manage their finances is very important.
There are four key areas that you need to have knowledge of to understand how to manage finances. First, you need to understand the cash flows a business is likely to have - how the cash cycle is calculated, how a business forecasts its cash requirements, and so forth. Secondly, you need to understand how a business manages its working capital as a whole, focusing particularly on how debtors are managed. Thirdly, you must familiarise yourself with how the banking system and financial markets work as a whole, what influences those markets and how a business seeks additional finance when it is required. Finally, you must understand what capital expenditure budgeting is and how a business decides whether or not to spend money on a particular project.
According to the famous English saying, you must speculate to accumulate. By this, we mean that you need to invest money into something before you can expect a return. This is true not only when starting a business, but also during the whole life of that business. If a business is to flourish and reach its full potential, money must continue to be ploughed back into it year after year. It is very tempting to extract the profits in the form of drawings or dividends, but failing to re-invest will cost the proprietors or shareholders dearly in the future.
Since capital investment is therefore so important to the success of a business, it is important in the overall context of managing finances.
Key areas of capital investment appraisal
The key areas of capital investment appraisal are as follows:
- steps in project appraisal
- relevant and non-relevant costs
- accounting rate of return
- payback period
- time value of money
- discounting and compound interest
and - discounted cash flow.
These are now discussed in turn below.
Steps in Project Appraisal
Different reference books may set out the steps in project appraisal differently, but the broad content is the same. You need to know what the steps are and be able to say a little bit about each. Broadly speaking, they are as follows:
Initial investigation of the proposal
First, a decision must be made as to whether the project is technically feasible and commercially viable. This involves assessing the risks and deciding whether the project is in line with the company's long-term strategic objectives.
Detailed evaluation
A detailed investigation will take place in order to examine the projected cash flows of the project. Sensitivity analysis is performed and sources of finance will be considered.
Authorisation
For significant projects, authorisation must be sought from the company's senior management and board of directors. This will only take place once such persons are satisfied that a detailed evaluation has been carried out, that the project will contribute to profitability and that the project is consistent with the company strategy.
Implementation
At this stage, responsibility for the project is assigned to a project manager or other responsible person. The resources will be made available for implementation and specific targets will be set.
Project monitoring
Now the project has started, progress must be monitored and senior management must be kept informed of progress. Costs and benefits may have to be re-assessed if unforeseen events occur.
Post-completion audit
At the end of the project, an audit will be carried out so that lessons can be learned to help future project planning.
Relevant and non-relevant costs
You need to understand the concept of relevant cash flows for decision-making. You may be required to either discuss relevant costing or apply the principles in a net present value (NPV) calculation. Relevant costs are future costs A relevant cost is a future cost arising as a direct consequence of a decision. A cost which has been incurred in the past is therefore totally irrelevant to any decision that is being made now. Such past costs are called 'sunk costs'.
Relevant costs are cash flows
Only those future costs that are in the form of cash should be included. This is because relevant costing works on the assumption that profits earn cash. Therefore, costs which do not reflect cash spending should be ignored for the purpose of decision-making. This means that depreciation charges should be ignored.
Relevant costs are incremental costs
A relevant cost is the increase in costs that results from making a particular decision. Any costs or benefits arising as a result of a past decision should be ignored.
Opportunity costs
An opportunity cost is the value of a benefit foregone as a result of choosing a particular course of action. Such a cost will always be a relevant cost.
Other non-relevant costs
Certain other costs will be irrelevant to decision-making, such as 'committed costs'. A committed cost is a future cash outflow that will be incurred anyway, regardless of what decision will be taken. Interest costs are also ignored. This is not because they do not meet the above criteria, but because they are taken into account in the discounting process. If these costs were included as relevant they would be double counted.
Accounting rate of return
You will need to be able to calculate the accounting rate of return (ARR) of a project. Since ARR is based on profits rather than cash flows, the calculations may involve reconciling cash flow to profit.
There are several ways of writing the ARR formula. Whichever you choose, be sure to use the same one throughout the calculation. It may be that the question specifically tells you to use a certain ARR formula. If this is the case, be sure to use the formula given or you will fail to gain maximum marks for that question. The most common formula is:
Estimated average profits x 100%
Estimated average investment
To calculate the value of the average investment you must first add the initial investment cost to the residual value. This gives the total amount of money tied up and it should be divided by two to find the average. Many candidates make the mistake of thinking that the average investment is calculated by taking the residual value from the initial cost. By doing this, candidates fail to gain easy marks. In an exam, you may also be required to discuss the usefulness of ARR as a method of project appraisal. The advantages and disadvantages are set out below:
Advantages
- easy to understand
- widely used
- data readily available to calculate it.
Disadvantages
- it does not take into account the time value of money
- it is based on accounting profits and these are subjective.
Payback period
You may be required to calculate a project's simple or discounted payback period, or to discuss the usefulness of this method of project appraisal. The simple payback period is calculated by identifying the point at which cumulative net cash inflows equal the cost of the initial investment.
To calculate the discounted payback period, all cash flows must first be discounted to take into account the time value of money. Then, as with simple payback, the payback period is calculated by identifying the point at which cumulative (discounted) net cash inflows equal the cost of the initial investment (also discounted if not occurring immediately).
It always surprises me, when marking exam papers, how many candidates automatically calculate the discounted payback period even though they have not been asked to do so. A lot of time is then wasted performing unnecessary calculations for which no marks are available. Read the question - if it says 'calculate the payback period' or 'calculate the simple payback period' then don't do any discounting.
The advantages and disadvantages of the payback period method of project appraisal are set out below.
Advantages
- easy to understand
- widely used
- helps to minimise risk by giving greater weight to earlier cash flows.
Disadvantages
- simple payback does not take into account the time value of money
- it ignores cash flows received after the end of the payback period
- it does not take into account the overall profitability of the project.
Time value of money
You need to be able to discuss the concept of the time value of money. Most candidates understand it when they are first introduced to it but some always struggle to actually explain it. You do not need to have a fantastic grasp of the English language to score marks in an exam question on the time value of money. You just need to be able to explain that most people would prefer £100 today rather than £100 in 10 years' time. Why? Because £100 will probably buy you less in 10 years' time than it will today.
Discounting and compound interest
Moving on from the concept that £100 today is worth more than £100 in 10 years' time, you will need to be able to discuss discounting and compounding.
Discounting helps us to understand how much we would need to invest today if we wanted to receive £100 in 10 years' time, given a certain rate of interest. Compounding is simply the reverse of this. It helps us to calculate the future sum that will be received if the £100 were invested today for 10 years.
Discounted cash flow
By taking into account the time value of money and discounting cash flows according to when monies are paid out or received, projects can be appraised before the investment decision is made. It is important to note that it is the cash flows of the project that are discounted, not the profits.
You may be asked to calculate the NPV of a project and interpret the result. Alternatively, you may need to explain this method of project appraisal. When performing NPV calculations, the following approach should be taken:
- identify the relevant cash inflows and outflows of the project, not forgetting the initial investment
- set up a table and discount each of the cash flows to its present value, using the company's required rate of return - discount tables will be provided on the day to facilitate calculations
- calculate the net present value of the project by taking the outflows away from the inflows
- decide whether or not the project should be accepted on the basis of whether or not it has a positive NPV.
The advantages and disadvantages of NPV as a method of project appraisal are set out below:
Advantages
- shareholder wealth is maximised
- it takes into account the time value of money
- it is based on cash flows, which are less subjective than profits.
Disadvantages
- it can be difficult to identify an appropriate discount rate
- some managers are unfamiliar with the concept of NPV
- cash flows are usually assumed to occur at the end of a year, but in practice this is over simplistic.
Internal rate of return (IRR)
You may be asked to calculate the internal rate of return and interpret the results, or discuss its uses as a method of investment appraisal. The internal rate of return tells us the rate at which the NPV of a project is neither positive nor negative. There are four steps to an IRR calculation:
- Calculate the project's NPV at any reasonable discount rate (this may be given to you in the exam).
- If the above NPV is positive, choose a higher discount rate (again this may be given in the exam) and calculate the NPV again. If the above NPV was negative, choose a lower discount rate.
- Either way, you must end up with one positive and one negative NPV. You must now calculate the IRR by using the following formula:
Where A is the lower discount rate and B is the higher rate, a is the NPV at the lower rate and b is the NPV at the higher rate. - The IRR must then be compared to the company's required rate of return. If it is higher than the required rate of return, the project should be accepted. If it is lower than the required rate of return, the project should be rejected.
Please note that all workings should be shown when performing NPV calculations. Even if you are using a sophisticated calculator to help you, you won't gain full marks unless your workings are clearly set out. Such calculators are really not that useful, and will not give you a competitive advantage. The advantages and disadvantages of IRR as a method of project appraisal are set out below:
Advantages
- it takes into account the time value of money, which is a good basis for decision-making
- results are expressed as a simple percentage, and are more easily understood than some other methods
- it indicates how sensitive decisions are to a change in interest rates.
Disadvantages
- projects with unconventional cash flows can have either negative or multiple IRRs - this can be confusing to the user
- IRR can be confused with ARR or Return on Capital Employed since all methods give answers in percentage terms - hence, a cash-based method can be confused with a profit-based method
- it may give conflicting recommendations to NPV
- some managers are unfamiliar with the IRR method
- IRR cannot accommodate changes in interest rates over the life of a project
- it assumes funds are re-invested at a rate equivalent to the IRR itself, which may be unrealistically high.
Ann Irons is an ACCA examiner