Managing Financial Resources and Decisions - Essay Example

Topic: Managing Financial Resources and Decisions Task 2 Part A: (P2.2, P2.3) Financial planning is an important aspect of financial management because it allows an organization to ensure that funds are available to meet both present and future needs. A significant number of organizations suffer from poor planning but it is always important to have a financial plan. There is always a tendency of expenses increasing and this is why the organization needs to have a financial plan so as to manage unexpected expenses and emergencies such as unexpected increases in operational costs. However, the most important part of financial planning is the identification of cash shortages as well as surpluses so as to ensure that money is put to good use. Failure to have a financial plan will always result in the organization being unable to meet its expenses whenever they arise (Berry, Jarvis, and Jarvis, 2005, p. 28). The success of any financial plan will largely depend on the effective disseminate of information to various decision makers within the organization. This is because it will ensure support and compliance among different stakeholders of the organization. It will also facilitate faster decision making which will ensure maximum utilization of business opportunities. Some of the key decision makers include: The CEO: he/she is responsible for the overall performance of the organization. The most important information for the CEO is the budget forecasts and financial statements. This information serves the purpose of providing information related to organizational needs and the overall performance of the business. The CFO: responsible for the allocation of the organization financial resources. The most important information for the CFO is the budget estimates because they present the financial needs of the organization. Other Employees: they are responsible for the running of daily activities within the company. The most important information is the company strategic plan which will guide their actions to ensure that the organization achieves its goals. Part B: (P2.4) Option 1: Obtaining a 1-year interest free loan of £10,000 from a partner restaurant This will increase the company’s current liabilities by £10,000 and eventually cash will increase by the same amount. Therefore, the final balance sheet amount will be £71,135 (10,000 + 61,135). Option 2: Obtaining a 2-year loan of £10,000 at 10% interest per annum Long term liabilities will increase to £ 23,400 [10,000 + 11,400 + (10*10000) + (10*10000)] The company will create an interest rate expense of 2,000 [(10*10000) + (10*10000)] Current assets will increase to 16,115 (6,115 + 10,000) The final balance on the balance sheet will be £ 73,135 (61,135 + 12,000) Option 3: Selling unused appliances worth £3,000 at their net realizable value, with no profit made on disposal and issuing an additional 2000 shares at £3.50 per share. Fixed assets will reduce by £3,000 Issued capital will increase by £7,000 (2,000*3.5) Current assets will increase by £10,000 (3,000 + 7,000) The final balance on the balance sheet will increase to £71,135. The first option is the best among the three because the business will manage to get financing at no extra cost. The second and third options are not attractive because they result in payment of interest and issuance of stock respectively. Task 3 PART A: (P3.1) The budget control process involves six sequential processes including: 1. Setting new budget: this is the first part of the budget control cycle whereby the original budget is established according to the needs of the organization. 2. Definition f performance measures: these are means against which the organization will measure the perfoanmnce of its budget. The most common measures include return on capital and profit targets. 3. Measurement of actual performance: involves the use of cost center numbers to record financial transactions into the company’s financial database (Juan, 2007. p. 17). 4. Comparing actual performance with the budget: at this point, the organization measures its financial performance against the original budget. 5. Examination of variances: identify any differences between the actual financial performance and the original budget as a percentage or absolute sum of money. 6. Taking necessary actions: this involves taking the initiative of making appropriate changes to the discrepancies identified on the original budget. Reasons for variances: The following could be the main reasons for variances between the original and actual budget: Faulty arithmetic in the budget figures: the errors include the errors of commission or duplication of financial figures. For instance, £ 22,500 may have been duplicated on either materials or direct labor. The occurrence of reality: this is possible especially when there is an occurrence of an event that may be beyond the control of the employees involved in the budget process. For instance, the variance in the amounts of units sold may have been as a result of market dynamics such as a fall in demand. Differences between budget assumptions and the actual outcome: all budgets are prone to contain errors in assumptions such as ‘customer demand will be positive with the introduction of the new product’. In this case, Yuri may have overestimated the amount of unit to be sold in its budget. PART B: (P3.2) 1. I will arrive at the total cost for the job and the cost per leaflet by computing the sum of direct materials, direct labor, and Selling, distribution and administration overheads. 2. Total Production cost: Direct Costs Paper 612 Ink 18 Labor Time 30 Indirect Costs Production Overheads and machine utilization 110 Selling, distribution and administration overheads 40 Total Production Cost 810 3. Mark-up = 10% Therefore, we can calculate the price to be quoted by computing the mark-up figure. 0.1*810 = 81 Price Quote= 810 + 81 891 4. i. Labor cost and selling, distribution and administration overheads will increase by £ 7.5 (0.5*15) and £ 10 (0.5*20) respectively. Therefore the total production cost will increase by £ 17.5 to £ 827.5. Therefore, the price quote will increase be £ 910.25 [(0.1*910.25) + 910.25] ii. Labor cost and selling, distribution and administration overheads will decrease by £ 7.5 (0.5*15) and £ 10 (0.5*20) respectively. The total production cost will amount to £ 792.5 after a decrease of £ 17.5. The price quote will be £ 871.75 [(0.1*871.75) + 871.75]. PART C: (P3.3) 1. Calculate for each project: i. The average annual rate of return on average capital invested (Accounting rate of return) ARR= Average Investment /Initial Investment Average Investment is calculated as the average of the sum between the initial investment and the final investment. Therefore ARR: Project A [(50000+20000)/2]/50000 = 0.70 Project B [(50,000+36,000)/2]/50000 =0.86 ii. The payback period PPB= A+ (B/C) Project A Year Cash Flow Cumulative Cash Flow 0 (50000) (50000) 1 35,000 15,000 2 30,000 (15,000) 3 25,000 (40,000) 4 20,000 (60,000) Payback period = 2 + (-15,000/25,000) = 2.6 years Project B Year Cash Flow Cumulative cash flow 0 (50000) (50000) 1 20,000 30,000 2 20,000 10,000 3 24,000 (14,000) 4 36,000 (50,000) Payback period =3 + (-14,000/36,000) =3.4 years iii. The net present value NPV = sum of all net cash inflow during the first to the last period – initial investment Net cash Inflow= Rn/(1+i)n where n is the period for the cash inflow. PV Factors: Year 1 = 1 ÷ (1 + 10%)1 ≈0.9091 Year 2 = 1 ÷ (1 + 10%)2 ≈0.8264 Year 3 = 1 ÷ (1 + 10%)3 ≈0.7513 Year 4 = 1 ÷ (1 + 10%)4 ≈0.6830 Project A Year 1 2 3 4 Net Cash Inflow 35,000 30,000 25,000 20,000 Salvage Value 10,000 Total Cash Inflow 35,000 30,000 25,000 10,000 × PV Factor 0.9091 0.8264 0.7513 0.6830 Present Value of Cash Flows 31,818.5 24,792.0 18,782.5 6,830.0 Total PV of Cash Inflows 82,223 − Initial Investment 50,000 Net Present Value 32,223 Project B Year 1 2 3 4 Net Cash Inflow 20,000 20,000 24,000 36,000 Salvage Value 10,000 Total Cash Inflow 20,000 20,000 24,000 26,000 × PV Factor 0.9091 0.8264 0.7513 0.6830 Present Value of Cash Flows 18,182.0 16,528.0 18,031.2 17,758.0 Total PV of Cash Inflows 70,499.2 − Initial Investment 50,000 Net Present Value 20,499.2 iv. The profitability index Profitability Index = 1 + (Net Present Value/Initial Investment) Profitability Index for Project A = 1 + (32,223/50,000) = 1.64 Profitability Index for Project B = 1 + (20,499.2/50,000) = 1. 41 2. Define the internal rate of return The internal rate of return is a discount method often used in the process of capital budgeting to make equate the Net Present Value of all projects to zero (Maher, Stickney and Weil, 2011, p. 55). Basically, it is used to rank the attractiveness of various projects that a company is planning to select and this makes it easy for top management to choose the most appropriate project. For instance, the project with the highest IRR would be considered the best among the all the possible project given that all conditions will be constant. 3. Briefly discuss the relative advantages and disadvantages of the four methods of evaluation mentioned in (1) above Advantages Accounting rate of return Does not require other special reports because of the fact that it is used on the basis of accounting information. It is very simple to understand and therefore easy to make calculations Can measure the profitability of an investment because it is based on accounting profit The payback period The formula is simple to understand and this makes it very easy to make computations Widely used in the field of capital budgeting and this makes it very easy to understand Has a strong emphasis on liquidity and this makes it easy for managers to make proposals on investments. Incorporates risk in its calculations and this makes it easy for management to identify the level of risk associated with a project. For instance, a project with the shortest payback period has less level of risk. Uses the short term approach which makes it very easy to calculate capital expenditure The net present value Accounts for the time value of money which makes it more reliable than the other techniques of investment appraisal that ignore accounting for time value of money including payback period and accounting rate of return. The profitability index Easy to understand because it uses a simple formula of division Takes into consideration the time value of money unlike the payback period and accounting rate of return methods. Disadvantages Accounting rate of return Ignores the terminal value of a project Ignores the use of cash flow from an investment Ignores the time value of money The payback period The formula does not recognize the time value of money Places high emphasis on liquidity at the expense of profitability Only considers cash flow before the payback period but ignores cash flow after the payback period The net present value The technique is mainly based on the use of estimates which may affect the accuracy of actual results because such estimates may deviate from the actual results. The profitability index The technique may result in the use of incorrect comparisons especially in the selection of mutually exclusive projects. This is based on the fact that it does not identify which of the projects has a shorter return duration (Juan, 2007. p. 176). Consequently, management may end up choosing a project that has a longer duration of return. The technique requires the use of estimates and this may lead to inaccuracies based on the fact that the estimates may be biased. Different investors have different assumptions and this can get worse should such assumptions not hold in the future. 4. Explain which project you would recommend for acceptance Project A is the most desirable because it meets the most decision rules for the four investment appraisal techniques. This is based on a number of factors including: Project A has the highest profitability index Project A has the highest Net Present Value Project A has the shortest payback period Task 4 PART A: (P4.1) Profit and Loss account presents the revenues and expenses of a company in a particular time period. The purposes of the profit and loss account to its users include: Enables shareholders/business owners to see whether the business has recorded an acceptable return. Allows business directors to satisfy the legal requirement that provides for the presentation of financial information Allows financiers to determine whether the business is in a position to generate sufficient profits and remain sustainable. Balance Sheet reports the assets, liabilities, and stockholder’s equity of a company as of a particular point in time (Maher, Stickney and Weil, 2011, p. 77).The balance sheet serves its users with an idea of the financial position including the company obligations and what it owns. Cash Flow Statement and Notes presents information related to changes in the cash and cash equivalents of a company. Users of the cash flow statement get a glimpse of how much the company has paid and what it has received within a specified time period. The government may use the statement to make tax computations. Some of the notable changes to reporting requirements under International Accounting Standards (IAS) include: Parent companies are required to present consolidated financial statements like a single economy entity. This is a replacement of the IAS 27 which required entities to prepare separate financial statements. IFRS 12 requires that business organizations provide extensive disclosure of information in place of the summary information that has been provided by business organizations. PART B: (P4.2, 4.3) Scenario 1: R Riggs and J & B Associates (a) What type of business are R Riggs and J & B Associates operating (e.g. Limited Liability Company, etc…)? For each business, justify your answer by identifying at least 3 factors that motivated your choice. R Riggs is a sole proprietorship business based on the following reasons: i. The balance sheet shows a record of drawings which indicates that owner has taken cash or other assets from the company. ii. The balance does not indicate significant balances which imply that the business is small in size and operations. iii. There is the use of a single name R Riggs which explains the fact that the business may be run by R Riggs. J & B Associates is a partnership business because of the following reasons: i. There is the use of the designation associates which is commonly associated with partnerships. ii. The profit and loss account indicates a split of drawings and salaries among J and B. iii. The balance sheet shows capital contributions from two people including J and B. (b) Which business appears to be the most profitable? Justify your answer. The best approach to determine the most profitable business is the use of profitability ratios. They include return on equity, profit margin, and return on assets (Juan, 2007, p. 100). Let’s compare the three ratios for the two companies and determine the most profitable company. Profit margin = Net Income/Sales Revenue R Riggs = 23,937/157,165 = 15.2% J & B Associates = 86,065/363,111 = 23.7% Return on Equity = Net Income/Shareholders Equity R Riggs = 23,937/11,400 = 209.97% J & B Associates = 86,065/175,000 = 49.18% Return on Assets = Net Income/Total Assets R Riggs = 23,937/18,237 = 131.26% J & B Associates = 86,065/206,365 = 41.71% R Riggs is the most profitable company because it has very high values for ROA and ROE which implies that the company has the highest amount of pound amount on assets as well as capital invested. The values for R Riggs include 209.97% and 131.26% for ROA and ROE respectively compared to J & B Associates’ 49.18% and 41.71%. (c) Which business appears to be less liquid? Justify your answer. Liquidity measurement ratios include quick, current, and cash ratios. Quick Ratio: (Current Assets - Inventories) / Current Liabilities R Riggs = (18,874 - 2,400)/ 5,657 = 2.9 J & B Associates = (140,490 - 74,210)/ 27,525 = 2.4 Current ratio: Current Assets/Current Liabilities R Riggs = 18,874/ 5,657 = 3.3 J & B Associates = 140,490/ 27,525 = 5.1 Cash Ratio: Total cash and cash equivalents/ Current liabilities R Riggs = 4,424/ 5,657 = 78.2% J & B Associates = 6,130/ 27,525 = 22.3% J & B Associates is the least liquid company given the fact that it has the lowest cash and quick ratios in comparison to R Riggs. Scenario 2: Staton plc. (a) Ratio formulae i. Gearing = (Long Term Debt/ Share Holder Equity) × 100 = 7,880,000/8,888,680 = 88.65% ii. Earnings per share (EPS) = (Net profit after tax − Preference dividend) / Number of equity shares (common shares) = (750,000 – 200,000)/ 478,600 = £ 1.15 iii. Dividend per share = Dividends/Share = 200,000/478,600 = £ 0.42 iv. Dividend yield = (Dividend per share/Share price) × 100 = 0.42/80 = 0.53% v. Dividend cover = Earnings per share/Dividend per share = 1.15/0.42 = 2.7 times vi. Price/earnings ratio = Stock Price / Earnings per Share = 80/1.15 = 69 times. (b) Advice on investing in the company Professionals in the field of investment consider the price earnings ratio to be the best known indicator of investment valuation. This is despite the fact that technique has its own imperfections. This is based on the fact that the ratio is an indicator of how much the market is willing to pay the for the company’s earnings (Wood and Sangster, 2008. P. 43). Using the price earnings ratio, I can confidently recommend that Jane should invest in Staton plc. This is mainly because the market is willing to pay 69 times for the company’s earnings (Dyson, 2007, p. 65). This is an excellent return from earnings given the fact that the average price earnings has been around 15 times. Market will get the opportunity to get four times more than the average of what the market is willing to pay for Staton plc’s earnings. The other reason is that Staton plc has a dividend cover of 2.7 times which implies that the company is very stable in terms of its earnings and can still be in a position to pay dividends even if it records a loss. The company is able to pay dividends two times over the profits recorded in a financial period. However, it is important to note that the company is operating in a very volatile business environment because of the high gearing ratio. Therefore, Jane should be ready to cushion her investments against the high leverage risk that the company has been exposed to (Drury, 2003, p. 77). References Berry, A., Jarvis, P. and Jarvis, R., 2005. Accounting In A Business Context. Chicago: Cengage Learning EMEA. Drury, C., 2003. Cost and Management Accounting: An Introduction. 5th edition. London: Thomson Learning. Dyson, J. R., 2007. Accounting for Non-Accounting Students. Chicago: Prentice Hall. Wood, F. and Sangster, A., 2008. Business Accounting 1. 11th edition. Harlow: Pearson Education Ltd. Juan, D. A., 2007. Fundamentals of Accounting: Basic Accounting Principles Simplified for Accounting Students. New York: AuthorHouse. Maher, M., Stickney, C. and Weil, R., 2011. Managerial Accounting: An Introduction to Concepts, Methods and Uses. Chicago: Cengage Learning. Read More