Download - Management consultancy-chapter-26-and-35
PFS : FINANCIAL ASPECT – PROJECT FINANCING AND EVALUATIONChapter 26
Determining Funds Requirements and Profitability
Projected Statement of Comprehensive Income Operating cost ratios (i.e. COS, SAE, to Sale)
Projected Statement of Financial Position Projected Cash Flow Statement
- to evaluate the economic viability of the project and its financial requirements, the following statement may be prepared
Sources of FinancingI. EquityII. Loan Financing
a) Short-term loansb) Long-term loans
Number of Local Calls
Mon
thly
Bas
ic
Tele
phon
e B
ill
Total fixed costs remain unchangedwhen activity changes.
Your monthly basictelephone bill probablydoes not change when
you make more local calls.
Total Fixed Cost
Number of Local Calls
Mon
thly
Bas
ic T
elep
hone
B
ill p
er L
ocal
Cal
l
Fixed costs per unit declineas activity increases.
Your average cost perlocal call decreases as
more local calls are made.
Total Fixed Cost
Minutes Talked
Tota
l Lon
g D
ista
nce
Tele
phon
e B
illTotal variable costs change
when activity changes.
Your total long distancetelephone bill is basedon how many minutes
you talk.
Total Fixed Cost
Minutes Talked
Per
Min
ute
Tele
phon
e C
harg
e
Variable costs per unit do not changeas activity increases.
The cost per long distanceminute talked is constant.
For example, 10cents per minute.
Variable Cost Per Unit
Summary of Variable and Fixed Cost BehaviorCost In Total Per Unit
Variable Changes as activity level changes.
Remains the same over wide ranges of activity.
Fixed Remains the same even when activity level changes.
Dereases as activity level increases.
Cost Behavior Summary
Mixed costs contain a fixed portion that is incurred even when facility is unused, and a variable portion that increases with usage.
Example: monthly electric utility charge Fixed service fee Variable charge per
kilowatt hour used
Mixed Costs
Variable Utility Charge
Activity (Kilowatt Hours)
Tota
l Util
ity C
ost
Total mixed cost
Fixed MonthlyUtility Charge
Slope isvariable cost
per unitof activity.
Mixed Costs
The break-even point (expressed in units of product or dollars of sales) is the unique sales level at
which a company neither earns a profit nor incurs a loss.
Computing Break-Even Point
Prior to calculating the BEP, the following assumptions should be observed:
1. Production costs are function of the volume of production or of sales (e.g. utilization of equipment)
2. Volume of production equals volume of sales3. Fixed operating costs are the same for every
volume of production4. Variable unit cost vary in proportion to the
volume of production5. Unit sale price for a product or product mix
are the same for all levels of output (sales) overtime. The sales value is therefore a linear function of the units sales prices and the quantity sold
Prior to calculating the BEP, the following assumptions should be observed:
6. Data from normal year of operation should be taken
7. The level of unit sale prices, variables and fixed operating costs remain constant
8. Single product is manufactured or, if several similar ones are produced, the mix should be convertible into a single product
9. Product mix should remain the same overtime
Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue.
Total UnitSales Revenue (2,000 units) 100,000$ 50$ Less: Variable costs 60,000 30 Contribution margin 40,000$ 20$ Less: Fixed costs 30,000 Operating income 10,000$
Computing Break-Even Point
How much contribution margin must this company have to cover its fixed costs (break even)?
Total UnitSales Revenue (2,000 units) 100,000$ 50$ Less: Variable costs 60,000 30 Contribution margin 40,000$ 20$ Less: Fixed costs 30,000 Operating income 10,000$
Computing Break-Even Point
How many units must this company sell to cover its fixed costs (break even)?
Total UnitSales Revenue (2,000 units) 100,000$ 50$ Less: Variable costs 60,000 30 Contribution margin 40,000$ 20$ Less: Fixed costs 30,000 Operating income 10,000$
Computing Break-Even Point
We have just seen one of the basic CVP relationships – the break-even computation.
Break-even point in units = Fixed costs
Contribution margin per unit
Unit sales price less unit variable cost($20 in previous example)
Formula for ComputingBreak-Even Sales (in Units)
The break-even formula may also be expressed in sales dollars.
Break-even point in dollars = Fixed costs
Contribution margin ratio
Unit sales price Unit variable cost
Formula for ComputingBreak-Even Sales (in Dollars)
ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even?
a. 100,000 unitsb. 40,000 units c. 200,000 units d. 66,667 units
Computing Break-Even SalesQuestion 1
Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs
are $200,000; unit sales price is $5.00; and unit variable cost is $3.00.
a. $200,000b. $300,000 c. $400,000 d. $500,000
Computing Break-Even SalesQuestion 2
Volume in Units
Cos
ts a
nd R
even
uein
Dol
lars
Revenue Starting at the origin, draw the total revenueline with a slope equal to the unit sales price.
Total fixed cost
Total fixed costextends horizontallyfrom the vertical axis.
Preparing a CVP Graph
Total cost
Volume in Units
Cos
ts a
nd R
even
uein
Dol
lars
Total fixed cost
Break-even Point Profit
Loss
Draw the total cost line with a slopeequal to the unit variable cost. Revenue
Preparing a CVP Graph
Break-even formulas may be adjusted to show the sales volume needed to earn
any amount of operating income.
Unit sales = Fixed costs + Target income
Contribution margin per unit
Dollar sales = Fixed costs + Target income
Contribution margin ratio
Computing Sales Needed to Achieve Target Operating Income
ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn operating
income of $40,000?
a. 100,000 unitsb. 120,000 units c. 80,000 units d. 200,000 units
Computing Sales Needed to Achieve Target Operating Income
Margin of safety is the amount by which sales may decline before reaching break-even sales:
Margin of safety provides a quick means of estimating operating income at any level of sales:
Margin of safety = Actual sales - Break-even sales
Operating Margin Contribution Income of safety margin ratio= ×
What is our Margin of Safety?
Oxco’s contribution margin ratio is 40 percent. If sales are $100,000 and break-even sales are $80,000, what is
operating income?
Operating Margin Contribution Income of safety margin ratio
= ×
Operating Income = $20,000 × .40 = $8,000
What is our Margin of Safety?
Once break-even is reached, every additional dollar of
contribution margin becomes operating income:
Oxco expects sales to increase by $15,000. How much will operating income increase?
Change in operating income = $15,000 × .40 = $6,000
Change in Change in Contributionoperating income sales volume margin ratio= ×
What Change in Operating Income Do We Anticipate?
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9-28
Bennett Company is a medium sized metal fabricator
that is currently contemplating two projects: Project A
requires an initial investment of $42,000, project B an
initial investment of $45,000. The relevant operating
cash flows for the two projects are presented in Table
9.1 and depicted on the time lines in Figure 9.1.
Capital Budgeting Techniques Chapter Problem
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Capital Budgeting Techniques (cont.)
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Capital Budgeting Techniques (cont.)
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9-31
Payback Period The payback method simply measures how
long (in years and/or months) it takes to recover the initial investment.
The maximum acceptable payback period is determined by management.
If the payback period is less than the maximum acceptable payback period, accept the project.
If the payback period is greater than the maximum acceptable payback period, reject the project.
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9-32
Pros and Cons of Payback Periods The payback method is widely used by
large firms to evaluate small projects and by small firms to evaluate most projects.
It is simple, intuitive, and considers cash flows rather than accounting profits.
It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.
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Pros and Cons of Payback Periods (cont.) One major weakness of the payback
method is that the appropriate payback period is a subjectively determined number.
It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value.
Thus, payback fails to fully consider the time value of money.
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Pros and Cons of Payback Periods (cont.)
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Pros and Cons of Payback Periods (cont.)
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9-36
Net Present Value (NPV) Net Present Value (NPV): Net Present
Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.
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Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
Net Present Value (NPV) (cont.) Net Present Value (NPV): Net Present Value is
found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.
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Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 9.2
Net Present Value (NPV) (cont.)
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Net Present Value (NPV) (cont.)
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9-40Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows.
The IRR is the project’s intrinsic rate of return.
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9-41
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
Internal Rate of Return (IRR) (cont.)
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows.
The IRR is the project’s intrinsic rate of return.
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9-42Internal Rate of Return (IRR) (cont.)
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Conflicting Rankings Conflicting rankings between two or more projects
using NPV and IRR sometimes occurs because of differences in the timing and magnitude of cash flows.
This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project.
NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.
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9-44
A project requiring a $170,000 initial investment is expected to provide cash inflows of $52,000, $78,000 and $100,000. The NPV of the project at 10% is $16,867 and it’s IRR is 15%. Table 9.5 on the following slide demonstrates the calculation of the project’s future value at the end of it’s 3-year life, assuming both a 10% (cost of capital) and 15% (IRR) interest rate.
Conflicting Rankings (cont.)
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9-45Conflicting Rankings (cont.)
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If the future value in each case in Table 9.5 were viewed as the return received 3 years from today from the $170,000 investment, then the cash flows would be those given in Table 9.6 on the following slide.
Conflicting Rankings (cont.)
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9-47Conflicting Rankings (cont.)
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9-48
Bennett Company’s projects A and B were found to have conflicting rankings at the firm’s 10% cost of capital as depicted in Table 9.4. If we review the project’s cash inflow pattern as presented in Table 9.1 and Figure 9.1, we see that although the projects require similar investments, they have dissimilar cash flow patterns. Table 9.7 on the following slide indicates that project B, which has higher early-year cash inflows than project A, would be preferred over project A at higher discount rates.
Conflicting Rankings (cont.)
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9-49Conflicting Rankings (cont.)
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9-50
Which Approach is Better? On a purely theoretical basis, NPV is the
better approach because: NPV assumes that intermediate cash flows are
reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR,
Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR.
Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return.
Operational Auditing Chapter 35
Operational audits - also known as management audits and
performance audits, are conducted to evaluate the effectiveness and/or efficiency of operations.
Effectiveness refers to the accomplishmentof objectives
Efficiency is defined as reducing costswithout reducing effectiveness
Effectiveness Versus Efficiency
Economy refers to an entity's success in
maximizing the use of its limited resources to achieve its goals and objectives.
Types of Inefficiency Example
Acquisition of goods andservices is too costly
Bids for purchases ofmaterials are not required
Raw materials are notavailable when needed
An assembly line was shutdown for lack of materials
A duplication of effortby employees exists
Production and accountingkeep identical records
Effectiveness Versus Efficiency
Work is done that servesno purpose
Vendors’ invoices andreceiving reports are filedwithout being used
There are too manyemployees
Office work could be donewith one less assistant
Types of Inefficiency Example
Effectiveness Versus Efficiency
Types of Operational Audits There are three broad categories of operational audits:
FUNCTIONAL, ORGANIZATIONAL, and SPECIAL ASSIGNMENTS.
In each case, part of the audit is likely to concern evaluating internal controls for efficiency and effectiveness.
Who Performs Operational Audit? - Among the activities of the internal auditor than can aptly be construed as part of operations audit are:• Reviewing the reliability and integrity of financial and operating
information and the means use to identify, measure, classify, and report such information.
• Reviewing the internal control structure established to ensure compliance with those policies, plans, procedures, laws, and regulations which could have significant impact on operations and reports and should determine whether the organization is In compliance.
• Reviewing the means of safeguarding the assets and, as appropriate, verify the existence of such assets.
• Appraising the economy and efficiency with which resources are employed.
• Reviewing operations or programs to ascertain whether the results are consistent with established objectives and goals and whether the operations or programs are being carried out as planned.
CPA firms
Government auditors
Internal auditorsWho Performs Operational Audits
The two most important qualitiesfor an operational auditor are:
Independence and Competenceof Operational Auditors
Independence Competence
Specific Criteria
Were all plant layouts approved by home office engineering at the time of original design?
Has home office engineering done a reevaluationstudy of plant layout in the past five years?
Questions that might be used to evaluateplant layouts:
Specific Criteria Is each piece of equipment operating
at least 60 percent of capacity forthree months or more each year?
Does layout facilitate the movement ofnew materials to the production floor?
Does layout facilitate the productionof finished goods?
Specific Criteria Does layout facilitate the movement of
finished goods to distribution centers?
Does the plant layout effectively useexisting equipment?
Is the safety of employees endangeredby the plant layout?
Sources of Criteria Historical performance
Benchmarking
Engineered standards
Discussion and agreement
Phases in Operational Auditing Planning
Evidence accumulation and evaluation
Reporting and follow up
Planning
Staffing
Understand internal control
Background information
Decide on appropriate evidence
Scope of engagement
Evidence Accumulation and Evaluation Documentation
Client inquiry
Analytical procedures
Observation
Reporting and Follow Up
1. In operational audits, the report is usually sent only to management
Two major differences in operationaland financial auditing reports:
2. Tailoring of each report is requiredin operational audits
Examples of OperationalAudit Findings
Outside janitorial firm saves $160,000
Use the right tool
Computer programs save manual labor