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$


How much contribution margin must this company have to cover its fixed costs (break even)?



How many units must this company sell to cover its fixed costs (break even)?



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?

Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

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


9-29

Capital Budgeting Techniques (cont.)


9-30

Capital Budgeting Techniques (cont.)


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.


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.


9-33

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.


9-34

Pros and Cons of Payback Periods (cont.)


9-35

Pros and Cons of Payback Periods (cont.)


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.


9-37

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.


9-38

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.)


9-39

Net Present Value (NPV) (cont.)


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.


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.


9-42Internal Rate of Return (IRR) (cont.)


9-43

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.


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.)


9-45Conflicting Rankings (cont.)


9-46

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.



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.



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


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


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

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