Zero Based budgeting and Functional budgeting in efficient management
Zero based budgeting is the basis by which every company attempts to make the best possible use of all its expenditures in terms of efficiency and cost-cutting. It is a very useful tool for the allocation of company expenditures into sectors such as marketing, training and development of employees, machinery maintenance, legal services, and research activities, etc. Zero based budgeting therefore gives a clear and controlled grip of the company's expenditures by focusing on the long term benefits and is used as an essential tool in many businesses. Decisions involved in zero based budgeting are made entirely by top management after proposals have been put forward by the budget holders.
Functional budgeting is to do with the budgeting process of a specific department within an organisation or business. This could be the production and manufacturing department, marketing department, etc. Functional budgeting focuses on processes like production, cots, budget, marketing cost, purchasing budget, etc. It is important to analyse separately the budgeting of each department or unit within an organisation in order to achieve the long term goals of the business. It also helps in the smooth running of the business by eliminating any possible technical hitches.
Examine in detail Weighted Average Cost of Capital technique to determine cost of capital of an organization.
This is a very widely used tool in order to determine the average cost of capital of a business. The weighted average cost of capital includes all types of capital claims payable by the business and is a discounted rate as such. It is used to reduce all the capital claims of the business into a single simplified discount rate, by using the following equation:
Debt market value Equity market value
wacc = ---------------------- x debt required rate + ------------------------ x equity required
Total market value Total market value
As can be seen from the equation, the weighted average cost of capital illustrates the risks involved in the operation of a project, by reflecting on the proportion of debt and equity financing in relation to the possible risks involved. The debt cost rate in some circumstances is substantially reduced in the name of tax rebates, which the government allows for by subsidising interest payments.
Debt Cost = Debt Required Return x (1- corporate income tax rate)
Therefore as can be seen, debt cost would be greatly reduced. NPV also does not require that a particular amount of debt be utilized. And so the only information necessary for this would be the calculated equity rates, tax cost rate deductions, free cash flows and overall finances relating to equity proportions. Therefore the Weighted Average Cost of Capital is used more often as a consistent tool as it requires lesser information to determine the net present value.
Critically analyse ratio analysis technique used for performance appraisal of a company.
A ratio analysis of a company is done by taking the company's income statement and dividing that by the balance sheet. Therefore the ratio analysis is simply a numerical term derived as a ratio from two other numerical quantities. This figure or financial ratio can then be used to assess the company's overall performance. Calculating this ratio is important as it provides the management with an in-depth understanding of the business strengths and weaknesses, and thus helps them to identify future goals and develop long-term planning. This ratio is therefore important for companies to develop and improve their business. Following are important ratios which are used to assess the overall performance of organisations:
LIQUIDITY RATIOS - These deal primarily with liquid assets and liabilities; short term operational facets of the business.
Current Ratio = Current Assets ,
Where current assets would be those assets of the business that could be turned into cash within the first 12 months, and the current liabilities would be those finances expected to be paid within that 12 month period. The higher this ratio is for the business, the better it is.
A ratio of 2 is considered to be financially stable and is used as the benchmark for most businesses.
Quick Ratio = Current Assets - Inventory
This is a much more simpler and direct way for a company to calculate their liquidity standings against their liabilities.
CAPITAL STRUCTURE RATIOS - This is a ratio of the company assets contributed by shareholders and the overall returns. Following are some examples:
Fixed to current assets ratio = Fixed Assets
Debt Ratio = Total Debt
PROFITABILITY RATIOS - The essential value of this ratio would be to assess whether or not the business is accumulating satisfactory returns over its investments, and whether or not the businesses' expenses are justified. Therefore this ratio is also an indicator of the long-term profitability of the business.
gross profit margin ratio = Operating Profit
This ratio allows for the management to assess whether or not the sales generated by the business are sufficient enough for other corporate expenditures. The higher this ratio, the more success it means for the business.
Profit margin ratio = Profit on ordinary activities before taxation
EFFICIENCY RATIOS -This is to do with the company's assets management, and affects overall performance.
Inventory Turnover = Cost of Sales
Average collection period = Debtors
Sales per day
Fixed Assets Turnover = Sales
Assess use of NPV and IRR methods in appraisal of national and international projects.
An essential part of business, it is one of the most vital tools in the finance world. The NPV
Works by attempting to bring all future cash flows to their present value, by employing something called cost of capital, which is essentially a rate of interest. All the values for future cash inflows and outflows are calculated, and this figure is deducted from the initial cash flow. The resulting sum is the deciding factor by which decisions based on investments are made. If the Net Present Value is positive, then the investment is considered one that is worth taking. If compared to alternative investments with different figures for NPV, then the investment that displays the highest figure for NPV is considered the one worth taking.
The internal rate of return, this is also known as the discounted cash flow rate of return. The rate of interest is first calculated, instead of discounting the cash flow by the cost of capital. The rate of interest itself discounts the net cash flow down to zero, which is that rate which would reflect the project to break. This rate of interest also exhibits the maximum amount of rate that any company can pay for the capital it borrowed. This is compared to the cost of the capital which the company intended to borrow, and this helps to decide whether the investment is worth taking or not.
The NPV method or technique is an absolute measure while the IRR technique is a relative one. Both would point the company towards the same path. However, both techniques may not give the same answers at all time. There have been examples in the business and finance world where companies have got a positive response from the NPV technique whereas the IRR procedure has given them a negative feedback, and so they had to reject the investment project. Reasons for this contradiction could be external factors such as political influence, economics, and inflation, etc. Therefore at the end of the day the onus lies with the management to make the best decision based on realistic practical results, keeping the long term goals on the organisation in mind.
Compare and contrast various risk analysis tools used for both local and international organization.
All kinds of project evaluations emphasise the importance of risk. Although it cannot be ignored, there is no practical solution in the business world to eliminate all kinds of risk. Risk and uncertainty are taken to be one and the same thing, as both could fall apart from theoretical results calculated. Therefore the onus is on management to come up with strategies that could significantly reduce the risk factor and thus undesirable results. However it is generally understood that the element of risk cannot be 100 % eliminated. High level theoretical assumptions based on mathematical techniques can only get a company so far.
Following are ways to address the problems of risk in any investment project:
The first approach would be to make realistic estimates and logical conclusions based on intellectual reasoning, after examining the theoretical evidence. For example, most evaluations are done on the discounted cash flow approach, and all other factors that could influence the final evaluation are analysed realistically.
Another approach used in the business world is the 'high hurdle test', where a project or investment plan goes through a very stringent procedure in order to gain acceptability. The company grades this project or investment into 3 levels of risk, these levels being high, medium, or low. The criteria for classifying a particular project or investment into a particular level of risk rests solely upon the management, that uses its past experiences of investments and projects to decide which level of risk is acceptable for the investment or project under consideration. A level of risk is based upon the amount of resources available to the business and an analysis of all the circumstances faced by the company. Once these levels of risk have been identified, the 'hurdle rate' is calculated.
LEVEL OF RISK
RATE OF RETURN
Such a kind of risk analysis always considers something called the 'margin of safety', which basically is an indication of the chances of a project or investment being accepted. The higher the margin of safety, more chances for the project being accepted and vice versa.
Using this technique, the cash inflow is subtracted from the outflow, and no discounting to the present value is done. It is a widely used method and gives a positive result even though using the discount factor would give different results and make a huge difference.
It is used as an aid in the evaluation and assessment of projects and investments. The value of the most crucial variable in a particular project evaluation is altered. The resulting changes are then monitored and an assessment is made into the final results. In this way, the importance of some variables in the project evaluation is crucially assessed, as these could have a large impact on the final result. This kind of assessment is practical and based on reality, where the management assesses and analyses the final results and then makes a decision on whether or not the risk factor plays an important role in that investment or business project, and can then act and make decision accordingly.
Many unthinkable factors can arise as risk factors, in the form of change in weather patterns, political disputes, war, change in government, etc. These are obviously very difficult to predict and usually tend to have a large scale impact on the final outcome of any project. In order to counter this businesses tend to use a range of values that intend to cover all possible aspects of risk. As a crude example, if the cost price of a product is set at $50, then the range of possible values that could cover the risk element could be within the range of $30 to $60. These ranges are purely hypothetical, based on the past experiences of management in previous endeavours. It must be understood that no matter what procedures are taken, risk cannot be entirely eliminated from a project or investment, only an attempt can be made to reduce it in the most theoretical, practical and realistic way possible.
Give your judgement about the merit of importance of tools and techniques used for financial appraisal and backup this judgement by discussing real examples as evidence.
Financial appraisal involves using a number of techniques, in order to calculate the future returns that are likely to result from an investment or project. These techniques of calculating expected returns are most vital for businesses in the increasingly competitive market.
The NPV and IRR procedures are the two most distinguished and vital methods of calculating discounted cash flow. Both are discounted approached which are calculated by subtracting the interest earned from a particular cash flow from the accumulated cash flows of a particular investment. Both methods' advantages and disadvantages have been previously discussed. In brief, then, the NPV and IRR techniques give an organisation an idea of whether or not a particular investment will be successful by calculating the value of an investment over time. One disadvantage of the NPV technique, however, is that the cost of capital also needs to be calculated. IRR in this case, is more preferable and a simpler technique.
Critically evaluate the role of benchmarking in re-engineering process to enhance performance of a business organization
Benchmarking is the accumulation of all relevant data required to assess and critically evaluate the performance of an investment. Companies normally choose to benchmark when they feel the need to improve the performance and overall returns of the business. Therefore benchmarking is an important strategic tool for all businesses in the financial world.
ADVANTAGES OF BENCHMARKING:
Promotes and magnifies attention to detail required in the key areas of optimum performance.
Provides warnings in advance of performance dropping, allowing for a change in strategy to arrest declining fortunes of the business beforehand.
Very flexible in nature, allowing for changes to be made to strategic plans where a change in environment is perceived.
Highly appreciable for its cost cutting aspects.
Business strategies are developed that essentially lead to profitability for the business.
Discuss, with examples, how these tools help contribute towards the achievement of strategic objectives of organization.
While the NPV and IRR techniques enable the calculative figure on the return of an investment, the procedure of Benchmarking allows for sound strategies for the development and growth of a business. Therefore all tools related to financial appraisal have been discussed and evaluated, with their advantages and disadvantages outlined.
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