Application of investment appraisal techniques and ratio analysis to different scenarios

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Task 1

The strategic plan of a company comprises of vision, mission, goals and objectives over some defined period and how the company plans to achieve them. To accomplish such objectives, the company needs to analyze what resources are at disposal to take advantage of opportunities present in the business environment enabling the company to perform more efficiently than its competitors or capitalize on existing opportunities (Burkhart and Reuss, 1993). Resources available to any organization are always limited and must be utilized properly. The ideas and intentions mostly outweigh the resources at hand and reviewing them parallel to your strategic plan and financials can make the strategic goals and objectives more realistic.

Finance is the money available to spend on the needs of the business. Right from the start of the business management, money is needed to spend on the needs of the business. Good financial management keeps tracks of all the resources put to use and prevent misuse while bad financial management often contributes to failure (Van Auken and Perez, 2003). As the business of a company expands, it needs to incur more capital expenditures to acquire new technology and additional capacity in order to reduce per unit costs and keep abreast with the competitors. Furthermore, financial resources are also needed to cover the operational costs of the business. Example can be cited of Google Inc which was a research project of the founders Page and Brin who met at Stanford in 1995. They received the first funding from Andy Bechtolsheim, the co founder of Sun Microsystems and later on a 25 million dollars round of financing was offered and Google is now considered as the 2nd most successful startup company of all time in terms of market capitalization, revenue and growth. Later on, an initial public offering was offered which proved successful. Throughout the years, Google has grown with the strategy of acquiring other companies and proving to be a success acknowledged worldwide (Thomas, 1995).

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In the above mentioned context, good financial management practices are essential for the efficient management of the resources. Such practices will not only enable the organization to ensure efficient use of the resources but it will also result in sound business decisions and will help in continuous monitoring of the finances and taking remedial actions if necessary. The resources or the finances are allocated to the departments through budgeting. While allocating the budgets for the departments, the following factors shall be considered:

  • The department strategy for the upcoming year and how the financial resources will be utilized to carry out the goals and objectives.
  • The activities of the department along with the approved expenditure.
  • The comparison of the overhead department along with the variance of previous year and its contribution towards the organizational goals. (Carter and Day, 1992)

Resources are allocated through budgeting. It facilitates how much budget each department of an organization will receive depending upon the income each department generates. An efficient financial planning system ensures that the departments have sufficient funds at hand to carry out all the activities planned. Normally this allocation is done on the basis of past patterns or any benchmark considered suitable.

The regular monitoring of the allocated budget is necessary in order to maintain efficient use of the resources. They are not only meant to compare allocated budget against the actual target but also to recognize the changing patterns or the circumstances that demands remedial measures. Proper procedure shall be enforced in every department to reinforce such mechanism such as appropriate reporting to comply with such elements.

Previous research (Ibarra, 1995; Van Auken and Howard, 1993) have shown that the main causes of business failures are lack of financial planning, lack of capital and capital mismanagement. Many of these problems can be termed as challenges that can be successfully dealt with financial strategies. When a company caters to all these challenges and responds to the market variables, it is said to be competitive. In this context, a company must develop certain functions in its operational and strategic activities with quality and efficiency to maintain its competitiveness. Porter (1980) argued that the competitive strategy developed by the organization is the gist on which the business competitiveness is determined and this strategy is selected on the basis of the market position of the organization within the business sector in which it is carrying out its operations. This implies that the strategies selected by the organization will shape up its competitiveness. Financial analysis and planning are the basic features that support an organizational strategy and play an important role in maintaining the business competitiveness of an organization.

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Task 2

Strategic investment decision making revolves around the process of identifying, evaluating and selection of the projects that will tend to have a significant impact on the organization competiveness and will result in an increase in the overall net worth of the company. There is a dire need to get all these decisions right (Pohlman, Santiago, & Markel, (1988). If such decisions prove successful, the company will experience significant strategic and operational advantages. On the other hand, if it proves to be a failure, then it would have utilized various resources making it a fruitless investment. There are two basis approaches that can be used to access these investments. The first approach is the traditional investment analysis framework involving the use of NPV which has several shortcomings such as the inflation rate adjustments and high discount factors.

The second approach is defined as the deviation from traditional approach which involves the use of methods such strategic cost management which aims to manage costs for both financial and competitive advantage. It involves a three step analysis which includes value chain analysis, competitive advantage analysis and cost driver analysis. By conducting these analyses, the managers begin to delve into the organization capabilities and try to examine the effects on the value chain and the impact of the decision on the firm competencies (Mallette, 2006).

Another method is the multi attribute decision model (MADM) which aims to develop a general measure of utility. The most significant feature of this model is that it can assess the impact of an investment when the project variables or factors cannot be quantified in terms of money. A few more methods can be cited here are the value analysis, the uncertainty method and the R & D methods. These methods define the criterion for the assessment of the investments (Zopounidis and Doumpos, 2002)

While examining the data for making decisions about the use of financial resources for the expansion of the business, it is better to define some of the terms that are helpful in making such decisions. These terms are defined as follows:

  • NPV = NPV is defined as the sum of present values for all the cash flows to be received in the upcoming years. In short, it can be stated as all the future cash flows divided by the appropriate discount rate.
  • IRR = it is the discount rate that makes the NPV equal to zero.
  • ARR = it is the return that an investment provides over time expressed as the percentage.
  • ROI = it is the return on the amount of investment.

Example of Data: A Project to create ecommerce website to sell your products online provides the following cash flow:

Current Year: Expected to spend $10,000 to develop the website.

Year-1: After website is deployed, it is expected to generate $4,000 in the first year.

Year-2: Expected to generate $5,000 in the second year.

Year-3: Expected to generate $5,000 in the third year

Year-4: Expected to generate $2,000 in the fourth year.

Year-5: Expected to generate $2,000 in the fifth year

ROI Calculation

In the above example, IRR is 27.3% (approx). It is the discount rate that makes the NPV zero (close to zero).

Payback Period:

The payback period is how long it will take to recover amount invested in a project (it is recommended to use discounted flows to calculate payback period)

In the above example, in scenario -1 the payback period is calculated by adding the discounted amounts every year until you meet or exceed the amount spend i. e $10,000 in the example):

ROI Calculation

Based on the calculated ROI factors analyze each project and compare their return on investment and use project portfolio management standards to approve projects.

ROI Calculation

Keeping the above mentioned factors in view, the projects that can increase the value of the company can be determined easily with the help of the above measures.

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Task 3

The selection of data for Scott’s plc can be justified in the context that the company’s efficiency is mainly determined by its organizational effectiveness and its performance (Kamath, 1997). Operational efficiency is defined as the ratio between the inputs such as finance, human resource or time and outputs which can be defined as the revenue or cash generated, new customers, innovation, satisfaction level of the customer’s etc. To improve operational efficiency, it is first calculated and then steps are taken to improve the input or output levels.

The operational efficiency of the organization can be measured by the use of its assets and equity i.e. how much the assets and the equity is used to generate sales. In the case of Scott’s plc the figures of net sales, the total assets and the fixed assets are given which can be used to calculate the operating efficiency ratios for Scott’s plc therefore the data provided is justified. Through this data, the ratios such as total assets turnover ratio, fixed assets turnover ratio and the equity turnover ratio which are defined as follows:

  • Total Asset Turnover: This ratio measures the company ability to generate sales through the utilization of its total assets. A ratio of 2 implies that for every one dollar invested in total assets the company will generate two dollars in sales or revenues. The formula for this is as follows:

Total asset turnover = net sales / average total assets

  • Fixed Assets turn over: This ratio is similar to that of the total assets turnover ratio but the denominator of total assets is replaced by the fixed assets.

Fixed-asset turnover = net sales / Average net fixed assets

  • Equity Turnover Ratio: This ratio measures a company’s ability to generate sales pertinent to its investment in total equity that comprises of both common and preferred shareholders.
  • Equity turnover = net sales / Average total equity.

In the light of above information, it can be observed that all the figures needed for the calculation of the operational efficiency are provided in the exhibit therefore, operational efficiency can be calculated.

The performance of a business can be deciphered from different key performance indicators different in every industry. The most commonly used financial measures are the net worth of an organization and the economic value added. The decision making for an organization is made with the intent that it will maximize share holder value. The business performance and operating ratios are calculated as follows:

2012 2013

Net Sales

9800

8200

Total Assets

8900

8160

Fixed Assets

6500

6800

Total Equity

4100

3750

TATO

1.101124

1.004902

FATO

1.507692

1.205882

ETO

2.390244

2.186667

It can be seen that all the three ratios have declined significantly due to that disaster in the industry. Furthermore, the sales have also deteriorated.

2012

2013

Net Worth

Total Assets

8900

8160

Total Liabilities

4600

3610

Net Worth

4300

4550

The net worth of the organization has increased but it cannot be regarded as a positive measure as there was a significant increase in the current assets comprising of inventory, accounts receivable and bank.

The economic value added is an estimate of the firm’s economic profit. It is the value created in addition of the return demanded by both the shareholders and debt holders. In short, it is the profit earned by a firm minus the cost of financing of the firm’s capital. The formula is a s follows:

EVA = NOPAT – (c × capital)

Where EVA = economic value added

NOPAT = net operating profit after tax

c= capital charge

2012

2013

NOPAT

310

-350

capital

500

500

capital charge

12.50%

12.50%

EVA

247.5

-412.5

From the exhibits, it is clearly implied that the company financial and operating performance is deteriorated very much. The sales revenue has decreased by 1.6 million pounds, posing a major threat to the organization which needs to be taken care of immediately. The noncurrent assets have increased by 300 while the currents assets declined significantly by 1040 (inventory by 10, accounts receivable by 230 and bank balance has been exhausted. A 600 addition has been made to the loans while the accounts payable have been reduced by 1150 along with the bank overdraft amounting to 240. The retained profit has also been reduced by an amount of 350.

This situation may pose certain threats as the resources are mismanaged. The sales need to be restored in order to increase revenue for the covering of the operational costs. The company has not been utilizing the internet potential which presents a large potential. Due to the increasing use of the customers on internet, this niche should be exploited. Furthermore, interest has increased ten folded so proper planning shall be established to create a regular stream of revenues and loans shall be paid off immediately to avoid debt servicing.

Task 4

The first and the foremost things in examining the cost behavior is the analysis of the costs. Costs can be variable fixed or mixed. The fixed costs are those that will incur whether the production continues or not while the variable costs will incur only if the production will continue. The fixed costs do not vary with the production level while the variable costs do. The most interesting attribute is that since the fixed costs remain the same, the more and more units you will produce, the fixed cost per unit will tend to decrease as the same amount of fixed cost is spread over more units (Lazaridis, 2002). The need here is to classify the costs in both fixed and variable and then an analysis is to be made hence providing a more planned budget. The costs implied in the structure are not easily distinguished whether they are fixed or variable. Furthermore, the sales are not defined into units which can assist in the calculation of break even margin and contribution margin calculations.

Comparing the performance of Scott plc against the cash budget and figures provided results in several anomalies. The cash budget receipts and payments are as follows:

May

June

July

opening balance

300

100

-75

Total receipts

1250

1875

2625

Total Payments

1450

2050

2550

closing balance

100

-75

0

It is explicitly stated from the cash budget that the receipts are less than the payments made which causes the closing balance of July to exhaust. This fact shall be taken care of as payments are more than the receipts of the organization. This fact can be attributed to the purchases that increased every month while the sales have not been increasing on the same level. Secondly, another point of concern is that the level of drawings remained constant irrespective of the business conditions which pose a major red flag in the working of the business. The business is suffering losses, is heavily debt burdened and the drawings are being made at constant level.

The immediate need is to properly plan out budgets as the cost of the disaster needs to be reduced through proper cost cuttings. First a detailed sales plan needs to be made, that shall clearly and explicitly state the number of units that shall be sold in the upcoming six months. Secondly a purchase budget shall be handed over to the purchase department and proper check and balances shall be maintained to strictly follow that budget. As already mentioned, sales need to be improved by stepping into the internet market, by going online in order to attract online sales as well. This boost in revenue will provide sufficient cash flow for the maintenance of the operating expenditures. Drawings shall be stopped or reduced to a minimal extent unless the company pays off its loans as to avoid interest expense.

The company shall calculate the optimal level of capital structure and that shall be maintained so that maximum value of the company can be reached. Accounts payables shall be renegotiated for a while to favor the company while credit policies for the debtors shall be properly pursued. Proper calculations of production in units along with the breakeven margin and the contribution margin analysis shall be done in order to have a clear picture of the circumstances we are left to deal with. The target for breakeven shall be defined and properly taken care of with strict conformity

References

Patrick J. Burkhart and Suzanne Reuss (1993). Successful Strategic Planning: A Guide for Nonprofit Agencies and Organizations. Newbury Park: Sage Publications.

Michael E. Porter, Competitive Strategy (New York: The Free Press, 1980), 3–33

Van Auken, H. and D. Perez, “Financial Strategies of Spanish Firms: A Comparative Analysis by Size of Firm,” Journal of Small Business and Entrepreneurship, 17 (Fall, 2003), 17-30.

Claburn, Thomas. "Google Founded By Sergey Brin, Larry Page...

Carter, N.; Klein, R. and Day, P. (1992), How Organisations Measure Success: the Use of Performance Indicators in Government,London, Routledge.

Pohlman, R., Santiago, E. & Markel, F. (1988) “Cash flow estimation practices of large firms”, Financial Management, vol. 17(2), p.71-79.

Mallette, F. (2006) “A Framework for Developing your Financial Strategy”, Corporate Financial Review, vol. 10 (5), p. 11-20.

Zopounidis, C. y Doumpos, M. (2002) “Multi-Criteria Decision Aid in Financial Decision Making: Methodologies and Literature Review”, Journal of Multicriteria Decision Analysis, vol. 11 (4-5), p. 167- 186.

Kamath, R. (1997) “Long Term Financing Decisions: View and Practices of Financial Managers of NYSE Firms”, The Financial Review, vol. 32(2), p. 331-356.

Lazaridis, I. (2002) “Cash flow estimation and forecasting practices of large firms in Cyprus: Survey findings”, Journal of Financial Management & Analysis, vol. 15(2), p. 62-68.