CLASS NOTES

WITH EXAM
STANDARD
QUESTIONS

MANAGEMENT ACCOUNTING

 INVESTMENT APRAISALS.
 FURTHER ASPECTS IN INVESTMENT
APPRAISALS.
 WORKING CAPITAL MANAGEMENT

THAKUR IMRAN MUZAFFAR

(ACMA, MPhil.)
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INVESTMENT APPRAISALS
DEFINATION:
Investment appraisal is a strategic decision and will impact the strategy of the business. These will foresee
where business would be in 3 or 4 or 7 years time. If we make a right decision, it will help the organisation and
if the decision is wrong, it will harm the organisation.
• THIS IS THE SINGLE MOST IMPORTANT DECISION.
• IT IS A FORM OF DECISION MAKING.
• WE USE "RELEVENT CASH FLOWS".

Following drawing can easily distinguish between two major categories of investment appraisal
measures / tools.

MEASURES

BASIC DISCOUNTED CASH FLOWS

 PAY BACK PERIOD  NPV

 RETURN ON CAPITAL EMPLOYED  IRR
(ROCE / ARR)  ANNUITIES
 PERPETUITIES

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PAY BACK

Payback is the length of the time, it takes for cash inflows from trading, to payback the initial investment.

EXAMPLE:
INITIAL INVESTMENT: 100
CASH INFLOWS:
YEAR 1 50
YEAR 2 40
YEAR 3 30
YEAR 4 25
• Find Payback period in years

SOLUTION: Year Cash Flow Cumulative

Cash flow
0 (100) (100)

1 50 (50)

2 40 (10)

3 30 20

 Our investment is returning in 3rd year, as we have an assumption that all cash flows occur at the
end of the year, so we may say the PAYBACK IS 3 YEARS.
 But, if we want to have absolute period we can calculate it as follows:

2 years + (10 / 30) = 2.3 years

Pay Back in case of ANNUITIES.

Annuity means "same amount of cash inflows p.a."

Example:

INVESTMENT = 60,000
INFLOW = 25,000 p.a.
Solution:
PAYBACK = 60,000 / 25,000
= 2.4 years

DECISION CRITERIA:
If payback is less than the life of the project... ACCEPT THE OPTION.

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ADVANTAGES:
 It is simple to use (calculate) and easy to understand.
 When company is facing liquidity problems and requires fast repayments of investment, this approach is
useful to rank projects.
 It is useful in situations where future cash flows are difficult to predict and risky investments are made in
uncertain market that are subject to rapid design and product changes.
 This method is often used with NPV and IRR and act as first step of screening the projects which are worthy
of further analysis.
 Payback uses cash flows rather than accounting profits, unlike other traditional methods.

DISADVANTAGES:
 It is not an absolute measure of return, so this can only be used in addition to other appraisal methods.
 It only considers cash flows up to the payback, any cash flow beyond that point are ignored.
 There is no definite measure of what an optimum or acceptable payback period is.

Example:
Dada Bhai (exam standard question amended)

DadaBhai plc manufactures bicycles for the UK and European markets, and has made a bid to take over
TIM's plc, their main UK competitor.

Dada Bhai anticipates labour savings of $700,000 per year, created by more efficient production and
distribution facilities, if the takeover is completed. In addition, the company intends to sell off surplus land
and buildings with a balance sheet value of $15 million, acquired in the course of the takeover.

For the year ended 31 December 20X7, TIM's reported an operating profit of $10 million. In calculating
profits, TIM's included a depreciation charge of $0.5 million.

The total amount to be invested in TIM's is $140m prior to any disposal of assets.

Required:
Assuming that the bid is accepted by TIM's, calculate the payback period (pre-tax) for the investment, if the
land and buildings are immediately sold for $5 million less than the balance sheet valuation, and TIM's
sales figures remain static. (3 marks)

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RETURN ON CAPITAL EMPLOYED (ROCE)/ ARR.

ROCE/ARR is an Impact of the investment on accounting profit. ROCE was a performance measure back in
F2 , F5 (Cost Accounting) and F7 (Financial Accounting) but now this is studied as an investment appraisal.
The main difference between the two can be distinguished as below.

ROCE as Investment ROCE as Performance

Appraisals measurement

TIME PERIOD Calculated for the life Calculated for only one year
of the project.

WHEN? Calculation for the future. Calculations on performance

related to past.

USE? Used for Investment appraisals. Used for Decision making

ROCE (ARR) = ESTIMATED AVERAGE ANNUAL PROFIT

AVERAGE INVESTMENT

Average all inflows over the time (less) depreciation.

Average = Total profit for the years / number of years

Average investment = (Opening Investment + Closing investment) / 2

DECISION CRITERIA:
If ROCE is greater than the required rate of return or Cost of capital.... ACCEPT THE OPTION.

ADVANTAGES:
• It is widely used.
• It is simple to understand and calculate.
• It is some measure of return.

DISADVANTAGES:
• It does not consider the time value of money.
• It is based on subjective accounting profits.
• It is not an absolute measure. It gives results in %age.

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TIME VALUE OF MONEY

The idea that money available at the present time is worth more than the same amount in the future due
to some valid reasons which may be as follows:
 Inflation
 Risk
 Opportunity Cost COMPOUND INTEREST:

If we are to compound the interest, we have to add the interest money, received in the end of the year, in the
original investment. And that will become the investment for the next period and we calculate the interest on
the new investment. This is called compounding.

YEAR PRESENT VALUE FUTURE VALUE

1 1000 x 1.1 1100
2 1000 x 1.1 X 1.1 1210
3 1000 x (1.1)3 1331
4 1000 x (1.1)4 1464.1

Number of
year
denoted by
1000 x (1 + 0.1)4 "t" or "n"

Original
investment Rate of
(Present return
Value) denoted by
“r”

So we cab formulate it as:

FUTURE VALUE = PRESENT VALUE x (1+r) t
Or
Fv = Pv (1+r)t

Similarly sometimes we have to calculate the present value of the cash flows which are to be occurring in
some future time. And we can calculate the present value with the help of same formula as:

Pv = Fv / (1+r)t Or Pv = Fv (1+r)-t

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NET PRESENT VALUE

Net present value is the net of present values of all cash flows relating to the project. As the project recovers cash
inflows in future dates, and the value of the cash is not same in different years due to time value of money. For the
reason of comparison, we need to have the same time value of all the cash flows, and we bring the future cash flows
to present value of 0 time period. And then we can "net" them and see if investment is feasible or not.
This can easily be understood by the following example and figure:

EXAMPLE:
INITIAL INVESTMENT: (100)
CASH INFLOWS:
YEAR 1 50
YEAR 2 40
YEAR 3 30
YEAR 4 25
YEAR 5 25
If COST OF CAPITAL IS 10% CALCULATE NET PRESENT VALUE

Solution:

DECISION CRITERIA: If NPV is greater than "0" i.e. if NPV is positive.... ACCEPT THE PROPOSAL

ADVANTAGES:
 It considers the time value of money.
 It is based in cash flows.

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 It is on absolute terms.
 It is theoretically, most sound technique.

DISADVANTAGES:
 It is difficult to explain to the shareholders, who are mostly non-financial people.
 It always needs cost of capital for calculations.
 It is not a relative measure.

ALWAYS REMEMBER:
Calculating the Future Value is called compounding and calculating the present value in called discounting.

COMPOUNDING

PRESENT VALUE FUTURE VALUE

DISCOUNTING

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INTERNAL RATE OF RETURN

A rate of return where net present value equals to zero. Or we can say where present value of inflows is
equal to the present value of outflows.
To calculate IRR, we will need two rates of returns, a rate of return where net present value is positive and
another where the net present value is Negative.
Afterwards we can place the results in a following formula to have an IRR.

Where:
L = Lower rate of return.
H = Higher rate of return.
NPVL = NPV at lower rate
NPVH = NPV at higher rate

Always remember NPV and rate of return has inverse relation, when we need to have lower NPV, we have
to increase the rate of return. Let us consider the previous example.

CASH DISCOUNT PRESENT DISCOUNT PRESENT

YEAR
FLOWS FACTOR (© 10% VALUE FACTOR @ 25% VALUE
0 -100 1 100 1 -100
1 50 0.91 45.45 0.8 40
2 40 0.83 33.06 0.64 25.6
3 30 0.75 22.54 0.51 15.36
4 25 0.68 17.08 0.41 10.24
5 25 0.62 15.52 0.33 8.19
NPV @10% 33.65 NPV @25% -0.61

= 24.7%

Internal rate of return is calculated as 24.7% aprox.

DECISION CRITERIA: If IRR is greater than Cost of Capital, ACCEPT THE PROJECT.

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ADVANTAGES:
 It considers the time value of money
 It considers the cash flows from the project
 The results are In %age terms, which could easily be understood.
 Cost of capital is not needed.
DISADVANTAGES:
 It is not in absolute terms.
 The decisions are poor in mutually exclusive projects.
 It is always an estimated rate of return, not real.
 We have to face a problem of "multiple IRRs" if cash flows are not conventional.

PRESENT VALUE OF ANNUITIES.

Annuities are the series of equal cash flows.
EXAMPLE: AGGER Ltd.
A project costing $2,000 has returns expected to be $1,000 each year for 3 years at a discount rate of 10%.

REQUIRED:
NPV using existing analysis.
NPV using annuity tables.

Solely considering the annuity, what if the cash flows commenced in:
Year 4
Year 6
Year 0

PRESENT VALUE OF PERPETUITIES.

It is a form of annuity that arises forever (in perpetuity). In this situation the calculation of the present value of the
future cash flows is very straightforward.

EXAMPLE: SEEBS Ltd

A company expects to receive £1,000 each year in perpetuity. The current discount rate is 9%. Required:
What is the present value of the perpetuity?
What is the value if the perpetuity starts in 5 years?

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RELEVENT COSTS AND INVESTMENT APPRAISALS.

Like any other form of decision making, Investment appraisals are also based on relevant costs. To deal
with the matter we should know what a relevant cost is. We already have studied relevant costs, to revise
lets discuss the main relevant and non relevant costs.

RELEVENT COSTS:
These three criteria must be fulfilled:
 It must be a FUTURE inflow or outflow.
 It must be a CASH flow.
 It must arise as a DIRECT consequence of the decision.
Examples for relevant costs may include:
Variable costs.
Opportunity costs.
Incremental costs.

NON RELEVENT COSTS:

 Sunk costs.
 Overhead absorbed.
 Commuted costs.
 Non cash flows (inflation).

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INFLATION IN (INVESTMENT APPRAISAL)

There are two ways of dealing with the inflation in investment appraisal question:
l. You have to account for the inflation and inflate the cash flows given to you.
2. You simply exclude inflation and use cash flows in the year 0 terms.

INCLUDE INFLATION (Money rate) EXCLUDE INFLATION (Real rate)

Inflate the cash flows with the inflation Do not inflate the cash flows, leave
rate them in year 0 terms,
AND AND
Use Money rate or Nominal rate Use real rate of return

 ALWAYS REMEMBER:  ALWAYS REMEMBER

Use this approach only when Use this approach where

you have different inflation rates for simple inflation is given, or there is
different things or you see more only one rate of inflation.
than one inflation rate.

The relationship between the money rate and the inflation rate is called FISHER's EFFECT, and this Fisher's
effect is given as follows:
(1 + m) = (1 + r) (1 + i)
WHERE:
m = money rate
r = real rate
i = inflation rate
EXAMPLE:
If real rate is 6% and inflation is 3%. Find the money rate.
SOLUTION
1 + m = (1.06) (1.03) m = 1.0918-1 m = 0.0918 or 9.18%

QUESTION
If money rate is 7% and inflation rate is 4%. Find the real rate.

EXAM TIP:
If in any question rate of return is given, always consider it to be a money rate, and always remember we
live in an inflationary environment, whenever we see a bank rate we must know that banks have already
incorporated the inflation factor in their rates. So if not told in exam it will always be a money rate. The
examiner will tell specifically if it is a real rate.
QUESTION:
A company has invested $50,000 in a project. The project generates net cash inflows of $14,000 each year
for 5 years in year 0 terms. The rate of return is 12% and inflation is expected to be 3.6%.
Required: Calculate the NPV using both the money and real analyses.

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EXAMPLE:
HOWDEN PLC (Exam standard question):
Howden plc is contemplating investment in an additional production line to produce its range of compact discs. A
market research study, undertaken by a well-known firm of consultants, has revealed scope to sell an additional
output of 400,000 units per annum. The study cost £100,000 but the account has not yet been settled.
The price and cost structure of a typical disc (net of royalties) is as follows.

£
Price per unit 12.00
Costs per unit of output:
Material cost per unit 1.50
Direct labour cost per unit 0.50
Variable overhead cost per unit 0.50
Fixed overhead cost per unit 1.50 04.00
Profit 08.00

The fixed overhead represents an apportionment of central administrative and marketing costs. These are
expected to raise in total by £500,000 per annum as a result of undertakings this project. The production
line is expected to operate for five years and to require a total cash outlay of £11 million, including £0.5
million of materials stocks. The equipment will have a residual value of £2 million. The working capital
balance will remain constant after allowing for inflation of materials. The production line will be
accommodated in a presently empty building for which an offer of £2 million has recently been received
from another company. If the building is retained, it is expected that property price Inflation will increase
its value to £3 million after five years.
While the precise rates of price and cost inflation are uncertain, economists in Howden’s corporate
planning department make the following forecasts for the average annual rates of inflation relevant to the
project {per annum).
Retail Price Index 6 per cent
Disc prices 5 per cent
Material prices 3 per cent
Direct labour wage rates 7 per cent
Variable overhead costs 7 per cent
Other overhead costs 5 per cent
Note. You may ignore taxes and capital allowances in this question.

Required:
Given that Howden’s shareholders require a real return of 8.5 per cent for projects of this degree of risk,
asses the financial viability of this proposal.

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TAX IN (INVESTMENT APPRAISAL)

3 KEY CONSIDERATIONS

Tax payable on additional Tax relief on Capital

profits (Net trading Expenditures (CAP-EX)
revenues) Time delay (1 year later) “WDA”

EXAMPLE:
An asset is bought on the first day of the year for £20,000 and will be used for four years after which it will
be disposed of (on the final day of year 4) for £5,000. Tax is payable at 30% one year in arrears. The tax
allowance is based on the reducing balance method of depreciation at 25%.
REQUIRED:
Calculate the writing down allowance and hence the tax savings for each year.

SOLUTION:

YEARS WDA @25% TAX @30% TIMING YEAR

Investment 20,000
WDA -5000 1500 2
W.D.Value 15,000
WDA -3750 1125 3
W.D.Value 11,250
WDA -2812.5 844 4
W.D. Value 8,438
Balance allowance -3,438 1031 5
Residual Value 5000
Continuing from the previous example, we are further told that net cash from trading is £8,000 per annum
from trading. The cost of capital is 10%.
Required:
Calculate the net present value (NPV).
YEARS 0 1 2 3 4 5
NET TRADING REVENUE 8000 8000 8000 8000
TAX PAYABLE -2400 -2400 -2400 -2400
CAPEX -20000
TAX RELIEF 1500 1125 844 1031
RESIDUAL VALUE 5000
-20000 8000 7100 6725 11444 -1369
PV FACTOR @ 10%
1.000 0.909 0.826 0.751 0.683 0.621
-20000 7272 5865 5050 7816 -850 5153
NPV

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EXAMPLE:
BLACKWATER (Exam standard question)

Black-water a manufacturer of speciality chemicals has been reported to the anti-pollution authorities on
several occasions in recent years, and fined substantial amounts for making excessive toxic discharges into
local rivers. Both the environmental lobby and Black-water's shareholders demand that it clean up its
operations. It is estimated that the total fines it may incur over the next four years can be summarised by
the following probability distribution (all figures are expressed in present values).

LEVEL OF FINE PROBABILITTY

0.5m 0.30
1.4m 0.50
2.0m 0.20

Filta & Strayne Limited (FSL), a firm of environmental consultants, has advised that, new equipment costing
£1 million can be installed to virtually eliminate illegal discharges. Unlike fines, expenditure on pollution
control equipment is tax-allowable via a 25 per cent writing-down allowance (reducing balance). The rate
of corporate tax is 33 per cent, paid with a one-year delay. The equipment will have no resale value after
its expected four-year working life, but can be in full working order immediately after Black-water's next
financial year. A European Union Common Pollution Policy grant of 25 per cent of gross expenditure is
available, but with payment delayed by a year, immediately on receipt of the grant from the EU, Black-
water will pay 20 per cent of the grant to FSL as commission. These transactions have no tax implications
for Black-water.
A disadvantage of the new equipment is that it will raise production costs by £30 per tonne over its
operating life. Current production is 10,000 tonnes per annum, but is expected to grow by 5 per cent
per annum compound. It can be assumed that other production costs and product price are constant
over the next four years. No change in working capital is envisaged. Black-water applies a discount rate
of 12 per cent after all taxes to investment projects of this nature. All cash inflows and outflows occur at
year ends. Required:
Calculate the expected net present value of the investment assuming a four-year operating period. Briefly
comment on your results. (12 marks)

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ASSET REPLACEMENT (INVESTMENT APPRAISAL)

Replacing an asset is not an issue; the real issue is "HOW" to replace it. Because we may have different
assets available, or we may have to decide "WHEN" to replace an asset (i.e. after 2 years, after 3 years or
so on).
We assume that the revenues are the same with any of the different options of assets so we ignore the
revenues and only consider the costs associated with the asset. So we may say:
 Revenues are ignored (they are assumed to be the same).
 We only consider costs:
 Purchase cost.
 Running costs.
 Residual value. (Inflow)
 The issue will be over the time period.
EXAMPLE:
A company is considering the replacement of an asset with the following two machines:

P H
£OOOs £OOOs
INVESTMENT COST 60 30
Life 3 years 2 years
Running costs 10 p.a. Yr 1: 20
Yr 2: 15
Residual value 5 nil

Required:
Determine which machine should be bought using a NPV analysis at a cost of capital of 10%.

EQUIVALENT ANNUAL COST (EAC)

Once we have calculated the NPV of the machines, now we know both machines have different years so
we have to, calculate some measure of equal cost for each year, and we do so by using the following
calculation:

CRITICISM ON ASSET REPLACEMENT:

 Assumes that the cash inflows are not affected:
 Quality
 Reliability
 Efficiency
 Ignores technical changes.

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EXAMPLE:
Machine cost 30,000
Running Cost:
Year 1 10,000
Year 2 11,500
Residual Value if sold after:
Year 1 19,000
Year 2 16,000
Cost of Capital 10%

REQUIRED:
Is it better to replace asset after every 2 years?

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CAPITAL RATIONING IN (INVESTMENT APPRAISAL)

Consider a situation where finance is a '"limiting factor''. And if we have limited funds the main aim is to use those
limited funds for the maximum utilization.

CAPITAL RATIONING

HARD SOFT
(Externally (Internally Imposed)
Imposed)

Economy Wide Company Specific Contrary to the AIM of  Unwilling to borrow

maximizing wealth  Limited managerial skills.
e.g. Credit  Maximising project’s
Crunch  Poor track record
 Lack of Asset potential.
security
 Poor Accounting
Records

2 ANALYSES

Multi Period Single Period

Limited funds in 2+ years Limited funds in 1 year

Linear Programming Scenarios

Divisible Projects Non-Divisible

Projects

Mutually Exclusive

DIVISIBLE PROJECTS
 These projects can be taken in parts.
 Return is proportionate. (10% investment in a project means 10% return from the project).
NON DIVISIBLE PROJECTS
 All or Nothing
KEY:

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EXAMPLE:
The funds available for investment are £200,000. All investments must be started now (Yr 0):

Project Initial investment (Yr 0) NPV

£000s £000s
A 100 25
B 200 35
C 80 21
D 75 10

REQUIRED:
Which project(s) should we invest in to maximise the return to the business?

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RISK IN (INVESTMENT APPRAISAL)

As we know that looking at the investment appraisals means looking in the future and as future is always
uncertain we are dealing with some degree of risk. To deal with the risk we must remember:
 Longer time scale.
 Large size of investment.
 Outflow is today, inflows are in future.
 Strategic decision.

 UNCERTAINITY & RISK

While discussing uncertainty we may say that uncertainty is unquantifiable. When know the things may
change in future but we are not sure about their degree of change; whereas risk is quantifiable and we
measure the degree with probability distribution.

 TECHNIQUES TO DEAL RISK

Following are the main techniques to deal with the risk:
 Sensitivity analysis.
 Expected value.
 Payback.
 Adjust the discount rate.
(If the project is risky than raise the discount rate to lower down the NPV)
SENSTIVITY ANALYSIS
In sensitivity analysis we take each variable in turn and measure the change it requires, in that variable,
before we reverse our original decision. In other words we take each variable in turn and measure the
change, when all other variables remain constant. In a typical investment appraisal we may came across
the following variables i.e. Sales Price, Sales Volume, Variable Costs, Fixed Costs, Investment, Discount Rate
and Term of Investment.
To assess the sensibility we have to calculate the Sensitivity Margin.

EXAMPLE:
An investment of £50,000 in year 0 is expected to give rise to inflows of £22,000 for each of years 1 to 3
the discount rate is 10%. The inflow p.a. is made up of fixed cost per annum of £8,000, selling price of
£10/unit and variable cost of £7/unit. Volume is estimated at 10,000 units.

REQUIRED:
Should we accept or reject the investment based on NPV analysis?
By how much would the values have to change for the decision to alter for:
 Initial investment
 Cash inflows (in detail)
 Discount factor?

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SOLUTION:
a)
YEAR CASH FLOW DISCOUNT FACTOR PRESENT VALUE
0 (50,000) 1.00 (50,000)
1-3 22,000 2.487 54,714
NPV 4,714
Always Remember:
SALES PRICE SALES VOLUME FIX COST
Cash flow under consideration: Total Revenue Contribution Fix Cost
 Sale Price:

= 1.897%
This means if there is a DECREASE in sale price by 1.897% we will reverse our decision.
 Sales Volume:

This means if there is a DECREASE in sales volume by 6.324% we will reverse the decision.
 Fixed Cost:

This means if there is an INCREASE in fix cost by 58.975% we will reverse the decision.
 Initial Investment:

This means if there is an INCREASE in initial investment by 9.436% we will reverse the decision.
 Discount Rate:
A discount rate where NPV becomes zero is IRR so we just calculate IRR here.
DRAWBACKS OF SENSTIVITY ANALYSIS:
 This is not a decision rule itself, this just facilitates in decision making.
 It ignores the inter relationship of the different variables.

EXPECTED VALUES
Expected values are the long term averages. While dealing with the expected values, we establish a
weighted average value. Expected values are useful when decisions are repeated. Expected values can be
determined with the help of the following formula:
EV = ∑px

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EXAMPLE:
A new project is being launched. There are four possible outcomes identified with the investment financial
impact (NPV) is given in £m. The management team attached the best estimate of probability to the
outcomes:

Outcome Profit/Loss Probability Working

(x) * (p) (px)
Strong success £25m 0.10
Reasonable success £10m 0.25
Weak success £3m 0.35
Failure (£20m) 0.30
REQUIRED:
What is the expected value of the project?
EXAMPLE:
EXAM STANDARD QUESTION: Burley Plc
Burley plc, a manufacturer of building products, mainly supplies the wholesale trade; it has recently suffered falling
demand due to economic recession, and thus has spare capacity. It now perceives an opportunity to produce
designer ceramic tiles for the home improvement market. It has already paid £0.5 million for development
expenditure, market research and a feasibility study. The initial analysis reveals scope for selling 150,000 boxes per
annum over a five-year period at a price of £20 per box. Estimated operating costs, largely based on experience, are
as follows.
Cost per box of tiles (at today's prices).
£
Materials cost 8.00
Direct labour 2.00
Variable overhead 1.50
Fixed overhead (allocated) 1.50
Distribution, etc 2.00
Production can take place in existing facilities although initial re-design and set-up costs would be £2 million after
allowing for all relevant tax reliefs. Returns from the project would be taxed at 33 per cent.
Burley's shareholders require a nominal return of 14 per cent per annum after tax, which includes
allowance for generally expected inflation of 5.5 per cent per annum. It can be assumed that all operating
cash flows occur at year ends.
REQUIRED:
a) Assess the financial desirability of this venture in real terms, finding both the net present value and the internal
rate of return (to the nearest 1 per cent) offered by the project. Note. Assume no tax delay. (7 marks)
b) Briefly explain the purpose of sensitivity analysis in relation to project appraisal, indicating the drawbacks with
this procedure. (6 marks)
c) Determine the values of:
 Price
 Volume
 at which the project's NPV becomes zero.
Discuss your results, suggesting appropriate management action. (7 marks)
(Total 20 marks)

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MANAGEMENT ACCOUNTING

WORKING CAPITAL MANAGEMENT

TREASURY FUNDING PAYABLES CASH
OVERVIEW RECEIVABLES INVENTORY

TREASURY:
Treasury function is simply the relationship between company and outside world with regard to financial
matters. To be specific, treasury people are the face of the company to deal with banks, suppliers,
shareholders and other stakeholders.

SHOULD WE CENTRALISED OR DE-CENTRALISED THE TREASURY

If we have a single finance or treasury department in our head office, this will mean the treasury is
centralised, otherwise if we have a separate department in each office we may have a de-centralised
treasury. The benefits to have a centralised treasury are:
 Borrowing money is cheaper.
 We can have better rates for investments; if investment is large.
 We can better assess the risk associated with the business if we have a bigger picture e.g. a division
purchase in dollars, other sell in dollars, we can net the effect if we have a centralised treasury.

Otherwise if we have a de-centralised treasury it may result in more specialised activities, we may be able
to respond quickly and some other benefits too. But comparing both always results with more votes to
have a centralised treasury.

SHOULD A TREASURY BE A COST OR PROFIT CENTRE?

The advantages for a treasury being a profit centre are,
 Treasury can sell it service to each division or it could sell its services to outside.
 Each division is aware of all costs and they can benchmark internal with outsiders.
 Individual departments can decide how much risk they can accommodate internally and how much
to sell off.

The disadvantage is that we may encourage treasury to profit, and if we let it do so, it will take risk on
itself. They sure will speculate. History is full with examples of such companies who let their treasury to act
as a profit centre, and ruin their business.
We may argue that "for a treasury, being a cost centre is a safer way.

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MANAGEMENT ACCOUNTING

OVERVIEW:
Always remember we look working capital as "CURRENT ASSETS MINUS CURRENT LIABILITIES

INVENTORY PAYABLES
RECEIVABLES
BANK / CASH IN HAND Balancing figure OVERDRAFT
REQUIRE FUNDINGS REQUIRE FUNDINGS

1. When we come to manage the working capital on day to day or weekly basis, we come to know
that we are looking to manage receivables, payables and inventory. And if we manage these three
we have the balancing figure either as cash in hand / bank or bank overdraft.
2. Current assets are considered to be good if we have plenty of them. But, with regard to working
capital, current assets may need financing. The higher the current asset, higher is the financing.
Higher the financing higher will be the financing cost. Ultimately higher the financing cost lower will
be the profit. So assets need funding and our aim should be to minimise current assets. In contrast
we cannot have little of the current assets so the basic mindset is "we hold as little as we need".
3. Similarly, liabilities are considered bad if they are in excess. But with the perspective of working
capital, it will be considered better if we can negotiate delayed payments. Our aim should be to
maximise our payables. We should pay our supplies but for working capital it's better to have large
payables

OVERVIEW

PROFITABILITY LIQUIDITY

 Level of Working Capital Overtrading

 Key determinants of WC Reasons Measures

Level of activity Operating cycle

Always remember for Working Capital, we should have enough but not too much. We should keep a balance in
working capital.

LEVEL OF WORKING CAPITAL:

1. First of all we should consider the INDUSTRY TYPE for assessing the level of Working capital. There
are major three types of industry; Manufacturing, Retail and Service industry. For example a
manufacturing firm may have a level of inventory of raw material as well as some inventory of
finished stock. But a service industry never has a stock. When we increase stock level, we also need
to increase our receivables level.

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MANAGEMENT ACCOUNTING

2. We have an element of UNCERTAINTY in our business. If we are maintaining a stock, there is a

possible reason of theft and spoilage. But when we use a just in time production, we can reduce the
uncertainty which lead to lower cost.
3. LEVEL OF ACTIVITY is another determinant of the level of working capital. If there is an increase in
sale volume, say, 20% this will lead to 20% more receivables. And to sell we have to buy the things
resulting in an increase of 20% in purchase and ultimately 20% increase in payable.

OPERATING CYCLE:
Operating cycle means the number of days require to sale and receive cash and paying it to suppliers. We
know we are looking at the management of Receivables days, Payables days and Inventory days.
RECEIVABLE DAYS + INVENTORY DAYS - PAYABLE DAYS

EXAMPLE:
Suppose a company has the following data:
SALES $ 600,000
GROSS PROFIT $ 200,000
RECEIVABLES $ 100,000
PAYABLES $ 120,000
INVENTORY $ 80,000

Calculate working capital operating cycle.

OVERTRADING (under Capitalisation):

There are two ways we can say a company is overtrading
1. When "Permanent Funding < Funding Needs". This means company is growing and nobody is there to
increase share capital or debt.
2. When company is unable to pay the suppliers

REASONS FOR OVERTRADING:

1. Fast growth in sales. When sales increase we have to increase WC.
2. Loss of permanent funding i.e. redemption of loan notes and unable to increase funds in future. Or
there may be a loss from stocks.

MEASURE FOR OVERTRADING:

The measures of overtrading will tell us if we are overtrading or not.
1. Liquidity ratios: i.e. current ratio and quick ratio.
2. Cash and balance: We look at the overall change in balance and balance it. <;t
3. Payable days: we look at a change and balance it. (We may be given some industry sector va I ue or
previous year's figures).
4. Level of activity: Sales volume.
5. Funding: Share capital + Debt

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MANAGEMENT ACCOUNTING

FUNDING OF WORKING CAPITAL:

SHORT TERM FUNDING:
We can fund it by payables or bank overdraft.
LONG TERM FUNDS:
We can fund working capital by long term debts and equity.
ADVANTAGES OF SHORT TERM OVER LONG TERM:
1. Cheaper; Liquidity preference.
2. Flexible: O/D interest only on balance we use.
3. Easier to arrange.
DISADVANTAGES:
1. O/D is repayable on demand.
2. Less frequent replenishment.

CURRENT ASSETS
SHORT TERM
FUNDS

AGGRESSIIVE SHORT TERM

POLICY FUNDS
PERMANENT CURRENT ASSETS
CONSERVATIVE LONG TERM
POLICY FUNDS

MANAGING RECEIVABLES:
We know we always see working capital management as a balancing act. Similarly, when we talk about
managing receivables, we have to maintain a balance here as well. But before going into hard discussion
let's ask ourselves a question. Why are we offering credit sales? The answer maybe, because it's an
industry norm to sell product on credit or everyone else is doing so. The impact of credit sales is we may
get bad debts or the creditors may pay late. The receivable management is all about administering these
payments. We know receivable is an asset and every asset has a cost. So we have to balance the need of
receivables against the cost associated with it.

MANAGING RECEIVABLES

MANAGEMENT COST OF FINANCING RECEIVABLES

INTERNAL EXTERNAL

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MANAGEMENT ACCOUNTING

INTERNAL MANAGEMENT OF RECEIVABLES

ASSESS CREDIT STATUS TERMS DAY TO DAY

(How to ensure payments)

Should we offer credit or not  Days. Every customer is a valued

 Existing Credit history.  Credit Limit. customer and if he delays his
 References  Interest.
payments he will be moving
o Banks  Discount.
o Another Supplier towards becoming bad debt.
 Financial Statements.
 Credit Rating Agency,  Statement of Accounts
o Rating,  Reminders (3).
o Country Court  Legal Action.
Judgments.  Take Action.

COST OF FINANCING RECEIVABLES:

The cost of financing receivables can be calculated as

INTEREST COST = RECEIVABLE BALANCE x INTEREST RATE

We know:

So we can calculate receivables as:

EXAMPLE:
Sales: Rs. 10 M
Receivables: Rs. 03 M
Interest Cost: 6%
Calculate Receivable days and Cost of financing.

 CASH DISCOUNTS.
If we encourage people to pay early, by offering them discounts for such payments, this will result in our
receivable balance to fall. When people are paying us early, our number of days in which the debtors pay
us will fall resulting in lowering our interest cost.

EXAMPLE:
Continuing with the previous example, a 0.5% discount is offered to customers who pay early over 30 days.
40% of the customers are expected to accept the offer. Calculate the cost of financing the receivables.

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MANAGEMENT ACCOUNTING

 CONCERNS WITH CASH DISCOUNTS:

1. What levels of discounts are to be offered?
2. Uncertainty.

EXTERNAL MANAGEMENT OF RECEIVABLES

(DEBT FACTORING)

3 FUNCTIONS

ADMINISTRATION OF DEBT COLLECTION FINANCING (Off balance sheet) CREDIT INSURANCE

EXAMPLE
Continued from previous example, further, a factor offers to collect the debt. At a fee of 0.75% of turnover,
and they believe they will collect it over only 80 days. Admin savings of Rs 20,000 are expected.

 ADVANTAGES AND DISADVANTSGES OF FACTORING:

Factoring may be beneficial for small and fast growing companies. Such companies may need cash
and their own credit control may not work well. But it may have following disadvantages.
 Bad reputation
 Customer may not need to deal with factor.
 In house credit control is cheaper than external.

 INVOICE DISCOUNTING:
We look at our receivable balance as asset. So we use this asset as a security to have loan. We have
 Borrowing against individual invoice
 Use customer credit status.
 Confidential Service.

MANAGING INVENTORIES:
To manage the inventories is also a balancing act. We want to have a wider range of finished stock for our
customers to have more choice, on the other hand we have to hold this stock and incur holding costs.
Larger the stock larger will be the holding costs. So we have to balance between the two.

MANAGING INVENTORIES

ECONOMIC ORDER QUANTITY (EOQ) JUST IN TIME PRODUCTION

 ECONOMIC ORDER QUANNTITY:

First of all let's have a look at the costs associated with stocks:
 Holding costs
 Warehousing (rent, staff)
 Insurance.
 Opportunity cost of capital.

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MANAGEMENT ACCOUNTING

 Ordering costs (clerical costs)

 Purchase department has to ring.
 Store has to receive. . .
 Accounts payable department has to pay off the bills.
 Stock out costs
 Idle time.
 Forgone contribution on lost sales.
 Purchase costs.

EXAMPLE:
Monthly demand: 1,000 kg
Ordering Costs: Rs. 30 per order
Holding costs: Rs, 2 per kg p.a.

If a company can order 400kg, 500 kg, 600 kg or 700 kg. Which ordering quantity will minimise the total annual
costs for inventory.
TOTAL COST
COST

HOLDING COST

EOQ

ORDERING COST

UNITS IN ONE ORDER

Numerically we can calculate the EOQ with the help of the following formula:

EXAMPLE:
A bulk discount is now offered for purchase of 1,000 kilos in one go. The price is Rs. 9.8 per kilo instead of
normal Rs. 10 per kilo. Should we accept the bulk purchase discount?

 JUST IN TIME (JIT):

We are concerned with the just in time supplier contract. But first we need to know what a JIT
means.
 JIT
 It's a holistic Approach,
 Aim: eliminate inventory.

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MANAGEMENT ACCOUNTING

 JIT SUPPLIER CONTRACT ISSUES:

 Reliability of Supply,
 Quality Measures,
 Single Supplier Status,
 New product development,
 Close System Links (near factory).

MANAGING CASH:
Similar issues as we have with any working capital management. Our company needs cash for day to day
issues but we cannot hold excess cash as cash is an idle asset with costs. So we need it but not too much,
we have to maintain a balance. For cash management we look it with three different areas

CASH MANAGEMENT

MILLER-ORR MODEL BAUMOL MODEL CASH BUDGET

 MILLER-ORR MODEL:
 Control Limits for Cash:
The basic principal is we cannot micromanage cash, we establish some very basic limits. We make
an upper limit and a lower limit. If cash is in between both we do not take any action and if it is
lower than the lower limit we know we r in need of cash. The difference between the two limits is
called "spread". And this is the range we are allowing cash to fluctuate. If cash balance crosses the
limit we take some action.
CASH

UPPER LIMIT

2/3
SPREAD
RETURN POINT
1/3
LOWER LIMIT

TIME
We are to calculate the SPREAD and formula is given in the formula sheet. The spread is calculated as:

Remember if you are not given with the variance, there must be standard deviation in the question. We
can use standard deviation but we have to square it. As we know from our past studies that variance is
always equal to the square of the standard deviation.

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MANAGEMENT ACCOUNTING

EXAMPLE:
Minimum level Rs. 25,000
Transaction Cost Rs. 50 per transaction.
Variance Rs. 250,000 (or SD = 500).
Daily interest rate 0.05%
CALCULATE SPREAD. (Rs. 7,970)

Now we can also calculate

MAXIMUM LEVEL = MINIMUM LEVEL + SPREAD
RETURN POINT = MINIMUM LEVEL + 1/3 SPREAD
 FEATURES:
 Environment of Uncertainty.
 Minimise:
 Transaction Cost,
 Opportunity cost of holding cash.

 BAUMOL MODEL:
The Baumol model is known as the economic order quantity for cash. According to Baumol:

 CASH BUDGETS
A budget which is prepared at least on monthly basis to ensure any company's cash position going forward.
Always keep in mind:
 Only consider inflows and outflows of cash.
 Ignore non cash flows.
 Present in a best possible and understandable pro forma .

EXAMPLE:
In the near future a company will purchase a manufacturing business for $315,000, this price to include
goodwill ($150,000), equipment and fittings ($120,000), and stock of raw materials and finished goods
($45,000). A delivery van will be purchased for $15,000 as soon as the business purchase is completed.
The delivery van will be paid for in the second month of operations.

The following forecasts have been made for the business following purchase:

i. Sales (before discounts) of the business’s single product, at a mark-up of 60% on production cost will
be:
Month 1 2 3 4 5 6
($000) 96 96 92 96 100 104

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25% of sales will be for cash; the remainder will be on credit, for settlement in the month following
that of sale. A discount of 10% will be given to selected credit customers, who represent 25% of gross
sales.

ii. Production cost will be $5.00 per unit. The production cost will be made up of:

Raw materials $2.50

Direct labour $1.50
Fixed overhead $1.00

iii. Production will be arranged so that closing stock at the end of any month is sufficient to meet sales
requirements in the following month. A value of $30,000 is placed on the stock of finished goods
which was acquired on purchase of the business. This valuation is based on the> forecast of
production cost per unit given in (ii) above.

iv. The single raw material will be purchased so that stock at the end of a month is sufficient to meet half
of the following month’s production requirements. Raw material stock acquired on purchase of the
business ($15,000) is valued at the cost per unit which is forecast as given in (ii) above. Raw materials
will be purchased on one month's credit. .

v. Costs of direct labour will be met as they are incurred in production.

vi. The fixed production overhead rate of SI.00 per unit is based upon a forecast of the first year's
production of 150,000 units. This rate includes depreciation of equipment and fittings on a straight-
line basis over the next five years.

vii. Selling and administration overheads are all fixed, and will be $208,000 in the first year. These
overheads include depreciation of the delivery van at 30% per annum on a reducing balance basis. All
fixed overheads will be incurred on a regular basis, with the exception of rent and rates. $25,000 is
payable for the year ahead in month one for rent and rates.

Required:
Prepare a monthly cash budget. You should include the business purchase and
the first four months of operations following purchase.

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