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SECTION 3

3.0 Introduction

Rock Field Plc is planning to undertake an investment proposal and directors have requested that
we should do the calculations of IRR of a project by calculating NPV we are also required to give
strengths and weakness of both techniques on financial and non financial grounds. on Executive
Directors of Rock Field PLc need some explanation about return on capital employed and payback period

3.1 Capital Investment

When a business spent money on new non current assets it is known as Capital Investment.
The process of appraising the potential projects is known as investment appraisal

3.1.1 Capital Budgeting and Investment Appraisal

A capital budget :

* is a programmed of capital expenditure covering several years


* includes authorized future projects and projects currently under consideration

A capital budgeting process consist of several stages

1 forecast capital requirement

2 identify suitable projects

3 appraise potential projects

4 select and approve the best alternative


5 make capital expenditure

6 compare actual and planned spending investigate deviation


and monitor benefits from project over time.

3.2 Investment Appraisal

The process of appraising the potential project is known as investment appraisal this appraisal
has the following features

* assessment of the level of expected returns earned for the level of expenditure made
* estimates of future costs and benefits over the projects life.

For the purpose of this section the following Appraisal techniques will be used as under

* NPV ( Net present value )


* IRR ( Internal Rate of return)
* ROCE ( Return on capital employed)
* Payback Period

3.2.1 Net present value

To appraise the overall impact of a project using DCF techniques involves discounting all the relevant
cash flows associated with the project back to their PV.

If we treat all the outflows of a project as negative and all inflows as positive the NPV of the project
is the sum of the PV of all flows as a result of doing the project.

3.2.2 Calculation Of NPV

Non executive Director of Rock Field has given the following expected cash flows for a proposed
capital investment.
Years Cash flows
$ 000

0 -89000
1 24000
2 49000
3 30000
4 20000

We will calculate the NPV of the project using 15% cost of capital as under:

Years Cash Flows DF @ 15% PV @ 15 % DF @ 20% PV @ 20%


$ 000 $ 000 $000

0 -89000 1.00 -89000 1.00 -89000


1 24000 0.88 21096 0.83 19992
2 49000 0.76 37044 0.69 34006
3 30000 0.66 19740 0.58 17370
4 20000 0.57 11440 0.48 9640

NPV 320 -7992

3.3 Internal Rate of Return

The IRR is another project appraisal method using DCF techniques.

IRR represent the discount rare at which the NPV of an investment is zero As such it represent
the break even cost of capital.
Projects should be accepted if their IRR is greater than the cost of capital.

3.3.1 Calculating IRR Using Linear Interpolation

IRR = L + NL * ( H -L )
NL-NH

Where :

L= Lower rate of interest i.e. 15%


H= Higher rate if interest i.e. 20%
NL = NPV at lower rate i.e. 320
N H= NPV at higher rate i.e. -7992

so,

IRR = 15% + 320 * ( 20% - 15 % )


320 - ( -7992)

IRR =
3.3.2 Strengths of IRR

IRR has a number of strengths as follows:

* consider the time value of money


* is a percentage and is easily understood
* uses cash flows not profits
* consider the whole life of the projects
* Selecting IRR where it exceeds the cost of capital increase shareholders wealth

3.3.3 Weakness of IRR

* It is not a measure of absolute profitability


* Interpolation only provides an estimates
* It is fairly complicated to calculate
* Non conventional cash flows may give rise to multiple IRRS

3.4 Return on Capital Employed

This is also known as accounting rate of return (ARR).

Average annual profits before interest and tax * 100%


ROCE=
Initial capital costs

Decision rule:
• If the expected ROCE for the investment is greater than the target or hurdle rate then the project should be accepted.
3.4.1- Advantages of ROCE
simplicity
links with other accounting measures.

3.5-Payback period

The payback period is the time a project will take to pay back the money spent on it. It is based on expected cash flows and provides a mea
Decision rule:
Only select projects which pay back within the specified time period
Choose between options on the basis of the fastest payback
Provides a measure of liquidity.
Constant annual cash flows
initial investment
Payback period = –––––––––––––
annual cash flow

A payback period may not be for an exact number of years.

3.5.1-Advantages of Payback period


It is important that you can discuss the features of payback as an investment appraisal technique as well as being able to do the calculation.

it is simple
it is useful in certain situations:-Rapidly changing technology and improving investment conditions.

it favors quick return:- helps company growth, minimizes risk and maximizes liquidity.
it uses cash flows, not accounting profit

3.5.2- Disadvantages of Payback period

it ignores returns after the payback period


it ignores timings
it is subjective – no definitive investment signal
it ignores project profitability
flows and provides a measure of liquidity.

able to do the calculation.

ns.
SECTION 2:

2.0 Introduction :

In this section managers of Rock Field have requested explanation about different
types of budgeting systems and we are also required to explain advantages and
disadvantages of each

Managers of Rock Field need assistance with the current rolling budget in place
and they want suggestion about new budgeting system as they are not happy with
current budget system.

At the end of this section we are required to analyze financial data given to us for
the purpose of variances analysis with appropriate reasoning's.

2.1 BUDGET

A budget is a quantitative plan prepared for a specific time period it is normally


expressed in financial terms and prepared for one year.

2.1.1 Purpose of Budgeting

The budget is a short term operating plan linked to the corporate plan and will
be used for detailed control.

A) Planning
A budgeting process forces a business to look to the future if a business does
not look to the future it will fail in short ,medium or long term.

B) Control
Actual results are compared against the budget and action is taken as appropriate
In many respects this is the most important aspect of budgeting.
C) Communication
The budget may form the basis of reporting hierarchy it is a formal communication
channel that allows junior and senior managers to converse.

D) Co-ordination
The business allows the business to co-ordinate all diverse actions towards
a common corporate goal

E) Evaluation
The budget may be used to evaluate the financial results of a part of business such
as cost centre It may further be used to evaluate the actions of a manager within
the business .

F) Motivation
The budget may be used as a target for managers to aim for Rewards should be
given for operating with in or under budgeted levels of expenditure

2.2 Approaches To Budgeting

There are two major types of approaches to budgeting as

2.2.1 Top Down Budget


A budget that is set without allowing the ultimate budget holder to have the
opportunity to participate in the budgeting process Also called Authoritative or
non participative

2.2.2 Bottom up Budget


A system of budget in which budget holders have the opportunity to participate
in setting their own budgets also called participative budgeting even here budgets
prepared by junior managers would be reviewed and challenged by senior
management.

2.2.3 Advantages of Participative budget


* increase motivation
* should contain better in formation especially in a fast moving or diverse
business
* increase managers understanding and commitment
* better communication
* senior managers can concentrate on strategy

2.2.4 Disadvantages of Participative Budgets


* senior managers may resent loss of control
* bad decisions from inexperienced managers
* budgets may not be in line with corporate objectives as managers lack
a strategic perspective and will focus just on divisional concern
* budget preparation is slower

2.3 Types of Budgets

This section will look at different types of budgets and their explanation with
advantages and disadvantages as requested bt the managers of Rock Field

2.3.1 Rolling budget


A budget kept continuously up to date by adding another accounting period when
the earliest accounting period has expired.

The aim is to keep tight control and always have an accurate budget for the next
12 months. its suitable if accurate forecast cannot be made.

2.3.2 Advantages Of Rolling Budget


* the budgeting process should be more accurate
* there should be much better information upon which to appraise the
performance management
* the budget will be much more relevant by the end of the traditional
budgeting period
* it forces management to take the budgeting process more seriously
2.3.3 Disadvantages of Rolling Budget
* They are more costly and time consuming
* An increase in budgeting work may lead to less control of actual result
* there is a danger that budget may become the last budget plus or minus
a bit.

2.3.4 Activity Based Budgeting


Activity based budgeting is a method of budgeting based on an activity frame work
and utilizing cost driver data in the budget setting and variance feedback processes

2.3.5 Advantages OF ABB


* ABB can provide useful information for a total quality management programmed
* It provide useful control information by emphasizing that activity cost might be
controllable
* It draws attention to the cost of overheads activities.

2.3.6 Disadvantages of ABB


* It can be argued that in short term many overhead costs are not controllable and
do not vary directly with changes in the volume of activity for the cost driver
* ABB might not be appropriate for the organization and its activities and cost
structure.
* ABB is time consuming in terms of identifying the key activity

2.3.7 Zero- Based Budgeting


A method of budgeting that requires each cost element to be specifically justified .

2.3.8 Advantages
* Recourses should be allocated efficiently and economically
* Attention is focused on outputs in relation to value of money
* Wasteful expenditure is avoided

2.3.9 Disadvantages
* It may emphasize short term benefits to the detriment of long term
benefits
* Time and cost involved ate much higher
* It is difficult to compare and rank completely different types of Activities

2.4 Sources of Information For budgeting

Budgeting requires lots of information which can be from internal or external sources
information can be brained from the following sources
* previous years actual results
* estimates of costs of new products using work study techniques
* EOQ can be used to forecast optimal inventory level
* external sources ma include sullpiers price lists, estimate of inflation
and exchange rate movements etc

2.5 New Budgeting System

Managers of Rock Field are currently using rolling budget for which they are not happy
This type of budgeting system is suitable if future forecast cannot be made accurately
and thus management at the end of each period compares the result and add another
extra period with adding or removing a bit

This type of budget also require time and are generally considered more costly as they
increase work load.

The incremental budget starts with the previous budget or actual results and an incremental
amount is adjusted to cover inflation and other known changes which produce results
almost as actual.

This type of budgeting system is more convenient for managers of Rock Field to use as it is
quickest and easiest method.

2.6 Variances Analysis

Some financial data has been given to us about Rock Field lets a subsidiary company of Rock
Field plc variances analysis is given as under

Standard Cost Variance Adverse/


Card figures /unit Actual Analysis Favorable
Results
Units 240000 nil
240000 £ 000
sales 5 £ 000 120 Adverse
ingredients 40% 2 1080 40 Adverse
Labour & energy 10% 0.5 520 10 Favorable
110
Gross Profit 0.25
630
Contribution 0.25
Fixed Overheads £300000 450 40 Adverse
340
Profits
110

2.6.1 Sales Variance


sales variances arises when there is a difference between the actual and budgeted sales volume or may
also arise due to the difference of selling price.

Causes Of Sales Variances


sales variance can be caused by the following reasons
* higher or lower discount then expected to customers
* More or less price charged due to competition
* Increase or decrease in product cost by suppliers

2.6.2 Material Variance


Material variance is also caused by the same reason but the more relevant for material is the change
in price.

Causes Of Material Variances


Material Variances can be caused by
* Wrong estimates of prices during budgeting
* Discounts by suppliers
* Excess prices due to shortage of material

2.6.3 Labour Variance


Labor variance is caused by
* wrong budgeting
* overtime payments
* Bonus payments
* higher or lower wages paid

2.6.4 Fixed Overhead Variance


Fixed overhead variances are of four types as follows
Expenditure variance
Volume variance
capacity variance
efficiency variance

Causes Of Variance
Fixed overhead expenditure variance can be caused by
* change in price relating to fixed overhead items
* seasonal effects
TABLE OF CONTENTS
Sr No Description
Section 1
1.0 Introduction
1.01 Back ground on Financial Management
1.1 REPORT TO THE MANAGING DIRECTOR OF ROCK FIELD PLC
1.2 Interpreting Financial Information
1.2.1 Users of Financial Statements
1.3 Ratio Analysis
1.3.1 Choice of Ratios
1.3.2 Users Need
1.3.3 DifferentDifferent
Types of Types
Ratios Of Ratios
1.3.4 Ratio analysis Of XYZ `s Financial Statements
1.4 Measuring Profitability Performance / Profitability Ratio Analysis
1.4.1 Ratio Analysis of Profitability
1.5 Measuring Working Capital Ratios
1.5.1 Working Capital Analysis using ratios
1.6 Long Term Financial Stability Ratios
1.6.1 Analysis of Long Term Financial Ratios
1.7 Investors Ratios
1.7.1 Analysis of Investor ratios
1.8 Share Holders Ratios
1.8.1 Dividend Based
1.8.2 Earning Based
1.9 Conclusion

Section 2
2.0 Introduction :
2.1 BUDGET
2.1.1 Purpose of Budgeting
2.2 Approaches To Budgeting
2.2.1 Top Down Budget
2.2.2 Bottom up Budget
2.2.3 Advantages of Participative budget
2.2.4 Disadvantages of Participative Budgets
2.3 Types of Budgets
2.3.1 Rolling budget
2.3.2 Advantages Of Rolling Budget
2.3.3 Disadvantages of Rolling Budget
2.3.4 Activity Based Budgeting
2.3.5 Advantages OF ABB
2.3.6 Disadvantages of ABB
2.3.7 Zero- Based Budgeting
2.3.8 Advantages
2.3.9 Disadvantages
2.4 Sources of Information For budgeting
2.5 New Budgeting System
2.6 Variances Analysis
2.6.1 Sales Variance
2.6.2 Material Variance
2.6.3 Labour Variance
2.6.4 Fixed Overhead Variance

Section 3
3.0 Introduction
3.1 Capital Investment
3.1.1 Capital Budgeting and Investment Appraisal
3.2 Investment Appraisal
3.2.1 Net present value
3.2.2 Calculation Of NPV
3.3 Internal Rate of Return
3.3.1 Calculating IRR Using Linear Interpolation
3.3.2 Strengths of IRR
3.3.3 Weakness of IRR
3.4 Return on Capital Employed
3.4.1 Advantages of ROCE
3.5 Payback period
3.5.1 Advantages of Payback period
3.5.2 Disadvantages of Payback period