BA 2 Short Notes

Syllabus Guide
Section A – Management Accounting (10%)
Section B – Costing (25%)
Section C – Planning and Control (30%)
Section D – Decision Making (35%)

Section A (10%)

1. MA Definition
2. Global MA Principles
3. About CIMA
4. Main Areas in MA

Section B (25%)

1. Costing concepts and cost classification

2. Forecasting cost
3. Cost accounting system
4. Pricing strategies

Section C (30%)

1. Budgeting
2. Standard costing
3. Cost bookkeeping
4. Job batch costing and service costing
5. Non-financial performance indicators

Section D (35%)

1. Risk and uncertainty

2. CVP (make or buy) – Breakeven
3. Relevant costing and Project Appraisal

Exam Structure

60 short questions – 2 hours

40 correct answers to pass

100/150

Section A – Management Accounting (10%)

Management Accounting
CIMA definition – Management Accounting is the application of the principles of accounting and financial management
to create, protect, preserve and increase the value for the stakeholders.

CIMA and AICPA – Four Global Management Principles

1. Influence 2. Relevance 3. Trust 4. Value 1

What each Level Handles? 2

1) Strategic Level
3
 BA 2 Short Notes
 Know about market development
 New technology
 Competitors Activity

2) Tactical Level
 Issues connected to product and service quality
 Customer complaints are handled quickly
 Customer satisfaction levels are high
 Employee skill levels and motivation

3) Operational Level
 Know about the number of rejects per machine
 The lead time for the delivery of materials

The 3 main purposes/aspects of Management Accounting

1). Planning 2). Decision Making 3). Control

Financial Accounting
Definition – Externally focused, it will classify and record all monetary transactions of an entity in accordance with
established concepts, principles and accounting standards.

Management Accounting Financial Accounting

1. Internally focused 1. Externally focused
2. At the discretion of Management 2. A Statutory requirement
3. Providing information to management 3. Concerned with the production of accounts
4. Any format can be used, not governed by rules 4. Governed by rules and regulations
and regulations

IFAC’s Main Activities/Roles of the Professional Accountants in Business

1. Generation or creation of value through the effective use of resources

2. Analysis and interpretation of information to management
3. Performance measurement and communication to stakeholders
4. Cost determination
5. The reduction of waste in resources through the use of process analysis and cost management
6. Risk management

5 Fundamental Principles of the Code of Ethics

1). Integrity 2). Objectivity 3). Professional Competence & Due Care 4). Confidentiality 5). Professional behavior

Section B – Costing (25%)

 BA 2 Short Notes
Cost Card

Standard Cost Card

Direct Materials XX
Direct Wages XX
Direct Expenses XX
PRIME COST XX

Indirect Material XX
Indirect Labor XX
Indirect Wages XX
Indirect Expenses XX
OVERHEADS XX

Total Production Cost

XX
XX
Selling & Distribution OH
XX XX
Administration OH

Total Cost XX
Profit XX
Selling Price XX

Relevant Costs
1). Future 2). Incremental 3). Cash Flow

Non-Relevant Costs
1). Sunk costs 2). Committed costs 3). Notional costs 4). Net Book Value 5). General Fixed Overheads

Predicting costs

Methods: -

1. High-low method
2. Scatter graph
3. Regression analysis

High-low method
Change in cost
Variable Cost per unit = ----------------------------------
Change in activity level

Co-efficient of Determination (COD = r2)

Overhead Analysis

1. Allocation
2. Apportionment
 BA 2 Short Notes
3. Re-apportionment
4. Reciprocal Re-apportionment
5. Absorption

Predetermined Overhead for the cost center

Predetermined OAR =----------------------------------------------------------------------------------------
Predetermined total of the absorption base connected to the CC

Over/Under Absorption of Overheads

Absorbed > Actual = Over absorption (Add to profits)

Absorbed < Actual = Under absorption (Deduct from profits)

Reasons for Over/Under Absorption

1. The actual number of hours was different compared to the budgeted hours in which case the actual overhead
cost per hour will be different compared to the predetermined rate.
2. The actual production overhead incurred may be different from the estimate contained in the predetermined
rate.

Reciprocal Service Cost Centers

1. Repeated distribution method

2. Simultaneous equation method

Activity based costing – This is another method of absorbing overheads where cost pools are identified with cost drivers
and overheads. Each category of overheads is absorbed using a combination of different bases, compared to the
traditional method which used only one absorption base, such as machine and labor hours.

Marginal and Absorption Costing

Difference lies in the treatment of production overheads.

Contribution = Selling Price – Variable Cost

Total Contribution = Contribution / unit x Sales unit
Profit = Contribution – Total Fixed Cost

Profit Statement Format – Absorption Costing

Sales XXX
(-) Full Production Cost of Sales
Opening Inventory XXX
+ Production Direct Material XXX
Direct Labor XXX
Direct Expenses XXX
Variable Production Overheads XXX
Fixed Production Overheads XXX
(-) Closing inventory (XXX) (XXX)
Gross Profit/ Loss XXX / (XXX)
Over/Under absorption of overheads XX / (XX)
(-) Non-production overheads (XX)
Net Profit/ Loss XX / (XX)
 BA 2 Short Notes
Profit Statement Format – Marginal Costing

Sales Revenue XXX

(-) Marginal Cost of Sales
Opening inventory XXX
Direct Material XXX
Direct Labor XXX
Direct Expenses XXX
Variable Production Overheads XXX
XXX
(-) Closing inventory (XX)
XXX
Variable Administration costs XXX
Variable Selling costs XXX (XXX)
CONTRIBUTION XXX
(-) Fixed Costs
Fixed Production Overheads XXX
Fixed Non-production Overheads XXX (XXX)
Profits/ Loss XXX / (XXX)
Profit

Mark Up Margin
Expressed as a % of cost Expressed as a % of sales

Section C – Planning and Control (30%)

Budgeting – ‘Quantified Plan of action relating to a given period of time.

Two main roles of a budget

1. Act as an authority to spend
2. A yardstick where actual performance is compared with budgeted so that it could be used for control purposes.

Sales Budget

Production Budget

Material Budget Labor Budget Overhead Budget

Cost of Sales Budget

Sales & Distn OH Budget Admin OH Budget

Master Budget

1. Budgeted IS
Capital Expenditure 2. Cash Budget/ Budgeted
Budget Cash flow Statement
3. Budgeted Balance Sheet
 BA 2 Short Notes
Opening Stock + Production – Closing Stock = Sales
Production = Sales + Closing Stock – Opening Stock
Direct Labor Required = Production x hrs/units
Direct Material Required = Production x kgs/units
Direct Purchases = Direct Material Required + Closing Stock – Opening Stock

Cash Budgets

1. All receipts and payments will be included in the cash budget based on the time period at which they are
expected to be recovered or paid. This will then identify the net cash position of the business. A cash budget will
warn us about possible problems so that necessary steps can be taken.
2. Non-cash items such as depreciation, bad debts and allowances (doubtful debts) are ignored when preparing the
cash budget.

Feed Forward Control – The use of forecast to modify actions so that potential threats are avoided and/or
opportunities exploited.

Fixed and Flexible Budgets

 A fixed budget is a budget that is designed to remain unchanged irrespective of the volume of output or
turnover.
 A flexible budget is one which is designed to adjust the allowed cost level to suit the level of activity actually
attained. More properly defined a flexible budget is a budget which by recognizing different cost behavior
patterns, is designed to change as the volume or output changes. This is done by flexing the original budget to
suit the actual levels of activity. Flexible budgets are vital for control purposes.

Multiple Functions of a Budget

1). Planning 2). Coordination 3). Communication 4). Motivation 5). Control 6). Performance Evaluation 7). Authorization

Types of Planning

1. Strategic / Corporate – Long term Planning 1

2. Budgetary – Short term Planning
3. Operational / Tactical – Short term & day to day planning 2

Budget Manual

1. An introductory explanation of the budget planning and control process, including a statement of the budgetary
objective and desired result.
2. A form of organization chart to show who is responsible for the preparation of each functional budget and the
way in which the budgets are interrelated
3. A timetable for the preparation of each budget. This will prevent the formation of a ‘bottleneck’ with the late
preparation of one budget holding up the preparations of all the others.
4. Copies of all forms to be completed by those responsible for preparing budgets, with explanations concerning
their completion.
5. A list of the organization’s account codes, with full explanations of how to use them.
6. Information concerning key assumptions to be made by managers in their budgets, example – inflation
7. The name and location of the person to be contacted concerning any problems encountered in preparing
budgetary plans. This will usually be the coordinator of the budget committee.
 BA 2 Short Notes
Principal Budget factor

The principal budget factor or the key budget factor is the factor that limits the activities of the organization. The early
identification of this factor is important in the budgetary planning process because it indicates which budget should be
prepared first. (This is thus the limiting factor).

The Master Budget

The master budget is a summary of all the functional budgets. It usually comprises the budgeted profit and loss account,
budgeted balance sheet and budgeted cash flow statement.

Participative Budgeting

A budgeting system in which all budget holders are given the opportunity to participate in setting their own budgets.
This may also be referred to as ‘bottom-up budgeting’. It contrasts with imposed or top-down budgets where the
ultimate budget holder does not have the opportunity to participate in the budgeting process.

Advantages of Participative Budgeting

1. Improved quality of forecasts to use as the basis for the budget

2. Improved Motivation/ Acceptance & Commitment
3. Goal Congruence

Disadvantages of Participative Budgeting

1. It tends to result in a more extended and complex budgetary process. Also, it’s more time consuming.
2. There can be a budget slack
3. There may arise a need for training for non-financial managers

Imposed Budgets/ Top-down budgets

A budget allowance which is set without permitting the ultimate budget holder to have the opportunity to participate in
the budgeting process.

Different types of budgets

Rolling / Continuous budgets

Rolling budgets can be particularly useful when future events cannot be forecast reliably. A budget continuously
updated by adding a further accounting period when the earliest accounting period has expired. It’s use is particularly
beneficial where future costs and/ or activities cannot be forecasted accurately.

Advantages of Rolling Budgeting

 Budget should be accurate

 Planning and control are based on recent and realistic budget

Disadvantages of Rolling Budgets

 Budgets are prepared several times a year, more money, time, preparation
 Managers doubt the usefulness of preparing one budget

Incremental Budget – An incremental budget system is a system whereby budgets are prepared by adjusting the
previous period’s budget/ actual values for expected changes in the level of activity and for expected price changes.

Zero based budgeting/ Priority Based budgeting

Method of budgeting that requires all costs to be specifically justified by the benefits to be expected.
 BA 2 Short Notes
The ZBB approach requires all activities to be justified and prioritized before the decision to devote resources to ones is
taken. Without justification the budgeted allowance will be zero. Here all activities are re-evaluated each time the
budget is prepared as though the budget is prepared for the first time.

Advantages of ZBB

 Inefficient or obsolete operations can be identified and discontinued

 It creates and inquisitorial attitude, represents value of money
 Wasteful expenditure is avoided
 Managers are forced to consider alternative methods of achieving their objectives
 Resources should be allocated efficiently and economically

Disadvantages of ZBB

 The time involved and the cost of preparing the budget is much greater than for less elaborate budgeting
methods
 It may emphasize short term benefits to the detriment of long-term benefits
 It is difficult to compare and rank completely different types of activity.
 Incremental costs and benefits of alternative courses of action are difficult to quantify accurately.

Budgetary Control Information

Budgetary control is achieved by comparing the actual results with the budget.

Each budget center will have its own budget and a manager will be responsible for managing the center and controlling
the budget.

Budgetary Control reports

1). Timely 2). Accurate 3). Relevant to the receipt 4). Communicated to the correct manager

Standard Costing and Variance Analysis

Standard Costing – This is a control technique which compare standard costs and revenues which actual result to obtain
a variance, which are used to stimulate improve performance.

Types of standards used in management accounting

1. Ideal/ Perfect standards

2. Attainable standards
3. Basics standards
4. Current standards

The main purpose of standard cost is to provide a yard stick against which actual performance can be monitored. The
comparison will be meaningful will be meaningful only if the standards is kept up to date.

Objectives of standard costing

1. Valuation of inventory and production cost for cost accounting purposes

2. Establish standards & prepare variance analysis as control devices
3. Alert management to take corrective action when to do so

Variance analysis

A variance is the difference between the expected standard and the actual revenue/ cost incurred.
 BA 2 Short Notes
Variance analysis involves breaking down the total variance to explain how much of it is caused by usage resources being
different from the standard and how much of it is caused by the price of resources being different from the standard.

A variance is said to be favorable if it causes actual profit to be greater than the budgeted and it is said to be adverse if it
causes actual profit to be less than budgeted.

Two main variance types

 Cost Variance
 Sales Variance

Cost Variance

 Direct Material Variance

 Direct Labor Variance
 Variable O/H Variance

Variance Favorable Adverse

Material Price Standard price set too high unexpected Standard price set too low unexpected general
Variance discount available, Lower quality material used. price. Higher quality material used, Careless
Careful purchasing, gaining bulk discounts. purchasing, losing bulk discounts.
Material Usage Standard usages set too high, Higher quality Standard usage is set too low, Lower quality
Variance material used. A higher grade of worker used, material used. A lower grade of worker used,
Strict quality control, material more efficient. theft, material less efficiently
Labor rate Standard rate is set too high, Lower grade Standard rate is set too low, higher grade of
Variance workers used worker used
Labor efficiency Standard hours set too high, Higher grade of Standard hours set too low, Lower grade of
worker used, Higher grade of material was worker used, Lower grade of material was
quicker to process slower to process
Idle time Shortage of work & DM, Machine breakdown.
Variable OH Standard hourly rate is too high Standard hourly rate is set too low
expenditure
Sales Price Higher quality produce commanded higher Increased competition forced a reduction a
Variance selling price than standard selling price below standard

Sales volume Increased marketing activity led to higher Quality control problems resulted in lower than
contribution budgeted sales volume budgeted sales volumes
Reasons for Variances

1. Incorrect standards
Adverse variance – Hard (Ideal) standard
Favorable variance – Easy (Basic) standard

2. Efficient/ inefficient operations/ control

Adverse variance – inefficient operations
Favorable variance – efficient operations

3. Errors in recording information

4. Macro & Macro information

Macro factors (Political/ Economical/ Social and Legal/ Technical)
Micro factors (Customers/ Suppliers/ Competitors)
 BA 2 Short Notes
5. Interrelationship of variances

Sources of Information

Standard material price

Standard material usage
Standard labor rate
Standard labor times

Standard costing in the modern business env

 Standard costing has been criticized as it was developed when env conditions were stable.
 Performance to standards used to be judged as satisfactory, but today we look at continuous improvement to
keep up with the competition.
 Emphasis on labor variances is no longer appropriate with the increased use of automated production methods
such as the use of robotics

Interrelationships Between Variances

(1). When DM price is adverse it may mean that high quality material was purchased. If so the direct material usage may
end up favorable as lesser amounts of material will be wasted as its of high quality. Giving a favorable labor efficiency
variance.

(2). When direct labor rate is favorable it may mean that unskilled labor had been hired. If that is the case the
employees may be inefficient as they are unskilled. Therefore, the labor efficiency may end up as adverse.

(3). If Variable OH are absorbed on direct labor hours, then the VOH efficiency and the labor efficiency will move in the
same direction.

(4). If actual prices have increased, then the sales price will be favorable as a result for this volume margin may end up
adverse due to reduced demand owning to the increase in the selling price.

(5). When a new machine is purchased the fixed OH expenditure may end up adverse due to increased depreciation. But
when the new machine helps to increase productivity the fixed OH volume and the two efficiency variances may end up
being favorable.

Variance Double Entry

Adverse Variance

 Variance Account – Dr
 Other Account – Cr

Favorable Variance

 Other Account – Dr
 Variance Account – Cr

Integrated Accounting

A set of accounting records that integrates both financial and cost accounts using a common input of data for all
accounting purposes.

Non-integrated/interlocking accounting systems is where cost accounts are distinguished from financial accounts. The
two sets of accounts are kept continuously in agreement by the use of the control accounts and this is reconciled
periodically.
 BA 2 Short Notes
Performance Measurement

This is the monitoring of budgets or targets against actual results to establish how well the business and its employees
are functioning as a whole and as individuals.

Responsibility Centers

A responsibility accounting system divides an organization into several parts or responsibility centers.
1). Cost Center 2). Profit Center 3). Revenue Center 4). Investment Center

Financial Performance Measures

Gross Profit
GP Margin = ------------------------ x 100
Sales
Operating Profit
OP Margin = --------------------------- x 100
Sales

Net Profit
NP Margin = ---------------------------- x 100
Sales

Operating Profit
ROCE = --------------------------------- x 100
Capital Employed

Issues surrounding the use of financial performance indicators to monitor performance

1. Short termism
2. Manipulation of results
 Accelerating revenues
 Delaying costs
 Understating a provision or accrual
 Manipulation of accounting principles
3. Do not convey the full picture

Non-Financial Indicators (NFPI)

 Having a wide range of products that people want

 Having a strong brand name and image
 Low Prices
 Quick delivery
 Customer satisfaction

Importance of NFPI’s

1. Information provided quickly

2. Anything can be measured
3. Easy to calculate
4. Difficult to manipulate
5. Can be quantitative and qualitative
6. Provides customer satisfaction
7. Indicator of future prospects
 BA 2 Short Notes
Problems with NFPI’s

1. Overloaded information
2. Needed to be linked with financial measures
3. Needed to be revised regularly
4. Time consuming and costly
5. Managers mat find it difficult to understand
6. There’s no specific list, there’s a lot to choose from

Balanced Scorecard

System that includes both financial and non-financial factors is called a Balance Scorecard. It links the short-term
operational goals of the organization with its long-term objectives and strategy, by forcing it to control and monitor day
to day operations.

The balance scorecard measures an organization’s performance in four key areas

 Customer satisfaction
 Financial Performance
 Internal business
 Learning and growth
Balanced Scorecard Strategic Perspectives

Financial

Customer Vision and Strategy INT Business Processes

Learning and Growth

Financial Perspectives – The focus is on financial measures.

Customer Perspectives – Here we look at technique to measure customer satisfaction.
Internal Business Perspectives – Measures the output in terms of technical excellence and customer needs.
Learning & Growth Perspectives – Focuses on continuous improvement of products and techniques and also developing
new ones to meet the changing customer needs.

Section D – Decision Making (35%)

Job, Batch & Service Costing

Costing systems :–
Specific order costing is the costing system used when the work done by an organization consist of separately
identifiable job/batches. (Job & Batch costing)
Continuous operation costing is the costing method used when goods or services produced. As a direct result of a
sequence of continuous operations or process. (Service & Process costing)

Job costing

Job costing is a form of specific order costing, and it is used when a customer orders a specific job to be done. Each job is
priced separately, and each job is unique.
 BA 2 Short Notes
Job card

A job card contains all the details relating to the cost incurred on a job. It separately lists the material, labor and
overhead cost incurred on a job.

 Job number
 Description of the job
 Customer details
 Estimated cost, analyzed by cost element
 Selling price, and hence estimated profit
 Delivery date promised
 Actual costs to date, analyzed by cost element
 Actual delivery date, once the job is completed
 Sales details, delivery note or invoice no.

Types of costs considered under Job Costing

 Direct Material – All Types of material – both specific and general

 Direct Labor – Time Sheets are used to find the time spent on each
job
 Direct Expenses
 Production Overheads – Absorbed using a Predetermined rate
 Non-Production Overheads – Absorbed using a Predetermined rate

Batch costing

A group of similar articles which maintains its identity throughout one or more stages of production and it’s treated as a
cost unit. (Manufacturing of garments, manufacturing of furniture, manufacturing of plastic baskets).

Total cost of the batch

Cost per unit (in the batch) =---------------------------------------
Number of units made

Service and Operation Costing

Service costing is the procedure applied for determining the cost of the services. Features of services :-

 Intangibility
 Heterogeneity
 Simultaneous production & consumption
 Perishability

Total Cost for the period

Cost per unit = --------------------------------------------------------------
Number of service cost units in the period

NFPI’s – such organizations will measure performance using,

 Economy – quality inputs at minimum cost

 Efficiency – using inputs to maximize output
 Effectiveness – using inputs to achieve organizational goals
 BA 2 Short Notes
Risk

CIMA definition – A condition in which there exists a quantifiable dispersion in the possible outcomes of any activity.

Uncertainty

CIMA definition – The inability to predict the outcome from an activity due to the lack of information about the required
output input relationships or about the environment within which the activity takes place.

Measures of Central Tendency

Median – The median is defined as the middle of a set of values, when arranged in ascending order. Most suitable for a
skewed data set and is unaffected by extreme values.

Mode – This is that value that occurs most often

The Mean – The arithmetic mean, also known as the ‘average’.

Sum of values of x / Number of values

Range = Highest value – Lowest value +1

Range = Upper most interval limit – Lowest interval limit

Variance and Standard Deviation

The variance is simply the standard deviation squared.

COV – Coefficient of Variation

COV = Standard deviation/ Mean *100%

Risk II

Probability

Total no. of outcomes which constitutes the event

P (event) = ----------------------------------------------------------------------------
Total no. of possible outcomes

Complementary probability = Chances of an event not happening = 1-P(X)

Types of probability

1. Exact – Can be applied to the population of outcomes and is based on Logic when there are equal outcomes.
2. Empirical – These can be calculated from samples of observations from the past through experiments
3. Subjective/Judgmental – Based on the judgement of an expert.

Discrete Probability Distribution – A list of discrete variables together with their corresponding probabilities.
Expected Values (EV) – The mean/ average of a probability distribution.
 BA 2 Short Notes
Data/ Payoff tables is an approach used to identify the various outcomes possible when multiple variables are changing.

Decision Trees, in reality the end uncertainty is due to a chain reaction, therefore normal probability distribution will not
work unless a more useful technique like a ‘decision tree’ is applied.

Normal Distribution – A continuous probability distribution where the data is symmetrical and peaks in the center.

Characteristics

 Bell shaped and symmetric about its mean

 The curve never meets the x axis
 Mean = Median = Mode
 Area under the curve is 1 thus each half is 0.5
 Defined by its mean and standard deviation

Converting a normal distribution into a standard normal distribution

The random variable is denoted by Z

The normal distribution has mean of 0 and a standard deviation of 1
X = Value considered or observed value.

X – Mean
Z = ------------------------------
Standard deviation

BEP Analysis

Comparison of Conventional Breakeven Chart, Contribution Breakeven Chart & Profit Volume Chart

Conventional Breakeven Chart

Advantages

 Shows clearly the constant nature of the fixed costs.

 The angle of the profit ‘wedge’ gives a visual representation of the profitability of the product.

Disadvantages

 Although profit can be read directly from the chart, readings at two separate points are required to do so.
 It can be difficult to adapt the chart to show the effect of changes in any of the variables
 Contribution cannot be read directly from the chart

Contribution breakeven chart

Advantages

 Contribution can be read directly from the chart

 As with the conventional chart, the angle of the profit ‘wedge’ gives a visual representation of the profitability of
the product.

Disadvantages

 Although profit can be read from the chart, reading at two separate points are required in order to do so.
 It can be difficult to adapt the chart to show the effect of changes in any of the variables.
 BA 2 Short Notes
Profit-volume chart

Advantages

 Profit or loss for any level of activity can be read directly from the chart.
 The angle or profit line gives a visual representation of the profitability of the product
 The loss below breakeven point is very clearly highlighted
 Several charts can be drawn on a common set of axes to clearly shows the effect of changes in any of the
variables.

Disadvantages

 The cost behavior patterns are not depicted.

The Limitations of Breakeven (or CVP) Analysis

1. Costs are assumed to behave in a linear fashion.

2. Sales revenues are assumed to be constant for each unit sold.
3. There is assumed to be no change in stocks
4. It’s assumed that activity is the only factor affecting costs and factors such as inflation are ignored.
5. Apart from the unrealistic situation of a constant product mix, the charts can only be applied to a single product
or service.
6. Efficiency are productivity are to be unchanged
7. The analysis seems to suggest that as long as the activity level is above the breakeven point, then a profit will be
achieved.

Make or Buy Decisions

Relevant Costing

Planning with Limiting Factors

When considering Limiting factors the approach is to maximize the contribution earned.
Limiting Factors include,

Limited Demand
Limited Production resources like Material & Labor
Limited Finance – Capital Rationing
 BA 2 Short Notes
Key Factors Analysis – One Limiting Factor

Identifying the limiting factor

Rank the options based on Contribution per limiting factor
Allocate the resources based on the rankings

Financial Mathematics

Interest – Interest is the amount of money earned or money payable during the period of investments made or money
borrowed over a specified time. Interest compensates the lender for not being able to use the funds and for the risk that
the borrower may not repay the loan.

Future value – is the value at a future date, of an amount invested today at a particular simple or compound interest
rate.

FV = PV + 1

Compound Interest – If the interest is earned at each period end on the total amount inclusive of interest earned up to
date, then it is known as compound interest. With compound interest, interest is paid on the original principal amount
plus accrued interest; hence interest earns interest,

1 = FV – PV

Difference between Compound Interest and Simple Interest

1. Simple interest is calculated on the original principal only whereas compound interest is calculated in each
period on the original principal plus the interest accumulated during the past periods.
2. Simple interest gives lower returns as compared to compound interest since under the compounding method
interest is charged on interest. Compound interest is hence more beneficial from an investor point view.

Compounding v Discounting

In the process of compounding, we proceeded from the preset value and found the future value by adding on or
compounding interest. Discounting is the opposite; interest is deducted from the future value in order to ascertain the
present value.

PV = FV / (1+r)n

Present Value of an Ordinary Annuity

An annuity is a constant flow of cash that occurs annually. However, if a fixed amount is invested annually, at a fixed
interest rate, annuities can be used to calculate the present value.

Present Value of Perpetuity

The annuity discussed above included calculations for a certain number of years. The annuity that is to be received or
paid indefinitely into the future, eg :- forever, is called perpetuity

PV of a perpetuity = C/r PV of a perpetuity Due = C + C/r

 BA 2 Short Notes
C = amount of perpetuity

r = rate of discounting

Capital Investment

When a business spends money on new non-current assents it is known as capital investment or capital expenditure.
Spending is normally irregular and for large amounts. It is expected to generate long-term benefits

Many different investment projects

 Replacement/ purchase of assets

 Cost-reduction schemes
 New product/ service departments
 Product/ service expansions
 Statutory, env and welfare proposals

Payback period

Payback period = Initial Investment / Annual constant cash inflow

Cumulative cash flow before payback

Number of years + (------------------------------------------------------------- x 12)
Cash flow in the year of payback

Advantages of payback period

 It is simple to understand and easy to calculate

 The quick cash flow returns on initial investments help to maximize the liquidity.
 The quick cash flow returns on initial investments help to minimize risks
 Uses Cashflows and net profits

Disadvantages of payback period

 It doesn’t take time value of money into consideration

 Payback ignores the profitability
 Ignores cashflows beyond the payback period

Net Present Value

The NPV of an investment is the difference between the amount of initial investment and the sum of the discounted
cash flow which the investment is predicted to generate.

NPV = Present value of cash inflows – Present value of cash outflows

Advantages of NPV

1. It considers the Time Value of Money

2. It is a measure of absolute profitability
3. Uses Cashflows and not profits
4. Considers the whole life of the project
5. Maximizes Shareholder wealth

Disadvantages of NPV

1. It’s Complex
 BA 2 Short Notes
2. Not easily understood by non-financial managers
3. It may be difficult to estimate the cost of capital and the cashflows

Internal Rate of return (IRR)

We use the interpolation method and the NPV at two discount rates will be required, one giving a positive NPV and
other giving a negative NPV.

Decision Rule

Accept all independent projects where IRR is greater than the company’s cost of capital or target rate or return.

Advantages of IRR

1. It considers the time value of money

2. It is a percentage/ relative measure and therefore can be used to compare projects
3. Uses cashflows and net profits
4. Considers the whole life of the project
5. Maximizes Shareholder wealth
6. Can be compared without the cost of capital

Disadvantages of IRR

1. It’s Complex
2. Not easily understood by non-financial managers
3. It is not a measure of absolute profitability
4. The calculation is only an estimate, the real IRR may be slightly different
5. There cab be multiple IRRs, with the projects having non-conventional cashflows
6. May conflict with the NPV, in which case the NPV is superior
BA 2 Short Notes