University of Wolverhampton

Module Title & Code: Managing Financial Performance (7AC006)

Student Number: xxxxxxxxxxxxxxx

Tutor: Michael Smith

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OP ▪ Profitability Analysis
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▪ Zero Base Budgeting
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▪ Balanced Scorecard
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▪ Investment Appraisal
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 Table of Contents
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Part 1 - Profitability Analysis

1. Introduction 1
2. Operating Profit Margin 1
3. Return on Capital Employed 2
4. Earnings per Share 3
5. Conclusion 3
References 5
Appendix 6

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Part 2 - Zero Base Budgeting

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1. Introduction 7
2. Benefits of ZBB 7
3. Drawbacks of ZBB 8
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4. Circumstances when ZBB is Appropriate 9
References 10

Part 3 - Balanced Scorecard

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1. Introduction 12
2. Strengths of the Balanced Scorecard 12
3. Weaknesses of the Balanced Scorecard 13
4. Balanced Scorecard Adoption and Drawbacks by Global Companies 13
5. Conclusion 14
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References 16

Part 4 - Investment Appraisal

1. Introduction 19
2. Financing 19
3. Cash Flows 19
4. Net Present Value and Internal Rate of Return 19
5. Payback Period 20
6. Sensitivity Analysis 21
7. Conclusion 21
1. Introduction
In analysing the profitability of GlaxoSmithKline PLC (GSK) the ratios listed below, as
reported in the GSK 2017 financial results (GSK.com, 2018) are critically interpreted
relative to the 2016 results. The analysis includes the impact of the competitive
pharmaceutical macroeconomic environment on performance, which is also
compared to its peer company, AstraZeneca. It should be noted that all figures in this
report are quoted at CER.

2. Operating Profit Margin

The Operating Profit Margin (OPM) ratio measures how efficiently a company
produces profits (EBIT) and generates revenue by managing its expenses, namely

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how much revenue is left after all variable and fixed costs have been paid (Vause,

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2001).

GSK’s adjusted OPM (28.4%) for 2017 increased by 90 basis points with operating
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profit up 5% (£8.8bn) and revenue up 3% (£30.2bn) (GSK.com, 2018).

Its largest revenue geographic market, the US, was the most profitable and grew by
6% (£11.3bn), compared to zero growth from Europe (£940m) and the “rest of the
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world” achieving a 3% growth (£17.9bn), in line with GSK’s total revenue growth
percentage. This performance was achieved by Vaccines and Pharma revenue
growing at 6% and 3% respectively and Consumer HealthCare up a respectable 2%
(GSK.com, 2018). These positive figures contributed to the high OPM.
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GSK attributed its increased operating profit to “improved operating leverage”,

revenue growth across all three divisions, coupled with a 1.3 percentage point
increase in both vaccines and consumer healthcare operating margin and “continued
tight control of ongoing costs” (GSK.com, 2018). It meant that GSK’s fixed costs
were higher in proportion to its variable costs, resulting in a high operating leverage
ratio and hence GSK was able to generate a larger profit from each incremental sale.
Worth noting is that operating profit (Appendix 1) is linked to remuneration, which
would be an added incentive for management to improve this figure.

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AstraZeneca in contrast to GSK increased OPM by 100 basis points from 29.2% to
30.5%. Operating profit was unchanged at $6.9bn and revenue declined 2% to
$22.5bn. Revenue in its largest markets, the US and Europe declined 16% and 7%
respectively largely caused by new generic US competitors to its cholesterol drug
(Crestor) coupled with the loss of exclusivity of some of its key drugs in Europe.
Operating profit remained unchanged, as gross profit declined 3%, driven by a 7%
increase in the cost of sales (due to new medicines) and increased manufacturing
capacity. This AstraZeneca claimed was in line with its restructuring consolidation
phase (AstraZeneca.com, 2018).

3. Return on Capital Employed

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Return on Capital Employed (ROCE) also a profitability ratio, measures the

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efficiency with which a company (management) can generate profits from its capital
employed (equity plus long-term borrowings) by comparing it to operating profit
(White, Sondhi and Fried, 1998; Jones, 2013).
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Despite a modest increase in operating profit, GSK reported a ROCE of 48.4%
(2017) and 39.2% (2016) as at 31st December respectively. This increase in ROCE
largely reflects a lower level of capital employed. Total equity decreased to £3.49bn
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from £4.96bn and long-term borrowing reduced from £14.7bn to £14.3bn, with
£10.3bn falling due in over five years. Included in this is the impact of paying
dividends that exceeded the total profit for the year. Despite this, the rating agencies
gave GSK a stable outlook (A+ and A2) rating.
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In contrast, AstraZeneca’s ROCE decreased from 21.6% to 21.3%. Total equity

remained unchanged at $16.6bn, long-term borrowings increased by $1bn to
$15.6bn, and operating profit remained unchanged. Thus, further confirming
AstraZeneca reported restructuring growth-phase.

Vause, (2001) argues that ROCE is reported at an aggregate and consequently the
use of the Du Pont approach will give a better understanding of profitability. ROCE is
also one of the KPI that managements remunerations bonuses are based on
(GSK.com, 2018), hence it can be open to creative accounting (Dyson, 2010).

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4. Earnings per Share
Earnings per Share (EPS) can be used to explain share price movements, as
changes in EPS are often reflected in share price behaviour (Robbetze, Villiers, and
Harmse, 2017).

GSK reported a 4% increase in adjusted EPS (111.8p). The profit attributable to

ordinary shareholders (4.9 million) based on a weighted average was £5.5bn
compared to £4.9bn in 2016. This improvement was related to its 5% increase in
operating profit (mentioned above). In addition to this was the influences of the
changing tax regimes in the US and Switzerland. The overall tax rate for 2017 was
38.5% compared to 45.2% in 2016.

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AstraZeneca’s core EPS declined 2% (CER) for the same period, from $4.30 to
$4.28. The profit attributable to ordinary shareholders was $3.0bn (2107) and $3.5bn
(2016), based on a weighted average of 1.27 million shares. Its operating profit
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during this period was unchanged and total revenue was down 2%. It reported that
its tax rate was impacted by deferments (AstraZeneca, 2018)

Vause (2001) states that EPS should not be used to compare profitability, as the
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differences in EPS can be brought about by dissimilarities in the share capital
structure. The most effective way is to use the compound growth rate to determine
the company’s ability to improve their earnings. GSK’s EPS is on an upward trend
and if operating profit and revenue continue to improve, it makes it an attractive
proposition for investors. AstraZeneca, however, appears to have adopted a
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defensive strategy and needs to reassure investor confidence and providing them
with a pragmatic growth map.

5. Conclusion
Based on the performance and analysis of both companies during this period, GSK
is more profitable and is more proactive in utilising its resources to produce better
returns on its revenue. While its current OPM is being driven by targeted increased
investment in R&D and growth in the US, its future OPM is looking very positive as it
hopes to strengthen its dominance in the respiratory drug sector market with the new
approved
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 three-in-one respiratory inhaler. The expectation is that it will become its new
blockbuster drug and drive revenue upwards.
Although GSK’s ROCE is high, the concern is that the earnings are not being
retained or re-employed into the business which could inhibit its ability to effectively
respond to the challenges of its macroenvironment. This is in addition to technology,
artificial intelligence and blockchain disrupting traditional pharmaceutical business
models.

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References
AstraZeneca.com (2018) What science can do. AstraZeneca Annual Report and
Form 20-F Information 2017. Available at:
http://www.astrazeneca.com/content/dam/az/Investor_Relations/annual-report-2017/
annualreport2017.pdf (Accessed: 1 December 2018).

Dyson, J. R. (2010) Accounting for non-accounting students. 8th edn. Essex: Pearson
Education Ltd.

GSK.com (2018) GSK Annual Report. Available at:

http://www.gsk.com/media/4751/annual-report.pdf (Accessed: 1 December 2018).

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Jones, M. J. (2013) Accounting. 3rd edn. West Sussex: John Wiley & Sons, Ltd.

Robbetze, N., de Villiers, R., and Harmse, L. (2017) ‘The Effect of Earnings Per
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Share Categories on Share Price Behaviour: Some South African evidence’, Journal
of Applied Business Research, 33(1), pp.141-152.

Vause, B. (2001) Guide to Analysing Companies 3rd edn. London: Profile Books Ltd.
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White, G. I., Sondhi, A. C. and Fried, D. 1998 The analysis and use of financial
statements. 2nd edn. New York: Wiley.
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Appendix 1

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(Source, GSK.com, 2018, p. 18)

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1. Introduction
Zero-base budgeting (ZBB) can be viewed as a controversial approach to planning
and budgeting, with discussion and debates of the benefits and drawbacks being
based on opinion rather than rigorously designed and empirical research (Wetherbe
and Montanari, 1981).

Although it was developed as an accounting tool in the 1960s, its popularity grew
following the 2008 crisis when numerous companies were forced to find new
management solutions to survive (Gondim, 2017). Because there is no ‘one size fits
all’ approach, it is currently being applied in varying degrees. The process requires
the need for all costs to be justified, the benefits evaluated and to convince senior

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management that all activities will represent ‘value for money’, thereby ensuring the

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efficient use of business resources (Atrill and McLaney, 2015).

2. Benefits of ZBB
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The majority of companies that have implemented ZBB claim that it has effectively
improved resource allocation, decision making, facilitation of planning, and reduction
in costs and personnel (Dean and Cowen, 1979). Also, the evidence from past ZBB
applications indicate that substantial value can be gained by re-evaluating budget
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programs and activities to determine relevant costs, benefits and alternatives
(Ibrahim el at, 2017). Importantly, it can eliminate a sense of entitlement to costs
increases thus leading to containment and simultaneously encourage more
meaningful discussions among management (NACM, 2004).
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If management adopts it selectively Steven (2007) claims that this will ensure that
inappropriate activities are not undertaken as the evaluation of existing activities will
be undertaken relative to future needs of the business. Thus, while benefits will be
gained by using ZBB, the overall cost will be much reduced (Atrill and McLaney,
2015).

In surveying the use of ZBB in the public sector, Sherlekar and Dean (1980)
concluded that this sector perceived it as an effective tool for the allocation of
resources. When the priority of effort was ranked, it was found that effective budgets
were produced, management actively participated in the decision-making process
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and there was constructive trade-off within and across programs. Levine (1980)
however, argued

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that as ZBB is a rational comparison process, it will invite the general public to closer
inspect and criticise public sector budgetary decisions. Also, while a public sector
agency that is used to making decisions with little oversight the benefit is that the use
of ZBB will enhance public confidence in the agency.

3. Drawbacks of ZBB
If ZBB is used too frequently, managers could become complacent and continue to
use similar arguments to justify their activities, thereby actively or passively
undermining the entire process (Atrill and McLaney, 2015). This in addition to the fact
that successful implementation requires a significant educational element which is
not present or ignored could result in confusion and user backlash and inappropriate

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implementation.

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Brown (1981) questions the cost-effectiveness of ZBB as it requires a good
accounting system and commitment from managers at all levels, this is in addition to
it being extremely time-consuming, as it requires the gathering, analysis and
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evaluation of large amounts of data (Steven, 2007). Therefore, the costs increases
could span over software implementation, staff training, time and additional staff.
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Most government agencies reported that ZBB did not produce any cost saving and
that the excessive time and effort required, impacted negatively on the daily
management functions. In addition, conflicts occurred when decisions had to be
made between cost analysis and political considerations. This was due to the fact
that each as a different rationale (Hermanson and Minmier,1977).
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Generating meaningful output measurements can be difficult to generate as it can be

difficult to justify and categorise costs by department and function. The issue then
becomes one of comparing them to the inputs (costs) in order to create a
cost-effective ratio, which in itself is a difficult task because an objective input is
being compared to a subjective output. Whilst, it can be done it requires a high level
of managerial experience and judgement, which may not be available (Brown,1981).

The ZBB process requires the consolidation of a number of different decision

packages. Participants in the process could find it extremely difficult to focus on how

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significant changes could be made to the way a service is provided. Hence, they will
tend to focus on the current service models and divide that into decision packages,
thus, defeating the object of the exercise (Kavanagh, 2012).

4. Circumstances when ZBB is Appropriate

There is evidence to support the argument that in times of fiscal restraint and
economic downturn, and when governments want to send a strong message that
spending and taxes will be kept in check, ZBB can be appropriate and effective (Atrill
and McLaney, 2015; Heinrich, Garton, and Martin, 2016).

NACM (2004) maintains that when management wants to ‘shake things up’

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especially in circumstances like mergers and acquisitions or severe industry

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downturn, efficiently implemented ZBB can produce positive results. Similarly, when
venture capital and private equity fund companies are in search of fast returns, they
can implement ZBB to provide more profitable exists when needed (Gondim, 2017).
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Brown (1981) suggested that ZBB is more appropriate when there; (i) are
widespread budget problems, (ii) a desire to get an overview of the entire
organisation from a financial point of view, and (iii) a budget has to present the cost
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of all activities from bottom up.

More recently Diageo reported that the ZBB process forced finance managers to
justify costs and the evaluate the benefits, which resulted in savings in packaging
and business travel. Heineken also reported that based on the past success of ZBB
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they will be adapting the ZBB process regionally by using their local knowledge
(Trentmann, 2017). Thus, confirming that ZBB is not a ‘one size fit all’. Verizon also
revealed that ZBB processes will result in cost cuts of $10bn by 2021 (Pesce, 2017).

Finally, based on the current disruption and confusion in the automotive industry due
and governments wanting the move away from petrol and diesel vehicles, it would be
appropriate for motor vehicle manufacturers to adopt ZBB, especially as the
development, production and marketing of electric vehicles will require an entirely
new way of thinking.

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References
Atrill, P. and McLaney, E. (2015) Management Accounting for Decision Makers. 8th
edn. Harlow: Pearson Education Ltd.

Brown, R. (1981) ‘Beyond Zero-Base Budgeting’, Journal of Accountancy, 151(3), p.

44.

Dean, B., and Cowen, S. (1979) ‘Zero-base budgeting in the private sector’,
Business Horizons, 22(4), 73-83. doi: 10.1016/0007-6813(79)90072-7.

Gondim, F. (2017). ‘Generating great results through ZBB (zero-based budgeting)’,

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Journal of Private Equity, 20(2), pp.12-14. doi:10.3905/jpe.2017.20.2.012.

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Heinrich, J., Garton, E. and Martin, B. (2016) How Zero-Based Budgeting Can
Inspire Employees. Available at: http://forbes.com/sites/baininsights/ (Accessed: 01
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December 2018).

Hermanson, R.H. and Minmier, G.S. (1977) ‘A look at Zero-Base Budgeting – The
Georgia Experience’, Government Accountants Journal, Winter 1976.
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Ibrahim, M., Ashigar, A., Bello, B.M. and Mamuda, A.U. (2017) ‘Zero-Based
Budgeting is a Panacea to Fiscal Distress: Do the Perceived Benefits Significantly
Influence its Adoption in Borno State?’ Saudi Journal of Business and Management
Studies, 2(10), pp. 943-950. doi: 10.21276/sjbms.2017.2.10.11.
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Kavanagh, S. (2012) ‘ZERO-BASE BUDGETING: Modern experiences and current

perspectives’, Government Finance Review, 28(2), pp. 8-14.

Levine, C. H. (1980) Managing fiscal stress: The crisis in the public sector. Chatham:
Chatham House.

NACM (National Association of Credit Management) (2004) ‘What exactly is a best

practice?’, Business Credit, 106(1), pp. 39-46.

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Pesce, N.L. (2017) Verizon and Coca-Cola’s budgeting plan may be the smartest
way for you to spend less and save more. Available at:
http://marketwatch.com/story/verizon-and-coca-colas-budgeting-plan-may-be-the-sm
artest-way-for-you-to-spend-less-and-save-more-2017-09-18 (Accessed 01
December 2018).

Sherlekar, V. and Dean, B. (1980) ‘AN EVALUATION OF THE INITIAL YEAR OF

ZERO-BASE BUDGETING IN THE FEDERAL GOVERNMENT’, Management
Science, 26(8), p.750. doi: 10.1287/mnsc.26.8.750.

Steven, G. (2007) ‘Management Accounting Performance Evaluation: activity-based

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budgeting’, Financial management-London, 147, pp. 48-53.

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Trentmann, N. (2018) Global Companies Extend Use of Zero-Based Budgeting to
Slash Costs. Available at: http://wsj.com/cfo/ (Accessed 01 December 2018).
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Wetherbe, J. and Montanari, J. (1981) ‘Zero Based Budgeting in the Planning
Process’, Strategic Management Journal, 2(1), p.1.
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1. Introduction
Porter (1992) noted that if a business relied solely on financial performance
measures it could promote behaviour that sacrifices long-term value creation for
short-term benefits. The Balanced Scorecard (BSC) is a management tool that
adopts a more strategic and less short-sighted perspective by emphasising the use
of qualitative information to complement the organisation’s financial
performance/information (Perramon el at., 2016). Its underlying philosophy is to
translate an organisation’s vision and strategy into operational objectives and
performance measures, by looking at perspectives from the view of the (i)
Shareholders, (ii) Customers, (iii) Business Processes, and (iv) Learning and Growth
(Atrill and McLaney, 2015; Drury, 2012).

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2. Strengths of the Balanced Scorecard
A major strength of the BSC approach is the emphasis it places on linking
performance measures with business unit strategy (Otley, 1999) thus encouraging
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management teams to explore the beliefs and assumptions, which underpin their
organisation’s strategy Neely (1998).

Crucially it supports a holistic business performance approach by incorporating

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different additional perspectives to address issues that are critical to the business. Its
causality structure described by means of the BSC map shows the connection
between the issues an organisation is planning to learn and its long-term planned
financial results. These cause-and-effect assumptions highlight the relative strength
of these linkages, the time delays involved and the certainty of these linkages in the
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face of external competition and change (Tejedor et al., 2014).

Other strengths include its sequential objectives; (i) the capacity to support long-term
programs, (ii) the potential to select relevant performance measures based on real
data, and (iii) the two levels of feedback to enable controlling and updating of
long-term programs. All of which could lead to the optimisation of operational
efficiency (Roos et al., 1997; Bontis et al., 1999; Russ, 2001).

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A key strength lies its power to effectively communicate managerial issues across
the organisation with Malina and Selto’s (2001) finding that is causal relationships
presents significant opportunities to develop, communicate and implement the

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strategy. Drury (2012) added that it helps to improve communication across divisions
within an organisation by combining organisational strategy across disparate
divisions.

3. Weaknesses of the Balanced Scorecard

Voelpel (2005) was critical of the BSC, claiming that when applied in the current
economy its rigidity, inability to deal with knowledge creation, and linear thinking
could endanger an organisations survival in a rapidly changing and networked
corporate environment. Additionally, the absence of a time dimension in the
scorecard map creates a time lag between causes and their effects (Nørrekit, 2000).

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Researchers agree that there are many issues around stakeholders. Neely and

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Kennerley (2003) claim that a serious flaw is that it ignores the perspectives of the
organisation’s external environment especially the competitor perspective, and
Susilawati et al., (2013) mentioning that employees are tucked under the learning
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and growth perspective thereby giving the impression that innovation can be attained
with or without them, in addition to employee’s motivation not being recorded
(Smith,1998).
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Platts and Tan (2002) say that simply looking at different measures simultaneously is
not enough and that the linkages between them must also be understood. Also, the
failure to identify performance measurement as a two-way process (Mooraj, Oyon,
and Hostettler, 1999) and the lack of integration between senior management, the
strategic scorecard, and operational-level measures could lead to the creation of
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static organisations (Hudson et al., 2001).

While BSC provides constructs for multiple measures thus overcoming the limitations
of single measures, there is no clear provision for very long-term measures; the
distinctions between means and ends is not well defined (Maltz et al., 2003).

4. Balanced Scorecard Adoption and Drawbacks by Global Companies

In 1993 Mobil Oil adopted BSC and by 1995 it moved from the last place to first
place in industry profitability, maintain this position for the next four years (Kaplan
and Norton, 2000). Wiersma (2009) reported that some large corporates have used it
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as a ‘management by objectives’ system, based on targets and rewards and others
used it

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as an information system to provide their managers with a tool to improve
performance.

Landry, Wai Yee, and Jalbert, (2002) argue that BSC in its current form restricts
multinationals (MNEs) from communicating its intended international strategy.
Yeniyurt (2003) and Dossi and Patelli, (2010) argue that the effects and complexities
of globalisation and international trade make it challenging for MNEs to align their
worldwide actions with global strategy. This is in addition to the different cultural
attributes between the parent company and its subsidiaries.

Landry, Wai Yee, and Jalbert, (2002) propose a fifth perspective be added to The

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BSC that focuses specifically on international critical success factors. They use

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managing transfer costs of political risks as examples but stress that the MNEs
measures and goals will differ based on their core competencies and abilities to
compete. Hence, for an MNE to achieve world-class performance it is important that
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the global processes and individuals within the teams in these multinationals are in
agreement.

5. Conclusion
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Despite its worldwide dissemination, Gomes and Romão (2013) claim that some of
the advantages of the BSC process can also be interpreted as disadvantages. As
with any framework, there are pros and cons. What the analysis above does
highlight is that the different perspectives give management an alternative to pure
financial performance analysis.
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However, in the absence of an improved model, organisations and particularly its key
decision-makers need to understand the motivation behind the process and what
specific outputs it wants to measure. It was Drury (2012) who made the point that the
perspectives were not cast in concrete, indicating the option to adapt the model.
Additionally, Kanji (2002) says that the BSC can be improved by utilising principles of
total quality management and other key indicators and should not be restricted to the
four perspectives. According to Lueg and Carvalho (2013), some organisations have
adopted a versatile approach by adapting the Key Performance Indicators to their
specific needs.
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Finally, in the absence of an improved model (nationally and internationally) and with
the emergence of new business models, rapid advances in technology, and the
impact of social media on business, to name a few, organisations should
complement the BSC with other models.

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References
Atrill, P. and McLaney, E. (2015) Management Accounting for Decision Makers. 8th
edn. Harlow: Pearson Education Ltd.

Bontis, N., Dragonetti, N.C., Jacobsen, K. and Roos, G. (1999) ‘The knowledge
toolbox: A review of the tools available to measure and manage intangible
resources’, European Management Journal, 17(4), pp. 391-403.

Drury, C. (2012) Management and Cost Accounting. 8th edn. Hampshire: Cengage
Learning.

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Gomes, J. and Romão, M. (2013) ‘How benefits management helps balanced

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scorecard to deal with business dynamic environments’, Tourism & Management
Studies, 9(1), pp. 129-138.
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Hudson, M., Smart, A. and Bourne, M. (2001) ‘Theory and practice in SME
performance measurement systems’, International Journal of Operations and
Production. Management, 21(8), pp. 1096-1115.
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Kaplan, R.S. and Norton, D.P. (2000) The Strategy-Focused Organization. Boston:
Harvard Business School Press.

Kanji, G. K. (2002) ‘Business excellence: Make it happen’, Total Quality

Management, 13(8), pp. 1115-1124.
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Landry, S.P., Wai Yee, C.C. and Jalbert, T. (2002) ‘Balanced scorecard for
multinationals’, The Journal of Corporate Accounting & Finance, 13(6), pp. 31-40.

Lueg, R. and Carvalho, A. (2013) ‘When one size does not fit at all: A literature
review on the modifications of the balanced scorecard’, Problems and Perspectives
in Management, 11(3), pp. 86-94.

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Malina, M.A. and Selto, F.H. (2001) ‘Communicating and controlling strategy: an
empirical study of the effectiveness of the balanced scorecard’, Journal of
Management Accounting Research, 243(3), pp. 935-982.

Maltz, A.C., Shenhar, A.J. and Reilly, R.R. (2003) ‘Beyond the balanced scorecard:
Refining the search for organizational success measures’, Long Range Planning, 36,
pp. 187-204.

Mooraj, S., Oyon, D. and Hostettler, D. (1999) ‘The balanced scorecard: a necessary
good or an unnecessary evil?’, European Management Journal, 17(5), pp. 481-491.
doi.org/10.1016/S0263-2373(99)00034-1

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Neely, A. (1998) Measuring business performance: Why what and how. London:
Economist Books.
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Neely, A. and Kennerley, M. (2003) ‘Measuring performance in a changing
environment’, International Journal of Operations Management and Production
Management, 23(2), pp.213-229.
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Nørrekit, H. (2000) ‘The balance on the balanced scorecard – a critical analysis of
some of its assumptions’, Management Accounting Research, 11(1), pp. 65-88.

Otley, D. (1999) ‘Performance management: a framework for management control

systems research’, Management Accounting Research,10, pp. 363-382.
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Perramon, J., Rocafortb, A., Bagur-Femeniasa, L. and Llachcl, J. (2016) ‘Learning to

create value through the “balanced scorecard’’ model: an empirical study”’, Total
Quality Management & Business Excellence, 27(9/10), pp. 1121-1139. doi:
10.1080/14783363.2015.1060853.

Porter, M.E. (1992) ‘Capital Disadvantage: America’s Failing Capital Investment

System’, Harvard Business Review, 70(5), pp.65-82.

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Platts, K.W. and Tan, K.H. (2002) ‘Designing linked performance measures - A
connectance based approach’, Seminar on Production Economics, 2, pp. 367-373

Roos, J., Roos, G., Dragonetti, N.C. and Edvinsson, L. (1997) Intellectual capital:
Navigating in the new business landscape. Houndsmills: Macmillan.

Smith, M. (1998) ‘Measuring organizational effectiveness’, Management Accounting,

pp. 34-36.

Susilawati, A., Tan, J., Bell, D. and Sarwa, M. (2013) ‘Develop a framework of
performance measurement and improvement system for lean manufacturing activity’,

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International Journal of Lean Thinking, pp. 51-64.

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Voelpel, S., Leibold, M., Eckhoff, R. and Davenport, T. (2005) ‘The Tyranny of the
Balanced Scorecard in the Innovation Economy’, Paper presented at 4th
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International Critical Management Studies Conference - Intellectual Capital Stream.
Cambridge University.

Wiersma, E. (2009) ‘For which purposes do managers use the balanced scorecard?’,
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Management Accounting Research, 20, pp. 239–251.

Yeniyurt, S. (2003) ‘A literature review and integrative performance measurement

framework for multinational companies’, Marketing Intelligence & Planning, 21(3,) pp.
134-142.
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1. Introduction
When appraising an investment proposal, the appraiser first needs to ensure that the
investment supports the organisation’s long-term strategic objectives and that the
inflows will both repay the initial investment and yield an adequate profit/surplus (in
excess of inflation or other financial instrument returns). This is in addition to
compensating the company for taking the risk. Especially when making a significant
financial commitment to a new project the following factors have to be considered; (i)
the availability, source and cost of capital, (ii) timespan of the project, (iii) capital
allowance and taxation, (iv) government grants, (v) the residual value of the asset
and (vi) the results of sensitivity analysis.

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2. Financing

OP
The manager must ensure that the source and type of finance complement the
needs of the investment and the financial objectives of the organisation. Some of the
key questions that need to be asked include; whether the method of funding and the
TC
terms of the loan match the reason for the finance, the source of the finance, is it a
combination of debt and equity, what is the debt to equity ratio and has it been
critically analysed, the investment’s impact on the company’s cash flow and have all
finance options been critically explored? While interest on the debt is tax deductible,
NO
the appraiser needs to ensure that sufficient cash flow will be generated to finance
the debt timeously. If satisfied with the answers, proceed with the appraisal process.

3. Cash Flows
Another key factor in an investment appraisal decision is to confirm that the cash
DO

flows used, are directly attributable to the investment. Additionally, they must be real
and not accounting cash flows so as not to distort the returns, and also incremental,
hence determining the impact of the investment on cash flows. Finally, there should
be a scenario to note the impact on cash flow, should the investment proposal be
rejected.

4. Net Present Value and Internal Rate of Return

There is much debate between to use of net present value (NPV) and internal rate of
return (IRR) when evaluating the profits from an investment project. While both take

19
into account the time value of money (TVM) and are similar, there are marked
differences.

Y
OP
TC
NO
DO

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NPV, or discounted cash flow, is used to calculate the present value of the cash
flows based on the opportunity cost of capital and derives the value which will be
added to the wealth of the shareholders if that project is undertaken. IRR or
economic rate of return ignores the required rate of return and is used to determines
the rate at which the project breaks even. And, the concept of TVM is based on the
idea that, money which is available at the present time is worth more than the same
amount in the future due to its potential earning capacity.

The criticism against IRR, is that it assumes that future cash flows from a project are
reinvested at the IRR, and not at not at the cost of capital, and therefore is not as
accurate as NPV. Financial analysists suggest a modified internal rate of return,

Y
which assumes that positive cash flows are reinvested at the company’s cost of

OP
capital and the initial outlays are financed at the company’s financing cost, hence
reflecting the cost and profitability of the project more accurately.
TC
When comparing the two methods, it is important to note that NPV presents a
monetary return that will indicate how much value the project will create for the
company whereas IRR provides a percentage return and does inform on the
monetary return, hence the size and scale of the project is not obvious.
NO
The appraiser must also ensure that the NPV value has been compared with an
alternative equal risk financial investment (opportunity costs) and that the NPV yields
a greater return. This will help the manager to weigh up the wisdom of the
investment.
DO

A positive NPV is usually a sign that the investment is profitable and worth perusing,
that is on the assumption that the estimated cash flows are reasonably accurate. If it
is marginally positive, then question the discount rate (perhaps it is too high) and if
NPV is negative, consider making adjustments before abandoning the investment.

5. Payback Period
Another popular appraisal tool is the payback period (PBP). However, it ignores the
TVM and the profitability of the project including cash flows after the PBP. While it is

20
more suited to smaller investments, it has the advantage of providing a snapshot of
how long it will take the investment to repay in cash terms, the initial capital outlay.

Y
OP
TC
NO
DO

20
6. Sensitivity Analysis
As mentioned above, much of the calculation is based on assumption and best
thinking, which would translate to investments being subject to a degree of
uncertainty and possible failure. Hence to mitigate some of these uncertainties a
sensitivity analysis should be used to better analyse the project before making the
investment. Sensitivity analysis involves changing the critical variables in a
calculation to see the impact it would have on the project's finances. Especially when
an investment is substantial and has a long-time span, these variables should be
viewed at company (operating costs, revenue) country, (GDP, inflation, exchange
rate, interest rates) and business sector level. Different scenarios at these levels will
not only add to the credibility of the investment return but present different

Y
perspectives to mitigate the risks that the project could be exposed to. The

OP
appraising manager needs to have a holistic understanding of the assumptions and
variables as they may be linked and since only one assumption/variable at a time
can be tested.
TC
7. Conclusion
After having critically analysed the inputs and outputs of these capital investment
tools including the sensitivity analysis and risk assessment and confirming that the
NO
investment is aligned to the organisation’s strategy and financial objectives, the
manager will be in a position to make a decision. Finally, the question that the
investment appraiser needs to ask is whether any of the decisions are being
influenced by remuneration performance measures. If the answer is no, then one
can safely assume that a financially informed decision will be made.
DO

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