FINANCIAL MANAGEMENT

• BY: MIRZOHID SALIMOV

• LECTURE: 2
 REVISION OF LECTURE 1

• WHAT IS THE PURPOSE OF FINANCIAL MANAGEMENT?

• STATE KEY OBJECTIVES OF BUSINESS ENTITIES AND THE
WAYS OF MEASURING THE ACHIEVEMENT OF THOSE
OBJECTIVES.
• STATE KEY OBJECTIVES OF NOT-FOR-PROFIT
ORGANISATIONS AND THE WAYS OF ACHIEVEMENT OF
THOSE OBJECTIVES.
 INVESTMENT APPRAISAL VS PERFORMANCE APPRAISAL

INVESTMENT APPRAISAL IS DIFFERENT THAN PERFORMANCE APPRAISAL. KEY DIFFERENCES:

Investment Performance
appraisal appraisal
Time period Over the life of A single year
the project
When? Future Past

Use Decision making Assessment,

control and reward
 LECTURE 2: INVESTMENT APPRAISAL TECHNIQUES
Performance Simple (basic) Discounted cash
appraisal techniques flow techniques
ROCE ARR (ROCE) NPV
ROE Payback period Discounted payback
period
EPS IRR
DPS
Total shareholder
return
 CAPITAL BUDGETING
CAPITAL BUDGETING IS THE PROCESS OF APPRAISING AND DETERMINING THE
LONG-TERM FINANCIAL PROFITABILITY OF ANY INVESTMENT MADE ON
BEHALF OF THE ORGANIZATION. PUT IN SIMPLER TERMS, CAPITAL BUDGETING
IS HOW BUSINESSES DECIDE WHAT TO INVEST IN.
 USAGE OF RELEVANT COST IN INVESTMENT APPRAISAL

Relevant for decision Non relevant for decision

Cash items only Non cash items (e.g. depreciation)
Future related costs and income Sunk cost (past costs)
Incremental costs and income Committed costs
Opportunity cost Apportioned costs
Taxation (tax on the new project)
Capital allowance
Working capital
 RELEVANT COST OF MATERIALS
A company is considering making a new product which requires several types of raw material:

Units in inventory Units Additional information

required
Material X Nil 50 Current purchase price is $8/unit.
Material Y 100 units purchased 150 Current purchase price is $14/unit. The
for $10/unit material has no use in the company other
than for the project under consideration.
Units in inventory can be sold for
$12/unit.
Material Z 50 purchased 120 Current purchase price is $22/unit. The
for $20/unit material is regularly used in current
manufacturing operations.
 RELEVANT COST OF LABOUR
A company has a new project which requires the following three types of labour:
Hours Additional information
required
Unskilled 12,000 Paid at $8 per hour and existing staff are fully utilised. The company will
hire new staff to meet this additional demand.

Semi-skilled 2,000 Paid at $12 per hour. These employees are difficult to recruit and the
company retains a number of permanently employed staff, even if there
is no work to do. There is currently 800 hours of idle time available and
any additional hours would be fulfilled by temporary staff that would be
paid at $14/hour.

Skilled 8,000 Paid at $15 per hour. There is a severe shortage of employees with these
skills and the only way that this labour can be provided for the new
project would be for the company to move employees away from making
Product X. A unit of Product X takes 4 hours to make and makes a
contribution of $24/unit.
 PAYBACK PERIOD- TIME REQUIRED TO RECOVER
THE INITIAL INVESTMENT
Advantages Disadvantages
Simple to use and understand Does not consider time value of
money
Considers cash flows not Does not consider the whole life of
accounting profits the project
Indirectly avoids risk, by choosing It does not focus on shareholders’
investments with shorty payback wealth maximisation
period
It helps the company minimise risk Does not consider the size of the
and maximise liquidity projects
ARR (ROCE)

Benefits
Simple to use and understand
Takes into account of the whole
life of the project
ARR
Drawbacks
Does not consider the time value
of the money
Uses accounting profit not cash, so
can be manipulated
It does not take into account of
risk and uncertainty of future
profits
 NET PRESENT VALUE (NPV)
THE CUMULATIVE PRESENT VALUE OF FUTURE CASH FLOWS IS THE MAXIMUM
THAT THE COMPANY WOULD BE PREPARED TO INVEST IN THE PROJECT; THE
VALUE TO INVESTORS OF THE PROJECT.
IF INVESTMENT < NPV, THEN ACCEPTING THE PROJECT WILL INCREASE THE
SHAREHOLDERS’ WEALTH.
IF INVESTMENT >NPV, THEN ACCEPTING THE PROJECT WILL NOT INCREASE THE
SHAREHOLDERS’ WEALTH, THAT’S WHY NOT ACCEPTABLE ON FINANCIAL
GROUNDS UNLESS IT IS STRATEGICALLY IMPORTANT.
 ASSUMPTIONS USED IN DISCOUNTING

UNLESS THE EXAMINER TELLS YOU OTHERWISE, THE

FOLLOWING ASSUMPTIONS ARE MADE ABOUT CASH FLOWS
WHEN CALCULATING THE NET PRESENT VALUE:
• ALL CASH FLOWS OCCUR AT THE START OR END OF A YEAR
• INITIAL INVESTMENTS OCCUR AT YEAR 0 (TODAY)
• OTHER CASH FLOWS START ONE YEAR AFTER THAT (YEAR 1).
 ADVANTAGES AND DISADVANTAGES OF NPV
Advantages Disadvantages
considers the time value of money It is relatively complex

is an absolute measure of return It is difficult to explain to non

finance managers
is based on cash flows, not profits It requires knowledge of the cost of
capital

considers the whole life of the

project
should lead to maximisation of
shareholder wealth
 INTERNAL RATE OF RETURN (IRR)
THE IRR REPRESENTS THE DISCOUNT RATE AT WHICH THE NPV OF AN
INVESTMENT IS ZERO. AS SUCH, IT REPRESENTS A BREAKEVEN COST OF
CAPITAL.
DECISION RULE:
- PROJECTS SHOULD BE ACCEPTED IF THEIR IRR IS GREATER THAN THE COST
OF CAPITAL.
FOR THE EXAM, THE SIMPLER IRR FUNCTION WILL BE ADEQUATE.
TO CALCULATE THE IRR FOR THE DATA ABOVE, THE FORMULA WOULD BE AS
FOLLOWS:
=IRR(A2:E2)

Strength
considers the time value of money
is a percentage and therefore easily
understood in many cases
uses cash flows not profits
considers the whole life of the project
means a firm selecting projects where the
IRR exceeds the cost of capital should
increase shareholders' wealth
IRR
Limitations
It is fairly complicated to calculate.
It is not a measure of absolute
profitability. So ignores the size of the
investment
Non-conventional cash flows may give rise
to multiple IRRs, which means the
interpolation method can't be used.
Interpolation only provides an estimate and
an accurate estimate requires the use of a
spreadsheet programme.
Contains an inherent assumption that cash
returned from the project will be re-
invested at the project’s IRR, which may be
unrealistic.