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Ins …Ahmed H…..Production Engineering (MSc)…17/01/2014 0

Chapter Four: Enterprise Finance Management

Objectives

After studying this unit, you will be able to:

 To familiarize the student with the concept of finance

 To describe the managerial finance function

 To discuss the sources of finance and concept of financial statement

 To understand the concept of capital budgeting techniques like

payback period, break even analysis and net present value.
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Finance definition: what is finance? 1
 Finance is the science and art of managing
money which includes activities like
investing, borrowing, lending, budgeting,
saving and forecasting in order to achieve
the appropriate firm objectives
 Basically, finance represents money
management and the process of acquiring
needed fund
 Faineance can be covered in wider areas,
it can be seen in different context such as
personal, government and business context.
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1. Personal context 2
 How to earn adequate amount of money
 How much money to spend and save money
 How much to borrow
 How much money to invest money
 Where and when to invest money
2. Government context
 Generating government revenue example by deciding how
much to tax
 Public spending
 Budgeting
 Government debit
 Production and distribution of public goods
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3. Business context 3
➢ Capital budgeting: is the process of decisions making with respect to
investments in fixed assets, that is should a proposed project be accepted or
rejected. And in what fixed assets to invest Example new equipment, new
machinery, patents, building.

➢ Capital structure: how to raise money for the investment

➢ From the owners (equity)
➢ From the creditors as (debt)

➢ working capital management: how to manage the short-term

cash flows
➢ Cash budgeting
➢ Managing current assets …cash received, inventories
➢ Managing current liabilities …
➢ How much to reinvest in the business?
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2. Sources of Debt Financing 5
 Entrepreneurs with a convincing business idea and a good plan
of activities illustrating its potential profitability may qualify for a
loan from a financial institution.
 An established business can usually get a line of credit from a
bank, which it can borrow against.
 Line of credit an arrangement whereby a lender agrees to lend
up to a specific amount of money at a certain interest rate for a
specific period of time.
 Banks look for the 5C’s:
➢ Character-Trait of entrepreneur
➢ Capacity- ability to pay (sufficient +ve cash flow)
➢ Capital (equity>>liability)
➢ Collateral-what things of value they can claim if the business
does not repay its loan
➢ Conditions-all conditions such as: potential for growth, amount
of competition, location, form of ownership…
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Capital budgeting techniques/methods
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 Investment decision are generally called capital
budgeting decisions.
 How do you decide whether you should invest in
project A or project B?
 What is the value of the investment or time value of
money (opportunity cost) Example
 Invest in a bank: bank annual return 8%
 Invest in a project: project annual return 10%
 What is opportunity cost if you invest in a
bank?
 What is opportunity cost if you invest in the
project?
 These are mutually exclusive So, where should you
invest your money?
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 Net Present Value (NPV)
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Calculating NPV
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 Where, k is rate of annual interest (i)

 n is number of years
Steps
1. Calculate the PV value of year 1, 2, 3, 4 and 5.
2. Sum up the PV value of all years
3. NPV = Present values of all cash inflows –present
values of all cash outflows
4. If NPV is positive, accept the project. If not reject
the project.
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Exercises 1 NPV 11
Group work
A sum of $400,000 dollars invested today in an IT
project may give a series of below cash inflows in
future:
➢ $70,000 in year 1
➢ $120,000 in year 2
➢ $140,000 in year 3
➢ $140,000 in year 4
➢ $40,000 in year 5 and
➢ If opportunity cost of capital is 8%. Then should
we accept or reject
➢ If opportunity cost of capital is 15%. Then should
we accept or reject
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Exercises 2 profitability index 14
 A sum of $25,000 invested today in a
project may give a series of cash inflows
in future describes as below:
 $5000 in year 1
 $9000 in year 2
 $10000 in year 3
 $10,000 in year 4
 $3000 in year 5
 If the required rate of return is 12%

 What is the profitability index?

 Should we accept or reject the project?
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Example 1: The ABC company is planning to purchase a
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machine known as machine X. Machine X would cost $25,000 and
would have a useful life of 10 years with zero salvage value. The
expected annual cash inflow of the machine is $10,000.

➢ Compute payback period of machine X and conclude whether or not the

machine would be purchased if the maximum desired payback period of ABC
company is 3 years.

 Solution : Since the annual cash inflow is even in this project, we can simply
divide the initial investment by the annual cash inflow to compute the payback
period. It is shown below:

Payback period =25,000/10,000 = 2.5 𝑦𝑒𝑎𝑟𝑠

 According to payback period analysis, the purchase of machine X is desirable

because it’s payback period is 2.5 years which is shorter than the maximum

payback period of the company.

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 Exercises 3: GROUP WORK 17
Due to increased demand, the management of XYZ Food Company is
considering to purchase a new equipment to increase the production and
revenues. The useful life of the equipment is 10 years and the company’s
maximum desired payback period is 4 years. The inflow and outflow of cash
associated with the new equipment is given below:

➢ Initial cost of equipment: $37,500

➢ Annual cash inflows from Sales: $75,000

➢ Annual cash Outflows :

 Cost of ingredients: $45,000

 Salaries expenses: $13,500

 Maintenance expenses: $1,500

 Compute the payback period of the equipment.

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 Example 2: Assume that you invest $100,000 in a project. A18
year
later you invest another $50,000. From the second year onwards the
net cash you receive is $45,000 per year over a period of five years.
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Exercises 4: Group Work 19
 An industry is considering investment in a project
which cost is $600,000 and cash inflows are
120,000,…140,000…180,000…200,000…250,000.
 Calculate the payback period of the project
 Solutions: use case two

Years(n) Cash flows Cumulative cash flows

0
1
2
3
4
5
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Break-even Analysis 20
➢ One of the most common tools used in evaluating the
economic feasibility of a new enterprise or product is the break-
even analysis.
➢ The break-even point is the point at which revenue is exactly
equal to costs.
➢ At this point, no profit is made and no losses are incurred.
➢ The break-even point can be expressed in terms of unit sales or
dollar sales.
➢ That is, the break-even units indicate the level of sales that are
required to cover costs.
➢ Sales above that number result in profit and sales below that
number result in a loss.
➢ The break-even sales indicates the dollars of gross sales required
to break-even
➢ The break-even is an excellent tool to help quantify the level of
production needed for a new business or a new product.
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 21
Break-even analysis is based on two types of costs:
which are fixed costs and variable costs.
 Fixed costs are overhead-type expenses that are
constant and do not change as the level of
output changes.
 Variable expenses are not constant and do
change with the level of output. Because of this,
variable expenses are often stated on a per unit
basis.
 The fundamental accounting equation
 Profit = Revenues – Costs
 Revenue = SP*units sold
 Costs = FC + VC(units manufactured)
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Uses of break- even analysis 24
 Break-even analysis can be very helpful in the
evaluation of a new venture. In most instances,
success takes time.

 Many new enterprises and products actually

operate at a loss (at a point below break-even) in
the early stages of development.

 Knowing the price or volume necessary to break-

even is critical to evaluating the time-frame in
which losses are permissible.
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The break-even is also an excellent benchmark
by which a company’s short-term goals can be
measured/tracked.
 Break-even analysis mandates that costs be
analyzed. It also keeps a focus on then
connection between production and marketing
 It enables a business organization to:
 Measure profit and loss at different levels of production
and sales
 To predict the effect of changes in price of sales
 To analyze the relationship between fixed cost and
variable cost
 To predict the effect on profitability if changes in cost
and efficiency
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 Exercise 5 26
A small street side cafe offers fresh traditional
coffee to the general public. Total variable costs
per coffee (including coffee beans, water,
firewood, sugar) amount to ETB 1.60 per cup. The
cafe has fixed costs per week of ETB 360.00, being
the rental of the place. The selling price is ETB 4.00.
 Calculate
1. The number of units to break-even
2. Break-even revenue and the profit / loss that
the business will make
3. The diagrammatic presentation of the break –
even analysis.
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 Exercise 6: group work 27
Mr. x sells a product for $10 and it cost $5 to
produce (UVC) and has fixed cost (FC) of
$25,000.
I. How much will he need to sell to break-
even?
II. How much will he need to sell to make a
target profit of $1000?
III. The diagrammatic presentation of the
break – even analysis.
IV. Discuss demerits of Break Even analysis
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Exercises 7: Group work 28
A local livestock producer utilizes compost
waste to develop an organic fertilizer product.
The fertilizer is prepared for retail sale in 50
pound bags. The retail sales price is $5.00 per
bag. The average variable cost per bag is
$2.80 and average annual fixed costs are
$60,000. calculate the number of bags that
must be sold in order to break-even as well as
the total dollar of sales needed to break-even.
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 SUMMRY 29
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