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- 1. PFS : FINANCIAL ASPECT – PROJECT FINANCING AND EVALUATION Chapter 26
- 2. Determining Funds Requirements and Profitability Projected Statement of Comprehensive Income Operating cost ratios (i.e. COS, SAE, to Sale) Projected Statement of Financial Position Projected Cash Flow Statement - to evaluate the economic viability of the project and its financial requirements, the following statement may be prepared
- 3. Sources of Financing I. Equity II. Loan Financing a) Short-term loans b) Long-term loans
- 4. Number of Local Calls MonthlyBasic TelephoneBill Total fixed costs remain unchanged when activity changes. Your monthly basic telephone bill probably does not change when you make more local calls. Total Fixed Cost
- 5. Number of Local Calls MonthlyBasicTelephone BillperLocalCall Fixed costs per unit decline as activity increases. Your average cost per local call decreases as more local calls are made. Total Fixed Cost
- 6. Minutes Talked TotalLongDistance TelephoneBill Total variable costs change when activity changes. Your total long distance telephone bill is based on how many minutes you talk. Total Fixed Cost
- 7. Minutes Talked PerMinute TelephoneCharge Variable costs per unit do not change as activity increases. The cost per long distance minute talked is constant. For example, 10 cents per minute. Variable Cost Per Unit
- 8. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Changes as activity level changes. Remains the same over wide ranges of activity. Fixed Remains the same even when activity level changes. Dereases as activity level increases. Cost Behavior Summary
- 9. Mixed costs contain a fixed portion that is incurred even when facility is unused, and a variable portion that increases with usage. Example: monthly electric utility charge Fixed service fee Variable charge per kilowatt hour used Mixed Costs
- 10. Variable Utility Charge Activity (Kilowatt Hours) TotalUtilityCost Fixed Monthly Utility Charge Slope is variable cost per unit of activity. Mixed Costs
- 11. The break-even point (expressed in units of product or dollars of sales) is the unique sales level at which a company neither earns a profit nor incurs a loss. Computing Break-Even Point
- 12. Prior to calculating the BEP, the following assumptions should be observed: 1. Production costs are function of the volume of production or of sales (e.g. utilization of equipment) 2. Volume of production equals volume of sales 3. Fixed operating costs are the same for every volume of production 4. Variable unit cost vary in proportion to the volume of production 5. Unit sale price for a product or product mix are the same for all levels of output (sales) overtime. The sales value is therefore a linear function of the units sales prices and the quantity sold
- 13. Prior to calculating the BEP, the following assumptions should be observed: 6. Data from normal year of operation should be taken 7. The level of unit sale prices, variables and fixed operating costs remain constant 8. Single product is manufactured or, if several similar ones are produced, the mix should be convertible into a single product 9. Product mix should remain the same overtime
- 14. Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue. Total Unit Sales Revenue (2,000 units) 100,000$ 50$ Less: Variable costs 60,000 30 Contribution margin 40,000$ 20$ Less: Fixed costs 30,000 Operating income 10,000$ Computing Break-Even Point
- 15. How much contribution margin must this company have to cover its fixed costs (break even)? Total Unit Sales Revenue (2,000 units) 100,000$ 50$ Less: Variable costs 60,000 30 Contribution margin 40,000$ 20$ Less: Fixed costs 30,000 Operating income 10,000$ Computing Break-Even Point
- 16. How many units must this company sell to cover its fixed costs (break even)? Total Unit Sales Revenue (2,000 units) 100,000$ 50$ Less: Variable costs 60,000 30 Contribution margin 40,000$ 20$ Less: Fixed costs 30,000 Operating income 10,000$ Computing Break-Even Point
- 17. We have just seen one of the basic CVP relationships – the break-even computation. Break-even point in units = Fixed costs Contribution margin per unit Unit sales price less unit variable cost ($20 in previous example) Formula for Computing Break-Even Sales (in Units)
- 18. The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed costs Contribution margin ratio Unit sales price Unit variable cost Formula for Computing Break-Even Sales (in Dollars)
- 19. ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? a. 100,000 units b. 40,000 units c. 200,000 units d. 66,667 units Computing Break-Even Sales Question 1
- 20. Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200,000; unit sales price is $5.00; and unit variable cost is $3.00. a. $200,000 b. $300,000 c. $400,000 d. $500,000 Computing Break-Even Sales Question 2
- 21. Volume in Units CostsandRevenue inDollars Revenue Starting at the origin, draw the total revenue line with a slope equal to the unit sales price. Total fixed cost Total fixed cost extends horizontally from the vertical axis. Preparing a CVP Graph
- 22. Total cost Volume in Units CostsandRevenue inDollars Total fixed cost Break-even Point Profit Loss Draw the total cost line with a slope equal to the unit variable cost. Revenue Preparing a CVP Graph
- 23. Break-even formulas may be adjusted to show the sales volume needed to earn any amount of operating income. Unit sales = Fixed costs + Target income Contribution margin per unit Dollar sales = Fixed costs + Target income Contribution margin ratio Computing Sales Needed to Achieve Target Operating Income
- 24. ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn operating income of $40,000? a. 100,000 units b. 120,000 units c. 80,000 units d. 200,000 units Computing Sales Needed to Achieve Target Operating Income
- 25. Margin of safety is the amount by which sales may decline before reaching break-even sales: Margin of safety provides a quick means of estimating operating income at any level of sales: Margin of safety = Actual sales - Break-even sales Operating Margin Contribution Income of safety margin ratio= × What is our Margin of Safety?
- 26. Oxco’s contribution margin ratio is 40 percent. If sales are $100,000 and break-even sales are $80,000, what is operating income? Operating Margin Contribution Income of safety margin ratio = × Operating Income = $20,000 × .40 = $8,000 What is our Margin of Safety?
- 27. Once break-even is reached, every additional dollar of contribution margin becomes operating income: Oxco expects sales to increase by $15,000. How much will operating income increase? Change in operating income = $15,000 × .40 = $6,000 Change in Change in Contribution operating income sales volume margin ratio= × What Change in Operating Income Do We Anticipate?
- 28. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-28 Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1. Capital Budgeting Techniques Chapter Problem
- 29. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-29 Capital Budgeting Techniques (cont.)
- 30. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-30 Capital Budgeting Techniques (cont.)
- 31. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-31 Payback Period The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. The maximum acceptable payback period is determined by management. If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project.
- 32. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-32 Pros and Cons of Payback Periods The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. It is simple, intuitive, and considers cash flows rather than accounting profits. It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.
- 33. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-33 Pros and Cons of Payback Periods (cont.) One major weakness of the payback method is that the appropriate payback period is a subjectively determined number. It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value. Thus, payback fails to fully consider the time value of money.
- 34. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-34 Pros and Cons of Payback Periods (cont.)
- 35. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-35 Pros and Cons of Payback Periods (cont.)
- 36. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-36 Net Present Value (NPV) Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.
- 37. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-37 Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent Net Present Value (NPV) (cont.) Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.
- 38. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-38 Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 9.2 Net Present Value (NPV) (cont.)
- 39. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-39 Net Present Value (NPV) (cont.)
- 40. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-40 Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return.
- 41. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-41 Decision Criteria If IRR > k, accept the project If IRR < k, reject the project If IRR = k, technically indifferent Internal Rate of Return (IRR) (cont.) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return.
- 42. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-42 Internal Rate of Return (IRR) (cont.)
- 43. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-43 Conflicting Rankings Conflicting rankings between two or more projects using NPV and IRR sometimes occurs because of differences in the timing and magnitude of cash flows. This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project. NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.
- 44. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-44 A project requiring a $170,000 initial investment is expected to provide cash inflows of $52,000, $78,000 and $100,000. The NPV of the project at 10% is $16,867 and it’s IRR is 15%. Table 9.5 on the following slide demonstrates the calculation of the project’s future value at the end of it’s 3-year life, assuming both a 10% (cost of capital) and 15% (IRR) interest rate. Conflicting Rankings (cont.)
- 45. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-45 Conflicting Rankings (cont.)
- 46. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-46 If the future value in each case in Table 9.5 were viewed as the return received 3 years from today from the $170,000 investment, then the cash flows would be those given in Table 9.6 on the following slide. Conflicting Rankings (cont.)
- 47. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-47 Conflicting Rankings (cont.)
- 48. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-48 Bennett Company’s projects A and B were found to have conflicting rankings at the firm’s 10% cost of capital as depicted in Table 9.4. If we review the project’s cash inflow pattern as presented in Table 9.1 and Figure 9.1, we see that although the projects require similar investments, they have dissimilar cash flow patterns. Table 9.7 on the following slide indicates that project B, which has higher early-year cash inflows than project A, would be preferred over project A at higher discount rates. Conflicting Rankings (cont.)
- 49. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-49 Conflicting Rankings (cont.)
- 50. Copyright © 2006 Pearson Addison- Wesley. All rights reserved. 9-50 Which Approach is Better? On a purely theoretical basis, NPV is the better approach because: NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR. Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return.
- 52. Operational audits - also known as management audits and performance audits, are conducted to evaluate the effectiveness and/or efficiency of operations.
- 53. Effectiveness refers to the accomplishment of objectives Efficiency is defined as reducing costs without reducing effectiveness Effectiveness Versus Efficiency
- 54. Economy refers to an entity's success in maximizing the use of its limited resources to achieve its goals and objectives.
- 55. Types of Inefficiency Example Acquisition of goods and services is too costly Bids for purchases of materials are not required Raw materials are not available when needed An assembly line was shut down for lack of materials A duplication of effort by employees exists Production and accounting keep identical records Effectiveness Versus Efficiency
- 56. Work is done that serves no purpose Vendors’ invoices and receiving reports are filed without being used There are too many employees Office work could be done with one less assistant Types of Inefficiency Example Effectiveness Versus Efficiency
- 59. Types of Operational Audits There are three broad categories of operational audits: FUNCTIONAL, ORGANIZATIONAL, and SPECIAL ASSIGNMENTS. In each case, part of the audit is likely to concern evaluating internal controls for efficiency and effectiveness.
- 62. Who Performs Operational Audit? - Among the activities of the internal auditor than can aptly be construed as part of operations audit are: • Reviewing the reliability and integrity of financial and operating information and the means use to identify, measure, classify, and report such information. • Reviewing the internal control structure established to ensure compliance with those policies, plans, procedures, laws, and regulations which could have significant impact on operations and reports and should determine whether the organization is In compliance. • Reviewing the means of safeguarding the assets and, as appropriate, verify the existence of such assets. • Appraising the economy and efficiency with which resources are employed. • Reviewing operations or programs to ascertain whether the results are consistent with established objectives and goals and whether the operations or programs are being carried out as planned.
- 63. CPA firms Government auditors Internal auditors Who Performs Operational Audits
- 64. The two most important qualities for an operational auditor are: Independence and Competence of Operational Auditors Independence Competence
- 65. Specific Criteria Were all plant layouts approved by home office engineering at the time of original design? Has home office engineering done a reevaluation study of plant layout in the past five years? Questions that might be used to evaluate plant layouts:
- 66. Specific Criteria Is each piece of equipment operating at least 60 percent of capacity for three months or more each year? Does layout facilitate the movement of new materials to the production floor? Does layout facilitate the production of finished goods?
- 67. Specific Criteria Does layout facilitate the movement of finished goods to distribution centers? Does the plant layout effectively use existing equipment? Is the safety of employees endangered by the plant layout?
- 68. Sources of Criteria Historical performance Benchmarking Engineered standards Discussion and agreement
- 69. Phases in Operational Auditing Planning Evidence accumulation and evaluation Reporting and follow up
- 70. Planning Staffing Understand internal control Background information Decide on appropriate evidence Scope of engagement
- 71. Evidence Accumulation and Evaluation Documentation Client inquiry Analytical procedures Observation
- 72. Reporting and Follow Up 1. In operational audits, the report is usually sent only to management Two major differences in operational and financial auditing reports: 2. Tailoring of each report is required in operational audits
- 73. Examples of Operational Audit Findings Outside janitorial firm saves $160,000 Use the right tool Computer programs save manual labor