Ignou Mba Ms - 04 Solved Assignments July 2011-Restricted

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IGNOU MBA MS - 04 Solved Assignments July 2011

Course Code : MS - 04

Course Title : Accounting and Finance for Managers

Assignment Code : MS-04/SEM - I /2011

Coverage : All Blocks

Note: Answer all the questions and send them to the Coordinator of the Study Centre you are

attached with.

1. Discuss and explain the relevance of the following accounting conceptsa) Business entityb) Money measurementc) Continuityd) Coste) Accrualf) Conservatismg) Materialityh) Consistencyi) Periodicity

Solution: FUNDAMENTAL CONCEPTS OF ACCOUNTINGAccounting is the language of business and it is used to communicate financial information. Inorder for that information to make sense, accounting is based on 12 fundamental concepts.These fundamental concepts then form the basis for all of the Generally Accepted AccountingPrinciples (GAAP). By using these concepts as the foundation, readers of financial statementsand other accounting information do not need to make assumptions about what the numbersmean.

For instance, the difference between reading that a truck has a value of $9000 on the balancesheet and understanding what that $9000 represents is huge. Can you turn around and sell thetruck for $9000? If you had to buy the truck today, would you pay $9000? Or, perhaps theoriginal purchase price of the truck was $9000. All of these assumptions lead to very differentevaluations of the worth of that asset and how it contributes to the company’s financial situation.

For this reason it is imperative to know and understand the eleven key concepts.

a)Business equitity:


When starting or expanding a business, many owners wonder if they should form a business entity and, if so, which one they shoulduse. There is a wide variety of information and "pitches" being made on the Internet regarding the benefits of certain entities versusothers. When you cut through the flak, however, the primary reason for forming a business entity is to create protection frompersonal liability arising from your business activities.It is well established that up to eighty percent of businesses will fail in their first two years. Many of these businesses, and probablyyours, carry a high level of personal risk for their owners. If you are not using the correct entity for your particular business, you aregoing to be personally liable if the business fails. Do you want to expose your home, car and other assets? How about the assetsowned by your spouse or their paycheck from a regular job? Selecting the correct entity for your business prevents such nightmaresfrom occurring. More importantly, you can sleep at night knowing that the worst thing that can happen is losing your investment inthe business, not your home.

Business StructuresThere are a number of business structure options that exist in the modern corporate world. Following is a short explanation of themost common business structures.CorporationsCorporations come in two basic forms, a "C" corporation and an "S" corporation. There are a variety of differences, but the centralone is a tax issue. Briefly put, "C" corporations are taxed on their revenues and you are then taxed separately on any money youtake out of the corporation. An "S" corporation "passes through" all taxes to the shareholders with the information being reported onyour personal tax returns.Regardless of the tax classification, a corporation is considered an independent entity from a legal standpoint. This independentstatus acts as a shield between the activities of the business and your personal assets. As a practical example, Kmart recently filedbankruptcy. The individual shareholders were not required to file bankruptcy and lost nothing more than their investment in the stockof the company. Forming and using a corporation for your business activities will have the same effect, to wit, your personal assetswill not be wiped out if the business fails.Limited Liability CompanyA limited liability company, or "LLC" as it is better known, was a very popular entity choice in the early 1990s. LLCs are similar tocorporations, but can be taxed as a partnership. In California, the LLC can have either one owner or two. Regardless of the number,these owners carry the legal title of "member." The LLC provides a shield for your personal assets just like a corporation.PartnershipsIn my opinion, it is better to have died a small child then be in a partnership. Unfortunately, many business owners form partnershipsand don't even know it. This occurs when they go into business with another person. If no business entity is formed, the lawconsiders the business to be a partnership and treats it accordingly.Partnerships are dangerous for one primary reason: a partnership does not provide any protection from liability and, in many ways,invites personal liability. Under well-established law, most partnerships are classified as "general". This simply means that all thepartners are contributing to the administration and running of the partnership business. This classification can have grisly results.In a general partnership, each partner is jointly liable for the debts of any other partner arising from the business. For instance, youand your partner go to a business dinner with a client. Your partner has a drink and then a few more. They then get into an accidenton the way home. Each of the partners is liable for the damages claimed by the injured people. That means YOU! Even if you werenot in the car, did not rent the car, never saw the car and don't drink!Partnerships are a recipe for disaster. Stay away from them whenever possible.Limited PartnershipsLimited Partnerships ["LP"] are perhaps the most misunderstood business entity. A limited partnership is similar to a generalpartnership, but allows a number of the partners to limit their liability by being limited partners. It is critical to note that these limitedpartners are restricted to simply making a capital [cash, content, equipment] contribution to the partnership. They cannot be involvedin actively running the business. If they are, they lose any protection from partnership debts. Many limited partnerships enddisastrously. If you are married to the idea of pursuing a limited partnership, you must do so in combination with corporations. Thatparticular strategy is well beyond the scope of this article, but feels free to contact me if you wish to pursue a limited partnership.Business owners should protect themselves by forming entities for their business activities. The real issue is identifying the structurethat is best for your particular situation.

B) Money Measurement


MONEY MEASUREMENT CONCEPT

Only financial transactions are recorded

Non-financial data are ignored

Qualitative information are ignored

Money measure at the time of transaction, no allowance for changing price level

This concept ignores important economic information

By now, knowing this concept, you should realize that the financial statements will not generatequalitative, economic and non financial information. At times, this limitation might pose a disadvantage tothe users of the financial statement like the investors, funds managers, suppliers and others.

Illustration No.1:Say if you are an investor who is interested in purchasing over a company who own a factory. In thecompany’s financial statement, do you think you are able to see such statistics like consumer price index,number of loyal customers, industrial output, the factory’s productivity ratio, factory staff turnover rate,number of shift, wastage % , and so on ?The answer will be no as this concept deals with resources and obligations that can be measured andquantified into financial terms!

Relevance ofMonetary

measurement

Accountants do not account for items unless they can be quantified in monetary terms. Itemsthat are not accounted for (unless someone is prepared to pay something for them) include

things like workforce skill, morale, market leadership, brand recognition, quality ofmanagement etc.

C) Countinuity

The COUNTINUITY influences the economic value of assets and in many cases, the values or maturity ofliabilities, especially when the extinction of BODY has determined period, intended or expected.

The observance of the principle of COUNTINUITY is essential to the correct application of the principle ofJURISDICTION the effect of linking directly to quantify the components property & training of the outcomeand to be as important to assess the ability of future generation of result.

These rules, concepts or principles aimed at a uniform accounting treatment & serve as a guide for theaudit to examine the quality of accounting reports. The basic structure of accounting acknowledge theneed to priories these concepts called them of these postulates: Aliceerces, or Pillers basis of accounting


Therefore, the authorities considered a continuing enterprise, operating in continuity.

Based on continuity, the company has major investment, build building, technology purchases, contractsetc. funding.

The continuity as a basic principle of accounting, contributing remarkably to the monetary valuation of theassets of the company and consequently thereby generating all other principles of Opportunity,Registration of the Original value, Update of monetary, Jurisdiction and the of prudence, that they areintrinsically linked to the entity and its continuity or if it should detect the impossibility of continuing theventure, the discontinuity through data revealing, evidence, such as in losses, court settlement so.

D) Cost concept :

According to the cost concept of accounting, business transactions should be recorded at cost. The term

cost means the sacrifice that one makes for purchase of any goods or services.

In addition, it states that cost should the basis of future transactions. It may be noted that depreciation too

is provided on permanent assets on the basis of the cost. Thus the profit/loss made on the sale of the

asset will be calculated on the basis of cost.

E) Accrual

The most commonly used accounting method, which reports income when earned andexpenses when incurred, as opposed to cash basis accounting, which reports income when


received and expenses when paid. Under the accrual method, companies do have somediscretion as to when income and expenses are recognized, but there are rules governing therecognition. In addition, companies are required to make prudent estimates against revenuesthat are recorded but may not be received, called a bad debt expense.

F) ConservatismWith this convention, accounts recognise transactions (and any profits arising from them) at the point of sale ortransfer of legal ownership - rather than just when cash actually changes hands. For example, a company that makesa sale to a customer can recognise that sale when the transaction is legal - at the point of contract. The actualpayment due from the customer may not arise until several weeks (or months) later - if the customer has beengranted some credit terms

g) Materiality:

An important convention. As we can see from the application of accounting standards and accounting policies, thepreparation of accounts involves a high degree of judgement. Where decisions are required about theappropriateness of a particular accounting judgement, the "materiality" convention suggests that this should only bean issue if the judgement is "significant" or "material" to a user of the accounts. The concept of "materiality" is animportant issue for auditors of financial accounts.

h) Consistency:

Transactions and valuation methods are treated the same way from year to year, or period to period. Users ofaccounts can, therefore, make more meaningful comparisons of financial performance from year to year. Whereaccounting policies are changed, companies are required to disclose this fact and explain the impact of any change.

J) PERIODICITY

THE PERIODICITY ASSUMPTION: Business activity is fluid. Revenue and expense generatingactivities are in constant motion. Just because it is time to turn a page on a calendar does not mean thatall business activity ceases. But, for purposes of measuring performance, it is necessary to "draw a linein the sand of time." A periodicity assumption is made that business activity can be divided intomeasurement intervals, such as months, quarters, and years.

ACCOUNTING IMPLICATIONS: Accounting must divide the continuous business process, and produceperiodic reports. An annual reporting period may follow the calendar year by running from January 1through December 31. Annual periods are usually further divided into quarterly periods containing activityfor three months.

In the alternative, a fiscal year may be adopted, running from any point of beginning to one year later.Fiscal years often attempt to follow natural business year cycles, such as in the retail business where afiscal year may end on January 31 (allowing all of the Christmas rush, and corresponding returns, to cycle


through). Note in the following illustration that the "2008 Fiscal Year" is so named because it ends in2008:

You should also consider that internal reports may beprepared on even more frequent monthly intervals. As ageneral rule, the more narrowly defined a reporting period,the more challenging it becomes to capture and measurebusiness activity. This results because continuousbusiness activity must be divided and apportioned amongperiods; the more periods, the more likely that "ongoing"transactions must be allocated to more than one reportingperiod. Once a measurement period is adopted, theaccountant's task is to apply the various rules andprocedures of generally accepted accounting principles(GAAP) to assign revenues and expenses to the reportingperiod. This process is called "accrual basis" accounting --

accrue means to come about as a natural growth or increase -- thus, accrual basis accounting isreflective of measuring revenues as earned and expenses as incurred.

The importance of correctly assigning revenues and expenses to time periods is pivotal in thedetermination of income. It probably goes without saying that reported income is of great concern toinvestors and creditors, and its proper determination is crucial. These measurement issues can becomehighly complex. For example, if a software company sells a product for $25,000 (in year 20X1), andagrees to provide updates at no cost to the customer for 20X2 and 20X3, then how much revenue is"earned" in 20X1, 20X2, and 20X3? Such questions are vexing, and they make accounting far morechallenging than most realize. At this point, suffice it to say that we would need more information aboutthe software company to answer their specific question. But, there are several basic rules about revenueand expense recognition that you should understand, and they will be introduced in the following sections.

Before moving away from the periodicity assumption, and its accounting implications, there is oneimportant factor for you to note. If accounting did not require periodic measurement, and instead, tookthe view that we could report only at the end of a process, measurement would be easy. For example, ifthe software company were to report income for the three-year period 20X1 through 20X3, then revenueof $25,000 would be easy to measure. It is the periodicity assumption that muddies the water. Why notjust wait? Two reasons: first, you might wait a long time for activities to close and become measurablewith certainty, and second, investors cannot wait long periods of time before learning how a business isdoing. Timeliness of data is critical to its relevance for decision making. Therefore, procedures andassumptions are needed to produce timely data, and that is why the periodicity assumption is put in play.

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2. From the Profit and Loss Account of X Limited given below, find out the amount offunds from operations.

Profit and Loss Account of X Ltd.For the year ending 31st December, 2010

To SalariesTo Printing andStationeryTo AdvertisementTo Depreciation onAssetsTo Discount on Issue ofSharesTo CommissionTo Good will written ofTo Loss on Sale ofInvestmentTo EstablishmentExpensesTo Provision for TaxationTo Net Profit

To General ReserveTo Proposed DividendTo Balance c/d

Rs.15,000

2,0008,000

15,0004,000

3,00012,000

4,50015,00080,000

2,41,5004,00,000

15,00075,000

1,96,5002,86,500

By Gross Profit b/dBy Profit on Sales ofFixedAssets

By Dividend received

By Balance b/dBy Net Profit for theyearBy Tax Refunds

Rs.3,70.000

20,00010,000

4,00,000

25,0002,41,50020,000

2,86,500

Solution: - Funds from operation By Direct Method:


Debits Credits


To Salaries

To Printing andStationery

To Commission

To EstablishmentExpenses

To Advertisement

To Funds fromOperation

Rs.15,000

2,000

3,000

15,000

8,000

3,37,000

3,80,000

By Gross Profit b/d

By Dividend received

Rs.3,70.000

10,000

3,80,000

2nd method--Funds from operation By using Adjusted Profit & Loss Account method:


Debit

To Depreciation onAssets

To Discount on Issue ofShares

To Good will written of

To Loss on Sale ofInvestment

To Provision for Taxation

To Net Profit

Rs.15,000

4,000

12,000

4,500

80,000

2,41,5003,57,000

Credit

By Funds fromOperations ( Balancingfigure)

By Profit on Sales ofFixed Assets

Rs.3,70.000

20,000

________3,57,000


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3. What is CVP analysis? Does it differ from break-even analysis?

Solution: CPV analysis is a system used for checking how changes in the volume of production affect thecosts and thus the profits. It is an expanded form of break-even analysis, which simply identifies the breakevenpoint. CVP analysis is somewhat simplified and relies on some assumptions that do not hold in reality, meaningit is best used for simple "big picture" analysis rather than detailed examination.

Breakeven analysis takes account of the fact that production incurs both fixed and variable costs. Fixed costsinclude machinery, factory real estate and, to some extent, marketing. Variable costs include labor and rawmaterials; more of these resources are used as more products are made. The break-even point is calculated asthe fixed costs divided by the contribution per unit. The contribution per unit is the price the company sells theproduct at, minus the specific variable costs associated with producing that individual unit.

CVP analysis takes its name from cost, volume and profit. The associated analysis plots two lines on a graphwith a horizontal axis that shows the total number of units produced. The two lines represent the total revenueand the total cost for that number of units. In virtually every case, the revenue line will start out higher than thecost line, but go up at a steeper angle and eventually narrow the gap before overtaking the cost line and thenwidening its lead. This represents increasing sales lowering losses, hitting the breakeven point and thenproducing increasing profits.

There are several significant limitations to these figures which result from simplified assumptions in theprocess. One obvious one is that it assumes that every unit produced will automatically be sold. This is oftennot the case in reality, and the more units that are produced, the greater the risk of being left with unsold stock.

Another problem with CVP analysis is that in reality there is some crossover between fixed and variable costs.For example, the fixed cost of machinery will increase once it is running at full capacity and production is thenincreased. Meanwhile variable costs don't always vary perfectly in line with the volume of production. Abusiness may be able to increase production without increasing labor costs to the same extent if it is able topick up some slack in the staff's workload.

CVP analysis also has the limitation that it fails to account for all the ways figures may vary. The sales price istreated as a constant, but in the real world, increased sales may entail some buyers getting a bulk discount.Similarly, the variable cost per unit may not be consistent, for example, if materials can be bought in largequantities at a lower price.

Difference between CVP Analysis and Break Even PointI will utilize this fictional company as an example in each of the post below. My fictional company, Henry’s Miracle StomachElixer Co, produces and sells stomach elixir next to the Saint Henry River in Escuintla, Guatemala, a very popular touristattraction. The bottles are sold to tourists at a stand adjacent to said river at a price of $7 (American dollars). This water isrumored to cure travelers diarrhea, but only if it is blessed by the local priest, Enrique, who has signed an exclusive contractwith this company. Henry, the company’s owner, produces a weekly balance sheet and income statement at the end of eachweek. We will utilize the first week of June of 2009 which starts on a Monday.

On the last Friday in May Henry, the company’s owner, produces a balance sheet and income statement from the weekbefore. From this exercise Henry records some facts and numbers that will be useful for the next week;


Variable Costso Decorative Bottles used to store 8 fl ounces of Henry’s Miracle Stomach Elixir at a cost of $1 eacho Decorative String used to decorate the bottles at a cost of .05 each.o Decorative sticky labels that are put on the bottle at a cost of .05 eacho Fine print legal disclaimer stickers bought from Henry’s brother, Heinz, the town lawyer at a cost of .75 each.o Bottles of American bottled water at a cost of .50 each purchased from the town import export expert, Harry.o Tablets of Loperamide (Imodium) to be dissolved in water at .25 each. Purchased from the town doctor, Enrico.o Fixed Costs

$10 a week. Rent for souvenir stand spot in between the public water fountain and the verypopular Taco Grande stand.

Raw Materials Beginning Inventory and Cost 1000 decorative bottles 1000 decorative strings 1000 decorative sticky labels 1000 fine print legal disclaimer stickers 1000 bottles of American bottled water There is never work in process inventory. Henry buys new raw materials on the 15th of each month Direct Labor Costs

o Henrietta, Henry’s wife, assembles the bottles at .25 cents per bottle.o Enrique, Henry’s son and also the town priest gets paid .25 cents per

blessing of one bottle.o Indirect Labor Costs

Harriet , Henry’s daughter gets paid 10.00 a week salary to cleanup the assembly work space

Finished Goods Inventory 100 bottles at a cost of $2.60 (direct materials and direct

labor) each. The company’s salesman Heinrick gets paid a

commission of .25 a bottle and no salary.

It was midnight on Friday and Henry could not sleep. After reviewing his favorite blogs he stumbled upon a site that coveredvariable vs. fixed costs, cost-volume profit (CVP) relationships and break even analysis. These concepts interested Henrybecause he was never sure what his profit would be until the end of the week. Being the curious businessman he is, Henrydecided to see how all of this relates to his Miracle Stomach Elixir business. Henry was familiar with the concept of variablevs. fixed costs. His weekly summary always broke down costs by variable vs. fixed. Variable costs are costs that vary, intotal, in proportion to the changes in levels of activity. All of Henry’s direct materials and direct labor costs were variablecosts. Fixed costs are costs that remain constant in total within the relevant range. Henry’s weekly rent and daughter’ssalary were fixed expenses. In order to get started in applying CVP Henry had to first create a Contribution Margin IncomeStatement. The Contribution Margin Income Statement tells managers what their contribution margin is. The contributionmargin is the difference between total sales and total variable expenses. This amount is used to cover fixed expenses andwhat is left over is net operating income. Once you have the contribution margin you are able to calculate your breakevenpoint. The breakeven point is the point at which profit is equal to 0. It is the point where the contribution margin covers yourfixed expenses. Below is Henry’s Contribution Margin Income statement:


Contribution Margin Income Statement (1Week) TOTAL PER UNIT

Sales (200 bottles at $7 per unit) $ 1,400.00 $ 7.00

Goods Available For Sale $ 1,055.00

(less)Ending Inventory $ (390.00)

Variable Cost of Goods Sold $ 665.00

Adjust Cost of Goods Sold (minus Harriet’s fixedsalary) $ (10.00)

Variable Selling and Admin Expenses (Heinrick’sCommission) $ 50.00

$ 705.00 $ 3.53

Contribution Margin $ 695.00 $ 3.48

Fixed Expenses (Rent and Harriet’sSalary) $ (20.00)

Net Operating Income $ 675.00

From here Henry can determine his breakeven point by using the following formula;

(Break Even Point in Units = Fixed expenses/Contribution margin)(Breakeven point in Units sold=20/3.48=5.7 units (6 Units)

Henry must sell six units a week in order to break even. In order to determine Henry’s breakeven point in total sales dollarsHenry must first calculate the company’s contribution margin ratio using the following formula;

(CM Ratio=Contribution margin/ total sales)(CM Ratio = 695/1400=49.6%).

Henry can utilize the CM ratio to calculate the breakeven point in sales dollars by using the following formula;

(Breakeven Point in Sales Dollars = Fixed expenses/CM Ratio)(Breakeven point in sales dollars=20/49.6%=$40.32)

Henry must make 40.32 a week in order to break even.


At this point Henry can also play what if games like how many units he has to sell to profit $1000 a week or what wouldhappen if he wanted to rent an elixir bottle dispenser, at $25 a week, to be placed across town next Montezuma’s RevengeChili dogs.

In order to figure out how many units he has to sell in order to attain $1000 a week Henry must use the following formula;

(Unit Sales to Attain Target Profit= Fixed Expenses + Target Profit/ Unit contribution margin) (Unit Sales to attaintarget profit = (20+1000/3.48) =294 units

Henry must sell 294 units in order to make $1000 a week.

In order to calculate the Dollar sales to attain target profit Henry should use the following formula;

(Dollar Sales to attain target profit= Fixed Expenses + Target Profit/ CM Ratio)(Dollar Sales to attain target profit = (20+1000/46.9%)=$2174.84

If Henry were to rent the elixir bottle dispenser at $25 a week he would need to increase the fixed expenses variables in thecalculations above by $25.

(Break Even Point in Units with elixir dispensing machine = Fixed expenses/Contribution margin)(Breakeven point in Units sold with elixir dispensing machine =45/3.48=12.93 units (13 Units)

(Breakeven Point in Sales Dollars = Fixed expenses/CM Ratio)(Breakeven point in sales dollars=45/49.6%=$90.73)

(Unit Sales to Attain Target Profit= Fixed Expenses + Target Profit/ Unit contribution margin) (Unit Sales toattain target profit = (45+1000/3.48) =301 units

(Dollar Sales to attain target profit= Fixed Expenses + Target Profit/ CM Ratio)(Dollar Sales to attain target profit = (45+1000/46.9%)=$2228.15

Henry’s current weekly unit sales were 200 units. Henry predicts that the elixir dispensing machine would be able to sell atleast 120 more units. This would have him selling 320 units a week which would earn him $66.12 (3.48 * 19) more than thetarget $1000 dollars a week. Henry decided to rent the elixir machine.

The above examples demonstrate the power of CVP analysis. Utilizing CVP analysis Henry was able to take make informeddecisions for his business.

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4. S Limited is considering for purchase of a machine. There are two possiblemachines which will produce the additional output. Details of these machines are asfollows:

Machine x Machine YRs. Rs.

Capital CostSales at standard

60,0001,00,000

60,00080,000


PriceCosts:LabourMaterialsFactory OverheadsAdministration CostSelling CostsExpected life in years

10,0008,000

12,0004,0002,000

2

6,00010,00010,0002,0002,0003

Other Information:(a) The costs shown above relate to annual expenditure resulting from eachmachine. Sales

are expected to continue at the rates shown for each year for the full life of eachmachine;(b) Tax to be paid may be assumed at 50% of net earnings;(c) Interest on capital is to be ignored;(d) The appropriate rate of interest for converting to present value may be taken at10%.

On the basis of the facts given above, show the most profitable investment by thefollowing methods.

(i) Pay-back Period,(ii) Return on Investment; and(iii) Net Present Value on Investment.

Solution: Capital budgeting is a required managerial tool. One duty of a financial manager is to chooseinvestments with satisfactory cash flows and rates of return. Therefore, a financial manager must be ableto decide whether an investment is worth undertaking and be able to choose intelligently between two ormore alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed.This procedure is called capital budgeting.

A. THE PROCESS OF PROJECT EVALUATION(Suggestions by R. Bruner)

1. Carefully estimate expected future cash flows.2. Select a discount rate consistent with the risk of those future cash flows.3. Compute a “base-case” NPV.4. Identify risks and uncertainties. Run a sensitivity analysis. Identify “key value drivers”.

Identify break-even assumptions.

Estimate scenario values.

Bound the range of value.


5. Identify qualitative issues.:Flexibility,Quality,Know-how & Learning6. Decide

II. Basic Steps of Capital Budgeting1. Estimate the cash flows

2. Assess the riskiness of the cash flows.

3. Determine the appropriate discount rate.

4. Find the PV of the expected cash flows.

5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or payback < policy

Definitions: Independent versus mutually exclusive projects.

Normal versus nonnormal projects.

Basic Data

Expected Net Cash Flow

YearProject L Project S

0

1

2

3

($100)

10

60

80

($100)

70

50

20

III. Evaluation Techniques

A. Payback periodB. Net present value (NPV)

C. Internal rate of return (IRR)

D. Modified internal rate of return (MIRR)E. Profitability index

A. PAYBACK PERIOD

Payback period = Expected number of years required to recover a project’s cost.


Project L

Expected Net Cash Flow

YearProject L Project S

0

1

2

3

($100)

10

60

80

($100)

(90)

(30)

50

PaybackL = 2 + $30/$80 years = 2.4 years.

PaybackS = 1.6 years.

Weaknesses of Payback:

1.Ignores the time value of money. This weakness is eliminated with the discounted payback method.

2. Ignores cash flows occurring after the payback period.

B. NET PRESENT VALUE

n

0t tk)(1tCF

NPV

Project L:

9.09

49.59

60.11

NPVL = $ 18.79

0 1 2 3

100.00 10 60 80


NPVS = $19.98

If the projects are independent, accept both.

If the projects are mutually exclusive, accept Project S since NPVS > NPVL.

Note: NPV declines as k increases, and NPV rises as k decreases.

C. INTERNAL RATE OF RETURN

NPV$0

n

0t tIRR1tCF

:IRR

.

Project L:

8.47

43.02

48.57

$ 0.06 $0

IRRL = 18.1%

IRRS = 23.6%

If the projects are independent, accept both because IRR > k.

If the projects are mutually exclusive, accept Project S since IRRS > IRRL.

Note: IRR is independent of the cost of capital.

0 1 2 3

100.00 10 60 8018.1%

18.1%

18.1%


1. ADVANTAGES AND DISADVANTAGES OF IRR AND NPV

A number of surveys have shown that, in practice, the IRR method is more popular than the NPVapproach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes thetime value of money, like the NPV. In other words, while the IRR method is easy and understandable, itdoes not have the drawbacks of the ARR and the payback period, both of which ignore the time value ofmoney.

The main problem with the IRR method is that it often gives unrealistic rates of return. Suppose thecutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the management shouldimmediately accept the project because its IRR is 40%. The answer is no! An IRR of 40% assumes thata firm has the opportunity to reinvest future cash flows at 40%. If past experience and the economyindicate that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect. Simplyspeaking, an IRR of 40% is too good to be true! So unless the calculated IRR is a reasonable rate forreinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project.

Another problem with the IRR method is that it may give different rates of return. Suppose there aretwo discount rates (two IRRs) that make the present value equal to the initial investment. In this case,which rate should be used for comparison with the cutoff rate? The purpose of this question is not toresolve the cases where there are different IRRs. The purpose is to let you know that the IRR method,despite its popularity in the business world, entails more problems than a practitioner may think.

2. WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS:When comparing two projects, the use of the NPV and the IRR methods may give different results. Aproject selected according to the NPV may be rejected if the IRR method is used.

Suppose there are two alternative projects, X and Y. The initial investment in each project is $2,500.Project X will provide annual cash flows of $500 for the next 10 years. Project Y has annual cash flows of$100, $200, $300, $400, $500, $600, $700, $800, $900, and $1,000 in the same period. Using the trialand error method explained before, you find that the IRR of Project X is 17% and the IRR of Project Y isaround 13%. If you use the IRR, Project X should be preferred because its IRR is 4% more than the IRRof Project Y. But what happens to your decision if the NPV method is used? The answer is that thedecision will change depending on the discount rate you use. For instance, at a 5% discount rate, ProjectY has a higher NPV than X does. But at a discount rate of 8%, Project X is preferred because of a higherNPV.


The purpose of this numerical example is to illustrate an important distinction: The use of the IRRalways leads to the selection of the same project, whereas project selection using the NPV methoddepends on the discount rate chosen.


PROJECT SIZE AND LIFEThere are reasons why the NPV and the IRR are sometimes in conflict: the size and life of the projectbeing studied are the most common ones. A 10-year project with an initial investment of $100,000 canhardly be compared with a small 3-year project costing $10,000. Actually, the large project could bethought of as ten small projects. So if you insist on using the IRR and the NPV methods to compare abig, long-term project with a small, short-term project, don’t be surprised if you get different selectionresults. (See the equivalent annual annuity discussed later for a good way to compare projects withunequal lives.)

DIFFERENT CASH FLOWSFurthermore, even two projects of the same length may have different patterns of cash flow. The cashflow of one project may continuously increase over time, while the cash flows of the other project mayincrease, decrease, stop, or become negative. These two projects have completely different forms ofcash flow, and if the discount rate is changed when using the NPV approach, the result will probably bedifferent orders of ranking. For example, at 10% the NPV of Project A may be higher than that of ProjectB. As soon as you change the discount rate to 15%, Project B may be more attractive.

WHEN ARE THE NPV AND IRR RELIABLE?Generally speaking, you can use and rely on both the NPV and the IRR if two conditions are met.First, if projects are compared using the NPV, a discount rate that fairly reflects the risk of eachproject should be chosen. There is no problem if two projects are discounted at two different ratesbecause one project is riskier than the other. Remember that the result of the NPV is as reliable asthe discount rate that is chosen. If the discount rate is unrealistic, the decision to accept or reject theproject is baseless and unreliable. Second, if the IRR method is used, the project must not beaccepted only because its IRR is very high. Management must ask whether such an impressive IRRis possible to maintain. In other words, management should look into past records, and existing andfuture business, to see whether an opportunity to reinvest cash flows at such a high IRR really exists.If the firm is convinced that such an IRR is realistic, the project is acceptable. Otherwise, the projectmust be reevaluated by the NPV method, using a more realistic discount rate.

D. Modified IRR (MIRR)The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two weaknesses ofthe IRR. The MIRR correctly assumes reinvestment at the project’s cost of capital and avoids theproblem of multiple IRRs. However, please note that the MIRR is not used as widely as the IRR inpractice.

There are 3 basic steps of the MIRR:

(1) Estimate all cash flows as in IRR.(2) Calculate the future value of all cash inflows at the last year of the project’s life.(3) Determine the discount rate that causes the future value of all cash inflows determined in step 2,

to be equal to the firm’s investment at time zero. This discount rate is know as the MIRR.

Project L:0 1 2 3

-100.00 10 60 80.0066.00

12.10

$158.10 = TV of inflows100.00

$ 0.00 = NPV

PV outflows = $100

TV inflows = $158.10.

10%

MIRR = 16.5%


MIRRs =16.9%

MIRR is better than IRR because

1. MIRR correctly assumes reinvestment at project’s cost of capital.

2. MIRR avoids the problem of multiple IRRs.

PVcosts = nMIRR1

TV


IV. PROJECT DECISION ANALYSIS

B. MAKING GO/NO-GO PROJECT DECISION(Suggestions by R. Bruner)Virtually all general managers face capital-budgeting decisions in the course of their careers.The most common of these is the simple “yes” versus “no” choice about a capital investment.The following are some general guidelines to orient the decision maker in these situations.

1. Focus on cash flows, not profits. One wants to get as close as possible to the economicreality of the project. Accounting profits contain many kinds of economic fiction. Flows ofcash, on the other hand, are economic facts.

2. Focus on incremental cash flows. The point of the whole analytical exercise is to judgewhether the firm will be better off or worse off if it undertakes the project. Thus one wants tofocus on the changes in cash flows effected by the project. The analysis may require somecareful thought: a project decision identified as a simple go/no-go question may hide asubtle substitution or choice among alternatives. For instance, a proposal to invest in anautomated machine should trigger many questions: Will the machine expand capacity (andthus permit us to exploit demand beyond our current limits)? Will the machine reduce costs(at the current level of demand) and thus permit us to operate more efficiently than beforewe had the machine? Will the machine create other benefits (e.g., higher quality, moreoperational flexibility)? The key economic question asked of project proposals should be,“How will things change (i.e., be better or worse) if we undertake the project?”

3. Account for time. Time is money. We prefer to receive cash sooner rather than later. UseNPV as the technique to summarize the quantitative attractiveness of the project. Quitesimply, NPV can be interpreted as the amount by which the market value of the firm’s equitywill change as a result of undertaking the project.

4. Account for risk. Not all projects present the same level or risk. One wants to becompensated with a higher return for taking more risk. The way to control for variations inrisk from project to project is to use a discount rate to value a flow of cash that is consistentwith the risk of that flow.

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5. What is working capital? Explain the importance of working capital management anddiscuss about the determinants of working capital requirement.

Solution: Working capital is a measurement of an entity’s current assets, after subtracting its liabilities.Sometimes referred to as operating capital, it is a valuation of the amount of liquidity a business or organizationhas for the running and building of the business. Generally speaking, companies with higher amounts ofworking capital are better positioned for success. They have the liquid assets needed to expand their businessoperations as desired.

Sometimes, a company will have a large amount of assets, but have very little with which to build the businessand improve processes. Even a profitable company may have this problem. This can occur when a companyhas assets that are not easy to convert into cash.

Working capital can be expressed as a positive or negative number. When a company has more debts thancurrent assets, it has negative working capital. When current assets outweigh debts, a company has positiveworking capital.


Changes in working capital will impact a business’ cash flow. When working capital increases, the effect oncash flow is negative. This is often caused by the liquidation of inventory or the drawing of money fromaccounts that are due to be paid by the business. On the other hand, a decrease in working capital translatesinto less money to settle short-term debts.

Working capital is among the many important things that contribute to the success of a business. Without it, abusiness may cease to function properly or at all. Not only does a lack of working capital render a companyunable to build and grow, but it may also leave a company with too little cash to pay its short-term obligations.Simply put, a company with a very low amount of working capital may be at risk of running out of money.

When a company has too little working capital, it can face financial difficulties and may even be forced towardbankruptcy. This is true of both very small companies and billion-dollar organizations. A company with thisproblem may pay creditors late or even skip payments. It may borrow money in an attempt to remain afloat. Iflate payments have affected the company’s credit rating, it may have difficulty obtaining a loan at an affordableinterest rate.

In some types of businesses, it isn’t as much of a problem to have a lower amount of working capital.Companies that are operated on as cash basis, have fast inventory turnovers, and can generate cash quicklydon’t necessarily need as much working capital. For example, a grocery store might meet these requirementsand do well with less working capital.

Accounting Formula to Determine a Business’ Working Capital:

Current Assets - Current Liabilities = Working Capital

Working capital can be reflected as a positive or negative number depending on how much debt the business is carrying.

Where Does Working Capital Come From:

From an accounting standpoint, working capital comes from:

Net income; Long-term loans (non-current liabilities); Sale of capital (non-current) assets; and Funds contributed by the owners and investors (stockholders).

Working Capital is Required to Start and Grow a Business

When you first start a business you need start-up working capital since the business is not yet making money to sustain itself. Thenumber one reason most businesses fail during their first two years of operation is due to a lack of working capital.

Having ample working capital not only helps you to meet your obligations, it is vital to growing your business.

Working capital is the money you need to cover business expenses, meet short-term obligations, and to grow your business. Start-up capital is the money you need to start a business until it generates enough revenue to pay for itself. Start-up and working capitalcan come from loans, grants, investors and partners, but many business women use their personal financial resources to fund theirbusinesses.

Importance of working capital—


The term working capital refers to the amount of capital which is readily available to a company.That is, working capital is the difference between resources in cash or readily convertible intocash (Current Assets) and organisational commitments for which cash will soon be required(Current Liabilities).

Current Assets are resources which are in cash or will soon be converted into cash in "theordinary course of business".

Current Liabilities are commitments which will soon require cash settlement in "the ordinarycourse of business".

Thus:WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

In a company's balance sheet components of working capital are reported under the followingheadings:

Current Assets:Liquid Assets (cash and bank deposits)InventoryDebtors and Receivables

Current Liabilities:Bank OverdraftCreditors and PayablesOther Short Term Liabilities

The Importance of Good Working Capital Management:From a company's point of view, excess working capital means operating inefficiencies. Moneythat is tied up in inventory or money that customers still owe to the company cannot be used topay off any of the company's obligations. So, if a company is not operating in the most efficientmanner (slow collection), it will show up as an increase in the working capital. This can be seenby comparing the working capital from one period to another; slow collection may signal anunderlying problem in the company's operations.

Approaches to Working Capital ManagementThe objective of working capital management is to maintain the optimum balance of each of theworking capital components. This includes making sure that funds are held as cash in bankdeposits for as long as and in the largest amounts possible, thereby maximising the interestearned. However, such cash may more appropriately be "invested" in other assets or inreducing other liabilities.

Working capital management takes place on two levels:* Ratio analysis can be used to monitor overall trends in working capital and to identify areas


requiring closer management* The individual components of working capital can be effectively managed by using varioustechniques and strategies

When considering these techniques and strategies, companies need to recognise that eachdepartment has a unique mix of working capital components. The emphasis that needs to beplaced on each component varies according to department. For example, some departmentshave significant inventory levels; others have little if any inventory.

Furthermore, working capital management is not an end in itself. It is an integral part of thedepartment's overall management. The needs of efficient working capital management must beconsidered in relation to other aspects of the department's financial and non-financialperformance.

In working capital, the main types of cash inflow and outflow in a typical business:

Outflows Inflows

Purchasing finished goods for re-sale Cash sales to customers

Purchasing raw materials and othercomponents needed for the manufacturing

of the final product

Receipts from customers who were allowedto buy on credit (trade debtors)

Paying salaries and wages and otheroperating expenses

Interest on bank and other balances

Purchasing fixed assets Proceeds from sale of fixed assets

Paying the interest on, or repayment ofloans

Investment by shareholders

Paying taxes

Cash flow can be described as a cycle:

The business uses cash to acquire resources (assets such as stocks) The resources are put to work and goods and services produced. These are then sold to customers

Some customers pay in cash (great), but others ask for time to pay. Eventually they pay and these funds are usedto settle any liabilities of the business (e.g. pay suppliers)

And so the cycle repeats

Hopefully, each time through the cash flow cycle, a little more money is put back into the business than flows out. But notnecessarily, and if management don’t carefully monitor cash flow and take corrective action when necessary, a business

may find itself sinking into trouble.

The cash needed to make the cycle above work effectively is known as working capital.


Working capital is the cash needed to pay for the day to day operations of the business.

In other words, working capital is needed by the business to:

Pay suppliers and other creditors Pay employees Pay for stocks

Allow for customers who are allowed to buy now, but pay later (so-called “trade debtors”)

What is crucially important, therefore, is that a business actively manages working capital. It is the timing of cash flowswhich can be vital to the success, or otherwise, of the business. Just because a business is making a profit does not

necessarily mean that there is cash coming into and out of the business.

There are many advantages to a business that actively manages its cash flow:

It knows where its cash is tied up, spotting potential bottlenecks and acting to reduce their impact It can plan ahead with more confidence. Management are in better control of the business and can make informed

decisions for future development and expansion It can reduce its dependence on the bank and save interest charges It can identify surpluses which can be invested to earn interest

Determinants of Working CapitalThe level of working capital is influenced by many factors. They are:

1.Nature of Business :This is one of the main factors. Usually in trading businesses the working capitalneeds are higher as most of their investment is concentrated in stock or inventory. Manufacturingbusinesses also need a good amount of working capital to meet their production requirements. Whereas,those companies that sell services and not goods, on a cash basis require least working capital becausethere is no requirement on their part to maintain heavy inventories.

2. Size of Business :Size of business is another influencing factor. As size increases, the working capitalrequirement is also more and vice versa.

1. Credit Terms / Credit Policy :Credit terms greatly influence working capital needs. If terms are:

i. buy on credit and sell by cash, working capital is lowerii. buy on credit and sell on credit, working capital is mediumiii. buy on cash and sell on cash, working capital is mediumiv. buy on cash and sell on credit, working capital is higher.

Prevailing trade practices and changing economic condition do generally exert greater influenceon the credit policy of concern.


e. A liberal credit policy if adopted more trade debtors would result and when the same istightened, size of debtors gets slim.

f. Credit periods also influence the size and composition of working capital. When longercredit period is allowed to debtors as against the one extended to the firm by its creditors,more working capital is needed and vice versa.

g. Collection policy is another influencing factor. A stringent collection policy might notonly deter away some credit customers, but also force the existing customers to beprompt in settling dues resulting in lower level of working capital. The opposite holds wellwith a liberal collection policy.

h. Collection procedure also influences the working capital needs. A decentralizedcollection of dues from customers and centralized payments to suppliers shall reduce thesize of working capital. Centralized collections and centralized payments would lead tomoderate level of working capital. But with centralized collections and decentralizedpayments, the working capital need would be the highest.

2. Seasonality

Seasonality of Production :Agriculture and food processing and preservation industries have aseasonal production. During seasons, when production activities are in their peak, working capital need ishigh.

a)Seasonality in supply of raw materials :This also affects the size of working capital. Industries thatuse raw materials which are available during seasons only, have to buy and stock those raw materials.They cannot afford to buy these items in a phased way, since either supplies would get reduced or priceswould be higher. Also, from the point of view of quality of raw materials, it pays to buy in bulk during theseasons. Hence the high level of working capital needed when season exists for raw materials.

b)Seasonality of demand for finished goods :In case of products like umbrella, rain-coats and otherseasonal items, the demand is high during peak seasons. But the production of these items has to becontinuous throughout the year to meet the high demand during peak seasons. Thus, working capitalrequirement would be higher.

3.Trade Cycle :Trade cycle refers to the periodic turns in business opportunities from extremely peaklevels, via a slackening to extremely tough levels and from there, via a recovery phase to peak levels,thus completing a business cycle. There are 4 phases of trade cycle.

. Boom Period – more business, more production, more working capital.a. Depression period – less business, less production, less working capital.b. Recession period – slackening business, stock pile-up, more working capital.c. Recovery period – recouping business, stock speedily converts to sales, less working

capital.

4)Inflation: Under inflationary conditions generally working capital increases, since with rising pricesdemand reduces resulting in stock pile-up and consequent increase in working capital.

5)Production cycle :The time lapse between feeding of raw material into the machine and obtaining thefinished goods out from the machine is what is described as the length of manufacturing process. It isotherwise known as conversion time. Longer this time period, higher is the volume and value of work-in-progress and hence higher the requirement of working capital and vice versa.

6)System of Production process :If capital intensive, high-technology automated system is adopted forproduction, more investment in fixed assets and less investment in current assets are involved. Also, theconversion time is likely to be lower, resulting in further drop in the level of working capital. On the other


hand, if labor intensive technology is adopted, less investment in fixed assets and more investment incurrent assets which would lead to higher requirement of working capital.

7)Growth and expansion plans :Growth and expansion industries need more working capital than thosethat are static.

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Ignou Mba Ms - 04 Solved Assignments July 2011-Restricted