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Unit 5 - Finance Management (4) - Coggle Diagram
Unit 5 - Finance Management (4)
5.8 Investment Appraisal
Investment appraisal
refers to the quantitative techniques used in evaluating the viability or attractiveness of an investment proposal.
It attempts to assess and justify the capital expenditure allocated to a particular project.
Payback Period
this method estimates the length of time required for an investment project to pay back its initial cost outlay
formula: Payback period = initial investment cost/annual cash flow from investment
Advantages of the payback period
it is simple and fast to calculate
useful method in rapidly changing industries such as technology. It helps to estimate how fast the initial investment will be recovered before another machine
helps firms with cash-flow problems because they can choose the investment projects
Disadvantages of the payback period
does not consider the cash carried after the payback period which could influence major investment decisions
ignores the overall profitability of an investment project by focusing only on how fast it will pay back
annual cash flows could be affected by unexpected external changes in demand
Average rate of Return
this method measures the annual net return on an investment as a percentage of its capital cost.
its assesses the profitability per annum generated by a project over a period of time
formula: average rate of return = (total return -capital cost)/years of usage/capital cost x 100
Advantages of ARR
shows the profitability of an investment project over a given period of time
makes use of all the cash flows in a business
allows for easy comparisons with other competing projects
business can use its own criterion rate and check this with the ARR for a project
Disadvantages of ARR
considers a longer time period, likely to be forecasting errors
does not consider the timing of cash inflows
effects on the time value of money are not considered
Net Present Value
defined as the difference in the summation of present values of future cash inflows or returns and the original cost of investment
Present value is today's value of an amount of money available in the future.
formula: NVP= total present values - original cost
Advantages of NPV
opportunity cost and the time value of money is put into consideration in its calculations
cash flows including their timing are included in its computation
discount rate can be changed to suit any expected changes in economic variables
Disadvantages of NPV
more complicated to calculate than the payback period of ARR
can only be used to compare investment projects with the same initial cost outlay
discount rate greatly influences the final NPV result obtained, which may be affected by inaccurate interest rate predictions
5.9 Budgets
budget
quantitative financial plan that estimates revenue and expenditure over a specified future time period
Budgets can be prepared for individuals, government or simply any type of organization.
importance of budgets for organizations
planning: setting targets, managers ensure that budgets help to provide a sense of direction or purpose for organizations
motivation: budget holders who are responsible for budgetary control feel empowered and trusted, which boosts their morale.
resource allocation: budgets help to prioritize how resources will be used in the organization. demands for financial resources could be very high, budgets set certain boundaries that ensure availability of resources
coordination: budgets help to bring people from different departments together to work for a common purpose.
control: budgets act as monitoring and evaluation tools to check how funds are being spent in each department.
Cost and Profit centers
cost centers
section of a business where costs are incurred and recorded. help managers to collect and use cost data effectively
by department: finance, productions, marketing, where each department is a specific cost centre
by product: a business producing several products could ensure that each product is a cost centre
by geographical location: businesses location is important to now how much it is being cost
Profit centre
section of a business where both costs and revenues are identified and recorded.
The role of cost and profit centre
aiding decision making: help in provide managers with financial information about the different parts of a business and this information can assist them in decision making
better accountability: cost and profit centre help to provide specific business sections accountable
tracking problem areas: enable particular problem areas in a business to be detected
increasing motivation: providing departmental managers and staff with incentives such as promotion to enable them to achieve set targets helps to increase motivation
benchmarking: comparing the performances in the various cost and profit centre in a business can help to check areas of most or least efficiency
Problems of cost and profit centre
indirect cost allocation: indirect costs such as advertising, rent are difficult to allocate specifically to particular cost centres.
external factors: factors beyond the control of business like competition may affect specific cost and centre. Competition is one centre may be higher than in another
centre conflicts: staff and managers may consider the performance in their own centre to be superior to the overall performance of the organization
staff stress: the pressure of managing a cost and profit centre may be very high for some staff
Variance Analysis
variance is the difference between the budgeted figure and the actual figure. variance is calculated at end of a budget period once the actual amounts are determined
The role of budgets and variances
strategic planning, an organization defines its future direction and decides on how to allocate its resources accordingly to fulfill its vision.
Advantages of using budgets and variances in strategic planning
Budgets help control revenue and expenditure by regulating how money is spent to minimize losses and wastage of resources
budgets provides realistic targets that are clearly understood by all internal stakeholders to aid in the attainment of an organization's goals
budgets help in the coordination of the various business departments, improving flows fo communication and ensuring a sense of people working together
Variance analysis aims to compare actual performance to budgeted performance, thereby helping to assess organizational performance
Variance assists in detecting the causes of any deviations in the budget so that corrective measures can be taken to rectify them
Limitations of budgets in strategic planning
inflexible budgets that don't consider any unforeseen changes in the external environment, increases in raw material costs
significant differences between the budgeted and actual results could make the budget lose its importance as a planning tool
highly underspent budgets towards the end of the year could result in unjustified wasteful expenditure by managers
setting budgets without involving some people could result in their resentment and affect their motivation levels