Finance Assignment

Report on Managing Finance for the Mayor Ltd.-2009

Submitted To

Mr. Dan Sookun (Lecturer)

Icon College of Technology and Management

Submitted By

Mashukur Rahman

Id. 4098

Page 1 of 45 Managing Finance Mashukur Rahman Id: 4098

Table of Content

Serial No. Topic Page Number

1 Overview of Organisation 03 to 03

2

Outcome 01 04 to 18

Sources of Finance (04 - 16)

Factors to be Considered Before Deciding Sources of Finance (17 - 18)

3

Outcome 02 19 to 25

Cash Budget (19 - 19)

Benefits and Significance of Cash Budget (19 - 20)

Projected Cash Flow Statement (21 -21)

Function of Preparing Budget (22 - 23)

Implication of Preparing the Budget at the Lower Level of Management

(24 - 25)

4

Outcome 03 26 to 32

Steps of Project Implementation (26 - 27)

Projects Appraisal Techniques (NPV, IRR, Payback Period) (28 - 30)

Projects Analysis Through NPV, IRR, Payback Period (31 - 32)

5

Outcome 04 33 to 37

Types of Ratio Analysis (33 - 35)

Limitation of Ratio Analysis (35 - 35)

Comparative Analysis of Ratio with Industry (36 - 37)

6 Bibliography 38 to 39

7 Appendix 40 to 45


Overview of Organisation

Mayor Ltd is a private limited company that produces baby foods. All of its share are

generate by the Mayor family. Recently Mayor Ltd has got a three-year contract to

Doratex Plc with a range of products. As a supplier, Mayor Ltd. needs more current assets

for keep available stocks (inventory financing) as well as credit sales. Because Doratex Plc

already given the condition that, required orders must delivered within two days and also

always pay the money after three months of received the order.

Therefore, it is needs to be sufficient funds for Mayor Ltd. starting and running the

business with Doratex Plc and also those funds is of critical importance. If Mayor Plc. will

failure that issue might be fall in liquidity difficulties.


Outcome: 1.0

The finance available for a business may be divided by two types-

Internal

External

Internal sources

This is a source of finance, which comes from owner’s equity, owner personal savings or

selling assets, business angels (owners family and friends) and owner's business activities

(retained profits).

Advantages of internal sources of finance

Flexibility: Internal sources of finance usually have the advantage that they are

flexible, because this sources are might use current assets financing as well as

long term financing also it will be use for future invest proposal.

Immediate arrange: This sources are obtained very quickly-particularly for

working capital finance.

No Interest: Using this sources no need to required to paying any interest.

No third party and cost: It could be arrange without any cost and compliance

of other parties. The business owners have power to the profits without

agreement of the shareholders.

According to McLaney et al (2005) (PG-515), “Internal sources mean sources that

do not require the agreement of anyone beyond the directors and managers.”


Finance

Internal(Retained profits, Owner’s equity, Business angels)

External(Selling share,

Bank over drafts, Trade credits,Loan, Finance leases,

Hire purchase, Govt. grants etc.)

Internal sources includes following:

Retained Profits

Retained profits are the major source of internal finance for most business.

Retained profits consider an internal source because owner has a power to retain

profit without agreement of the shareholders. In financial year-2007, Mayor Ltd.

was made profit £50,000 (Financial Statements-2007). That is the retained profits f

or Mayor Ltd. This amount might be use as internal sources of finance for raising

the funds.

Owners Equity

This is the fund provided by its owners that does not have to be repaid as long as

organisation continues as a going concern. The business owners finance in the

business by own cash as well as personal savings. It is a cheapest form of finance

since it carries no obligation to pay any interest. On the other side, equity is

expensive forms of finance because of owners are expected that dividend will be

higher than the interest rate.

Business Angels

Business angels means that family members and friends of a business owners who

are a common source of finance for a private limited company. They are most likely

to invest due to their relationship with the business owner. Family members and

friends provide a small amount of equity funding. Although, it is relatively easy to

obtain money from family members and friends without paying any interest.


Internal Sources

Retained Profits

Owners Equity Business Angels

Advantages and disadvantages of business angels

If the business owners finance in the business by get the money from family

members and friends, than business will be benefited because against that money

no need to paid any interest.

Sometimes family members or friends may want to get the business share also

want to get the profit of the business against their money. In these circumstances,

the relationship between business owners and business angels will be fall.

All sources of finance, there are positive and negative aspects. The Mayor Ltd

should carefully consider the effect of the investment on the family members or

friends before accept the money. Otherwise, if the relationships between business

owners and family members or friends fall in hardship, that might be the result of

business fall.

External sources

Generally, external sources of finance are sources that come from outside the business.

When internal funds are no longer sufficient, small business turn to a variety of external

sources. External sources includes the increase shareholders by selling share, bank loan,

bank overdrafts, debentures, trade credits, hire purchase (HP), finance leases,

governments grants etc.

“This is finance that comes from outside the business. It involves the business

owing money to outside individuals or institutions.” (http://www.teachnet-uk.org.uk)

The Mayor Ltd. is not listed on a recognised stock exchange. Mayor Ltd also decided

that they does not wish to raise new capital by issuing new shares. As a result sources of

selling shares and debentures are not apply for the finance.


External sources of finance includes the following:

Overdrafts

Overdraft financing is provided when businesses make payments from their

business current account exceeding the available cash balance. An overdraft

facility enables businesses to obtain short-term funding - although in theory the

amount loaned is repayable on demand by the bank. The bank may also charge

interest as an overdraft facility fee. Interest is charged on the amount overdrawn - at

a rate that is above the Bank Base Rate.

Overdrafts are generally meant to cover short-term financing requirements that

are not generally meant to provide a permanent source of finance. Many

Businesses use an overdraft for support to working capital; helping buy stock, pay

staff, etc in order for business to function. It is ideal for business day-to-day

expenses, particularly uses in cash flow problems.


External Sources

Overdrafts

Bank Loan

Hire Purchase

Finance

Leases

Trade Credits

Govt. Grants

As per Watson et al (2007) (PG-70), “An overdrafts is a flexible source of

finance in that a company only uses it when the needs arises. However, an

overdrafts is technically repayable on demand, even though a bank is likely in

practice to give warning its intention to withdraw agreed overdrafts

facilities. .......

Overdrafts interests are only paid on the amount borrowed, not on the agreed drafts

limits.”

Advantages of overdrafts

Interest: Customer only pays interest when overdrawn amount borrowed not the

agreed overdrafts limits.

Flexibility: Bank gives the flexibility to review and adjust the level of the

overdraft facility, perhaps on a short-term basis.

Immediate arrange: Overdraft effectively and immediately could be used as a

source of finance for raises working capital.

Financial gearing: Being part of short-term debt, the overdraft balance is not

normally included in calculations of the business’ financial gearing.

Quick: Overdrafts are easy and quick to arrange, providing a good cash flow

backup with the minimum of fuss.

Disadvantages of overdrafts

High interest rate: Overdrafts carry high interest rate and fees, it is too much

higher then the bank loan.

Not suitable: Overdrafts is not suitable for long-term finance because an

overdraft is likely to cost and expensive more than a bank loan.

Security: Using overdrafts may need to be secured against business assets,

which put them at risk if the business cannot meet repayments.


Bank Loan

Bank provides a specified amount of money to business organisation (customers)

for finance in the business as a form of loan. And that amount must needs to be

repaid with interest before fixed date.

Bank loan includes the following:

Specified sum of money

Repayments date (period of loan- short-term/long-term)

Rate of interest

Consumers instalments, overdrafts, credit cards

Residential mortgage

Security

Direct financing leases

According to Gallati (2003) (Pg-130), “ A 'loan' is a financial assets resulting from

the delivery of cash or other assets by a lender to a borrower in return for an

obligation to repay on a specified date or dates, or an demand, usually with

interests.”

Advantages of Bank Loan/Debt Financing

For raising the fund it is cheaper method than the issue of new share to the

shareholders.

In inflation borrower might be beneficial because the value of interest payments

will diminish.

Bank loan interests are expenses, which is assumed before corporate tax is

assessed, while dividend is accumulated after corporate tax. In this

circumstances, bank loan is the better than the issuing new share for the Mayor

Plc.

There are no dilutions of ownership with debt/loan financing.


Disadvantages of Bank Loan/Debt Financing

Loan is one kind of contract between lender and borrower. This contract represents

that, borrower commitment to pay the lender the principle amount with interests. If

the borrower is unable or fail to make its repayments on due time, then it can face

serious consequence such as foreclosure. Foreclosure can result in the liquidation

of the business. When the business is liquidated, government agencies and other

creditors are at the front of the line when the businesses are converted into cash.

The owners of the business get the table scraps if any exist when the liquidation is

completed.

Another disadvantage is any loan charge must be paid irrespective of business

performance. And also excessive finance by loan may affect business flexibility.

Finally, Debt or loan must be repaid even when a business looses/decline the profits

or costs rises unexpectedly.

Trade Credits

Many businesses rely on their creditors as a form of short-term finance. Because

most of the suppliers allows their customers to take somewhere between one and

three months to pay for goods supplied, the debtor company can use what is

effectively an interest free loan of up to 90 days to pay others bills. Creditors will

often give incentives in the form of cash discount if payment is made earlier, but by

delaying payment, the debtor can use money owned to finance other current assets.

This is the most important and suitable source of short-term finance for Mayor Ltd.

According to Watson and et al (2007) (Pg-70), “ Trade credit is an agreement to

take payments for goods and services at later date than that on which the goods

and services are supplied to the consuming company. It is the common to find one,

two or even three months credit being offered on commercial transactions and trade

credit is a major source of short-term finance for major companies.”


Advantages of Trade Credit

Reduced capital requirements: This source is very useful to someone who

has very little amount of money but has a good idea about starting a new

business. So, Mayor Ltd could be using this source for short-term finance.

Improve cash flow: Trade credit with improves the cash flows and therefore

provides smoother operation for the business.

Buy now pay later: This mean that, if the business organisation don't have

sufficient money, at first purchase the product/raw materials by credit. Then after

the sell business make the payments and profits have been made.

Disadvantage of Trade Credit

No discount: If the Mayor Ltd finance by using trade credit, then as a debtor

company Mayor Ltd may does not get any discount on purchase from creditors.

Finance Leases

A lease is an agreement between two parties- one is lessor other is lessee. The

lessor owns a capital asset, but allows the lessee to use it. The lessee makes

payments under the terms of the lease to the lesser, for a specific period of time.

Leasing is, therefore, a form of rental. Leased assets have usually been plant and

machinery, cars and commercial vehicles, but might also be computers and office

equipments.

The business pays a regular amount for a period of time, but the item belongs to the

leasing company. Most owners’ cars are leased to business. The business pays the

monthly fees for using the car.

According to Geoff Black (2005) (Pg-136), “ A finance lease means by which

companies obtain the right to use assets over a period time. The ownership of the

assets never passes to the actual users of the assets.”


Advantages of Finance Leases

Cheaper in the short run investment. Cash flow management easier because of regular payments.

Disadvantages of Finance Leases:

More expensive in the long run, the leasing company charges fees that make the total cost greater than the original cost.

Hire Purchase

Hire purchase is a form of instalment credit. It is similar to leasing, with the

exception that ownership of the goods passes to the hire purchase customer on

payment of the final credit instalment, whereas a lessee never becomes the owner

of the goods. Hire purchase agreements usually involve a finance house.

The Mayor Ltd may use the hire purchase finance from a finance house in order to

purchase the fixed asset. Goods bought by businesses on hire purchase include

company vehicles, plant and machinery, office equipment and farming machinery.

In hire purchase system buyer gets only physical possession of goods but not gets

the ownership. The price of goods is agreed to be payable in easy instalments with

interest. After finish all instalments of price of goods, and then buyer gets the

ownership of that product.

According to Rao (2005) (Pg-736), “ Hire purchase is a methods of sale under

which the seller undertakes to sale the goods with an agreement to receive cash

price in convenient instalments. The physical possession goods are delivered at the

time of agreement.”


Advantages of Hire Purchase

A hire purchase agreement allows a consumer to make monthly/quarterly/yearly

repayments over a pre-specified period of time.

The hire purchase agreement allows a consumer to purchase the goods when

they are not in a position to pay in cash.

The rate of acceptance on hire purchase agreements is higher than other forms

of unsecured borrowing because the lenders have collateral.

Disadvantage of Hire Purchaser

In hire purchase agreements, buyer needs paying more money than the original

price of product.

If buyer miss any instalment, the result is might be lose the product with what he

already paid.

If the buyer breaks or lost the purchase items, he still has to pay all instalments

of those items as well having to replace the items.

Government Grants

The government provides finance to companies in cash grants and other forms

such as lotteries of direct assistance, as part of its policy of helping to develop the

national economy, especially in production related industries and in areas have a

high unemployment opportunity. The Mayor Ltd may take this financial source for

short-term as well as medium-term financing. Mayor Ltd have a opportunity for get

a government grants because of they are producing company.


On the basis of duration or period, sources of finance may be three types (Short-Term,

Medium-Term and Long-Term) those are appearing in diagram in following:

Short-term Finance

Short-term finance is finance that uses for a period of less than a year. It is required to

provide working capital for the business. The working capital is needed to purchase of raw

material, payment of wages, salaries, and keeping stocks and meeting day-to-day

expanses of the business.

In short-term period Mayor Ltd may use the following sources:

Retained Profits

Business Angels

Bank Overdrafts

Trade Credits

Short-term Bank Loan etc.


Finance

1. Retained Profits 2. Hire purchase (HP) 3. Finance leases 4. Govt. grants

Short Term Medium Term Long Term

1. Retained Profits 2. Business Angels 3. Bank Overdrafts 4. Trade Credits 5. Short-term bank loan

1. Retained profits 2. Long-term bank loan 3. Financial Institution

Medium-Term Finance

In financial language “medium-term” can be thought as consulting a broad and ill-defined

border between short-term and long-term finance. Medium-term finance is a finance that is

uses for more than one five years. Sources of medium-term finance is include the following

those are can be uses by Mayor Ltd:

Retained profits

Finance leases

Government grants

Hire purchase (HP) etc.

Long-Term Finance

Long-term sources of finance are those that are needed over a longer period of time -

generally over five years. For example, to invest in the new project organisation should be

uses long-term finance.

Mayor Ltd should be takes the long-term finance for investment in the new project

appraisal and their fund may be raises by using following sources:

Long-term Bank Loan

Retained Profits

Owners equity

Other financial Institutions etc


Summary of finance sources

Sources Terms Internal

External

Short-term Retained ProfitsBusiness Angels

OverdraftsTrade CreditsShort-term Bank Loan

Medium-term Retained Profits Hire PurchaseFinance LeasesGovt. Grants

Long-term Retained ProfitsOwners Equity

Long-term Bank LoanOther Financial Institution


Factors to be considers before deciding appropriate sources of finance:

Organisation financial planning should be related with organisation's goals and objectives

and then it would be developing ways achieving goals. To be able to do this, financial

manager must have realistic knowledge about finance within the organisation, for example

when need to raise the finance, how much and which sources will be use for the finance

etc.

The Mayor Ltd should consider into following factors before deciding how to satisfy its

financial requirements:

Structure of Organisation

Decision about finance may determine the type of business structure on

organisation takes.

Length or Period of Finance

Before financing it is very important for Mayor Ltd that for what times fund will be

taken- (short-term / long-term / medium-term).

Cost of Fund

It is also be considered that the cost of finance before financing in the business. The

Mayor Ltd should take the decision that which sources they use for financing. For

example, cost of equity finance is more than high then the debt finance.

Risk of the Finance

Generally, short-term sources of finance are riskier then the long-term sources from

the borrowers points of view in that they may not be renewed or may be renewed on

less favourable terms. Another risk for the short-term borrowers is that interest rate

of short-term loan is not a constant the long-term loan and this risk is

compounded if floating rate short-term debt such as overdrafts is used. So, Mayor

Ltd should consider this factor before finance.


Effect of Gearing

If the organisation arranging finance by taking more debt then may affect business

flexibility and also the company might be fall in serious difficulties such as bankrupt.

Usually interest has to be paid on the debt. Debt or loan must be repaid even when

a business looses/decline the profits or costs rises unexpectedly.


Outcome: 2.0

Cash Budget

Definition

Cash budget is a one of the important business planning mechanism or tool which aid to

the managers anticipate the expected cash inflows that means cash receipts and outflows

that mean cash payments for a budget period. Cash budget ensure and makes the

provision for minimum cash balance has to be maintained all time.

According to Horne et al (2008) (Pg-180)“ A cash budget is arrived at through a

projection of future cash receipts and cash disbursements of the firm over various

intervals of time. It reveals the timing and amount of expected cash inflows and

outflows over the period studied.”

Benefits and Significance of Cash Budget

Planning Tool

Cash budget is a planning tool. The major benefit of the statement of cash flows is

that users may get the reasonably detailed picture of a company's operating,

investing and financing transactions involving cash.

Forecasting the Future Needs

Cash budget forecasts the future needs of funds, its time and the amount well in

advance. It, thus, helps planning for raising the funds through the most profitable

sources at reasonable terms and costs.

Maintenance of Cash Balance

Cash is the basis of liquidity of the enterprise. Cash budget helps in maintaining the

liquidity. It suggests sufficient cash balance for expected requirements and a fair

margin for the contingencies.


Controlling Cash Expenditure

Cash budget acts as a controlling device. The expenses of various departments in

the firm can best be controlled so as not to exceed the budgeted limit.

Evaluation of Performance

Cash budget acts as a standard for evaluating the financial performance.

Bank Purpose

The management demonstrate of the ability of company its working capital ability.

Its also represents the lifeblood of a company. Many lenders and or creditors lend

the money to the company after reviewing the company's cash budget. So, to

getting loan company should be prepared and maintain the cash budget statement

regularly.


The Mayor LtdProjected Cash Flow Statement

(From January-2010 to June-2010)

Months Jan-2010 Feb-2010 Mar-2010 Apr-2010 May-2010 Jun-2010

Cash Receive

Receipts from cash sales £60,000 £63,500 £55,000 £52,000 £65,000 £68,000

Cash from debtors £35,000 £40,000 £38,000 £30,000 £45,000 £40,000

Cash from selling furniture --- --- --- --- --- £6,000

Total Collection £95,000 £103,500 £93,000 £82,000 £110,000 £114,000

Payments

Purchase Materials £27,000 £25,000 £29,500 £27,000 £25,500 £30,000

Purchase Fixed Assets --- --- --- --- £22,000 ---

Staff Salary and wages £24,000 £25,500 £24,500 £23,500 £27,000 £22,500

Administrative Expenses £12,000 £11,700 £9,800 £14,500 £17,000 £16,500

Miscellaneous Expenses £5,000 £4,500 £5,500 £5,000 £5,700 £4,500

Tax --- --- --- --- --- £15,000

Other Equipment --- --- --- --- £30,000 ---

Total Payments (£68,000) (£66700) (£69,300) (£70,000) (£127,000) (£88,500)

Surplus (Deficits) £27,000 £36,800 £23,700 £12,000 (£17,000) £25,500

Cash in Bank (£35,000) (£8,000) £28,800 £52,500 £64,500 £47,500

Closing Balance (£8,000) £28,800 £52,500 £64,500 £47,500 £73,000


Function of Preparing a Budget

Budget is a integrated part of long-term planning process for business organisation.

Budgeting is concern with the implementation of the long-term plan for the following year.

Budgets are a clear indication of what is expected to be achieve during the budget period

whereas long-term plans represent the broad directions the top management intend to

follow. For implementing budget, top management should follow the following steps:

Planning

The budgeting process ensures that managers do plan for future operations, and

that they consider how conditions in the next year might change and what steps

they should take now to respond to these conditions. This process encourage

managers to anticipate problems before they arise, and hasty decisions that are

made on the spur on the moment.

Coordination

The budget serves as a vehicle through which the actions of the different parts of

an organisations can be brought together and reconcile into a common plan.

Without any guidance, managers may each make their own decisions, believing that

they are working in the best interests of the organisation.

Communication

Through the budget, top management communicates its expectations to lower-level

management, so that all members of organisation may understand organisation's

expectations and objectives and can coordinate their activities to attain them.

Motivation

The budget can be useful device for influencing managerial behaviour and

motivating managers to perform in the line with the organisational objectives. A

budget provides a standard that under certain circumstances, a manager may be

motivated to strive to achieve. If individuals have have actively participated in

preparing the budget, and it is used as a tool of assist managers in managing their

departments, it can act as a strong motivational device by providing a challenge.


Control

A budget assists managers in managing and controlling the activities for which they

are responsible. By comparing the actual results with the budgeted amounts of

different categories of expenses, managers can ascertain which costs do not

conform to the original plan thus require the attention.

Performance Evaluation

A manager's performance is often evaluated by measuring his or her success in

meeting the budget. Most of the organisation give award or promotion on the basis

of an manager's or employee's ability to achieve the targets specified in the budget

period. So, the use of budgets as a methods of performance evaluation also

influences human behaviour.


Implication of Preparing the Budget at the Lower Level of Management

Organisational Structures are represent by pyramid:

Behavioural Aspects of Budgeting

Communication

The budget can helps the different division, departments and different levels within

organisation to communicate their plans and needs to each other and it can helps

managers at all levels to anticipate potential problems. This communication activity

is one of the most important benefits of the budgeting process.

Motivation

The budget can be useful device for influencing managerial behaviour and

motivating managers to perform in the line with the organisational objectives. Lower

level employee of organisation will be motivated when they participates in

implementing the budget.


Strategic Level

Mid-level Management

Lower Level Management

Goal Congruence

When implementation of budget, all employee of organisation, that means lower

level to top level, will follow the same directions i,e everybody follow the how to

achieve organisation's goals and objectives.

Target

Budget is setting of future target of organisation. As a result, by setting of budget all

employee of organisation known that what will be next production target or sales

target.

Slack

When the budget contains easy targets, its described as containing slack.


Outcome: 3.0

Methods of New Projects Appraisal

Projects

A project is a specific plan or design presented for consideration. A project can be long

term or short term, limited or comprehensive, single sector concentrated or multi sector

concentrated.

As per United Nations Industrial Development Organisation (1998), “A project

as a proposal for an investment to crate and or develop certain facilities in order to

increase the production of goods/services in a community certain period of time.”

Steps of Project Implementation

Identifying the Project

The first phase of project management is the concerned with identifying the project

to achieve the desired objectives. The initial task coming under project identification

is to find out the sources of the project.

Project Analysis

The factors included under project need analysis are the, problem, solutions,

beneficiaries and decisions. The problem should exhibit an immediate intervention.

The focus should be to identify the beneficiaries. The solutions should be based on

the original problem. The decision to take up the project lies on how these three

factors problem, solutions and beneficiaries are important to project intervention.

Project Planning

Project planning is a scientific and systematic process in which logical linkages are

clearly established among the various elements of projects. Successful

implementation of the project depends on effective project plan. Based on the

anticipated goals and objectives the project planning to be made.


Project Budget

This project budget is to calculate the cost of each project out put. The estimation

of the project cost should be made on fairly realistic sense of financial values. In the

multi year projects the inflation rate also to be anticipated in advance.

Financial Feasibility Analysis

One of the very important factors that a project team should meticulously prepare is

the financial viability of the entire project. This involves the preparation of cost

estimates, means of financing, financial institutions, financial projections, break-

even point, cash-flows, pay back period, ratio analysis, profitability analysis by

NPV, IRR etc.

Environmental Analysis

Environmental appraisal concerns with the impact of environment on the project.

The factors include the water, air, land, sound, geographical location etc.

Project Implementation

This is the period in which all the activities that are planned in the initial phases of

the project get materialized through operation. It is the task of the project managers

to apply different techniques like as PERT (Programme Evaluation and Review

Technique), CPM (Critical Path Method) for implementing the project.

Evaluation

The final stage is the evaluation of the project. Upon the conclusion of the project

success in attaining the goals, and to determine how future projects could be

managed. Here the effectiveness of the degree of the objective achievement, the

efficiency of the financial, human, and time resources to be observed by

performance appraisal, work audit, result evaluation, cost benefit evaluation, impact

analysis etc.


Projects Appraisal Techniques

There are different types of techniques are uses for analysis of new project financial

feasibility such as Pay-back period, Net Present Value (NPV), Internal Rate of Return

(IRR) etc.

Payback Period

Generally, pay-back period means the length of time required to pay back the

original investment. This methods focus on the recovering period of cost of

investment.

As per Berman et al (2006)(Pg-187), “The payback method is probably the

simplest to evaluate the future cash flow from a capital expenditure. It measures the

time required for the cash flow from the project to return the original investment.”

Advantages

It is easy to calculate.

Manager can take the decision instantly.

Considers timing of cash flows.

Disadvantages

It does not consider profits of the project.

It does not take into consideration time value of money. It ignores taxes and

inflation.

Net Present Value (NPV)

Generally, Net Present Value (NPV) is the sum of all discounted cash flows.

Broadly, NPV is an amount which is the result of difference between present value

of cash inflows and present value of cash outflows. This amount is the expected

result of investment. NPV is used in capital budgeting to analyse the profitability of

an investment or project. If the present value of a project's future cash inflow is

greater than the initial investment, that project should be undertaken for future

investment.

As per Horne et al (2005)(Pg-323), “The net present value (NPV) of an investment

proposal is the present value of the proposal's net cash flows less the proposal's

initial cash outflow.”


Formula of NPV is following below:

Here,

I-0 mean initial investment or cash outflows

I-1 mean cash inflows in first period or first year

I-2 mean cash inflows in 2nd period

'n' mean the last number or year to investment

and r mean discount rate of factor.

Advantages of Net Present Value Method

It consider time value of money.

It also consider all relevant cash flows rather than the net earnings.

The NPV method is capital budgeting, therefore, should ultimately lead to more

wealth for the owner of the company.

Disadvantages of Net Present Value Method

NPV is calculated with consideration of predicted cash flows. Overestimation or

underestimation of future cash flows may lead to the acceptance of project that

should be rejected, or the rejection of project that should be accepted.

The NPV method also assumes that the predicted discount rate which is the

same over the whole period of the project. The discount rate of project like as

the interest rate, which is changes from one year to another. Opportunities of

reinvestment future cash flows , future interest rate and the cost of raising new

capital can all affect the discount rate.

NPV method is more difficult to calculate, needs table of discount factor.


�

I0 +I1

(1+r)1+

I2

(1+r)2 +........ +In

(1+r)n

Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is the discount rate that results in the net present

value of zero for a series of future cash flows. It is the measure of the rate of

profitability.

According to Groppelli et al (2000)(Pg-159), “ IRR is the discount rate that makes

the present value of cash flows equal to the initial investment.”

Advantages of Internal Rate of Return (IRR) method

It gives consideration to the time value of money.

Considers all relevant cash flows.

Disadvantages of Internal Rate of Return (IRR) method

Difficult to calculate.

Less understand by non-financial managers.

Assumes that all intermediate cash flow's are reinvested at company's internal

rate of return.


Result of NPV, IRR and Pay-back Period for project 'X' and 'Y' in following below:

(See appendix for calculation)

Project ' X ' Project ' Y '

Net Present Value (NPV at 10% ) £63235 £14074

Internal Rate of Return (IRR) 22.85% 13.83%

Payback Period 2.89 Years 3.67 Years

Since as per NPV method, both project would be profitable because both project NPV is

positive. But project 'X's NPV is higher then the project 'Y'. It means project 'X' will be more

profitable then the project 'Y'. Therefore, project 'X' should be preferred for future

investment appraisal to Mayor Ltd.

As per IRR method, project 'X' also should be preferred for future investment. Because

project 'X' will give the more then 22 percents return on the initial investment. While project

'Y' will give only 13.83 percents return on the investment.

Based on Pay-back method, if the Mayor Ltd will invest £200000 on project 'Y' then Mayor

Ltd recover the initial investment after 3.67 years where as project 'X' will give to return it

within 2.89 years. So, Pay-back Period method represents that project 'X' should be better

for future investment than the project 'Y'.

Since, among the all project appraisal method project 'X' is better and more profitable

comparing with project 'Y'. Therefore, if the Mayor Ltd want to finance by investing in the

project, project 'X' would be recommended for future investment.


Chart No. 01

This line chart represents that, when discount rate is 10% that time project (X) NPV is

£63235 and with 30% discount rate, NPV is (-£35145). And Internal Rate of Return (IRR)

of project X is 22.85%. Where as, when discount rate is 10% that time project (Y) NPV is

£14074 and with 30% discount rate, NPV is (-£59419). And these two NPV were intersect

on discount rate line which value is 13.83%, this percentage would be called IRR for

project 'Y'.


IRR(Y)=13.83%

IRR(X)=22.85%

Discount Rate

NPV

Outcome No. 4.0

Ratio Analysis

Ratio analysis is businesses performance measurement tools which analyse and

investigate the financial health of business by considering information of financial

statements, balance sheet as well cash flows statements. Ratios are calculated from

current year numbers and are then compared to previous years, other companies, to other

industry, or even the economy to judge the performance of the company.

“Financial ratio analysis is the calculation and comparison of ratios which are

derived from the information in a company's financial statements. The level and

historical trends of these ratios can be used to make inferences about a company's

financial condition, its operations and attractiveness as an investment”.

http://www.finpipe.com/equity/finratan.htm

Ratio might be grouped into four categories, each of which relates to a particular aspects

of financial performance or position.

Strengths of Business Organisation

Profitability, Liquidity, Gearing and Efficiency are strengths of any business organisation.

When all four strengths are exists in an organisation that organisation would be called very

good organisation. An business organisation may measure these four strengths by using

ratio analysis.


Financial Gearing

ProfitabilityLiqu

idity

Eff

icie

ncy

Profitability Ratio

Profitability Ratio concerned with the firm's effectiveness at generating profits. This

ratio use for margin analysis and show the return on sales and capital employed.

The profitability ratio demonstrate that a firm's business performance during a

financial period. Profitability ratio includes the Gross Profit Margin (GPM), Net Profit

Margin and Return on Capital Employed.

As per Nikolai et al (2007)(Pg-279), “ Profitability ratios are used to evaluate how

effective a company has been in meeting the profit (i.e, return) objectives of its

owners.”

liquidity ratio

liquidity deals with the amount of cash a firm can manage quickly in order to

immediate debts or short-term obligation. Liquidity ratio concerned with the ability to

meet short-term debt. Liquidity ratio may includes the current ratio, acid test.

According to Floyd (2004)(Pg-83), “Liquidity ratio help establish whether a firm is

over drafting, expanding without sufficient long-term capital. This puts pressure on

its working capital, the excess of current assets over current liabilities.”

Financial Gearing

Gearing ratio illustrate the level of debt a firm have taken to finance for its

activities. Gearing ratio concern with the relationship between equity and debt

financing. This strength may measure by the gearing ratio and interest coverage

ratio.

As per Elliott et al (2007) (Pg-659), “ The gearing ratio represents that proportion of

capital employed which is accounted for by long-term fixed interest debt. The

gearing structure of a company refers to the amount of borrowings compared with

the amount of shareholders funds.”


Efficiency

Efficiency ratio may be used to measure the efficiency with which particular

resources have been used within the organisation such as stock or inventory,

debtor, creditor etc. There are different types of ratio are uses for measuring the

firm's efficiency such as stock turnover ratio, debtor turnover ratio, creditor turnover

ratio, fixed assets turnover ratio, debtor collection period etc.

Limitation of Ratio Analysis

Although the ratio analysis may may provide useful information concerning firm's

operations and financial conditions, however it does have some limitations that necessitate

care and judgment those are given below:

Ratio analysis consider only financial figure but it does not consider other

environmental factors.

Many large firms operate different divisions in different industries, such as Virgin,

for such company's it is difficult to develop a meaningful set of a industry

average. Therefore, ratio analysis is more useful for small, narrowly focused

firms than for large, multi-divisional ones.

Ratio analysis does not identify short-term fluctuation within one year in assets

and liabilities as appraisal is based on a balance sheet which provides value of

assets and liabilities as at a point in time.

A ratio does not indicate the quality of its components.


Profitability Measurement of Mayor Ltd Compared with Industry


Ratio Mayor Ltd (2007) Industry (2007) Industry (2006)

Gross Profit Margin 48.14% N.A N.A

Net Profit Margin 7.00% 5.00% 5.00%

Return on Capital Employed 12.50% 10% 10%

The gross profit margin of Mayor Ltd was 48.14% in 2007 financial year which is

very good for any business firm. However, net profit margin was only 7% over the

sales revenue which is huge declined comparatively gross profit margin. This was

probably caused by high operating expenses which was £300,000 in one financial

period. So, Mayor Ltd should try to give more consideration to minimise the

operating cost.

The Industry's gross profit margin is not available, therefore it is not possible to

compare the results. However, the net profit margin of Mayor Ltd is

comparatively better by 2% than the Industry's net profit margin.

In 2007 financial year the Mayor Ltd's return on capital employed (ROCE) was

12.5%, it means Mayor Ltd got the 12.5 pence on each pound investment. In

relation, Mayor Ltd's ROCE (2007) is the quite better by 2.5% than the Industry's

ROCE (2006 &2007).

Liquidity Measurement of Mayor Ltd Compared with Industry



Current Ratio 2.05:1 1.2:1 1.5:1

Acid test 1.10:1 1:1 1:1

The Mayor Ltd's current ratio was 2.05:1, it means, for every pound liabilities there

are more than 2 pounds current assets available. This also means that, Mayor Ltd's

will have no difficulty in raising short-term finance either credit sales or keeping

stock. Mayor Ltd's current assets were more than sufficient to cover its current

liabilities. In relation, Mayor Ltd's current ratio looks very good compare to Industry's

current ratio, which was 1.2:1 in 2006 and 1.5:1 in 2007 financial period.


On the other hand in acid test, Mayor Ltd was very strong on the liquid assets.

Mayor Ltd's no difficulties to handle the current liabilities. For every pound liability

there are 1.10 pound quick assets were available. On the basis of acid test, Mayor

Ltd is quite good than the Industry acid test.

Gearing Measurement of Mayor Ltd Compared with Industry



Gearing Ratio 15.00% N/A N/A

The gearing ratio illustrate that, level of debt a company have taken to finance of its

activities. In 2007 financial year, gearing ratio of Mayor Ltd was 15%. It means the

level of gearing is quite low. And the Mayor Ltd's will not have problem in

increasing long-term debt. Because the Industry's gearing ratio is not available, so it

is difficult to compare a sound judgement with Mayor Ltd.

Efficiency Measurement of Mayor Ltd Compared with Industry



Debtor Turnover Ratio 31.52 times N/A N/A

Creditor Turnover Ratio 15.24 times N/A N/A

Fixed Assets Turnover Ratio 1.80 times N/A N/A


Bibliography

Berman, K., Knight, J. and Case, J.(2006), Financial Intelligence, 1st Edition (Pg-

187), Harvard Business School Press.

Black, G. (2005) Introduction to Accounting and Finance.1st Edition (Pg-136)

Elliott, B. and Elliott, J.(2007), Financial Accounting and Reporting, 11th Edition,

(Page-659), Pearson Education Limited.

Floyd, D.(2004), Business Studies, 2nd Edition, (Page-83), Letts Educational

Chiswich Centre.

Gallati, R. (2003) Risk Management and Capital Adequacy (Pg-130)

Groppelli, A.and Nikbakht, E.(2000), Finance, 4th Edition (Page-159), Berron's

Education Series, Inc.

Horne, J. and Wachowicz, J. (2008), Fundamentals of Financial Management. 13th

Edition (Pg-180),Pearson Education Limited.

Horne, J. and Wachowicz, J. (2005), Fundamentals of Financial Management. 12th

Edition (Pg-323), Pearson Education Limited.

Mclaney, E. and Atrill, P. (2005) Accounting: an introduction. 3rd Edition (PG-515)

Nikolai, L., Bazley, J. and Jones, J.(2007), Intermediate Accounting, 11th Edition,

(Page-279), South-Western Cengage Learning.

Rao, M. (2005) Advanced Accounting.1st Volume (Page-736)-New Age International

(P) Ltd.

United Nations Industrial Development Organisation (1998), Manual For Evaluation

of Industrial Projects, Oxford and IBH New York.

Watson, D. and Head, A. (2007) Corporate Finance: Principle and Practices. 4th

Edition (Pg-70)


http://www.finpipe.com/equity/finratan.htm

http://www.teachnet-uk.org.uk/2007%20Projects/Biz-GCSE

%20Finance/sources/external.htm


Appendix

1) Calculation of Net Present Value (NPV)

Formula of NPV=

Here,

I-0 mean initial investment or cash outflows

I-1 mean cash inflows in first period or first year

I-2 mean cash inflows in 2nd period

'n' mean the last number or year to investment

and r mean discount rate of factor which is 10%.

NPV of Project 'X' =

= £63235 [ using calculator]

NPV of Project 'Y'=

= £14074 [ using calculator]


�

−200000 +40000

(1 + 0.1)1+

80000

(1 + 0.1)2 +90000

(1 + 0.1)3 +100000

(1 + 0.1)4 +40000

(1 + 0.1)5

�

I0 +I1

(1+ r)1+

I2

(1+ r)2 +........ +In

(1+ r)n

�

−200000 +80000

(1+ 0.1)1 +40000

(1+ 0.1)2 +40000

(1+ 0.1)3 +60000

(1+ 0.1)4 +60000

(1+ 0.1)5

2) Calculation of Internal Rate of Return (IRR)

IRR of project 'X'

For calculating IRR, its need to another NPV with different discount factor.

Let, guess a discount factor is 30%

So, New NPV=

= -35143

Formula of IRR=

=

= 22.85%

IRR of project 'Y'

For calculating IRR, its need to another NPV with different discount factor.

Let, guess a discount factor is 30%.

So,New NPV=

= -59419

Formula of IRR=

=

= 13.83%


�

−200000 +80000

(1+ 0.3)1 +40000

(1+ 0.3)2 +40000

(1+ 0.3)3 +60000

(1+ 0.3)4 +60000

(1+ 0.3)5

�

−200000 +40000

(1+ 0.3)1 +80000

(1+ 0.3)2 +90000

(1+ 0.3)3 +100000(1+ 0.3)4 +

40000(1+ 0.3)5

�

Lowerdiscountfactor +(HigherNPV

HigherNPV - LowerNPV)Higherdiscountfactor - Lowerdiscountfactor

�

10%+(63235

63235 - (- 35143 ))30%- 10%

�

Lowerdiscountfactor + (HigherNPV

HigherNPV - LowerNPV)Higherdiscountfactor - Lowerdiscountfactor

�

10%+(14074

14074 - (- 59419 ))30%- 10%

3) Calculation of payback period

Formula of Pay-back Period =

Last year with the negative cash flow + ( ) × 12 months

Cash flows of project 'X'

Year Cash flow Amount left to recovering

0 -200000 -200000

1 40000 -160000

2 80000 -80000

3 90000 10000

4 100000 110000

5 40000 150000

So, Pay-back Period of project 'X' = 2 years +(80000/90000)× 12

= 2 years 10 months and 20 days or 2.89 years

Cash flows of project 'Y'

Year Cash flow Amount left to recovering

0 -200000 -200000

1 80000 -120000

2 40000 -80000

3 40000 -40000

4 60000 20000

5 60000 80000

So, Pay-back Period of project 'X' = 3 years +(40000/60000)× 12

= 3 years and 8 months or 3.67 years


Total amount paid back in final year

Amount left to pay back in final year

4) Calculation of Profitability

Formula of Gross Profit Margin = × 100

= × 100

= 48.14%

Formula of Net Profit Margin = × 100

= × 100

= 7%

Formula of Return on Capital Employed (ROCE)= × 100

= × 100

= 12.50%

5) Calculation of Liquidity

Formula of Current ratio =

=

= 2.05:1


Gross profit

Sales Revenue

£3,49000

£725,000

Net profit

Sales Revenue

£50,000

£725,000

Net Profit

Net Assets

£50,000

£400,000

Current Liabilities

£107,000

£52,000

Current Assets

Formula of Acid test =

=

= 1.10:1

6) Calculation of Gearing

Formula of Gearing Ratio = × 100

= × 100

= 15%

7) Calculation of Efficiency

Formula of Debt Turnover =

=

= 31.52 times

* [N.B: There are no credit sales figure in Financial Statements of Mayor Ltd, so sales revenue considered as a credit sales.]

* [N.B: There are no opening balance of debtors in Balance sheet of Mayor Ltd, so ending balance of debtors has been considered as a average debtors.]

Formula of Credit Turnover =

=

= 15.24 times


Current Liabilities

£107,000 - £50,000

£52,000

Current Assets - Stock

£60,000

£400,000

Long-term Liabilities

Total Assets

Average Debtor*

£725,000

£23000

Credit Sales*

Credit Purchase*

Average Creditors*

£25000

£381,000

* [N.B: There are no credit purchase figure in Financial Statements of Mayor Ltd, so purchase considered as a credit purchase.]

* [N.B: There are no opening balance of creditors in Balance sheet of Mayor Ltd, so ending balance of creditors has been considered as a average creditors.]

Fixed Assets turnover ratio =

=

= 1.80 times


Turnover

Fixed Assets

£725,000

£405,000

Finance Assignment

Documents

business owners finance

sources of finance outcome

business share

finance available

business angels owners

owners business activities

finance leases

capital finance