Management consultancy-chapter-26-and-35

PFS : FINANCIAL
ASPECT –
PROJECT
FINANCING AND
EVALUATION
Chapter 26

Determining Funds Requirements
and Profitability
 Projected Statement of Comprehensive
Income
 Operating cost ratios (i.e. COS, SAE, to Sale)
 Projected Statement of Financial Position
 Projected Cash Flow Statement
- to evaluate the economic viability of the project and its
financial requirements, the following statement may be prepared

Sources of Financing
I. Equity
II. Loan Financing
a) Short-term loans
b) Long-term loans

Number of Local Calls
MonthlyBasic
TelephoneBill
Total fixed costs remain unchanged
when activity changes.
Your monthly basic
telephone bill probably
does not change when
you make more local calls.
Total Fixed Cost

Number of Local Calls
MonthlyBasicTelephone
BillperLocalCall
Fixed costs per unit decline
as activity increases.
Your average cost per
local call decreases as
more local calls are made.
Total Fixed Cost

Minutes Talked
TotalLongDistance
TelephoneBill
Total variable costs change
when activity changes.
Your total long distance
telephone bill is based
on how many minutes
you talk.
Total Fixed Cost

Minutes Talked
PerMinute
TelephoneCharge
Variable costs per unit do not change
as activity increases.
The cost per long distance
minute talked is constant.
For example, 10
cents per minute.
Variable Cost Per Unit

Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable
Changes as activity level
changes.
Remains the same over wide
ranges of activity.
Fixed
Remains the same even
when activity level changes.
Dereases as activity level
increases.
Cost Behavior Summary

Mixed costs contain a fixed portion that is incurred
even when facility is unused, and a variable
portion that increases with usage.
Example: monthly electric utility charge
 Fixed service fee
 Variable charge per
kilowatt hour used
Mixed Costs

Variable
Utility Charge
Activity (Kilowatt Hours)
TotalUtilityCost
Fixed Monthly
Utility Charge
Slope is
variable cost
per unit
of activity.
Mixed Costs

The break-even point (expressed in units of product or
dollars of sales) is the unique sales level at which a
company neither earns a profit nor incurs a loss.
Computing Break-Even Point

Prior to calculating the BEP, the following
assumptions should be observed:
1. Production costs are function of the volume of
production or of sales (e.g. utilization of equipment)
2. Volume of production equals volume of sales
3. Fixed operating costs are the same for every
volume of production
4. Variable unit cost vary in proportion to the volume
of production
5. Unit sale price for a product or product mix are the
same for all levels of output (sales) overtime. The
sales value is therefore a linear function of the
units sales prices and the quantity sold

Prior to calculating the BEP, the following
assumptions should be observed:
6. Data from normal year of operation should be
taken
7. The level of unit sale prices, variables and
fixed operating costs remain constant
8. Single product is manufactured or, if several
similar ones are produced, the mix should be
convertible into a single product
9. Product mix should remain the same overtime

Contribution margin is amount by which revenue exceeds the variable
costs of producing the revenue.
Total Unit
Sales Revenue (2,000 units) 100,000$ 50$
Less: Variable costs 60,000 30
Contribution margin 40,000$ 20$
Less: Fixed costs 30,000
Operating income 10,000$

How much contribution margin must this company have to cover its
fixed costs (break even)?
Total Unit

How many units must this company sell to cover its fixed costs
(break even)?
Total Unit

We have just seen one of the basic CVP relationships – the
break-even computation.
Break-even point in units =
Fixed costs
Contribution margin per unit
Unit sales price less unit variable cost
($20 in previous example)
Formula for Computing
Break-Even Sales (in Units)

The break-even formula may also be expressed in sales
dollars.
Break-even point in dollars =
Fixed costs
Contribution margin ratio
Unit sales price
Unit variable cost
Formula for Computing
Break-Even Sales (in Dollars)

ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are
$200,000 and variable costs are $3.00 per unit, how many
units must be sold to break even?
a. 100,000 units
b. 40,000 units
c. 200,000 units
d. 66,667 units
Computing Break-Even Sales
Question 1

Use the contribution margin ratio formula to determine the amount
of sales revenue ABC must have to break even. All information
remains unchanged: fixed costs are $200,000; unit sales price is
$5.00; and unit variable cost is $3.00.
a. $200,000
b. $300,000
c. $400,000
d. $500,000
Computing Break-Even Sales
Question 2

Volume in Units
CostsandRevenue
inDollars
Revenue
 Starting at the origin, draw the total revenue
line with a slope equal to the unit sales price.
Total fixed cost
 Total fixed cost
extends horizontally
from the vertical axis.
Preparing a CVP Graph

Total cost
Volume in Units
CostsandRevenue
inDollars
Total fixed cost
Break-even
Point
Profit
Loss
 Draw the total cost line with a slope
equal to the unit variable cost.
Revenue
Preparing a CVP Graph

Break-even formulas may be adjusted to show the sales volume
needed to earn
any amount of operating income.
Unit sales =
Fixed costs + Target income
Contribution margin per unit
Dollar sales =
Fixed costs + Target income
Contribution margin ratio
Computing Sales Needed to Achieve
Target Operating Income

ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are
$200,000 and variable costs are $3.00 per unit, how many
units must be sold to earn operating income of $40,000?
a. 100,000 units
b. 120,000 units
c. 80,000 units
d. 200,000 units
Computing Sales Needed to Achieve
Target Operating Income

Margin of safety is the amount by which sales may decline before
reaching break-even sales:
Margin of safety provides a quick means of estimating operating income
at any level of sales:
Margin of safety = Actual sales - Break-even sales
Operating Margin Contribution
Income of safety margin ratio= ×
What is our Margin of Safety?

Oxco’s contribution margin ratio is 40 percent. If sales are $100,000
and break-even sales are $80,000, what is operating income?
Operating Margin Contribution
Income of safety margin ratio
= ×
Operating
Income = $20,000 × .40 = $8,000
What is our Margin of Safety?

Once break-even is reached, every additional dollar of contribution
margin becomes operating income:
Oxco expects sales to increase by $15,000. How much will operating
income increase?
Change in
operating income = $15,000 × .40 = $6,000
Change in Change in Contribution
operating income sales volume margin ratio= ×
What Change in Operating Income Do We
Anticipate?

Copyright © 2006 Pearson Addison-
Wesley. All rights reserved.
9-28
Bennett Company is a medium sized metal fabricator
that is currently contemplating two projects: Project A
requires an initial investment of $42,000, project B an
initial investment of $45,000. The relevant operating
cash flows for the two projects are presented in Table
9.1 and depicted on the time lines in Figure 9.1.
Capital Budgeting Techniques
 Chapter Problem

9-29
Capital Budgeting Techniques (cont.)

9-30
Capital Budgeting Techniques (cont.)

9-31
Payback Period
 The payback method simply measures how
long (in years and/or months) it takes to
recover the initial investment.
 The maximum acceptable payback period is
determined by management.
 If the payback period is less than the
maximum acceptable payback period, accept
the project.
 If the payback period is greater than the
maximum acceptable payback period, reject
the project.

9-32
Pros and Cons of Payback
Periods
 The payback method is widely used by large
firms to evaluate small projects and by small
firms to evaluate most projects.
 It is simple, intuitive, and considers cash flows
rather than accounting profits.
 It also gives implicit consideration to the
timing of cash flows and is widely used as a
supplement to other methods such as Net
Present Value and Internal Rate of Return.

9-33
Pros and Cons
of Payback Periods (cont.)
 One major weakness of the payback method
is that the appropriate payback period is a
subjectively determined number.
 It also fails to consider the principle of wealth
maximization because it is not based on
discounted cash flows and thus provides no
indication as to whether a project adds to
firm value.
 Thus, payback fails to fully consider the time
value of money.

9-34
Pros and Cons

9-35
Pros and Cons

9-36
Net Present Value (NPV)
 Net Present Value (NPV): Net Present Value
is found by subtracting the present value of
the after-tax outflows from the present value
of the after-tax inflows.

9-37
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
Net Present Value (NPV) (cont.)
 Net Present Value (NPV): Net Present Value is found by
subtracting the present value of the after-tax outflows
from the present value of the after-tax inflows.

9-38
Using the Bennett Company data from Table 9.1, assume
the firm has a 10% cost of capital. Based on the given
cash flows and cost of capital (required return), the NPV
can be calculated as shown in Figure 9.2

9-39

9-40
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the
discount rate that will equate the present value
of the outflows with the present value of
the inflows.
The IRR is the project’s intrinsic rate of return.

9-41
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
Internal Rate of Return (IRR) (cont.)
 The Internal Rate of Return (IRR) is the discount rate
that will equate the present value of the outflows with the
present value of
the inflows.
 The IRR is the project’s intrinsic rate of return.

9-42
Internal Rate of Return (IRR) (cont.)

9-43
Conflicting Rankings
 Conflicting rankings between two or more projects
using NPV and IRR sometimes occurs because of
differences in the timing and magnitude of cash flows.
 This underlying cause of conflicting rankings is the
implicit assumption concerning the reinvestment of
intermediate cash inflows—cash inflows received
prior to the termination of the project.
 NPV assumes intermediate cash flows are reinvested
at the cost of capital, while IRR assumes that they are
reinvested at the IRR.

9-44
A project requiring a $170,000 initial investment is
expected to provide cash inflows of $52,000, $78,000
and $100,000. The NPV of the project at 10% is
$16,867 and it’s IRR is 15%. Table 9.5 on the
following slide demonstrates the calculation of the
project’s future value at the end of it’s 3-year life,
assuming both a 10% (cost of capital) and 15% (IRR)
interest rate.
Conflicting Rankings (cont.)

9-45

9-46
If the future value in each case in Table 9.5 were
viewed as the return received 3 years from today from
the $170,000 investment, then the cash flows would be
those given in Table 9.6 on the following slide.

9-47

9-48
Bennett Company’s projects A and B were found to have
conflicting rankings at the firm’s 10% cost of capital as
depicted in Table 9.4. If we review the project’s cash inflow
pattern as presented in Table 9.1 and Figure 9.1, we see
that although the projects require similar investments, they
have dissimilar cash flow patterns. Table 9.7 on the
following slide indicates that project B, which has higher
early-year cash inflows than project A, would be preferred
over project A at higher discount rates.

9-49

9-50
Which Approach is Better?
 On a purely theoretical basis, NPV is the
better approach because:
 NPV assumes that intermediate cash flows are
reinvested at the cost of capital whereas IRR
assumes they are reinvested at the IRR,
 Certain mathematical properties may cause a project
with non-conventional cash flows to have zero or
more than one real IRR.
 Despite its theoretical superiority, however,
financial managers prefer to use the IRR
because of the preference for rates of return.

Operational
Auditing
Chapter 35

Operational audits
 - also known as management audits and
performance audits, are conducted to
evaluate the effectiveness and/or efficiency of
operations.

 Effectiveness refers to the accomplishment
of objectives
 Efficiency is defined as reducing costs
without reducing effectiveness
Effectiveness Versus Efficiency

Economy
 refers to an entity's success in maximizing the
use of its limited resources to achieve its
goals and objectives.

Types of Inefficiency Example
Acquisition of goods and
services is too costly
Bids for purchases of
materials are not required
Raw materials are not
available when needed
An assembly line was shut
down for lack of materials
A duplication of effort
by employees exists
Production and accounting
keep identical records

Work is done that serves
no purpose
Vendors’ invoices and
receiving reports are filed
without being used
There are too many
employees
Office work could be done
with one less assistant
Types of Inefficiency Example

Types of Operational Audits
 There are three broad categories of operational audits:
FUNCTIONAL, ORGANIZATIONAL, and SPECIAL
ASSIGNMENTS.
 In each case, part of the audit is likely to concern evaluating
internal controls for efficiency and effectiveness.

Who Performs Operational Audit? - Among the activities of the
internal auditor than can aptly be construed as part of operations
audit are:
• Reviewing the reliability and integrity of financial and operating
information and the means use to identify, measure, classify, and report
such information.
• Reviewing the internal control structure established to ensure compliance
with those policies, plans, procedures, laws, and regulations which could
have significant impact on operations and reports and should determine
whether the organization is In compliance.
• Reviewing the means of safeguarding the assets and, as appropriate,
verify the existence of such assets.
• Appraising the economy and efficiency with which resources are
employed.
• Reviewing operations or programs to ascertain whether the results are
consistent with established objectives and goals and whether the
operations or programs are being carried out as planned.

 CPA firms
 Government auditors
 Internal auditors
Who Performs Operational Audits

The two most important qualities
for an operational auditor are:
Independence and Competence
of Operational Auditors
 Independence
 Competence

Specific Criteria
 Were all plant layouts approved by home office
engineering at the time of original design?
 Has home office engineering done a reevaluation
study of plant layout in the past five years?
Questions that might be used to evaluate
plant layouts:

Specific Criteria
 Is each piece of equipment operating
at least 60 percent of capacity for
three months or more each year?
 Does layout facilitate the movement of
new materials to the production floor?
 Does layout facilitate the production
of finished goods?

Specific Criteria
 Does layout facilitate the movement of
finished goods to distribution centers?
 Does the plant layout effectively use
existing equipment?
 Is the safety of employees endangered
by the plant layout?

Sources of Criteria
 Historical performance
 Benchmarking
 Engineered standards
 Discussion and agreement

Phases in Operational Auditing
 Planning
 Evidence accumulation and evaluation
 Reporting and follow up

Planning
 Staffing
 Understand internal control
 Background information
 Decide on appropriate evidence
 Scope of engagement

Evidence Accumulation and Evaluation
 Documentation
 Client inquiry
 Analytical procedures
 Observation

Reporting and Follow Up
1. In operational audits, the report is
usually sent only to management
Two major differences in operational
and financial auditing reports:
2. Tailoring of each report is required
in operational audits

Examples of Operational
Audit Findings
 Outside janitorial firm saves $160,000
 Use the right tool
 Computer programs save manual labor

Management consultancy-chapter-26-and-35

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