# Financial management Essay Example

Financial management 7

Financial Management

Lecturer

Q1 Capital budgeting

1. i) accounting rate of return

Accounting rate of return is the ratio of estimated accounting profits of a project to the average investment made in the project. It is a method of investment appraisal as Myers (1974) asserts.

ARR = average accounting income/ average investments

Depreciation = (\$20,000,000 +\$ 1,910,000)/5

= \$4,382,000

Average income = \$(1,100,000 + 4,250,000 + 8,625,000 + 10,000,000)/4

= \$23,975,000/4

= \$5,993,750

= \$5,993,750 — \$ 4,382,000

= \$1,611,750

ARR = (\$1,611,750/\$21,910,000) x 100

= 0.0736 x 100

Using ARR this project should not be accepted because the ARR is below the required rate of return of 10%

1. Payback period

This is the time in which the initial cash outflow of the investment is expected to be recovered from the cash inflow expected from the investment. It’s also a method of an investment appraisal as Gebhardt & Swaminathan (2001) argues.

Payback period = initial investment/ cash inflow per period or

Payback period = negative cash flows + (cumulative cash flow at end of negative period/cash flow after negative period)

= 3 + (\$3,440,000/\$8,625,000)

= 3 + 0.399

= 3.4 years

1. The net present value

This is the net present value of the net cash inflows generated by the project.

 − Initial Investment

Where I is the target rate of return

R1 is the cash flow during the first period

R2 is the cash flow during the second period

R3 is the cash flow during the third period and so on until the last period.

= 1 ÷ (1 + 10%) ^1

NPV = (2,090,000 x 0.9091 + 5,100,000x 0.4545 + 8,250,000 x 0.3030 + 12,652,000 x 0.2272 + 14,000,000 x 0.1818) – 20,000,000

= (1,900,019 + 2,317,950 + 2,499,750 + 2,874,534 + 2,545,200) – 20,000,000

= 12,137,453 – 20,000,000

= (7,862,547)

1. Deference between independent projects and exclusive projects.

Independent projects are a project whose feasibility can be assessed without consideration of any other project. Exclusive projects are those which only one of the designed projects can be accepted.

1. Disagree

1. i) Operating cycle

COGS per day \$99,680/365 = 273.10

Days inventory outstanding \$12,890/273.1 = 47.20

It takes 47.20 days to turn inventory in to sales.

Revenues per day \$124,600/365 = 341.37

Days sales outstanding \$12,800/341.37 = 37.50

How many days it takes to collect cash from sales

Days payable outstanding \$12,670/273.10 = 46.39

Days it takes to pay suppliers for inventory

Operating cycle = 47.20 + 37.50

= 84.7 days

ii) Cash conversion cycle

Time it takes a company to convert its resource inputs in to cash, how effective the company is managing its working capital.

Cash conversion cycle = days sales outstanding + days inventory outstanding – days payable outstanding

= (47.20 + 37.50) – 46.39

= 84.7 – 46.39

= 38.31 days

1. Efficiency of working capital management of Mega Mart

If the industry averages operating cycle of 75 days and cash conversion cycle of 40 days shows that mega mart is not efficient. To be efficient it should have less than the industries average. It is taking too long mega mart to convert its resources in to sales. It is not efficient.

b) Just in time inventory management system

Just in time inventory management system is the process of ordering and receiving inventory for production and customer sales only as it is needed and not before. This implies that a company cannot hold stocks safety and at the same time operaqt5es with very little inventory. This in turn helps to lower the inventory holding costs.

1. The beta coefficient measures the part of the assets statistical variance that cannot be moved by the diversion given by the portfolio of the risk assets, because of the correlation of its return with the returns of the other assets that are also in the portfolio.

2. The systematic risk in relation to each other is that company B is more stable than company A. the lower the beta coefficient the more stable it is. The systematic risk in relation to the market is that company A is more vulnerable to market risks than company B. Company B cannot be affected by market changes as company A would. Conditions in the market will affect company A more than company B.

3. Required rate of return

= E(R) = RFR + β stock (Rmarket – RFR) where

• E(R) = the required rate of return, or expected return

References

Myers, S (1974) Interactions of corporate financing and investment decisions implications for capital budgeting The Journal of finance, 29(1), 1-25

Froot, K, & Stein, J, (1998) Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach Journal of Financial Economics, 47(1), 55-82.

Shin, H, & Soenen, L, (1998) Efficiency of working capital management and corporate profitability Financial Practice and Education, 8, 37-45

Jain, P, Singh, S, & Yadav, S, (2013) Working Capital Management in Financial Management Practices (pp. 177-255). Springer India

Hurley, W, & Johnson, L, (1994) A realistic dividend valuation model Financial Analysts Journal, 50-54.

Ross, S, \$ Westerfield, R, (2002) Corporate finance (Vol. 7) Boston: McGraw-Hill/Irwin

Brealey, R, & Allen, F (2006) Corporate finance McGraw-Hill/Irwin

Gebhardt, W, & Swaminathan, B, (2001) toward an implied cost of capital Journal of accounting research, 39(1), 135-176.