How much will the product cost? What benefits will the system provide?

Tangible benefits Intangible benefits

Is the proposed project cost effective?

Break-Even Analysis Payback Period Analysis Cash-Flow Analysis Net Present Value (NPV) Return-on-Investment (ROI) Analysis

Guidelines to select the method for comparing alternatives:

Use Break-Even Analysis if the project needs

to be justified in terms of cost, not benefits Use Payback Period Analysis when the improved tangible benefits form a convincing argument for the proposed project.

Guidelines to select the method for comparing alternatives:

Use Cash-Flow Analysis when the project is

expensive, relative to the size of the company Use Net Present Value (or ROI) when the payback period is long or when the cost of borrowing money is high

Measure of the effectiveness of an investment of capital Financial efficiency Advantage: easily understood by management and investors

Rate of Return = Net Annual Profit Capital Invested

Length of time required to recover the first cost of an investment from the net cash flow produced by that investment for an interest rate of zero Payout Period = Investment Salvage value Net Annual Cash Flow

An investment of PhP 270,000 can be made in a project that will produce a uniform annual revenue of PhP185,400 for 5 years and then have a salvage value of 10% of the investment. Out-of-pocket costs for operation and maintenance will be PhP81,000 per year. Taxes and insurance will be 4% of the first cost per year. The company experts capital to earn not less than 25% before income taxes. Is this a desirable investment? What is the payback period of the investment?

Breakeven analysis examines the short run relationship between changes in volume and changes in total sales revenue, expenses and net profit Also known as C-V-P analysis (Cost Volume Profit Analysis)

C-V-P analysis is an important tool in terms of short-term planning and decision making It looks at the relationship between costs, revenue, output levels and profit Short run decisions where C-V-P is used include choice of sales mix, pricing policy etc.

How many units must be sold to breakeven? How many units must be sold to achieve a target profit? Should a special order be accepted? How will profits be affected if we introduce a new product or service?

Break even point-the point at which a company makes neither a profit or a loss. Contribution per unit-the sales price minus the variable cost per unit. It measures the contribution made by each item of output to the fixed costs and profit of the organisation.

Margin of safety-a measure in which the budgeted volume of sales is compared with the volume of sales required to break even Marginal Cost cost of producing one extra unit of output

Fixed Costs *Contribution per unit

*Contribution per unit = Selling Price per unit Variable Cost per unit

The difference between budgeted or actual sales and the breakeven point The margin of safety may be expressed in units or revenue terms Shows the amount by which sales can drop before a loss will be incurred

Using the following data, calculate the breakeven point and margin of safety in units: Selling Price = PhP50 Variable Cost = PhP40 Fixed Cost = PhP70,000 Budgeted Sales = 7,500 units

Contribution = PhP50 - PhP40 = PhP10 per unit Breakeven point = PhP70,000/PhP10 = 7,000 units Margin of safety = 7500 7000 = 500 units

What if a firm doesnt just want to breakeven it requires a target profit Contribution per unit will need to cover profit as well as fixed costs Required profit is treated as an addition to Fixed Costs

Using the following data, calculate the level of sales required to generate a profit of PhP10,000: Selling Price = PhP35 Variable Cost = PhP20 Fixed Costs = PhP50,000

Contribution = PhP35 PhP20 = PhP15 Level of sales required to generate profit of PhP10,000: PhP50,000 + PhP10,000 PhP15 4000 units

Costs are either fixed or variable Fixed and variable costs are clearly discernable over the whole range of output Production = Sales One product/constant sales mix Selling price remains constant Efficiency remains unchanged Volume is the only factor affecting costs

Absorption

Marginal

Fixed costs included in Product Cost FC not treated as period cost closing/opening stock values Under/over absorption of costs Complies with Financial Accounting standards

Fixed costs not included in Product Cost FC treated as period cost No under/over absorption of costs Does not comply with Financial Accounting standards

Each cash flow activity will increase or decease over time depending upon the life-cycle of the companys products. Here is the most common pattern for revenues, net income, and cash flows.

Cash flow analysis can be used to address a variety of questions regarding a firm's cash flow dynamics: How strong is the firm's internal cash flow generation?
Is the cash flow from operations positive or

negative? If it is negative, why? Is it because the company is growing? Is it because its operations are unprofitable? Or is it having difficulty managing its working capital properly?

Does the company have the ability to meet its short-term financial obligations, such as interest payments, from its operating cash flow?
Can it continue to meet these obligations

How much cash did the company invest in growth?

strategy? Did the company use internal cash flow to finance growth, or did it rely on external financing?

without reducing its operating flexibility?

Are these investments consistent with its business

Did the company pay dividends from internal free cash flow, or did it have to rely on external financing?

If the company had to fund its dividends from

What type of external financing does the company rely on?

overall business risk?

external sources, is the company's dividend policy sustainable?

Equity, short-term debt, or long-term debt? Is the financing consistent with the company's

Does the company have excess cash flow after making capital investments?
the free cash flow?

Is it a long-term trend? What plans does management have to deploy

Although it is possible to answer these questions using the GAAP SCF format, recasting the SCF makes answering these questions easier. In addition, using a standard format makes comparison between companies easier. Here is the model that we will use in this class.

Traditional SCF Format

Recast SCF Format

Net Income + Depreciation and Amortization Deferred Taxes Gains/Losses Changes in Working Capital = Cash Flow from Operating Activities
- Purchases of Long Term Assets + Sales of Long Term Assets = Cash Flow from Investing Activities + Sale of Stock + New Borrowing - Debt Payments - Dividends - Stock Repurchases = Cash Flow from Financing Activities Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities = Net Change in Cash

Net Income + Interest Expense (Net of Tax) + Depreciation and Amortization Deferred Taxes Gains/Losses = OCF before Working Capital Investments Changes in Working Capital = OCF before Investment in Long Term Assets - Purchases of Long Term Assets + Sales of Long Term Assets = FCF Available to Debt and Equity - Interest Expense (Net of Tax) - Debt Payments + New Borrowing = FCF Available to Equity + Sale of Stock - Dividends - Stock Repurchases = Net Change in Cash
OCF = Operating Cash Flow FCF = Free Cash Flow

Operating Cash Flow is broken up into two components, OCF before working capital investments and OCF before investments in long term assets. Over the long run OCF must be positive, but firms in the early stages of development, growing rapidly, or investing heavily in research and development, marketing and advertising, and other future growth opportunities will have negative OCF.

If cash flow after investing in long term assets is not positive then the firm did not generate enough cash from operations to pursue long-term growth opportunities and must rely on external financing. These firms have less flexibility than firms that can generate the necessary funds internally. Cash flow after long term investments is cash flow available to both debt and equity holders.

Payments to debt holders include interest and principal payments. Firms with negative free cash flow after investments in long term assets must borrow additional funds to meet their interest and principal payments. They can also reduce their investments in working capital, long term investments, or issue additional equity.

Cash flow after payments to creditors is free cash flow available to owners. Payments to equity holders include dividends and stock repurchases. If firms pay dividends despite negative cash flows available to equity holders then they are borrowing to pay dividends. This is not sustainable in the long term.

Examine cash flow from operations before investment in working capital to verify the company is able to generate a cash surplus from its operations. Examine cash flow from operations before investment in long term assets to how the firms working capital is being managed and to see if the company can invest in long-term assets for future growth.

Examine free cash flow to debt and equity holders to asses a firms ability to meet its principal and interest payments. Examine free cash flow to equity holders to asses a firms ability to sustain its dividend policy. All cash flow analysis must be done taking into consideration the companys business, its growth strategy, and its financial policies.

The Quality of Income Ratio is calculated as Cash Flow from Operations Net Income OR Cash Flow from Operations Net Income + Depreciation This ratio should be > 1 for a healthy firm.

If there are significant differences between net income and operating cash flow ask the following questions:
What are the sources of the difference? Is it due to accounting policy? Is it due to one-time events or on-going

activities?

Is the relationship changing over time?

If so, why? (see above for possible reasons). Is it because of changes in business

conditions or accounting policies and estimates?

What is the time lag between recognition of revenues and expenses and the receipt or payment of cash?
What uncertainties are there regarding cash

collection or cash payments (e.g. bad debts, contingent liabilities, etc.)

Are the changes in working capital accounts normal?

If not, is there an adequate explanation for

the changes?