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Finance for management

I will critially look at issues which concern finance for management. I will illustrate my points with calculations. Towards to end of the essay i will look at cources of finance.

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A company may have a great demand for its goods and need to increase capacity. A plan to build an extension is put forward, costed out at half a million dollars, and the plan is accepted as this is seen as affordable without the company needing to increase borrowing. The plan is approved and the project begins.  (Glen-Arnold 2005)

The projects hits some difficulties, but an underground cavern needs to be filled before foundations for the extension can be completed and problems with one of the suppliers means an alternative has to be found. This may be found at the same cost, but the delay adds to the costs. For the company that has not budgeted, these additional costs may be surprising, and the project will run into funding difficulties. If the company was monitoring and controlling the budget, then the problems would be foreseen and the company may then be able to make alterative or increase the available funding.  (Glen-Arnold 2005)

There are many examples of projects that did not have enough budgeting control. One such example is The Millennium Dome.

This was to be a large project to house an exhibition celebrating the millennium. It was built in Greenwich, England on the

Meridian Line to celebrate the historic event. The project was formulated by the government and funding was to come from a variety of sources, yet a lack of capital budgeting meant that project very nearly failed, and had it been a commercial venture it is likely it would have failed, as it came in 1.2 billion British Pounds over budget. This indicates the importance of capital budgeting. (http://www.aviewoncities.com).

It may also be argued that in any company the managament need to ensure there is the need to maximize the use of resources.

These will include capital that is available and also borrowing facilities. It is important to note that any company will have opportunities or competing needs; in most instances a company will need to choose between different opportunities. Therefore, the best choice needs to be made that will create the highest value for a company. The projects may be very different; there may be a long-term research and development project that can be capitalized, such as the building of new offices or the i nvestment in plant and machinery.

Alternatively the company may have the opportunity to diversify and have choices such as investing in different manufacturing facilities. These are all different projects and as a result are difficult to compare, the new factor may be seen as lasting for twenty years, whereas investment into research and development may only be five years. There are different models that can be used. Two common examples are the net present value model (NPV) and the internal rate of return (IRR). (Glen-Arnold 2005)

NPV is a way of comparing the value of money now with the value of money in the future. To figure NPV you need a determined discount rate percentage, which reflects the time value of money. An example of figuring NPV follows:

· if a discount rate of 5% was applied and someone wanted to give you $1000 now or $2000 ten years down the line. In 10 years the NPV of $2000 would be $1227.83, so you would be better off with the $2000 in 10 years.

The IRR method also allows you to consider the time value of money. Essentially, it allows you to find the interest rate that is equivalent to the dollar returns you expect from your project. As an example of how the internal rate of return works, let’s say you’re looking at a project costing $7,500 that is expected to return $2,000 per year for five years, or $10,000 in total. The IRR calculated for the project would be 10 percent. If your cost of borrowing for the project is less than 10 percent, the project may be worthwhile. If the cost of borrowing is 10 percent or greater, it won’t make sense to do the project (at least from a financial perspective) because, at best, you’ll be breaking even (http://www.toolkit.cch.com).

By using budgeting to develop these models, the company can estimate the overall return and the best investment. It may also use the model to compare to other investments since, after all, it may not be viable making any investment if the return is less than can be gained in other investments.  (Glen-Arnold 2005) Capital Budgeting can help the management to choose which projects to undertake, and can control projects which are underway. This can save a company from failing due to lack of control or making the wrong choices. As well as aiding in these aspects of capital expenditure, capital budgeting may also be used to plan future purchases and integrate them in with the needs of the operations of the company. This makes it easier to plan the funding over time. Some companies need to make very large investments that need to be planned many years in advance, such as airline companies. An example of this is Air New Zealand Ltd. who made an announcement in 2002 that they were going to invest in 15 new aircraft over the next ten years, with an option for a further twenty (Asia Pulse News, 2002). The need to plan ahead is also important, as very few capital investments will have an unlimited life.  (Glen-Arnold 2005) They will need to be replaced and this may mean a decision between repairing and replacing. Budgeting will allow for the optimum actions to be taken and if necessary, replacements may be planned in advance which may also increases choices and negotiation power, again increasing value.

The role of capital budgeting and the reason it is so valuable is in the way that it creates a strong foundation, where the capital spending is understood and controlled in order to give value rather than be a drain on the company. This may also aid the company with capital structure decisions. Cost of capital is present in whatever form it takes, both debt and shareholders expected return on investment. By looking at these options and the different routes of financing a capital expenditure, there is yet another way in which the company may gain value from a department that specializes in capital budgeting. For example, an increase in debt may have the impact of creating a higher expectation of risk in shareholders, and as such they will expect a higher return on the shares they invest in. As such the investment made with the debt needs to produce higher returns. A company with lower debt may be seen as safer, and the return will not need to be as high as a result of a lower risk premium.

Therefore, the capital structure may reflect in the way the company needs to operate within the contemporary market setting.

Overall there is a role that capital budgeting plays, and this is the creation of value in the way it makes strategic decisions over the use of the available company assets for the long term good of the company, and then controls the way these assets are used. This is essential for any company that wants to pursue a strategy of resource maximization. (Glen-Arnold 2005)

The primary purpose of costing joint products is to charge some portion of production cost to inventories in order to determine accounting income in compliance with generally accepted accounting principles. This is an example of the matching principle that pervades current accounting practice and influences reporting methods.. (McKinsey & Co)  A secondary purpose of costing joint products is to  report profits by product or by product line in order to satisfy external reporting requirements. The value of such information is very limited because of the arbitrary methods that must be used to assign joint costs to joint products.

The pro-ration of joint costs is not useful for decision-making purposes, so providing information for decision-making purposes is not a purpose served by joint cost pro-ration techniques. Joint costs arise when a single process gives rise to several products.  (Glen-Arnold 2005)

There is a need to allocate the cost of the joint process to those several products for inventory valuation purposes, regulatory reasons, cost reimbursement etc

Example – The Utah Mining Co. processed a chunk of ore at a cost of $1,000 and extracted two minerals – zinc and copper.

The chunk yielded:

-50 grams of zinc, which could be sold on the open market at $12 per gram, and

-50 grams of copper, which had a market value of $30 per gram.

The firm sold 40 grams of zinc during the period. In addition, it processed the entire copper yield into 40 strands of copper wire at a processing cost of $400. It sold 30 strands of the wire at a price of $55 per strand. There were no opening inventories.

Required: How are the joint costs of the mining process allocated between the firm’s products? What is the gross margin for the products under each method of allocation?

Note – The joint cost is $1,000. All the methods that follow essentially attempt to divide up that $1,000 between the two products – zinc and copper wire – using different allocation bases or criteria.

– All allocation is inherently arbitrary in the absence of a cause-and-effect relationship. . (McKinsey ; Co)

Some texts use weight and other measures of production volume to prorate joint Costs, but these methods are potentially misleading because some products may show a loss while others show a profit. The more acceptable methods of prorating joint costs are based on the relative values of the joint products. (Glen-Arnold 2005) In the relative-sales-value at the split-off point method, the joint costs are assigned to individual products in proportion to the sales value of each product relative to the sales value of all products at the split-off point. This method is used without regard to the planned method of disposition of the products. The imputed-sales-value at split-off can be used instead of the actual sales value when the latter information is not available.

Also called the net realizable value method, this approach involves determining the net realizable value of the joint products as of the split-off point, where net realizable value is the final sale price (actual or projected) less all costs to complete the product in its final form. Some accountants prefer this approach because it incorporates more information into the determination of the relative value of the products at the split-off point. (McKinsey ; Co)

The uniform gross margin method incorporates information about costs after the split-off point. After it has been decided which products are to be sold at split-off and which products are to be processed further, then the joint costs can be allocated in the following manner. The over-all gross profit percentage is used to (1) determine the gross profit for each product, (2) deduct the gross profit from sales value to find the total cost, and (3) reduce total cost by each product’s further processing costs to find the joint cost shares for each product.

The preferred method of accounting for inventories of joint products may well be net realizable value. The net realizable value, not the prorated joint cost, is of interest for decision-making purposes. Therefore, the net realizable value of the joint products is of some relevance, where the prorated joint production cost is not useful for decision-making purposes.

A brief look at sources of finance for management

External Sources of Finance

This source of finance comes from outside the business and involves the business owing money to an outside individual(s) or companies. The most obvious ones are bank loans, overdrafts, donations etc.

Factoring Services

Businesses are often owed money from customers who have made a purchase on credit. The payment for the products would then be maid within a set amount of time. Usually a set amount of time will be about 30 days, which would be interest free to give a bigger incentive for the customer to pay the bill on time. After this time the company can charge a rate of interest on the money owed to them. (E.J. McLaney ) Even with the threat of interest a business may have difficulty in collecting its debts from its customers, which could cause some financial difficulty for the company. For the company to be able to retrieve their money a special factoring company may offer to handle the debt collection process for a charge. The factoring company pays the business around 80% of the value of the debt first and would then collect the money from the debtor on behalf of the company.

The factoring company would then take their 80% back and some profit from the 20% left over.

Leasing and Hire Purchase

Leasing involves businesses renting equipment that it may use for several years or months but never own outright. Businesses will have a contract with a company over the machine being used and in some circumstances some contracts may offer the company to upgrade the machine if a newer model is available. The benefit to leasing machinery is that the company does not have to pay of the maintenance or servicing of the machine throughout the time the company use it. Equipment often leased to companies are such items as photocopiers, paper shredders, etc… (E.J. McLaney )

Internal Sources of Finance

These sources of finance come from the business’ assets or activities. Shares can be issued. (E.J. McLaney )

Retained Profit

If the business had a successful trading year and made a profit after paying all its areas of expenditure, it could use some of that profit to finance future activities. This can be a very useful source of long term and on going finance, provided the business is generating profit.

Bibliograhpy

http://www.aviewoncities.com

http://www.toolkit.cch.com

Asia Pulse News, 2002

Corporate-Financial-Management-Glen-Arnold/d 26 May 2005

Measuring and managing the value of companies McKinsey & Company, Tim Koller, Marc Goedhart, and David Wessels (Hardcover – 10 Jun 2005

Business finance, theory and practice by E.J. McLaney 25 Oct 2005

Public sector financial manageent by Hugh M. Coombs and D.E. Jenkins 31 Jan 2002

 

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