B. Capital Investment Decision making Flashcards
1
Q
what is a relevant cash flow?
A
future, incremental cash flow
2
Q
what are examples of non relevant cash flows?
A
sunk costs:past event
fixed costs:not incremental
committed costs:not affected by future decision
opportunity costs
absorbed fixed overheads: won’t change as a result of decision
depreciation:non cash
3
Q
what is an opportunity cost?
A
value of the best alternative that is forgone when a particular course of action is taken
-relevant cost
4
Q
what is a notional cost?
A
- similar to opportunity cost
- e.g notional rent is forgone if company occupies premises themselves
- opp cost if there is a willing renter, otw it is not an opp cost
5
Q
what is an avoidable cost?
A
specific costs of an activity or sector of a business which would be avoided if that activity or sector did not exist
-not relevant if attributable, specific fixed or apportioned
6
Q
what is a differential/incremental cost?
A
the difference in total cost between alternatives. Calculated to assist decision making
7
Q
what is another name for sunk costs?
A
irrecoverable costs
8
Q
how is relevant cash flow calculated?
A
cash flow if project accepted - cash flow if project rejected
9
Q
why are qualitative factors ignored in investment appraisal exercises?
A
difficult to measure
10
Q
what are some examples of qualitative benefits and costs?
A
benefits:
- employee morale
- reduced product dev time
- improved service
- increase in manufacturing flexibility
costs:
- brand/reputition damage
- increased noise level
- lower morale
11
Q
what are some examples of quantitative benefits and costs?
A
benefits:
- IT system upgrade
- selling inv
- aligning depts
- lower costs
costs:
-input costs;DM, DL, OH
12
Q
what is the difference between data and information?
A
data: raw, unprocessed, can’t base decisions on
information: data that is processed, has meaning, improves quality of their decision making
13
Q
what are some examples of internal data?
A
sales ledger system purchase ledger system payroll system fixed asset system production sales marketing
14
Q
what are some examples of external sources of information?
A
supplier:prices, specifications
newspaper: share prices, info on competition, market research
government: statistics, tax policy, demographic stats, economic growth
customers: product requirements, price sensitivity
employees:wage demands, working conditions
banks: info on customers, national markets
business enquiry agents:info on competitors, customers
internet: almost everything via public and private databases
15
Q
what are the limitations of externally generated information?
A
- accuracy
- out of date
- publisher may not be reputable
- external info may not meet exact needs
- difficult to gather external info e.g from customers or competitors
16
Q
what benefits does collecting, analysing and presenting high quality data present?
A
collaborative working
customer insight
risk management
governance
17
Q
what is cited as the most significant challenge to product and service innovation faced by organisations?
A
identifying changes in customer behaviour
18
Q
what costs does collecting, analysing and presenting high quality data present?
A
- software license costs:cost of initially acquiring and deploying software
- software maintenance costs:annual charges
- IT training costs:training IT to manage and maintain
- user training costs:training users of software
- integration costs:making multiple projects work together
- redundant infrastructure costs:cost of managing and maintaining multiple data stores, metadata repositories and other components
19
Q
what are the main issues with collecting high quality data?
A
duplication
privacy
integrity
security
20
Q
why is duplication an issue with high quality data?
A
in ERP (Enterprise Resource Planning) systems, sometimes info is duplicated or multiplied, making it difficult to ensure consistency and security
- inter-department reports rarely agree
- even from the same source, reports may not reconcile due to extraction process
21
Q
what are some solutions to the threat of natural disasters in IS?
A
fire procedures
location: not in basement
physical environment:a/c, dust controls
back up procedures
22
Q
what are some solutions to the threat of malfunction of hardware or software in IS?
A
network design: cope with high volumes
back-up procedures
23
Q
what are some solutions to viruses in IS?
A
antivirus software:run and updated regularly
formal security policy and procedures:downloads from reputable sources
regular audits for unauthorised software
24
Q
what are some solutions to hackers in IS?
A
deliberate access to systems
firewall software: provide protection from unauthorised access to the system from the internet passwords and usernames formal security policy and procedures user awareness training of risks data encryption
25
what are some solutions to electronic eavesdropping in IS?
users accessing private information
data encryption: scrambled prior to transmission and is recovered in a readable format once transmission is complete
passwords and usernames; limit unauthorised access to the system
26
what are some solutions to human errors in IS?
unintentional errors from using computers and network
training:adequate staff training and operating procedures
27
what are some solutions to human resource risk in IS?
e.g repetitive strain injury (RSI), headaches and eye strain from computer screens, tripping over loose wires
ergonomic design of workstations should reduce problems such as RSI
anti-glare screens to reduce eye strain
cables should be in ducts
28
what issue did the NHS face in 2017?
virus infection with ransom demand
appointments cancelled and ambulances diverted
40 hospital trusts became infected by ransomware
part of biggest ransomware attack in history with 57k infections in 99 countries being observed
29
what are the 2 categories that computer controls fall into?
application controls and general controls
30
what is an application/Program control?
manual or automated procedures that apply to INDIVIDUAL areas within the system to ensure the completeness, accuracy and validity of the recording and processing of transactions
- completeness checks to ensure all data is processed
- validity checks to ensure only valid data is input/processed
- identification and authorisation checks to ensure users are identifies and authorised
- problem management facilities to ensure problems and recorded/managed on a timely basis
performed automatically by system
31
what are some examples of application control?
- batch total checks
- sequence checks
- matching master files to transaction records
- arithmetic checks
- range checks
- existence checks
- authorisation
- exception reporting
32
what is a general control?
policies and procedures that relate to MANY applications and support the effective function of application controls by helping to ensure the continued proper operation of information systems
- personnel controls
- access controls
- computer equipment controls
- business continuity planning
OVERALL CONTROL
33
what are some examples of general controls?
- network access controls
- staff training
- systems testing and installation controls
- password protection
- restricting physical access to central computers by locks/keypads
- back-up procedures
- disaster recovery procedures
- virus checks
34
what controls are required in a database to ensure that data integrity and security are maintained?
- control of access to workstations
- user identification required for access by individual passwords
- users only see the icons for the functions where they have access rights
- restrictions on access to certain aspects of the database e.g. using passwords
- users only to have access to those aspects that they need to do their job
- restrictions on use of functions or programs e.g. writing off debts as bad debts
- transaction logs maintained automatically for checking and for back-up purposes
35
what is business intelligence 'BI'?
the technical architecture of systems that extract, assemble, store and access data to provide reports and analysis.
It can also be used to to describe the reporting and analysis applications or performance management tools at the top of the BI stack
36
how is BI used to improve decision making?
company wide recognition that a company's data is an important strategic asset that can yield valuable management information and implement change so that this information is used to improve decision making
- provides MAs with a wider range of information in more accessible formats
- more forward looking
- financial and non-financial information
37
what does the base of the BI stack consist of?
source data systems from where data is extracted, translated and loaded by extract, transform and load (ETL) software into a data warehouse
38
what is the application layer (or BI layer) of the BI stack?
data warehouse and data mining
| storage layer
39
what is in the presentation/delivery layer?
exec dashboards
scorecards and other tools making it easier for managers to find and understand the information and proactively use it in decision making
40
what is data analysis?
process of collecting, organising and analysing large sets of data to generate trends and other information to aid decision making
-complex analysis, data mining and predictive modelling enabled by BI applications which can access both financial and non-financial data from the business's data warehouse and external sources
41
what is data mining?
process of sorting through data to identify PATTERNS and RELATIONSHIPS within a data set between different items, usually with the use of statistical ALGORITHMS
42
how is the BI scope expanding?
used to spot patterns and trends from structured data
| now includes unstructured data
43
what are sequences in data trends?
forecasting future purchases
| e.g if consumer bought pram, they're likely to buy booster seat next
44
what is clustering?
splitting consumers into groups so you can target them at a specific time or with a specific need
45
what is data forecasting?
predicting future e.g sales revenue
46
what is structured data?
data that is contained within a field in a data record or file e.g databases, data warehouses and spreadsheets
-archived and ordered in an organised manner
47
what is unstructured data?
data that is not easily contained within structured data fields e.g pictures, videos, webpages, PDF filed, emails, blogs
-often stored in data lakes
48
what is a data lake?
contains data in its rawest form
- fresh from capture
- unadulterated by processing or analysis
- data just 'poured' in
- each piece of data is similar to a molecule of water and can be moved anywhere, is an equal unit and is agile and can be configured and reconfigured as necessary
- unstructured data can be more quickly shaped into necessary form
49
how can BI lead to increased profitability?
can be used for new reports and analysis which should lead to increased profitability through improved operating performance and better strategic focus on profitable products and segments
50
what are some examples of how BI can lead to improved profitability?
- better informed sales people can cater to customers
- greater transparency enhances performance. Internal benchmarking between individuals and divisions which are measured on a consistence basis can help to identify best practice and raise standards
- negotiators are better informed of current economy for contracts with customers/suppliers
- advertising and promotional spend can be targeted
- can sell data to others e.g. supermarkets sell EPoD (Electronic Point of Sale) to their suppliers
51
how does BI reduce costs?
- BI tools are user friendly, cut out need for IT
- savings will include EFFICIENCY gains, often expressed as numbers of full time equivalent (FTE) employees
- BI tools REPLACE others so no need for software licensing and training costs
- BI solution can meet REPORTING standards which are usually done ad hoc so time saving
- reporting can include FINANCIAL and NON-FINANCIAL indicators in commentary
- BI may present READILY ACCESSIBLE data that complies with regulations that didn't exist before
52
what are some intangible benefits of BI?
- identifying trends early leads to more accurate forecasts
- prompt month end close gives good impression to investors, especially in terms of risk level and increase in shareholder value
- greater clarity on products, segments, clusters can improve retention or attracting from competition. get rid of less economic customers or improve revenue
- emerging trends spotted earlier, quicker commitment of resources early on so more value delivered
53
why is it important to consider the time value of money?
capital expenditure projects cash flow usually arises over long term e.g 12m+
54
what are the 8 steps of the capital investment process?
1. Identify objectives
2. Search for investment opportunities
3. Identify states of nature
4. List possible outcomes
5. Measure payoffs
6. Select investment projects
7. Obtain authorisation and implement projects
8. Review capital investment decisions
55
which stages are the creation phase of the capital investment process?
1. Identify objectives
2. Search for investment opportunities
3. Identify states of nature
56
which stages are the decision phase of the capital investment process?
4. List possible outcomes
5. Measure payoffs
6. Select investment projects
57
which stages are the impementation phase of the capital investment process?
7. Obtain authorisation and implement projects
| 8. Review capital investment decisions
58
What does the first stage of the capital investment process entail?
achieve maximisation of wealth by maximising NPV of future net cash inflows
59
what is a firm's prosperity dependent on?
ability to create investment opportunities (Stage 2)
60
what does stage 3 of the capital investment process entail?
data to be gathered about possible future environments that may affect the outcomes of the project
- e.g economic booms/busts, high inflation
- might need to adjust medium term objectives accordingly
61
what is the role of a Capital Expenditure Committee?
establish an approval procedure that both encourages managers to submit realistic, achievable proposals and ensures that the long-term objectives of the firm are being met
62
when is the post completion audit/appraisal of the capital investment process usually started?
12 months into the investment project
63
what are the unctions of the Capital Expenditure Committee?
- co-ordinate capital expenditure policy
- appraise and authorise capital expenditure on specific projects
- review actual expenditure on capital projects against the budget
64
what might a multidisciplinary/working party set up to investigate individual proposals and report finding comprise of?
- project engineer
- production engineer
- management accountant
- relevant specialist e.g personnel officer
65
what are the initial assumptions of a capital investment appraisal?
1. all cash inflows and outflows are known with certainty
2. sufficient funds are available to undertake all profitable investments
3. there is zero inflation
4. there is zero taxation
66
what is the time value of money?
money received today is worth more than the same sum received in the future
67
how do we account for the time value of money when appraising investments?
discounting cash flow (DCF) techniques
68
what are the 3 main reasons for the time value of money?
consumption preference: receive sooner rather than later
inflation: price rises cause loss of purchasing power
risk: more certainty if received earlier
69
what is the terminal value? how is it calculates?
future value
V=X (1+r)^n
V=future or terminal value
X= initial value (PV)
r = interest rate
n=number of periods
70
what does compound interest assume?
that interest is earned on both the initial investment and any interest earned
71
what is discounting?
opposite of compounding
considers sum receivable in the future in today's equivalent i.e PRESENT VALUE
72
how is present value calculated?
present value = future value x discount factor
where discount factor = (1+r)^-n
where r is interest rate
n is the number of time periods
73
what are the alternative terms used to refer to the rate a firm should use to take account of the time value of money?
cost of capital
discount rate
required rate of return
all are the cost of finance that will be ties up in the investment
74
what are 4 widely used appraisal methods?
1. NPV consider the time value of money and uses discounted cash flow techniques
2. IRR considers time value of money and uses discounted cash flow technique
3. Payback period
4. Accounting Rate of Return (ARR)
75
what is the NPV?
net benefit/loss in PV terms of an investment opportunity
i.e surplus funds earned on project and impacts on shareholder's wealth
'difference between the sum of the projected discounted cash inflows and outflows attributable to a capital investment or other long-term project'
76
what is the decision criteria for NPV projects?
- viable if positive NPV
- not viable if negative NPV
- mutually exclusive projects, pick highest NPV
77
what does an NPV of zero mean?
no surplus on investment so exact rate of return therefore worth accepting
78
what are the assumptions used in NPV?
- all cash flows occur at the start or end of a year
| - initial investments occur at once (T0), other cash flows start in one year's time (T1)
79
why is NPV considered superior in theory to most other appraisal methods?
- considers TIME VALUE of money - ignored by payback and ARR
- ABSOLUTE measure of return - ignored by payback and ARR
- based on CASH FLOWS not profits-less subjective
- considers the WHOLE LFIE of the project- ignored by payback
- should lead to maximisation of SHAREHOLDER WEALTH- a primary objective
- can easily account for RISK
80
what are the drawbacks of NPV?
- fairly complex
- difficult to explain to non-financial managers-not as intuitive as payback
- may be difficult to determine the cost of capital
- only considers the long-term, so may lead to short-term demotivation
81
what is the IRR?
the rate of return at which the project has a NPV of zero
82
what is the decision criteria for IRR?
if IRR > cost of capital, project should be accepted
| IRR< cost of capital, project should be rejected
83
what method is used to estimate the IRR?
linear interpolation i.e assuming linear relationship between NPV and rate
- graph is curved so true IRR is less than estimation
- rates that are too far apart lead to larger error in calculation
84
what 2 criteria should be satisfied for the accuracy of the IRR formula?
- rates that aren't too far apart i.e 5% difference
| - aim for one positive and one negative NPV
85
what advantage does NPV have vs IRR?
tells us absolute increase of shareholder's wealth from a project
IRR only tells us how far the cost of capital COULD increase before the project would not be worth accepting
86
when deciding between NPV and IRR, which should be used?
NPV results i.e project with highest NPV
87
what is the IRR of perpetuity?
annual inflow/initial investment x 100
88
what are the advantages of IRR?
- IRR considers time value of money
- as % return, it is easily understood by non-financial managers
- considers cash flows
- considers the whole life of the project
- the IRR can be calculated without reference to the cost of capital
- a company selecting projects where the IRR exceeds the cost of capital will normally increase shareholders' wealth
89
what are the disadvantages of IRR?
- makes no allowance for initial investment
- interpolation only provides estimation of true IRR
- fairly complicated to calculate
- basing decisions on the IRR of projects may conflict with looking at NPVs. if this occurs, the NPV must take precedence
- it is not a measure of absolute profitability, and does not necessarily reflect the impact on shareholders wealth
- ignores the length of the investment period
- non-conventional cash flows may give rise to no IRR or multiple IRR
90
when do multiple IRRs occur?
associated with two or more periods when the project has outflow
-unlikely if second is small e.g closure costs
91
what is MIRR?
modified IRR = project's return
if return > cost of finance => accept project
92
what does MIRR assume?
measures the economic yield under the assumption that any cash surpluses are reinvested at the firm's current cost of capital
93
when can the annuity factor be used?
equal annual cash flows
94
what is the annuity factor?
name given to the sum of the individual DF i.e cumulative PV
95
how is the PV of annuity calculated?
PV= annual cash flow x AF
AF= 1 - (1+r)^-n/r
where
r=cost of capital
n=number of periods
96
what is perpetuity?
annual cash flow that occurs forever
97
what is the PV of perpetuity?
PV=cash flow x (1/ r)
where 1/r is perpetuity factor
98
in changing discount rates, how is the discount factor calculated from previous year?
divide previous year by (1+cost of capital for the year in question)
99
how do find discount factor for non-annual period?
(1+i)^ n - 1 where n is pro rated e.g n = 1/4 for quarters
100
when does capital rationing take place?
when insufficient funds are available to undertake all beneficial projects
-with unlimited funds, all positive NPV can be undertaken
101
what is hard capital rationing?
if capital is restricted because of external constraints
| e.g lack of capital
102
what is soft capital rationing?
solutions where firm internally imposes a budget ceiling on the amount of capital expenditure
103
what is the objective of capital rationing exercises?
maximisation of the total NPV of the chosen projects' cash flows at the cost of capital
-necessary to rank projects to enable the optimum combination to be undertaken
104
what are the underlying assumptions of capital rationing?
- individual projects are divisible so resulting NPV will be pro-rated
- annual cash flows cannot be delayed or brought forward
- capital funds are restricted in just one period (year 0)
105
what is the profitability index?
measure of NPV to each $1 invested
NPV/initial cash outflows
106
what is the optimal investment plan determined by?
1. calculating a PI for each project
2. ranking the projects according to their PI
3. allocating funds according to the project' rankings until they are used
107
what is the DPBI?
discounted payback profitability index
measure of the number of times a project recovers initial funds
DBPI should be > 1
present value / initial cash outlay
108
what are the 4 real options when it comes to investment appraisal?
SADE
switch/redeploy: switch the use of assets, should market conditions change
delay/defer: creates call option
abandon: continue or abandon at the end of each stage
expand/contract : adjust scale
109
how can indivisible projects cause issues with ranking?
might be more profitable to ignore ranking and go with the combinations that provide highest NPV
110
how does flexibility add value to an investment?
- can be staggered so future costs can be avoided if issues take place
- core to this lies in reducing downside risk exposure but keeping upside potential open i.e in making probability distributions asymmetric
- financial options are an example where this flexibility can be valued
- a call option on a share allows an investor to 'wait and see' what happens to a share price before decision whether to exercise the option and will thus benefit from favourable price movements without being affected by adverse movements
111
how does real options theory attempt to classify and value flexibility?
taking the ideas of financial options pricing and developing them
- financial option gives the owner the right, but not the obligation, to buy or sell a security at a given price. Analogously, companies that make strategic investments have the right, but not the obligation, to exploit these opportunities in the future
- as with financial options most real options involve spending more up front (analogous to the option premium) to give additional flexibility later
112
why do conventional investment -appraisal techniques typically undervalue flexibility within projects with high uncertainty?
high uncertainty within a NPV context will result in a higher discount rate and lower NPV. However with such uncertainty any embedded real options will become more valuable
113
what factors affect decision to abandon a project?
- future cash outflows associated with the project (ensure NPV is still positive)
- future cash inflows associated with the project
- revenues/costs that would arise if the project were abandoned e.g alternatives
114
why conduct a post completion audit?
can use expertise from past/current project to influence decision making on future projects
organisational learning
- forward looking
- review against expectations
115
what are the benefits of post-completion audit?
- will cause management to set realistic and accurate plans knowing there will be a review
- can improve management efficiency for next project\
- might identify weaknesses in the forecasting techniques and the estimating techniques used to evaluate project
- managers motivated to achieve results
- reveals reliability and quality of contractors and suppliers involved in the project
- appraisal may highlight the reasons for success or failure in previous projects : learning experience for managers to aid better decision making in the future
116
what are the issues with post-completion aduti?
- might not be possible to identify separately the costs and benefits of a single project
- can be time-consuming and costly exercise
- applies punitively, completion appraisal may lead managers to becoming over-cautious and risk averse
- strategic effects of a capital investment project may take years to materialise and it may never be possible to identify and quantify them correctly
- there are many uncontrollable factors in long-term investments. Post-completion appraisal will not help managers change these factors in the future
117
what is the difference between routine monitoring and audit?
- routine monitoring will report any large deviations
- audit will look at more than costs, revenues and future outlook too
- audit will provide wisdom to management
118
how is payback calculated?
payback = initial investment / annual CF
119
what are the advantages of the payback method as a form of appraisal?
- the payback method is SIMPLE to understand
- selecting projects on the basis of payback may help reduce the RISK of liquidity problems
- uses cash flows, not subjective accounting profits
- emphasises the CASH FLOWS in the earlier years
- shows where return is QUICKEST
120
what are the disadvantages of the payback method as a form of investment appraisal?
- not a measure of absolute profitability
- ignored the time value of money (a discounted payback period may be calculated to overcome this problem)
- does not take into account cash flows beyond the payback period
- lack of objectivity
121
what is ARR?
Accounting Rate of Return
calculates the percentage return provided by the accounting profits of the project
average annual profit/ average value of investment
where average annual profit = net CF-depreciation/ years and
average value of investment = initial investment plus residual value/2
122
what are the advantages of the ARR method?
- simple to understand, % terms
- widely used and accepted
- considers the whole life of the project
- link with other measures such as ROCE
123
what are the disadvantages of the ARR method?
- ignores the time value of money
- not a measure of absolute profitability
- does not take into account cash flows and uses subjective accounting profits, which include depreciation
- doesn't consider project life or risk
- will vary with accounting standards due to subjectivity
- not an absolute measure of gain
- not reliable for project evaluation
124
what are the assumptions of the payback period method?
cash flows occur evenly during the year
125
what does average value of the investment represent in the ARR calculation?
the average capital employed over the life of the project
initial investment + scrap value
126
what does average annual profit represent in the ARR calculation?
net cash flow is usually profit before depreciation so deduct depreciation
net CF - depreciation
127
what is discounted payback?
payback period doesn't take time value of money into account
use discounted payback to solve this
128
why is taxation relevant?
- impact on capital investment project
| - future cash flow
129
what is the assumption for taxable profits?
net cash flows from the project less any tax depreciation
130
what effects does taxation have on investment appraisal?
- tax on operating cash flows: give rise to taxation which itself has an impact on project appraisal
- tax depreciation: organisation benefits from claiming tax depreciation (capital allowances) as it reduces the tax due but it is not a cash flow
131
what factors influence taxation?
- taxable profits and tax rate
- the company's accounting period and tax payment dates
- whether assets qualify for tax depreciation
- losses available for set off
132
what is a balancing allowance/charge?
allowance: tax depreciation < fall in value
charge: tax depreciation > fall in value
133
what assumptions do we make about the timing of asset purchase?
- asset are assumed to be bought at T0
- asset bought at the start of the accounting period and therefore the first tax depreciation is offset against the year 1 net cash flows
134
why is only the change in working capital treated as a cash flow?
WC does not qualify as tax relief
at the end of a project, the working capital 'released' is treated as a cash inflow equal to the total investment in working capital
135
what are current cash flows or real cash flows?
where cash flows have not been increased for expected inflation
136
what are money cash flows or nominal cash flows?
where cash flows have been increased to take account of expected inflation
137
what are the 2 methods of dealing with inflation?
real method:do not inflate, real flows
| money/nominal method:inflate
138
what is the real rate of return?
return on today's price
139
what are the 2 types of inflation?
specific inflation rate:impacts all the individual cash flow items
general rate of inflation: impacts the investors' overall required rate of return
140
why can we not use the real method where there are a number of specific inflation rates?
inflation can impact different types of products in different ways: prices don't all rise at exactly the same rate
141
is it advisable to use the money method as the real method with specific rates is extremely complex. what is this method?
- inflating the cash flows at their specific inflation rates
| - discounting using the money rate
142
what method should be used when both tax and inflation are involved?
money method:
1. inflate costs and revenues, where necessary, before determining their tax implications
2. ensure that the cost and disposal values have been inflated before calculating tax depreciation
3. always calculate working capital on these inflated figures, unless given
4. use a post-tax money discount rate
143
how do we decide between mutually-exclusive options with unequal lives?
calculate equivalent annual cost then pick cheapest
equivalent annual cost = PV of costs / annuity factor for years n
144
what is the lowest common multiple method?
alternative to equivalent annual cost method
-find the smallest number, which we can divide into by each of a set of numbers and evaluate the NPV cost over this period
145
why is it important to find the optimum replacement cycles?
as machines age the residual value decreases and the annual running costs increase
companies are unlikely to want to replace assets too frequently because of the capital outlay associated with the purchase
146
what factors affect the capital replacement decision?
- capital cost of new equipment
- operating costs may increase due to:
- -increased repair and maintenance costs
- -loss of production due to 'down-time' resulting from increased repair and maintenance time
- -lower quality and quantity of output
- resale value
- taxation and investment incentives
- inflation
147
what is the optimum replacement cycle method?
1. consider each possible replacement cycle in turn:1 year, 2 year, 3 year etc
2. calculate the PV of costs for each cycle
3. divide this PV by the annuity factor to find the equivalent annual cost
4. select the replacement cycle with the lowest equivalent annual cost
148
what are the limitations of the replacement cycle analysis?
assumed that the firm replaces like with like each time it needs to replace an existing asset but ignores:
- changing technology: machines fast become obsolete and can only be replaced with a more up-to-date model which will be more efficient and perhaps perform different functions
- inflation: increase in price over time increases the cost structure of the different assets, meaning that the optimal replacement cycle can vary over time
- change in production plans: firms cannot predict with accuracy the market environment they will be facing in the future and whether they will even need to make use of the asset at the time
149
what 3 factors interact to result in profit?
cost volume and price
| -all affect eachother
150
what is price elasticity of demand?
change in demand as a result of change in price
PED=% change QD/% change PD
151
how do we interpret PED?
elastic if >1 i.e demand is very responsive to change so decrease price to increase revenue
inelastic if <1 i.e demand is not responsive to change so increase in price increases total revenue
152
what does a perfectly inelastic demand graph look like?
i
sold at one quantity no matter price
more vertical, more inelastic i.e smaller change in demand
153
what does a perfectly elastic demand graph look like?
------
| any other price means nothing is sold
154
why is PED calculated in %s?
number of units would distort measurements
155
how do different products in the same industry have different price elasticity?
sold in slightly different markets due to product differentiation
156
what does a kinked demand curve show?
price stickiness
- competitors tend to follow price cuts with cuts of their own, but don't copy price rises
- PED elastic above kink, and inelastic below
e.g newspaper industry
157
what factors affect price elasticity?
```
scope of the market
information within the market
availability of substitutes
complementary products
disposable income
necessities
habits
```
158
why is PED not used in practice?
hard to determine under different circumstances
| -they just have a general idea of the elasticity
159
how does scope of the market affect PED?
larger the defined market, more inelastic the demand
160
how do complementary products affect demand?
interdependency results in price inelasticity as volume sales of the dependent good rely on sales of the primary good
161
how does disposable income affect PED?
relative wealth over time affects total demand
| -luxury doos have high price elasticity, necessities are usually inelastic
162
what is a perfectly competitive market?
every buyer and seller is a 'price taker' and no participant influences the price of the product it buys or sells
163
what are the characteristics of a perfectly competitive market include?
- zero entry/exit barriers
- perfect information
- companies aim to maximise profits
- homogenous products
164
what is imperfect competition?
market conditions don't meet perfect competition requirements
165
what is a monopoly?
only one seller of a good
dominates many buyers
uses market power to set profit-max price
166
what is an oligopoly?
few companies dominate the market and are inter-dependent
| firms need to consider competitors reaction
167
what is monopolistic competition?
products are similar but not identical
many producers ('price setters' and many consumers
no business has total control
e.g retail products
168
what theory is the profit-maximisation model based on?
theory that profit is maximised at the output level where MC=MR
- if MC>MR, not worth producing good
- if MR>MC, worthwhile
169
what do a and b represent in P=a -bQ?
a is y intercept
| b is slope of the change in price over change in quantity graph
170
what are the steps to obtaining optimum price of product?
1. find a and b: P=a-bQ
2. double gradient to find MR: MR=a-2bQ
3. establish MC (variable cost per unit)
4. maximise profits (MC=MR) and find Q
5. Substitute Q into P=a-bQ to find optimum price
6. calculate max profit
171
what are the limitations of the profit-maximisation model?
- unlikely that organisations will be able to determine the demand function for their products or services with any DEGREE FO ACCURACY
- the majority of organisations aim to achieve a TARGET PROFIT, rather than the theoretical maximum profit
- determining an accurate and reliable figure for marginal or variable cost poses difficulties for the management accountant
- unit marginal costs are likely to VARY depending on the quantity sold e.g bulk discounts may reduce the unit materials cost for higher output volumes
- other factors in addition to price will affect the demand e.g. the level of advertising or changes in the income of customers
172
what is cost-plus pricing?
adding a mark-up to the total cost of the product to price at the selling price
-more appropriate for jobbing companies
173
what are the advantages of cost-plus pricing?
- required profit will be made if budgeted sales volumes are achieved
- particularly useful method in contract costing industries where a few large individual contracts can consume the majority of the annual fixed costs and the FCs are low in relations to the VCs
- assuming organisation knows its cost structures, cost-plus is quick and cheap to employ, saving management time
- cost-plus pricing can be useful in justifying selling prices to customers
174
what are the issues with cost-plus pricing?
- always be issues with 'suitability' on which FC to charge to individual products and services, could lead to over or under pricing
- if prices are set on the basis of normal volume, and actual volume turns out to be considerably lower, overheads will not be fully recovered from sales and predicted profits may not be attainable
- cost-plus pricing takes no account of factors such as competitor activity
- cost-plus overlooks the need for flexibility in the different stages of a product's life cycle. It takes no account of the price customers are willing to pay and PED
175
what is marginal cost plus pricing?
variable cost + % contribution margin
176
why is marginal cost-plus pricing sometimes preferred to total cost plus pricing?
- just as accurate
- can price below total cost when times are bad
- draws management attention to contribution and the effects of higher or lower sales volumes on profit
- good for pricing specific contracts-recognises relevant costs
- facilitates decision making when resources are scarce e.g bottleneck resources
177
what are the cons of marginal cost-plus pricing?
- does not ensure that sufficient attention is paid to demand conditions, competitors prices and profit maximisation
- ignores fixed overheads in the pricing decision. FCs may not be recovered in the long term
- difficult to raise prices where mark-ups are low
- may encourage price wars
178
what is the main con of marginal cost-plus pricing?
price wars leading to customer loss
-2 companies try to reduce prices to attract customers to the point where it becomes unsustainable leading to loss of business or customer resistance is prices are raised again
179
what is premium pricing?
if the product is unique/superior, can charge more based on:
- quantity
- image/style
- reliability/robustness
- durability
- after-sales services
- extended warranties
180
what are the qualities of a premium priced product?
- brand image
- high initial marketing expenditure
- charge higher price due to customer loyalty
- price inelasticity
181
what is market skimming?
- high price initially so most desperate customers will buy
- lower price to make product more accessible
- keep lowering
aim: MAXIMUM REVENUE or prolong life of older products
182
what are the characteristics of market skimming?
- heavy advertising
- customers prepared to pay high prices to be 'one up'
- short lifecycle:development costs need to be recovered quickly
183
what needs to happen if profitable skimming is to be sustained beyond introductory phase?
there must be significant barriers to entry to the market to deter competitors entering for high returns
e. g with books, only one publisher
- consumer durable products usually have high manufacturing costs that deter entrants
184
what is penetration pricing?
- set very low price initially for new product
- usually below total cost
- establish large market share quickly by encouraging customers to try product and repeat buy
185
what are the required market conditions for penetration pricing?
low barriers to entry and high price elasticity. establish large market share to discourage new entrants
186
what are the characteristics of penetration pricing?
- to discourage new entrants
- shorten initial period of the product lifecycle
- economics of scale
187
what is price differentiation?
market split into different segments, each quite separate from the others and with its own individual demand function, it is possible to sell the same product to different customers at different prices
-marketing techniques can create market
188
how can marketing techniques create market segmentation if they don't exist?
segmentation based on:
- time
- quantity
- type of customer
- outlet/function
- geographical location
- product content
189
what products usually use price differentiation?
- when there is a high proportion of fixed costs
| - attract people to less popular time/location to improve profitability
190
what is loss leader pricing?
when a range consists of one of more main products and a series of related optional 'extra's which customer can add on, set low price for main and high for extras
aim: stimulate sufficient demand for low price item to ensure the target return from sales of the latter
- draw customers into the door
191
what are some examples of loss leader pricing?
aircraft engine manufacturers: low price product but servicing is high cost
Gillette: sold cheap razors but relatively high priced blades to max profit
printers: cheap printers but expensive ink
192
what is discount pricing?
long-term pricing strategy based on low cost high volume and low margins
-lower price but same quality
aim: large market share counteracting reduction in sales price
- must ensure customers don't find drop suspicious
193
what are some short-term reasons to use discounts in pricing?
- get cash quickly
- differentiate between different types of customers
- increase sales volume during poor sales period
- some industries give discounts as normal practice
- perishables to get off shelf near end of life or past sell by
194
what happens when a previously nationalised industry in the UK is privatised?
there is a constraining influence: the regulator
- many of these companies are monopolistic so need regulation in the form of price especially
- quality and volumes regulated too
195
what is the price elasticity when industry prices are regulated?
price elasticity is zero
- no price change is allowed
- over the years there have been some discounts for large customers
196
what is product bundling?
bundling is putting a package of products together to make, for example, a complete kit for customers which can then be sold at a temptingly low price
- creates value for customer thus increasing company profits
- often used in recession when there is a need to maintain sales volumes
- some may be put off if they deem additional products unecessary
197
when is it ideal to product bundle?
when one product is valued more than the others
| -exploit price differentiation
198
what happens in the introduction phase of the product life cycle?
- DEMAND WILL BE LOW
| - heavy ADVERTISING COSTS required to bring attention
199
what happens in the growth phase of the product life cycle?
-steady and often RAPID INCREASE IN DEMAND
-the COST PER UNIT FALLS due to EOD with greater level of production
-aim is to establish LARGE MARKET SHARE
most profitable stage for the initial supplier
-competitors start entering
200
what happens in the maturity phase of the product life cycle?
- increase in demand slows down as the product reaches mass market
- sales curve flattens and eventually begins to fall. as maturity is reached the org becomes more interested in minimising elasticity
- have to differentiate products to maintain market position from new competition
- lower profits than growth stage
201
what happens in the decline phase of the product life cycle?
- saturation point: sales curve begins to decline
- price wars erupt as organisations with products which have elastic demand seek to maintain full utilisation of their production capacity
- profits can still be made during the early part of this stage, and the products will be managed to generate cash for newer products
202
what is the critical mass of a product?
sales volume required to ensure product is viable in medium term
