Management Accounting Flashcards

Question

What is the difference between relevant/avoidable costs & revenues and irrelevant/unavoidable costs & revenues

Answer 1

Relevant/ Avoidable costs and revenues: - are changed by a future decision Irrelevant/ unavoidable costs and revenues: - are not changed by a future decision

Answer 2

the direct cost of a commodity in terms of the materials and labour involved in its production, excluding fixed costs Eg. Direct materials + Direct labour = Prime cost

Answer 3

Production overheads: - Rent and rates - Factory power - Factory heat and light - Factory expenses - Depreciation of plant Non-production overheads: - Selling and distribution - Advertising - Admin expenses (salaries of office staff and office expenses)

Answer 4

What type of materials are held by businesses will depend on the type of business Manufacturing: - Raw materials - Work in progress - Finished goods Merchandising/retail: - Tangible products for resale i.e. finished goods inventory Service organisations: - Provide a service that cannot be stored, but may have work in progress

Answer 5

- Accumulates costs by classifying them into certain categories (e.g. labour, materials and overheads); - Assigns costs to cost objects.

Answer 6

It is important to be able to identify the amount of fixed and variable costs. Sometimes the information is given to you but sometimes it is not. Where total costs are known for two levels of output, the amounts of fixed and variable costs can be worked out using the ‘high/low’ method

Answer 7

Variable cost per unit - £2000/1000 = £2.00 For 1,000 units: Total cost = £7,000 Variable cost = 1,000 x £2 = 2,000 Fixed cost = 5,000

Answer 8

Job-order costing: - Assume that there are individual products or batches of products - The products or batches incur different costs so that there is a need to keep track of each product or batch Process-order costing: - Used in industries where masses of the same product are produced in a flow process

Answer 9

- Direct costs - Direct tracing to - Cost Objects - Indirect costs - go under cost allocations to either: - cause and effect allocations (the more we purchase, the more the cost will increase) or - arbitrary allocations (like direct labour hours or machine hours)

Answer 10

Arbitrary Allocations - Based on direct labour hours or - Based on machine hours

Answer 11

This is the simplest of all methods and applies overheads direct to a production department. This method is only valid for more simple businesses who do not have complex departments or multiple products. Advantages: - Simple to calculate, - low cost to implement Disadvantages: - Arbitrary, - simplistic, - inaccurate

Answer 12

**Stage 1** 1. Assign all manufacturing overheads to production and service centres 2. Reallocate the costs assigned to service cost centres to production centres **Stage 2** 3. Compute separate overhead rates for each production cost centre 4. Assign cost centre overheads to cost objects

Answer 13

What might be used as cost centres in a traditional costing system? - Mattress line – border added - Building section – where fillings are added, may include tufting and tape edging. - Delivery What might be used as an activity cost centre in an activity-based costing system? - Steel frame - Adding border, hand stitching - Building bed – adding fillings - Tufting - Tape Edging

Answer 14

**Stage 1** 1. Activities are divided into activity cost centres. 2. The total cost associated with each activity is allocated to the relevant activity cost centre. **Stage 2** 3. The total cost in each cost centre is then charged to output using a cost driver.

Answer 15

- Direct costing = Direct cost tracing only assigns direct manufacturing costs, not fixed manufacturing costs, to products or services - Overhead absorption costing = involves allocating production overheads to cost objects: - Plant wide / Blanket Overhead Absorption Rate – OAR based on machine hours and labour hours – different overhead allocation to the 2 jobs. - 2 – stage allocation process for both traditional absorption costing systems and Activity Based Costing systems

Answer 16

- The OAR is based on budgeted overheads and budgeted activity e.g. number of labour hours. - At the end of the period, we know what the actual activity was and apply the OAR to the actual activity. - The difference between the absorbed overheads and the actual overheads is a period cost adjustment in the financial accounts. The period may be a month, quarter, or year for example.

Answer 17

There is a delay in finding product costs, so essential information for decision making is not available until the end of the accounting period - Monthly profit calculations - Inventory valuation - Basis for setting prices - If this is done monthly, then fluctuations in OAR will occur Seasonality – changes in activity, customers want to know the price - Need to use an estimated normal product cost based on average long-run activity rather than an actual product cost - Establish a budgeted overhead rate based on annual estimated overhead expenditure and activity

Answer 18

It is very unlikely that the actual overheads and / or production levels are the same as the budgeted overheads and production levels used to calculate the OAR Therefore, overheads will be under or over recovered - Under or over recovery of overhead due to the activity level being different to the budgeted activity level is called a FIXED OVERHEAD VOLUME VARIANCE - Under or over recovery of overhead due to the actual fixed overhead expenditure being different to the budget is called a FIXED OVERHEAD EXPENDITURE VARIANCE - Financial accounting regulations require that under or over recovery of overheads is treated as a period cost adjustment

Answer 19

Financial accounting regulations specify that only manufacturing overheads should be allocated to products. Non-manufacturing costs should be assigned to products for decision-making (particularly cost-plus pricing). Some non-manufacturing costs may be a direct cost, of the product Examples: - Delivery costs, - Sales commission, - Travel costs Generally, aim to select an allocation base/cost driver that corresponds to the causation of non-manufacturing overhead For many non-manufacturing overheads, it may be hard to determine an appropriate basis for allocation. A widely used approach is to allocate based on the product’s production costs

Answer 20

- Manufacturing: per item made - Chemical business: kilogram of chemical - Transport company: passenger mile - Nursing home: resident day - University: student

Answer 21

- Job costing is used where each job can be separately identified from other jobs and costs are charged to that specific job. - All direct costs are easy to identify, and the overheads are added on a predetermined basis, such as labour hours or machine hours. - The overheads are allocated on a predetermined OAR basis.

Answer 22

- Used where masses of similar products or services are produced in a flow process. - In the manufacturing industry, this could be making food. In this case, process costing is the method used. - In this situation, the total costs of the process for a given period of time are collected together and averaged per unit of output for that period.

Answer 23

Marginal and absorption costing These two costing systems are often used in cost accounting, but for different purposes: - Marginal (variable) costing – helps with short-term decision making. - Absorption costing – is used to calculate inventory valuations and profit calculations. The use of each system is dependent on the informational needs of the business: - ‘can we afford to sell 1,000 units of our product at a discount of 20%?’ – this is marginal costing - ‘what profit have we made this year?’ – absorption costing

Answer 24

Marginal costing is effectively the cost of producing one extra unit of output. Cost are classified by their behaviour (variable, fixed) so that it is easy to work out the cost of producing one extra unit. The marginal cost of a unit is usually (but not always) the total of the variable costs of producing a unit of output. Knowing this cost allows managers to consider the contribution to the business by each unit. The contribution is: selling price less variable cost.

Answer 25

**Marginal costing** Variable costs: - Variable direct materials - Variable direct labour - Variable direct expenses - Variable overheads Fixed costs: - Fixed direct expenses - Fixed overheads **Absorption costing** Direct costs: - Direct materials - Direct labour - Direct expenses Indirect costs: - Variable overheads - Fixed overheads

Answer 26

**Marginal costing** Main use? - To help with short term decision making How does it work? - Costs are classified as either variable or fixed - Contribution towards fixed costs is calculated as selling price less variable costs Main focus? - Marginal cost - Contribution Usefulness? - Concept of contribution is easy to understand - Useful for short term decision making Limitations? - Costs must be identified as either fixed or variable - All overheads must be recovered, or a loss will be made - Not acceptable under IAS 2 Inventories **Absorption costing** Main use? - To calculate profit - To calculate inventory How does it work? - Overheads are charged to output through an overhead absorption rate, often based on labour hours or machine hours Main focus? - All production overheads charged to output - Calculating profit - Calculating inventory valuation Usefulness? - Acceptable under IAS 2 - Appropriate for traditional industries where overheads are charged to output based on direct labour or machine hours Limitations? - Not as useful for short term decision making

Answer 27

- Once the contribution per unit has been established, the total contribution for the period can be established. - The fixed costs are then deducted, to arrive at the profit for the period.

Answer 28

- Contribution per unit is clearly identified - Effect on changes to costs easily identified - Effect on changes to selling price easily identified - Helps with short-term decision making such as: - Break even analysis - Margin of safety - Target profit - Contribution sales ratio - Limiting factors

Answer 29

This method answers the question ... ‘What does it cost to make one unit of output?' - Direct materials - Direct labour - Direct expenses - Production overheads (variable and fixed) - Absorption cost

Answer 30

https://1drv.ms/i/s!AqdQnHr6sa5_xQIa3T5BM1IVbbm7?e=Q1AHmZhttps://1drv.ms/i/s!AqdQnHr6sa5_xQIa3T5BM1IVbbm7?e=Q1AHmZ

Answer 31

Marginal and absorption costing treat fixed overheads differently; therefore, the two methods will produce different levels of profit when there is closing inventory. This is because: - under marginal costing the closing inventory is valued at variable production cost. - Whereas under absorption costing, there is a share of fixed production costs in closing inventory. IAS 2 Inventories – provides guidance for determining the cost of inventories and the subsequent recognition of the cost as an expense Absorption costing has to be used for external reporting

Answer 32

- Planning annual operations - Coordinating activities - Communicating plans - Motivating managers - Controlling activities - Evaluating performance

Answer 33

- Participatory – managers at all levels are involved. - Zero based budgeting – justify every figure in the budget (can be time-consuming) - Incremental budgeting – start with prior period and adjust the figure (with percentages) (could add budgetary slack and become inaccurate) - Rolling budgets – always have a budget for the next time period e.g. next 12 months

Answer 34

1. Communicate details of budget policy and guidelines to those people responsible for preparing the budget. 2. Determine the factor that restricts output. 3. Preparation of the sales budget. 4. Initial preparation of budgets. 5. Negotiation of budgets with higher management. 6. Coordination and review of budgets. 7. Final acceptance of budgets. 8. Ongoing review of the budgets.

Answer 35

- Sales - Production including inventory levels - Materials usage - Materials purchase - Labour utilisation - Production overhead budget - Functional budgets - eg. finance, admin - Capital expenditure - Cash flow - Master, budgeted profit or loss and balance sheet

Answer 36

We have already looked at why budgets are produced – the main reason is for control purposes. They are compared to actual figures over the period so that those responsible can understand how they are performing. Favourable = sales price increase = increase net profit Adverse = cost of materials increase = decrease net profit

Answer 37

- Poorly set budget - Inaccurate cost behaviour assumptions - Change in suppliers - Government changes – e.g. living wage - International changes – e.g. price of oil - Bad management - High wastage

Answer 38

So, once the budgets are completed, what happens? - They are compared to actual figures over the period so that those responsible can understand how they are performing. - The difference between the budget figures and the actual figures can be either a favourable variance or an adverse variance.

Answer 39

From the perspective of Net Profit - Favourable - Adverse (unfavourable)

Answer 40

- Standard costs are target costs for each operation that can be built up to produce a product standard cost. - A budget relates to the cost for the total activity, whereas standard relates to a cost per unit of activity Establishing standard costs: Two approaches: - past historical records; Labour and Material usage - engineering studies

Answer 41

Standard Hours Produced - Used to measure output where more than one product is produced. Example Standard (target) times: X = 5 hours, Y = 2 hours, Z = 3 hours Output = 100 units of X, 200 units of Y, 300 units of Z What is the Standard Hours Produced? (100 × 5 hours) + (200 × 2 hours) + (300 × 3 hours) = 1,800 hours - If actual DLH are less than 1,800 the department will be efficient, - If hours exceed 1,800 the department will be inefficient. Note: Different activity measures and other factors (besides activity) will influence cost behaviour. Standard Hours Produced

Answer 42

Fixed budgets remain the same irrespective of the level of activity. A flexed budget changes with the level of activity. This is commonly used inmanufacturing businesses because if the level of activity changes, then every comparison between budget and actual will have variances – but this variance could be mainly due to activity levels being different. - Once the flexed budget is produced, the variance analysis can be carriedout. Note we are looking at variance analysis with a variable costing system

Answer 43

This variance handles the change from original budget to flexed budget. As the only difference between these budgets is the level of activity, this variance considersthat in one figure. - A reduction in sales volume would lead to an adverse variance. - An Increase in sales volume would lead to a favourable variance

Answer 44

This variance compares the number of hours budgeted against the actual number of hours taken. This difference is then shown at the budgeted hourly rate. - A reduction in the number of hours taken would lead to a favourable variance. - An increase in the number of hours taken would lead to an adverse variance

Answer 45

This variance compares the budgeted cost per hour with the actual cost per hour. - A reduction in the cost per hour would lead to a favourable variance. - An increase in the cost per hour would lead to an adverse variance.

Answer 46

This variance compares the quantity of materials budgeted against the actual quantity used. This difference is then shown at the budgeted material cost - A reduction in the quantity of materials usedwould lead to a favourable variance. - An increase in the quantity of materials used would lead to an adverse variance.

Answer 47

This variance compares the budgeted cost per unit of material with the actual cost per unit of material. - A reduction in the cost per unit would lead to a favourable variance. - An increase in the cost per unit would lead to an adverse variance

Answer 48

- In Marginal costing costs are classified as either fixed or variable. - Companies need to know how many units need to be sold to cover all the fixed costs Contribution per unit (CPU) = Selling price – variable cost Profit = Contribution per unit x number of units sold) – Fixed costs

Answer 49

C = cost of the unit V = volume of the unit P = profit made Breakeven Point (BEP) is the point at which neither a profit nor a loss is made BEP is the number of units that need to be sold to cover the fixed costs - BEP = Fixed costs / contribution per unit

Answer 50

This is the amount by which the sales exceed the BEP. It can be expressed as: - Number of units - Sales revenue amount - Percentage: current output – break even output/current output x 100 = % margin of safety

Answer 51

Contribution expressed as a % of the selling price. Contribution sales ratio % = Contribution / Selling price We can use the CS ratio to find the sales revenue at which the company breaks even, or the sales revenue to give a target profit Break even sales revenue = Fixed cost / CS ratio

Answer 52

Some companies will want (need) to make a certain amount of profit, so this can be inbuilt into the breakeven analysis to ensure that the right amount of units are produced. Fixed costs + target profit / CPU = number of units

Answer 53

- Before starting a new business - When making changes - To measure profits and losses - To answer ‘what if’ questions - To evaluate alternatives

Answer 54

- Assumes all output is sold - All costs and revenues can be represented by a straight line - Fixed costs remain fixed – and not stepped -There is a direct relationship between revenue and cost- in some case the more that is produced the cheaper it is per unit - Only applies to the relevant range

Answer 55

Limiting factors are those aspects of a business which affect output. - Lack of availability of materials - Lack of availability of labour (especially skilled) - Lack of availability of capital resources (machinery) - Finance - Volume of units that can be sold Where there are no limiting factors, company should concentrate on the product making the highest CS ratio However, when there are limiting factors, production should be based on the highest contribution from each unit of the limiting factor

Answer 56

Reconciliation statements can be used to show the differences between the standard cost of production and the actual cost. Computing the differences for variable and fixed costs is more complex when using standard costing.

Answer 57

Under marginal (variable) costing – fixed costs are ignored. Therefore, where there is a difference between projected and actual fixed costs, the overhead variance is simply the difference between the two figures. * i.e. Fixed Overhead Expenditure Variance

Answer 58

Under absorption costing – one advantage of standard absorption costing is that the cost for a unit will be a ‘full’ cost and will incorporate a portion of all the costs of production. - If the actual production level is close to the projected level, and all cost estimates are reasonably accurate, then standard cost will be close to the actual full cost However if this does not occur, fixed overhead variances will need to take into account: * Production volumes and * Overhead costs

Answer 59

As we know, the OAR is worked out before production is underway. The OAR is worked out so that, based on a measure, the total fixed overheads are covered by the volume of units expected to be made. * So, what happens if: * Fixed overheads change? * The measure (labour hours, machine hours) change? * Volume of units produced / sold change? These changes will provide two fixed overhead variances: - Fixed overhead expenditure variance – this is the difference in the actual amount spent on fixed overheads. - Fixed overhead volume variance – this is the difference in the actual volume of output. The combination of these two variances will result in an overall total fixed overhead variance.

Answer 60

Remember that fixed overheads can be apportioned uses a variety of measures. The three main ones are: - actual units, - labour hours - machine hours. How the OAR has been worked out will change the waythat the fixed overhead variances are worked out.

Answer 61

For deeper analysis, the volume variance can also be sub-divided into efficiency variance and capacity variance. Volume Capacity variance - this compares the time the budgeted production should have taken with the actual hours worked. - (actual hours taken – budgeted hours) x OAR Volume Efficiency variance - this compares the time the actual production should have taken with the time it actually took to make. - (std hours for output – actual hours for output) x OAR

Answer 62

the process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information

Answer 63

1. internal users within the organization (management accounting). 2. external parties outside the organization (financial accounting). (Drury, 2020)

Answer 64

1. Financial Accounting (not Finance): - provide information to those external to the organisation. Shareholders would be a typical user of this information. - mainly uses historical data and is essentially backward-looking. - very heavily regulated and controlled by parties external to the organisation, such as the IASB. - Financial accounting reports describe the whole of the business 2. Management Accounting: - seeks to provide information which is for those internal to the organisation. - Managers would be a typical user of this information. - mainly concerned with future planning and is very forward-looking. (Key term: decision making) - not regulated at all. (Although there are guidelines) - Financial accounting reports describe the whole of the business

Answer 65

(Drury, 2020)

Answer 66

- allocate costs between products sold, and fully and partly completed products that are unsold. - provide relevant information to help managers make better decisions. - provide information for planning, control, performance measurement and continuous improvement (Drury, 2020)

Answer 67

Any activity or output for which a separate measurement of costs is desired.

Answer 68

Classify costs into categories e.g., by type of expense, by cost behaviour, then assign costs to cost objects. Choosing an appropriate cost unit is critical within a business as it is to this object that all costs are allocated.

Answer 69

- Managers require information that will assist them in their decision-making and control activities; for example, information is needed on the estimated selling prices, costs, demand, competitive position and profitability of various products/services that are provided by the organization. - Shareholders require information on the value of their investment and the income that is derived from their shareholding. Likewise, potential investors are interested in their potential returns. - Employees require information on the ability of the firm to meet wage demands and avoid redundancies, their potential for continued employment. - Creditors and the providers of loan capital require information on a firm’s ability to meet its financial obligations. - Government agencies such as the Central Statistical Office collect accounting information and require such information as the details of sales activity, profits, investments, stocks (i.e. inventories), dividends paid, the proportion of profits absorbed by taxation and so on. In addition, government taxation authorities require information on the amount of profits that are subject to taxation. All this information is important for determining policies to manage the economy.

Answer 70

- Financing decision: Planning and controlling the provision of resources (where funds are raised from) - Investment decision: The allocation of resources (where funds are deployed to) - Dividend decision: the amount and timing of any cash payments made to the firm’s shareholders.

Answer 71

1. Relationship between risk and return 2. Time value of money

Answer 72

Return: - financial rewards gained as a result of making an investment. - E.g., profit, dividend payments, capital gains, interest payments Risk: - possibility that the actual return may be different from the expected return. - E.g., risky investment (where there is a significant possibility of actual return being different from its expected return) Relationship between risk and return: - “high risk high return” (Investors and companies demand a higher expected return if they think that the possibility of actual return increases)

Answer 73

Time value of money refers to the fact that the value of money changes over time. particularly important to companies because the financing, investment and dividend decisions made by companies result in substantial cash flows OVER a variety of periods of time. 1. Time 2. Inflation 3. Risk

Answer 74

- Legal entity - Owned by shareholders - Can make contracts - Carry on a business - Borrow or lend money - Pay taxes but can’t vote Private company - Shares are not publicly traded Limited liability - No responsibility for corporation’ debt E.g. Case of Lehman brothers in 2008 Public company - Own the corporation - Can’t manage & control it - Can sell their shares to new investors via stock market without disrupting the operations of the business

Answer 75

Broadly, corporate governance is the way in which organisations are directed, administered and controlled. It is concerned with the relationship between internal and external stakeholders, with essentially: - Internal stakeholders are managers and directors - External stakeholders are the shareholders.

Answer 76

Investment decision: - Is related to the purchase of real assets - Involves in managing assets already in place - Decides when to shut down and dispose of real assets when they are no longer profitable - Manages and control risks of investments Financing decision - Is related to the sale of financial assets and securities - Whether to raise money from new and existing owners by selling more shares of stock (equity) or to borrow (debt) - The choice between debt and equity is called capital structure decision - Includes the meeting its obligations to banks, bondholders, and stockholders that have contributed financing in the past. Example: repay debts when they become due. If not, it ends up insolvent and bankrupt!

Answer 77

- Make the most profit - Pay the highest dividend - Be the best employer - Be the most environmentally friendly - Be the cheapest - Be the biggest - Have the best product

Answer 78

- Traditionally, the main goal of organisations (public) was the maximise shareholder wealth. - This means capital and revenue returns need to be as high as possible: Capital = share price and Revenue = dividends - To transform that wealth into the most desirable time pattern of consumption - To manage risk characteristics of that consumption plan However profit maximisation might not be a well-defined objective, for at least two reasons: - A corporation might be able to increase current profit by cutting back on outlays for maintenance or staff training (which have long term added value) - Company may increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. Might not be in shareholders interest if company earns only a modest return on money.

Answer 79

Conflicts between shareholders’ and managers’ objectives Agency problems arise when agents (managers) work for principals (shareholders or owners) – A separation of ownership and control

Answer 80

1. Divergence of ownership and control 2. Interest conflicts between managers (agents) and shareholders (principals). 3. Asymmetry of information exists between agents and principals

Answer 81

- Involve current outlays in return for a stream of benefits in future years - Involve long-term investment (i.e., a significant elapses between the outlay and recoupment of the investment) - normally longer than one-year period - Represent the most important decisions that a corporation makes, because they commit a substantial proportion of a firm’s resources to actions that are likely to be irreversible. Examples: the projected capital expenditure for Tesco plc for 2016 were £2.6 billion. - Are applicable to all sectors of society. - Corporate investment decisions: plant & machinery, research & development, advertising & warehouse facilities. - Public investment decisions new roads, school, airports. - Individuals’ investment decisions house buying, the purchase of consumer durables, education. Initially that all cash inflows and outflows are known with certainty, and that sufficient funds are available to undertake all profitable investment. No tax, no inflation!

Answer 82

Rule 1: Comparing and Combining Values - It is only possible to compare or combine values at the same point in time. - A dollar($) today and a dollar($) in one year are not equivalent - To compare or combine cash flows that occur at different points in time, you need to convert the cash flows into the same units or move them to the same point in time Rule 2: To move a cash flow forward in time, you must compound it Rule 3: To move a cash flow back in time, you must discount it

Answer 83

Techniques that take into account the time value of money: - Net Present Value (NPV) - Internal rate of return (IRR) Techniques that ignore the time value of money - Payback Period (Payback) - Accounting rate of return (ARR)

Answer 84

Technique that takes into account the time value of money Suppose you want to value a stream of cash flows extending over a number of years. For multiple period, we have the discounted cash flow (or DCF) formula: Net Present Value (NPV) of an investment decision: 𝑵𝑷𝑽=𝑷𝑽(𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔)−𝑷𝑽(𝒄𝒐𝒔𝒕𝒔) To find the Net present value (NPV), we minus the initial cash flow of investment Where I0 refers to investment outlay at time t, C refers to future cash flow and r refers to Discount rate Alternatively, the NPV can be calculated by referring to a published table of present values: - To use the table, simply find the discount factors by referring to each year of the cash flows and the appropriate interest rate. | see miro

Answer 85

Advantages: - Assumption of reinvestment, or take into account the time value of money - Consideration of all cash flows - Simple to interpret. Easy to visualise by manager. Disadvantages - Difficulty in determining the discount rate - Assumes investment returns are static - Difference in size of projects - Extent of risk unknowns NET PRESENT VALUE lets you know whether the value of all cash flows that a project generates will exceed the cost of starting that particular project. Basically, it will tell you whether your project has a positive or a negative outlook.. That is, whether the project should be undertaken or not

Answer 86

Alternative technique for use in making capital investment decisions that also takes into account the time value of money IRR is the rate of return that gives an NPV of zero - IRR represents the true interest rate earned on an investment over the course of its economic life Trial and error method: Use a number of discount factors until the NPV equals zero. To calculate IRR, two discount rates are used to calculate the NPV, one giving a positive result and one giving a negative result.

Answer 87

Advantages - Take into account the time value of money - Simple to interpret. Easy to visualise by manager - No requirement of finding hurdle rate (required rate of return or discount rate) Disadvantages - Express the result as a percentage rather than in monetary terms. Comparison of percentage can be misleading as the economies of scale (scale of investment) are ignored. - Where a project has unconventional cash flows, the IRR has a technical shortcoming. - Does not directly address wealth maximisation

Answer 88

Technique that ignore the time value of money It is the length of time that is required for a stream of cash proceeds from an investment to recover the original cash outlay required by the investment. In another words, it simply considers the time taken for the initial investment to be repaid in terms of net cash flows. It uses CASH rather than account profit. A simple example: If an investment requires an initial outlay of £60,000 and is expected to produce annual cash flows of £20,000 per year for five years, the payback period will be £60,000/£20,000 = 3 years. How to calculate it: the payback period is calculated by adding up the cash inflows expected in successive years until the total is equal to the original outlay (initial investment).

Answer 89

Advantages - It is widely used in practice because it is particularly useful approach for ranking projects where a firm faces liquidity constraints and requires a fast repayment of investments. - It is appropriate in situations where risky investments are made in uncertain markets that are subject to fast design and product changes or where future cash flows are extremely difficult to predict. Disadvantages - Does not take into account cash flows that are earned after the payback period - Ignore the time value of money: fails to take into account the differences in the timing of the proceeds that are earned before payback period --> discounted payback method - Can result in the acceptance of projects that have a negative NPV

Answer 90

Technique that ignores the time value of money - Also known as the return on investment and return on capital employed ARR = Average annual profits / average investment - Assumption: depreciation represents the only non-cash expense, profit is equivalent to cash flows less depreciation -- If straight line depreciation is used, it is presumed that: average investment = ½*initial investment + ½*Scrap value

Answer 91

Advantages - Is superior to the payback period in one respect: it allows for differences in the useful lives of the assets being compared. - Is used in practice because it is frequently used to measure the managerial performance of different business units within a firm. Disadvantages - Ignore the time value of money

Answer 92

Equity: - is raised through the sale of ordinary shares to investors (long-term) Debt: - a bank loan or an issue of fixed interest securities such as bonds.(>1 years loan)

Answer 93

- E.g., a sale of shares to new owners, perhaps through the stock market as part of a company’s initial listing - E.g., a sale of shares to existing shareholders by means of a rights issue. Ordinary shares are bought and sold regularly on stock exchanges throughout the world and ordinary shareholders (as firm owners want a satisfactory return on their investment) ORDER: 1. Secured creditors: debenture holders and banks (entitled to receive in full both unpaid interest and the outstanding capital or principal.) 2. Unsecured creditors: suppliers of goods and services 3. Preference shareholders 4. Ordinary shareholders: are not entitled to receive any of the proceeds of liquidation until the amounts owning to creditors, both secured and unsecured, and preference shareholders have been satisfied in full.

Answer 94

**Nominal value (par value or face value):** - The value shown on the face of the ordinary shares (securities). - It is the original cost of the shares as listed on the certificate. - Ordinary shares of a company must have a par value (nominal value or face value) by law and can’t be issued for less than this amount. E.g., 1p, 5p, 10p, 25p, 50p, or £1 **Market value (market capitalization ):** - The value at which the share is traded on the listed stock exchange. - Nominal value bears no relation to its market value. E.g., ordinary shares with a par value of 25p may have a market value (price) of several pounds. - Market value per share = total value of the company in the market / total number of shares issued by the company NOTE: New shares, whether issued at the foundation of a company or subsequently, are almost always issued at a premium to their nominal value. The nominal value of shares is represented in the balance sheet (one of three main financial statements) by the ordinary share account. The additional funds raised by selling shares at an issue price greater than the par value are represented by the share premium account **Book value:** - The value of share in the company’s books. Book value per share = (total assets – total liabilities)/total number of shares issued by the company OR Book value per share = ((Equity share capital + reserves and surplus) /total number of shares issued by the company - P/B (price to book value): highly useful comparison tool while taking an investment decision

Answer 95

The portion of a business’s net profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Dividends can be distributed in the form of cash or stock. Both forms of distribution reduce retained earnings (RE). The formula is: Beginnning Period retained earnings = Net income/loss - (cash dividends + stock dividends) Should a company retain the profits within the business or pay the profits out in dividends? Factors affect RE: factors affect net income (e.g., - sales revenue, - cost of goods sold, - depreciation, - other operating expenses) and - dividends.

Answer 96

- New shares can be offered to any investors, new and existing. - Usually if the company is newly listing, it will be listed on the FTSE AIM (Alternative Investment Market). - If already listed, then additional shares will be added to the existing ones. - Directors need approval by the shareholders to do this (company law area regarding legality on this) as introducing new shares may have a major impact on the existing shareholders.

Answer 97

**Suggested answer:** - Additional regulation: they will need to produce additional published financial reports. Additional compliance costs often involve more staff to deal with the extra requirements. - Extra capital will be raised, but there will be legal and other professional fees involved. These could be 10% of the total raised, if not higher. If the company is hoping to raise £1,250,000, fees could be £125,000 or more. - This needs factoring into their cash flow workings for the new warehouse. - Directors need to be prepared for the additional scrutiny and PR that surrounds being listed – meeting financial journalists, for example. - Share price may fluctuate which directors need to consider regarding their duty to maximise shareholder wealth. - Impact on dividend payments for the future – 50% increase in the number of shares will affect the level of dividends payable – how will that affect directors’ personal ‘salary’?

Answer 98

A rights issue is an offer to existing shareholders to subscribe for new shares, at a discount to the current market value, in proportion to their existing holdings. This usually has the effect of diluting the existing share price and hence has an impact for existing shareholders The issue is expressed as: 1 for XX shares at £X Shareholders not wishing to take up their rights can sell them on the stock market. We need to consider the TERP (theoretical ex-rights price) - The new share price after the issue and it is calculated by finding the weighted average of the old price and the rights price, weighted by the number of shares. TERP (ex-rights price) = (𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑎𝑙𝑟𝑒𝑎𝑑𝑦 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒 + 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝑓𝑟𝑜𝑚 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒 𝑖𝑠𝑠𝑢𝑒 )/(𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡ℎ𝑒 𝑟𝑖𝑔ℎ𝑡𝑠 𝑖𝑠𝑠𝑢𝑒 (𝑒𝑥 𝑟𝑖𝑔ℎ𝑡))

Answer 99

**Advantages:** - Cheaper than a public share issue - is made at the discretion of the directors, without consent of the shareholders or the Stock Exchange - rarely fails - existing shareholders' equity stakes are not diluted, provided they take up their rights. **Disadvantages:** - There is a limit to how much can be raised through this method as existing shareholders are only willing to invest so much. - Will affect Earning per Share (EPS) which affects Price/Earnings (P/E) - If shareholders do not take up their rights, then their shareholding will be diluted.

Answer 100

**Bank term loan** - A loan from a bank or other financial institution that is repayable on a certain date in the future. - This is simplest form of debt financing and can be arranged by companies of all sizes and types. - The loans are normally secured on the assets of the company. - Repayment of the principal can be at the end of the period, or over of period of time. - The interest rate charged by the bank can be fixed or floating. - The interest rate is fixed by the finance provider, depending on the risk they perceive of the borrower.

Answer 101

- Bank term loan - Straight bond - Zero coupon - Unsecured bond - Convertible bond - Straight bond with warrants attached - Leasing

Answer 102

**Straight bond** - Straight bond, marketable debt, loan note and debenture basically all mean the same thing. - They refer to a situation where a company issues a - block of debt to investors through the Stock Exchange which is normally secured on the assets of the company. - Therefore, the issuing company must be listed on the stock exchange and the debt is bought and sold through the stock exchange in a similar way to shares. - The debt carries a fixed rate of interest set on the date that the debt is issued. - A crucial difference between this type of debt and bank lending is that an investor buying a bond can sell that bond at any time. - This type of debt is therefore a lot more 'liquid' to an investor, than bank lending. Example: The market price of a straight bond is normally quoted per $100 nominal value of the bond. Interest is calculated on the basis of the nominal value. If a 12% bond was trading as $92 for example, this would mean that an investor would be prepared to pay $92 for a block debt with a nominal value of $100. The investor would then receive 12% x $100 = $12 of interest each year, but at a cost of $92.

Answer 103

**Zero coupon** - This works in principle the same as a straight bond, except a zero coupon bond is one that is issued at a significant discount to the redemption value. - No interest is paid but the investor will obtain a significant known return in the form of a capital gain between the date of issue and the redemption date. - A deep discounted bond is similar except that a small amount of interest is payable each year. - The main benefit of a zero bond is that a company avoids having to pay significant amounts of cash to an investor until the debt is redeemed. This is most useful if a company is financing a long term investment that will not generate cash returns for some time. - However, the overall percentage return that an investor will demand will be higher than the return on a normal bond. It is therefore relatively expensive. The company will also need to find a large amount of cash to redeem the debt on the redemption date.

Answer 104

**Unsecured bond** - This is also known as mezzanine finance. This is a bond issued without security on the assets of the company. - An investor in mezzanine finance would therefore rank below an investor in secured debt in the event of the company going bankrupt or winding up. - High risk debt -> the return that the company needs to offer investors is often extremely high. It is therefore used mainly where companies do not have assets to use as security.

Answer 105

**Convertible bond** - This is a type of bond which provides the holder with the option to convert the bond into a certain number of shares at a future date or alternatively, to have the bond redeemed for a cash lump sum. Interest is paid on the bond each year up to the date of conversion or redemption. - As the investor has the potential to makes a capital growth on the bond through the increase in the share price, the interest payable on the bond tends to be low by comparison to other similar bonds. - The company will therefore benefit from paying less interest over the period of the bond, but there is no detrimental impact on the company irrespective of the share price movement. - If conversion takes place, the company has a huge advantage of not having to find the cash to redeem the bond, but there will be negative impact on the EPS / P/E ratio / share price of the company’s shares.

Answer 106

**Straight bond with warrants attached** - This is similar to the straight bond described above, but when the investor purchases the straight bond, they are also given warrants to buy shares in the company which normally mature on the redemption date of the straight bond. - A warrant is an option to buy shares in the company, issued by the company itself. If the warrant is exercised by the holder, the company issues new share capital for cash.

Answer 107

**Leasing** - Long term leasing of assets is a very useful form of financing for certain types of assets. Most types of non-current assets can be leased or bought.

Answer 108

- Bank loans - Overdrafts - Venture capital - Business angels

Answer 109

**Bank loans** - This is the primary source of financing for small companies. It could be very almost any time period and usually has quite considerable flexibility, especially over the period of the loan. - A major drawback of loans is that in many cases, the personal assets of the owner(s) of the business are used as security. This means that if something goes wrong, the owner(s) could lose their house as well as their business.

Answer 110

**Overdrafts** - This is also very popular, but tends to be one of the most expensive forms of finance, particularly if used long term.

Answer 111

**Venture Capital** - Venture capital organisations specialise in providing capital to high potential growth, but risky, private companies. High technology and R&D companies are examples. They would normally demand a significant equity stake in the company in return for the finance. - There are various advantages of this method of finance, but companies tend to take it out when there is no other alternative. This is partly because the VC will own a proportion (sometimes significant) of the business and therefore the true ‘owners’ loss control.

Answer 112

**Business Angels** This refers to wealthy individuals or groups of individuals, who are willing to invest in small businesses. Like VC, they would normally take a significant equity stake.

Answer 113

- Current assets = assets with maturities of less than one year E.g., raw materials, work-in-progress and finished goods, trade receivables, short-term investments and cash - Current liabilities = liabilities with maturities of less than one year E.g., trade payables, overdrafts and short-term loans (Net) Working Capital = current assets - current liabilities

Answer 114

The level of current assets is a key factor in a company’s liquidity position. A company must have or be able to generate enough cash to meet its short-term needs if it is to continue in business. Therefore, working capital management is a key factor in the company’s long-term success: without the ‘oil’ of working capital, the ‘engine’ of non-current (fixed) assets will not function. The greater the extent to which current assets exceed current liabilities, the more solvent or liquid a company is likely to be, depending on the nature of its current assets

Answer 115

- Increase the profitability of a company - Ensure that the company has sufficient liquidity to meet short-term obligation - The twin goals of profitability and liquidity will often conflict since liquid assets give the lowest returns. E.g., cash kept in a safe will not generate a return.

Answer 116

- An aggressive policy: a company chooses to operate with lower levels of inventory, trade receivables and cash for a given level of activity or sales. - increase profitability but increase risk - A conservative and more flexible working capital policy for a given level of turnover: would be associated with maintaining a larger cash balance. - lower risk of financial problems or investment problems but reduce profitability - A moderate policy: would tread a middle path between the aggressive and conservative approaches.

Answer 117

- Overdraft: an agreement by a bank to allow a company to borrow up to a certain limit without the need for further discussion. - The company will borrow as much or as little as it needs up to the overdraft limit and the bank will charge daily interest at a variable rate on the debt outstanding. - An overdraft is a flexible source of finance in that a company only uses it when the need arises. - Short-term bank loans: a fixed amount of debt finance borrowed by a company from a bank, with repayment to be made in the near future, for example, after one year. - The company pays interest on the loan at either a fixed or a floating (i.e., variable) rate at regular intervals, for example quarterly. - less flexible than an overdraft - Trade credit: an agreement to take payment for goods and services at a later date than that on which the goods and services are supplied to the consuming company. - It is common to find one, two or even three months’ credit being offered on commercial transactions - a major source of short-term finance for most companies. - Short-term sources of finance are usually cheaper and more flexible than long-term ones. - Short-term interest rates are usually lower than long-tern interest rates

Answer 118

CCC: interaction between the components of working capital and the flow of cash within a company - CCC can be used to determine the amount of cash needed for any sales level. - CCC is the period of time between outlay of cash on raw materials and the inflow of cash from the sale of finished goods, and represents the number of days of operation for which financing is needed. - The longer the CCC, the greater the amount of investment required in working capital.

Answer 119

The length of the CCC depends on the length of: - Inventory conversion period: the average time taken to use up raw materials PLUS the average time taken to convert raw materials into finished goods PLUS the average time taken to sell finished goods to customers. - Trade receivables collection period: the average time taken by credit customers to settle their accounts - Trade payables deferral period: the average time taken by a company to pay its trade payables (i.e., its suppliers) CCC = Inventory days + Trade receivables days – Trade payables days

Answer 120

When a business has decided on the level of working capital needed, it then needs to decide how this working capital is to be financed. Three different types of assets: - Non-current assets (NCA): long-term assets from which a company expects to derive benefit over several periods, e.g., factory building, production machinery. - Permanent current assets (PCA): the core level of investment needed to sustain normal levels of business or trading activity, e.g., investment in inventories and average level of a company’s trade receivables. - Fluctuating current assets (FCA): correspond to the variations in the level of current assets arising from normal business activity. Permanent: this is the minimum net current assets that the business is likely to need to continue to operate. At no point in the business cycle is the level of net current assets likely to fall below this. Fluctuating: in many businesses, the net current assets will fluctuate between minimum and maximum levels.

Answer 121

Three different funding policies: - Matching funding policy: finances fluctuating current assets (FCA) with short-term funds and permanent current assets (PCA) and non-current assets (NCA) with long-term funds. The maturity of the funds roughly matches the maturity of the different types of assets. - Conservative funding policy: uses long-term funds to finance not only non-current assets (NCA) and permanent current assets (PCA), but some fluctuating current assets (FCA) as well  lower risk but higher cost of long-term finance (lower profitability). - Aggressive funding policy: uses short-term funds to finance not only fluctuating current assets (FCA), but some permanent current assets (PCA) as well.  greatest risk to solvency, but highest profitability and increases shareholder value. Which one is chosen is dependent on: - Companies access to finance - Extent of liquidity issues - Ability to pay finance costs - Other finance commitments

Answer 122

- Capital is the term used to refer to the financial resource that a company uses to pay for its activities and projects. - Usually, the term “capital” is specifically used to refer to its permanent or long-term finance, rather than its short-term financing. - Long-term capital is provided by the company’s investors: - Equity capital is provided by shareholders - Debt capital is provided by lenders

Answer 123

- The investors do not provide their capital for free. - Equity capital is provided by shareholders in return for dividends and/or increased market value of their shares (ie capital gains). - Debt capital is provided by lenders. Usually this is in the form of interest. Some forms of market-traded debt can generate capital gains too. - Dividends, interest and capital gains are types of return for the investor. - Dividends, interest and capital gains must be generated by the company to keep the investors happy. From the company’s point of view, the returns expected by shareholders are referred to as a cost, THE COST OF CAPITAL

Answer 124

Cost of debt capital = - the interest rate on the company’s borrowings Cost of equity capital = - the rate of return the company delivers to its ordinary shareholders We will then use these two costs to work out the company’s overall average cost of capital. Usually referred to as the weighted average cost of capital (or WACC) - The cost of capital is ALWAYS quantified as a % per year. - It is the annual % return that investors expect/require on the money they put into the company.

Answer 125

The cost of debt capital is the annual interest rate%. - With debt the return for lenders is the interest rate %. Companies pay tax on profits after interest so the cost of debt for the company should be lower because the interest expense reduces taxable profit and therefore reduces the corporate tax charge. If the interest rate is 6% and the company pays tax at 25% the post-tax cost of debt = 6% x (1-0.25) = 4.5% - Remember with bonds or debentures the interest payable by a company is the fixed coupon (interest) rate multiplied by its nominal value not its market value.

Answer 126

- We have to ensure that our company engages in activities that can generate enough return to satisfy the investors. - If our investors require 10% returns each year. We know that our company can only invest in projects that generate at least 10% - The cost of capital is therefore used as the discount rate for NPV calculations

Answer 127

Most companies are financed by a combination of debt and equity capital. These companies aim to maintain target proportions of debt and equity. - Cost of debt capital: the after-tax interest cost of raising new debt. - Cost of equity capital the rate of return a firm pays out equity investors. It can be calculated by using Capital Asset Pricing Model (CAPM) Cost of capital: is the average cost of all of the firm’s various sources of finance, weighted according to the proportion each element contributes to the total funding (also called the weighted average cost of capital (WACC)).

Answer 128

- The cost of capital is ALWAYS quantified as a %. - It is the % return that investors expect/require on the money they put into the company.

Answer 129

Example: Assume that the after-tax cost of new debt capital is 6% and the required rate of return on equity capital is 14%, and that company intends to maintain a capital structure of 50% debt and 50% equity. The overall cost of capital for the company is calculated as follows: Weighted Average Cost of Capital (WACC) = proportion of debt capital x after-tax cost of debt capital + proportion of equity capital x cost of equity capital = 0.5 x 6% + 0.5 x 14% = 10%. - The overall cost of capital is also called the weighted average cost of capital (WACC). - For the discount rate used in NPV computations, it is (usually) the WACC that is used. - WACC can be measured by using either historical values (ie Balance Sheet) or market values (but only for listed companies)

Answer 130

1. Find cost of equity 2. Find cost of debt 3. Find proportions of debt and equity for the company 4. Average the costs of equity and cost of debt using the market values as weightings. 5. Use book values if market values are not given (eg if unlisted)

Answer 131

**Advantages** * Easier, quicker and cheaper to raise * Interest can be fixed so a bit more predictable * Tax shield on interest payments makes debt finance cheaper * Debtholders bare less risk so cost of debt is cheaper **Disadvantages** * Interest has to be paid (dividends don’t) * Reduces the amount of profit that can be distributed to shareholders which can be seen as risky for them, so the cost of equity will raise

Answer 132

- ‘Gearing’ refers to the proportion of a company’s financing that is in the form of debt as opposed to equity. A high gearing percentage indicates a high level of debt. - The term ‘leverage’ is used to refer to gearing in North America. The calculation of gearing can be done in a number of ways, the two most commonly used are: - Debt/Equity (value of debt divided by the value of shareholders’ funds) - Debt/(Debt + Equity) (value of debt divided by total capital employed) In FINANCE we prefer to use market values if they are available. In FINANCIAL ACCOUNTING the book values are used. Capital structure is an alternative term which describes the mix of debt and equity

Answer 133

The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimising its cost of capital. The value of a company is like the value of a project or an investment. Its NPV is higher if the discount rate (the WACC) is lower. To maximise the value of the company, we therefore need to minimise WACC.

Answer 134

Key factors: * Lenders are guaranteed by law to receive their interest and their capital. Shareholders have no such rights generally. * Lenders must be paid their interest in full even if there is no profit. Dividends can be cut by the directors if there is a shortage of profit and/or cash. * In the event of a liquidation, lenders are more likely to recover their investment than shareholders because lenders rank more highly in the pecking order once the company is in financial difficulty. * As investors, ordinary shareholders bear more risk than lenders. * Shareholders expect a higher return to compensate for this higher risk. * When gearing goes up, the shareholders perceive that as additional risk * Cost of equity is nearly always higher than the cost of debt. * Cost of equity usually goes up when debt is increased.

Answer 135

**Traditional theory** - There is an ideal level of gearing which minimises the company’s WACC **Modigliani & Miller’s theory (no tax)** - WACC is unaffected by gearing so makes no difference to the value of the company

Answer 136

* As debt is increased the company’s cost of debt remains relatively constant as long as any increase in debt is incremental so it doesn’t adversely affect creditworthiness. Only when debt gets very high does the company’s cost of debt begin to rise because lenders start to worry about the company’s ability to pay back debt. * Cost of equity starts to rise too, but debt is a more direct risk to the shareholders’ dividend, so the shareholders begin to demand higher returns on their equity much earlier. Cost of equity increases more dramatically as the gearing increases. * Weighted average cost of capital starts to fall as the much cheaper debt becomes bigger within the capital structure. The cheap debt brings down the average cost of capital. However, past a certain point the increasing much greater increases in the cost of equity starts to pull the WACC up. * Best to have gearing where the WACC is at its lowest.

Answer 137

- this states that cost of capital is unaffected by gearing. Their theory was that, provided there is a ‘perfect’ capital market (i.e., no tax, no transaction cost and no information asymmetry). ), that: - Two firms in the same sector with the same production potential yielding identical cash flows with the same risk complexity, will have the same total capital value, irrespective of their capital structure.  no optimal capital structure exists for a particular company. - In other words, whether the capital is equity or debt, or a mix, the WACC will remain the same.

Answer 138

A dividend is a cash payment made on a quarterly or semi-annual basis by a company to its shareholders (owners). It is a distribution of after-tax profit. The objectives of a company’s dividend policy should be consistent with the overall objective of maximisation of shareholder wealth. Therefore, a company should pay a dividend only if it leads to such an increase in wealth. A very simple model for analysing dividend payments was put forward by Porterfield (1965), who suggested that paying a dividend will increase shareholder wealth only when: d1 + P1 > P0 where d1 = cash value of dividend paid to shareholders; P1 = expected ex-dividend share price (share price after paying dividends) P0 = market price before the dividend was announced. If the expression is modified to: d1 + P1 = P0 - this implies that dividends DO NOT affect shareholder wealth and hence, dividends are irrelevant.

Answer 139

Research suggests that in a real world, a dividend policy does have a significant impact on shareholder wealth. In other words, dividends are relevant. This can be reflected via some theories. Dividend signalling: - Due to the asymmetry of information existing between shareholders and managers, shareholders see dividend decisions as conveying new information about the company and its prospects. - A dividend INCREASE is usually seen by the market as conveying GOOD NEWS, meaning that the company has favourable prospects. - A dividend DECREASE is usually seen as BAD NEWS, indicating a gloomy future for the company. - However, fuller information could reverse these perceptions.

Answer 140

- The existence of preferences for either dividends or capital gains means that investors will be attracted to companies whose dividend policies meet their requirements. - Each companies will therefore build up a clientele of shareholders who are satisfied by its dividend policy. - The implication for a company is that a significant change in its dividend policy could give rise to dissatisfaction among its shareholders, resulting in downward pressure on its share price.

Answer 141

Agency theory: * Board of directors will make the dividend decision * But making it on behalf of potentially diverse range of shareholders – which decision is best for them all? * Decision could be made for the best of the directors instead of best for shareholders.

Answer 142

- Constant dividend, and constant growth in dividends or steadily increase dividends: the most common policy. This tends to lead to share price stability. (1) Constant payout ratio: a fixed percentage of earnings is paid out in dividends. It maintains a constant payout ratio. - Advantages: it is relatively easy to operate and send a clear signal to investors about the level of the company’ performance. - Disadvantages: it imposes a constraint on the amount of funds it is able to retain for reinvestment. This dividend policy is unsuitable for companies with volatile profits which have shareholders requiring a stable dividend payment.

Answer 143

(2) constant growth in dividend or steadily increase dividends: dividend increases are kept in line with long-term sustainable earnings It is important for the company to avoid volatility in dividend payments as doing so can help to maintain a stable share price The drawback of keeping dividend constant or of steadily increasing them is that investors may expect that dividend payments will continue on this trend indefinitely. This can cause major problems when companies wish to reduce dividend payments, either to fund reinvestment or in the name of financial prudence. Companies tend to increase dividend slowly over time, to reflect the new profit level, when they are confident that the new level is sustainable.

Answer 144

This helps them: * Identify problems * Control costs * Measure how resources are being used * Measure employee performance * Plan for needed changes * Plan for future (short term, medium term and long term)

Answer 145

Liquidity (covered in ACC1010): - current ratio and quick ratio, etc. Leverage: - this is the gearing aspects and we covered some of this previously. For example: debt/equity ratio, interest cover, etc. these ratios are measures of financial risk. Activity (covered both in ACC1010 and previously): - inventory days, trade receivables and trade payables days, etc. These ratios are important in the management of working capital Profitability (covered in ACC1010): - gross profit margin, operating profit margin, return on capital employed, return on assets, return on equity, etc. When analysing financial performance, it is important to recognise that performance measures and financial ratios in isolation have little significance. In order to interpret the meaning of performance measures and ratios, they must be compared against appropriate benchmarks, of which the following are examples: - Financial targets set by a company’s strategic plan. E.g., a target return on capital employed or economic profit - Performance measures and ratios of companies engaged in similar business activities - Average performance measures and ratios for the company’s operations, i.e., sector averages. - Performance measures and ratios for the company from previous years, adjusted for inflation if necessary.

Answer 146

**Non-financial indicators** This is data which is expressed in numbers, but is not financially orientated. _Examples:_ * Hours worked * Number of employees * Number of customers * Units produced * Units sold * Level of wastage **Qualitative measures** This is data which is not numerically based. _Examples:_ * Opinions * Judgements * Appraisals * Attitudes These can be more important measure of performance in a service industry than in a manufacturing one.

Answer 147

This is a way of viewing performance from four perspectives: 1. Financial perspective (How do we look to shareholders?). 2. Customer perspective (How do customers see us?). 3. Internal business perspective (What must we excel at to satisfy our shareholders and customers?) 4. Learning and growth perspective (How can we continue to improve and create value?)

Answer 148

There are three core financial themes that drive the business strategy: - revenue growth and mix, - cost reduction and - asset utilization. specifies the financial performance objectives anticipated from pursuing the organisation’s strategy and also the economic consequences of the outcomes from achieving the objectives speciexpectedfied from the other three perspectives. Therefore, the objectives and measures from the other perspectives should be selected to ensure that the financial outcomes will be achieved.

Answer 149

The figure lists five typical core or generic objectives, and some additional measures (customer value propositions). should identify the customer and market segments in which the business will compete. The customer perspective underpins the revenue element for the financial perspective objectives. Therefore, the achievement of customer objectives should ensure that target revenues will be generated.

Answer 150

The process value chain consists of three processes: - the innovation process, - the operations process and - the post-sales process. requires that managers identify the critical internal processes for which the organization must excel in implementing its strategy. Critical processes should be identified that are required to achieve the organization’s customer and financial objectives.

Answer 151

There are three major enabling factors for this perspective: - employee capabilities, - information system capabilities and - the organisational climate for motivation, empowerment and alignment. The organisation and its employees must keep learning and developing to ensure that an organisation will continue to have loyal and satisfied customers in the future and continue to make excellent use of its resources. Therefore, there is a need for a perspective that focuses on the capabilities that an organisation needs to create long-term growth and improvement. This perspective stresses the importance of organisations investing in their infrastructure (people, systems, and organisational procedures) to provide the capabilities that enable the accomplishment of the other three perspectives’ objectives.