Module 4, Chapter 14 - Introduction To Financial Decision Making

Question 1

What is financial decision making?

Answer 1

Financial decision making is when management makes decisions about the business to achieve its objectives.

Question 2

Financial decisions are made about a range of topics and business functions. Provide five examples.

Answer 2

1. Investments the business should make (the investment decision)
2. Any long-term financing the business needs to raise (the financing decision)
3. How profits should be distributed to shareholders (the dividend decision)
4. Short-term financing (working capital management)

Question 3

There are several objectives a company’s management (and therefore a company itself) may pursue when making
decisions. List three financial objectives.

Answer 3

1. Maximising shareholder wealth.
2. Reinvesting in the company.
3. Non-financial objectives.

Question 4

How does a company achieve maximising shareholder wealth (or shareholder value)?

Answer 4

By maximising its combined value to maximise the returns paid out to shareholders, usually in the form of dividends (also known as distributions).

Question 5

The amount that is paid out to shareholders via dividends is governed by what?

Answer 5

The company’s dividend policy - this sets out the amount of dividend per share that is to be paid while taking into consideration the need to maintain adequate liquidity in the company or funds for future investment.

Question 6

What does a company’s dividend policy depend upon?

Answer 6

The level of growth it expects, as well as the nature of the company and the industry sector it operates in.

Question 7

Why might investors and potential investors use the company’s dividend policy?

Answer 7

To assess how well the company is performing financially and therefore assessing how attractive an investment prospect the company is.

Question 8

What is the main way businesses maximise their shareholder value?

Answer 8

By maximising the business’s profit in a period.

Question 9

The level of risk a business must take in pursuit of profit is driven by the goal of maximising shareholder wealth. What should the business consider and do to ensure it is successful in maximising shareholder wealth?

Answer 9

Maximising shareholder wealth should be incorporated in a business’s strategy and decision making.

Question 10

Why might management reinvest its profits back into a company?

Answer 10

1. For future growth - a company may, for instance, need to obtain capital to fund new developments by borrowing finance.
2. Another possible reason for investing profits in the company rather than paying them out to shareholders is to maximise
   balance sheet or net asset values. It might well be in the company’s interest to increase its net asset value – either as an indicator of its ability to generate future profits or to make the company less risky as regards bank lending.

Question 11

The company might also want to pursue objectives that are not financial. Provide examples.

Answer 11

1. Differentiating products and services so as to make them more attractive to customers than those of their competitors.
2. Providing products and services of high quality.
3. Innovation.
4. Raising the skills of the workforce.
5. Complying with the law.
6. Sustainability, including maintaining a lower carbon footprint.
7. Fair trade.

Question 12

Financial decision making can involve making decisions about non-financial objectives. These can impact on a business’s financial performance in the long term. How?

Answer 12

These non-financial objectives aim to help the business financially in the long term in some way, such as establishing
the company as one that is more attractive to a particular type of customer or protecting or boosting the company’s
reputation (reputation management) or brand, which should therefore help to ensure long-term profitability.

Question 13

What does cost–volume profit (CVP) examine?

Answer 13

Cost–volume profit (CVP) examines how total revenues, total costs and operating profit changes as the following
variables change:

1. Level of output
2. Selling price
3. Variable costs
4. Fixed costs.

Question 14

Why is CVP useful?

Answer 14

It is useful for answering questions on, for example, how revenues might be affected if the selling price changes
or how costs might change if 500 more units were produced or what might happen if the company expands its business
overseas.

Question 15

What is the contribution margin used to calculate?

Answer 15

The contribution margin allows the business to determine how profitable individual products or services are. Management
can use the contribution margin when deciding what price a product or service should sell for.

Question 16

What is the equation for contribution margin?

Answer 16

Contribution margin = price per unit – variable cost per unit

Question 17

What does a contribution margin that is low – or even negative – suggest?

Answer 17

That a product, business segment or service is not profitable.

Question 18

Define ‘the contribution’.

Answer 18

The contribution is the amount remaining after all variable costs have been subtracted from revenue.

Question 19

What is the equation for the contribution?

Answer 19

Contribution = revenue – variable costs

Question 20

Working out the contribution (or even the contribution margin) can be useful for making decision. List three areas which benefit from working out the contribution.

Answer 20

1. Discount sales – special deals on price should earn some contribution so that the business doesn’t lose money on
   each sale, even with the discount on price.
2. Budgets – management can forecast profit levels in subsequent accounting periods by estimating revenue, variable
   costs, and fixed costs.
3. Capital expenditures – management can use the contribution to estimate how fixed asset purchases change the
   direct costs incurred, and thus how determine how profit changes (e.g. a machine purchase might reduce direct
   labour costs while increasing fixed costs).

Question 21

What is meant by the ‘break-even’ point?

Answer 21

The break-even point is when revenue is equal to total expenses and the business has made neither a loss nor a profit.

Question 22

Define ‘contribution margin’.

Answer 22

The contribution margin is what’s left over when subtracting the variable cost of a unit from a unit’s price.

Question 23

Provide examples of the advantages and disadvantages of CVP analysis.

Answer 23

The advantages of CVP analysis is that it is reasonably simple and provides a detailed snapshot of activity within the
business. This snapshot can be used – as we have seen above – to make decisions on pricing, profit forecasts, cost reduction decisions and even capital spending.

The disadvantages are that it can only provide approximate answers to both real and hypothetical problems. It must be carried out for each specific product, service or business segment, especially where pricing or costs involved are different – and in the case of some businesses with many product or service lines, such as restaurants where each item on the menu will have different direct costs associated with its production and sale, CVP analysis would be very difficult and complex to undertake.

Question 24

What is integrated reporting?

Answer 24

An integrated report is a periodic report from an organisation consisting of the business’s financial information,
governance and remuneration, sustainability information and management commentary. It details value creation (in
the short, medium and long term), corporate governance and sustainability.

Question 25

What is one benefit of integrated reporting?

Answer 25

Integrated reporting benefits include providing stakeholders with a range of information that is not just financial, as well as encouraging management to think in a way that recognises a business’s interconnectivity and how non-financial impacts are linked to financial impacts.

Question 26

What is meant by value creation?

Answer 26

Value creation is the primary aim of any business, whether that’s creating value for shareholders (i.e. maximising
shareholder wealth) or creating value for customers in order to sell the business’s products or services, and thus impact
profitability.

Question 27

What is meant by ‘corporate governance’?

Answer 27

Corporate governance is the practice under which a company is directed and controlled. The board of directors is
usually responsible for this. It includes providing effective leadership, setting the business’s strategic aims, supervising
how the business is managed, deciding how much board members and directors should be paid (remuneration) and
reporting all of this to the company shareholders.

Question 28

What is meant by ‘sustainability’?

Answer 28

Sustainability is the ability of a business to continue indefinitely while focusing on meeting the needs of the present
without compromising the ability of future generations to meet their needs. It can be broken down into three different
types:

1. Economic (i.e. profit)
2. Environmental (i.e. the planet)
3. Social (i.e. people)

Question 29

What does integrated reporting aim to do?

Answer 29

1. Improve the quality of information available to providers of financial capital to enable a more efficient and productive
   allocation of capital.
2. Promote a more cohesive and efficient approach to corporate reporting that draws on different reporting strands and
   communicates the full range of factors that materially affect the ability of an organisation to create value over time.
3. Enhance accountability and stewardship for the broad base of capitals (financial, manufactured, intellectual, human,
   social and relationship, and natural) and promote understanding of their interdependencies.
4. Support integrated thinking, decision making and actions that focus on the creation of value over the short, medium
   and long term.