Revision Flashcards
What affects companies opinion about real options?
size, location, sector, industry, public/private
Advice on real options
- NPV useful if certainty
- issues are training, experience
- probabilities based on manager’s judgement, little actual data available
- identifying optimal solution diffficult in practice
- decision based on real options may differ from decision based on direct cashflows
- different assumptions change options dramatically
Advice on risks
- different risks have different impact on project
- need to identify risks that could seriously damage project, e.g. high material costs
- people interpret risk in different ways
Why is payback more popular than real options?
- RO too complex, need user-friendly software to handle that
- managers mindset: only focused on short-term CF but should be all about optimal long-term positioning of firm
- lack of expertise of finance people and top management
- lack of top management. support
- payback is a proven method (took long to get established too!)
- requires too much sophistication
- encourages excessive risk-taking
- managers satisfied with existing method
- obtaining data time-consuming
Benefits of RO?
- helps form strategic vision
- way to think about uncertainty and effects over time
- complements traditional techniques
- long-term competitive advantage through better decision making
- allows flexibility
Is the use of probabilities as in RO likely to improve decision-making?
- controversial
- some managers opposed to probabilities because difficult to identify or agree
- need to know accuracy of previous forecast
- need base case based on previous experience
types of ROs - Abandonment Option
High salvage values are attractive. Probability of success difficult to estimate
Useful when wanting to get out of loss making business.
Ros - Growth option
Refer to flexibility to increase scale of investment. Example add postgraduate option for undergraduates. Students can stay with university and use exemptions from previous study. Difficult to forecast demand.
ROs - Expansion option
Similar to growth. BT has expanded into broadband. Need to identify how many customers buy additional products.
ROs - investment timing option
-waiting could help avoiding a less profitable option
being first not always best before incuring earlier cash outflows
- but decision could become more complex and more complexity doesn’t mean more accurate and even less reliable
ROs - How to evaluate projects
- projects with lowest and highest upside potential (loss)
- project with narrowest outcome range
- compare traditional NPV
- important to identify range of outcomes to see which project is most suited for ROs
When is NPV a good choice?
- for straightforward decisions i.e. investment completely independant, no additional investment opportunities
- CFs predicted accurately
- project doesn;t change over lifetime
- risk seen as low, company operating in fully developed environment
When is RO suitable?
- high levels of uncertainty, i.e. opportunities like large dynamic international company
- uncertainty may increase value of options
- managers can use flexibility to change business strategy,i.e.through abandonment option
- risk structure may change over time, can avoid certain types of risks and increase NPV and returns
RI (Residual Income) Formula
RI =Net Profit - Capital Charge
Note: Capital charge = Capital employed x required rate of return
ROI (Return on investment) Formula
ROI = Net Profit / Capital employed
ROI Advantages
- easily understood
- good for divisions of different size
- encourages managers to minimize working capital
- used by external analysts
- % so can compare with inflation rate and returns of competitors
- compare with COC
ROI Disadvantages
- when disposing of asset which earns less than average ROI overall ROI improved despite assets return being greater than COC
- inconsistent with NPV
- manipulation of assets possible
- managers hold on to old assets to improve ROI
- need to compare depreciation policy between divisions
- difficult to identify for individual projects
RI Theoretical advantages
- measures managerial performance, consistent with responsibility accountIng
- consistent with NPV
- makes managers aware that they have to earn return > COC
RI - Practical Advantages
- precise target for planning
- different interest rates can be used for different asset types
RI Theoretical disadvantages
- difficult to identify controllable profits and investments and calculate COC
- difficult to apply to company with many different divisions and divisions trade with each other
RI - Practical Disadvantages
- using different cost of capital for different divisions difficult to justify
- not as popular with managers
How to decide which bonus scheme to go for?
- is RI positive and significant
- if not significant affect only if no better alternative
- depends on whether RI or ROI chosen
- managers act in own interest - behavioural aspects of management accounting important, can be complex
- every scheme has advantages and disadvantages
- problem of goal congruence
- if scheme rejected are future investments affected?
Growth strategy
- new division hopes for high sales growth
- business units invest in distribution networks/ facilities/ systems
- low ROI typical, negative CFs
- should focus on sales growth %, also in target regions, markets, customer groups
Sustain strategy
- established successful business
- want to keep investing market share plus small growth
- invest in expanding capacity & relieve bottlenecks
- need high ROI and focus on profitability and gross margin
Harvest strategy
- low investment and limited prospects
- no significant investment, no R&D
- need short payback
- ROI less relevant, don’t max it but max CFs and reduce WC
EVA (Economic value added) Formula
EVA = NOPAT - (Cost of Capital x invested capital)
NOPAT = Net operating profit after tax
invested capital = net assets or SH funds
problems with EVA
- adjustments put pressure on managers
- problems with using book values
- assumes company allocates shared OHs fairly
- poor data
- identifying cost of capital difficult
- dysfunctional if used for bonuses
- can be manipulated
- short-term measure
- accepting high EVA projects may increase risk
- doesn’t measure time or quality so should be used along other tools
- doesn’t account for TVM so unsuitable for capital budgeting
What influences managers in decision to adopt/reject a technique?
- different managers may see different benefits
- inconsistent research, different surveys have different findings, could be sector or country specific
- reasons for using: time saving, pressure from head management, senior managers support
- reasons for not using: lack of expertise, time-consuming, delays in reports. rejected by senior management, little motivation to change if company profitable
- other reasons: resistance to change, company culture, following market leader
- applies to traditional and contemporary techniques
How can small companies develop strategies to create long term wealth using EVA? (generally)
disadvantage is lack of resources
- increase operating profit without increasing capital, i.e. use machines more effeciently, lower employee costs, avoid short-term measures like cutting advertising because will affect LT profitability
- reduce COC: increase debt finance, more from equity to debt but difficult because of limited debt capacity, can replace high-cost debt with lower cost debt, capitalise RD as investment to improve NOPAT
How can small companies develop strategies to create long term wealth using EVA for investments earning less than their capital charge?
- eliminate investments with negative EVA
- improve working capital by reducing receivables and inventory days
- EVA shows unproductive assets, sell those or close them down
How can small companies develop strategies to create long term wealth using EVA for investments earning more than their capital charge?
- identify those investments
- DCF analysis inconsistent with ROI
- both, DCF analysis and EVA subject to bias
- difficult to measure individual investments with EVA because of joint costs and revenues
All of the manufacturing is based at a single location. Explain how this may affect the data collection for the calculations for ROI and RI.
Problem of:
- identifying capital employed for different products
- using single required rate of return
- adapting discount rate for riskiness of different products
- manipulating data
- valuing assets – historical or market value
- estimating costs – lot of costs shared
- identifying fixed / variable costs
When is an investment suitable for real options?
- investment sunk or irreversible? If irreversible identify options carefully
- lenght: long project enables you to consider options, e.g. 10yrs
- managers judgement: will options give significantly different answer?
- uncertainty: the higher the more options
- range: the higher the more likely options significant
- discuss limitations
Weaknesses of bonus schemes and alternative measures
- banking sector earns high short-term returns followed by corrections leading to losses & write-offs
- no negative pay so managers won’t pay back excessive bonuses
- pay cash or better in shares?
- is it justified to pay bigger bonuses for higher RI?
- new divisions maybe not profitable but managers work hard without reward - reward sales growth?
- mature divisions may have low profitability but good CFS - reward those
- conclusion: can’t rely on financial measures
EMA benefits
- more informed decision making
- revenue opportunities from recycling and waste management activities
- improved product pricing
- increased competitive advantage
- improved reputation
- staff retention and development
impact of environmental behaviour on financial performance
- direct costs increase (cheaper to reuse than send waste to landfill)
- revenue decreases (reputational damage, customer boycotts)
- financial stability decreases (brand value worsens, lending curbed, insurance cover withdrawn)
- failure costs (fines, penalties, lawsuits)
Why has EMA been ignored for so long? Wrong assumptions
- environmental costs unimportant
- externalities won’t affect business
- no need to separate internal development costs from general costs
- no significant impact on business decisions
Consequences of wrong assumptions regarding EMA
- SM unaware of environmental costs, no info on how to manage, no incentive to reduce
- bad decisions re product mix, pricing, development
- added-value not maximised
- increased risk profile for investment decisions
Techniques used in EMA
ABC: removes environmental costs from general OHs and traces them to products and services for more accurate product costing
Lifecycle costing: includes total costs (some environment related, i.e. site clearance, disposal) for product during life span
Financial perspective
How company looks at its shareholders Measures: revenue growth and mix, cost reduction, Asset utilisation KPIs: revenue growth, net profit, ROI, margin, CCC
Customer perspective
How organisation appears to customers
Measures: customer satisfaction
If customer objective achieved revenue objective achieved too
KPIs: Net promoter score, retention rate, profitability score, market share
Internal perspective
What must we excel at to achieve our customer and financial perspective?
Need to be efficient
Measures:
Innovation process
Operation process
Post sales process
KPIs: capacity utilisation, project cost variance, quality index, delivery time
Learning and growth perspective
How can company improve and add value?
Invest in infrastructure: people, systems, organisational procedures
Helps other 3 perspectives to be achieved
KPIs: staff advocacy, 360 degree feedback, absenteism, employee engagement
Balanced scorecard
A tool that uses financial and non-financial information in an integrated and holistic way to assist managers to map out and aim for strategic goals: Financial Customer Internal Learning and growth
Advantages BSC
Better strategic planning: communicate strategy, show cause-effect relationship
Improved strategy communication and execution: better understanding through mapping
Better management information: KPIs measure what matters
Improved performance reporting: more transparency, better performance reports
Better Strategic alignment: align organisation with strategic objectives
Better organisational alignment: align budgeting,planning with strategy
Disadvantages BSC
Not linking measures to strategy: can’t just use off the shelve approach
Not validating links: measure too many things that don’t matter because don’t understand cause-effect relationships
Not setting right performance targets: customers who are 100% satisfied don’t spend more than 80% satisfied ones
Measuring incorrectly: i.e. too simplistic measures like satisfaction rating of 1-5
Performance measurement
seeing how an organisation is doing in comparison to its aims and targets
Holistic
adopting a broad perspective of business activity across multiple functions and levels of hierarchy
Integrated
if organisational perspective is not just viewed in isolation
Lag indicators
outcome measures: show achievement in perspective
Lead indicator
performance driver: activity to help achieve objective of a perspective
KPI
- help understand how organisation is performing in terms of goals and objectives
- show SHs if organisation is on track or not
- reduce complex organisational performance to small number of managable key indicators which assist decision making and imrprove performance
