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AMA > Revision > Flashcards

Revision Flashcards

1
Q

What affects companies opinion about real options?

A

size, location, sector, industry, public/private

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2
Q

Advice on real options

A
  • 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
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3
Q

Advice on risks

A
  • 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
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4
Q

Why is payback more popular than real options?

A
  • 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
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5
Q

Benefits of RO?

A
  • 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
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6
Q

Is the use of probabilities as in RO likely to improve decision-making?

A
  • 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
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7
Q

types of ROs - Abandonment Option

A

High salvage values are attractive. Probability of success difficult to estimate
Useful when wanting to get out of loss making business.

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8
Q

Ros - Growth option

A

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.

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9
Q

ROs - Expansion option

A

Similar to growth. BT has expanded into broadband. Need to identify how many customers buy additional products.

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10
Q

ROs - investment timing option

A

-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

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11
Q

ROs - How to evaluate projects

A
  • 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
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12
Q

When is NPV a good choice?

A
  • 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
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13
Q

When is RO suitable?

A
  • 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
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14
Q

RI (Residual Income) Formula

A

RI =Net Profit - Capital Charge

Note: Capital charge = Capital employed x required rate of return

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15
Q

ROI (Return on investment) Formula

A

ROI = Net Profit / Capital employed

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16
Q

ROI Advantages

A
  • 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
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17
Q

ROI Disadvantages

A
  • 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
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18
Q

RI Theoretical advantages

A
  • measures managerial performance, consistent with responsibility accountIng
  • consistent with NPV
  • makes managers aware that they have to earn return > COC
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19
Q

RI - Practical Advantages

A
  • precise target for planning

- different interest rates can be used for different asset types

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20
Q

RI Theoretical disadvantages

A
  • 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
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21
Q

RI - Practical Disadvantages

A
  • using different cost of capital for different divisions difficult to justify
  • not as popular with managers
22
Q

How to decide which bonus scheme to go for?

A
  • 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?
23
Q

Growth strategy

A
  • 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
24
Q

Sustain strategy

A
  • 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
25
Q

Harvest strategy

A
  • 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
26
Q

EVA (Economic value added) Formula

A

EVA = NOPAT - (Cost of Capital x invested capital)
NOPAT = Net operating profit after tax
invested capital = net assets or SH funds

27
Q

problems with EVA

A
  • 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
28
Q

What influences managers in decision to adopt/reject a technique?

A
  • 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
29
Q

How can small companies develop strategies to create long term wealth using EVA? (generally)

A

disadvantage is lack of resources

  1. 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
  2. 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
30
Q

How can small companies develop strategies to create long term wealth using EVA for investments earning less than their capital charge?

A
  • eliminate investments with negative EVA
  • improve working capital by reducing receivables and inventory days
  • EVA shows unproductive assets, sell those or close them down
31
Q

How can small companies develop strategies to create long term wealth using EVA for investments earning more than their capital charge?

A
  • 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
32
Q

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.

A

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
33
Q

When is an investment suitable for real options?

A
  • 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
34
Q

Weaknesses of bonus schemes and alternative measures

A
  • 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
35
Q

EMA benefits

A
  • more informed decision making
  • revenue opportunities from recycling and waste management activities
  • improved product pricing
  • increased competitive advantage
  • improved reputation
  • staff retention and development
36
Q

impact of environmental behaviour on financial performance

A
  • 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)
37
Q

Why has EMA been ignored for so long? Wrong assumptions

A
  • environmental costs unimportant
  • externalities won’t affect business
  • no need to separate internal development costs from general costs
  • no significant impact on business decisions
38
Q

Consequences of wrong assumptions regarding EMA

A
  • 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
39
Q

Techniques used in EMA

A

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

40
Q

Financial perspective

A 
How company looks at its shareholders 
Measures: 
revenue growth and mix, 
cost reduction,
Asset utilisation
KPIs: revenue growth, net profit, ROI, margin, CCC
41
Q

Customer perspective

A

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

42
Q

Internal perspective

A

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

43
Q

Learning and growth perspective

A

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

44
Q

Balanced scorecard

A 
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
45
Q

Advantages BSC

A

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

46
Q

Disadvantages BSC

A

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

47
Q

Performance measurement

A

seeing how an organisation is doing in comparison to its aims and targets

48
Q

Holistic

A

adopting a broad perspective of business activity across multiple functions and levels of hierarchy

49
Q

Integrated

A

if organisational perspective is not just viewed in isolation

50
Q

Lag indicators

A

outcome measures: show achievement in perspective

51
Q

Lead indicator

A

performance driver: activity to help achieve objective of a perspective

52
Q

KPI

A
  • 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

AMA (2 decks)

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