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## Working Capital Mgt.

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**Working Capital Mgt.**• Important to source funds for an enterprise • Equally important to manage investment in working capital • Supports/necessitated by operation of fixed assets • Elements of Working Capital: Stock; Debtors; Bank/Cash; Creditors**Working Capital Mgt. - Stock**• Primary requirement: stock levels should be optimal, ie. Not too large or too small • Stock levels too high: • excess capital tied up • costs of storage • risk of deterioration • obsolescence**Working Capital Mgt. - stock**• Stocks too low: • disruptions risk to activities, eg. Production • frequent ordering and related costs • economies of bulk buying lost • Elements of a stock control system: • Physical Security of stock assured • Diversified control of stock ordering / issue • Documentation of stock movements / issues**Working Capital Mgt. - Stock**• Economic Model allowing efficient stock control • Economic Order Quantity (EOQ Model): • Assumes that order costs are known; that delivery times and consumption rates known with certainty • EOQ = (2BN/C)**Working Capital Mgt. - Stock**• 2 aspects: • Holding Costs - costs of holding stock • Ordering Costs - costs of ordering stock • Average stock is average of high/low levels of stock over a period (Q/2) • Cost of holding stock (C ) • Annual Holding Cost is CQ/2**Working Capital Mgt. - Stock**• No. of units used p.a. is N • Thus, no. of orders placed is N/Q • Costs of ordering is thus associated with no. of orders placed (B) • Total Ordering Costs thus BN/Q • Total cost of stockholding is thus: • (CQ/2) + (BN/Q)**Working Cap. Mgt. - Stock**• Ie. Costs of ordering plus holding costs • So, as one cost rises, the other falls • Therefore derive the Economic Order Quantity or EOQ: • EOQ = (2BN/C) • Alternatives to EOQ Model: JIT/MRP**Working Capital Mgt. - Debtors**• Debtors: customers to whom goods have been sold on credit • This is effectively an ‘interest free loan’ to customers for goods received and unpaid • This activity has a cost, ie. The value of goods sold plus an implied ‘interest cost’**Working Capital Mgt. - Debtors**• Factors to consider: • offer cash discount to encourage early payment • official period of credit offered • assessing credit worthiness of customers • action taken regarding late payments • Effective ‘Credit Control’ required**Working Capital Mgt. - Debtors**• Other option is that of ‘Factoring’: the sales are ‘bought’ by an agency, who in turn pursues payment, with client receiving up to say 95% of original invoice • May benefit some enterprises, ie. Less hassle pursuing payments/no defaults. • Need to consider level of capital tied up in credit sales/debtors & risk of bad debts**Working Capital Mgt. - Cash**• Advanced planning of cash requirements is important • cash budget a useful device to determine future requirements • derived by ref. to: timing of cash flows • monitor cash inflows and cash outflows • avoid overdrafts/shortages • maximise returns on cash surpluses**Sources of Finance**• 2 main sources of finance: • Equity: shareholders funds/retained earnings • Debt: loans/debentures • Each source of finance has an associated cost • Referred to as ‘Cost of Capital’**Sources of Finance**• Cost of Capital is implied interest cost of each source • Cost of Equity: cost of returns to shareholders, likely to be the dividends paid (Ke) • Cost of Debt: cost of interest payable on loan (Kd); (must consider after-tax cost of debt within a UK context)**Cost of Capital**• Combination of 2 elements of Cost of Capital results in Weighted Average Cost of Capital for an enterprise (WACC) • WACC = ((Ke+Kd)/2) • 2 approaches: • WACC calculated using interest rate/rate of return • WACC calculated using implied interest rates/rates of return & market values of sources**Cost of Capital**• Cost of Equity: • 2 approaches: • Dividend Growth Model (Gordon Growth Model): • Return = (d/m) + g • where, d is dividend; m is market value; g is growth rate**Cost of Capital**• Capital Asset Pricing Model (CAPM): • Return = Rf + ßj(Rm - Rf) • where, Rf is risk free rate of investment; ßj is Beta factor of investment; Rm is expected return on market. • Each model has a number of implicit assumptions & each calculates return from different perspective**Sources of Finance**• Financial Markets • Stock Exchange • Listing (Regulations, Yellow Book) • Placing; Offer for sale; Tender • Process of flotation; finance house; underwriting issues • Consider other sources, eg. Debentures • Consider impact on Gearing Levels**Investment Appraisal**• Most enterprises undertake capital investment projects • Characteristics of Capital Investments: • long time scales • large sums of money • uncertainty with respect to future cash flows, returns, inflation/tax rates**Investment Appraisal**• Standardise appraisals: alternative appraisal methods: • Payback • Present Values/Net Present Value (NPV) • Internal Rate of Return (IRR) • All above use CASHFLOWS in their evaluation • Accounting Rate of Return (ARR) • This method uses profits in evaluation**Investment Appraisal**• Payback: indicates the length of time taken to recover the initial investment • Net Present Value: indicates the NPV of a project which would maximise the risk adjusted cashflows of an enterprise and in turn maximises it’s wealth • IRR: indicates that NPV forcing the project to recover initial risk adjusted cash flows**Investment Appraisal**• ARR: the return expected on a project for a given level investment (based on profits/profitability of project); similar to R.O.C.E. ratio. • Consider also the acceptance criteria or targets set for the project • Consider qualitative aspects of projects**Investment Appraisal**• Payback: commitment of funds to a project involves forgoing the use of funds in alternatives; also, risk that the money invested is permanently lost. • Longer funds are tied up in a project the greater the risk of non-recovery • based on concern to recover initial outlay a.s.a.p.**Investment Appraisal**• Payback - Advantages: • simple to understand/apply • promotes cautious investment policy • empirically validated • Disadvantages: • disregards total contributions and thus cashflows after cut-off date, which could be larger more advantageous compared to payback period cashflows**Investment Appraisal**• Accounting Rate of Return (ARR): recognises the profitability of a project is important and relates it to amount of capital invested. • Method uses profits - thus can be taken as a return measure similar to R.O.C.E.**Investment Appraisal**• Various Methods: • Total profit/total capital invested x 100% • Average annual profit/average annual investment x 100% • Factors to consider: • determination of profits • profits not same as cashflows • disposals and related profit/loss on disposal**Investment Appraisal**• Net Present Value (NPV): works on the assumption of discounting, ie. That £1 now is more valuable than at any stage in the future under given set of economic conditions, eg. Inflation rates, purchasing power, interest rates • Uses discounting techniques to restate future values in present day values • Employs discount factors, 10%, 20% etc.**Investment Appraisal**• Discount factor represents value of £1 restated to todays values under given rates of inflation/interest etc. • eg. At 10% DF, £1 in one year’s time is 90.91p; two year’s time is 82.64p etc. • Double check by reference to discount table • Under NPV all future cash flows must be discounted over projects lifetime**Investment Appraisal**• All cashflows discounted and netted to yield a ‘NPV’ at end of project lifespan, which is either positive or negative. • Decision Rule: ACCEPT THAT PROJECT WHICH YIELDS THE HIGHEST NPV. • BY DOING SO, THE WEALTH OF THE ENTERPRISE IS MAXIMISED**Investment Appraisal**• Other influences on NPV: • Taxation: • Time Delay assumed - one year • possible grants on initial investment • tax payments extend project lifespan by 1 year • capital allowances on initial investment • Be careful not to tax any allowances received**Investment Appraisal**• Other issues: • Discount Factor represents the Cost of Capital or vice versa, which in turn would represent the return expected by providers of capital • Inflationary pressures - Fisher Formula - easier to adjust the discount rate/factor employed rather than individual cashflows • If cashflows each year are same, cumulative discount tables can be used**Investment Appraisal**• Internal Rate of Return (IRR): this is that discount rate which forces the NPV of a project to be zero • Found by interpolation (remember!!): • DR1 + ((NPV1/(NPV1+NPV2)) x (DR2-DR1)) • or • DR2 - ((NPV2/(NPV1+NPV2)) X (DR2-DR2))**Investment Appraisal**• Where the IRR of a project exceeds the cost of capital the implication is that the investment will be profitable and should proceed • In general, the case information should be considered, and any targets/criteria observed in forming decisions about project evaluation/acceptance**Investment Appraisal - Summary**• Payback: computes length of time required for project to recoup initial outlay • Shorter the payback, the more favourable the project. Deadline usually set. • Decision rule is that a project with a shorter payback period will be accepted**Investment Appraisal - Summary**• ARR: determines overall profitability of project by subtracting initial cost from expected returns • Expressed as either absolute amount or as annual percentage • Returns compared with cost of capital**Investment Appraisal - Summary**• NPV: theoretically sound appraisal based on discounting principle • future monies are less valuable than present values • future returns are discounted by a factor related to the rate of interest considered appropriate • Project yielding highest NPV is accepted**Investment Appraisal -Summary**• IRR: determines rate of discount required to equate the PV of project to initial investment • If it is not less than cost of capital, project is generally accepted • Profitability Index: PV(Benefits)/PV(Outlay) • generally greater than 1.0 • (PV(B) equals initial outlay + NPV)**Management Accounting**• 3 objectives: • 1 to allocate costs between cost of goods sold and stocks for internal/external profit reporting; • 2 to provide relevant info. To assist with decision making; • 3 to provide info. For planning, operational control and performance measurement**Management accounting**• Encompasses: • Budgeting/planning - cash budget & master budget • Costing - costing of products/services; costing/pricing strategies; costing of activities; profit calculations. • Control - monitoring/analysis of current information compared to planned; variances.**Stock Valuation Methods**• Principle: Stock valuation required in order to determine stock values for inclusion in accounts - both financial and management • Valuation Methods: Choice: • LIFO: LAST IN FIRST OUT • FIFO: FIRST IN FIRST OUT • AVCO: AVERAGE COST**Product/Service Costing**• Costs allocated to products/services • Direct costs traced easily • Indirect costs not traced easily • Various allocation bases used from simplistic(units based) to complicated (ABC systems - 2 stage procedures) • Elements: Material/Labour/Overheads**Product/Service Costs**• Cost structure: Hotel Room £ • Material (linen etc) 20.00 • Labour (cleaning, porters etc.) 10.00 • Overhead (light/heat etc) 10.00 • Margin 10.00 • Sales Price/Rate 50.00**Process Costing**• P.C. system is an average cost system for stock valuation/profit measurement • Appropriate where units all identical or process followed in production eg. Oil refining etc. • Cost per unit is simply total costs of process divided by no. of units output at end of process**Process Costing**• Dr Process Account -oil Cr • ltrs £ ltrs £ • Mat’l 10 100 Proc. 2/F.G. 10 1000 • Prod’n 10 900 • Total 10 1000 10 1000 • So, 10 ltrs of oil cost £1000, 1 Ltr = £100.**Process Costing**• Must take account of: • Normal losses: inherent in process, borne by good production • Abnormal losses: avoidable, not reported as part of production but w/off in P&L A/c. • Work In Progress/Partly Finished Goods: translate to Equivalent units and include in process accounts.**Breakeven (CVP) Analysis**• Breakeven point is that point at which neither a profit nor a loss is made • Information required: • Revenue; Costs; Quantity; Relevant Range; Linear Relationship between costs/revenue; Contribution; Fixed Cost; Variable Cost; Profit • Assumes linear relationship cost/revenues**Breakeven (CVP) analysis**• Assumptions: • all variables remain constant • analysis based on single product/constant sales mix • profits calculated on variable costing basis • costs accurately divided between fixed and variable elements • short term horizon/relevant range**Breakeven (CVP) Analysis**• Multi-product environment: • Calculate c/s ratio for each product • rank according to highest c/s ratio • plot profit/sales revenue on a cumulative basis, starting with product yielding highest c/s ratio first, progressing to lowest • by cumulating in this order, total will equal total contribution and total sales revenues**Budgeting - Networking**• Network Analysis: idea is to identify the critical path**Budgeting - Cost Reduction**• Cost Reduction: • Value Analysis:**Budgeting - Learning Curve**• Learning Curve: Constant rate of learning will lead to a doubling of output/reduction of costs

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