Financial Management for Decision Making Order Instructions:
Financial Management for Decision Making Sample Answer
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MODULE TITLE: Financial Management for Decision Making
MODULE NUMBER: ACC 11407
NAME OF MODULE LEADER: Sarah Borthwick
DATE OF SUBMISSION: December 11, 2015
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Question A:
Understanding the movement of money within the organization is important. For instance, when to pay your invoices enables an organization to comprehend the financial situation of the income statement and budget. A business can be profitable but poor management of cash flow may lead to costly expenses that would have otherwise been avoided. Cash flow budget is a very important tool for the estimation of cash inflows and outflows for a company. Cash flow budget can be termed as a chronological overview of expected income and expenses over a given period (Kaplan & Atkinson, 2015). Cash flow budget is almost similar to the operating budget sharing some similar features. Cash flow budget is important for companies since it enables an organization to make decisions, for instance, the decision on how much credit to extend to clients before liquidity problems begin to arise.
Financial Management for Decision Making Cash Flow Budget
Cash Inflow Year 1 Year 2 Year3 Year 4
Sale of JR 500,000 500,000 500,000 500,000
Total Inflow 500,000 500,000 500,000 500,000
Cash Expenditure
Direct Labor 200,000 200,000 220,000 242,000
Material Cost 50,000 55,000 60,500 66,550
Variable Over heads 55,000 55,000 55,000 55,000
Fixed Cost 84,000 48,000 48,000 48,000
Cost of Capital 42,000
Research cost 20,000
Total Outflow 451,000 358,000 383,500 411,550
Yearly Net Cash flow 49000 142000 116500 88450
Cumulative Net CF 49000 191,000 307,500 395,950
Question B:
The payback period can be defined categorically as the amount of time (years) it will take for the net cash proceeds generated from an investment equal the original cost of that venture (Davies & Crawford, 2011). It is the time that the results of investment are realized and also the determinant that decides for the investor when to undertake a project since investment positions are not always entailed by longer payback periods. It is a mostly used tool for analyzing, as it is meant to be understood easily by people and hence easy in applying. It is a tool that can also be used to compare investments of the same kind. When the cost products is divided into the annual cash flow the payback period is realized. When keeping all the other factors of investment constant, the best investment is the one that has a shorter payback period.
The payback period has got some limitations since it does not consider the time value of money. This limitation, therefore, makes it not clear to evaluate the cash flows of a project or investment. The long-term limitation of the payback is that the cash flows that come after the end of the payback period is not taken into consideration. It ignores the fact that cash flows will continue being provided according to most capital expenditures. It, therefore, suggests that the payback period are short-term focused. In the course, a valuable project may be found overlooked.
Prospective investment’s payback period
| Year | Cumulative
Cash Flow |
Total |
| 1 | 9,000 | |
| 2 | 49000+14200 | 191,000 |
| 3 | 191000+116500 | 307,500 |
| 4 | 307500+88450 | 395,950 |
The payback period is three years because; by the end of the third year, 327,500 will have been generated regarding net cash flow from the purchase of the machine that is more than the original cost of the machine.
Therefore, I recommend that the investment should proceed because the company will be able to recover its capital and generate a profit of £115,950 by the end of the four-year period.
Question C:
If there is a risk that sales will drop to 20,000 units from year two onwards due to the presence of rival brands entering the market, the new payback period and net present value will be:
| Year | Cumulative cash flow | Total
Profit |
| 1 | 49000 | |
| 2 | 49000+42000 | 91,000 |
| 3 | 91,000+16450 | 107,450 |
| 8 | 107,450+ (-11,550) | 95,900 |
From the payback period calculation, when the sales drop to 20,000units the company will not be able to recover the value of the purchased machine by the end of four years. If at all sales will drop to 20,000 units from the second year, I recommend that the company should not invest in selling Stetson hats. This is because the company will not be able to recover the initial capital invested in the project.
Question D:
“Payback is by far the most popular method of investment appraisal because it is the best method” discuss.
There are different investment appraisal techniques that can be used by managers when calculating returns from investments, for instance, payback period, internal rate of return, profitability index, and adjusted present value among others (Mott, 2012). It is imperative to note that the quicker an investment recovers its original cost quickly, and then the venture will be less risky compared to an alternative investment that takes a long time to recover its initial capital invested. Payback period is used by investment managers to and make decision on the best investment to undertake. For instance if project A capital cost is $60,000 and the returns are $2000 per year. It will take 3 years to recoup the capital invested. On the other hand, if project B capital cost is $60,000 also and the returns is $30,000 per year then it will take 2 years to recoup the capital invested. Therefore, a manager may choose to invest in alternative B rather than alternative A. This is because investment B will be able to recoup its capital faster as compared to investment A. From the illustration, it is simple to calculate and understand the concept of profitability using payback period.
Although payback technique has some disadvantages such as ignoring income arising after payback period and ignoring of the timing of the cash flows. But still, many managers and investors still use this method of investment appraisal because:
Simplicity: The payback appraisal technique is simple to compute. Therefore, it is attractive to corporate managers and innovative entrepreneurs because it is simple to compute and understand the results as compared to other techniques such as time value of money and internal rate of returns (DRURY, 2013). Payback simply supplies information about when one is likely to get his money back as well as providing insights into project flexibility and future liquidity.
Easy to understand: calculating and interpreting of payback period is easy to understand and does not even require expertise in accounting for the managers and entrepreneurs to compute and understand the information obtained. Understanding such information is important as it enables them to make better-informed decisions (Collier, 2015).
The payback method also biases an investor from long-term projects that are risky: The method discounts future cash flow generated from an investment beyond a certain threshold period with the goal of reducing the present value of the cash flow to zero. This concept is most appropriate investments with considerable uncertainty regarding profitability and other business risks.
Payback period emphasizes on the magnitude of cash flow in making investment decision process: cash flow is an important concept in investment because capital is scarce and without cash business operations may not take place. Therefore, by emphasizing on cash flow when making the investment decision, management can choose the best alternative that is easy to manage and do not require a lot of capital.
Payback technique is better than accounting rate of return (ARR) because payback is based on cash flows as compared with ARR that is based on profits and ignores the time value of money (Needles et al., 2013). The impact of cash flow and the time value of money play an important role in making an investment decision. Therefore, ARR is good for getting a brief overview of the project and managers should not use it as a primary investment appraisal method.
On the other hand, the Internal Rate of Return (IRR) may also be used for capital investment appraisal. IRR assumes a linear relationship between net present values obtained from using different discount rates. IRR ignores the dollar value of the project. The technique may not be ideal for capital investment appraisal because it ignores the size of the investment project. Secondly, some cash flows may not have declining net present value when the discount rates increase resulting in false interpretation. Thirdly, there exist some cases where the solution to the equation NPV=0 may be more than one. This may make the company arrive at more than one value. Finally, it is difficult to calculate IRR if the discounting factors vary over the years.
Question E:
The meaning of relevant costs and revenues in both short and long-term decision-making
Managers face decision-making situations about day to day operations. Some of the decisions are of short term in nature. That is decisions relating to periods of less than one year. While others are long term, that is a period of more than one year. The differential analysis encompass the comparison of two or more alternatives in business and make up a decision on which is the best option. The relevant costs can be compared to evaluate their result in the long-run. These are Costs that have already been used for business activities but not put in consideration.
When performing differential analysis, considerations are made for non-monetary and elusive benefits of any of the choices made. Managers make difficult financial decisions daily, and the outcome of each decision can cause great impact on the success of the business. Costly decisions should, therefore, follow a consistent route every time they can be made. The differential analysis gives the manager an idea of the possible stand on any decision made.
The concepts of decision making are applicable in all management contexts. However, the application of management principle varies depending on the nature of the issue as in whether it is short term or long term in nature (Hill et al., 2014).
Relevant costs and revenue refers to the costs and revenues that are specific to a particular decision (Mott, 2012). That is future costs and revenues that vary according to the decision taken. These costs are also referred to as avoidable costs and revenues. Relevant costs and revenues differ between alternatives. This cost tries to find out the objective cost of a business decision. That is, the extent of cash outflows that occur due to the implementation of a decision.
Sunk costs, on the other hand, refer to costs arising from a decision that has been made earlier. Sunk costs often remain the same between different alternatives and are not relevant to any future decision. And Opportunity costs are costs of opportunity that is foregone by choosing one course of action instead of another or opportunity that is lost (Hitt et al.,2012). Opportunity cost is applicable in a situation where there are scarce resources.
Some of the features of relevant costs and revenues include:
- They are future costs and revenues,
- They are cash flows due to direct consequences of the decision taken, and finally
- They are incremental costs in nature.
There are different types of relevant costs such as:
- Future Cash Flows: These are cash expenses that an organization expects to incur in future due to a decision made by an organization.
- Avoidable costs: those costs will be regarded as relevant to a decision if it can be avoided and the decision disregarded
- Opportunity costs: Money inflow that will have to be lost due to a particular management decision also is a relevant costs.
- Incremental cost: When a manager has to choose between different alternatives, relevant costs will be incremental or differential cost between the different alternatives that are being weighed upon.
When a firm is faced with a situation where they are required to make short term decision, management considers only relevant costs and revenues. As such, sunk costs are pointed out and removed from the analysis. On the same note, it is important to point out opportunity costs and calculate it to be included in the analysis before making a decision.
Some of the types of decisions that a manager may face in the short-term include;
- Special pricing decisions,
- Product mix decisions where there is capacity constraint,
- Make or buy decisions,
- Whether to replace equipment, and
- Discontinuance decisions.
Relevant costing is important in making a short-term financial decision. However, it should not be used as a basis for all pricing decision because a business should charge a price that offers sufficient profit margin to be sustainable in the long-term. Some of the long-term financial decisions include shutdown decisions, investment appraisal, and disinvestment. In the case of the long term, most costs are incremental when considered in the long-term and should, therefore, include sunk costs and opportunity costs before making decisions.
Financial Management for Decision Making References
Collier, P. M. (2015). Accounting for managers: Interpreting accounting information for decision making. John Wiley & Sons. Accessed on December 1, 2015
Davies, T., & Crawford, I. (2011). Business accounting and finance. Pearson. Accessed on December 7, 2015
Drury, C. M. (2013). Management and cost accounting. Springer. Accessed on December 11, 2015
Hill, C., Jones, G., & Schilling, M. (2014). Strategic management: theory: an integrated approach. Cengage Learning. Accessed on December 9, 2015
Hitt, M., Ireland, R. D., & Hoskisson, R. (2012). Strategic management cases: competitiveness and globalization. Cengage Learning. Accessed on December 11, 2015
Kaplan, R. S., & Atkinson, A. A. (2015). Advanced management accounting. PHI Learning. Accessed on December 7, 2015
Mott, G. (2012). Accounting for non-accountants: a manual for managers and students. Kogan Page Publishers. Accessed on December 8, 2015
Needles, B., Powers, M., & Crosson, S. (2013). Financial and managerial accounting. Cengage Learning. Accessed on December 12, 2015
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