Investment appraisal

investment appraisal ACCA FM

Investment appraisal is a number of methods used to classify the attractiveness of an investment.

Investment appraisal ACCA
Investment appraisal ACCA Financial Management ACCA

Investment appraisal actually from Investment decision, Which project has to finance, Business has to make the investment, And you have to pick up which project I best for investment

  • Capital expenditure results in the acquisition of non-current assets or an improvement in their earning capacity.
  • It is not charged as an expense in the statement of profit or loss; it appears as a non-current asset in the statement of financial position.
  • Capital expenditure and income arising from it usually occur in different accounting periods, so special techniques are needed to evaluate it.
  • The underlying motive is generally to assess the impact on shareholder wealth

Investment appraisal for Commercial organizations

Investment by commercial organizations might include investment in:

  • Plant and machinery
  • Research and development
  • Advertising
  • Warehouse facilities

Investment by the commercial sector is generally based on financial considerations alone.

Investment appraisal for Not For-profit organizations

Evaluation of investment by not for profit organizations is more challenging:

  • Most not for profit organizations investments are not made with the intention of earning a financial return.
  • As well as considering financial costs and financial benefits, social costs and social benefits are important.
  • The cost of capital that is applied to project cash flows by the public sector will be
  • one that is determined by the government.

Capital Rationing

It is a situation in which limited funds is available to invest in positive NPV Projects

Budget limits or constraints can arise from:

  • Soft capital rationing, where constraints are imposed internally by management. ( Eg via a capital expenditure budget.)
  • Hard capital rationing, where constraints are imposed by external factors,
  • such as restrictions on the amount of external financing available.

Soft Capital Rationing Vs Hard Capital Rationing

Soft Capital Rationing Hard Capital Rationing
It is a situation in which limited funds are available to
invest in a positive NPV project because of
internal Factor’s
It is a situation in which limited funds are available to
invest in a positive NPV project because of
External Factors
Management may be reluctant to issue further shares
because of dilution in the control of existing
shareholders.
The company can not rais further funds by issuing shares
because stock prices are depressed in the stock exchange
Management may be unwilling to issue further share
because of dilution in EPS (Earning per share)
There may be a restriction on bank lending due to
government controls
Company has the policy to finance all new projects only
from Retain Earnings.
Lending institution may considerr yours company too
risky for further lending
Management may not rais further debts because of fixed
the commitment of interest payments
Cost of funds for arranging new loan is too high

Both types of constraints mean that investment has to be carefully planned to ensure the best use of funds.


Capital Budgeting Cycle

  1. Idea generation
  2. Project Screening
    • Availability of funds
    • Link to the strategic objective
    • Government Rejection/Mandatory
  3. Financial Analysis
    • Initial Method
      Simple payback period
      ARR
    • Advanced Method
      NPV
      Discounted Payback period
      IRR
  4. Non-Financial Analysis
    • Political factors
    • Ethical issues
    • investment issues
    • social issues
    • Legal issues
  5. Approval (e.g From the board of directors)
  6. Implementation e.g Project Manager
  7. Ongoing Monitoring
  8. Post completion

Why Project screening – a qualitative analysis

  • What is the purpose of the project?
  • Does it ‘fit’ with the organization’s long term objectives?
  • Is it a mandatory investment eg to comply with laws?
  • What resources are required eg money, labor?
  • Do we have the necessary management expertise?
  • Does the project expose the organization to high risk?
  • How long will the project last?
  • What factors are key to their success?
  • Have all possible alternatives been considered?

Financial analysis during Investment appraisal

Will use the preferred investment appraisal techniques.

  1. What cash flows/profits arise from the project and when?
  2. Has inflation been considered in the estimates?
  3. What are the results of the financial appraisal?
  4. What risk analysis has been done and its results?
  5. How have non-tangible benefits been assessed?

Intangible costs and benefits during Investment appraisal

In addition to easily quantified financial benefits there might also be important intangible, non-quantifiable effects:

  • Greater customer satisfaction (eg because of a computerized sales and delivery service).
  • Better recognition because of an improved website.
  • Improved staff morale from working with higher-quality assets or better systems.
  • Better decision making from better information systems.

Hard to quantify does not mean ‘not important’

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  • Inflation
  • Taxation
  • Working capital
  • Relevant/irrelevant cashflows
  • Fixed appraisal horizon

Working Capital Cash Management

Reasons for holding cash

Various reasons for holding cash, Discuss and apply the use of relevant techniques in Cash Management, Including

  1. Preparing a cash flow forecast to determine future cash flows and cash balances.
  2. Assessing the benefits of centralized treasury management and cash control.
  3. Cash management models, such as the Baumol Model and the Miller-Orr Model.
  4. Investing in the short term

Calculate the level of working capital investment in current assets and discuss the key factors determining this level, Including

  • The length of the working capital cycle and terms of trade
  • An organizations policy on the level of investment in current assets
  • The industry in which the organization operates

Key factors in determining working capital funding strategies, Including

  1. The distinction between permanent and fluctuating current assets
  2. The relative cost and risk of short term and long term finance
  3. The matching principle
  4. The relative costs and benefits of aggressive, conservative and matching funding policies

Key factors in determining working capital funding strategies, Including

  • the distinction between permanent and fluctuating current assets
  • The relative cost and risk of short term and long term finance
  • The matching principle
  • The relative cost and benefits of aggressive, conservative and matching funding policies
  • Management attitude to risk, Previous decision and organization size
  1. Permanent Current asset: Which are using permanently in business
  2. Fluctuating Current asset: Aditional working capital which needed in peak seasons, like in seasonal business need to change working capital, E.g Icecream Business

The Nature of Cash

Cash is King

  • Cash is ready money in the bank Or in the business, unlikely inventory and receivables. it can be used to pay Wages, Rent and suppliers.
  • Having good profits does not necessarily mean that a business has enough cash.
  • Monitoring cash inflows and outflows to ensure that there is enough cash is one of the most important management tasks for the business
  • Ultimately it is a lack of cash when its needed that causes a business to fail

Reasons for Holding Cash

There are three reason or motives for holding cash

  1. Transaction Motive: To meet the day to day transaction of running a business
  2. Precautionary Motive: As a safety net for unexpected events such as a large customer failing, An overdraft facility or line of credit will also provide this safety, Whatever you need to keep a little bit extra in the pocket
  3. Speculative Motive; To take advantage of opportunities. E.g Bulk buy discounts or investments in a new line of business when the opportunity arises. Like can pay to suppliers to get the extra discount, Extra opportunities

Cash Flow Problems

Cash flow problems can arise for the following reason

  • Making losses: This can eventually lead to failures.
  • Inflation: Asset costs increase and will be expensive to replace.
  • Growth: Cash is needed to provide inventory and fund receivables as business grown (Overdrafting)
  • One-Off item of expenditure: Foe example Tax, Dividends, Legal costs.

Cash Flow Forecasts

Cash flow forecasts or cash flow budgets are the key tool when managing cash.

  1. They should include both revenue and capital flows
  2. Careful attention needs to be paid to the timing of a receipt or payment
  3. They should be based on the budgeted statement of profit or loss and statement of financial position.
  4. Essentially we are producing a bank statement in advance.

Cash Flow Forecasts- Timings

  • Correct timings of receipts from customer and payments to suppliers are essential
  • In the exam, these calculations are not difficult but they are repetitive and initially care is needed to get started correctly
  • It is essential to provide clear workings both to help your accuracy and so that a member can follow what you have done
Cash Flow Forecasts
Cash Flow Forecasts

Not every aspect of the statement or profit or loss amount will have cash flow consequences. Similarly, some SOFP items will affect the cash flow forecast, Like in the table below some examples of Non-Csh items

Non cash expenses list
Non cash expenses list Non cash items

Dealing with Cash Shortages

  • Postpone capital expenditures
  • Try to accelerate inflows (e.g Discounts)
    • Take longer credit(but don’t upset suppliers)
    • Re-Negociate loan payments
    • Reduce or postpone dividend payments
  • Liquidate inventory by having a sale
  • Try to sell surplus assets, For example, sell vehicles to a fleet management company and rent them back (Lease and buyback)
  • Finance- Re-schedule loan, Reduce dividends, Rais loan/equity finance if time allows

Cash Flow Forecast and Un-Certainty

  1. Cash flow forecast depends on estimating future Sales, Purchases, Cash receipts, and Cash payments
  2. These are inherently un-certain )Means sales can be next year 2M or 5M or 8M)
  3. Review cash forecasts regularly and use the latest and most accurate data available
  4. Examine the sensitivity of cash balance to assumptions about the timing and amount of cash flows
  5. Ensure sufficient contingent funds are available
  6. Questions can assign probabilities to certain flows occurring

Question for Cash Flow Forecast and Un-Certainty

Question

Cash Flow Forecast and Un-Certainty
Cash Flow Forecast and Un-Certainty cash management working capital

Answer

Cash Management
cash flow forecast and uncertainty
cash management working capital

Treasury Management

A large organization will have a separate specialized treasury department typically to manage. (Where the company has all funds, its called treasury fund management, They collect every cash in one place and manage from there)

  • Liquidity ( They assure sufficient cash is available)
  • Short term investment
  • Borrowings
  • Foreign exchange risk (Risk Management Topic)
  • Specialized areas such as forward contracts and futures (like derivatives, Forward, Future Option)

Advantages of Centralising the Treasury Functions

  • Precautionary motive accomplished on a group basis
  • Profit center motivation
  • Borrowing needs pooling to get better rates
  • Foreign currency risk assessed on group basis match inflows and outflows
  • Overdrafts & surplus can be netted off
  • Cash pooled to get better returns
  • Expertise

Dis-advantages

  • Better matching to local assets
  • Greater autonomy for local managers (they feel more powerful)
  • Better matching to local market needs
  • Opportunities for Fast, Specialised solutions

Cash Management Model’s

1-Baumol Cash Management Model

The Baumol Model considers a business needing a certain amount of cash per time period and works out the most economical way you raise the cash. (This model is the same as EOQ. Here use cash quantity instead inventory etc)

  • If a lot of cash raised in one go then there will be a high cost of servicing that cash (e.g Intrest), even though it might not all be needed immediately
  • If cash is raised frequently in small amounts then the transaction cost will be high
  • The model is analogous to the economic order quantity model for inventory where there is a compromise between high holding cost and high ordering costs
baumol cash management model working capital
baumol cash management model working capital

Where

  • Q= The amount to be borrowed/drown down each time
  • C= The cost of raising the cash e.g the cost o selling securities to receive cash
  • S= Amount of cash used in each time period
  • i= Intrest cost of holding cash or cash equivalent

Problems with Baumo Model

  • Future cash needs are unlikely to be constant
  • The cost of holding cash is likely to change frequently as interest rates fluctuate
  • The cost of holding cash is likely to fluctuate with the amount of cash on deposit i.e large deposits attract higher interest
  • No account is taken of keeping buffer (safe) cash

2-Miller-Orr Cash Management Model

The Miller-orr Cash Management Model seeks to control the limits between the cash balance move

  • Too much cash wastes money(It should be earning a return)
  • Too little risk running out of cash so increases risk
  • Cash balance is adjusted by buying and selling securities (Or moving cash to and from deposit accounts).
Miller orr cash management model working capital cash management

Cash is allowed to fluctuate between the upper and lower limits. When a limit is reached securities are bought or sold to restore cash to the return point. The Spread is the difference between the upper or lower limit and is given by:

  1. Set the lower limit e.g based on Calculation, Precautionary motive, and Experience
  2. Estimate the variance of the cash flows (Varience= the square of the standard deviation)
  3. Find interest rate and the transaction cost
  4. Calculate the SPREAD
  5. The return point is the lower limit plus 1/3 of spread
  6. The upper limit is the lower limit plus the spread

The variance or stander deviation will be supplied in any question along with the other variables.

Note; This model does not set the lower limit for cash fluctuations, Also interest rate is usually the daily interest rate

Example


Investing Surplus Cash

Companies with a more modest amount should be investing surplus cash to earn interest.

  • Leave enough in a current or on short term deposit to ensure adequate liquidity
  • Look for a return commensurate with the risk
  • Avoid capital losses (Means losses on investment)
  • Think carefully about the term and how long it might take to realize any investment
  • Are international markets attractive?
  • Do some investments require a minimum amount

Where to invest surplus cash

  • Short term investments such as bank deposit, Tradeable investment or listed share
  • Money market landing
  • Certificates of deposit
  • Treasury Bills

Working Capital Funding Strategies

  1. Working capital can be funded by a mixture of
    • Short term funding
    • Long term funding
  2. The business should be aware of the distinction between fluctuating and permanent assets
  3. Permanent current assets are the amount requires to meet long term minimum needs
  4. Fluctuating current assets are the current assets which vary according to normal business activity
  5. Permanent asset should be funded by long term capital fluctuating assets can be funded by short term capital
  6. Policy A: Conservative approach —> Most finding is long term with little reliance on short term finance, Despite asset often falling below what the permanent funding supports. (This policy is Safe but Wasteful)
  7. Policy B: Aggressive approach –> Most funding is short term, long term capital cover non-current assets but most funding of current asset, even permanent current asset relies on short term source. (This policy is Risky but Profitable)
  8. Policy C: Balance approach —> Permanent current asset and non-current assets are funded by long term capital, Fluctuating current assets are funded by short term capital (Such as Overdraft)

Other Factors

Working capital Cash Management is also affected by:

  • Industry Norms: For example what the normal receivables and payables periods are for the industry, straying too far from these might make the company un-competitive
  • Industry type: Erratic sale implies more working capital is a need for the bad times
  • The manufacturing: Long term manufacturing time implies a high amount of work in the capital
  • Management issue: For example attitude to Risk, Quality of the information system e.g if PPR buffer inventories may be needed

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ACCA FM Syllabus 2021 (Financial Management)

ACCA Financial Management FM F9

ACCA Financial Management (FM) – Previously Know as F9 ¬ ACCA FM Paper


ACCA FM Syllabus 2021

  • Investment Appraisal
    • Basic Methods
    • Taxation Method
    • Specific Decision
    • Risk & Uncertainty
  • Cost of Capital
    • Cost of Equity
    • Cost of debt
    • Weight average cost of capital
    • Capital Structure theories
  • Business Valuation
    • Equity Valuation
    • Debt Valuation
  • Sources of Finance
  • Risk Management
    • Interest Rate Management
    • Foreign Currency rate management
  • Working Capital

FM paper pattern

First of all, The final exam in which you are going to appear will include two sections

  1. Section A: OT Questions
    • 15 OT questions having 2 marks each
  2. Section B: OT Cases
    • 3 OT cases having 5 OT in each case
  3. Section C: 2
    • Constructive response questions, 20 Marks each question

Probably Reason of unsuccessful attempts of FM

  • Not enough practice the past paper questions
  • Poor time management in the exam
  • Similarly Not attempting all parts of the given question
  • Not explaining answer as expected by the examiner
  • Almost Lack of sufficient knowledge about the subject area
  • Panic in the exam when you see something unseen on the question booklet
  • Many students just read the solution of questions, they don’t try to write every part of the question by themself

In FM you have to do practice in 3 different types of areas,
1- Simple MCQ’s OR OT question (30 Marks questions)
2-OT case- A case study will be given and related 5 questions, you need to read and understand case study and answer related 5 questions. (30 Marks)
3-Constructive Response area: (40 Marks)
Must Practice all area from past papers


Therefore Remember mostly students when fails a 49, They claim that they are failed by 1 mark, This is not true, Almost you were failed by 51 Marks 🙂 Keep in mind and practice very well

FM ACCA Books & Revision Kits

FM Pass Rate

Dec 2017Jun 2018Dec 2018Jun 2018Dec 2019
48%48%43%46%43%

FM video lectures

Ratio Analysis

Ratio Analysis

Financial Ratio Analysis

Ratio Analysis Plays a key Roll to determine the business circumstance, here are few Ratios are given below.

In the examination, you will be asked to calculate and interpret the ratios used in analytical procedures at the audit planning stage and when collecting audit evidence. Ratios and comparisons can be used to identify where the accounts might be wrong or right, and where additional auditing effort should be the need to spent. 

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