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FINANCIAL ANALYSIS

AND MANAGEMENT

Student Name |

Tran Thi Thuy

Student ID

B0436DHDH1112

CONTENTS
INTRODUCTION................................................................................................2
LITERATURE REVIEW........................................................................................3
Non-discount Methods..................................................................................3
Accounting Rate of Return.........................................................................3
Payback Period..........................................................................................5
Discounted Cash Flows (DCF) Analysis Methods..........................................8
Net Present Value (NPV)............................................................................8
Internal Rate of Return (IRR)...................................................................11
Advantages and Disadvantages of DCF Methods....................................11
CONCLUSION..................................................................................................14
REFERENCES..................................................................................................15

INTRODUCTION
Over the past decades, the fluctuations of interest rate, inflations and
foreign currencies exchange has made the financial risk management
become important matter beside the other risks related to the industrial
operation. Regarding to Vernimmen, et al. (2009), the role of financial
managers have been increased since their primary role is ensuring the
sufficient supply of capital.
However, there are variety of methods that can be applied to help the
managers enhancing their investment decisions. The very first part mentions
about the traditional or non-discounted cashflows methods: Average Rate of
Return (ARR) and Payback Method. The common sense of these two
techniques is that they do not include the time value of money.
The discounted cashflows analysis would help the both public and
private sectors to resolve those related issues. However, there would be the
difference in analysing the risks factors as well as cost of capital between the
two sectors.

LITERATURE REVIEW
NON-DISCOUNT METHODS
Accounting Rate of Return
The Accounting Rate of Return (ARR) or the Return on Capital
Employed (ROCE) is the figure that shows the companys efficiency in
creating the profits based from the employed assets (Pike & Neale, 2009). It
is helpful to measure the return of per invested dollar (Brealey, et al., 2011).
The formula to calculate the ARR is:
Profit Before Interest Tax
100
Capital Employed ( AssetsCurrent Liabilities)

The ARR relates totally to the profits and concerns to the employed
capital; hence, it is easy to understand and communicate among managers.
It has become one of the main business ratio. The ARR is later can be used to
calculate the Economic Value Added (EVA) which can help to shows the
current performance of the firm (Vernimmen, et al., 2009):
EVA = Capital Employed (ROCE WACC (Weighted Average Cost of
Capital))
For example, a company which has the income statement and balance
sheet as below:
INCOME STATEMENT
Revenue
Cost of sales
Wages and Salaries
Other costs
Profit before interest and

000
24,000
8,000
5,000
4,000
7,000

taxation
Interest
Tax
Profit after interest and taxation

900
1,000
6,000
3

BALANCE SHEET
Total assets
Shareholders equity

000
17,600
6,000

Non-current liabilities
Bank loan

4,900

Current liabilities
Payable account
Bank overdraft

3,800
2,900
6,700

The ARR then would be:


7,000
100=64.2
17,6006,700
The 64.2% ratio means the company has the ability to generate the
profit of 64.2 for every of 100 capital employed.
However, one of the problems of ARR is that it focuses solely on the
profit. Therefore, the question would arise here for both private and public
sectors is that whether the profit maximisation is the sole objective for the
business? The answer would be definitely no in the investment context.
Firstly, high profit means the company has to encounter with the
increase in risk. The ARR, however, does not take into account the risk and
this can lead the managers may ignore the risk factors. Secondly, the
calculation of profit in the ARR would be helpful in accounting basis;
however, it does not calculate the timing pattern of the project. For example,
the Project A has the higher profit than the Project B but it does take 5 years
to generate while the Project B can take only 1 or 2 years. Last but not least,
if the profit is the sole objective, it means the other rights and benefits of
shareholders in private firms or citizens in public organisations may be

ignored. Once these people interests are ignored, it would not surprise if the
business cannot withstand on the marketplace.

Payback Period
The payback method is the simplest approach regarding to the
investment appraisal and mostly preferred by the small business owners or
sole traders because of its obvious simplicity. Regarding to Brealey, et al.
(2011), payback method is used to rate the project paybacks period which is
counted by the number of years it takes before the cumulative cash flow
equals the initial investment. With the payback method, there are two cases
that happen (Zutter & Gitman, 2012); firstly, in the case of an annuity, the
payback period can be counted by dividing the initial investment by the
annual cash inflow. Secondly, if the cash inflows is mixed stream, the yearly
cash flow must be accumulated until the initial investment is recovered.
Since the calculation of the payback method is quite simple; hence, the
decision criteria of this method is basically accept or reject decision.
Regarding to Ross, et al. (2008), the applied decision criteria for this method
would be:

In the case that calculated payback period is less than the planned

acceptable payback period, just accept the project.


If the calculated payback period is greater than the planned
acceptable payback period, reject the project.

For example, the table below illustrates the cash flow of two projects:
Project A and Project B. An assumption is made that both projects have the
innitial investment of 1,200,000:
Year

Project A

Project B

1
2
3
4
5

(000)
400
400
400
400
400

(000)
250
355
490
595
675
6

Total

2000

2365

For the Project A, because it has the annuity of cash inflows, the
payback period is:
1200
=3 years
400
For the Project B, with the mixed stream of cash inflows, the payback
period would be:

Payback=4 years+

Year

Project

Cumulative Cash

0
1
2
3
4
5

B
-1200
250
355
490
595
675

Inflows
-1200
-950
-595
-105

105
365=4 years64 days
595

If the management set that the acceptable payback period would be 4


years and less; it means the Project A would be accepted although the
forecasted total cash inflows after 5 years would be less. This may happen in
case the management can prevail the high level of risk in the future.
In another hand, regarding to Zutter & Gitman (2012), the acceptable
payback period is decided by the board of management which means it is set
subjectively by a number of factors such as the type of project, perceived
risk of the project, the relationship between the payback period and the
share value. Hereby, the advantages and disadvantages of this method
would be discussed:
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The payback period method would be very easy to apply and


communicate and in someway, it can be considered as a kind of breakeven measure (Ross, et al., 2008). Moreover, the paybacks philosophy is
the projects that can retrieve initial investment quickly are much more
attractive than the projects needed longer payback period; hence, it
emphasizes the liquidity of the projects (Atrill & McLaney, 2006).
However, regarding to Brealey, et al. (2011), the payback period can
give the misleading answers due to its two rules:

The payback ignores all the cash flows after the cut-off date. It is
not concerned with the profitability of the projects. Regarding to the
aspect of the private sector, this means it totally ignores the

objective of optimizing the business return of the shareholders.


The payback gives the equal weight to all cash flows before the cutoff date. This means it is not concerned with time value of money;
the faster project can recoup initial investment, the more attractive
it is.

Because the payback period ignores the time value of money, no


discount rate is concerned and furthermore, no risk or uncertainty would be
counted.
In the field of public sector, due to the easy understanding and
communication, the non-discounted payback method can play a role in
interpreting the efficiency of management within the government. Since
most of public sector is funded through the tax and taxpayers are not always
professional financial users; therefore, a simple payback method report
would be useful to help the citizens catch up with the efficiency in liquidity of
governments projects.

DISCOUNTED CASH FLOWS (DCF) ANALYSIS METHODS


Net Present Value (NPV)

The Net Present Value (NPV) is one of the discounted cash flows
investment appraisal techniques. The NPV has the formula as below:
n

NPV =
t=1

CF t
(1+r )t

C 0

The decision making process based on the value of the NPV then can
be considered simply as: an investment should be accepted in case the NPV
is positive and rejected if the NPVs value is negative (Ross, et al., 2008).

One of the important objectives for the managers in corporate finance


is that creating as much wealth as possible for the owners or shareholders
through the efficient use of existing and even future resources (Pike & Neale,
2009). Therefore, the investors need to consider the value of the current and
future benefit less costs arising from the investment. In order to use the NPV
efficiently, these rules must be followed (Brealey, et al., 2011):
1. Net present value takes into account of future cash flows. The cash
flows is simply the difference between the received cash and the
paid-out cash. With NPV techniques, only cash flow is relevant.
2. The cash flows must be estimated on the incremental basis. It
means the value of the project takes into account of all the
additional cash flows that follow from the project acceptance.
Therefore, regarding to Brealey, et al. (2011), there are some
aspects that can be considered when the managers want to decide
which cashflows need to be included:
The incidental effects that a project can cause to the

remaining firms business.


The managers must make a forecast of the present sales
revenue of the project and incremental after-sale cash
flows.

The required working capital should not be forgotten. The


net working capital is the difference between short term

assets and liabilities of the firms.


The managers should carry out the calculation of the

opportunity costs.
Ignoring the sunk costs since they are in the past and

cannot gain back.


The managers should be aware the allocation of the

overhead costs.
The salvage value of the project should be mentioned.
3. The inflation should be treated consistently. This means the
managers must discount the nominal cash flows at a nominal
discount rate and treat the discount real cash flows with the real
rate. It is not wise to mix the different types of cash flows and rate.
For example of NPV, a company wants to make investment and the
managers have three projects with the discount rate of 12%, the detailed
tables are:
Year
(Initial
investment)
1
2
3
4
5

Project A
(000)
-1500

Project B
(000)
-1500

Project C
(000)
-1500

235
390
567
721
811

115
218
765
826
985

325
339
409
514
535

Therefore, the NPV tables of these projects would be:


Yea

Project A

Present Value @

Discounted Cash flow

r
1
2
3
4

235
390
567
721

12%
0.893
0.797
0.712
0.636

(DCF)
209.855
310.83
403.704
458.556

10

0.567
459.837
Total DCF
1842.78
Initial Investment
1500
NPV
342.78
The NPV of the Project A is positive, therefore, it can be accepted.

Yea

811

Project B

Present Value @

Discounted Cashflow

r
1
2
3
4
5

12%
(DCF)
115
0.893
102.70
218
0.797
173.75
765
0.712
544.68
826
0.636
525.34
985
0.567
558.50
Total DCF
1904.95
Initial Investment
1500.00
NPV
404.95
The NPV of the Project B is also positive, therefore, it is accepted.

Yea

Project C

r
1
2
3
4
5

325
339
409
514
535

Present Value @

Discounted Cashflow

12%
(DCF)
0.893
290.23
0.797
270.18
0.712
291.21
0.636
326.90
0.567
303.35
Total DCF
1481.87
Initial Investment
1500.00
NPV
(18.14)
The NPV of the Project C is negative, it is neglected.
The NPV of the Project B is larger than the Project A; therefore, it would

be selected instead of Project A although the first two years of the Project A,
the cash flows may be greater.

Internal Rate of Return (IRR):


The internal rate of return (IRR), regarding to Ross, et al. (2008) is the
discount rate that makes the NPV of an investment zero. The rule of IRR is
simple, an investment is considered acceptable if the IRR exceeds the
required return. The formula of the IRR can be seen as:
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IRR=R 1+

NPV 1
( R2R1 )
NPV 1NPV 2

Meanwhile:
R1 = Rate used to obtain the NPV1 with positive value
R2 = Rate used to obtain the NPV2 with negative value
NPV1 = Positive NPV
NPV2 = Negative NPV

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Advantages and Disadvantages of DCF Methods


The discounted cash flows analysis techniques makes a very good
sense in helping the managers to give out the investment decisions since it
has the followed advantages:

The managers seek to upsurge the wealth of the shareholders


through maximising the cash flows through time (Pike & Neale,
2009). Therefore, the market rate of exchange between the current
and future wealth in the NPV technique can be imitated in the

current rate of interest.


Unlike the payback period method, the NPV takes into account of all

relevant cash flows, not just only the break even point.
NPV focuses in the real business objectives that concern to the cost
of capital.

Therefore, in the aspect of private sectors, the NPV has played an


important role in order to help the board of directors handle the agency
problems. The shareholders and managers are united together in the single
objective of maximizing the shareholders wealth (Brealey, et al., 1997). NPV,
hence, can be an effective tool of communication for the managers to deal
with the shareholders expectation regarding to the use of capital and cash
flows. The value of the cash flows after that can be used in order to make the
rate toward the efficiency in allocating the capital resources of the
managers. The performance of the managerial staffs is monitored and
readily measured through the ratios such as earnings per share, share price
and so on. The shareholders may replace the managers if they cannot meet
the expectation in maximizing the wealth. The transparency and
commitment between the shareholders and managers would be much more
obvious and clear. Additionally, shareholders can also make the comparison
between the firms with the other competitors to bring more values to
customers. They may also create the linkage of remuneration with the share

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price to help motivating the managers to boost the performance (Connolly,


2007).

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With the public sectors, the citizens in a democracy context will play
the role of shareholders and they help to elect the government. Regarding to
Brealey, et al. (1997), the voters not only have the divergent objectives but
there is also no guarantee that a majority voting system will let the
government act so as to maximize the aggregate net benefits to all voters:
Voters and government consider not only with the issue of maximizing the
net benefits but also the government must ensure the equitable wealth
distribution among the voters. As a result, the investment in public sectors
may only respond to political economy motives rather than simple economic
efficiency considerations (Dabla-Norris, et al., 2012). Moreover, the disparate
objectives of the voters can help enhancing the discretion of the government
and further their scope for self-serving behaviour (Brealey, et al., 1997).
Consequently, regarding to Lant Pritchett (2000) in a journal of Dabla-Norris
et al., (2012), no probable behavioral model would occur in which every
dollar that the public sector spends as investment creates economically
valuable capital. The judgment regarding to the government efficiency,
hence, is much more challenging.
In the other hand, it is quite difficult in practice for the private sectors
to estimate the appropriate discount rate and the NPV is quite difficult to
understand regarding to the non-financial managers (Pike & Neale, 2009).
Therefore, it is quite important for the managers to analyse carefully the risk
that can occur in the future context of the project. With the public sector, the
government can make the intervention in order to ensure the welfare
maximization. Hence, the risk pressure for the government to make the
investment is low. Regarding to Brealey, et al. (1997), the government has
the right to make the taxation in order to overcome the free-ride problem.
The free-ride refers to the consumers who have the incentive to benefit from
the resources, goods, or service without paying the costs. In another way,
the government may regulate the price of the monopoly.

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For example, when a private firm wants to make an investment toward


a project, the managers must take into account of the tax. In this case, an
assumption the tax rate of 15% on the net profit, with the discount rate of
12%, an initial investment of 1,500,000; then the details would be:

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Yea

Net Profit

Profit

(000)

after tax @

345
490
568
736
913

15%
293.25
416.5
482.8
625.6
776.05

1
2
3
4
5

PV @ 12%

DCF
(000)

0.893
0.797
0.712
0.636
0.567
Total DCF
Initial

261.87
331.95
343.75
397.88
440.02
1775.48
1500.00

Investment
NPV
275.48
The NPV of this project for private sector would be 275,480.00.
The tax appearance in the NPV table means that the private sectors
would have the motivation to pursuit the tax-minimizing strategies in order
to increase the NPV of the project. Moreover, the managers must also take
into account the risk that the tax may vary in the future. The government,
however, surely ignore it since regarding to Bailey and Jensen (1972) in a
journal of Brealy, et al. (1997) stated that: (a) the risk of public-sector
projects is distributed over the entire population, (b) the risks are diversified
through the ownership of government can enhance eliminating the risks to a
very large extent and (c) the diversification can be accomplished more
cheaply by the government than the financial markets. As a result, when
applying the NPV or IRR or any DCF methods, the public-sector projects
should be valued by discounting their pre-tax cash flows by the pre-tax
interest rate (Brealey, et al., 1997).

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CONCLUSION
In conclusion, every investment appraisal method has its own
strengths and weaknesses. It would depend on the purpose and ability of the
users. The non-financial users would like to have the simple format of non
DCF methods while the financial directors would need to have the detail
capital budgeting report to give out appropriate decision. In the business
context, while the private corporate can be united in the common objective
of maximizing the shareholders benefit, the public sector in another hand
focuses in analyzing the projects in order to adapt with the various
requirements of the citizens. This can lead to the different projects approach
between the two sectors. The private firms financial managers must
acknowledge about the risk as well as the fluctuation regarding to the
discount rate that can have impact toward the employed capital. The public
sector can have the ability to make the intervention toward the investment
environment and diversify the risk factors.

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