MODULE TITLE: Financial Management for Decision Making
MODULE NUMBER: ACC 11407
NAME OF MODULE LEADER: Sarah
DATE OF SUBMISSION: December 11, 2015
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Question A:
Understanding movement of money within the organization is important. For instance,
when to pay your invoices enables an organization 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 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.
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 an 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 analysing,
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 107,45
0
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.
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
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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
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Needles, B., Powers, M., & Crosson, S. (2013). Financial and managerial accounting. Cengage
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