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R O I
(Return on Investment)
DEFINATION The term finance can be defined as the management of the flows of money through an organisation, whether it will be a corporation, school, Bank or Government agency. Finance is the life blood of various managerial function, viz., production, marketing, Human Resource (personnel) and Research & Development (R&D).
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Finance
Production
Marketing
Functions Of Finance
Three major decisions that the firm must make: 1) Investment Decision: Capital Budgeting. 2) Financing Decision: Issue of Shares, Debentures, etc 3) Dividend Decision: Dividend and Retained Earnings. Financial Management is that managerial activity which is concerned with the planning and controlling of the firms financial resources.
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Proper utilisation of funds Maximisation of Return on Investment (ROI) so that the company need not depend on external borrowings and give shareholders better returns in the form of dividend and bonus. Survival due to competition, change in consumer behaviour or technology, labour problem. Cash flow to ensure availability of adequate cash flow to meet the working capital requirements. Break Even Point no profit no loss Total Revenue= Total Cost
Minimum profits to earn minimum profits in short term so as to cover up the cost of capital. No Profit, No Business. Ensure Co-ordination proper co-ordination in the activities of finance department with those of the other departments in the organisation. Good Image for the Organisation good name, reputation, image and goodwill.
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Definition
Ezra Solomon has defined wealth maximisation objectives in the following manner:the gross present worth of a course of action is equal to the capitalised value of the flow of future expected benefits, discounted at a rate which reflects the certainty or uncertainty. net present value is the difference between gross present worth and the amount of capital investment required to
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Du Pont Chart
Net Profit Margin
Net Profit
X Net sales
Net Sales
Total Cost
Operating Expenses
Average Debtors
Interest
Average of others
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Net PAT Total Assets Return on Equity = Net Profit After Tax (NAT) (ROE) Shareholders Equity
ROI =
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4)
5)
By increasing net profit for same amount of sales By increasing sales volume for the same amount of investment Reducing the cost- e.g. In case of a replacement proposal where the asset has worn out or become outdated, the firm has to decide in terms of lower operational cost and outlay cost that would be needed to replace the old machine. Increasing Profits-by expansion of present operation or development of new product line. By diversification, productivity, improvement, expansion, product improvement. 17
ROI not the end of Financial Objectives (only a tool for analysis)
It is only a ratio. It is calculated from financial statements which are affected by financial policies adopted eg. Depreciation, valuation of stock. Financial statements do not represent a complete picture of business , dont refer to other factors which effect performance. Overuse of ROI is dangerous. Management may simply concentrate on improving the ratio than on dealing with
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Illustration 1
The comparative Bal/Sheet & Income statement for ABC ltd for the years 2004-2008
Comparative Financial Statement Part A : Bal Sheet (Rs in Crores) 2004 Share Capital Reserves & Surplus 2005 2006 2007 2008 11.20 6.90 10.00 10.00 15.00 15.00 15.00 6.50 10.50 2.25 7.60 2.60 8.50 9.10 10.60 2.40 7.60 2.50
Secured Loans
Unsecured Loans Current Liabilities & Provisions Fixed Assets (Net)
Investments
Current Assets, Loans & Advances Debtors Inventories
1.00
6.10 6.00
1.00
6.90 8.20
1.00
7.35 8.00
1.00
1.00
0.80
0.70
0.60
0.50
0.50
Part B : Income Statement (Rs in Crores) 2004 2005 2006 2007 2008
Net Sales
Cost Of Goods Sold Gross Profit Operating Expenses
Operating Profits
Non Operating Surplus/ Deficit P/EBIT Interest
8.80 12.10
11.70
0.90 2.50 4.20 5.90 2.30
9.90
9.30
8.90 2.10
PBT
TAX PAT Dividends
8.30
4.10 4.20 2.70
6.80
3.50 3.30 2.70
Retained Earnings
2.20
4.00
3.60
1.50
0.60
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Illustration 2
The comparative Bal/Sheet & Income statement for XYZ Ltd for the years 2004-2008 Comparative Balance Sheet s(Rs in Crores)
2005
2006
2007
2008
10.80 1.20
3.10 5.10 1.10 21.30
11.90 2.60
1.80 4.60 1.60 22.50
14.80 0.70
2.80 6.20 3.10 27.60
19.60 0.60
2.90 8.20 2.70 34.00
23.20 1.10
2.00 9.30 2.40 38.00
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Gross Profit
Operating Expenses Operating Profits Non Operating Surplus/ Deficit
5.30
3.70 1.60 0.20
8.70
4.20 4.50 0.10
8.60
4.60 4.00 0.20
8.50
4.90 3.60 0.50
11.60
7.00 4.60 0.40
P/EBIT
Interest PBT TAX
1.80
1.00 0.80 -
4.60
0.90 3.50 0.60
4.20
0.80 3.40 1.20
4.10
1.50 2.60 -
5.00
2.00 3.00 -
PAT
Dividends Retained Earnings
0.80
0.60 0.20
2.90
0.60 2.30
2.20
0.90 1.30
2.60
0.90 1.50
3.00
1.10 1.90
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Case Study
Assume
that there are two firms A and B, having total assets amounting to Rs 5,00,000 and average net profits of 10% that is Rs 50,000 each. Firm A has sales of Rs 5,00,000 whereas the sales of firm B aggregates Rs 50,00,000. Determine the earning power of firms A and B.
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Case Study
SOL:
1 Nets Sales Firm A 5,00,000 Firm B 50,00,000
2 3
4 5 6
50,000 5,00,000
10% 1 times 10 %
50,000 5,00,000
1% 10 times 10 %
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of new machinery Expansion of product lines Replacement of worn out or less productive existing assets Mergers/acquisition
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Discounted techniques
Net present value Discounted payback period
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Assumptions of C. E. Projects
All the alternative investment proposals are riskless or carry equal amount of risks Cash inflows are net of corporate tax Investment outlays are made at the beginning of the year, and cash inflows are received at the end of the year. Sunk cost : are part of cash outflow which have already been incurred and therefore have no effect on cash flows relevant to current decision.
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Cash flows are of uneven amounts Payback Period = xxx years + ( Required Amt
* 12 Months) Annual net inflows
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ARR Method
ARR = Average Net Profit after Tax * 100 Original Investment 2. ARR = Average Net Profit after Tax * 100 Average Investment Where, Net Profit can be NPBT before Depn. NPAT before Deprn. NPAT after Deprn. Average Annual Profits = Total Profits of all years No. Of years
1.
Average = Initial cost of machinery - salvage value + Additional Net + Salvage value Investment 2 Working capital
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3. ARR = Incremental Earnings or Profits * 100 Incremental Investment Consideration of old and new machines NPAT Machine B NPAT Machine A * 100
Purchase Price of new mach sale proceeds of old mach
Illustration 1
Payback period
PQR co ltd. has invested in a machine at a cost of Rs 9,00,000. following details are estimated:
retrenchment in staff 4 staff @ salary of Rs 20000 Additional staff required 1 staff @ salary of Rs 40000 saving in wastage Rs 40000 savings in maintenance Rs 10000 Additional electricity bill Rs 15000 Calculate : payback period, ignore taxation & depreciation
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Illustration 2
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Illustration 3
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Illustration 4
Better Co Ltd. is considering the purchase of New Machine for the immediate expansion programme. There are three types of machines in the market for this purpose. Their details are as follows:
Particulars Mach A Mach B Mach C
17500 400 2750 100 750 10 12500 750 6000 400 550 800 6 Cost of Mach Estimated savings in Scrap per year Est. Savings in direct wages per year Add cost of indirect mat. per year Expected saving in indirect mat. p.a. Add cost of maint. p.a. Add cost of supervision Est. Life of mach(Yrs) 9000 250 2250 250 500 5
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You are required to advise the mgt to which type of mach should be purchased on the basis of payback period
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Illustration 6
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Illustration 7
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Illustration 8
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Illustration 9
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Illustration 10
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(C is the Outlay)
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IRR =D1 + PVD1 PVC *(D2 D1) PVD1 PVD2 Where, D1= Lower rate of discount D2 = Higher rate of discount PVc = Present value of Outflows PVD1= Present value of cash inflows at D1 PVD2= Present value of cash inflows at D2
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Interpolation Technique
IRR =D1 + PVD1 PVC *(D2 D1) PVD1 PVD2 Fake payback period (F) F= Cash Outlay Average annual cash inflows Fake Average Payback = Initial Outlay OR Original Investment Fake Annuity Average Annual CFAT Fake Annuity = CFAT(including salvage) No. Of years
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Locate the factor closest to the Fake payback in the Annuity factor table along the economic life of the Machine. Actual cash flows in the earlier years is more than average cash flows take higher Interest Rate. Actual cash flows in the earlier years is less than average cash flows take lower interest Rate.
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Illustration 39
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