Finance in

Planning &
Decision
Making
Chapter 4
Funding
Strategies
Funding strategies may vary
from business to business.
BCG Matrix can be used to
decide the funding strategy
for each business unit within
the group (Star, Cash Cow,
Dog, Question Mark).
Cash flow projections are
prepared to see whether
there is a funding deficit or
surplus.
 Sources of Funds / Options
in Case of Shortfall

Equity:
• Ordinary share capital (IPO or right shares)
• Retained earnings
• Reserves
Sources of Funds / Options
in Case of Shortfall
Debt:
• Debentures
• Preference shares
• Leasing
• Bank loans
• Bank overdrafts or running finance
• Trade credit
Others:
• Sell short-term investments
• Tighter working capital
management
(e.g., leading and lagging)
Sources of Funds / Options
in Case of Shortfall
Others:
• Sell short-term investments
• Tighter working capital management
(e.g., leading and lagging)
Factors to Consider When
Deciding Funding Sources

• Purpose and amount

• Duration of requirement
(short term or long term)
• Legal status of the company
(e.g., sole proprietor, partnership or
company)
• Debt / loan financing:
• Interest not linked with business
performance
• Availability of collaterals
• Current gearing level
Factors to Consider When
Deciding Funding Sources
Equity financing:
• Cost linked with profitability
• Dilutes existing shareholding pattern
• Outside shareholders / institutional investor involvement
Business risk vs financing risks
• Business risk: the chances that business will not make profit
• Financing risk: chances that business will have to pay
interest on borrowed funds, despite the fact that it is in a
loss (e.g., debentures)
• When business risk is high, financing risk should be kept low
(e.g.. by taking equity financing and not debentures / loans)
Options in Case of
Surplus
Interest bearing bank accounts
Short term investment
Treasury Bills
Term deposits
Long term investments
Changing Role of Finance and Accountants
Changing Role of Finance
and Accountants
Traditionally, finance function
focused on three key roles:
collections, payments and financial
reporting.
However, these tasks have now
become automated and hence the
traditional roles of finance function
as well as accountants has
transformed.
Modern organizations now expect
finance function to be strategic,
forward looking, proactive and
focusing on creating value for the
business.
 Changing Role of Finance
and Accountants
Current roles for finance function (and
accountants) focus more on:
1. Support in strategic management, i.e., analyzing
options, implementing and monitoring of
strategies
2. Providing in-depth analysis to business
3. Long term business planning and scenario
building
4. Support complex decision making
5. Performance measurement of the organization
 Changing Role of Finance
and Accountants
Current roles for finance function (and accountants) focus
more on:

6. Finding areas of cost efficiency

7. Funding sources & working capital management
8. Managing financial risks
9. Legal compliance
10. Accounting and reporting
 • Several working models have evolved in recent years to increase
efficiencies of Finance function. These working models are possible
Modern due to IT advancements such as internet, cloud computing, etc.

Structure of Outsourcing
Finance • Non-core tasks can be outsourced to a specialist vendor to avail
economies of scale and cost savings. Common tasks include
Function invoicing, payment processing, bookkeeping, payroll, collections,
etc. Harmon’s Process Strategy Matric can be used in deciding
which tasks can be outsourced.
Modern Shared Services Model
Structure of • In global organizations with multiple business units / locations,
finance function can be centralized under a shared service model,
Finance whereby it will provide support to all business units.
• This leads to significant cost savings as well as better
Function standardization across the globe (covered in detail in next Chapter
5).
 • Ratio analysis is used for comparison, analysis and

Ratio performance measurement purposes. Limitations of

ratio analysis includes:
Non-availability of comparable information

Analysis Difference in accounting policies

Lack of standard formula
 Selected Ratios to be used in Exams:
• P&L Ratios
Sales trend
Gross profit margin %

Ratio Net profit margin %

ROCE
• Balance Sheet Ratios

Analysis Current asset ratio

Gearing
Interest cover
• Efficiency Ratio
Revenue per employees
Long term Decision
Making - Investment
Appraisal Techniques

Once all costs and benefits of the project have been

listed, then these are compared to see if the
investment in project is financially beneficial
(investment appraisal). In a typical project, there would
be substantial cash outflow in the start in anticipation
of long-term cash inflows. Hence careful investment
appraisal is done as huge amounts are involved and it
becomes difficult to pull out in the middle. Following
are commonly used investment appraisal techniques:
 Payback Period
• Determines the time (e.g., number of years) the company can recover its initial investment in
the project. This method is based on the cash flows. The lower the payback period, the
better.

Advantage:
Easy to calculate and understand
Emphasis on cash liquidity of a project, i.e., earlier the recovery of initial investment, the
better
Can be used for preliminary screening of options.

Disadvantage:
Ignores cash flows after the payback period (i.e., ignores the profitability of the project)
Ignores the amounts involved and only focuses on the time period (years)
Ignores inflation aspects
 Accounting Rate of Return (ARR)
• Determines the % return on investment (based on accounting numbers and not cash flows). There
are numerous formulae to calculate ARR. The formula adopted by a company to calculate ARR
should be consistently applied to all projects, in order to enable correct comparison.
The higher the ARR, the better.
Advantage:
Easy to calculate and understand.

Disadvantage:
Ignores the timing of cash flows
Ignores the 'amount' of the return
Ignores inflation aspects
 Discounted Cash Flows - Net Present Value
(NPV) & Internal Rate of Return (IRR)
DCF 'discounts' the cash flows of the project by using an appropriate ‘hurdle rate %’

‘Hurdle rate %’ takes into account:

• Time value of money (inflation)
• Cost of funds (if money is borrowed)
• Interest foregone / opportunity cost
• Level of risk
Discounted Cash Flows - Net Present Value
(NPV) & Internal Rate of Return (IRR)

DCF is based on cash flow basis (i.e., relevant costing)

There are two methods of investment appraisal using DCF
• Net present value (NPV) - gives the final profit / loss of the project in AMOUNT
• Internal Rate of Return (IRR) - gives the final profit / loss of the project as a PERCENTAGE
 Discounted Cash Flows - Net Present Value
(NPV) & Internal Rate of Return (IRR)
Some characteristics of NPV
• A positive NPV means profit
• The higher the NPV, the better
Some characteristics of IRR
• It is the % rate at which the NPV is zero
• The higher the IRR, the better
• If the IRR is higher than your target rate of return, you will accept the project.
• NPV is more preferred than IRR, especially if the scale of investment is same / similar.
 Discounted Cash Flows - Net Present Value
(NPV) & Internal Rate of Return (IRR)
Advantage:
• Focuses on cash flows
• Considers the time value of money, cost of funds, desired profitability and risks
Disadvantage:
• Difficult to ‘reliably’ estimate long-term cash inflows and outflows
• Does not consider ‘qualitative’ or ‘non-quantifiable’ benefits
• Difficult to calculate and understand.
EXAM TIP FOR FINANCIAL PROJECTIONS
GIVEN IN THE SCENARIO

• In the case study, make sure that below 3 things are

covered for any financial projection data.
• In case any step is missing, then identify that step in
your answer / analysis:
The projections is based on cash flow (and not
accounting flow).
The cash flow is discounted (if over one year).
Sensitivity / what-if analysis is done.
 Expected Values and
Decision Trees
Expected Values
• Expected Values (EV) is the weighted average value
based on probabilities.
• E.g., : Say, a new product research will cost $150 M and
it is expected that if the product becomes successful,
the income would be $200 M (80% chance) and if the
product is not successful, then the income would $30
M (20 % chance). Hence the expected value would be
($200 M X 80%) + ($ 30 M X 20%) = $166 M (i.e.,
weighted average).
Decision Trees
• Decision trees are diagrams which shows possible
outcomes (probabilities) along with their monetary
outcome and Expected Values.
 Expected Values
and Decision Trees

Short coming of a decision tree:

It uses probabilities, which by
nature are subjective and difficult to
determine.
The costs/benefits are also
estimated, so too much estimation /
subjectivity involved
Just considers quantitative aspects
and ignores qualitative aspects.
Short Term Decision
Making –
Marginal / Relevant
Costing Techniques
Breakeven Analysis / Cost-Volume-Profit Analysis (CVP)
• Breakeven means where sales revenue equals total costs, i.e., no
profit no loss position
• Contribution Margin = Sales Price per unit – Variable Cost per unit
• Breakeven volume/quantity is calculated by:
FIXED COSTS/CONTRIBUTION MARGIN PER UNIT
 Marginal Analysis /
Relevant Costing

• When decision making is done between

two options, only “incremental”
revenue and “incremental” costs
should be considered, i.e., existing fixed
costs should not be considered, if it is
not changing. This is known as marginal
analysis or relevant costing. This
technique is useful in four key areas of
decision making.
 Marginal Analysis /
Relevant Costing
1. Accepting / Rejecting Special Contracts
• ABC Ltd manufactures photo frames. The
fixed cost for operating the workshop is $
600 per month. Each frame requires
material of $ 2. Each frame requires one
hour to make, and labour is paid $ 12 per
hour. The frames are sold for $ 17.
• The labour currently has some spare time
available, and an overseas retail chain has
requested an order of 400 frames at a
price of $ 15. Should the business accept
the order?
 Marginal Analysis /
Relevant Costing Product A Product B Product C

2. Efficient Use of Scarce Resources Selling price per 25 20 23

unit ($)
• When the resources are scarce or
limited (e.g., production capacity), Variable cost per 9 5 11
then those products are manufactured unit ($)
first which have the “highest Contribution margin 16 15 12
contribution margin per limiting factor”
Machine time per 4 3 4
• A business makes three different unit (hours)
products, as follows:
Weekly demand 25 20 20
(units)
• Fixed costs are not affected by the
choice of product. Machine time is
limited to 148 hours per week. Which
combination of products should be
manufactured if the business is to
produce the highest profit?
 Marginal Analysis /
Relevant Costing MAKE
3. Make or Buy Decisions
• Shark Ltd needs a component for one of its
product. It can purchase the components
BUY
from Ray Ltd for $ 20 each, or it can produce
them internally for total variable cost of $ 15
per component. Should the component be
produced internally or purchased from Ray,
IF:
• A- If Shark Ltd has spare capacity available
• B- Is Shark has no spare capacity and could
only produce the component internally by
reducing its output of another of its
products, whose contribution margin is $ 6.
 Marginal Analysis / Cat Cat Cat
Relevant Costing Food Toys House
TOTAL

Sales revenue 254 183 97 534

4. Closing or Continuation Decisions
Mog Town Ltd is a retail shop with 3 Variable cost 167 117 60 344
departments all located on the same premises,
occupying similar space. Below is the annual Contribution 87 66 37 190
P&L of the 3 departments along with total for margin
the company as a whole:
Fixed cost 46 46 46 138
(rent)

Profit / (loss) 41 20 -9 52

Should we close Cat House department as it is

incurring losses, so that our profits can increase
by $ 9000?
 Decision Making
- Financial Reporting & Tax
 • Decision making techniques are generally based
on ‘cash flows’ rather than accounting profit.
• This is because using cash flows are more
Decision objective and harder to manipulate than profits.
Making and • However, shareholders focus on profitability,
which is based on accrual basis for accounting.
Financial • In long term, the cash impact and profit impact
Reporting of the decision would be same, but in short term,
the profit and cash flow is likely to be different
from each other, due to timing differences
between cash flow accounting and accrual-based
accounting, e.g.. capital expenditure
 • Shareholders tend to react more on profitability
Decision rather than change in cash flows.
• f a decision adversely affects current profitability,
Making and it will reduce the EPS and the share prices in short
Financial term.
• Hence decision makers need to consider the
Reporting impact of major decisions on short term
profitability / financial statements so that
appropriate disclosures could be made in the
financial statements in order to give shareholders
the long-term perspective.
 • Another factor may be the tax implications of the
decision. In addition to the normal tax rate being
applied on the project, the decision may have “more
than normal” tax impact on the overall organization,
Decision such as:
The decision may move the organization into another
Making and tax bracket
Tax The decision may change organization’s eligibility of tax
relieve (either favorable or unfavorable)
Implications
The decision may impact the timing of tax payments as
tax is based on profits and not cash
These factors become further factors for decision makers
to consider over and above the simple outcomes from
relevant costing or investment appraisal analysis.
Budgetary
Process
 Introduction

• Budgets are plans expressed in financial

terms. It converts strategic plans into
specific financial targets. Once prepared,
budgets should be closely monitored
against actuals (i.e., variance analysis) to
ensure that planned activities actually take
place.
 Introduction

• Budgets are important to control the

organization as they provide a yardstick
against which actual performance is
assessed.
Period Budget is prepared for one year
– e.g., January to December 2011
Rolling Budget is budgets which is
continuously updated for the next 12
months
Master Budgets
• Budgets are prepared for each department
and then summarized in Master Budget.
Usually, Sales Budget is prepared first and
then other budgets are prepared on the
basis of Sales Budget, such as production
budget, raw material / purchase budgets,
cash flows, etc.
Flexed Budgets
• Flexed budgets are revised budgets based
on actual sales trend. In case the budgeted
sales is not achieved, then production and
expenses budget are revised based on
actual sales volume. This helps in analyzing
the performance of all departments in light
of the lower sales
Advantages of Budgets
Promotes forward thinking
Helps to coordinate various functions of the
Organization
Having defined targets can motivate
managers
Control and performance measurement
tool
Limitations of Budgets
Unrealistic targets
Short term focus
May encourage Malpractice or Unethical
practice
Effective Budgetary Controls Depends
On:
Senior management takes the budgetary
process seriously
Targets should be realistic and achievable
Clear responsibility and accountability
should be affixed
Regular comparison of budget versus
actuals along with investigation of the
variances, reasons and corrective measures.
Usually, this activity is done monthly or
quarterly
Standard Costing
Standard Costing:
Standard costing means estimating
total costs based on pre-determined
unit cost
Variance:
Difference between total estimated
costs and total actual costs
Variance Analysis:
Analysing and investigating the
variances
 Sales Variances
Sales Price Variance:
(Actual Selling Price – Standard Selling Price) X Actual
Quantity
Possible Reasons for Unfavorable Sales Price Variances:
Selling price has been lowered due to tough market
conditions or due to increase market share
(Price penetration strategy)
Sales Volume Variance:
(Actual Sale Quantity – Standard Sale Quantity) X Standard
Selling Price
Possible Reasons for Unfavourable Sales Volume Variances:
Poor performance by sales staff, poor quality of our product
leading to lower customer demand, competitor has launched
a new or better product, etc.
 Material Variances
Material Price Variance:
(Actual Unit Cost – Standard Unit Cost) X Actual Quantity
Possible Reasons for Unfavourable Material Price Variances:
Increase in prices of materials due to shortage, better quality
raw material is being is used, poor performance by purchase
department staff, etc.

Material Usage Variance:

(Actual Usage Quantity – Standard Usage Quantity) X
Standard Unit Cost
Possible Reasons for Unfavourable Material Usage Variances:
Poor performance of production staff, substandard raw
materials, faulty machinery or production process
 Direct Labour Variances
Labour Rate Variance:
(Actual Labour Rate – Standard Labour Rate) X Actual Labour
Hours
Possible Reasons for Unfavourable Labour Rate Variances:
Increase in labour prices due to shortage of labour, better
quality / high-skill labour is being is used, poor performance by
HR staff in negotiating prices, etc.

Labour Efficiency Variance:

(Actual Labour Hours – Standard Labour Hours) X Standard
Labour Rate
Possible Reasons for Unfavourable Labour Efficiency Variances:
Poor supervision, untrained / low-skill labour, poor quality raw
materials is being used, faulty machinery or production process,
delay in supply of raw materials, etc.
 Fixed Overheads Variances
Fixed Overhead Variances
Actual Fixed Overheads – Flexed Fixed Overheads
Flexed means that the budgeted overheads are recalculated
based on actual production volume and then compared to
the Actual Fixed Overheads (in order to have apple to apple
comparison). Here the concept of fixed and semi-fixed costs
are considered.
Possible Reasons for Unfavourable Fixed Overheads
Variances:
Poor supervision of overheads, general increase in costs not
considered in the budget.
Standard Costing
Advantages of Standard Costing
Helps in accurate budgeting
Provides a yardstick to measure
actual costs
Having defined standards improves
performance as staff will make efforts
to achieve the standards
Limitations of Standard Costing
Can only be used for routine or
repetitive processes
Standards can quickly become
outdated, hence regular monitoring
and updation is required.
Forecasting
Techniques
QUALITATIVE TECHNIQUES:

Delphi Technique:
• Panels of experts are selected and each of
them produces an independent forecast.
Then the forecasts are shared and then
revised forecast is produced. The process
continues until they are all in agreement
with one set of forecast
Sales Force Opinions:
• Input is gathered from the sales force
based on their market knowledge and then
converted into an aggregate forecast
QUALITATIVE TECHNIQUES:

Executive Opinions:
• Input is gathered from various high
executives based on their own knowledge
and then converted into an aggregate
forecast.
Market Research:
• Involves use of customer surveys to
evaluate potential demand.
QUANTITATIVE TECHNIQUES:
Least Square or Linear Regression Analysis
It uses the ‘line of best fit’ approach to find out
the relationship / trend between two variables.
One variable is independent (X) and another
variable is dependent (Y). For e.g., in sales data,
X can be the quarter (on X axis) and Y can be the
Amount of Sales (on Y axis). Least square
Analysis is based on an equation Y = a + bX,
where:
X = independent variable
Y = dependent variable
a = where the line intercepts Y axis on the graph
b = the gradient of the line
The above equation is used to predict the sales
value for next quarter
QUANTITATIVE TECHNIQUES:

Correlation Coefficient (R)

The correlation coefficient (R) shows strength of
relationship between the two variables, i.e., how
much Y is dependent on X. The value of
correlation coefficient (R) ranges from -1 to 1
and will be given in the question. For e.g., the
correlation coefficient can be 0.3. The coefficient
of determination (R2) shows that only 9% (0.32)
of the variation in sales (Y) is due to passage of
time (X).
QUANTITATIVE TECHNIQUES:
Correlation Coefficient (R)
If correlation coefficient (and determination) is
low (say <0.7), then it means that Y is not highly
dependent on X and there is a lot of seasonality
factor involved in the sales trend. If correlation
coefficient (and determination) is high (say >0.7),
then it means that Y is highly dependent on X
and it will be easy to predict Y based on X.
Least Square Analysis Is Appropriate, Where
Correlation coefficient is high (say >0.7)
There is low seasonality affect in the sales
trend
Large pool of historic data is required e.g.,
annual sales data.
QUANTITATIVE TECHNIQUES:
Time Series Analysis
A Time Series Analysis uses moving average to
define a trend. It identifies the seasonal
variations from data in order to determine the
underlying / actual trend. In time series, X-axis
will always represent time (e.g., years, quarters,
months, weeks, etc.).

Time Series Analysis Is Appropriate Where

Correlation coefficient is high(say>0.7)
There is high seasonality affect in the sales
trend