Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
402: Strategic Management Accounting
Course Teacher:
Md.Monowar Hossain
MBA,FCIA,CIPFA(UK), FCPA,FCS,ACA,FCMA
GM & Head of Internal Control and Compliance (ICC)
AGRANI BANK LIMITED
Email: md.monowar@gmail.com
Page # 2
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
First edition : August - 2015
Second edition : October - 2015
Third edition : March – 2016
Fourth edition : October-2016
Subject Code :SMA 402 Strategic Management Accounting
Professional Level –IV
Course Objectives:
To provide the students with an in-depth knowledge of management accounting to make them competent to prepare
and analyses accounting data, apply it to a range of planning, control and decision-making situations and adopt it to
accommodate changes. On completion of this course they will be able to:
a.
b.
c.
d.
e.
apply management accounting techniques in planning, control and decision-making situations.
apply and evaluate alternative methods of investment appraisal.
apply and evaluate techniques for allocating and managing resources.
discuss and evaluate performance of strategic management accounting decisions.
apply quantitative models for management planning and control.
Class Plan
Class
No.
01
02
&
03
Code
Topics
402.01
Capital Budgeting
402.02
Advanced Capital
Budgeting Topics
Details
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
04
402.03
Responsibility
Accounting and
Transfer Pricing
in Decentralized
Organization
05
&
06
402.03
Responsibility
Accounting and
Transfer Pricing
in Decentralized
Organization
(continuing)
07
402.04
Measuring
Organizational
Performance
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
Capital Budgeting- An Investment Concept;
Capital Budgeting Process;
Cash Flow Estimation;
Capital Budgeting Evaluation Methods:
(i) Discounted Cash Flow Methods and
(ii) Non-discounted Cash Flow Methods;
The Ranking of Investment Projects;
Post-investment Audit.
The Effect of Depreciation on After-Tax Cash Flow;
Sensitivity Analysis for Capital Budgeting Decisions Under
Uncertainty;
Inflation in the Capital Budgeting Process;
Ranking Multiple Capital Projects;
Ranking Projects Under Capital Rationing;
Capital Budgeting in the Contemporary Manufacturing
Environment;
Strategic Cost Management and Capital Budgeting;
Behavioral Issues in Capital Budgeting.
Decentralization;
Advantages and Disadvantages of Decentralization;
Responsibility Accounting System;
Types of Responsibility Centres;
Traditional vs. Contemporary Responsibility Accounting;
Limitations of Traditional Responsibility Accounting:
Activity Based Management.
Transfer Pricing: Transfer Price;
Objectives of Transfer Price;
Transfer Pricing Methods:
(i) Cost-Based Transfer Prices,
(ii) Market-Based Transfer Prices,
(iii) Negotiated Transfer prices,
(iv) Dual Transfer Pricing;
Choosing the Right Transfer Pricing Method;
Transfer price for Service Departmens;
Multinational Transfer pricing;
Behavioral Implications of Transfer Pricing.
Traditional Financial Performance Measures:
Divisional Profits,
Cash Flow,
Return on Investment,
Residual Income;
Page # 3
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
08
402.05
Total Quality
Management
09
402.06
Managing
Productivity
10
402.07
Inventory
Management and
JIT
11
402.08
Quantitative
Models for
Planning and
Control
12
402.09
Management
Control
13
&
14
402.10
The Balanced
Scorecard,
Benchmarking,
EMA and Six
Sigma
34. Limitations of Traditional Methods for Evaluating Segment
performance;
35. Non-financial Performance Measures;
36. Throughput as a Non-financial performance Measure;
37. Activity-Based Costing and performance Evaluation;
38. Performance Evaluation in Multinational Selling.
39. Definition of Quality;
40. TQM Implementation Guidelines;
41. Types of Conformance;
42. Costs of Quality43. Types of Quality Cost (QC),
44. Distribution of QC,
45. Reporting Quality Costs;
46. TQM in Service Organizations;
47. TQM and Management Accountants.
48. Definition Productivity;
49. Measuring Productivity: Partial and Total;
50. Measuring Changes in Activity Efficiency:
51. Activity Productivity Analysis,
52. process productivity Analysis;
53. Quality and Productivity.
54. Pull-System,
55. Setup and carrying costs,
56. The JIT Approach,
57. Due-date Performance,
58. The JIT Solution,
59. Avoidance of Shutdown and Process Reliability60. The JIT Approach;
61. Discounts and Price Increases,
62. JIT Purchasing Versus Holding Inventories;
63. JIT’s Limitations
64. Manufacturing Resource Planning (MRP-II).
65. Linear Programming 66. Effects of Constraints,
67. Linear Programming Requirements,
68. Optimal Solution under LP using Graph and simplex,
69. Critical Path Method;
70. Network Models:
71. PERT;
72. PERT-Cost Analysis;
73. Queuing theory;
74. Decision Tree Analysis;
75. Discounted Expected Value of Decision,
76. Game theory and investment analysis,
77. Transportation model,
78. shadow price and
79. Sensitivity analysis.
80. Definition of Management Control;
81. Objectives of Management Control;
82. Operational Control vs. Management Control;
83. Design of Management Control Systems:
84. Informal Systems and Formal Systems;
85. Open and closed Loop Control System,
86. Feedback:
87. Positive and Negative Feedback;
88. Behavioral Aspects of the Control process.
89. Balanced Scorecard:
90. Measuring Total Business unit performance –
91. The BSC –
(i) Financial perspective –
(ii) customer perspective –
(iii) internal business process perspective –
(iv) Learning and Growth perspective.
Page # 4
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
15
402.11
Strategic risk,
Operational risk,
Reporting risk
and Compliance
risk
92. Four perspectives and their sufficiency.
93. Benchmarking:
94. Meaning –
95. Benefits of Benchmarking analysis –
96. Types of benchmarking –
97. Benchmarking process –
98. TQM and Benchmarking –
99. Management accounting for benchmarking.
100. Environmental Management Accounting (EMA) –
101. Six Sigma.
102. Definition and distinguishing among strategic risk, operational
risk, reporting risk, and compliance risk for a given
organization.
103. The external risks related to the organization's strategic
objectives, the impact of those risks, and the necessity for risk
management.
104. Potential shifts in the external environment and implications of
such shifts for a given organization's exposure to risk.
105. An appropriate risk response strategy, including procedures for
managing risk, for a given organization.
106. Reporting mechanisms for compliance and risk issues (e.g. risk
reporting, whistle blowing) within the context of a given
organization.
107. Methods of measuring organizational performance in relation to
internal operational goals set by the planning and budgeting
function.
Review Class /Exam
Best practices and emerging issues in performance measurement in a given industry (e.g. strategy mapping, target
setting, performance-based budgeting).
Texts Books
1. Advanced Management Accounting 3rd Edition – Kaplan, R. S. and A. A. Atkinson. 1998 (Prentice–Hall).
2. Cost Management: Strategic for Management Decisions - Hilton, R. W., M. W. Maher, and F. H. Selto,
2003.
3. Cost Accounting, - L. Gayle Rayburn (6th edition)
4. Managerial Accounting: R.H. Garrison (10th edition)
5. Management Science - Turburn & Merdith (6th edition)
Reference Books
1. Cost Management - Blocher, Chen & Lin (1st edition) - 1999
2. Cost Management: Hansen and Mowen (4th edition)
3. Cost Accounting: Barfield, Raiborn and Kinney (3rd edition)
4. Introduction to Management Accounting – C.T. Horngren (12th edition)
Page # 5
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
CMA
Professional Level –IV
402: Strategic Management Accounting
Class
No. 1
402.01
Capital
Budgeting
Capital is the stock of assets
that will generate a flow of
income in the future.
Capital Budgeting- An Investment Concept;
Capital Budgeting Process;
Cash Flow Estimation;
Capital Budgeting Evaluation Methods:
Discounted Cash Flow Methods and
Non-discounted Cash Flow Methods;
The Ranking of Investment Projects;
Post-investment Audit.
Capital budgeting - is the planning process for allocating all expenditures that
will have an expected benefit to the organization for more than one year.
Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that
are significant in amount.
Capital budgeting is a process used by
companies for evaluating and ranking potential
expenditures or investments that are significant
in amount. The large expenditures could
include the purchase of new equipment,
rebuilding existing equipment, purchasing
delivery vehicles, constructing additions to
buildings, etc. The large amounts spent for
these types of projects are known as capital
expenditures.
Capital budgeting usually involves
the calculation of each project's future
accounting profit by period, the cash
flow by period, the present value of the
cash flows after considering the time
value of money, the number of years it
takes for a project's cash flow to pay
back the initial cash investment, an
assessment of risk, and other factors.
Capital budgeting is
a tool for maximizing
a company's future
profits since most
companies are able to
manage only a limited
number of large
projects at any one
time.
Capital Budgeting-An Investment Concept:
Investment refers to an outlay of
funds on which management expects a
return. An investment creates value for
shareholders when expected returns
from investment exceed its cost.
Making decisions having
significant future benefits or
costs for various entities and
their stakeholders.
Capital Expenditure
refers to long term
commitment of resources
that provide future benefits
to business.
Why investment is made?
Expansion Plants, Growth Strategies, Capacity Increase
Increase of the efficiency of the manufacturing facilities
Deploying of Fixed Assets, Copy Rights, Franchises, licenses, Patents
Establishing new brands, new lines of business, new products
Opening new offices, new factories, overseas branches
Finance Manager is concerned with Planning
and Financing investment decisions.
Financing Decisions relate to determination
of amount of long term finance and decision
on sources for financing the same.
Investment decisions also termed as "Capital
Budgeting Decisions" involve Cost-Benefit
Analysis.
Investment decisions are based on careful
consideration of factors like profitability,
safety, liquidity, solvency, etc.
Capital Budgeting Decisions
o Cost reduction decisions - (Should a new equipment be
purchase in order to reduce costs?)
o Plant expansion decisions -(Should a new plant,
warehouse, or other facility be acquired in order to
increase capacity and sales?)
o Equipment selection decisions -(Would machine A,
machine B, or machine C be the most cost-effective?)
o Lease or buy decisions - (Should new plant facility be
leased or purchased?)
o Equipment replacement decisions - (Should old
equipment be replaced now or later?)
Page # 6
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
Screening decisions – whether the proposed
project meets some preset standards of
acceptance
Preference decisions – relate to selecting from among
several competing courses of action
Should we accept the machine?
yes , if cost reduction promises a return of 20%
before tax
Which machine should replace an existing machine on the
assembley line?
Characteristics of Business Investment
•
Most business investments involve depreciable assets - which have little or no resale value at the end of
their useful lives, thus any returns provided by such assets must be sufficient to:
– provide a return on the original investment
– return the total amount of the original investment itself
•
The returns on most business investments extend over long periods of time - the time value of
money techniques must be employed
Time Value of Money
Which account?
Interest 45% capitalized yearly
Interest 40% capitalized quarterly
year 1
X
Beginning
Interest
End
Y
beginning
interest
End
year 2
1,450
1,000
450
1,450
Q1
1,000
100
1,100
Q2
1,100
110
1,210
Page # 7
Q3
1,210
121
1,331
Q4
1,331
133
1,464
1,464
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
Future Value
Present Value
FV = PV ( 1 + i )n
PV = FV / ( 1 + i )
n
FV - Future Value
i – interest rate
n – number of periods
PV - Present Value
i - interest
n – number of periods
Capital Budgeting Process:
1.
2.
3.
4.
Generating ideas—the most important part of
the process.
Analyzing individual proposals—including
forecasting cash flows and evaluating the
project.
Planning the capital budget—this will take
into account a firm’s financial and real
resource constraints; it will decide which
projects fit into the firm’s strategies.
Monitoring and post-auditing—comparing
actual results with predicted results and
explaining the differences. This is very
important; it helps improve the forecasting
process and focuses attention on costs or
revenues that are not meeting expectations.
Complexity of Capital Budgeting Process
The budgeting process needs the involvement of different departments in the business. Planning for capital investments
can be very complex, often involving many persons inside and outside of the company. Information about marketing,
science, engineering, regulation, taxation, finance, production, and behavioral issues must be systematically gathered
and evaluated.
The authority to make capital decisions depends on the size and complexity of the project. Lower-level
managers may have discretion to make decisions that involve less than a given amount of money, or that
do not exceed a given capital budget. Larger and more complex decisions are reserved for top
management, and some are so significant that the company's board of directors ultimately has the
decision-making authority. Like everything else, capital budgeting is a cost-benefit exercise. At the margin,
the benefits from the improved decision making should exceed the costs of the capital budgeting efforts.
Capital budgeting is the allocation of funds to long-lived capital projects.
A capital project is a long-term investment in tangible assets.
The principles and tools of capital budgeting are applied in many different aspects of a business entity’s decision
making and in security valuation and portfolio management.
A company’s capital budgeting process and prowess are important in valuing a company.
Basic principles of Capital Budgeting
• Decisions are based on cash flows.
• The timing of cash flows is crucial.
• Cash flows are incremental.
• Cash flows are on an after-tax basis.
• Financing costs are ignored.
Capital budgeting is the process by which the financial manager decides whether to invest in specific capital projects or
assets. In some situations, the process may entail in acquiring assets that are completely new to the firm. In other
situations, it may mean replacing an existing obsolete asset to maintain efficiency.
During the capital budgeting process answers to the following questions are sought:
• What projects are good investment opportunities to the firm?
• From this group which assets are the most desirable to acquire?
• How much should the firm invest in each of these assets?
Page # 8
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
Components of Capital Budgeting
Initial Investment
Outlay:
It includes the cash
required to acquire the
new equipment or build
the new plant less any net
cash proceeds from the
disposal of the replaced
equipment. The initial
outlay also includes any
additional working capital
related to the new
equipment. Only changes
that occur at the beginning
of the project are included
as part of the initial
investment outlay. Any
additional working capital
needed or no longer
needed in a future period
is accounted for as a cash
outflow or cash inflow
during that period.
Net Cash benefits or
savings from the
operations:
Terminal Cash flow:
This component is
calculated as under:(The incremental change
in operating revenues
minus the incremental
change in the operating
cost = Incremental net
revenue) minus (taxes)
plus or minus (changes in
the working capital and
other adjustments).
It includes the net cash
generated from the sale of
the assets, tax effects from
the termination of the asset
and the release of net
working capital.
The Net Present Value
technique:
Although there are several
methods used in Capital
Budgeting, the Net Present
Value technique is more
commonly used. Under
this method a project with
a positive NPV implies
that it is worth investing
in.
Example:
A company is studying the feasibility of acquiring a new machine. This machine will cost $350,000 and have a useful
life of 3 years after which it will have no salvage value. It is estimated that the machine will generate operating
revenues of $300,000 and incur $75,000 in annual operating expenses over the useful life of 3 years. The project
requires an initial investment of $15,000 in working capital which will be recovered at the end of the 3 years. The
firm’s cost of capital is 16%. The firm’s tax rate is 25%. Depreciation is not considered.
Solution:
Initial Investment is $350,000
Initial Net Working Capital is $15,000
Present Value of the annual operating cash flow after tax
= ($300,000-$75,000) x (1-0.25) x PVIFA(16%,3years)
= $225,000 x 0.75 x 2.2459
= $378,996
Note: The number 2.2459 can be obtained by using an ordinary calculator. Procedure to be followed:
For Year 1, divide 1 by 1.16 = 0.8621
For Year 2, the calculator screen shows 0.8621, press the = key, you will get 0.7432
For Year 3, the calculator screen shows 0.7432, press the = key, you will get 0.6406
Add up all the three to get 2.2459
Since the asset will not have any salvage value at the end of the third year we need not calculate the Present Value.
Present Value of the net working capital at the end of the project
= $15,000 x PVIFA(16%,3rd year)
= $15,000 x 0.6406
= $9,609
Net Present Value = ($ 350,000) + ($ 15,000) + $ 378,996 + $ 9,609 = $ 23,605
Since the NPV is positive it is feasible to purchase the equipment.
Popular methods of capital budgeting include (1) Net Present Value (NPV),
(2) Internal Rate of Return (IRR),
(3) Discounted Cash Flow (DCF) and
(4) Payback Period.
Page # 9
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
Cash Flow Estimation:
Estimating the cash flows is the most important part of the capital budgeting process. Cash flow estimation
is a must for assessing the investment decisions of any kind.
• New or Expansion Project
• Other Cash Flow Estimation Issues
• Replacement Project
There are two basic types of projects, Expansion
Type of Project
and Replacement. In either of these two, we are
concerned with the additional cash flows that will
be provided.
Expansion
Replacement
For the expansion project, this is straight forward.
For the replacement type project, the additional
In both types of projects we will have three
cash flows are those that occur as a result of the
categories of incremental cash flows:
new project, in other words, the incremental cash
(1) The Initial outlay/investment
flows. From here onwards the term incremental
(2) The Annual after-tax operating cash flows and
will be used in both cases.
(3) The terminal cash flows.
Capital Budgeting Steps
For a potential projecti.
Forecast the project cash flows
ii.
Estimate the cost of capital
iii.
Discount the future cash flows at
the cost of capital
iv.
Find NPV of project = PV of future
cash flows - required investment,
and accept if NPV > 0.
A cost
that has
been
incurred
and may
be
related
to a
project
but
should
not be a
part of
the
decision
to
accept/
reject a
project sunk
cost
The cash
flows that
the asset of
project is
expected to
generate
over its life
incremental
cash flows
The cost of
not
choosing
another
mutually
exclusive
project by
accepting a
particular
project opportunity
cost
•
•
•
The effects
on other
parts of the
firm
externalities
Cash Flow Estimation
Need to estimate incremental after tax cash flows
that the project is expected to generate.
General form: Cash Flow = Incremental Net
Income + Depreciation
Other "special" cash flows
- Initial costs
- Extra ending or terminal cash flows at the end of
the project's expected useful life.
The
specific
cash flows
that
should be
considered
in a
capital
budgeting
decision relevant
cash flows
Page # 10
Externalities
- the effects
on other
parts of the
firm. ex: a
loss of sales
in one retail
store
because
another
store opens
in the same
area
Relevant
Cash flows
- specific
cash flows
that
should be
considered
in a
capital
budgeting
decision.
only cash
flows that
change if
the project
is
accepted
should be
included
un the
capital
budgeting
analysis. A
sunk cost
is an
irrelevant
cash flow
October 17, 2016
The
problem
with
using a
risk
adjusted
cost of
capital
when
trying to
adjust for
projects
that are
more
risky or
less risky
than a
firms
average
project is
that these
adjustmen
ts are
extremely
subjective
and
difficult
to justify
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
Basic Principles of Cash Flow Estimation
Incremental principle:
The cash flow of a project
must be measured in
incremental terms.
To ascertain a project's
incremental cash flow one has
to look at what happens to the
cash flows of the firm with the
project and without the
project. The difference
between the two reflects the
incremental cash flows
attributable to the project.
In estimating the incremental
cash flows of a project, the
following guidelines must be
consider in mind:
• Consider all incidental
effects
• Ignore sunk costs
• Include opportunity
costs
• Question the allocation
of overhead costs
• Estimate working
capital properly
Separation principle
There are two sides of a project:
(1) The investment (or asset) side
(2) The financing side
The cash flows associated with these sides
should be separated.
Example: Suppose a firm is considering a
1 year project that requires an investment
of $1,000 in fixed assets and working
capital at time 0. The project is expected to
generate a cash inflow of $ 1,200 at the end
of the year 1 (only cash flow). The project
will be financed entirely by debt carrying
an interest rate @ 15% and maturity after 1
year. Assume that the project is in tax free
sector.
Financing side:
Investment side:
Time Cash flow Time Cash flow
0
+ 1,000 0
- 1,000
1
- 1,150 1
+ 1,200
Cost of capital :
Rate of Return :
@15%
@20%
Post-tax
principle
Cash
flow
should be
measured
on an
after-tax
basis.
This is
used to
bring out
the
project
cash
flows
with
accuracy.
Consistency
principle
Once you
adopt an
accounting
principle or
method, you
should
continue to
follow it
consistently
in future
accounting
periods.
Initial investment: Long-term funds invested in the project.
This is equal to:
Fixed assets + working capital margin (this represents the portion of current assets
supported by long-term funds).
Operating cash inflow:
Profit after tax+ Depreciation + Other noncash charges + Interest on long-term
borrowings (1-Tax Rate).
Terminal cash inflow:
Net salvage value of fixed assets + Net recovery of working capital margin.
Initial outlay
What is the cash flow at "time 0" ?
General Steps:
(Purchase price of the asset)
Add:( shipping and installation costs)
(Depreciable assets)
Add: (Investment in working capital)
Net Initial Outlay
Page # 11
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
For expansion projects, this will consist of the cash flows resulting from acquiring the new asset and will
consist of:
(1) The Purchase price of the new asset
(2) Installation costs of the new asset e.g. transportation, shipping, handling etc.
(3) Increases in working capital requirements e.g. inventory i.e. raw materials, finished goods etc.
(4) After-tax non-capital expenditures e.g. costs to train employees to operate asset
(5) Investment tax credit (ITC) given by government due to the nature of the company's business.
(This ITC could be given at any time during the project's life).
Note - the sum of the cash flows at (1). And (2). above is equal to the recorded value of the new
asset in the company's books. (i.e. the value at which the asset will be depreciated).
For the replacement project, we would also have to incorporate:
(6) those after-tax cash flows resulting from the sale of the existing asset. This is determined as
follows:
(1)Proceeds of sale.
(2)Less: Current Book Value.
(3)Profit/Loss
(4)Less: Tax/Tax Credit
(5)Profit/Loss after tax
(6)Add: Current Book Value
xxxxxxxx
xxxxxxxx
xxx/(xxx)
xxx/(xxx)
xxx/(xxx)
xxxxxxxx
(7)After tax cash inflow (5) + (6)
xxxxxxxx
OR
(1) Proceeds of sale
xxxxxxxx
(2) Less: Current Book Value xxxxxxxx
(3) Profit/Loss
xxx/(xxx)
(4) Tax/Tax Credit
xxx/(xxx)
(5) After tax cash inflow (1) - (4)
xxxxxxx
Investment in Net Operating Working Capital
Working Capital (net) = Current Assets - Current Liabilities
Most new projects require additional short-term (current) assets and often additional current
liabilities, such as
Additional receivables from increased credit sales.
Additional inventories (raw materials) necessary to produce additional new products.
Additional trade credit (accounts payables) and taxes and wages payable.
Any needed increase in Net Working Capital is an outflow of cash, but these outflows are
recovered by the end of the project.
Annual after-tax operating cash flows ( ^ = incremental and T = Tax rate)
These cash flows occur on a yearly basis throughout the life of the new project. In practice, the yearly cash
flows will not be constant but will more likely increase due to inflation. However, unless otherwise stated,
we are assuming that the yearly cash flows will be constant.
(1)
^ Revenues
....xxxxxxxx
(2)Less: ^ Costs
xxxxxxxx
(3)Less: ^ Depreciation
xxxxxxxx
(4)
^ Profit before Tax
xxxxxxxx
(5)Less: ^Tax
xxxxxxxx
(6)
^ Profit after Tax
xxxxxxxx
(7)Add: ^ Depreciation
xxxxxxxx
(8)After tax cash flow (6) + (7)
xxxxxxxx
OR
(1)
(^ Revenues - ^ Costs)(1 - T) .
....xxxxxxxx
(2) Add: (^ Depreciation)(T) .
xxxxxxx
(3) After tax cash flow (1) + (2)
xxxxxxx
Note - Interest expenses are not to be included as costs. In other words, they are not to be deducted
from ^ Revenues when determining ^ Profit before tax (as normal accounting rules stipulate).
Page # 12
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
To do this would be double counting as interest expense (cost of debt) is already accounted for in the cost of
capital (which is used to discount the cash flows).
Terminal cash flows
For both the expansion and replacement projects this will comprises of those cash flows that occur as a result
of termination of the new project. These may include:
a. The after-tax cash flows resulting from the sale of the new asset (calculation is similar to above, see
Initial outlay)
b. Recovery of working capital, i.e. the working capital cash outflows experienced in the initial outlay
will be recovered
c. Any other after-tax clean-up costs
Other types of cash flows:
1. Sunk costs
These are cash outflows that have already occurred and therefore do not affect the capital budgeting decision.
2. Opportunity costs
In Economics, this is referred to as benefits foregone. In other words, opportunity costs are benefits that
are not going to be achieved due to a particular action/decision. These must be accounted for in the capital
budgeting decision as cash outflows, on an after-tax basis.
In a replacement project analysis, we assume that the existing asset will be sold and the new asset bought.
However, if that 'old' asset were kept in operation until the end of its useful life, the company may have been
able to receive some cash by selling it afterwards. If such a salvage value existed, then the company would
not be able to fetch this amount if they went ahead and replaced the old asset with the new one. Therefore, the
after-tax effects of this opportunity cost would have to be incorporated in the analysis. Using this example of
the asset's foregone salvage value, the procedure for determining the after-tax effect would be identical to that
mentioned earlier (see Initial outlay above), except that the result would be an after-tax cash outflow.
3. Externalities
In Economics, this refers to the effects of a project on other parts of the firm/company. If the increased
revenues or the cost savings derived by a new project result in decreased revenues for other existing
projects/products in a company, this effect must be factored into the capital budgeting process. To account for
this, the decreased revenues of the existing project/products must be applied to offset/ reduce the
increased revenues of the new project (or be treated as increased costs of the new project).
Alternatively, the increased revenues or the cost savings derived by the new project could result increased
revenues for other existing projects/products in a company. In this case, the increased revenues of the
other existing projects/products would be treated as additional increased revenues for the new project.
For expansion, replacement or new project analysis, incremental effects on revenues and expenses must
be considered.
Careful estimation and evaluation of the timing and magnitude of incremental cash flows is very
important.
Important issues to be kept track of:
Sunk cost
Opportunity cost
Erosion
Synergy gains
Working capital
Capital expenditures
Depreciation or cost recovery of assets
Q1) How can the senior management play an active role in cash flow estimation?
Ans. The senior management should play an active role in coordinating the activities of the various
departments. This is because the final cash flow is prepared on basis of the inputs provided by various
departments. The purchase and engineering departments may give estimates of initial investment involved.
Marketing and product development teams may give sales forecasts. Production personnel, cost accountants,
tax experts etc may give an estimate of operating costs. Apart from coordination, the senior management has
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October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
to ensure consideration of all important factors. An important responsibility is to ensure that no deliberate
bias is built into the cash flow estimation exercise.
Q2) What are the errors that are typically found in estimation of cash flows?
Ans. In simplified terms, the two types of errors found are underestimation and overestimation of cash
flows. These may be done deliberately or unintentionally. As the term indicates underestimation means
being conservative in estimation. Excessive underestimation of the cash inflows after project implementation
should be avoided as one will not get a true picture. Consequently, the firm may end up rejecting even good
projects. A conscious effort should therefore be made at avoiding underestimation.
Q3) What are the instances of underestimation of cash flows?
Ans. An example is when one ignores the intangible benefits arising due to the project like brand loyalty,
market position etc. Often this occurs as it is difficult to estimate and quantify intangible benefits. Difficulty
in estimation can also be cited as the reason for another type of underestimation when one ignores strategic
payoffs. Typical examples of such strategic payoffs are the opening up of new markets or investment
opportunities consequent to the concerned project being undertaken. Underestimation of cash flows also
occurs when one underestimates the salvage value of the project.
Q4) What is salvage value of the project?
Ans. One of the key assumptions in project finance is that all assets have a useful life. At the end of the
useful life, the assets are sold at salvage value. Thus in simplified terms, salvage value means recoverable
value. Generally, the net salvage value of fixed assets is assumed to be only 5% of the original value. This is
because the value of the fixed assets is assumed to depreciate (lose value) over a period of time due to wear
and tear. However, in reality, the actual value realised (salvage value) is higher than the assumed 5%. Thus
this assumption of salvage value often leads to underestimation. At the same time one should also be careful
that there is no overestimation of cash flows.
Q5) What are the causes of overestimation of cash flows?
Ans. The common reason for overestimation is that as one tends to be emotionally attached to the project.
Under such circumstances a person tends to ignore the risks attached to the project and focuses excessively
on the positive aspects of the project. These types of errors can be avoided when the project is screened by
more than one person. Another unfortunate reason for overestimation is the intentional over-statement of the
benefits of the project. This is quite common when one has to choose from many projects due to lack of
finance. Again the experienced senior management can assist in solving both these problems of over and
under estimation effectively.
Page # 14
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
Q6) How can these problems of over and under estimation be effectively solved?
Ans. Often lack of experience is the reason for both overestimation and underestimation of the cash flows.
This is exactly where the senior management can contribute effectively by using their valuable experience.
The senior management should ensure that the estimates are based on a set of consistent assumptions. In
practice, overestimation is far more common than underestimation of cash flows. In such circumstances, it is
useful to subject the project to sensitivity analysis as a final step in evaluation.
Q7) What is sensitivity analysis?
Ans. In simplified terms, sensitivity analysis refers to situations when things go wrong. Sensitivity analysis
can be carried out by identifying three (some analysts assume five) most critical assumptions. Typically, one
of these factors is sales. Other factors could be cost of raw materials, cost of labor, interest rate etc. The
financial model is then checked for negative impacts of these factors. For example, one impact could be drop
in sales by 10%, another could be increase in the cost of raw materials & labor by 10%.
Q8) When will the project pass the sensitivity analysis?
Ans. One should first ascertain the negative impacts of each of the above mentioned factors individually. In
case the project is viable even after considering the same, then the project has passed the sensitivity analysis.
It will be excellent if the project is viable even after considering the negative impact of all these factors
together. In such a case, the project is said to have passed the acid test of sensitivity analysis. An important
step in sensitivity analysis is the identification of industry cost drivers.
Q9) What are cost drivers of an industry?
Ans. All industries have cost drivers. Cost drivers refer to the variables which contribute to a significant cost
of the final product. For example, in case of ferroalloy and allied industries where melting is involved the
cost of power is an important cost driver as it contributes to nearly 55% of the cost incurred in
manufacturing the product. Similarly, in case of IT & financial service companies etc, salaries is a
significant cost element. In case of FMCG industry, selling and distribution expenses are important cost
drivers. Identification of cost drivers can help in identifying the strategic advantage enjoyed by the project.
Problem No. 01
(a) (calculating
working capital required)
The amount of working capital required by a company can be estimated from information on the value of
relevant working capital inputs and outputs, such as raw material costs and credit purchases, together with
information on the length of the components of the cash conversion cycle.
Assume that Muttakeen plc expects credit sales of US$18m in the next year and has budgeted production
costs as follows:
US$ m
Raw materials
4.00
Direct labour
5.00
Production overheads
3.00
Total production costs
12.00
Raw materials are in inventory for an average of three weeks and finished goods are in inventory for an
average of four weeks. All raw materials are added at the start of the production cycle, which takes five weeks
and incurs labour costs and production overheads at a constant rate. Suppliers of raw materials allow four
weeks’ credit, whereas customers are given 12 weeks to pay. The production takes place evenly
throughout the year.
Required: Calculate the total working capital requirement?
(b) (Evaluating a change in trade receivables policy)
Muttakeen plc has annual credit sales of $15m and allows 90 days’ credit. It is considering introducing a 2%
discount for payment within 15 days, and reducing the credit period to 60 days. It estimates that 60% of its
customers will take advantage of the discount, while the volume of sales will not be affected.
The company finances working capital from an overdraft at a cost of 10%.
Is the proposed change in policy worth implementing?
Page # 15
October 17, 2016
Class Note: 402:SMA
By Md.Monowar Hossain, FCMA,CPA,FCS,ACA
md.monowar@gmail.com
Problem No. 02 [Expansion type project}:
FYR is considering the purchase of an industrial incubator for the production of day old chicks. The firm does
not currently own such a machine. A consultant was paid Tk.250,000 six months ago to estimate the relevant
cash flows which are summarized as follows:
The incubator would save Tk.500,000 per year in costs and provide additional revenues of Tk.400,000
annually. It would cost Tk.1,400,000 and installation and shipping costs would amount to Tk.300,000 and
Tk.100,00 respectively. FYR would need to train its staff to operate the incubator at an after-tax cost of
Tk.200,000. The firm would also need to increase its stock of eggs at the hatchery by Tk.500,000. The
company plans to issue debt to fund the project and this will increase interest expenses by Tk.465,000 per
year. The machine will be depreciated towards a salvage value of Tk.400,000 over its useful life of 5 years. At
the end of the machine’s useful life it is expected that it can be sold for Tk.500,000. The NBR will also give
the firm a tax credit of Tk.74,993 at the end of the project as agreed with the firm for partial recovery of import
duties. FYR has a cost of capital of 20% and a tax rate of 33 1/3 %
Required:
a)
b)
c)
Calculate the NPV.
Calculate the PI of the project?
Should the project be accepted? Why or why not?
Problem No. 03 [Replacement type project]:
A local juice making company with a cost of capital of 15% and a marginal tax rate of 34%, is considering
replacing the current hand-operated machine with an automated machine. The following information is
available:
Existing Situation:
Proposed Situation
Two full-time operators: salaries $12,000 each per year Cost of machine: $55,000
Cost of maintenance: $6,000 per year
Installation costs: $6,000
Cost of defects: $5,000 per year
Cost of defects: $2,500 per year
Original cost of old machine: $40,000
Expected life: 5 years
Expected life: 10 years and Age: 5 years
Expected salvage value: $0
Expected salvage at the end of useful life: $5,000
Depreciation method: straight-line over 5 years
Dep: Straight-line over 10 years down to a value of zero.
Current salvage value: $10,000
Required: Determine the Payback Period and the IRR. Should the automated machine be acquired? Why?
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October 17, 2016