Comprehensive Notes of Financial Management By SHAIR HAIDER MALIK ACCA In the name of Allah The most gracious The

Most Merciful

COMPREHENSIVE NOTES OF

FINANCIAL MANAGEMENT 1ST EDITION

By: Shair Haidar Malik ACCA

All rights are reserved pertaining to the material written. In the case of imitation alleged party will be sued. Copyrights@2013 BY: SHAIR HAIDER MALIK ACCA 1

Comprehensive Notes of Financial Management By SHAIR HAIDER MALIK ACCA

Contents
Introduction .................................................................................................................................................. 3 How to Study? ....................................................................................................................................... 3 ACCA Exam Tips..................................................................................................................................... 3 Why to Study Examiner Articles and Reports? ..................................................................................... 3 What is Investment Appraisal? ..................................................................................................................... 4 Average Rate of Return:............................................................................................................................ 4 Net Present Value: .................................................................................................................................... 5 Internal Rate of Return: ............................................................................................................................ 5 Modified Internal Rate of Return:............................................................................................................. 5 Payback Period:......................................................................................................................................... 6 Discounted Payback Period: ..................................................................................................................... 6

BY: SHAIR HAIDER MALIK ACCA

Comprehensive Notes of Financial Management By SHAIR HAIDER MALIK ACCA

Fresh Start to Financial Management

Introduction
Dear readers if you want to study Financial Management, you must be familiar that investment appraisal is the back bone of financial management. It wouldnt be wrong and unreasonable to tell you that the whole financial management rotates around the investment appraisal. Now the students who are to attempt ACCA paper F9 Financial Management and further intend to appear in P4 Advance Financial Management would certainly get benefit by revising the concepts which are written on the next pages. It would be helpful for the students studying MBA. How to Study? Understand the concepts (Memorize where necessary but with clear understanding) Apply it on your daily life Discus with friends in a comfortable environment ACCA Exam Tips Understand the scenario completely Understand the requirement of question Apply the knowledge carefully Dont go beyond the case Attempt all the questions Why to Study Examiner Articles and Reports? Examiner highlights the failure reasons Key exam tips are conveyed Overall approach of exam is discussed Different important topics are conceptualized and explained

BY: SHAIR HAIDER MALIK ACCA

Comprehensive Notes of Financial Management By SHAIR HAIDER MALIK ACCA

What is Investment Appraisal?

The evaluation of attractiveness and durability of an investment is called investment appraisal. Different following methods are used to appraise an investment; Average rate of return (ARR) Net Present Value (NPV) Internal rate of return (IRR) Modified internal rate of return (MIRR) Payback Period Discounted Payback Period

Average Rate of Return:

It shows the return on investment. Accounting profit is divided by the number of years to get ARR. Before understanding other methods of investment appraisal, we should be familiar with the concept of Time Value of Money. Time Value of Money: Money which is available at the present time is worth more than the same amount in the future due to its potential earning capacity. For example, if money is invested today money will get increased (amount deposited in saving account will earn interest). If simple example is taken, you used to purchase 2 candies against Re.1 seven to eight years ago but now you can purchase only one candy against Re.1, it means Re.1 had more worth than todays Re.1. Inflation and interest impacts are added. Amount you have today is the present value of that amount, the amount equal to todays worth you would have after a year is future value. For example, assuming a 5% interest rate, $100 invested today will be worth $105 in one year ($100 multiplied by 1.05) If it is compounded (present value to future value) for one year, answer will be $105. If it is discounted (future value to present value) then it will result in present value. (Present Value= $105 divided by 1.05, it will be $100).

BY: SHAIR HAIDER MALIK ACCA

Comprehensive Notes of Financial Management By SHAIR HAIDER MALIK ACCA

Net Present Value:

The difference between present value of cash inflows and present value of cash outflow. It is used to analyze the profitability of the project in capital budgeting. NPV compares the value of the money today to the value of the same money in future accounting for inflationary and interests impacts. It simply means what is worth of the amount today which will we get say after five years. NPV shows the actual increase in wealth (in cash terms). If NPV of the project is positive, accept the project. If NPV of the project is negative, reject the project.

Internal Rate of Return:

It is a discount rate used in capital budgeting at which NPV of a project is ZERO. IRR is the rate of growth of a project, it is actual rate of return of the project. Sometimes IRR is referred to as Economic Rate of Return (ERR). If IRR is greater than the rate prevailing in market, accept the project. If IRR is lower than the rate prevailing in market, reject the project. DRAWBACKS: However IRR has some drawbacks. Sometimes IRR gives conflicting answers when compared to NPV of mutually exclusive projects. There may arise multiple IRR issue (More than one IRR may be found). Multiple IRR problem arises, when there are abnormal cash flows. IRR assumes that the cash flow from the project can be reinvested at IRR. To get rid of issues pertaining to IRR, modified method is introduced called Modified Internal Rate of Return (MIRR).

Modified Internal Rate of Return:

Mainly MIRR overcame the major drawback of IRR. IRR assumes that the cash flow from the project can be reinvested at IRR whereas MIRR assumes that positive cash flow is reinvested at the firm cost of capital

Explanation of MIRR and IRR:

For example, say a two-year project with an initial outlay of $195 and a cost of capital of 12%, will return $121 in the first year and $131 in the second year. To find the IRR of the project so that the net present value (NPV) = 0:

BY: SHAIR HAIDER MALIK ACCA

Comprehensive Notes of Financial Management By SHAIR HAIDER MALIK ACCA

NPV = 0 = -195 + 121/ (1+ IRR) + 131/ (1 + IRR)

NPV = 0 when IRR = 18.66%

to calculate the MIRR of the project, we have to assume that the positive cash flows will be reinvested at the 12% cost of capital. So the future value of the positive cash flows is computed as:

$121(1.12) + $131 = $266.52 = Future Value of positive cash flows at t = 2

Now you divide the future value of the cash flows by the present value of the initial outlay, which was $195, and find the geometric return for 2 periods.

=sqrt ($266.52/195) -1 = 16.91% MIRR

You can see here that the 16.91% MIRR is materially lower than the IRR of 18.66%. In this case, the IRR gives a too optimistic picture of the potential of the project, while the MIRR gives a more realistic evaluation of the project.

Payback Period:
It is the length of time required to recover the cost of investment (amount invested). Drawbacks: It ignores any benefit that occurs after the payback period. It ignores time value of money.

Discounted Payback Period:

The number of years taken to recover the initial investment (expenditure). It is same as payback period, the difference is it accounts for time value of money. Cash flows are taken in calculation.

BY: SHAIR HAIDER MALIK ACCA

Comprehensive Notes of Financial Management By SHAIR HAIDER MALIK ACCA

GOOD LUCK HOPE THE CONCEPTS WOULD BE HELPFUL TO YOU 2ND EDITION WILL BE SOON AVAILABLE IN WHICH OTHER CONCEPTS OF INVESTMENT APPRAISAL (COST OF CPITAL AND COST OF DEBT) WILL BE EXPLAINED

BY: SHAIR HAIDER MALIK ACCA