Value chain analysis – Idea was first suggested by Michael Porter in 1985.

It assesses how the perceived value of the customer grows along the
“chain” of activities that the firm goes through to bring its product to the
marketplace. Shanks and Govindarajan’s work in 1993 indicated that the firm itself
Two major categories of business value activities exist:
is a part of the overall value chain of the industry. In this view, the
value starts with the suppliers who provide the raw material for the
Primary activities – Activities involved with the direct manufacture of production process, continues with the firm and its strategic plan,
products, the delivery of the products through distribution channels, and continues further with the value created by the customers, and then
the support of the product that exists after the sale is made. (e.g. ends with the disposal and recycling of the materials.
handling the raw materials, the manufacturing process, taking product
orders, advertising and servicing the product.)

Secondary activities – Activities that are performed by the support staff of

an organization (e.g. accounting, finance, purchasing of supplies and
materials).

When firms must assess every part of the value chain to allow them to
provide their customers with maximum value, they must determine the
parts of the value chain that will provide them with the largest amount of Vertical linkage analysis – It means understanding the activities of
competitive advantage. There are three major forms: the suppliers and buyers of the product and determining where value
Internal cost analysis – The sources of profit and costs of the internal
can be created external to the firm’s operations.
activities within the firm must be analyzed.
The greatest competitive advantage stems from the information
Internal differentiation analysis – The firm may analyze its ability to create obtained from this analysis because of the activities that create the
value through differentiation when the customer perceives that the firm’s most and least amount of value can be determined.
product is superior to those of its rivals.

Vertical linkage analysis – See Index Card

Steps in the Value Chain Analysis include:

1) Identify value chain activities (Value activities are general The three framework strategies in a value chain analysis include:
those processes that are involved with designing, 1) Industry structure analysis
preparing, manufacturing, and delivering a good or 2) Core competencies analysis
service.) 3) Segmentation analysis

2) Identify cost drivers associated with each activity.

3) Develop a competitive advantage by reducing cost or

adding value.
- Costs leadership strategies will look at cost saving
opportunities.
- Differentiation strategies will look at opportunities
for innovation.
Industry structure analysis – Michael Porter’s work in 1980 and
1985 identified five forces that influence profitability for the firm,
and thus, impact the competitive environment of a firm. These Core competencies analysis – It provides answer to why one firm is
five forces include: able to create, attain, and sustain new types of competitive
advantage and profits while another firm always seems to follow or
1) Barriers to market entry why some firms are always able to come up with the best
2) Market competitiveness innovations while others attempt to copy them. It also attempts to
3) Existence of substitute products reveal what it is within the firm that enables it to create advantage.
4) Bargaining power of the customers
5) Bargaining power of the suppliers

Core competencies are the glue that allows a firm to work as a

team and to transfer good ideas from one product or segment of a
business to another.
A competency is deemed a core competency if it has the ability to:
1) Reduce the threat that competitors may copy the
product,
2) Increase perceived customer value, and
3) Provide leverage (i.e. Can a large amount of markets be
assessed?)
Segmentation analysis – When vertical integration exists within a
firm (it is involved in almost every aspect of the firm’s value chain,
from supplying the raw materials to distributions to the ultimate
consumer) and when analysis of the industry structure and the core
competencies varies among the activities in the value chain,
segmentation analysis, which takes a look at the competitive
advantages that exist in the various segments, is often helpful.

When various parts of the value chain exist in different parts of the world,
this often poses problems of costs of transportation and lack of control
and communication, which can negatively impact the overall customer
value. Porter indicated four major factors that impact global competitive
advantage (GCA):
1) Conditions of the factors of production – If the nation has a
strong set of production (e.g. skilled labor force), it will fare better
with regard to GCA.
2) Conditions of domestic demand – If the nation’s domestic
demand for the product is high, the nation will fare better with
regard to GCA.
3) Related and supporting industries – If suppliers or material
inputs exist within the nation, it may help the nation fare better
with regard to GCA.
4) Firm strategy, structure, and rivalry – The practices of a
nation with respect to how companies are managed and
organized, along with the laws of the nation that regulate the
The SCOR Model assists a firm in mapping out its true supply chain
and then configuring it to best fit the needs of the firm and consists
of four-key management processes. They are:
1) Plan – Consists of developing a way to properly balance
aggregate demand and aggregate supply within the goals and
objectives of the firm and plan for the necessary
infrastructure.
2) Source – Procure the resources required to meet it and to
mange the infrastructure that exists for the sources.
3) Make – Includes all activities that turn the raw materials into
finished products that are produced to meet a planned
demand.
4) Deliver – Includes all activities of getting the finished product
into the hand of the ultimate consumers to meet their
planned demand.
 formation of companies and how intense the rivalry is with
respect to competing firms within the nation.

Integrated Enterprise – Management will move away from

simple consolidation of its operations to an internally-integrated
supply chain, which all work together with cross-functional
purposes (rather than simply cross-functional communications)
towards the main business issue of the cost of customer service.
It is essential that the people involved are able to work well as a
team and eliminate bias so that they are all aligned with the goals
of the firm. The firm will focus on the total cost of delivery, being
profitable, and responding to customer needs.
Extended Supply Chain – If integration of the supply chain moves
external to the firm, firms may see potential for increased profits by
unifying the supply chain and forming mutual objectives. The need
for those involved to be able to work as a unified team without bias
is even more essential, as this process strives to integrate the supply
chains of many operations, not just those internally.

Benefits of implementing supply chain management include:

General steps in implementing integrated supply chain management:
1) Reduced costs in inventory management
2) Reduced costs in warehousing 1) Assess the opportunities in the supply chain
3) Optimization of the distribution network and facility 2) Develop a vision for ISCM
locations 3) Develop a strategy for ISCM
4) Enhanced revenues 4) Create an optimum organization structure for ISCM
5) Improved service times 5) Establish an information and communication network for ISCM
6) Strategic shipment consolidation 6) Translate the ISCM strategy into actions
7) Reduced cost in packaging
8) Improved delivery times
9) Integration of suppliers
10) Management of suppliers

A firm must be able to manage its supply chain in way that is
aligned with its business strategy, which is directed at serving the
needs of the consumers of the firm’s products.
The supply chain of a firm must be both responsive to the
changing needs of customers and allow the firm to do so in an
efficient manner. This is essentially the ability of the firm to
increase its market share and protect profits.
Currency option hedges use the same principles as forward hedge
contracts and money market transactions. However, instead of
requiring a commitment to a transaction, the currency option
hedge give the business the option of executing the option
contract or purely settling its originally negotiated transaction
without the benefit of the hedge, depending on which result is
most favorable.
A put option is an option to sell. It is used to mitigate the
transaction exposure associated with exchange rate risk for
receivables.
Generally, if the option price is more than the exchange rate at
the time of settlement, the business will exercise its option. If the
option price is less than the exchange rate at the time of
settlement, the business will allow the option to expire.
While premiums are used to compute any net savings associated
with option transactions, they are a suck cost and are irrelevant to
the decision to exercise the options.
The five supply chain drivers are:
1) Production
2) Inventory
3) Location
4) Transportation
5) Information
A call option is an option to buy. It is used to mitigate the
transaction exposure associated with exchange rate risk for
payables.
Generally, if the option price is less than the exchange rate at the
time of settlement, the business will exercise its option. If the option
price is more than the exchange rate at the time of settlement, the
business will allow the option to expire.
While premiums are used to compute any net savings associated
with option transactions, they are a suck cost and are irrelevant to
the decision to exercise the options.
The nominal cost of hedging a foreign currency is the known
exchange rate for the currency times the underlying.
Example: Assume the cost of the Canadian dollar is $.75. The
nominal cost of hedging C$1,000,000 is known to be $750,000.
The nominal cost of hedging a foreign currency represents the
expected value of a transaction settlement given a range of
exchange rates and associated probabilities.
The real cost of hedging payables is expressed in the following
formula:
RCH = NCH - NC
Terms are defined below:
RCH - Real cost of hedging payables
NCH - Nominal cost of hedging payables
NC - Nominal cost of payables without hedging
Negative results indicate the business should enter into a hedge
transaction, while positive results indicate that the business
should not hedge the transaction.
Limitation of hedging are:
1) Uncertainty – To avoid the potential of overhedging, the
company should only hedge the minimum amount known
to be due or payable.
2) Continual short-term hedging – Consistent short-term
hedging can be ineffective over time because it mirrors the
current trends of the market.
Parallel Loan - Two firms may mitigate their transaction
exposure to long-term exchange rate loss by exchanging or
swapping their domestic currencies for a foreign currency and
simultaneously agreeing to re-exchange or repurchase their
domestic currency at a later date.
The real cost of hedging receivables is expressed in the following
formula:
RCH = NR - NRH
Terms are defined below:
RCH - Real cost of hedging receivables
NR - Nominal domestic revenues received without hedging
NRH - Nominal domestic revenues received from hedging
Negative results indicate the business should enter into a hedge
transaction, while positive results indicate that the business should
not hedge the transaction.
Long-term forward contracts – They deals with the same issues
as any other forwards contracts. Long-term forward contracts are
set up to stabilize transaction exposure over long periods. Long-
term purchase contracts may be hedged with long-term forward
contracts.
Other techniques for transaction exposure mitigation (alternative
hedging techniques) include:
1) Leading and lagging
2) Cross-hedging – Involves those transactions that cannot be
hedged. Hedging one instrument’s risk with a different
instrument by taking a position is a related derivatives
contract.
3) Currency diversification – Simplest hedge for long-term
transactions. Diversify foreign currency holdings over time.

Economic Exposure – It is defined by the degree to which cash
flows of the business can be impacted by fluctuations in exchange
rates. The extent to which revenues and expenses are
denominated in different currencies could seriously impact the
profitability of an organization and represents economic exposure.
Very little can be done to mitigate the generalized risk of
operating within a foreign economy and to changes in the political
climate. However, international companies can perform a country
risk analysis to fully assess the degree of their exposure.
Unsatisfactory evaluation of country risk could either result in
divestiture of foreign operations or avoidance of development of
foreign operations in a particular country.
Country risk analysis for political risk considerations include:
1) Bureaucracies and related inefficiencies or barrier to trade
2) Corruption
3) Host government attitude toward foreign firms
4) Attitude of consumers toward foreign firms
5) Inconvertibility of foreign currency
6) War
Economic exposure typically relate to organization-wide issues and can
usually only be mitigated with organization-wide approaches with involve
restructuring and adjustments to the business plan.
Restructuring
a) Decrease in sales – A company fearful of depreciating foreign
currency used by a foreign subsidiary may elect to reduce foreign
sales to preserve cash flows.
b) Increase in expenses – A company anticipating a depreciating
foreign currency may elect to increase reliance on those suppliers to
take advantage of paying for raw materials or supplies with cheaper
currency.
Restructuring tends to be more difficult than ordinary hedges. Economic
exposures to exchange rate fluctuations are viewed as more difficult to
manage than transaction exposures.
Country risk analysis for foreign economy considerations include:
1) Foreign demand – Weakening demand may cause the foreign
government to implement tariffs or other regulatory
measures that reduce foreign penetration.
2) Interest rates – High interest rates indicate slower economic
growth and reduced demand. Low interest rates may be
indicative of increased growth and demand.
3) Inflation – Higher local inflation and reduced purchasing
power makes imported goods more expensive and reduces
local demand for them.
4) Exchange rate – Weak local currency reduces demand for
imported goods. Strong local currency increases demand for
imported goods.

CAAT – Auditors can use manual audit procedures, computer-
assisted audit techniques (CAAT), or a combination of both.
In either event, because the reliability of automated systems is
highly dependent on the adequacy of control design and
execution, it is critical that the auditor gains a thorough
understanding of the structure and usage of the computerized
control system through inquiry and observation.
CAAT
Test Deck (Test Data) – A technique that uses an application
program to process a set of test data, the results of which are
already known. The client’s system is used to process the
auditor’s data off-line. An advantage of this technique is that live
computer data is not affected in any way.
Integrated Test Facility – A technique similar to the test data
approach that the test data is commingled with live data. The
client’s system is used to process the auditor’s data online. The
test data must be separated from the live data before the reports
are created. Client personnel are not informed that the test is
being run.
CAAT
Transaction tagging – A technique the auditor uses to
electronically mark (or “tag”) specific transactions and to follow
them through the client’s system. It tests both the computerized
processing and the manual handling of the transactions.
Embedded audit modules (EAM) – EAMs are sections of the
application program code that collect transaction data for the
auditor. They are most often built into an application program when
the program is developed.
CAAT
Parallel Simulation – A technique where the auditor reprocesses
some or all of the client’s live data using a copy of the client’s
software controlled by the auditor and then compares the results
with the client’s files.
With controlled reprocessing:
- The auditor observes the actual processing and compares
the actual results to the expected results.
- The auditor uses an archived copy of the program in
question (generally the auditor’s control copy) to reprocess
transactions. The results are then compared to the results
from the normal processing run.
- Differences indicate that there have been changes to the
program.
CAAT – Parallel Simulation cont.
Source code comparison programs – Programs that compare
two versions of software to determine if they match. This type of
software can be used to look for unauthorized changes.
Types of software – Programs to accomplish parallel processing
can be:
- Developed for the application
- Bought as a packaged program or utility
- Produced by a generalized audit software package
Tasks typically performed by GASPs include:
1) Examining transactions for control compliance
2) Selecting items meeting specified criteria
3) Recalculating amounts and totals
4) Reconciling data from two separate files
5) Performing statistical analysis on transactions
Generalized audit software packages (GASPs) - Allow the
auditor to perform tests of controls and substantive tests directly on
the client’s system. The auditor first defines the client’s system to
the GASP and then specifies the tests and selections of data to be
made. The GASP generates the programs necessary to access the
files and extract and analyze the data.
Advantages of using GASPs include:
1) GASPs allow the auditor to sample and test a much higher
percentage of transactions, which results in a more reliable
audit
2) GASPs require little technical knowledge
3) After the initial use, GASPs can significantly reduce audit time
without sacrificing quality.
Perfect Competition Monopolistic Competition

- Many firms in the industry - Many firms in the industry

- Highly competitive
- Size of firm relative to industry is small
- No barriers to entry
- All firms sell the same commodity product
- Perfectly elastic (Firm sells as much, or as little, as it wants at
the given market price)
- Firm has control over quantity produced only; price is set by
the market, firm must accept the market price
- Pricing strategy: Accepts market price; can only adjust
production so that P=MR=MC
- Long run profitability: Zero economic profit
- Highly competitive
- Size of firm relative to industry is small
- Low barriers to entry
- Firms sell slightly different products that are close substitutes
- Highly elastic but downward sloping (Firm can adjust quantity of
products sold without affecting the price very much)
- Firm has control mostly over quantity produced; price is mostly
set by the market
- Pricing strategy: Searches for best price to maximize profits
P>MR=MC in the short run
- Long run profitability: Zero economic profit

Oligopoly Monopoly

- Few firms in the industry - Only one firm in the industry

- Moderately competitive
- Size of firm relative to industry is large
- High barriers to entry (Difficult to enter industry because of
economies of scale)
- Firms usually sell differentiated products
- Inelastic (Firms face a kinked downward-sloping demand
curve)
- Firm has control over both quantity produced and the price
charged
- Pricing strategy: Does not engage in price competition
P>MR=MC
- Long run profitability: Positive economic profit
- No competition
- Size of firm relative to industry is 100% of industry
- Barriers to entry: Insurmountable (No entry is possible)
- One firm sells only one product
- Inelastic (Firms faces the entire demand curve for the product,
which slopes downward)
- Firm has control over both price and quantity
- Pricing strategy: Searches for optimum price P>MR=MC in the
short and long run
- Long run profitability: Positive economic profit

General Partnership Limited Partnership

- Can be formed by verbal or written agreement, or mere - File Certificate of Limited Partnership with state
conduct - Liability of Owners
- Unlimited personal liability for all partnership obligations - General Partnership: Unlimited Personal Liability
- Owners manage directly or can agree to appoint managing - Limited Partnership: Only investment is at risk
partner - Management
- Partners cannot transfer ownership interest without - General Partners are exclusive managers
unanimous consent - Limited Partners cannot manage
- “Flow through” taxation - Partners (whether general or limited) cannot transfer
ownership interest
without unanimous consent
- “Flow through” taxation (but limited partners have passive
loss restrictions)
Corporation Subchapter S Corporation

- File Articles of Incorporation or Corporate Charter with state - File Articles of Incorporation or Corporate Charter and File “S”
- Shareholders generally not personally liable beyond their Election
investment - Shareholders generally not personally liable beyond their
- Managed by Board of Directors, who appoint officers to run investment
day-to-day - Managed by Board of Directors, who appoint officers to run
operations day-to-day
- Shareholders are free to transfer ownership interest unless operations
they agree - Shareholders are free to transfer ownership interest unless they
otherwise agree
- Income taxed at corporate level and taxed again to Otherwise; but can’t transfer to foreign or entity shareholders
shareholders when - Owners manage directly or can agree to appoint managing
dividends are distributed partner
- “Flow through” taxation (but shareholders not managing have
passive loss
restrictions)
Limited Liability Company (LLC) Limited Liability Partnership (LLP)

- File Articles of Incorporation with state - File Statement of Qualification with state
- Shareholders generally not personally liable beyond their - Partners are generally not liable for partnership obligations,
investment unless caused by
- Members manage directly or can agree to appoint a their own negligence
manager - Partners manage directly or can agree to appoint a managing
- Absent agreement otherwise, members cannot transfer partner
ownership interest without unanimous consent - Partners cannot transfer ownership interest without unanimous
- Flow through” taxation (but members not managing have consent
passive loss - Flow through” taxation (but partners not managing have
restrictions) passive loss
restrictions)
Accounting Rate of Return (ARR) is the same as Return on Investment
(ROI).

On the CPA Exam, if the information is given, use the “average” Advantages of ARR
investment in the denominator.
- Simple and easy to use
ARR = Increase in expected average annual net income - Total project profitability is considered (unlike the
Net initial investment payback method)

ARR is similar to the internal rate of return (IRR) in that both calculate a Disadvantages of ARR
rate-of-return percentage. - Ignores the time value of money
ARR – Uses operating income after accruals
IRR – Uses cash flows and time value of money

* The main difference is depreciation of the investment asset.

The formula notation for the cost of retained earnings is the symbol kre.

A firm should earn at least as much on any earnings retained and reinvested
in the business as stockholders could have earned on alternative
If income tax considerations are ignored, how is depreciation investments of equivalent risk. This return is represented by the cost of
handled by the following capital budgeting techniques? retained earnings, kre.

Internal Rate of Return Accounting Rate of Return Three common methods of computing kre are:
Payback
Excluded Included 1) Capital Asset Pricing Model (CAPM)
Excluded 2) Discounted Cash Flow (DCF)
3) Bond Yield plus Risk Premium (BYRP)

The average of the three cost amounts could be used as the estimate of the
cost of retained earnings (kre) if there is sufficient consistency in the results
of the three methods.
CAPM Model
Assumptions:
- Cost of retained earnings is equal to the risk-free rate plus a risk
premium.
- Risk premium is equal to the risks associated with the entire
market risk.
- Risk premium is the product of systematic (non-diversifiable)
risk.
kre = Risk-free Rate + Risk Premium
kre = krf + (bi x PMR)
kre = krf + [bi x (km-krf)]
* Risk premium = the stock’s beta coefficient (bi) times the
market risk premium (PMR)
* Market risk premium (PMR) = the market rate (km) minus the
risk-free rate (krf)
Bond-Yield-Plus-Risk-Premium Model
Assumptions:
- Equity and debt security values are comparable before taxes.
- Risks are associated with both the individual firm and the sate of the
economy. Risk premiums depend on non-diversifiable risk.
- Risk estimation can be derived by using a market analysts’ survey
approach or by subtracting the yield on an average (A-rated) corporate LT
bond from an estimate of the market rate.
kre = kdt + PMR
* Pre-tax cost of long-term debt = kdt
* Market risk premium (PMR) = the market rate (km) minus the risk-free
rate (krf)
The riskiness of a stock is measured by its beta coefficient. The
beta coefficient of a stock reflects its price volatility in relationship
to the overall market and is calculated by dividing the percentage
change in the price of an individual stock by the percentage
change in the price of the greater market.
A beta greater than 1 implies that the stock is more volatile (risky)
than the market.
A beta less than 1 implies that the stock is less volatile (risky) than
the market.
Discounted Cash Flow (DCF) Model
Assumptions:
- Stocks are normally in equilibrium relative to risk and return.
- The estimated expected rate of return will yield an estimated
required rate of return
- The expected growth rate may be based on projections of past
growth rates, a retention growth model, or analysts’ forecasts.
kre = (D1/P0) + g
* Current market value or price of the outstanding common stock =
P0
* The dividend per share expected at the end of one year = D1
* The constant rate of dividends = g
The CAPM is the basic theory that links together risk and return for
all assets. Risk of a firm (or investment in a firm) is a function of the
risks that exist independent of the investment (the nondiversifiable
risk of the marketplace measured by a beta coefficient) and the
firm’s (or investment specific) diversifiable risk.
CAPM Model
By using the beta coefficient (b) to measure nondiversifiable risk, the
capital asset pricing model equation divides risk into two parts:
1) The risk-free rate of return (RF) and
2) The risk premium ([RM – RF] x b).
The (RM – RF) potion of the risk premium is called the “market risk
premium” because it represents the premium an investor expects to
receive in return for taking the average amount of risk associated
with holding the market portfolio of assets.
CAPM Model CAPM Model - When the capital asset pricing model (CAPM) is
depicted graphically, that graph is referred to as the security market
kre = Risk-free Rate + Risk Premium line. The SML is an upward sloping straight line that reflects the
kre = krf + (bi x PMR)  RA = RF + ([RM required return in the marketplace for each level of nondiversifiable
– RF] x b) risk (or beta).
kre = krf + [bi x (km-krf)]

The required return on an asset (RA) is an increasing function of

beta (b). Assuming risk averse behavior:

- The higher the risk, the higher the required rate of return.
- The lower the risk, the lower the required rate of return.

Note: Risk-free rate of return (RF) and risk premium ([RM – RF] x
b).

Changes in the Security Market Line

The required returns of equity investors are not fixed by contract and
fluctuate with changes in the market. Consequently, the SML does not
remain stable over time. The position and slope of the SML are affected
In capital budgeting decisions, the discount rate used is the hurdle
by two major forces: rate, which is the desired (minimum) rate of return that is set by
management to evaluate investments. This could be any rate
1) Inflationary expectations – Because the risk-free rate (RF) is a determined by management.
basis component of all rates of return, any change in RF will be
reflected in all required rates of return and will result in parallel If the project cash flows are more or less risky than is normal for the
shifts in the SML in direct response to the magnitude and firm, the discount rate may be adjusted to reflect management’s
direction of the change. assessment of the risk associated with the project.
2) Risk aversion – Most investors are risk-averse, which means that
they require increased returns for increased risk. The slope of the
SML reflects the degree of risk aversion. The steeper the slope,
the greater the degree of risk aversion, because a higher level of
return would be required for each level of risk as measured by the
beta.
WACC – Company Cost of Capital
The company cost of capital (WACC) is often used by companies
to evaluate business decision when discount analysis is used.
The WACC is often referred to as the target rate. Use of the WACC
ensures that the firm is going to evaluate its investment
alternatives at the cost of obtaining investment funds. A company
that faces more risk than a firm of average risk will be expected to
have a higher company cost of capital than an average firm.
Different rates may be used to evaluate different projects.
Beta
Beta is used to define the relative level of risk in a project or
company where risk is equated to price volatility.
Beta is on the horizontal axis of the security market line and the
required return percentage is on the horizontal axis. (See graph
on CAPM model flashcard.)
Betas can change over time.
The beta of the company of that of its industry can be used to
estimate the risk likely associated with a project. The discount
rate can then be inferred by using the SML.
Why companies use WACC (Company Cost of Capital)
1) Most projects are considered to be average risk in relation to
other assets a company may have. The WACC is an
appropriate discount rate to use in situations where the risk is
deemed to be average for the company.
2) Even if a project is not considered to be of average risk for a
company, the WACC can be used as a good starting point to
determine the discount the company cost of capital as the
initial starting point and adjust for risk from that point rather
than attempting to calculate one from scratch.
In this case, the WACC is not a hurdle rate because it is
simply being used as a benchmark to which adjustments will
be made.
Beta
The manager should look at the characteristics of the behavior of the
asset to estimate risk, even if the beta cannot be determined.
1) Operating leverage – The amount of operating leverage (the
commitment of the company to fixed production charges) a company
has will affect its beta. There is a higher beta when the ratio of fixed
cots to project value increases.
2) Cyclical reaction of the company – If the company’s
performance (i.e. revenues, earnings, etc.) is dependent upon the
performance of the economy, a manager could assume that the
company is a high-beta firm. The higher the ratio of the present
value of fixed costs to the present value of the project, the higher
the beta of the project.
In any capital budgeting technique, cash flows must be estimated.
Near term cash flows are easier and more reliably estimated than
longer term cash flows. Capital projects carry higher risk of
inaccurate cash flow estimated due to their duration.
Most of the time, projects will use a single discount rate and only
adjust separately for risk and time if the market risk or other risk
changes throughout the project’s life.
The interest rate may be adjusted to compensate for this added
risk related to the timing of the cash flows, however, this is only
done if the beta of the project is not expected to be constant over
the life of the project.
When risks of different components of the project’s cash flows
differ, it is acceptable to adjust the discount rates for each
separate cash flow (a benefit of using the NPV approach) to a rate
that reflects the degree of risk associated with the respective cash
flow.
Funding alternatives for investments in specific situations
A. Long term debt – The funding of long-lived assets will
typically be done with long-term debt.
B. Short term loans and leases – The funding of
equipment and vehicles will typically be made through the use of
shorter-term financing or leases.
C. Retained earnings – Often used when acceptable
funding cannot be located, but only for those investments whose
return duplicates the risk-adjusted rate of return of the
organization (possibly determined using the CAPM or the WACC).
The return must duplicate or exceed the risk-adjusted rate of
return because this is demanded by the shareholders, who desire
to maintain or increase shareholder wealth (i.e., they wish to
maintain the beta of the firm with respect to other firms in the
market.
If management looks at two alternative investments and determines
that one of them appears more risky than the other (e.g., it has
greater than expected estimated returns or is a type of investment
that has not been purchased by the company before), management
may decide to adjust the discount rate.
The adjustment in this case would be an increase in the rate to
compensate for the added risk contemplated by management.
The effect of increasing the discount rate in capital budgeting
decisions is to reduce the amount of present value for the future net
cash flows. The higher the discount rate set by management, the
higher the risk management ahs assigned to the project.
When comparing two investment alternatives with the same
estimated net cash flow, the alternative with the higher risk will have
a lower net present value that the investment with the lower risk.
Debt Financing
Debt financing is less costly than equity financing.
Debt involves default risk (i.e., the risk that borrowers may default,
which will cause lenders to foreclose).
Debt financing involves surrendering some financing flexibility for
emergencies. Long-term debt should not be used to the extent that
it exhausts reserve borrowing capacity and financing flexibility that
permits the firm to issue new debt at favorable terms on short
notice.
Equity Financing Capital investment decisions are not made based on quantitative financial
measure only. Various qualitative measures must be considered as well,
Equity financing is the most costly long-term financing alternative. many which assist in meeting the strategic objectives of the firm. Some
measures include:
Conservative use of leverage may set a target capital structure A. Shifts on the market supply and demand
that uses so little long-term debt that the weighted average cost B. Technology changes
of capital is not minimized and shareholder value is not C. Industry actions
maximized. D. Economic effects
E. Desire for public safety and the safety of employees
Establishing and maintaining a minimum degree of control may F. Regulatory requirements
influence management’s capital structure decisions. A target G. Contractual requirements
capital structure that includes more long-term debt financing than H. Maintenance of market share
a truly optimal capital structure may be used if maintaining voting I. Social welfare
J. Public policy
control is an overriding issue.
K. Environmental protection
An annual profit plan consists of a master (or comprehensive)
budget and a variety of supporting schedules.
A master budget is a comprehensive set of an organization’s
budget schedules and pro forma (projected) financial statements.
Master budgets are generally comprised of operating budgets and
financial budgets prepared in anticipation of achieving a single
level of sales volume for a specific period of time.
Sales budgets represent the anticipated sales of the organization in
both units and dollars. Sales budgets (particularly units) are the
foundation of the entire budget process. Inventory levels,
purchases, and operating expenses are coordinated with sales levels.
Sales budgets are the first budgets prepared, and they drive the
development of most other components of the master budget.

Operating budgets – Comprised of sales budget and related costs
and expenses anticipated in relation to achievement of the
budgeted level of sales.
Financial budgets – Comprised of pro forma financial statements.
Sales budget units drive the number of units required by the
production budget.
Sales budget dollars drive the anticipated cash and revenue figures.

Sales forecasts are derived from input received from numerous

organizational resources, including the opinions of sales staff, statistical
analysis of correlation between sales and economic indicators, and
opinions of line management. Sales budgets represent the sales forecast associated with planned
or anticipated conditions. They are based upon and selected from
Sales forecasts are developed after consideration of the following factors:
1) Past patterns of sales sales forecasts. The sales forecast becomes the sale budget after
2) Sales force estimates revision and after acceptance by management as an objective.
3) General economic conditions
4) Competitors’ actions
5) Changes in the firm’s prices
6) Changes in product mix
7) Results of market research studies
8) Advertising and sales promotions plans

Establishing required levels of production

Production/inventory budgets are prepared for each product or
each department and anticipate the amount that will be produced,
stated in units. The production budget anticipates the
accumulation and coordination of resources necessary to sustain
manufacturing operations and fulfill budgeted sales goals.
Production/inventory budgets are prepared in a manner consistent
with the production and inventory levels anticipated by the sales
budget, with modifications for increases or decreases in inventory
levels.

It is comprised of the amounts spent for direct labor, direct Formula:

materials, and factory overhead. Budgeted Sales
+ Desired ending inventory
The amount of the production budget is primarily defined by the - Beginning inventory
amounts of inventory on hand and the planned inventory amounts = Budgeted production
necessary to sustain sales.
The direct materials required to support the production budget are
defined by the direct materials usage budget and the direct
materials purchases budget.

Direct materials purchases budget – Represents the dollar amount

of purchases of direct material required to sustain production
requirements.

Units of DM to be purchased for the period

x Cost per unit
= Cost of direct materials to be purchased for the period

Direct materials usage budget – Represents the number of units

of direct materials required to sustain production requirements
along with the related cost of those direct materials.