Financial Management Summary
THE KEY DECISIONS OF FINANCIAL MANAGEMENT
Three key decisions of financial management that can be identified are:
Investment – what projects should be undertaken by the organisation?
Finance – how should the necessary funds be raised?
Dividends – how much cash should be allocated each year to be paid as a return to
shareholders? These three areas are very closely interlinked.
Links between the three key decisions (interrelationship)
Investment decisions cannot be taken without consideration of where and how the funds are to be
raised to finance them. The type of finance available will, in turn, depend to some extent on the
nature of the project – its size, duration, risk, capital asset backing, etc.
Dividends represent the payment of returns on the investment back to the shareholders, the level
and risk of which will depend upon the project itself, and how it was financed.
Fixed debt finance, for example, can be cheap (particularly where interest is tax deductible) but
requires a fixed payment to be made out of project earnings, which can increase the risk of the
shareholders’ dividends.
, INVESTMENT APPRAISAL
Limitations of payback period
Ignores timing of cash flows within the payback period, the cash flows after the payback
period and therefore the total project return.
Ignores the time value of money.
Is unable to distinguish between projects with the same payback period.
Tends to favour short-term (often smaller) projects over longer term projects.
Takes account of the risk of the timing of cash flows but not the variability of those cash
flows.
Strengths of payback period
Simple to calculate and understand – important when management resources are limited.
Also helpful in communicating information about minimum requirements to managers
responsible for submitting projects.
Can be used for first-stage screening in eliminating obviously inappropriate projects prior to
more detailed evaluation.
Bias in favour of short-term projects which means that it tends to minimise both financial
and business risks.
Can be used when there is a capital rationing situation to identify those projects which
generate additional cash for investment quickly
ACCOUNTING RATE OF RETURN (ARR)
Limitations
Figures are easily manipulated, e.g. by changing the method of depreciation or the estimate
of disposal value.
Ignores the actual/incremental cash flows associated with the project, and the effect of the
timing of those cash flows on the real return
Double counting – depreciation is deducted from the profit figure in full, but the use of the
average assets figure means that part of this is also included in the denominator. The effect
is to depress the calculated return.
Strengths
Expressed in terms familiar to managers – profit and capital employed.
Easy to calculate the likely effect of the project on the reported profit and loss
account/balance sheet. Managers are frequently rewarded in relation to performance
against these variables.
Business is judged by ROI by financial markets.
NET PRESENT VALUE
Strengths
Any project with a positive NPV increases the wealth of the company. The primary financial
aim is to maximise the wealth of the ordinary shareholders, and selection of projects on an
NPV basis is consistent with this objective.
Takes account of the time value of money and therefore the opportunity cost.
THE KEY DECISIONS OF FINANCIAL MANAGEMENT
Three key decisions of financial management that can be identified are:
Investment – what projects should be undertaken by the organisation?
Finance – how should the necessary funds be raised?
Dividends – how much cash should be allocated each year to be paid as a return to
shareholders? These three areas are very closely interlinked.
Links between the three key decisions (interrelationship)
Investment decisions cannot be taken without consideration of where and how the funds are to be
raised to finance them. The type of finance available will, in turn, depend to some extent on the
nature of the project – its size, duration, risk, capital asset backing, etc.
Dividends represent the payment of returns on the investment back to the shareholders, the level
and risk of which will depend upon the project itself, and how it was financed.
Fixed debt finance, for example, can be cheap (particularly where interest is tax deductible) but
requires a fixed payment to be made out of project earnings, which can increase the risk of the
shareholders’ dividends.
, INVESTMENT APPRAISAL
Limitations of payback period
Ignores timing of cash flows within the payback period, the cash flows after the payback
period and therefore the total project return.
Ignores the time value of money.
Is unable to distinguish between projects with the same payback period.
Tends to favour short-term (often smaller) projects over longer term projects.
Takes account of the risk of the timing of cash flows but not the variability of those cash
flows.
Strengths of payback period
Simple to calculate and understand – important when management resources are limited.
Also helpful in communicating information about minimum requirements to managers
responsible for submitting projects.
Can be used for first-stage screening in eliminating obviously inappropriate projects prior to
more detailed evaluation.
Bias in favour of short-term projects which means that it tends to minimise both financial
and business risks.
Can be used when there is a capital rationing situation to identify those projects which
generate additional cash for investment quickly
ACCOUNTING RATE OF RETURN (ARR)
Limitations
Figures are easily manipulated, e.g. by changing the method of depreciation or the estimate
of disposal value.
Ignores the actual/incremental cash flows associated with the project, and the effect of the
timing of those cash flows on the real return
Double counting – depreciation is deducted from the profit figure in full, but the use of the
average assets figure means that part of this is also included in the denominator. The effect
is to depress the calculated return.
Strengths
Expressed in terms familiar to managers – profit and capital employed.
Easy to calculate the likely effect of the project on the reported profit and loss
account/balance sheet. Managers are frequently rewarded in relation to performance
against these variables.
Business is judged by ROI by financial markets.
NET PRESENT VALUE
Strengths
Any project with a positive NPV increases the wealth of the company. The primary financial
aim is to maximise the wealth of the ordinary shareholders, and selection of projects on an
NPV basis is consistent with this objective.
Takes account of the time value of money and therefore the opportunity cost.
