Q.1 Describe how Break-Even Analysis can be of assistance to a new business in assessing its future financial viability.

Also explain in details ways in which the Break-Even Point can be reduced? Answer: One of the most common tools used in evaluating the economic feasibility of a new enterprise or product is the break-even analysis. The break-even point is the point at which revenue is exactly equal to costs. At this point, no profit is made and no losses are incurred. The break-even point can be expressed in terms of unit sales or dollar Sales. That is, the break-even units indicate the level of sales that are required to cover costs. Sales above that number result in profit and sales below that number result in a loss. The break-even sales indicate the dollars of gross sales required to break-even. It is important to realize that a company will not necessarily produce a product just because it is expected to breakeven. Many times, a certain level of profitability or return on investment is desired. If this objective cannot be reached, which may mean selling a substantial number of units above break-even, the product may not be produced. However, the break-even is an excellent tool to help quantify the level of production needed for a new business or a new product. Break-even analysis is based on two types of costs: fixed costs and variable costs. Fixed costs are overhead-type Expenses that are constant and do not change as the level of output changes. Variable expenses are not constant and do change with the level of output. Because of this, variable expenses are often stated on a per unit basis. Once the break-even point is met, assuming no change in selling price, fixed and variable cost, a profit in the amount of the difference in the selling price and the variable costs will be recognized. One important aspect of break-even analysis is that it is normally not this simple. In many instances, the selling price, fixed costs or variable costs will not remain constant resulting in a change in the break-even. And these changes will change the break-even. So, a break-even cannot be calculated only once. It should be calculated on a regular basis to reflect changes in costs and prices and in order to maintain profitability or make adjustments in the product line.
What is Break-Even?

Break-even analysis another essential decision making tool. A break-even analysis tells you how many units of a product (or service) must be sold, or how much revenue must be generated, in order to break even. Only after you cross the breakeven point will your business start to make a profit. The break-even point is defined as Total Sales minus Variable Costs minus Fixed Costs equals Zero; the point where a companys total sales equal total costs. Breaking even depends on a variety of factors: Fixed Costs: those that remain the same regardless of how much of your product or service you sell such as rent, mortgage, utilities, insurance, and so on. Variable Costs: those that vary in relation to the amount you sell or produce such as servicing supplies, raw materials, sales commissions, labor that is dependent on the amount manufactured, and so on.

 Per unit selling price: the price you determine you must sell a product or unit of service at. A Break-even Analysis examines the interaction of fixed costs, variable costs, price, and unit volume to help you determine what combination of elements is necessary to break even. The analysis is also useful for showing a prospective financing source that you are aware of how much money you need to get your company going, or to keep it going. It can also be used to chart positive cash flow for a planned new product or service.
Breakeven calculation:

Definitions: Variable costs: those that change based on the amount produced/sold. These include items such as raw materials, packaging, certain labor costs, transportation and freight. In many instances all costs associated with the production of a product or service are lumped together under the heading cost of goods or cost of sales or cost of goods sold (COGS). For example, suppose that it costs $4.00 to make one unit of a particular product or to create one unit of a particular service offering. If you produce 200 units of that product or service, it will cost you $800 in cost of goods; if you produce 500, it will cost you $2,000 worth of cost of goods. The costs vary with the amount of product produced and are therefore termed variable. Fixed costs: those that do not change regardless of how many units are produced/sold. These include items such as rent, utilities, loan payments, insurance and other overhead costs such as advertising, market research costs, etc. Unit price: per unit selling price. Your unit selling price must cover all costs of goods (or services) sold in order for you to break even. To calculate break-even then, first determine the price at which all variable costs to produce the product or service are covered. Next, determine what your total fixed costs are. (Use total annual fixed costs for calculating your annual break-even, or total monthly fixed costs for calculating a monthly break-even.) The formulas for calculating break-even in both units and dollars are shown below: Break-even units = Total Fixed Costs______ Unit Price Unit Variable Costs

This figure is the number of units that you have to sell in order to break even. If you are selling more than this, then you should be making a profit and if you sell less than this, you will not even be covering your fixed expenses. Break-even dollar sales = Total Fixed Costs___ _________ (Unit Price - Unit Variable Costs) Unit Price

This figure is the level of sales that you must reach in order to break even. Again, if you are reaching more than this, then you should be making a profit and if you are not, you will not be selling enough to cover your fixed expenses. A Break-even analysis lets you examine the impacts of price and unit volume adjustments. For example, lets assume it costs you $8,000 each month to run the business. As well, you had determined that the per-unit variable costs of your product would be $10 within a volume range of 1,000 to 2,500 units. The break-even dollar sales each month is then $8,000 divided by ($20 - $10) divided by $20, or $16,000. Break-even units would be $8,000 divided by ($20-$10) or 800 units. Lets assume you estimated that at a per-unit selling price of $20 you could sell 1,200 units per month. Results of this combination would be that at that volume and price, this business would generate monthly sales of $24,000 and operating profit of $4,000. ($24,000 in sales minus $12,000 of variable costs minus $8,000 of fixed costs.) If, however, you were to lower your price to $17 and could then sell 2,300 units per month, the business would generate monthly sales of $39,100 and operating profit of $8,100. By using this analysis, it is possible to determine the impacts of sales volumes early on so that you can make adjustments. For example if you had a monthly breakeven of $16,000 dollars or 800 units and you were open 22 days each month on average, you know that you need to make an average sales of 36 units each day to break even. Track your sales daily,compare the total often to your break-even calculation, and you will know where you stand in relation to coveringyour monthly costs. Three ways you can reduce the break even: Reduce fixed costs Reduce the variable cost per unit Increase revenue per unit

Q.2 what are the constituent parts of working capital cycle? How can altering these constituent parts affect a companys working capital? What is the working capital cycle and what does it represent? Answer: Approaches to Working capital Management: Working capital management takes place on two levels: Ratio analysis can be used to monitor overall trends in working capital and to identify areas requiring closer management. The individual components of working capital can be effectively managed by using various techniques and strategies. When considering these techniques and strategies, companies need to recognize that each department has a unique mix of working capital components. The emphasis that needs to be placed on each component varies according to the companies. For example, some companies have significant inventory levels; others have little if any inventory. Furthermore, working capital management is not an end in itself. It is an integral part of the companys overall management. The needs of efficient working capital management must be considered in relation to other aspects of the companys financial and non-financial performance. The term working capital refers to the amount of capital which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities). Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course of business". Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of business". WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES In a department's Statement of Financial Position, these components of working capital are reported under the following headings: Current Assets Liquid Assets (cash and bank deposits) Inventory Debtors and Receivables Current Liabilities Bank Overdraft Creditors and Payables Other Short Term Liabilities Component of Working Capital Stock of raw material Basis of Valuation Purchase cost of raw Materials

Stock of work in process Stock of finished goods Debtors Cash

At cost or market value, whichever is lower Cost of production Cost value of sales or sales

Working expenses

Working Capital Cycle: Working capital cycle involves conversions and rotation of various constituents/components of the working capital. Initially cash is converted into raw materials. Cash flows in a cycle into, around and out of a business. It is the business's life blood and every manager's primary task is to help keep it flowing and to use the cash flow to generate profits. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't generate surpluses, the business will eventually run out of cash and expire. The faster a business expands the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash will help improve profits and reduce risks. The cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm's total profits. The usage of fixed assets result in value additions, the raw materials get converted into work in process and then into finished goods. When sold on credit, the finished goods assume the form of debtors who give the business cash on due date. Thus cash assumes its original form again at the end of one such working capital cycle but in the course it passes through various other forms of current assets too. This is how various components of current assets keep on changing their forms due to value addition. As a result, they rotate and business operations continue. Thus, the working capital cycle involves rotation of various constituents of the working capital. While managing the working capital, two characteristics of current assets should be kept in mind viz. short life span, and Swift transformation into other form of current asset. Each constituent of current asset has comparatively very short life span. Investment remains in a particular form of current asset for a short period. The life span of current assets depends upon the time required in the activities of procurement; production, sales and collection and degree of synchronization among them. A very short life span of current assets results into swift transformation into other form of current assets for a running business. These characteristics have certain implications: 1. Decision regarding management of the working capital has to be taken frequently and on a repeat basis. 2. The various components of the working capital are closely related and mismanagement of any one component adversely affects the other components. 3. The difference between the present value and the book value of profit is not significant. If money moves faster around the cycle (e.g. collect monies due from debtors more quickly) or the amount of money tied up is reduced (e.g. reduce inventory levels

relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, the cost of bank interest can be reduced or additional free money will be available to support additional sales growth or investment. Similarly, if improved terms with suppliers are negotiated e.g. longer credit or an increased credit limit, then free finance to help fund future sales can be effectively created. Management of components of Working capital: Inventory Management Inventory includes all types of stocks. For effective working capital management, inventory needs to be managed effectively. The level of inventory should be such that the total cost of ordering and holding inventory is the least. Simultaneously, stock out costs should be minimized. Business, therefore, should fix the minimum safety stock level, re-order level and ordering quantity so that the inventory cost is reduced and its management becomes efficient. Average stock-holding periods will be influenced by the nature of the business. For example, a fresh vegetable shop might turn over its entire stock every few days while a motor factor would be much slower as it may carry a wide range of rarely-used spare parts in case somebody needs them. Many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks take up little space, minimize stock-holding and virtually eliminate the risks of obsolete or damaged stock. Because JIT manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a good model to strive for as it embraces all the principles of prudent stock management. Debtors Management: The objective of any management policy pertaining to debtors would be to ensure that the benefits arising due to the debtors are more than the cost incurred for debtors and the gap between benefits and cost increases profits. An effective control of receivables helps a great deal in property managing it. Creditors Management: Creditors are a vital part of effective cash management and should be managed carefully to enhance the cash position. Purchasing initiates cash outflows and an over-zealous purchasing function can create liquidity problems. Thus, the following factors should be considered: The purchasing authority in the company and whether it is tightly managed or spread among a number of people. The purchase quantities should be geared to demand forecasts. Order quantities should be used that take into account stock-holding and purchasing costs. The cost of carrying stock should be known. Dependency on a single supplier should be avoided and facilities like best discounts, credit terms etc. should be used from alternative suppliers. Suppliers returns policy should be considered. Cash Management Cash is the most liquid current asset. It is of vital importance to the daily operations of business. While the proportion of assets held in the form of cash is very small, its efficient management is crucial to the solvency of the business. Therefore, planning cash and controlling its use are very important tasks.

Q.3 Investment Appraisals Techniques? Answer: 1. Payback Period: At first glance, payback is a simple investment appraisal technique, but it can quickly become complex. What It Measures How long it will take to earn back the money invested in a project. Why It Is Important The straight payback period method is the simplest way of determining the investment potential of a major project. Expressed in time, it tells a management how many months or years it will take to recover the original cash cost of the projectalways a vital consideration, and especially so for managements evaluating several projects at once. This evaluation becomes even more important if it includes an examination of what the present value of future revenues will be. How It Works in Practice The straight payback period formula is: Payback period = Cost of project Annual cash revenues

Thus, if a project costs $100,000 and is expected to generate $28,000 annually, the payback period would be: 100,000 28,000 = 3.57 years If the revenues generated by the project are expected to vary from year to year, add the revenues expected for each succeeding year until you arrive at the total cost of the project. For example: say the revenues expected to be generated by the $100,000 project are: Year Revenue Total Year 1 $19,000 $19,000 Year 2 $25,000 $44,000 Year 3 $30,000 $74,000 Year 4 $30,000 $104,000 Year 5 $30,000 $134,000 Thus, the project would be fully paid for in Year 4, since it is in that year that the total revenue reaches the initial cost of $100,000. The picture becomes complex when the time value of money principle is introduced into the calculations. Tricks of the Trade Clearly, a main defect of the straight payback period method is that it ignores the time value of money principle, which, in turn, can produce unrealistic expectations. A second drawback is that it ignores any benefits generated after the payback period, and thus a project that would return $1 million after, say, six years might be ranked lower than a project with a three-year payback that returns only $100,000 thereafter. Another alternative to calculating by payback period is to develop an internal rate of return.

Under most analyses, projects with shorter payback periods rank higher than those with longer paybacks, even if the latter promise higher returns. Longer paybacks can be affected by such factors as market changes, changes in interest rates, and economic shifts. Shorter cash paybacks also enable companies to recoup an investment sooner and put it to work elsewhere. Generally, a payback period of three years or less is desirable; if a projects payback period is less than a year, some contend it should be judged essential.

2. Accounting Rate of Return (ARR) or Return on Capital Employed (ROCE): The accounting rate of return (ARR), which focuses on a projects net income rather than its cash flow, is the second-oldest evaluation technique. In its most commonly used form, the ARR is measured as the ratio of the projects average annual expected net income to its average investment. Average annual income = Average cash flow - Average annual depreciation Average investment = Cost - Salvage value 2 AARs = Average annual income Average investment Let's use this simple example to illustrate the ARR: A project to replace an item of machinery is being appraised. The machine will cost 240 000 and is expected to generate total revenues of 45 000 over the project's five year life. What is the ARR for this project? ARR = (45 000 / 5) / 240 000 * 100 = (9 000) / 240 000 * 100 = 3.75% Advantages of ARR: As with the Payback method, the chief advantage with ARR is its simplicity. This makes it relatively easy to understand. There is also a link with some accounting measures that are commonly used. The Average Rate of Return is similar to the Return on Capital Employed in its construction; this may make the ARR easier for business planners to understand. The ARR is expressed in percentage terms and this, again, may make it easier for managers to use. Criticism against ARR: Firstly, the ARR doesn't take account of the project duration or the timing of cash flows over the course of the project. Secondly, the concept of profit can be very subjective, varying with specific accounting practice and the capitalisation of project costs. As a result, the ARR calculation for identical projects would be likely to result in different outcomes from business to business. Thirdly, there is no definitive signal given by the ARR to help managers decide whether or not to invest. This lack of a guide for decision making means that investment decisions remain subjective.

3. Net Present Value: The valuation technique, known as net present value or NPV, allows a company to project the projects potential profitability by discounting future cash flow expectations and comparing the sum of these cash flows to the initial capital expenditure required to fund the project. Future cash flows must be discounted to perform an apples to apples comparison. For example, $100 today is not the same as $100 in 3 years. $100 today will have the opportunity to earn risk-free compounded interest for 3 years and therefore will have a value which is higher than $100 at the end of 3 years. This is why we must discount or remove the interest component from the future cash flow, allowing us to put the initial capital investment and future cash flows on a level playing field. NPV Formula Below, you will see the formula for calculating net present value. Basically, we are discounting each future cash flow by a discount factor to arrive at the present value of each cash flow. The formula then sums up each of these values and subtracts the intial investment into the project. A NPV greater than 0 indicates that the project will add value to the company, while a NPV of less than 0 indicates that the company will be negatively impacted by the project; however, it may need to proceed with the project for purposes of damage control or further loss prevention. There is a grey area where the NPV is near 0 or at 0. In this case, management will have to decide if there are intangible benefits such as increased brand awareness or leadership in bringing a product to market which will positively influence the company down the road. Present Value = Future cash flow X discounted factor at d cost of capital The formula for the NPV can be written as: NPV = - Cost (Investment) + PV of All CF FOR EXAMPLE Decide to buy land this year for 85,000 and sell it next year for 91,000. (Discount rate:10%) NVP = -85,000 + 91,000/1.10 NVP= -2,273 Accept Positive NPV Advantages NPV is essential for financial appraisal of long-term projects, It measures the excess or shortfall of cash flows, In the NPV model it is assumed to be reinvested at the discount rate used. This is appropriate in the absence of capital rationing. Disadvantages Yes it does have some disadvantages like adjustment for risk by adding a premium to the discount rate thus making cost higher, 2nd is compounding of Risk Premium, Now we all know that Risk premium is composite of Risk free rate, Such compounding results very low NPV.

4.

Internal Rate of Return(IRR): The Internal Rate of Return (IRR) is the discount rate that generates a zero net present value for a series of future cash flows. This essentially means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or an investment) equal its current market value. Internal Rate of Return provides a simple hurdle rate, whereby any project should be avoided if the cost of capital exceeds this rate. Usually a financial calculator has to be used to calculate this IRR, though it can also be mathematically calculated using the following formula: IRR = P% + P x (N% - P %) (P+N)

Where by: P% = Interest rate that result in positive NPV N% = Interest rate that result in negative NPV P = Positive NPV N = Negative NPV Internal Rate of Return is the flip side of Net Present Value (NPV), where NPV is the discounted value of a stream of cash flows, generated from an investment. IRR thus computes the break-even rate of return showing the discount rate, below which an investment results in a positive NPV. A simple decision-making criteria can be stated to accept a project if its Internal Rate of Return exceeds the cost of capital and rejected if this IRR is less than the cost of capital. However, it should be kept in mind that the use of IRR may result in a number of complexities such as a project with multiple IRRs or no IRR. Moreover, IRR neglects the size of the project and assumes that cash flows are reinvested at a constant rate. The most important alternative to NPV approach. (IRR) Consider a simple project (-$100, $110). For a given rate, the NPV is: NPV = -100 + $110 / 1 + r (where r is the discount rate) How we calculate r? Use the trial-and-error procedure. Use a discount rate of 0.08 (8%) NPV = -100 + $110 / 1 + r 1.85 = -100 + $110 / 1 + 0.08 NPV is positive; its not 8%, must be? Use a discount rate of 0.12 (12%) NPV = -100 + $110 / 1 + r -1.79= -100 + $110 / 1 + 0.12 Use a discount rate of 0.1 (10%); this yields 0 = -100 + 110 / 1.1 We say that 10 percent is the projects IRR.

Advantages NPV is essential for financial appraisal of long-term projects, It measures the excess or shortfall of cash flows, In the NPV model it is assumed to be reinvested at the discount rate used. This is appropriate in the absence of capital rationing. Disadvantages Yes it does have some disadvantages like adjustment for risk by adding a premium to the discount rate thus making cost higher, 2nd is compounding of Risk Premium, Now we all know that Risk premium is composite of Risk free rate, Such compounding results very low NPV.

4. COST VALUE PROFIT ANALYSIS o CVP Analysis o CVP Formulae o Break-Even Point o Contribution Margin CVP analysis The CVP model is widely used when assessing the potential impact of costs, prices, and volume on the organizations profits. CVP analysis is often helpful in making decisions concerning pricing of products, choice of product lines, and utilization of production facilities. Furthermore, the model is easy to use and is logically appealing because of its relationship to the income statements. The assumptions of CVP analysis are that: 1. Revenues and costs are linear throughout the relevant range. This means that revenues and costs can be shown on a line graph as straight lines with sales volume on the horizontal axis. For this to happen, sales prices must remain constant per unit, and costs must be categorized into variable or fixed elements. The total cost function is linear within the relevant range. In reality however, changes in efficiency are likely to result in a cost function, which is non-linear. 2. Inventory quantities remain unchanged during the year. The number of units in beginning work-in-process and finished goods equal the number of units in these ending inventories. 3. Sales-mix remains constant. The sales mix of multiple products or services is constant. The sales-mix refers to the relative portion of unit or dollar sales derived from each product or service. If products have different selling prices and costs, changes in the mix will affect CVP model results. The sales-mix is the combination of products that makes up total sales. 4. All costs are classified as fixed or variable. 5. It is assumed that all other costs, such as mixed costs, can be broken into fixed and variable cost elements. 6. There is only one cost driver. 7. CVP analysis assumes that the only cost driver relevant to the relationships being studied is unit or dollar sales volume.

CVP formulae: Formulae concerning the relationship between costs, volume and price can be derived from the general relationship: Profit = total revenues - total costs In this equation, Total revenues = selling price x unit sales volume Total costs = fixed costs + (variable costs per unit x unit sales volume). Therefore, the equation can be restated as: Profit = (selling price x unit sales volume) - (FC + [variable costs per unit x unit Sales volume]). Break-even point: This relationship is of great interest to the management of the organization since it enables a break-even point to be determined. The break-even point is simply the unit or dollar sales volume at which total revenues equal total costs. Put another way, the break-even point is the volume of sales at which there is zero result. Until the breakeven sales quantity is reached, the product, service, or business segment under consideration operates at a loss. However, beyond this point increasing levels of profits are achieved. It should be clearly understood, however, that the break-even point is merely an estimate. Its accuracy depends upon the realism of the models assumptions and the precision of the numbers used in the calculation. The break-even point may be calculated as: BEP (units) = BEP (dollars) = fixed costs unit contribution margin Contribution margin per unit fixed costs contribution margin ratio Contribution margin ratio

Note that fixed costs include all costs classified as fixed. These include fixed manufacturing overhead, fixed selling and administrative expenses; not merely those expenses related to manufacturing and production. Contribution margin: The contribution margin per unit is calculated as the selling price per unit less the variable cost per unit. It can be thought of as the incremental profit from one unit of product available to recover the fixed costs. Once fixed costs have been recovered, the contribution margin is the amount each unit sale contributes to profit. A useful extension of the contribution margin per unit is the contribution margin ratio; the ratio of the contribution margin per unit to the selling price per unit. Contribution margin ratio = contribution Selling Price