Download The Economist guide to financial management PDF

TitleThe Economist guide to financial management
TagsThe Economist
File Size8.4 MB
Total Pages345
Table of Contents
                            Cover Page
Title Page
Copyright Page
1 Defining a successful business
2 Business structures
3 The role of the finance department
4 Financial statements and accounting systems
5 Accounting concepts and principles
6 Investors
7 Cost to serve
8 Product pricing and profitability
9 Portfolio management
10 Investment appraisal
11 Business planning, budgeting and reporting
12 Operational ratios and measures
13 Stockmarket and investor measures
14 Working capital management
15 Published reports and accounts
16 Accounting complexities
Glossary of financial terms
List of companies
Document Text Contents
Page 172

TABLE 10.9 Payback

The problem with the payback principle is that it is short term. It fails to
consider cash flows beyond the payback period (for example, project A could
make $2m in year 6 and its payback would still be four years).

It should also be noted that payback makes no allowance for interest (for
which a discounted payback is used, see below) and therefore does not measure
the return made by a project.

Net present value

This measure shows the surplus cash made by an investment after funding costs
have been deducted. It uses the principle of discounting cash flows. For
example, if someone is offered $100 now or $100 in one year’s time, they will
choose to receive $100 today, because if interest rates are 10% and the $100 is
invested, in one year it will have grown to $110. This is the concept of the time
value of money. The future value of $100 at a 10% interest rate is shown in
Table 10.10.

TABLE 10.10 Future value of $100 at 10% interest rate

Page 173

This uses the principle of compound interest. However, if someone is offered
$110 in one year’s time or $121 in two years’ time, the choice becomes more
difficult. From Table 10.10 it is clear that they are both worth $121 at the end of
two years. The ability to compare depends on choosing the same point in time
whether it is now, in two years’ time or in ten years’ time. Each cash flow needs
to be either compounded to find a future value or discounted to find a present

The two options would both be the equivalent of receiving $100 today. The
principle of working out what a future cash flow is worth now is the basis for all
project appraisal and company valuations. The year 0 value of a future cash flow
is known as its present value (PV). Adding together the PV of each cash flow in
a project provides the net present value (NPV).

To find the NPV of the cash flows in project A the procedure is as follows:
using a discount rate of 10%, each future cash flow can be multiplied by 100 and
divided by the compound interest value from Table 10.10 (see Figure 10.5).

The NPV of project A is therefore $651, which is substantially less than the
apparent surplus of $5,000 found by simply adding the series of cash flows. The
reduction is caused by having to fund the investment in the early years of the

FIG 10.5 NPV calculation

A better way to find the PV of a cash flow is to use the formula:

To apply the formula the interest rate is expressed as a fraction so 10% would
be shown as 0.1. The ^ symbol means “to the power”, for example if the number

Page 344

perception 130–134, 141
proposition 134–137
realisation 138

value-added tax 193–194
value pricing 141, 142
variable costs 107–109, 339
variance analysis 221–228, 340
Vause, Bob 233
vendor financed programmes 301
vendor-managed inventory (VMI) 291–292, 340
vertical analysis 216–217, 340
vertical integration 145
volume discounts 158–160, 303
vouchers, incentive 69–70

WACC (weighted average cost of capital) 9–12, 99–101, 340

factors affecting 98
inflation impact 191–192
taxation impact 194
use for calculating NPV 186–187

warranties 58–59
warrants 80
wastage 120
weighted average cost of capital (WACC) 9–12, 99–101, 340

factors affecting 98
inflation impact 191–192
taxation impact 194
use for calculating NPV 186–187

wholesale businesses 111
work in progress 340
working capital 38, 179–181, 340

cycle 251

Page 345

funding 82–83
inventory management 284–294, 304
optimisation 281–284
payables 302–304
receivables management 294–301

working capital turnover 250–251, 283

yield variances 225–226

Zehle, S. 204
zero-based budgeting 212, 340
zero-coupon 101

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