Question

1.​Explain the relationship that exists among the following terms: the accounting equation, investing decisions, financing decisions, and effectiveness and efficiency.

a) Explain what is meant by the “size of the pie” versus “size of the slice of the pie” in the context of this course.

b) Discuss what is meant by a required rate of return and how it relates to an expected rate of return.

c) how capital budgeting and cost-volume-profit could be used in operating a business.

a b and c different answers qhstd not clear?

means whats no clear

Answer 1

Q. 1: ​Explain the relationship that exists among the following terms:

A) the accounting equation,

B) investing decisions, financing decisions, and

C) effectiveness and efficiency

A) Accounting Equation:

Accounting Equation is the basic accounting principle.

Following is the Equation:

Total Assets = Total Liabilities + Owner’s / Shareholder’s Equity

This equation sets the foundation of double-entry accounting and highlights the structure of the balance sheet. Double-entry accounting is a system where every transaction affects both sides of the accounting equation. For every change to an asset account, there must be an equal change to a related liability or shareholder’s equity account. It is important to keep the accounting equation in mind when performing journal entries.

Assets: Company's resources, in simple terms, things the company owns.

Eg. Cash, Accounts receivable, Inventory, Prepaid insurance, Investments, Land, Buildings, etc.

Liabilities: Company's obligations, in simple terms, amounts the company owes.

Eg.: Notes payable, Accounts payable, Salaries and wages payable, Interest payable, taxes payable, etc.

Owner's equity or shareholders’ equity: is the amount left over after liabilities are deducted from assets: Assets - Liabilities = Owner's (or Stockholders') or Share Capital + Retained Earnings

Owner's or stockholders' equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.

B) Investing and financing decisions:

The basic function of finance basically includes the three financial decisions such as:

INVESTMENT DECISION:

It is the first and foremost important financial decision. The business generally has limited finance but the opportunities to invest are much wider. Hence the finance manager is required to access the profitability or return of various investment decisions and decide a policy which ensures high liquidity, profitably and sound health of an organization.

It includes short term investment decisions known as working capital management decisions and long term investment decisions known as capital budgeting decisions.

FINANCING DECISION:

Once the requirement of funds has been estimated, the next important step is to determine the sources of finance. The manager should try to maintain a balance between debt and equity so as to ensure minimized risk and maximum profitability to business.

DIVIDEND DECISION:

The third and last function of finance includes dividend decisions. Dividend is that part of profit, which is distributed to shareholders as a reward to high risk investment in business. It is basically concerned with deciding as to how much part of profit will be retained for the future investments and how much part of profit will be distributed among shareholders. High rate of dividend ensures higher wealth of shareholders and also increase market price of shares.

INVESTING, FINANCIAL AND DIVIDEND DECISIONS ARE ALL INTERLINKED:

Although the basic decisions of finance includes three types of decisions i.e. investing, finance and dividend decisions but they are interlinked with each other somehow. It can be evident from the following points:

The main objective of all the above decisions is same which is profit maximization of business and wealth maximization of shareholders.

In order to make investment decisions such as investing in some major projects, the first thing we need to consider is the finance available and required to make investment.

Finance decision is also influenced by dividend decision. If more of the dividend is distributed, there is a need to raise more finance from external sources.

If more of the profits are retained for long term investment, there is less need of outside financing.

Hence, there is a need to take into account the joint impact of all the three decisions and effect of each of the decision on the market value of the company and its shares to achieve the overall objective of the business.

C) Effectiveness and Efficiency:

Let’s first see the dictionary meaning of both terms:

Effective (adj.) : Adequate to accomplish a purpose; producing the intended or expected result.

Efficient (adj.) : Performing or functioning in the best possible manner with the least waste of time and effort.

Effectiveness and efficiency are two mutually exclusive terms. If one is present, the other may not be present and vice-versa. There are some major differences between them which is must for all of us to know as it is useful in our professional as well as personal life:

Effectiveness

Efficiency

Effectiveness is about accomplishing a task or producing a desired result

Efficiency is about performing a task in a best possible manner

It focuses on achieving the objective

It focuses on maximum result with least time and effort

Being effective means doing the right things

Being efficient means doing things in right manner

Effectiveness focuses on producing the result

Efficiency focuses on completing task using minimum time, effort and resources

Higher quality result can be expected from an effective person

Quick and intelligent work can be expected from an efficient person

Effectiveness is primarily concerned about results, not use of resources

Efficiency is primarily concerned on the use of time, energy and resources, not necessarily the results

It is not process and time oriented

It is process and time oriented

It looks at whether the something is done or not

It looks at how the activity is done

Effectiveness has no/less economic sense

Efficiency has higher economic sense

Effectiveness is the end result

Efficiency looks at the process/means of doing a task

It is result oriented

It is yield oriented

Effectiveness has long run perspective. It is used to achieve sustainable growth and long-term profits

Efficiency has short run perspective. It is used to achieve short term goals

Here, the effectiveness of strategies are measured

It is measured in operations of the organization

Effectiveness can be considered as an extroverted approach as it is measured between one or more organizations

Efficiency can be considered as an introvert approach as it measures the performance issues (cost, time and resources) within the organization

It refers to the usefulness of a thing

It refers to the way in which something is done

Being effective means producing better and higher degree of success

Being efficient means, there is minimum waste, expenses and unnecessary effort

Effectiveness does not look at input to output ratio

Efficiency looks at input to output ratio

Effectiveness in a work/organization should come first

Efficiency should be followed by effectiveness

Being effective means being on the right track with regard to the objective

Being efficient may not necessarily mean being on the right track with regard to the objective

Q. 2) Discuss what is meant by a required rate of return and how it relates to an expected rate of return.

1) Required Rate Of Return

Before investing your money, you probably want to know whether you’re making a good investment or a bad one. This is the main purpose of a required rate of return. The RRR represents the absolute minimum return on investment you would accept for that investment to be worthwhile.

If you need a 4 percent return on your money to make your investment advantageous, then this is your RRR. Any investment you take on should churn out a profit that’s above your RRR. For eg., if your RRR is 4 percent and the investment returns 2 percent, then you probably want to skip it.

The required rate of return is the minimum return an investor will accept for owning a company's stock, as compensation for a given level of risk associated with holding the stock. The RRR is also used in corporate finance to analyze the profitability of potential investment projects.

The required rate of return is also known as the hurdle rate, which like RRR, denotes the appropriate compensation needed for the level of risk present. Riskier projects usually have higher hurdle rates or RRRs than those that are less risky.

The required rate of return is the minimum return an investor will accept for owning a company's stock, that compensates them for a given level of risk.

Inflation must also be factored into an RRR calculation, which finds the minimum rate of return an investor considers acceptable, taking into account their cost of capital, inflation and the return available on other investments.

The RRR is a subjective minimum rate of return, and a retiree will have a lower risk tolerance and therefore accept a smaller return than an investor who recently graduated college.

The required rate of return (RRR) is the minimum amount an investor or company seeks, or will receive, when they embark on an investment or project.

The RRR can be used to determine an investment's return on investment (ROI).

The RRR for every investor differs due to the differing tolerance for risk.

Calculating the RRR involves discounting cash flows to arrive at the net present value (NPV) of an investment.

Equity investing utilizes the capital asset pricing model (CAPM) to find the RRR.

When evaluating stocks with dividends, the dividend discount model is a useful calculation.

In corporate finance, when looking at an investment decision, the overall required rate of return will be the weighted average cost of capital (WACC).

2) Expected Rate Of Return

An expected rate of return is the return on investment you expect to collect when investing in a stock. So, for comparison purposes, the RRR is the minimum possible rate that would entice you to invest, and the expected rate of return is what you actually plan to make from that investment. This rate is calculated based on probability.

The truth is, in a volatile market it’s impossible to know what the exact rate of return will be on an investment. However, using information on the stock’s history, its volatility and its overall market returns, you can reasonably estimate what the rate of return will be over a period of time. This is the expected rate of return: what you actually think you might make back on your investment.

Expected rate of return is that rate of return which a firm expects from the investment. For eg. the capital borrowed from the bank is invested in a project from where 6% of return is expected.

Thus expected return may be more than, equal to or less than the required rate of return.

Q3) How capital budgeting and cost-volume-profit could be used in operating a business.

i) Cost Volume Profit (CVP) Analysis:

To have a strong and successful business, you need to have a clear understanding of the financial impact that your most basic business decisions may have.

For eg. do you know:

· What are your most profitable products or services, so that you (or your salespeople) can really push those?

· What will happen if your sales volume drops?

· How far can sales drop before you really start to eat red ink?

· If you lower your prices in order to sell more, how much more will you have to sell?

· If you take out a loan and your fixed costs rise because of the interest on the loan, what sales volume will you need to cover those increased costs?

Cost/Volume/Profit (CVP) analysis can help you answer these, and many more, questions about your business operations. CVP analysis, as it is sometimes known, is a way of checking the relationship between your fixed and variable costs, your volume (in terms of units or in terms of dollars), and your profits.

Cost Volume Profit Analysis explains the behavior of profits in response to a change in cost and volume. In other words, it is an analysis presenting the impact of cost and volume on profits. Commonly called as CVP Analysis, a manager can find out the level of sales where the company will be in a no-profit-no-loss situation with this analysis. This situation is called break-even point. In a similar fashion, CVP analysis can also explain the no. of units of sales required to achieve a particular targeted operating income

There are three main tools offered by CVP analysis:

· contribution margin analysis, which compares the profitability of different products, lines or services you offer

· breakeven analysis, which tells you the sales volume you need to break even under different price or cost scenarios

· operating leverage, which checks the degree to which your business uses fixed costs, which magnifies your profits as sales increase, but also magnifies your losses as sales drop

ii) Capital Budgeting:

Capital budgeting is the process of determining which long-term capital investments a company will make in order to profit in the long-term.

Capital budgeting requires detailed financial analysis, including estimating the rate of return for a capital project.

Capital budgeting differs from expense budgeting because it focuses on long-term investments and not immediate expenses.

Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment.

The process involves analyzing a project’s cash inflows and outflows to determine whether the expected return meets a set benchmark.  

The major methods of capital budgeting include discounted cash flow, payback, and throughput analyses.

Preparing a Capital Budgeting Analysis

Step 1: Determine the total amount of the investment.

Step 2: Determine the cash flows the investment will return.

Step 3: Determine the residual/terminal value

Step 4: Calculate the annual cash flows of the investment

Step 5: Calculate the NPV of the cash flows

Thank you!