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Exhibit 27-1 Weighted Average Cost of Capital Funding Total Percentage Cost of Dollar Cost Source Funding ϫ Funding of Funding Debt $ 950,000 ϫ 5.221% $ 49,600 Preferred stock 500,000 ϫ 12.000% 60,000 Common stock 2,500,000 ϫ 12.963 % 324,075 Totals $3,950,000 ϫ 10.979% $433,675 In the exhibit, there is a large proportion of high-cost common stock to debt and pre- ferred stock, which gives the company a minimal risk of not meeting its fixed interest pay- ments. If a company’s management were inclined to reduce the cost of capital, it could do so by obtaining more debt and using it to buy back common stock. This would certainly eliminate some high-cost common stock, but at the price of increasing the size of interest payments, which in turn would increase the amount of fixed costs, and therefore raise the breakeven point for the company, which can be risky if it is already operating at close to the breakeven level. Thus, there is an increased risk of business failure for those compa- nies that attempt to reduce their cost of capital by transferring their sources of funding from equity to debt. Though we have just reviewed the calculations for determining a company’s exist- ing cost of capital, this does not necessarily mean that it is the cost that should be applied to the valuation of all prospective capital projects. There are two issues that may require one to use a different cost of capital. The first is that the company may have to alter its capital structure in order to obtain any additional funding. For example, lenders may have informed the company that no more debt will be available unless more equity is added to its capital base. In this instance, the cost of capital to be applied to a new capital purchase should be the incremental cost of funds that will specifically apply to the next investment. The second issue is that the cost of capital just calculated was for the existing blend of debt and equity, whose costs may very well have changed on the open market since the date when it was obtained. Debt costs will vary on the open mar- ket, as will investor expectations for returns on stock. Consequently, it may be advis- able to periodically recalculate the cost of capital not only to reflect current market conditions for new funding, but also on an incremental basis, which can then be applied to a review of new capital investments. The only case where these strictures would not apply is when the amount of new capital investments is so small that there is little like- lihood that obtaining funds for them will require a significant change in the existing capital structure. If there are too many possible capital investments for the amount of funding avail- able, one can keep increasing the cost of capital that is used to discount the cash flows from each project (as noted in the next section) in order to see which projects have the highest discounted cash flows. However, capital investments that are only based on dis- counted cash flow will ignore other issues that should have a bearing on the investment decision. One such factor is the risk of the project; it will be higher if the investment is in a new market, as opposed to one that is an extension of an existing market. Also, if there is a history of good returns on investment in a particular area, then there is a lower risk of loss on future investments in the same area. Further, the risk of heightened competition in some areas should be factored into the investment decision. Consequently, it is better to 27-2 The Cost of Capital 361 use the cost of capital to throw out only those capital investments that are clearly inca- pable of achieving a minimum return, and then further narrow the field of potential invest- ment candidates by carefully reviewing other strategic and tactical factors related to each project. One must also be aware of changes in the cost of capital that may arise in various subsidiaries of a conglomerate, where there may be significantly different levels of busi- ness risk in each one. One of the reasons why conglomerates are assembled is to combine the varying levels of business risk in each component business, so that the average level of risk, as defined by the probability of achieving an even stream of cash flows, is maxi- mized. The problem with using a blended cost of capital that is based on a multitude of disparate businesses is that the rate may be applied to individual businesses whose levels of risk would normally involve a much higher cost of capital, while other businesses oper- ating in mature industries with predictable results may be constrained by the use of a cost of capital that is too high. One way to avoid this problem is to derive a cost of capital that is based on the debt and equity structure of other companies that are located solely in the industries within which specific subsidiaries operate. This yields a cost of capital for the subsidiary, which may be a more accurate measure for determining the discounted return on various capital projects. However, there may be some companies within the industry that have excessively aggressive or conservative capital structures, which may result in a range of possible costs of capital. 27-3 CAPITAL PURCHASE EVALUATIONS When evaluating whether or not one should invest a considerable amount of funds in cap- ital projects, the accountant has a number of tools available, such as the hurdle rate, pay- back period, net present value, and internal rate of return—all of which are covered in this section. The hurdle rate, with some variations, is a company’s cost of capital, which we covered in the last section. Most capital projects must generate a stream of cash flows that, when discounted at the hurdle rate, will generate a positive cash balance. If this were not the case, then a company would be investing funds at a rate of return less than the cost of the capital it would be using to pay for the project. However, there are cases where the hurdle rate will diverge from the cost of capital. For instance, if a project is perceived to have an extremely high level of risk (such as investments in unproven technology), then the rate may be increased substantially. Another example is a government-mandated enhancement to the air “scrubbers” in a coal-fired electrical generating plant, which must be installed irrespective of the hurdle rate. Thus, there can be justifiable variations between the hurdle rate and the cost of capital. The hurdle rate is used to discount the stream of cash flows spun off by a capital project, so that the cash flows are translated into their current-period value. To do so, we use a discounting factor that is listed in the “Compound Interest (Present Value of 1 Due in N Periods)” table in Appendix C to discount a cash flow estimated to occur in a future period back to the present period, using the hurdle rate as the discount rate. For example, if we have a cash flow of $100,000 occurring in Year Four, and assume a hurdle rate of 9%, then we will use a discount rate of .7084 to determine that the current value of this 362 Ch. 27 Financial Analysis cash flow is $70,840. In case one’s assumptions fall outside of the table in Appendix C, the formula to use is: 1 ________________________________ (1 + discount rate) number of years If one is using Microsoft Excel to derive the calculation, then the formula in that elec- tronic spreadsheet is: =1/((1+[enter the discount rate]) ^ [enter the number of years]) Virtually all cash flows caused by a capital project should be subject to cash dis- counting. For example, Exhibit 27-2 shows a stream of cash flows for a capital project that are spread over a five-year period. They relate to the initial capital and working capital cost, ongoing maintenance costs, annual gross margin on sale of products created by the capital item (net of income taxes), and the sale of equipment and release of working cap- ital at the end of the project. Each cash flow is assigned a discounting factor that is based on the year in which it occurs, based on an assigned hurdle rate of 7%. The exhibit shows a stream of cash flows that results in a slight positive cash flow, and so should be approved. A more comprehensive review would also include the positive tax impact of depreciation costs on the cash flows, and any personnel or other overhead costs associated with the project. This summation of all discounted cash flows is called the “net present value” method (NPV), and is a commonly used technique for evaluating capital investments. Exhibit 27-2 Discounted Cash Flows from a Capital Project Discount Year Description Cash Flow Factor Present Value 0 Initial capital purchase –$250,000 1.000 –$250,000 0 Working capital requirement –175,000 1.000 –175,000 1 Gross margin on product sales +45,000 .9346 +42,057 1 Project maintenance costs –10,000 .9346 –9,346 2 Gross margin on product sales +85,000 .8734 +74,239 2 Project maintenance costs –15,000 .8734 –13,101 3 Gross margin on product sales +120,000 .8163 +97,956 3 Project maintenance costs –20,000 .8163 –16,326 4 Gross margin on product sales +120,000 .7629 +91,548 4 Project maintenance costs –25,000 .7629 –19,073 5 Gross margin on product sales +60,000 .7130 +42,780 5 Project maintenance costs –27,500 .7130 –19,608 5 Release of working capital +175,000 .7130 +124,775 5 Sale of capital equipment +60,000 .7130 +42,780 Present value of cash flows — — 13,681 27-3 Capital Purchase Evaluations 363 Another evaluation method that relies on discounting is the “internal rate of return” method (IRR). This approach alters the discount rate until the stream of discounted cash flows equals zero. By doing so, one can see if the adjusted discount rate is relatively close to the standard corporate hurdle rate, and so may require only minor changes to the cash flow estimates to bring them up to or in excess of the hurdle rate. It is also useful when the management team wants to compare the rates of return on different projects, usually when there is only limited funding available and it wants to invest in those projects with the highest possible rate of return. It is determined manually with a “high-low” approach of calculating discounted cash flows that gradually brings the accountant to the correct IRR value. It is more easily calculated with an electronic spreadsheet, such as Microsoft Excel. If that software is used, the calculation would be: = ([range of values],[guess as to the value of the IRR]) The NPV and IRR methods are quantitatively valid ways to either justify or cancel proposed capital investments. However, they involve estimates of cash flows that may be well into the future, and calculations using discount rates that may also be subject to some degree of dispute. In cases where these issues make the use of NPV or IRR somewhat questionable, one can fall back on the old technique of “payback.” Under the payback approach, we ignore the time value of money and instead create a simple calculation that estimates the earliest date on which the initial investment in a capital project is paid back to the company. If the payback period is quite short, then the company’s risk of loss on investment is minimal. Unfortunately, this technique does not focus on the potential for substantial cash flows from a project some years into the future, and may result in invest- ments only in projects with rapid returns, which is not a way to run a business with a long- range view of its prospects. To calculate a project’s payback, one can divide the total investment in it by its aver- age annual cash flows. For example, a project with an initial investment of $500,000 and average annual returns of $175,000 would have a payback period of 2.86 years ($500,000/$175,000). However, this approach may yield flawed results if the cash flows vary widely from year to year. This concept is illustrated in Exhibit 27-3, where we see that the cash flows resulting from the $500,000 investment are skewed well into the future, even though their average annual cash flow is $175,000, resulting in a payback that does not actually occur until 4.0 years have passed. Consequently, it is safer to calculate payback on a year-by-year basis. Exhibit 27-3 Payback Calculation on a Year-By-Year Basis Year Net Cash Flow Net Unreturned Investment 0 –$500,000 –$500,000 1 0 –500,000 2 0 –500,000 3 200,000 –300,000 4 300,000 0 5 375,000 +375,000 364 Ch. 27 Financial Analysis The accountant is likely to not only evaluate capital proposals with the preceding evaluation methods, but also to handle much of the application paperwork associated with them. A sample of a capital request form is shown in Exhibit 27-4. This form con- tains the fields needed to conduct a discounted cash flow analysis, for it requires a detailed list of expected cash flows by year, by using a number of key revenue and expense categories. The “type of project” section is also of importance, for it tells the reviewer if a project is subject to a different hurdle rate. For example, a project that is being implemented to resolve a safety issue will probably be approved, irrespective of the hurdle rate or the presence of any positive cash flows at all. The bottom section of the form is crucial for the approval process. It notes the range of approval signatures that must be obtained before the proposal will be completed, with the number of approvals rising with the level of proposed investment in the project. This form should be issued to the sponsors of capital projects with a sample form and instructions, so they can easily see how it is to be filled out. After a capital proposal has been approved, the accountant should continue to track actual cash flows and compare them to budgeted levels, so that the management team can see if some project sponsors have a history of incorrectly estimating cash flows in order to obtain project approvals. The post-approval review will also spot any control issues that may arise with the capital approval process, so that the process can subsequently be enhanced for future capital investments. 27-4 BREAKEVEN ANALYSIS Every accountant should be aware of a company’s breakeven point, for this tells manage- ment what revenue level it must maintain in order to achieve a profit. The formula for breakeven is simple enough—just add up all fixed costs for the period, divide by the gross margin percentage, and the result will be the total revenue level to be achieved in order to yield a profit of exactly zero. For example, a company with fixed costs of $3,700,000 and gross margins of 33% must sell more than $11,212,121 to earn a profit. It can be of use to translate the breakeven formula into a graphical representation, such as the one noted in Exhibit 27-5. This graph contains a horizontal line that represents the level of fixed costs, such as salaries, rent, and leases, that will be incurred irrespective of the revenue level. The slanted line that connects at the x-intercept with the fixed cost line represents variable costs, such as the materials used to manufacture products. The slanted line beginning at the x-y intercept represents the revenue to be recognized at var- ious levels of production volume. According to the exhibit, the company will begin to generate a profit at an approximate capacity utilization level of 40%. Above the noted breakeven point, income taxes will be subtracted from profits, which are shown in the upper right corner of the graph. The breakeven chart shown in Exhibit 27-5 is a very simple one, because it assumes that there are no changes in costs at any volume level. In reality, additional fixed costs must be incurred as production volumes increase. For example, there will come a point where production capacity for one eight-hour shift cannot be expanded; only by hiring additional supervisors, production planners, maintenance staff, and materials management personnel for the second and third shifts can capacity be increased. All of these costs are shown in Exhibit 27-6, where there is a large jump in the level of fixed costs at about the time when production capacity reaches the 70% level. Because of this significant increase, 27-4 Breakeven Analysis 365 Capital Investment Proposal Form Name of Project Sponsor: H. Henderson Submission Date: 09/09/01 Investment Description: Additional press for newsprint. Cash Flows: Tax Effect of Working Annual Salvage Year Equipment Capital Maintenance Depreciation Value Revenue Taxes Total 0 –5,000,000 –400,000 800,000 – 5,400,000 1 –100000 320,000 1,650,000 –700,000 1,170,000 2 –100,000 320,000 1,650,000 –700,000 1,1700,00 3 –100,000 320,000 1,650,000 –700,000 1,170,000 4 –100,000 320,000 1,650,000 –700,000 1,170,000 5 400,000 –100,000 320,000 1,000,000 1,650,000 –700,000 2,570,000 Totals –5,000,000 0 –500,000 2,400,000 1,000,000 8,250,000 1,850,000 Tax Rate: 40% Hurdle Rate: 10% Payback Period: 4.28 Net Present Value: (86,809) Internal Rate of Return: 9.4% 366 Exhibit 27-4 Capital Request Form Type of Project (check one): Legal requirement __________ New product-related __________ Yes Old product extension __________ Repair/replacement __________ Safety issue __________ Approvals: Amount Approver Signature <$5,000 Supervisor ___________________________________ $5–19,999 General Mgr ___________________________________ $20–49,999 President ___________________________________ $50,000+ Board ___________________________________ 367 Reproduced with permission: Bragg, Financial Analysis: A Controller’s Guide, John Wiley & Sons, 2000, p. 24. Exhibit 27-5 Simplified Breakeven Chart Reproduced with permission: Bragg, Financial Analysis: A Controller’s Guide, John Wiley & Sons, 2000, p. 118. the exhibit shows that the point at which profits are maximized is just prior to the jump in fixed costs. The accountant should be aware of the points where costs will step up in this manner, and advise management of the resulting changes in profits. The breakeven graph is of particular use in determining the inherent risk in a busi- ness forecast. A well-designed forecast will contain high, median, and low revenue and cost levels that bracket the full range of expected company performance for the upcom- ing year. By adding the full range of these estimates to a breakeven graph, as shown in Exhibit 27-7, one can see if there is any risk of loss during the forecasted period. In the exhibit, the lowest level of projected revenue will result in a loss; this issue should be communicated back to management as part of the forecasting process, so that it can alter its budget to avoid the potential loss. Other situations in which the breakeven graph can be used are to determine the impact of a changed product mix on overall profits, changes in per-unit selling prices, the range of potential profits to be expected, production volumes needed to offset various per- unit prices, and the level of revenue needed to cover the cost of a capital acquisition. Thus, breakeven analysis is an essential tool for financial analysis. 368 Ch. 27 Financial Analysis Revenue 50% 0% 100% Percentage of Production Utilization Variable Costs Breakeven Point Income Taxes Sales Volume Fixed Costs Variable Costs Income Taxes Net Profit Exhibit 27-6 Breakeven Chart Including Impact of Step Costing Reproduced with permission: Bragg, Financial Analysis: A Controller’s Guide, John Wiley & Sons, 2000, p. 120. 27-5 RISK ANALYSIS The preceding forms of analysis all assume that the data being used as input to the vari- ous calculations is accurate. If not, then the results of each analysis may be incorrect, and lead to bad business decisions. There are several ways to improve the accuracy of data used, as well as quantify the level of risk associated with it. The primary area in which there is a high risk of inaccuracy is in forecasts of any kind. The information used for a forecast is frequently based on the opinions of a small number of people, who may have biases that skew their forecasts away from actual results. The accuracy of forecasts can be improved by a number of means, such as calling upon outside experts for independent analysis and review, using an internal review board that discusses the data and recommends changes where needed, or calling upon the sales staff (those with the best knowledge of market conditions) for an opinion. It is also useful to compare actual results against forecasts by person, to see who is consistently making the best (and worst) forecasts. Once all estimates have been received, the accountant should determine their range of values. If they are broadly dispersed, then there is a strong likelihood that using the 27-5 Risk Analysis 369 Revenue 50% 0% 100% Percentage of Production Utilization Breakeven Point Income Taxes Sales Volume Fixed Costs Variable Costs Income Taxes Net Profit Variable Costs Revenue Exhibit 27-7 Risk Analysis of a Business Forecast Reproduced with permission: Bragg, Financial Analysis: A Controller’s Guide, John Wiley & Sons, 2000, p. 125. median of all estimates as the basis for financial analysis will not include many of the esti- mates, which may be far higher or lower than the median. When there is a great deal of dispersion in the data, it is best to calculate its amount, and report this information along- side any resulting financial analysis, so that the reader can form an opinion regarding the level of risk for which the resulting analysis is not accurate. Dispersion can be determined with the standard deviation calculation. This measures the average scatter of data about the mean by arriving at a figure that represents the average distance of every data item from the midpoint. A large standard deviation means that the range of data is quite varied. In such cases, one should be wary of any resulting summarization of the data, since there are many possible outcomes that vary substantially from each other. The standard deviation can be converted into the coefficient of variation by divid- ing the standard deviation by the mean of the data. The coefficient of variation is a more useful number, because it restates the standard deviation in terms of a percentage. For example, a standard deviation may be 152.7, but one cannot tell if this is good or bad until it is converted into the coefficient of variation, where one then finds out that it represents 370 Ch. 27 Financial Analysis Revenue 50% 0% 100% Percentage of Production Utilization Fixed Costs Variable Costs Breakeven Point at Median Sales Level Income Taxes Sales Volume Fixed Costs Variable Costs Income Taxes Net Profit Predicted Loss at Lowest Expected Sales Level Predicted Profit at Highest Expected Sales Level [...]... Information Systems 28-1 28-2 28-3 28-4 28-5 28-6 INTRODUCTION 373 THE MANAGEMENT INFORMATION SYSTEMS STRATEGY 373 SOFTWARE EVALUATION AND SELECTION 374 SOFTWARE INSTALLATION 388 SOFTWARE TESTING 391 INFORMATION SYSTEM SECURITY 28 -7 28-8 28-9 28-10 28-11 393 28-12 AUTOMATED DATA COLLECTION TOOLS 395 DATA STORAGE TOOLS 396 INTEGRATION OF ACCOUNTING SOFTWARE WITH OTHER SYSTEMS 398 ELECTRONIC DATA INTERCHANGE... 401 OUTSOURCING MANAGEMENT INFORMATION SYSTEMS 402 SUMMARY 4 07 28-1 INTRODUCTION The accountant can no longer be skilled in just the management and technical aspects of accounting The continuing need to improve the efficiency and effectiveness of the accounting function has driven organizations to install the most technologically advanced accounting software systems, which allows them to automate some... evaluation and selection of an accounting software package at some point during his or her career When this happens, the chief issue to consider during the process is what features are needed for the software to be acceptable to the buyer The following list of features is grouped by the type of accounting module most likely to be found in the software, and covers the most important accounting features: 1 Accounts... screens that itemize the various accounting functions and how they are to be used This should include a table of contents or index that allows the user to enter the first few letters of the topic about which help is needed, which will bring up a list of close matches • On-line software tutorial Though the accounting staff may be sent off to training classes prior to using a new accounting system, refresher... a new accounting system It is evident from the previous discussion that a great deal of coordinated work by many specialists is required to ensure that a software installation is successful One can therefore equate the presence of a properly supported, fully staffed project team with the success of any new accounting software 28-5 SOFTWARE TESTING The type of software testing required for new accounting. .. alternative means of covering the risk 28 -7 AUTOMATED DATA COLLECTION TOOLS The basic accounting system calls for the services of a large number of clerks, who are responsible for entering accounts payable, billing, payroll, inventory, and cash receipts information into it The volume of data entry generally calls for the services of most of the employees in the accounting department, not only to initially... data collection is that accounting transactions arriving from business partners, such as invoices from suppliers, are in a standard electronic format that can be sent directly into the accounting database without any manual intervention This usually requires the creation of a custom interface that will reformat the incoming transaction into a format that is readable by the accounting software A point-of-sale... be made to it until pending credit issues are resolved A key issue is that the software should not just issue a warning regarding these customers, but must com- 28-3 Software Evaluation and Selection 377 pletely shut down any processing of related orders, so that the company does not waste time processing orders that may never be shipped • Customer statements The software should be capable of creating... journal entry in the following accounting period This keeps an accountant from having to re-enter the system and manually reverse the journal entry For example, a wage accrual must be reversed in the following period, and this can be completed most easily if the user simply checks off a reversing entry box in the journal entry screen 28-3 Software Evaluation and Selection 379 • Standard journal entries... data fields The general ledger can be used as a data warehouse by allowing for the entry of non -accounting information in some fields The user should be able to enter alphanumeric information in them, so that the operating or statistical data related to a reporting period can be permanently stored alongside the accounting data for that period • Unbalanced entry warning A very basic function is for the . costs –25,000 .76 29 –19, 073 5 Gross margin on product sales +60,000 .71 30 +42 ,78 0 5 Project maintenance costs – 27, 500 .71 30 –19,608 5 Release of working capital + 175 ,000 .71 30 +124 ,77 5 5 Sale of. 5,400,000 1 –100000 320,000 1,650,000 70 0,000 1, 170 ,000 2 –100,000 320,000 1,650,000 70 0,000 1, 170 0,00 3 –100,000 320,000 1,650,000 70 0,000 1, 170 ,000 4 –100,000 320,000 1,650,000 70 0,000 1, 170 ,000 5 400,000 –100,000 320,000 1,000,000. requirement – 175 ,000 1.000 – 175 ,000 1 Gross margin on product sales +45,000 .9346 +42,0 57 1 Project maintenance costs –10,000 .9346 –9,346 2 Gross margin on product sales +85,000 . 873 4 +74 ,239 2 Project