Easy Notes - By Manoj Singh

Steps in Calculation of Support & Resistance

This is the most popular non discounted cash flow capital budgeting techniques which is simplest to calculate & gives the answer to very first question asked by most of the stakeholders i.e. In how many years, invested amount will be recovered? In other words, the Payback period is the number of years required to recover the original investment in the project. Hence it is the number of years in which cumulative cash inflows equals the cash outflow.

Relevant Facts

a. The Payback period doesn’t have decision rule like NPV (Net Present Value) & IRR (internal Rate of Return). This is just a liquidity measure. 

b. Acceptance or rejection of the proposal totally depends on the specified timeframe in which company / individual wants their money back. 

c. Payback period should not be used alone. It should be used alongside any one of the DCF (Discounted cash flow) techniques i.e. NPV (Net Present Value) or IRR (Internal Rate of Return).

How to calculate Payback Period?

Suppose, Initial cash outflow is $90,000 for two projects i.e. A & B

Cash inflows for subsequent years are mentioned below.

4. It doesn't account for the profitability figure out of a project. Long term profitability should not be ignored during selection of project.

Mission statements are clear & concise one or two line statement which explains the purpose of existence for the organization. A well drafted Mission statement can define company’s business, goals, customers and its market in a very lucid manner.

Basic principles which should be kept in mind while calculating cash flows are mentioned below.

1. Incremental approach

While calculating cash flows, only those cash flows are considered which can be associated and attributed to adoption of a particular project. Finance manager should check for nature of expenses very wisely while evaluating proposals. Only incremental cash flows are considered for capital budgeting.

2. Financial cash flows 

As cost of debt or equity is already considered in WACC (weighted average cost of capital) which is used for discounting cash flows, financial cash flows are ignored in order to avoid error of double counting,

3. Cash flows are considered on after tax basis. Tax savings is considered as an inflow.

4. Depreciation is added back to PAT as they are of non-cash nature and provides a tax shield i.e. reduction in tax liability. All non-cash items should be added back to PAT to arrive at cash inflows.

5. Sunk cost is ignored as these are not incremental.

Sunk costs are that cost which has already been incurred in past, prior to evaluation of proposals and is thus ignored as this doesn't have effect on present or future decisions. Example, if a company has piece of land acquired in past and is considering to set up a plant on that land, then this cost land acquisition in past is considered as sunk cost.

If a new land has to be acquired for this new project then the cash outflows should be considered in capital budgeting.

6. Opportunity costs are considered as they are sacrificed. Opportunity costs of a resource is its value in its best alternative usage.

7. Unless given otherwise, it is assumed that cash outflows are considered to have occurred in the beginning of the year and inflows to be occurred at the end of the year.

8. While evaluating replacement decision, savings in costs are always considered as inflows and that to on after tax basis.

Calculation 

Cash inflows

PAT (Profit after tax) + Depreciation +Financial charge (1-tax rate) – Capital expenditure (if any) – Repairs (if any)

Where,

PAT is calculated as

Net sales revenue – Cost of goods sold – Selling, general & administration expenses – Depreciation – Interest – Taxes

Where,

Cost of goods sold is calculated as

Opening inventory + Purchases – Closing Inventory

Cash outflows

Cost of new plant + Installation expenses + Other capital expenditure + Additional working capital – Tax benefit on account of capital loss on sale of old plant (if any) – Salvage value of old plant + Tax liability on account of capital gain on sale of plant (if any)

If we talk about the global scenario, 

Under non – discounted cash flow category: Payback period is the most popular technique used worldwide.

Under discounted cash flow category: NPV (Net present value) & IRR (Internal rate of return) are the most popular methods.

Please have a look at the chart which shows the ranks of capital budgeting techniques based upon preference of respondents on a scale of 0 (never) to 4 (always) in 4 countries such as USA, UK, Germany & France. 

Source: As per report published by Graham & Harvey Surveys (2001) & Brownen, Dejong & Koedijk Survey report (2004) 

Below mentioned findings were further highlighted by similar surveys.

1. In European countries, most of the companies prefer Payback period method for making capital budgeting decisions.

2. In USA, IRR is still the favourite while taking decisions. Thereafter, NPV & Payback period is considered.

3. Companies managed by MBA degree holders have a strong preference for discounted cash flow techniques such as NPV / IRR.

Definition

Marketing your products or services through online tools (internet based) to reach out at your targeted customers is often termed as online marketing. There are various activities which are being done nowadays to promote products through online mediums such as website creation, SEO/SMO, content management, blog writing, reviews management & showcasing of products at online market space.

Marketing mix is a tool which was propounded by E. Jerome McCarthy in 1960s to help decision makers to decide on various components of product / services which affect a lot in their success and failures. Researchers / professionals generally call it as 4Ps / 7Ps / 4Cs of marketing. This mix answers most of the questions being asked related to product / services and helps a lot in gaining competitive advantage. 

Both the techniques are most popular discounted cash flow techniques used in capital budgeting but sometimes there could be situation where an analyst needs to choose between any of the two. When you are analyzing a single conventional project, then both the tool will give you the same decisions. Once there are mutually exclusive projects*, then dilemma can be faced by analysts while choosing the projects.

This term was propounded by Theodore Levitt in 1960’s and became most popular when it got published in Harvard Business Review (HBR) magazine in 60’s. This is the most common mistakes made by companies when they start focusing on the product / services which they sell instead of focusing on customer’s need. The main motive of doing business gets defeated when we don’t act as per consumers need and demand. We have seen in past as to how a brand / product get extinct or loses the market share when they don’t focus on consumer’s needs. Keep a constant eye on the changing preferences of end consumers and act accordingly. 

This is one of the important & most widely accepted discounted cash flow capital budgeting techniques which we generally use for evaluation of projects. NPV may be defined as the sum of present values of cash inflows less the total cash outflows. Present value is calculated by multiplying the cash inflows by discount factor which is further summed up in order to find out total present value of cash inflows. Total initial outflow is then deducted from total present value to arrive at Net present value.  

Below mentioned are 11 points which should be given due consideration while drafting effective marketing strategies. 

1. Identify your target customers first and focus on them only. Without identifying your customers, you can’t find them. Hence, this is the first step while preparation of marketing strategy.

2. Prepare your marketing budget and plan accordingly. Take special care while preparing budget & try hard on making this more realistic. This can be done by involving all relevant department heads in your company.

3. Measurable & Achievable: Make your plan measurable and achievable. Fix targets / goals in consultation with the marketing team & break them into quarterly, monthly & fortnightly targets.

4. Position yourselves correctly: Don’t confuse your customers as this is the most common mistakes which are generally made by companies. Make your customers clear about one basic questions i.e. what does your product stand for? E.g. If you talk about “Ferrari”, I understand sports car. If you say “Cartier”, I understand luxury watch. 

5. Create awareness: Advertise about your product through most suited advertisement medium. Plan in advance about this spend in your budget as this plays a very vital role in building a brand and impact a lot on revenue. One can choose between print media, online advertisement, TV commercials, outdoor hoardings and many more depending upon your pocket size and target customers. Most of the companies prefer more than one advertisement medium for increasing their presence faster.

6. Focus and strengthen your USP (unique selling proposition): If your product has some unique feature which your competitor doesn't have then please highlight those and harvest on the same through aggressive marketing campaigns. 

7. Watch your competitor closely: Know your competitors thoroughly and keep a close eye on their movement and marketing tactics. 

8. CSR (Corporate social responsibility): Include some CSR initiatives & highlight the same during all your advertisement campaigns. 

9. Flexible: Make your plan flexible enough for further changes as you may be required to alter your plans due to competitor’s move or customer’s requirement.

10. Make your online presence: This has become very important nowadays due to rising online customer base. Below mentioned are few activities which one should do in order to improve your online presence.

a) Get your website ready with user friendly features.

b) Create your pages on social media websites such as Facebook, Twitter, LinkedIn and many more.

c) Manage your reviews & testimonials tactfully and act promptly on negative reviews. 

d) Put product or company video on Youtube.com or other relevant websites.

e) Buy e-tailing space on leading online retailer’s website such as Amazon, e-bay, Alibaba etc by registering your product or company.

f) Get the SEO (search engine optimization) done for your website through good online marketing company. 

g) Submit blogs on relevant websites. 

h) Respond quickly to online queries posted by customers.

11. Control measures: After doing lots of hard work, one needs to know the real impact of the strategies which has been implemented during the year. One can compare the results through measuring sales figure of previous year and current year. If all your marketing strategies are not giving positive result then it would be advisable to re-work on the pricing strategies and re-define your target customers. 

Calculation of IRR (Internal Rate of Return) is bit tedious so i have tried to break the steps in simpler and easy to understandable form. For understanding IRR in detail, please refer to my separate post on this.

Internal Rate of Return is one of the most frequently discussed discounted cash flow technique in capital budgeting. This is one of the best tools for making investment decisions, especially important when you have two mutually exclusive projects. IRR is basically the discount rate at which present value of future after tax cash flows equals the total investment outlay. In other words, this is discount rate which produces a zero NPV (Net present value). Hence, at this rate, present value of cash inflows equals the present value of cash outflows.

There are various activities involved in order to make the final product available to customers & most of the companies generally involve themselves in one activity of the value chain. E.g. assembly & packaging out of other activities as mentioned in the value chain (See fig. below).  Sometimes, In order to strengthen the position over suppliers or distributors or service providers, companies add up one or more activities either towards raw material or towards end users (See fig.1 below). This strategy of adding up one or more activities is called Vertical integration. Example, Car manufacturing company acquires Tyre manufacturing company or ancillary parts manufacturing company (producing important auto parts) in order to solve their raw material shortage problems and reduce other relevant costs.

You may find few companies which prefer to control each and every activity starting from Raw material to Marketing & Sales and sometimes after sales service as well. E.g. Oil companies, Smartphone manufacturers & many more. Hence, level of integration may vary from industry to industry. Option is left with the companies that whether they want to integrate fully or partially?

Types of Vertical Integration

There are 3 types of Vertical Integration
Backward integration: If company is moving towards source of raw materials then it has adopted backward integration strategy. E.g. adding up manufacturing facility to start production of ancillary products (which was bought earlier from supplier) to support the production process. By doing this, companies can reduce their interdependencies on supplier and gain through reduction in input costs.

Forward integration: If company is adding few activities which make them nearer to the end users then this strategy is known as forward integration. E.g. establishing own distribution network or after sales service centre. E.g. Apparels manufacturer set-up its own stores throughout country and starts selling to customers directly.

Balanced integration: When company has gained control over one step backward and one step forward of the value chain then it is said that they are following balanced integration strategy. In other words, it is combination of both forward & backward integration strategies.

Advantages of Vertical Integration
1. Control over value chain: This strategy helps a lot in gaining control over various activities under value chain.
2. Barriers to entry: Huge capital investment is required for implementing this strategy. Hence, this huge investment creates an entry barrier for new entrants and thus improves the overall position of the company.
3. Reduced production cost: As there are no intermediaries’ & manufacturer’s margin and company is enjoying the benefits of economies of scale, cost of production is bound to decline.
4. Competitive advantage: Economies of scale produces cost effectiveness & barriers to entry. This in turn leads to competitive advantage.
5. Quality product: When you have better control over the production activities & raw materials, then quality of final goods automatically gets improved because of increased supervision & control.
6. Control over scarce resources: Through controlling over raw materials which are scarce & limited, companies have an advantage over competitors as unavailability of the same can cause serious problems to big industrial setup. Think of power companies owning coal blocks, oil companies owning gas basins.

Disadvantages of Vertical Integration
1. Can’t be reversed back: Most important drawback of this strategy is that it couldn’t be reversed back and can prove very fatal if it backfires. Hence, special care is taken while taking or implementing any of the vertical integration strategies.
2. Expensive: These are very expensive as it requires lot of capital infusion into new business line / activity.
3. Expertise issue: Initially you might face with this problem because of lack of experience in added line of businesses resultant from adaptation of any strategies as mentioned above.