Category: Financial Management

Financial management is the process of planning, organizing, controlling, and monitoring an organization’s financial resources to achieve its goals and objectives effectively. It involves making financial decisions, managing investments, and ensuring the financial health and sustainability of the business. Financial management is essential for both businesses and individuals. As it helps in optimizing financial resources and making informed decisions about money matters.

Key aspects of financial management include:

  1. Financial Planning: This involves setting financial goals and developing a comprehensive plan to achieve them. It includes budgeting, forecasting, and identifying potential sources of funding.
  2. Capital Budgeting: This process entails evaluating and selecting long-term investment projects that align with the organization’s objectives. It involves analyzing the potential returns and risks associated with different investment opportunities.
  3. Financing Decisions: Financial managers need to decide how to fund the organization’s operations and investments. This may involve choosing between debt financing (e.g., loans, bonds) and equity financing (e.g., issuing shares).
  4. Working Capital Management: It involves managing the organization’s short-term assets and liabilities to ensure smooth day-to-day operations. The goal is to maintain an optimal balance between cash flow, inventory, accounts receivable, and accounts payable.
  5. Risk Management: Financial managers must assess and mitigate financial risks that the organization may face. This includes market risks, credit risks, liquidity risks, and operational risks.
  6. Financial Reporting and Analysis: Preparation of accurate and timely financial statements (e.g., income statement, balance sheet, cash flow statement) is crucial for decision-making. Financial analysis helps interpret these statements to assess the company’s performance and identify areas for improvement.
  7. Financial Control: Monitoring financial performance and comparing actual results with budgeted figures is essential to identify deviations and take corrective actions as needed.
  8. Tax Planning: Financial managers need to consider tax implications while making financial decisions to optimize tax efficiency and compliance.

Financial management is vital for individuals as well. It involves budgeting, saving, investing, and managing personal finances to achieve financial goals. Such as buying a house, funding education, or planning for retirement.

Overall, financial management plays a crucial role in the success and sustainability of organizations and individuals by ensuring the effective allocation and utilization of financial resources. It helps create a sound financial foundation, minimize risks, and support long-term growth and prosperity.

  • Cost of Capital: Meaning, Classification, and Importance!

    Cost of Capital: Meaning, Classification, and Importance!

    Investment in capital projects needs funds. The Concept of the study Explains – Cost of Capital: Meaning, What is the Cost of Capital? Components of Cost of Capital, Significance of the Cost of Capital, Classification of Cost of Capital, and the Importance of Cost of Capital. These funds are provided by the investors like equity shareholders, preference shareholders, debenture holders, etc in expectation of a minimum return from the firm. The minimum return expected by the investors depends upon the risk perception of the investor as well as on the risk-return characteristics of the firm. Also learn, Cost of Capital: Meaning, Classification, and Importance!

    Understand and Learn, Cost of Capital: Meaning, Classification, and Importance! 

    This minimum return expected by the investors, which in turn, is the cost of procuring funds for the firm, is termed as the cost of capital of the firm. Thus, the cost of capital of a firm is the minimum rate of return that it must earn on its investments in order to satisfy the expectation of the various categories of investors who have invested in the firm.

    What is the Cost of Capital?

    Meaning By accounting coach: The cost of capital is the weighted-average, after-tax cost of a corporation’s long-term debt, preferred stock, and the stockholders’ equity associated with common stock. The cost of capital is a percentage and it is often used to compute the net present value of the cash flows in a proposed investment. It is also considered to be the minimum after-tax internal rate of return to be earned on new investments.

    By Wikipedia: In economics and accounting, the cost of capital is the cost of a company’s funds (both debt and equity), or, from an investor’s point of view “the required rate of return on a portfolio company’s existing securities”. It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

    A firm procures funds from various sources by issuing different securities to finance its projects. Each of these sources of finance entails the cost to the firm. Since the minimum rate of return expected by various investors – equity investor and debt investor – will be different depending upon their risk perception of the firm, the cost of each source of finance will be different. Thus the overall cost of capital of a firm will be the weighted average of the cost of different sources of finance, with the proportion of each source of finance as the weight. Unless the firm earns this minimum rate of return, the investors will be tempted to pull out of the company, let alone, to participate in any further capital issue.

    We have seen that the cost of capital of a firm is the minimum required rates of return of various investors – shareholders and debt investors- who supply funds to the firm. How does a firm determine the required rates of return of each investor? The required rates of return are market determined and are reflected in the market price of each security. An investor, before investing in a security, evaluates the risk-return profile of investment and assigns a risk premium to the security. This risk premium and the expected return of an investor is incorporated in the market price of the security. Thus the market price of a security is a function of the return expected by the investors.

    Basic three Components of Cost of Capital: 

    There are various sources of finance that are used by the firm for financing its investment activities. The major sources are equity capital and debt. Equity capital represents ownership capital. Equity shares are financial instruments to raise equity capital. A debt may be in the form of secured/unsecured loans, debentures, bonds, etc. The debt carries a fixed rate of interest and the payment of interest is mandatory irrespective of the profit earned or loss incurred by the firm.

    Since interest payable on debt is tax deductible, the usage of debt provides a tax shield to the company. Basic three components as follows:

    1. Cost of Equity Share Capital: Theoretically, the cost of equity share capital is the minimum return expected by the equity investors. The minimum return expected by the equity investors depends upon the risk perception of the investor as well as on the risk-return complexion of the firm.
    2. Cost of Preference Share Capital: The cost of preference share capital is the discount rate which equates the net proceeds from the issue of preference shares to the present value of the expected cash outflows in the form of dividend and principal repayment on redemption.
    3. Cost of Debentures or Bonds: The cost of debentures or bonds is defined as the discount rate which equates the net proceeds from the issue of debentures to the present value of the expected cash outflows in the form of interest and principal repayment.

    Basic Significance of Cost of Capital: 

    The basic objective of financial management is to maximize the wealth of the shareholders or the value of the firm. The value of a firm is inversely related to the cost of capital of the firm. So in order to maximize the value of a firm, the overall cost of capital of the firm should be minimized.

    The cost of capital is of utmost importance in capital structure planning and in capital budgeting decisions.

    • In capital structure planning a company strives to achieve the optimal capital structure in order to maximize the value of the firm. The optimal capital structure occurs at a point where the overall cost of capital is minimum.
    • Since the overall cost of capital is the minimum rate of return required by the investors, this rate is used as the discount rate or the cut-off rate for evaluating the capital budgeting proposals.

    The Classification of Cost of Capital:

    The cost of capital defines as the minimum rate of return a firm must earn on its investment in order to satisfy investors and to maintain its market value. It is the investors required the rate of return. Cost of capital also refers to the discount rate which is used while determining the present value of estimated future cash flows. The major classification of the cost of capital is:

    Historical Cost and future Cost:

    Historical Cost represents the cost which has already been incurred in financing a project. It is calculated on the basis of the past data. Future cost refers to the expected cost of funds to be raised for financing a project. Historical costs help in predicting future costs and provide an evaluation of the past performance when compared with standard costs. In financial decisions, future costs are more relevant than historical costs.

    Specific Costs and Composite Cost:

    Specific costs refer to the cost of a specific source of capital such as equity shares, Preference shares, debentures, retained earnings etc. Composite cost of capital refers to the combined cost of various sources of finance. In other words, it is a weighted average cost of capital. It is also termed as ‘overall costs of capital’. While evaluating a capital expenditure proposal, the composite cost of capital should be as an acceptance/ rejection criterion. When capital from more than one source is employed in the business, it is the composite cost which should be considered for decision-making and not the specific cost. But where capital from only one source is employed in the business, the specific cost of those sources of capital alone must be considered.

    Average Cost and Marginal Cost:

    The average cost of capital refers to the weighted average cost of capital calculated on the basis of the cost of each source of capital and weights are assigned to the ratio of their share to total capital funds. The marginal cost of capital may be defined as the ‘Cost of obtaining another dollar of new capital.’ When a firm raises additional capital from only one source (not different sources) than marginal cost is the specific or explicit cost. Marginal cost is considered more important in capital budgeting and financing decisions. Marginal cost tends to increase proportionately as the amount of debt increase.

    Explicit Cost and Implicit Cost:

    Explicit cost refers to the discount rate which equates the present value of cash outflows or value of the investment. Thus, the explicit cost of capital is the internal rate of return which a firm pays for procuring the finances. If a firm takes the interest-free loan, its explicit cost will be zero percent as no cash outflow in the form of interest is involved. On the other hand, the implicit cost represents the rate of return which can be earned by investing the funds in the alternative investments. In other words, the opportunity cost of the funds is the implicit cost.

    Implicit cost is the rate of return with the best investment opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted. Thus implicit cost arises only when funds are invested somewhere, otherwise not. For example, the implicit cost of retained earnings is the rate of return which the shareholder could have earn by investing these funds if the company would have distributed these earning to them as dividends. Therefore, the explicit cost will arise only when funds are raised whereas implicit cost arises when they are used.

    The Importance of Cost of Capital:

    The cost of capital is a very important concept in financial decision making. Cost of capital is the measurement of the sacrifice made by investors in order to invest with a view to getting a fair return in future on his investments as a reward for the postponement of his present needs. On the other hand from the point of view of the firm using the capital, cost of capital is the price paid to the investor for the use of capital provided by him. Thus, the cost of capital is the reward for the use of capital. The progressive management always likes to consider the importance cost of capital while taking financial decisions as it’s very relevant in the following spheres:

    Designing the capital structure: 

    The cost of capital is the significant factor in designing a balanced and optimal capital structure of a firm. While designing it, the management has to consider the objective of maximizing the value of the firm and minimizing the cost of capital. Comparing the various specific costs of different sources of capital, the financial manager can select the best and the most economical source of finance and can design a sound and balanced capital structure.

    Capital budgeting decisions: 

    The cost of capital sources as a very useful tool in the process of making capital budgeting decisions. Acceptance or rejection of any investment proposal depends upon the cost of capital. A proposal shall not be accepted till its rate of return is greater than the cost of capital. In various methods of discounted cash flows of capital budgeting, cost of capital measured the financial performance and determines the acceptability of all investment proposals by discounting the cash flows.

    Comparative study of sources of financing: 

    There are various sources of financing a project. Out of these, which source should be used at a particular point in time is to be decided by comparing the costs of different sources of financing. The source which bears the minimum cost of capital would be selected. Although the cost of capital is an important factor in such decisions, equally important are the considerations of retaining control and of avoiding risks.

    Evaluations of financial performance: 

    Cost of capital can be used to evaluate the financial performance of the capital projects. Such as evaluations can be done by comparing the actual profitability of the project undertaken with the actual cost of capital of funds raised to finance the project. If the actual profitability of the project is more than the actual cost of capital, the performance can be evaluated as satisfactory.

    Knowledge of firms expected income and inherent risks: 

    Investors can know the firms expected income and risk inherent therein by the cost of capital. If a firms cost of capital is high, it means the firms present rate of earnings is less, the risk is more and capital structure is imbalanced, in such situations, investors expect the higher rate of return.

    Financing and Dividend Decisions: 

    The concept of capital can be conveniently employed as a tool for making other important financial decisions. On the basis, decisions can be taken regarding dividend policy, capitalization of profits and selections of sources of working capital.

    In sum, the importance of cost of capital is that it is used to evaluate the new project of the company and allows the calculations to be easy so that it has a minimum return that investor expectations for providing investment to the company.

    Cost of Capital Meaning Classification and Importance - ilearnlot

  • Financial Services: Meaning, Features, and Scope

    Financial Services: Meaning, Features, and Scope

    Financial services can be defined as the products and services offered by institutions. The Concept of Financial Services is Explain – their Meaning, Definition, Functions, Characteristics or Features, and Scope. Like banks of various kinds for the facilitation of various financial transactions and other related activities in the world of finance like loans, insurance, credit cards, investment opportunities, and money management as well as providing information on the stock market and other issues like market trends.

    Explain and Learn, Financial Services: Meaning, Characteristics or Features, and Scope.

    Meaning of Financial Services is the economic services provided by the finance industry, which encompasses a broad range of businesses that manage money, including credit unions, banks, credit card companies, insurance companies, accountancy companies, consumer-finance companies, stock brokerages, investment funds, individual managers and some government-sponsored enterprises.

    Their companies are present in all economically developed geographic locations and tend to cluster in local, national, regional and international financial centers such as London, New York City, and Tokyo.

    Definition of Financial Services:

    Services and products provided to consumers; and businesses by financial institutions such as banks, insurance companies, brokerage firms, consumer finance companies, and investment companies all of which comprise the financial services industry.

    Facilities such as savings accounts, checking accounts, confirming, leasing, and money transfer, provided generally by banks, credit unions, and finance companies. Financial Services may simply define as services offered by financial and banking institutions like the loan, insurance, etc.

    The financial services concerns with the design and delivery of financial instruments and advisory services to individuals and businesses within the area of banking and related institutions, personal financial planning, investment, real assets, and insurance, etc.

    Financial services refer to services provided by the finance industry. The finance industry encompasses a broad range of organizations that deal with the management of money. Among these organizations are banks, credit card companies, insurance companies, consumer finance companies, stock brokerages, investment funds, and some government-sponsored enterprises.

    Functions of Financial Services: 

    The following functions of financial services below are;

    • Facilitating transactions (exchange of goods and services) in the economy.
    • Mobilizing savings (for which the outlets would otherwise be much more limited).
    • Allocating capital funds (notably to finance productive investment).
    • Monitoring managers (so that the funds allocated will spend as envisaged).
    • Transforming risk (reducing it through aggregation and enabling it to carry by those more willing to bear it).

    Characteristics and Features of Financial Services:

    The following Characteristics and Features of Financial Services below are;

    1] Customer-Specific: 

    They are usually customer focused. The firms providing these services, study the needs of their customers in detail before deciding their financial strategy, giving due regard to costs, liquidity and maturity considerations. Financial services firms continuously remain in touch with their customers, so that they can design products that can cater to the specific needs of their customers.

    The providers of financial services constantly carry out market surveys so they can offer new products much ahead of need and impending legislation. Newer technologies are being used to introduce innovative, customer-friendly products and services which indicate that the concentration of the providers of financial services is on generating firm/customer-specific services.

    2] Intangibility: 

    In a highly competitive global environment, brand image is very crucial. Unless the financial institutions providing financial products; and services have a good image, enjoying the confidence of their clients, they may not be successful. Thus institutions have to focus on the quality and innovativeness of their services to build up their credibility.

    3] Concomitant: 

    Production of financial services and the supply of these services have to be concomitant. Both these functions i.e. production of new and innovative services and supplying of these services are to perform simultaneously.

    4] The tendency to Perish: 

    Unlike any other service, they do tend to perish and hence cannot be stored. They have to supply as required by the customers. Hence financial institutions have to ensure proper synchronization of demand and supply.

    5] People-Based Services: 

    Marketing of financial services has to be people-intensive and hence it’s subjected to the variability of performance or quality of service. The personnel in their organizations need to select based on their suitability and trained properly so that they can perform their activities efficiently and effectively.

    6] Market Dynamics: 

    The market dynamics depends to a great extent, on socioeconomic changes such as disposable income, the standard of living and educational changes related to the various classes of customers.

    Therefore, they have to constantly redefine and refine taking into consideration the market dynamics.

    The institutions providing their services, while evolving new services could be proactive in visualizing in advance what the market wants, or being reactive to the needs and wants of their customers.

    The Scope of Financial Services: 

    The following scope of Financial services, and cover a wide range of activities. They can broadly classify into two, namely:

    1] Traditional Activities: 

    Traditionally, the financial intermediaries have been rendering a wide range of services encompassing both capital and money market activities. They can group under two heads, viz.

    • Fund based activities and
    • Non-fund based activities.
    A. Fund based activities:

    The traditional services which come under fund based activities are the following:

    • Underwriting or investment in shares, debentures, bonds, etc. of new issues (primary market activities).
    • Dealing with secondary market activities.
    • Participating in money market instruments like commercial papers, certificates of deposits, treasury bills, discounting of bills, etc.
    • Involving in equipment leasing, hire purchase, venture capital, seed capital, etc.
    • Dealing in foreign exchange market activities. Non-fund based activities
    B. Non-fund based activities: 

    Financial intermediaries provide services-based on non-fund activities also. This can calls “fee-based” activity. Today customers, whether individual or corporate, not satisfy mere provisions of finance. They expect more from their companies. Hence a wide variety of services, are being provided under this head.

    They include:
    • Managing the capital issue i.e. management of pre-issue and post-issue activities relating to the capital issued by the SEBI guidelines and thus enabling the promoters to market their issue.
    • Making arrangements for the placement of capital and debt instruments with investment institutions.
    • The arrangement of funds from financial institutions for the client’s project cost or his working capital requirements.
    • Assisting in the process of getting all Government and other clearances.

    2] Modern Activities: 

    Besides the above traditional services, the financial intermediaries render innumerable services in recent times. Most of them are like the non-fund based activities. Because of the importance, these activities have been in brief under the head “New-financial-products-and-services”. However, some of the modern services provided by them are given in brief hereunder.

    1. Rendering project advisory services right from the preparation of the project report until the raising of funds for starting the project with necessary Government approvals.
    2. Planning for M&A and assisting with their smooth carry out.
    3. Guiding corporate customers in capital restructuring.
    4. Acting as trustees to the debenture holders.
    5. Recommending suitable changes in the management structure and management style to achieve better results.
    6. Structuring the financial collaborations/joint ventures by identifying suitable joint venture partners and preparing joint venture agreements.
    7. Rehabilitating and restructuring sick companies through an appropriate scheme of reconstruction and facilitating the implementation of the scheme.
    More things…
    1. Hedging of risks due to exchange rate risk, interest rate risk, economic risk, and political risk by using swaps and other derivative products.
    2. Managing in-portfolio of large Public Sector Corporations.
    3. Undertaking risk management services like insurance services, buy-back options, etc.
    4. Advising the clients on the questions of selecting the best source of funds taking into consideration the quantum of funds required, their cost, lending period, etc.
    5. Guiding the clients in the minimization of the cost of debt and the determination of the optimum debt-equity mix.
    6. Promoting credit rating agencies for rating companies that want to go public by the issue of the debt instrument.
    7. Undertaking services relating to the capital market, such as 1) Clearing services, 2) Registration and transfers, 3) Safe custody of securities, 4) Collection of income on securities.
    Financial Services Meaning Features and Scope
    Financial Services Meaning Features and Scope, Image credit from ilearnlot.com.
  • The Factors Influencing and Importance of Financial Decisions!

    The Factors Influencing and Importance of Financial Decisions!

    The Concept of Financial Decisions, The Factors Influencing Financial Decisions: 1. External Factors, and 2. Internal Factors, Fully Explain It by PDF and Free Download, and What is the Importance of Financial Decisions? Definition: The Financing Decision is yet another crucial decision made by the financial manager relating to the financing-mix of an organization. It is concerned with the borrowing and allocation of funds required for the investment decisions. Also learned, The Factors Influencing and Importance of Financial Decisions!

    Learn and Understand, The Factors Influencing and Importance of Financial Decisions! 

    The financing decision involves two sources from where the funds can be raised: using a company’s own money, such as share capital, retained earnings or borrowing funds from the outside in the form debenture, loan, bond, etc. The objective of financial decision is to maintain an optimum capital structure, i.e. a proper mix of debt and equity, to ensure the trade-off between the risk and return to the shareholders.

    The Concept of Financial Decisions:

    Financial decisions refer to decisions concerning financial matters to a business concern. Decisions regarding the magnitude of funds to be invested to enable a firm to accomplish its ultimate goal, kind of assets to be acquired, the pattern of capitalization, pattern of distribution of firm’s income and similar other matters are included in financial decisions.

    These decisions are crucial for the well-being of a firm because they determine the firm’s ability to obtain plant and equipment when needed to carry the required amount of inventories and receivables, to avoid burdensome fixed charges when profits and sales decline and to avoid losing control of the company. Financial decisions are taken by a finance manager alone or in conjunction with his other executive colleagues of the enterprise. In principle, the finance manager is held responsible to handle all such problems as involve money matters.

    But in actual practice, he has to call on the expertise of those in other functional areas: marketing, production, accounting, and personnel to carry out his responsibilities wisely. For instance, the decision to acquire a capital asset is based on the expected net return from its use and on the associated risk. These cannot be given values by the finance manager alone. Instead, he must call on the expertise of those in charge of production and marketing.

    Similarly, the decision regarding allocation of funds as between different types of current assets cannot be taken by a finance manager in the vacuum. The policy decision in respect of receivables—whether to sell for credit, to what extent and on what terms is essentially financial matter and has to be handled by a finance manager. But at the operating level of carrying out the policies, sales may also be involved since decisions to tighten up or relax collection procedures may have repercussion on sales.

    Similarly, in respect of inventory, while determining types of goods to be carried in stock and their size are a basic part of the sales function, a decision regarding the quantum of funds to be invested in inventory is the primary responsibility of the finance manager since funds must be supplied to finance inventory.

    As against the above, the decision relating to the acquisition of funds for financing business activities is primarily a finance function. Likewise, the finance manager has to take a decision regarding the disposition of business income without consulting other executives since various factors involved in the decision affect the ability of a firm to raise funds. In sum, financial decisions are looked upon as cutting across functional, even disciplinary boundaries. It is in such an environment that a finance manager works as a part of total management.

    The Factors Influencing Financial Decisions:

    A finance manager has to exercise a great skill and prudence while taking financial decisions since they affect the financial health of an enterprise over a long period of time. It would, therefore, be in the fitness of things to take the decisions in the light of external and internal factors. We shall now give a brief account of the impact of these factors on financial decisions.

    External Factors:

    External factors refer to environmental factors within which a business enterprise has to operate. These factors are beyond the control and influence of the management. A wise management adopts policies that will be most suited to the present and prospective socio-economic and political conditions of the country.

    The following external factors enter into decision-making process:

    • The State of Economy.
    • Structure of Capital and Money Markets.
    • State Regulations.
    • Taxation Policy.
    • Requirements for Investors, and.
    • Lending Policy of Financial Institutions.
    Internal Factors:

    Internal factors refer to those factors which are related with internal conditions of the firm such as nature of business, size of business, expected return, cost and risk, asset structure of business, structure of ownership, expectations about regular and steady earnings, age of the firm, liquidity in company funds and its working capital requirements, restrictions in debt agreements, control factor and attitude of the management.

    Within the economic and legal environment of the country finance manager must take the financial decision, keeping in mind the numerous characteristics of the firm.

    Impact of each of these factors upon financial decisions will now be discussed in the following lines.

    • Nature of Business.
    • Size of Business.
    • Expected Return, Cost, and Risk.
    • Asset Structure of the Firm.
    • Structure of Ownership.
    • Probabilities of Regular and Steady Earnings.
    • Age of the Firm.
    • Liquidity Position of the Firm and Its Working Capital Requirements.
    • Restrictions in Debt Agreements, and.
    • Management Attitude.

    Fully Explain It by PDF and Free Download:

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    What is the Importance of Financial Decisions?

    These decisions are relatively more important because of the following reasons:

    (1) Long-term Growth and Effect:

    These decisions are concerned with long-term assets. These assets are helpful in production. Profit is earned by selling the goods so produced. It can, therefore, be said the more correct these decisions are, the greater will be the growth of business in the long run. In addition to that, these affect the future possibilities of the business.

    (2) Large Amount of Funds Involved:

    Decisions regarding fixed assets are included in the preview of capital budgeting. A large amount of capital is invested in these assets. If these decisions turn out to be wrong, there occurs the heavy loss of capital which is a scarce resource.

    (3) Risk Involved:

    Capital budgeting decisions are full of risk. There are two reasons for it. First, these decisions refer to a long period, and as such expected profits for several years are to be anticipated. These estimates may turn out to be wrong. Second, because of the heavy investment involved, it is very difficult to change the decision once taken.

    (4) Irreversible Decisions:

    Nature of these decisions is such as cannot be changed so quickly. For instance, if soon after setting up a cotton mill, it is thought of changing it, then the old machinery and other fixed assets will have to be sold at the throwaway price. In doing so, the heavy loss will have to be incurred. Changing these decisions, therefore, is very difficult.

    The Factors Influencing and Importance of Financial Decisions - ilearnlot

  • Capital Budgeting: Nature, Importance, and Limitations

    Capital Budgeting: Nature, Importance, and Limitations

    Definition and Meaning of Capital Budgeting: Economics is concerned with the allocation of scarce resources between alternative or choice uses to obtain the best purpose. The Concept of Capital Budgeting: Nature of Capital Budgeting, Importance of Capital Budgeting, and Limitations of Capital Budgeting. Capital expenditure/budgeting, on the other hand, concentrates on these allocations over time; on decisions that involve current outlays in return for expectations of future benefits, i.e., a return for an anticipated flow of future benefits. Also learned, Capital Budgeting: Nature, Importance, and Limitations!

    Learn, Explain Capital Budgeting and its Nature, Importance, and Limitations. 

    In other words, it is applied to evaluate expenditure decisions that involve current outlays but the benefits are likely to be produced in the future, i.e., over a longer period. The said benefits may be earned either in the form of the reduction in cost or the form of increased revenues. And that is why it includes addition, alteration, modification, disposition, and replacement of fixed assets.

    Nature of Capital Budgeting:

    It is the way toward settling on speculation choices in capital expenditures. Capital Expenditure may define as an expenditure for the benefits of which are expected to be received over a period exceeding one year.

    The main characteristic of capital expenditure is that the expenditure incurs or endure at one spot in time whereas the benefits of the expenditure are collected with realized at different spots in time in the future. In simple language, we may say that capital expenditure incurs or endure for acquiring or improving the fixed assets, the benefits of which expect to receive over several years in the future.

    The following are some of the examples of capital expenditure:

    • Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill, etc.
    • Cost of addition, expansion, improvement, or alteration in the fixed assets.
    • Research and development project cost, etc.
    • Cost of replacement of permanent assets.

    Capital expenditure:

    Capital expenditure involves the non-flexible long-term commitment of funds. Thus, capital expenditure decisions are also called long-term investment decisions. Capital budgeting involves the planning and control of capital expenditure. It is the process of deciding whether or not to commit resources to a particular long-term project whose benefits are to realize over some time, longer than one year. Capital budgeting also knows as Investment Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure, and Analysis of Capital Expenditure.

    • Charles T. Horngreen has defined capital budgeting as, “Capital budgeting is long-term planning for making and financing proposed capital outlays.”
    • According to G.C. Philippatos, “Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earnings from a project, with the immediate and subsequent streams of expenditures for it”.
    • Richard and Greenlaw have referred to capital budgeting as acquiring inputs with the long-run return.
    • In the words of Lynch, “Capital budgeting consists of planning development of available capital to maximize the long-term profitability of the concern.”

    Features, characteristics, symptoms, or highlights of Capital Budgeting:

    From the above description, it’s going to conclude that the important features which distinguish capital budgeting decision from the standard day to day business decisions are:

    • Capital budgeting decisions involve the exchange of current funds for the advantages to realize within the future.
    • The money or funds are invested in non-flexible and long-term activities, any funds can be investing for the long-term to get more profitable or return.
    • They have a long-term and significant effect on the profitability of the priority.
    • They involve, generally, huge funds.
    • The future benefits are expected to be realized over a series of years, and.
    • They are irreversible decisions.

    They are “strategic” investment decisions, involving large sums of cash, a serious departure from the past practices of the firm, a significant change of the firm’s expected earnings related to a high degree of risk, as compared to “tactical” investment decisions which involve a comparatively bit of funds that don’t end in a serious departure from the past practices of the firm.

    Need and Importance of Capital Budgeting:

    Capital budgeting means planning for capital assets.

    Capital budgeting decisions are vital to any organization as they include the choices as to:

    • Whether or not funds should invest in long-term projects such as setting an industry, purchase of plant and machinery, etc.
    • Analyze the offer with a proposal for expansion or creating additional efficiency.
    • To decide the replacement of permanent assets such as building and types of equipment.
    • To make the financial analysis of various proposals regarding capital investments to choose the best out of many alternative proposals.

    The importance of capital budgeting can well understand from the fact that an unsound investment decision may prove to be fatal to the very existence of the concern.

    The following the need, significance, or importance of capital budgeting arises mainly thanks to the follows below are:

    1] Large Investments:

    Capital budgeting decisions, generally, involve the large investment of funds. But the funds available with the firm always limit and the demand for funds far exceeds the resources. Hence, a firm needs to plan and control its capital expenditure.

    2] Long-term Commitment of Funds:

    Capital expenditure involves not only a large number of funds but also funds for long-term or more or less permanently. The long-term commitment of funds increase and grow the financial risk involved in the investment decision. The greater the risk involved, the greater is the need for careful planning of capital expenditure, i.e. Capital budgeting.

    3] Irreversible Nature:

    The capital expenditure decisions are irreversible. Once the decision for realization or acquiring a permanent asset takes; it becomes very difficult to dispose or determine of these assets without enduring and incurring heavy losses.

    4] Long-Term Effect on Profitability:

    Capital budgeting decisions have a long-term and significant effect on the profitability of a priority. Not only these earnings of the firm affect by the investments in capital assets but also the longer-term growth and profitability of the firm depend on the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the priority. Capital budgeting is of utmost importance or significance to avoid over-investment or under-investment in fixed assets.

    Difficulties of Investment Decisions:

    The long-term investment decisions are difficult to take because:

    • The decision extends to a series of years beyond the current accounting period,
    • Uncertainties of future and
    • The higher the degree of risk.
    1] National Importance:

    Investment decision though taken by individual concern is of national importance because it determines employment, economic activities, and economic process. Thus, we may say that without using capital budgeting techniques a firm may involve itself during a losing project. Proper timing of purchase, replacement, expansion, and alternation of assets is important.

    2] Importance of Capital Budgeting:

    Capital Budgeting decisions have given the first importance to financial decision-making since they’re the foremost crucial and important business decisions as they need a big impact on the profitability aspect of the firm. As the capital budgeting/expenditure decision affects the fixed assets only which are the sources of earning revenue, i.e., the profitability of the firm, special attention must give to their treatment.

    Capital budgeting decisions have established greater accentuation or emphasis due to:

    3] Capital budgeting has long-term implications:

    The most significant reason that capital budgeting decisions take is that its long-term implications, i.e. its effects will extend into the longer term, and can need to be endured for an extended period than the results of current operating expenditure. Because, a correct investment decision can yield spectacular returns, whereas a wrong investment decision can endanger the very survival of the firm.

    That is why it’s going to state that the capital budgeting decisions determine the longer-term destiny of the firm. Moreover, it also changes the danger of the complexion of the enterprise. When the typical benefits of the firm increase as a result of an investment proposal which can cause frequent fluctuations in its earnings which will become a risky situation.

    4] Capital budgeting requires a large number of funds:

    Capital investment decisions require a large number of funds which the majority of the firms cannot provide since they have scarce capital resources. As a result, investment decisions must be thoughtful, wise, and correct. Because a wrong/incorrect decision would result in losses and the same prevents the firm from earning profits from other investments as well due to the scarcity of resources.

    5] Capital budgeting is not reversible:

    Once the capital budgeting decisions take, they are not easily reversible. The rationale is that there may neither be any marketplace for such second-hand capital goods nor there’s any possibility of conversion of such capital assets into other usable assets, i.e., the sole remedy is to dispose-off an equivalent sustaining an important loss to the firm.

    They are the most difficult decisions:

    Capital investment decisions are, no doubt, the foremost significant since they’re very difficult to form. It is because their assessment depends on the future uncertain events and activities of the firm. Similarly, it is practically a difficult task to estimate the accurate future benefits and costs in terms of money as there are economic, political, and technological forces that affect the said benefits and costs.

    Capital Budgeting Nature Importance and Limitations Image
    Capital Budgeting: Nature, Importance, and Limitations, Image from Pixabay.

    Limitations of Capital Budgeting:

    Capital budgeting techniques suffer from the following limitations:

    • All the technology of capital budgeting presumes that various investment offers with proposals under opinion are mutually exclusive; which may not practically be true in some exceptional circumstances.
    • The techniques of capital budgeting require the estimation of future cash inflows and outflows. The future is always uncertain and the data collected for the future may not be exact. Obliviously the results based on wrong data may not be good.
    • There are certain factors like the morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.
    • Urgency is another limitation in the assessment of capital investment decisions.
    • Uncertainty and risk pose the biggest limitation to the technology of capital budgeting.
  • Capital Budgeting: Meaning, Definition, Nature, and Procedure

    Capital Budgeting: Meaning, Definition, Nature, and Procedure

    Capital expenditure budget or Capital budgeting is a process of making decisions regarding investments in fixed assets which are not meant for sales such as land, building, machinery, or furniture. Meaning of Capital Budgeting: Capital Budgeting is the process of making the investment decision in fixed assets or capital expenditure. Capital Budgeting also knows as an investment, decision making, planning of capital acquisition, planning and analysis of capital expenditure, etc. Also, learn about EVA and MVA.

    Learn, Explain Capital Budgeting and its Meaning, Definition, Concept, Nature, and Procedure. 

    The word investment refers to the expenditure which requires making in connection with the acquisition and the development of long-term facilities including fixed assets. It refers to the process by which management selects those investment proposals which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of the overall objectives of the firm.

    What is a capital expenditure? It is a very difficult question to answer. The terms capital expenditure associate with accounting. Normally capital expenditure is one which intends to benefit future periods i.e., in more than one year as opposed to revenue expenditure, the benefit of which suppose to exhaust within the year concern.

    Definition of Capital Budgeting:

    It is the process by which a company determines whether projects (such as investing in R&D, opening a new branch, replacing a machine) are worth pursuing. A scheme or plan or project is worth pursuing if it increases the value of the company.

    A project and scheme typically add value to the company if it earns a rate of return that exceeds the cost of capital. The opportunity cost of capital expects to return that is foregone by investing in the scheme rather than in comparable financial securities, such as shares, with the same risk as to the project under consideration.

    While capital budgeting is a fairly straightforward or easy process from a conceptual viewpoint, it can be very challenging in practice or training. Not only is it difficult to determine the group’s appropriate cost of capital, but it is also often even trickier to accurately forecast the incremental cash flows that result from taking on the project.

    Concept of Capital Budgeting:

    Capital budgeting may define as the decision-making process by which, firms evaluate the purchase of major fixed assets, including buildings, machinery, and equipment; It also covers decisions to acquire other firms, either through the purchase of their common stock; or, groups of assets that can use to conduct ongoing business.

    They scribes the firm’s formal planning process for the acquisition and investment of capital; and, results in capital budgets that is the firm’s formal plan for the expenditure of money to purchasing assets. A capital-budgeting decision is a two-sided process. First, the analyst must evaluate a proposed project to calculate the likely or expected return from the project.

    This calculation generally begins with the expenditure of the project’s service life; and, a stream of cash flowing into the firm over the life of the project. The calculation of expected, the turn may be done by two methods: 1) internal rate of return or 2) net present value, These two methods discuss later in this.

    Explanation;

    The second side of a capital-budgeting decision is to determine the required return from a project. We may calculate the likely return to being 12 percent but the question is whether this is good enough for the proposal to accept. To determine whether the return is adequate; the analysts must evaluate the degree of risk in the project and then must calculate the required return for the given risk level. Two techniques may use to perform this analysis.

    The weighted-average cost of capital uses when the new proposal assumes to have the same degree of risk as the firm’s existing activities. The capital asset pricing model uses if the risk in the project views as different from the firm’s current risk level. It is important for the future well-being of the firm; it is also a complex, conceptually difficult topic.

    A, we shall see later in this article, the optimum capital budget-the the level of investment that maximizes the present value of the firm simultaneously determined by the interaction of supply and demand forces under conditions of uncertainty. Supply forces refer to the supply of capital, the firm, or its cost of capital schedule or panel.

    Demand forces related to the investment opportunities or chance open to the firm; as measured by the stream of revenues that will result from an investment decision Uncertainty or non-calculability enters the decision; because, it is impossible to know exactly either the cost of capital; or, the stream of revenues that will derive from a project.

    Nature of Capital Budgeting:

    Nature of capital budgeting can explain in brief as under:

    • Capital expenditure plans involve a huge investment in fixed assets.
    • Capital expenditure once approved represents the long-term investment that cannot reserve or withdrawn without sustaining a loss.
    • Preparation of coital budget plans involves forecasting of several years profits in advance to judge the profitability of projects.

    It may assert here that the decision regarding capital investment should take very carefully; so that the plans of the company do not affect adversely.

    Capital Budgeting Meaning Definition Concept Nature and Procedure Image
    Capital Budgeting: Meaning, Definition, Concept, Nature, and Procedure, Image from Pixabay.

    The procedure of Capital Budgeting:

    Capital investment decisions of the firm have a pervasive influence on the entire spectrum of entrepreneurial activities; so careful consideration should regard in all aspects of financial management.

    In the capital budgeting process, the main points to be borne in mind how much money will need of implementing immediate plans; how much money is available for its completion, and how are the available funds going to assign tote various capital schemes or projects under consideration. The financial and risk policy of the management should be clear in mind before proceeding with their process.

    The following procedure may adopt in preparing capital budgeting:

    1] The organization of Investment Proposal.

    The first step in the capital budgeting process is the conception of a profit-making idea. The proposals may come from rank and file worker of any department or any line officer. The department head collects all the investment proposals and reviews them in light of the financial; and, risk policies of the organization to send them to the capital expenditure planning committee for consideration.

    2] Screening the Proposals.

    In large organizations, a capital expenditure planning board or committee establishes and sets up for the screening of various offers with the best proposals received by it from the heads of various departments and the line officers of the company. The committee screens the various proposals within the long-range policy-framework of the organization. It is to ascertain by the committee whether the proposals are within the selection criterion of the firm; or, they do no lead to department imbalances or they are profitable.

    3] Evaluation of Projects. 

    The next step in the capital budgeting process is to evaluate the different proposals in term of the cost of capital; the expected returns from alternative investment opportunities and the life of the assets with any of the following evaluation technology;

    • The degree of Urgency Method (Accounting Rate of return Method).
    • Pay-back Method.
    • Return on Investment Method, and.
    • Discounted Cash Flow Method.
    4] Establishing Priorities.

    After the proper screening of the proposals, uneconomic or unprofitable proposals drop. The profitable projects or in other words accepted projects than put in priority. It facilitates their acquisition or production according to the sources available and avoids Immaterial or unnecessary and costly delays and serious cot-overruns. Generally, priority is fixed in the following order.

    • Current and incomplete projects give priority.
    • Plans and schemes for maintaining the present efficiency of the firm.
    • Projects for supplementing income.
    • Safety projects and projects are necessary to carry on the legislative requirements.
    • Projects for the expansion of a new product.
    5] Final Approval.

    Proposals finally recommended by the committee are sent to the top management along with the detailed report; both of the capital expenditures and sources of funds to meet them. The management affirms its final seal to proposals with offers taking in view the urgency, beneficial or profitability of the projects, schemes, and the available financial resources. Projects are then sent to the budget committee for incorporating them into the capital budget.

    6] Evaluation. 

    Last but not the least important step in the capital budgeting process is an evaluation of the program after it has been fully implemented. Budget proposals and the net investment in the projects compare periodically and based on such evaluation; the budget figures may review and present more realistically.

  • The relationship between Economic and Market Value Added!

    Whether a company has positive or negative Market Value Added (MVA)  depends on the level of rate of return compared to the cost of capital. All this applies to Economic Value Added (EVA) also. Stewart has defined the relationship between EVA and MVA. When a business earns a rate of return higher than its cost of capital, EVA is positive. In other words, investors are earning more than their investment in that business than they could elsewhere. In response, investors bid up share prices, increasing the value of their business and driving up its MVA. Similarly, investors discount the value of businesses that earn a return below their cost of capital. Also learned, The relationship between Economic and Market Value Added!

    Learn, Explain The relationship between Economic and Market Value Added! 

    Thus, MVA is an estimate made by the investors of the net present value of all current and expected future investments in the business. In other words, it can be said that MVA is same as NPV and can be calculated as the present values of all future EVAs. Similarly, it can be the present value of future free cash flows, because discounted EVA and discounted free cash flows are mathematical equivalents.

    What Does Economic Value Added (EVA)?

    What is the definition of economic value added? EVA compares the rate of return on invested capital with the opportunity cost of investing elsewhere. This is important for businesses to keep track of, particularly those businesses that are capital intensive. When calculating economic value added, a positive outcome means that the company is creating value with its capital investments.

    Definition: Economic value added (EVA) is a financial measurement of the return earned by a firm that is in excess of the amount that the company needs to earn to appease shareholders. In other words, it is a measure of an organization’s economic profit that takes into account the opportunity cost of invested capital and ultimately measures whether the organizational value was created or lost.

    What Does Market Value Added Mean?

    What is the definition of market value added? MVA is a vital concept that investors use to gauge how well the company has been using its capital. The state of MVA, either positive or negative, can reinforce or undermine the company’s current direction. If it is negative, the firm might decide to change directions in favor of a more value-oriented approach. Also, negative MVA signals to investors that the company is not using its capital effectively or efficiently. Thus, it’s not a good investment.

    Definition: Market value added (MVA) is a financial calculation that measures the capital that investors have contributed to a company in excess of the market value of the company. In other words, it measures if the firm has created positive value or destroyed value from its investors.

    From the definition of Market Value Added (MVA), the value of the firm can be expressed as Market Value = Capital + MVA of the firm.

    However, MVA is the present value of all future EVAs. Therefore, the value of the firm can be expressed as the sum of its capital; current EVA capitalized as perpetuity and the present value of all the expected future EVA improvements.

    Market Value = Capital + Value of current EVA as perpetuity+ Present value of expected EVA Improvement

    Since market value is dependent on the market implications of all future performance, market values are sensitive to the changes in current EVA as well as expected EVA improvement. This results in an interesting problem for the management. They need to decide the level of focus on generating current results and future prospects. The solution seems to be clear. Management must focus on producing the best results today a while making significant efforts for the future simultaneously. The stress has to be in the long term and short term perspective both.

    In a nutshell, the relationship between Economic Value Added (EVA) and Market Value Added (MVA)  can be summarized as follows:

    • The relationship between EVA and MVA is more complicated than the one between EVA and The firm value.
    • MVA of a firm reflects not only expected EVA of assets in place but also expected EVA from future projects.
    • To the extent that the actual EVA is smaller than expected EVA, the market value can decrease even if EVA is higher.

    Market Value Added (MVA)  is, thus, in a way best performance measure because it focuses on cumulative value added or lost on invested capital. It is the difference between the capital investors have put in business (cash in) and the value they could get by selling their claims (cash out). It is a focus on wealth in dollar or rupees rather than the rate of return in percentage. It, therefore, recognizes all value-adding investments even if than original rate of return.

  • What is MVA (Market Value Added)?

    Learn, Explain What is MVA (Market Value Added)? 

    Economic Value Added (EVA) is aimed to be a measure of the wealth of shareholders. According to this theory, earning a return greater than the cost of capital increase value of company while earning less than the cost of capital decreases the value. For listed companies, Stewart defined another measure that assesses if the company has created shareholder value or not. Also Learned, EVA, What is MVA (Market Value Added)?

    If the total market value of a company is more than the amount of capital invested in it, the company has managed to create shareholder value. However, if market value is less than capital invested, the company has destroyed shareholder value. The difference between the company’s market value and book value is called Market Valued Added or MVA.

    From an investor’s point of view, Market Value Added (MVA) is the best final measure of a Company’s performance. Stewart states that MVA is a cumulative measure of corporate performance and that it represents the stock market’s assessment from a particular time onwards of the net present value of all a Company’s past and projected capital projects. MVA is calculated at a given moment, but in order to assess performance over time, the difference or change in MVA from one date to the next can be determined to see whether the value has been created or destroyed.

    The Market Value Added (MVA) measure is based on the assumption that the total market value of a firm is the sum of the market value of its equity and the market value of its debt. Stewart defines Market Value Added (MVA) as the excess of market value of capital (both debt and equity) over the book value of capital.

    Simply stated, Market Value Added (MVA) = Market value of the company – Capital invested in the company

    Where,

    • Market value: For a public listed company it is calculated as the number of shares outstanding x share price + book value of debt (since the market value of debt is generally not available). In order to calculate the market value of a firm, we have to value the equity part at its market price on the date the calculation is made. The total investment in the Company since day one is then calculated as the interest-bearing debt and equity, which includes retained earnings. Present market value is then compared with total investment. If the former amount is greater than the latter, the Company has created wealth.
    • Capital invested: It is the book value of investments in the business made up of debt and equity.

    Effectively, the formula becomes, Market Value Added (MVA) = Market value of equity – Book value of equity

    According to Stewart, Market Value Added (MVA) tells us how much value company has added to or subtracted from its shareholder’s investments. Successful companies add their MVA and thus, increase the value of capital invested in the company. Unsuccessful companies decrease the value of capital originally invested in the company. Whether a company succeeds in creating MVA (increasing shareholder value) or not, depends on its rate of return. 

    If a company’s rate of return exceeds its cost of capital, the company will sell on stock markets with premium compared to the original capital and thus, have positive MVA. On the other hand, companies that have the rate of return smaller than their cost of capital, sell with discount compared to the original capital invested in the company.

    Market Value Added (MVA) is a cumulative measure of corporate performance and that it represents the stock markets assessments from a particular time onwards of the net present value of all of a Company’s past and projected capital projects. The disadvantage of the method is that like EVA there can be a number of value-based adjustments made in order to arrive at the economic book value and that it is affected by the volatility from the market values since it tends to move in tandem with the market.

  • EVA (Economic Value Added): Definition, Calculation, and Implementation!

    EVA (Economic Value Added): Definition, Calculation, and Implementation!

    Economic Value Added (EVA) is a value-based financial performance measure, an investment decision tool and it is also a performance measure reflecting the absolute amount of shareholder value created. The Concept of EVA (Economic Value Added): Definition of Economic Value Added, Calculation of Economic Value Added, Measurement of Economic Value Added, formula, and Implementation Economic Value Added!

    Learn, Explain EVA (Economic Value Added) Meaning, Definition, Calculation, and Implementation!

    It computes as the product of the “excess return” made on investment or investments and the capital invested in that investment or investments. Also learned, EVA (Economic Value Added) Meaning, Definition, Calculation, formula, and Implementation!

    “Economic Value Added (EVA) is the net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise or project. It is an estimate of true economic profit or the amount by which earnings exceed or fall short of the required minimum rate of return investors could get by investing in other securities of comparable risk.”

    Economic Value Added (EVA) Meaning and definition is a variation of residual income with adjustments to how one calculates income and capital. Stern Stewart & Co., a consulting firm based in New York, introduced the concept of EVA as a measurement tool in 1989 and trademarked it. The EVA concept often calls Economic Profit (EP) to avoid problems caused by trademarking.

    What is the Economic Value Added (EVA)?

    Economic Value Added is the financial performance measure that comes closer than any other to capture the true economic profit of an enterprise; Economic Profit = Total revenues from the capital – Cost of capital. Also, The basic idea of this criterion is to find, in microeconomics; where it says that the main goal of a company is the maximization of profit. However, it does not mean book profit (the difference between revenues and costs) but economical profit. The difference between economic and book profit is economic profit. It is the difference between revenues and economic costs, which includes book costs and opportunity costs.

    Opportunity costs present by the amount of money lost by not investing sources (like capital, labor, and so on) to the best alternative use. Opportunity costs, in reality, represent mainly by interests from equity capital including risk-reward and sometimes lost wages too. In short; Book profit = Revenues – Costs. This leads to the conclusion that economic profit appears when its amount is higher than “normal” profit derived from the average cost of capital invested both by creditors (cost interests) and owners– shareholders (opportunity costs). Also, This is the basic idea of the new measure, EVA.

    Calculation of EVA (Economic Value Added):

    Economic Value Added (EVA) calculator is an operational measure that differs from conventional earnings measures in two ways. First, it explicitly charges for the use of capital (residual income measure). Secondly, it adjusts reported earnings to minimize accounting distortions and to better match the timing of revenue and expense recognition. As such, wealth maximization correlates with EVA maximization. Also, A positive EVA indicates that a company is generating economic profits; a negative EVA indicates that it is not; A measure of a company’s financial performance based on the residual wealth calculated by deducting the cost of capital from its operating profit after taxes. It also knows as economic profit.

    Defines:

    Economic Value Added (EVA) is defined as the estimate of true economic profit, the amount by which earnings exceed or fall short of the required minimum rate of return investors could get by investing in other securities of comparable risk. It is the net operating profit minus the appropriate charge for the opportunity cost of capital investment in an enterprise (both debt and equity). Also, The capital charge is the most distinctive and important aspect of EVA. Under conventional accounting, most of the companies appear profitable.

    However, many are actually destroying shareholder value because the profits they earn are less than their cost of capital. Also, EVA corrects this error by explicitly recognizing that when managers employ capital, they must pay for it. By considering all capital costs, including the cost of equity, EVA shows the amount of wealth a business has created or destroyed in each reporting period.

    Formula:

    Expressed as a formula, Economic Value Added (EVA) for a given period can write as:

    Economic Value Added (EVA) = NOPAT – Cost of Capital Employed = NOPAT – WACC x CE

    Where 01;
    • NOPAT: Refers to the amount of profit remaining of the business after tax and adding back interest payments. Also, It can calculate as per accounting concept after making necessary adjustments for certain non-operating incomes and expenses.
    • WACC: Weighted Average Cost of Capital. It defines as the weighted average cost of both equity capital and debt. Also, It is the weighted average of both the specified costs with weights equal to the proportion of each in total capital. The tax shield of the debt adjusts with the cost of the debt.
    • CE: Capital employed or Invested capital refers to total assets (net of revaluation) net of non-interest-bearing liabilities. From an operating perspective, invested capital can define as Net Fixed Assets, plus investments plus Net Current Assets. Net Current Assets denote current assets net of Non-Interest Bearing Current Liabilities (NIBCLS). From a financing perspective, the same can define as Net Worth plus total borrowings. Total borrowings denote all interest-bearing debts.

    OR equivalently, if the rate of return defines as NOPAT /Capital Employed; then, it tums into a more revealing formula.

    EVA (Economic Value Added) = (Rate of Return – Cost of Capital) x Capital Employed

    Where 02;
    • Rate of Return: NOPAT /Capital Employed
    • Capital Employed: Total of the balance sheet – Non Interest Bearing Current Liabilities (NIBCL) in the beginning of the year
    • Cost of Capital: (Cost of equity x Proportion of equity in Capital) + (Cost of debt x Proportion of debt in Capital)(1- Tax)

    If Return on Investment defines as above after taxes; EVA can present with the following familiar terms:

    EVA (Economic Value Added) = (ROI – WACC) x Capital Employed

    Where 03;
    • Capital Employed: Net fixed assets – Revenue reserve – Capital Work in progress + Current assets – Funds Deployed outside the business – NIBCL
    Measure:

    EVA (Economic Value Added) measures by comparing Return on Capital Employed with Cost of Capita; also called Return Spread. A positive Return Spread indicates that earning is more than the cost of capital; thereby creating wealth for owners or stockholders. A negative Return Spread means earning is less than cost-of-capital; thus reducing the wealth of owners and stockholders. Economic Value Added (EVA) is an indicator of the market value of the service center’s owner’s equity, a measure especially important to closely-held companies; which do not have the benefit of a published stock price. For publicly traded companies, EVA correlates very closely with the stock price.

    Economic Value Added (EVA) is an estimate of true economic profit and a tool that focuses on maximizing shareholders’ wealth. Also, Companies best utilize EVA as a comprehensive management tool. EVA has the strategic importance of focusing management and employees on the company’s primary goal of maximizing shareholder value. With this goal in mind, EVA can use tactically in several ways including shareholder reporting, financial benchmarking, management decision-making tools, and a foundation for incentive compensation plans.

    Measurement of EVA (Economic Value Added):

    It must note that the measurement of Economic Value Added (EVA) can make by using either an operating or financing approach. Under the operating approach, deducting cash operating expenses and depreciation from sales derives NOPAT. Interest expense excludes because it considers as a financing charge. Also, Adjustments, which refer to as equity equivalent adjustments, design; to reflect economic reality and move income and capital to a more economically based value. These adjustments consider with cash taxes deducted to arrive at NOPAT. EVA then measure by deducting the company’s cost of capital from the NOPAT value. The amount of capital to use in the EVA calculations is the same under either the operating or financing approach but calculate differently.

    The operating approach starts with assets and builds up to invested capital, including adjustments for economically derived equity equivalent values. The financing approach, on the other hand, starts with debt and adds all equity and equity equivalents to arrive at the invested capital. Finally, the weighted average cost of capital; based on the relative values of debt and equity and their respective cost rates; use to arrive at the cost of capital multiplied by the capital employed and deducted from the NOPAT value. The resulting amount is the current period’s EVA.

    Implementing EVA (Economic Value Added):

    When a company decides to adopt EVA as a corporate performance measure; here is what it must do:

    • Step 1: Run an EVA analysis of the company; its publicly traded peers and business units.
    • Step 2: Draw up a definition of EVA that is simple and meets the company’s information needs, existing accounting data, organization, and management.
    • Step 3: Work out a compensation scheme that fits into the company’s business and culture. The incentive plan has to marry the EVA design with traditional concerns of shareholders and directors.
    • Step 4: Train all employees on the basics of EVA and how it affects shareholder value.
    • Step 5: Demonstrate the difference between EVA-led decisions vis-à-vis conventional methods through computer simulation exercises.
    Positives of EVA:
    • No ceiling on the amount managers can take home as incentive pay.
    • Managers think like, act like, and are paid like owners.
    • Targets are set over a time horizon that is more than one year – usually three to five years – forcing a long-term view into managerial decision-making.
    • Cuts capital cost and inculcates financial discipline among employees.
    • Increasing EVA directly benefits the shareholder and has been found to have a positive influence on a company’s stock price.
    Negatives of EVA:
    • Involves lots of complexity. Globally, Stern Stewart is said, in some cases, to make as many as 165 adjustments to work out the weighted average capital cost of companies.
    • Works better at the individual level than team level, unless goals are appropriately structured.
    • May make companies risk-averse. Also, New investments that look risky or difficult to quantify in terms of expected payback may never be made using EVA.
    EVA (Economic Value Added) Meaning Definition Calculation and Implementation Image
    EVA (Economic Value Added): Meaning, Definition, Calculation, and Implementation; Image from Pixabay.
  • Value Added: Definition, Beneficiaries, and Uses!

    Value Added: Definition, Beneficiaries, and Uses!

    Learn, Explain Value Added: Definition, Beneficiaries, and Uses! 

    The traditional basic financial statements are balance sheet and Profit & Loss account. These statements generate and provide data related to financial performance only. The Concept of Value Added: Meaning of Value Added, Definition of Value Added, Beneficiaries of Value Added, and Uses of Value Added! They do not provide any information which shows the extent of the value or the wealth created by the company for a particular period. Hence, there arose a need to modify the existing accounting and financial reporting system so that the business unit is able to give importance to judge its performance by indicating the value or wealth created by it. Also learned, Value Added: Definition, Beneficiaries, and Uses!

    Meaning of Value Added: Value-added describes the enhancement a company gives its product or service before offering the product to customers. Value-added applies to instances where a firm takes a product that may be considered a homogeneous product, with few differences (if any) from that of a competitor, and provides potential customers with a feature or add-on that gives it a greater perception of value.

    To this direction inclusion of Value Added statement in financial reporting system is used. The Value Added concept is now a recognized part of the accountant’s repertoire. However, the concept of Value Added (VA) is not new. Value Added is a basic and broad measure of performance of an enterprise. It is a basic measure because it indicates the net output produced or wealth created by an enterprise. The Value Added of an enterprise may be described as the difference between the revenues received from the sale of its output, and the costs which are incurred in producing the output after making necessary stock adjustments.

    Definition of Value Added:

    Some definitions of Value Added are following:

    • E.S.Hendriksen has defined Value-added as: “The market price of the output of an enterprise less the price of the goods and services acquired by transfer from other firms.”
    • Morely has defined Value-added as:”The value, which the entity has added in a period that equals its sales fewer bought-in-goods and services.” i.e. This definition can be expressed in terms of the equation as follows: Value-added = (Sales) – (bought-in-goods &services)
    • The annual service of industries (ASI,1964) defines Value Added as: “Value Added (VA) = (gross ex-factory value of output)-(gross value of input) “. The term Value Added may simply be defined in economics as the difference between the value of output produced by a firm in a period, and the value of the inputs purchased from other firms.
    • According to John Sizer, “Value Added is the wealth the company has been able to create by its own and its employee’s efforts during a period. “
    • According to E.F.L Berch, “The added value of a firm or for any other organization is the Value Added to materials by the process of production. It also includes the gross margin on any merchanted or factored goods sold. “
    • According to Kohler, Value Added has been defined as: “That part of the costs of a manufactured or semi-manufactured product attributable to work performed on the constituent raw material. The value is arrived by deducting from the total value of the output of a firm and other incomes, the cost of raw materials, power, and fuel, water, etc, which are bought from other firms.” i.e, Value Added = (value of output + income from other sources) – (cost of material and services purchased from outside)
    • According to Evraert and Riahi Belkaoui, “Value Added is said to represent the total wealth of the firm that could be distributed to all capital providers, employees, and the government.”
    • According to Central Statistical Organization (CSO), India “Value Added represents the part of the value of the products which are created in the factory and is computed by deducting from the gross ex-factory value of output, the gross value of input”

    The concept of Value Added:

    The concept of value addition has been derived out from the very manufacturing process in which the firm’s raw materials are converted into finished goods. A company can add value to the efficient use of the resources available to it. These resources can be in the form of manual skills, technical skills, know-how, special purpose machines, factory layout, etc. The process of manufacturing begins with a certain quantum of raw material and goes through a conversion process to yield an output. This output is a product with new utility and market value which is different from the original cost of materials. The excess of such market value over the cost of materials is defined as Value Added.

    The concept of Value Added is considerably old. It originated in the US treasury in the 18th century and periodically accountants have deliberated upon whether the concept should be incorporated in financial accounting practices. The preparation, presentation, and disclosure of Value Added statements (VAS) have come to be seen with greater frequency in most countries of Europe more particularly in Britain.

    Value Added is the wealth created by the business during a particular period of time and the wealth or the value so created or added is distributed amongst different stakeholders who created it. The discussion paper `corporate report’ published in 1975 by the then Accounting Standards Steering Committee (now known as Accounting Standards Board) of UK advocated the publication of Value Added statement along with the conventional annual corporate report.

    Value Added indicates the `new value’ or `wealth’ created by the enterprise during a specified period. No enterprise can grow if it fails to generate wealth. Thus, Value Added is a form of wealth. However, things like land, minerals, metals, coal, oil, timber, water and similar sort of things are wealth but they are provided by nature. Value Added is the kind of wealth that is generated by the efforts and ingenuity of mankind.

    This can be understood from following examples:

    • At the primitive level, a man goes into the forest and cuts down a tree. He converts it into a house, furniture and other articles for his own use. In doing so he `adds value’ to the raw material provided by nature.
    • In the complex industrial society, a manufacturing business buys raw materials, components, fuel and other services. It converts these into products which can be sold for more than the cost of the raw materials and other purchases. In doing so, the business `adds value’ to the materials by the process of production.
    • A farmer-generated wealth by growing crops and breeding animals, then selling them for more than the cost of seeds, fertilizers, foodstuffs and other materials used.

    Value Added may be generated even when little or no material is involved. The gap between what the consumer pays and what the manufacturer or supplier has to pay for the raw material, and other brought in items, is the Value Added that has been generated.

    Value Added = Gross value of output – gross value of the input

    Where,

    • Output = Aggregate value of product*+ work done for customers + sale value of goods sold in the same condition as bought + stock of semi-finished goods (i.e. closing and opening).
    • *Value of Products= value of product manufactured for sale during a year where the value is ex-factory, exclusive of any incidental expenses on sale.
    • Input= Gross value of materials, fuels, etc + work done by other concerns for the firms+ non-industrial services done + depreciation + purchase value of goods sold in the same condition as bought.

    Thus,

    Value Added = value of production – the cost of materials, power, etc

    Where the value of production = sales value + value of increase or decrease in finished and semi-finished goods.

    Beneficiaries of Value Added:

    There are four main beneficiaries of the net value added created by an enterprise. These beneficiaries are workers, providers of capital, government, and the owners. As a matter of principle, the beneficiaries are the persons contributing or providing their efforts or facilities directly or indirectly.

    1. Workers: Labour is one of the major claimants of value added. The value-added statement shows the amount of value added that goes to the human resources. The payments to the workers can be in the form of :
      • Salaries and wages
      • Payment of bonus
      • Contribution to provident fund, ESU, etc.
      • Welfare expenses
      • Payment of gratuity
      • Directors’ remuneration, etc.
    2. Providers of capital: Banks, Financing institutions, public and the owners provide capital to the enterprise, but under this caption, providers of only interest-bearing funds are taken into consideration.
    3. Government: The government which provides not only infrastructural facilities but also conditions conducive for carrying out operational activities has also its claim in the value added. The payment to the government goes in the form of :
      • Excise duty
      • Octroi duty
      • Rates and taxes
      • Sales tax
      • Direct taxes
    4. Owners: Last but not the least owners or shareholders are the ultimate claimants of the value added. The transfer to owners may be in the form of the transfer to various non-statutory reserves or profits distributed.

    Uses of Value Added:

    Till recently, the yardstick to judge the efficiency and profitability was Return on Investment (ROI) but, nowadays too much interest has been shown on `value added’ and it is considered as another approach to measuring operational efficiency and profitability of a business enterprise. The reason behind this is that the performance of an enterprise is now judged by the `social obligation point of view’. The profit is a test for shareholders to measure the performance of an enterprise while `value added’ is a measure useful to all those of the society who have contributed in the process of generating value such as employees, investors of capital, government, etc. No enterprise can survive and grow if it fails to generate sufficient value.

    Value-added reflects the performance of a team, which is, employees, managers, shareholders, creditors. Value-added statement helps the employees to perceive them as responsible participators in a team effort with management and thus may motivate them to work harder. The value-added statement provides a better measure of the size and importance of a company. VA based ratios are interpreted as merely indicative of and predictive of the strength of the company than conventional ratios.

    • VA can be used as a basis for wage and salary policies. The index for value added per employee is a vital figure because it sets a limit to the average wage per employee. No company pays out more in wages per employee than it is generating in value added per employee. The higher the value added per employee, the higher can be the average wage per employee. The creation of value added depends not on the level of capital expenditure but on good marketing strategy, sound investment policy, effective management and employee co-operation to maximize the value added per employee.
    • VA can be used as a basis for bonus schemes. The conventional bonus incentive schemes which are either based on time or on piece work system have a limitation that they apply only to production workers or individuals or small group of employees. Since a better measure of output is value added, a bonus scheme can link the payroll to value added. This is known as value added based bonus scheme. The technical design of value-added based bonus scheme can vary quite circumstances. The traditional measure of business performance is profitability i.e. a ratio of profit to capital employed. The concept of profitability has some merits but it also has some serious defects. First, as a measure of performance, it can be very misleading. Second, in the modem climate of public opinion, it takes the somewhat narrow view. Third, it cannot be applied to non-profit organizations. Value added is more useful than the profitability ratio.
    • VA can be used as a measure of business performance.
    • VA can be used in the formulation of business policies. Value added is used in the formulation of various business policies. It includes (1) product analysis (2) pricing policies (3) capital investment decision, (4) marketing strategy, etc.
    • Another use of VA is that it links the company’s financial accounts to national income. The sum of the value added by each company will equal national income.
    • VAS is said to improve the attitude of employees towards their employing company because the value added statements reflect a broader view of the company’s objectives and responsibilities. When fully informed about value-added they should be better motivated to work, be more co-operative and more identified with their company.
    • Acts as an excellent measure of the size and importance of the company. VAS is used to construct VA based ratios that are considered as important diagnostic and predictive tools for making the comparison of company’s performance with other national and multi-national companies.
    • At present, both central and state governments use VAS to determine and collect tax on value added by an enterprise in its process of production.
    • VAS also provides important accounting and other information that facilitates better communication from concerned to a variety of users who are related or unrelated. Thus, it is more transparent in nature.

    From the above-mentioned uses of VAS, it is worthwhile to note that an organization may survive without earning profit but cannot survive without adding value. An organization, even if it is sick, especially non-profit making in nature, would remain useful so long as it generates value.

    Value Added Definition Beneficiaries and Uses - ilearnlot

  • Value Added Statements: Definition, Advantages, and Disadvantages!

    Value Added Statements: Definition, Advantages, and Disadvantages!

    Learn, Explain Value Added Statements: Definition, Advantages, and Disadvantages! 

    The main thrust of financial accounting development in the recent decades has been in the area of `how’ we measure income rather than `whose’ income we measure. The Concept of Value Added Statements: Meaning of Value Added Statements, Definition of Value Added Statements, Advantages of Value Added Statements, and Limitations or Disadvantages of Value Added Statements! The common belief of the traditional accountants that profit is a reward of the proprietors has been considered as a very narrow definition of income. This was so because previously the assets were assumed to be owned by the proprietor and liabilities were thought as proprietor’s obligations. Also learned, Guide to Theories in Human Resource Management! Value Added Statements: Definition, Advantages, and Disadvantages!

    This notion of proprietorship was accepted and practiced so as long as the nature of business did not experience revolutionary changes. However, with the emergence of corporate entities and the legal recognition of the existence of business entities separate from the personal affairs and interest of the owners led to the rejection of the proprietary theory.

    Definition: The financial statement which shows how much value (wealth) has been created by an enterprise through utilization of its capacity, capital, manpower, and other resources, and how it is allocated among different stakeholders (employees, lenders, shareholders, government, etc.) in an accounting period.

    Value added is now reported in the financial statements of companies in the form of a statement. Value Added Statement (VAS) is aimed at supplementing a new dimension to the existing system of corporate financial accounting and reporting. This is called value-added statement. This statement shows the value created; value added (value generated) and the distribution of it to interest groups viz. Employees, shareholders, promoters of capital and government. 

    Since VAS represents how the value or wealth created or generated by an entity is shared among different stakeholders, it is significant from the national point of view. ICAI, 1985 has defined Value Added Statement as a statement that reveals the value added by an enterprise which it has been able to generate, and its distribution among those contributing to its generation known as stakeholders.

    For the purpose of calculating the amount of value added and its distribution, the value added statement is prepared. The main concern of this statement lies in deriving a measure of wealth (i.e. value), the entity has contributed to the society through the collective efforts of the various stakeholders. This statement is prepared and published voluntarily with the annual financial reports. Thus the presentation of a statement of value-added aids in the disclosure of VA by an enterprise.

    The value-added statement may be defined as a statement, which shows the income of the company as an entity and how that is divided between the people who have contributed to its creation.

    Assumptions in Value Added Statements:

    Following are the basic assumptions which are used for computation of value-added income through the preparation of value-added statements.

    • VAS is a supplement, not a substitute to P&L account.
    • The same data which is recorded and processed by the conventional accounting system is used in the preparation of VAS.
    • The basic accounting concepts and principals of accounting remain the same in preparation of VAS.

    It is convenient to prepare Value Added statements from conventional Profit & Loss account. However, there is a lot of difference between these two statements since the income statements contain certain nonvalue-added items e.g. provisions, interests, non-trading profit, and losses, etc.

    Objectives of Value Added Statements:

    The main objectives of preparing Value Added Statements are:

    • To indicate the value or wealth created by an enterprise. In a way, it shows the wealth-creating ability of the organization.
    • To show the manner in which the wealth created is distributed amongst the employees, shareholders and the government. The pattern of distribution of value added can be clearly understood.
    • To indicate the organization’s contribution to national income.
    • To use it as a basis for making inter-firm and intra-firm analysis, for preparation of financial plans and targets, for developing productivity linked incentive schemes.

    Value Added Statements v/s Profit & Loss Account:

    The traditional Profit & Loss Account is prepared on the theory that the company was created by its shareholders and exists for their benefit. However, the traditional accounting system shows only the profits or losses made by a business enterprise and do not provide any information showing the extent to which the wealth is created by a business unit in a given period. 

    The newly developed accounting method of value added is aiming to add a new dimension to the existing system of corporate financial accounting and reporting through the disclosure of additional information regarding the amount of wealth an entity has created in an accounting period and how it has been divided up by the entity amongst those who have contributed to its creation.

    The statement of value-added conceives the company as the corporate entity in which those who provide capital and those who provide labor cooperate to create wealth which they share amongst themselves and with the government. When the value added statement is prepared, then the company is viewed as a `wealth’ producing entity of a number of groups which are known as stockholders. 

    The value-added statement shows the wealth obtained by its employees, government, providers of capital or business itself during a period of time and the manner in which the generated value is distributed among the employees, government and the providers of capital. It shows the companies contributing to the national income.

    The value-added statement is not a substitute, but a supplement to the Profit & Loss Account although it is based on the figures from the latter. The value-added statement is essentially a much simpler statement than the profit statement. The Profit & Loss Account is prepared on the basis of double entry system and its preparation is statutorily compulsory, but the value added statement is not prepared in the statutory account.

    Advantages of Value Added Statements:

    The following are some of the advantages of Value Added Statements:

    • Reporting on VA improves the attitude of employees towards their employing companies. This is because the VA statement reflects a broader view of the companies objectives and responsibilities
    • VA statement makes it easier for the company to introduce a productivity linked bonus scheme for employees based in VA. The employees may be given productivity bonus on the basis of VA/payroll ratio
    • VA based (e.g. VA/Payroll, taxation/VA, VA/sales, etc.) are useful diagnostic and predictive tools. Trends in VA ratios comparisons with other companies and international comparisons may be useful.
    • VA provides a very good measure of the size and importance of a company. To use sales figures or capital employed figures as a basis for company ranking can cause distortion. This is because sales may be inflated by large bought-in expenses or a capital-intensive company with a few employees may appear to be more important than a highly skilled labor intensive company
    • VA statement links a company’s financial accounts to national income. A company’s VA indicates the company’s contribution to national income.
    • Finally, VA statement is built on the basic conceptual foundation which is currently accepted on the balance sheet and income statements. Concepts such as going concern, matching, consistency, and substance over form are equally applicable to the VA statement.

    Criticisms and Limitations or disadvantages of Value Added Statements:

    It is argued that although the Value Added statements shows the application of VA to several interest groups (like employees, government, shareholders, etc.), the risk associated with the company is only borne by the shareholders. In other words, employees, government, and outside financers are only interested in getting their share in VA, but, when the company is in trouble the entire risk associated therein is borne only by shareholders. Therefore, the concept of showing value added as applied to several interested groups is being questioned by many academics. 

    They advocated that since the shareholders are ultimate risk-takers, the residual profit remaining after meeting the obligation of outside interest group should only be shown as value added accruing to the shareholders. However, academics have also admitted that from the overall point of view value-added statement may be shown as the supplementary statement of financial information. But in no case can the VA statement substitute the traditional income statement (i.e. Profit and loss account).

    Another contemporary criticism of VA statement is that such statements are non-standardized. However, this practice of non-standardization can be effectively eliminated by bringing out an accounting standard on value added. Therefore, this criticism is a temporary phenomenon.

    Thus, along with the advantages, the value added statements embody certain limitations also. These limitations are as follows:

    • Preparation and presentation of the value-added statement may lead to information overload and confusion, as an ordinary employee reading his company’s corporate annual report may not be able to reconcile the value added statement with the earnings statement.
    • Another limitation of Value-added statement is that it raises a danger that management may take the maximization of value added as their goal i.e. the inclusion of the value added may wrongly lead management to pursue maximization of firms value.
    • Another argument against a value-added statement is that its inclusion in the corporate annual report would involve extra work, therefore, extra costs and delay and also a slight loss of confidentiality in view of the additional disclosure involved.
    • The most severe limitation of value-added data emerges from lack of any uniformity and consistency amongst different companies in the preparation and presentation of Value Added statements. VAS is flagrantly standardized.
    • Since there are various methods of calculating VA, it is difficult to make inter-firm comparisons. An even intra-firm comparison is not possible if the treatment of these items is changed in the subsequent years.
    • Value Added statements may lead to confusion especially in the cases where wealth or value added is increasing while earnings are decreasing.

    In spite of these limitations, it may be said that the value-added statement brings about certain changes in emphasis rather than the change in the content in the traditional financial statement. Thus it is considered as a valuable means of social disclosure.

    Value Added Statements Definition Advantages and Disadvantages - ilearnlot