Unit-4

Risk Analysis

1. Risk refers to variability.

2. It is a complex and multi-faceted phenomenon.

3. Risk is inherent in almost every business decision.

4. The level of risk depends upon the type of business and ability of the entrepreneur to
handle the risks.

5. Risk analysis is one of the most complex and slippery aspects of capital budgeting.

6. There are two types of techniques used to handla risk in capital budgeting

a. Techniques that consider the stand alone risk of a project.

b. Techniques that consider the risk of a project in the context of the market.

A. Sources of Risk:

a. Project Specific Risk:

1. Due to an estimation error or lack of quality in management result in low earning and
cash flows.

b. Competitive Risk:

1. These risks may occur by the unanticipated actions of the competitors.

c. Industry-Specific Risk:

1. Unexpected technological developments and regulatory changes that are specific to the
industry to which the project belongs, will have an impact on the earnings and cash flows of
the project as well.

d. Market Risk:

1. Change in GDP growth rate, interest rate and inflation are some causes of market risks.

B. Measures of Risk:

1. A variety of measures are used to analyse the different facets of risks.

2. These measures are range, standard deviation, coefficient of variance, and semi-variance.
3. Among all above measures standard deviation is the most commonly used measure of
risk in finance.

4. Its main reasons are:

a. It contains all the information about its probability distribution.

b. The expected utility is a function of mean and standard deviation.

c. Standard deviation is analytically easily tractable.

C. Risk Analysis:

1. An entrepreneur must be aware and have a detailed knowledge of the risks involved in
his business,

2. He should apply a systematic approach to plan the handling of risks and he should analyse
the risks for their impact.

3. All the risks cannot be measured in financial l terms and yet it is desirable to study the
impact of those risks properly.

4. All the projects have different level of project risks.

5. An entrepreneur has to decide whether to go with the project or not after studying all the
possible risks involved in it.

Cost of Capital Approach

1. Capital is an important ingredient in the formulation of a project.

2 The term cost refers to the amount of expenditure incurred on.

3. Proper determination of the cost helps an entrepreneur in planning and controlling of the
project.

4. It reduces the labour cost and increases profit.

5. It also minimize the overhead expenses.

6. The components of the capital cost of a project are land, buildings, machinery,
transportation charges, overhead expenses, and margin money for working capital.

7. The cost of capital depends on the sources of capital, its amount and structure, risks
involved, repayment schedule, and other available alternatives.

8. Profitability of the project depends upon the cost of capital.

9. High cost of capital results in less profit.

10. Thus an entrepreneur should plan his financial issues in such a way to that the cost of
capital is minimum

11. There is always a gap between estimated cost of project and the actual cost of u project,
therefore proper selection of the investment options and planning their needs is very
essential so as to keep the things under control.

12. Controlling of this cost of capital is also essential

13. The variations in the cost of a project are due to the following reasons:

Delay in execution of the activities

b. Improper planning and controlling.

C. Change in the cost of input.

d. Wastage is in more quantity

e. Lack of team spirit.

f. Lack of experts.

14. Keeping all the above points in mind the entrepreneur not only save the

projected cost but also save the cost of capital resulting in overall

efficiency

15 A firm's cost of capital is the weighted average cost of various sources of finance used by
it

16. For example: equity, short term debt, long term debt etc.

17. The cost of capital is a central concept in financial management.

18. It is used for evaluating investment projects, for determining the capital structure, for
assessing leasing proposals, for setting the rates that regulated organization.

Cash Flow Statement

1. Estimating cash flows investment outlays and cash inflows after the project is
commissioned, is the most important step but also the most difficult stop in capital
budgeting.
2. In complex projects, forecast errors can be quite large.

3. Project cash flows involve numerous variables and many participate in this exercise.

4. Capital outlays are estimated by engineering, product development department, revenue

projections are provided by the marketing group, and the operating costs are estimated by
production people, cost accountants, purchase managers, tax experts etc.

5. A project which involves cash outflows followed by cash inflows comprises three basic
components:

a. Initial investment,

b. Operating cash inflows, and

c. Terminal cash inflow (cash outflows).

6. The role of the finance manager is to coordinate the efforts of various departments.

7. Inflow of the cash is due to many reasons like, procurement of capital, loans and
advances, sale of goods, receipt of interest fixed deposits, bank overdrafts, discounting of
bills of exchange etc.

8. Similarly main source of outflow of cash, may be purchase of materials, transportation

charges, insurance, advertisement, electricity bills, postal charges, donations, provident
fund, to carry on welfare activities and so on.

9. All the cash flows (inflows and outflows) should be planned carefully.

10. The finance manager should be able to manage both the cash flows.

11. He will prepare a cash flow statement.

12. Cash flow statement is a statement which shows a change in the position of cash from
one period to another.

13. It contains the receipts (inflows) and payments (outflows) of cash.

Needs of Cash Flow Statement:

a. Predicts Future Cash Flows: This statement is often used as an indicator of the amount,
timing and certainty of future cash flows on the basis of what happened in the past.

b. Determines the Ability to Pay Dividends and other Commitments: This statement
indicates the sources and uses of cash under operating, investing and financing activities,
helps shareholders to know whether the business can make the payment of amount of
dividends on their investment in shares and creditors to receivo interest and principal
amount in time.

c. Shows the Relationship of Net Income to Changes in the Business Cash: Generally there
is direct relation between net income and cash.

d. Efficiency in Cash Management: This statement is very useful to the management is

evaluating financial policies and cash position.

e. Discloses Movement of Cash: Actual results when compared with the original forecast
may highlight the trend of the movement of cash that may otherwise remain undetected.

f. Discloses Success or Failure of Cash Planning: It also provides a better measure for inter
period and inter firm con

Cash Flow Controlling

1. Cash is king when it comes to the financial management of a growing company.

2. The lag between the time you have to pay your suppliers and employees and the time
you collect from your customers is the problem, and the solution is cash flow management.

3. At its simplest, cash flow management means delaying outlays of cash ns long as possible
while encouraging anyone who owes your money to pay it as rapidly as possible.

A. Measuring Cash Flow :

1. Prepare cash flow projections for next year, next quarter and, for next week.

2. An accurate cash flow projection can alert you to trouble well before it strikes.

3. Understand that cash flow plans are not glimpses into the future.

4. They are educated guesses that balance a number of factors, including customer's
payment histories, your own thoroughness at identifying upcoming expenditures, and
vendor's patience.

5. Start your cash flow projection by adding cash on hand at the beginning of the period
with other cash to be received from various sources.

6. In the process, you will wind up gathering information from salespeople, service
representatives, collections, credit workers and your finance department.

9. The second part of making accurate cash flow projections is the detailed knowledge of
amounts and dates of upcoming cash outlays. That means not only knowing when each
penny will be spent, but also on what.
B. Improving Receivables:

1. The basic idea is to improve the speed with which you turn materials and supplies into
products, inventory into receivables, and receivables into cash.

2. Here are specific techniques for doing this:

a. Offer discounts to customers who pay their bills rapidly.

b. Ask customers to make deposit payments at the time orders are taken.

C Require credit checks on all new non-cash customers.

d. Get rid of old, outdated inventory.

C. Managing Payables:

1 Top-line sales growth can conceal a lot of problems sometimes too well.

2. When you are managing a growing company, you have to watch expenses carefully.

3. Do not be lulled into complacency by simply expanding sales.

4. Here are some more tips for using cash wisely:

a. Use electronic funds transfer to make payments on the last day they are due. You will
remain with suppliers while retaining use of your funds as long as possible.

b. Communicate with your suppliers so that they know your financial situation. If you ever
need to delay a payment, you will need their trust and understanding.

c. Do not always focus on the lowest price when choosing suppliers. Sometimes more
flexible payment terms can improve your cash flow more than a bargain-basement price.

D. Surviving Shortfalls:

1. Sooner or later, you will foresee or find yourself in a situation where you lack the cash to
pay your bills.

2. The key to managing cash shortfalls is to become aware of the problem as early and as
accurately as possible.

3. Banks are wary of borrowers who have to have money today.

4. They would much prefer lending to you before you need it, preferably months before.
5. When the reason you are caught short is that you failed to plan, a banker is not going to
be very interested in helping you out.

Depreciation:

1. Depreciation is a measure of the wearing out, consumption or other loss of value of

depreciable asset arising from use, effluxion of time or obsolescence through technology
and market changes.

2. Depreciation is allocated so as to charge a fair proportion of the depreciable amount in

each accounting period during the expected useful life of the asset.

3. Depreciation includes amortisation of assets whose useful life is predetermined.

4. Depreciable assets are assets which:

Are expected to be used during more than one accounting period,

b. Have a limited useful life, and

c. Are held by an enterprise for use in the production or supply of goods and services, for
rental to others or for administrative purposes and not for the purpose of sale in the
ordinary course of business.

B. Objects of Providing for Depreciation:

1. To find out net profit or loss for an accounting period, wo add the revenues of that period
and deduct all the expenses incurred in that period in earning those revenues.

2. To present a true and fair view of the state of affairs of the business, the assets must be
valued correctly on the balance sheet.

3. A continuous decline in the value of the asset over several years may lead to a decision to
replace the asset.

C. Reasons of callings Depreciation as a Non Cash Flow:

1. The main emphasis of the depreciation process is generally on the computation of

periodic charge to expense or the cost of the product to be method or the cost of the
product to be matched the revenues reported in each period.

2. The concept occupies a significant place in determination of income and in the

measurement of service potential of assets.

Lack of Financial Control:

A. Lack of Financial Control:

1. Weak financial control is the inability to pinpoint the products and customers on which
the industry is losing money.

2. They fail to demarcate where they are using cash and from where they are generating it.

3. Lack of funds affects the quality and quantity of raw materials and consequently stock of
their finished goods. Also, little amount is left to spend on attractive packing of goods
making them unattractive to buyers. Thus, it loses demand in the competitive market.

4. Fearing loss of credit worthiness, the owners start painting a rosy picture. In order to
avoid tightening of credit by banks, they pressurize their dealers and distributors for cash
payment and start losing customers.

5. When the economy is expected to turn down, the failure rate increases and share
proceeds fall as investors start losing confidence. Simultaneously, the creditors would also
start pressing for repayment, all this results in the downfall of a company.

6. As the economic cycle, credit availability and investor's confidence are all interlinked, a
firm's propensity is greater during periods of reduced economic growth, depressed stock
market and poor market performance.

B. In Appropriate Marketing:

1. Mast of sick units suffer from ineficient marketing management.

2. Most small-scale industries become sick mainly because of their inability to market their
products for various reasons such as poor quality of products, lack of market information,
poor advertising, obsolete technical hack-ups, and lack of professionalism, etc.

S. Most of the SSIs that net as ancillaries to large industry are forced to restrict their sales to
the heal market only, which lends to accumulation of stock coupled with lack of demand
and deficiency of working capital to procure raw material and other physical resources to
keep the unit moving. The restrictive marketing scenario thrust on SSIs compels them to
restrict their scale of operations, and forgo economics of scale that could lead them to
optimum position.

4. The ancillary industries face various problem of marketing like:

a Absence of a structured pricing system,

b. Inadequacy of technical support,

C. Delayed payments by their parent units,

d. Interference in decision making by parent industry, and

Total Quality Management:

1. TQM is a philosophy of management that is driven by customer needs and expectations

and focuses on continual improvement in the way employees do their work.

2. From focusing intensely on the customer to measuring accurately to empowering

employees, TQM promotes the pursuit of quality throughout the organization

3. For example, employees at the Aeroquip-Inoac Company facility in Livingston, Tennessee,

are dedicated to continuous improvement in how they do their job.

4. They use employee suggestions and benchmarking (the search for the best practices
among competitors or non-competitors that contribute to their superior performance) and
have built a reputation for delivering high-quality products.

5. The company's current quality assurance environment supports defect prevention rather
than defect detection.

6. Quality is the responsibility of all employees.

7. Employees and supervisors work together to solve quality problems and to provide
customers with the quality products they value.

B. Concepts of TQM:

a. Intense Focus on the Customer:

1. The customer includes not only outsiders who buy the organizations products or services
but also internal customers (such as shipping or accounts payable personnel) who interact
with and serve others in the organization.

b. Concern for Continual Improvement:

1. TQM is a commitment to never being satisfied. "Very good" is not good enough Quality
can always be improved.

C. Process-Focused:

1. TQM focuses on work processes as the quality of goods and services is continually
improved.

2. Improvement in the quality of everything the organization does. TQM uses a very broad
definition of equality.

3. It relates not only to the final product but also to how the organization handles deliveries,
how rapidly it responds to complaints, how politely the phones are answered, and the like.
d. Accurate Measurement:

1. TQM uses statistical techniques to measure every critical variable in the organization's
operations

2. These are compared against standards or benchmarks to identify problems, trace them to
their roots and eliminate their causes.

e. Empowerment of Employees:

1. TQM involves the people on the line in the improvement process.

2. Teams are widely used in TQM programs as empowerment vehicles for finding and
solving problems.

Difference between operation