Financial Calculations

This document discusses various financial calculations such as contribution margin, payback period, NPV, and working capital management. It explains the concepts, provides examples, and highlights the importance of these calculations in financial decision-making. The document also compares different budgeting techniques. Suitable for finance students and professionals.

FINANCIAL CALCULATIONS
Student ID:
[Pick the date]

Question 1
a) The contribution margin is obtained by deduction of variable cost from the revenue.
Contribution Margin = 1,575,000 - 825,000 = £ 750,000
Unit contribution margin = Contribution Margin/Sales = 750,000/7,500 = £ 100
Comment: The contribution margin for the company for the given sales level of 7,500 amounts
to £ 750,000. The contribution margin is relevant since deduction of fixed cost would lead to the
profits. Unit contribution margin has been computed as £100 which implies that profits by each
incremental sale would increase by this amount (Arnold, 2015).
b) It is known that the fixed overhead for the company is £ 180,000.
Comment: In the wake of the given cost, it can be concluded that 1,800 units would have to be
sold in order to ensure that break even is achieved which would lead to sales of £378,000.
c) Margin of safety (units) = Current unit sales – Break even unit sales = 7,500 – 1,800 = 5,700

Comment: The margin of safety seems to be quite sufficient considering present sales as
significant adverse movement would have to be observed for the company to book losses. Hence,
the chances of incurring losses are very minimal (Berk et. al., 2016).
d) In the given case, a pre-tax profit to the tune of £235,000 is to be made by the company.
Comment: A unit sale of 4,150 would have to be achieved in order to obtain a pre-tax profit to
the tune of £235,000 by the company. Failure to reach the above unit sales would lead to lower
profits than the desired figure.
e) Unit sales (given) = 8,500
Unit contribution margin (computed) = £100
Total contribution margin = Unit sales * Unit contribution margin = 8,500*100 = £850,000
There is no change in the fixed overheads which would assume the same level of £180,000 as
before.
Comment: Based on the given information, it is apparent that total profits for the company
amount to £670,000 assuming that the unit sale is 8,500.
Question 2
a) Payback Period Computation
Project A:

Total investment at t=0 is £ 360,000
Cumulative cash flows during the first two years = 180,000 + 120,000 = £300,000
Remaining amount for recovery = £ 360,000 - £300,000 = £60,000
Incremental time in 3rd year required to recover remaining investment= (60000/80000) = 0.75
Hence, payback period for the project = 2+ 0.75 = 2.75 years
Project B:
Total investment at t=0 is £ 380,000
Cumulative cash flows during the first two years = 200,000 + 140,000 = £340,000
Remaining amount for recovery = £ 380,000 - £340,000 = £40,000
Incremental time in 3rd year required to recover remaining investment= (40000/60000) = 0.67
Hence, payback period for the project = 2+ 0.67 = 2.67 years
NPV Computation
The NPV computation for the two projects based on the given 8% discount rate and the expected
cash flows during the project useful life is indicated as follows.
Conclusion
Based on the computation of NPV and payback period, it can be concluded that the superior
project is Project A. This is primarily on account of the NPV being superior for Project A when
compared to Project B. The payback period is lower for Project B and hence it would be
preferred over project A. However, since NPV is a more reliable measure, hence more weightage
would be given to NPV than payback period.

b) In relation to payback period, a noteworthy benefit is the underlying simplicity which makes
it easy to compute and understand. Additionally, there is no involvement of any discount rate
for payback period computation which makes it reliable. But, a key limitation of payback
period as a measure of capital budgeting is the failure to take into account the time value of
money as this method used cash flows which have not been adjusted for time. Also, payback
period takes into consideration the cash flows that tend to occur till the payback period and
ignores those cashflows which may occur after this period. As a result, this method is not
reliable when mutually exclusive projects ought to be compared (Ross et. al., 2015).
In relation to NPV, one of the biggest advantages is the reliability owing to which it is often used
for determining the superior project when mutually exclusive projects ought to be compared.
Also, unlike payback period, this considers all the cashflows occurring over the useful project
life in entirety and thereby provides accurate assessment. However, a key limitation of this
method is that it is complex to understand and implement. Additionally, the NPV tends to be
highly dependent on discount rate and thereby vulnerable to the accuracy of this input
(Damodaran, 2015).
Question 3
The difference in current assets and current liabilities is referred to as working capital. Prudent
management of this is imperative so as to ensure that external financing requirement is
minimised. Considering that there may be mismatch in the cash payments and cash receipts,
hence external finance may be required for normal business operations. The company first
procures inventory from the supplier which then would be sold. In the meanwhile, cost is
incurred with regards to storage and selling of this inventory. Further, some sale would be credit
based where the cash realization would take some time. However, the company would need to
meet the various obligations in regards to payments related to supplier, staff and labour. For
meeting these obligations, working capital financing may be required (Berk et. al., 2016).
There is a need on company’s part to manage the working capital. This would require efforts to
reduce the period for inventory turnover which would lower the costs related to inventory.
Besides, the company needs to make effort to lower the cash collection period from credit sales

without adversely impacting sales. Also, bad debts need to be prudently managed. Appropriate
incentives in the form of discounts may be offered to the debtors so as to make cash payment for
the sale at an early done. Besides, there is a need to secure bank funding based on the expected
shortfall in working capital requirements of the company. The importance of working capital
funding is comparatively higher in seasonal businesses where a significant amount of sales tend
to be concentrated in a limited time. In such a business, the profitability and revenue of the
business may be significantly impacted if working capital shortage is observed. As a result, it is
imperative that suitable arrangements ought to be made by the company so that enough cash is
available for servicing of current liabilities related to business (Arnold, 2015).
The discussion carried out above clearly highlights that there are two pivotal elements for
working capital management. The first element focuses on reducing the requirement of working
capital by ensuring better management of receivables, payable and inventory related days so that
cash conversion cycle is low. The second element relates to ensure that adequate funding is
available at the minimum cost so that there is no shortfall and business does not get adversely
impacted. Working capital management can potentially lead to higher profitability for the
business and also plays an enabling role in management of short term liquidity (Petty at. al.,
2016).
Question 4
There are a host of choices available to companies in relation to budgeting. One of the choices
available is incremental budgeting which tends to make incremental changes in the budget
allocation based on the previous year allocation. For ascertaining the validity of the statement
claiming that this technique is the best, it is essential to carry a critical analysis of this technique.
A big advantage associated with incremental budgeting is that there is stability as no radical
changes would be observed in budget since incremental changes are observed. This would result
in continuity as money allocation would continue with small differences for the projects that are
already under progress from previous year. This leads to lowering of risk related to major
changes in departmental allocation. The key assumption that drives the incremental budgeting is
that the allocations made in earlier year were accurate and hence tweaking the allocations would

be fine. Since, there is an existing base where changes ought to be made, hence this budgeting
system is quite simple to implement and understand. Additionally, the changes made in
budgetary allocation can be obtained by comparison with the previous year allocation
(Damodaran, 2015).
It is noteworthy that there are key limitations witnessed in the incremental budgeting
methodology. There is implicit incentive present for the departments to incur higher expenditure
than required so that the funding for the next year remains at same level or is improved. Failure
to incur the allocated resource spending would potentially lead to lower allocation in the next
year budget. As a result, there is no incentive for the rationalization of spending by the various
departments. However, arguably the most pivotal issue with this budgetary technique is that it
does not encourage change as the previous methodology and activity prioritization is maintained.
This makes this technique unsuitable for a company or industry which is in the midst of
sweeping changes or is at the cusp of same. In such a scenario, zero budgeting is recommended
as it does not make any assumption about the previous allocation and starts the budgetary
allocation from scratch considering the given business priorities and climate (Lasher, 2017).
The above discussion clearly highlights that incremental budgeting as a appropriate technique for
firms which have a stable internal and external environment and stability is desirable in budget.
But for businesses where may be witnessing significant change either internally or externally
would require to view budgeting from a fresh perspective and hence zero budgeting would be
found more useful as it can potentially be disruptive which is not possible with incremental
budgeting. Thus, the critical analysis of incremental budgeting clearly reflects that it is not the
most apt budgetary technique for firms which are witnessing change (Ross et. al., 2015).

References
Arnold, G. (2015) Corporate Financial Management. 3rd ed. Sydney: Financial Times
Management.
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2016) Fundamentals of
corporate finance. London: Pearson Higher Education AU.
Damodaran, A. (2015) Applied corporate finance: A user’s manual. 3rd ed. New York: Wiley,
John & Sons.
Lasher, W. R., (2017) Practical Financial Management. 5th ed. London: South- Western
College Publisher
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2016)
Financial Management, Principles and Applications. 6th ed. NSW: Pearson Education, French
Forest Australia.
Ross,S.A., Tryaler,R., Bird, R.,Westerfield, R.W. and Jorden,B.D. (2015) Essentials of Corporate
Finance. 2nd ed. New York City: McGraw-Hill.