Strategic Financial

Management
Module – II
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Module-2
Tools and Techniques of Financial Management
 Decision making using Capital Budgeting,
 Cost of Capital, CVP Analysis,
 Variance analysis,
 Project selection criterion,
 Balanced Scorecard and Building Block models of performance
measurement*. Value-for-money approach for evaluating financial
performance in for profit organizations and not- for-profit
organizations,
 Long term portfolio construction in mobilization and utilization of
funds.
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Capital Budgeting Proposals under

risk and uncertainty:
 There are several broad methods under capital budgeting proposals to handle risk and
uncertainty:
 1. Sensitivity Analysis: Analyzing how changes in key variables affect the project's
outcome.
 2. Scenario Analysis: Evaluating the project's outcome under different scenarios (e.g.,
best-case, worst-case, most-likely-case).
 3. Probability Distribution Approach: Estimating the probability distribution of the
project's cash flows or returns.
 4. Decision Tree Analysis: Visualizing the project's outcomes and probabilities using a
tree-like diagram.
 5. Monte Carlo Simulation: Simulating multiple scenarios using random variables to
estimate the project's outcome.
6. Break-Even Analysis: Calculating the point at which the project's cash inflows
equal its cash outflows.
7. Risk-Adjusted Discount Rate: Adjusting the discount rate to reflect the project's
risk level.
8. Certainty Equivalent Method: Converting uncertain cash flows to their certainty
equivalent values.
9. Real Options Analysis: Evaluating the project's flexibility and adaptability to
changing circumstances
Capital Budgeting
under inflation
Evaluating capital budgeting proposals under inflationary conditions
requires careful consideration of the impact of inflation on the project's
cash flows, costs, and returns.
Adjusting for Inflation
1. Nominal vs. Real Cash Flows: Distinguish between nominal and real
cash flows. Nominal cash flows include the effects of inflation, while real
cash flows exclude inflationary effects.
2. Inflation Rate: Estimate the expected inflation rate over the project's life.
This can be based on historical data, economic forecasts, or industry
trends.
3. Adjusting Cash Flows: Adjust the project's cash flows for inflation
using the estimated inflation rate.
Real Cash Flows
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Inflation-Adjusted Discount Rate ()

1. Nominal Discount Rate: The rate at which we discount future cash flows to their present
value, including the effects of inflation (10%)
2. Real Discount Rate: The real discount rate is the rate at which we discount future cash flows
to their present value, excluding the effects of inflation. (6%)
3. Inflation Premium: The inflation rate is the rate at which prices are expected to rise. Let's
assume an inflation rate of 4% per annum.
Sensitivity Analysis in Capital
Budgeting
 Sensitivity analysis is a technique used in capital budgeting to assess how
changes in key variables or assumptions affect the outcome of a project's
evaluation.
 It helps decision-makers understand the potential risks and uncertainties
associated with a project and identify the most critical factors that impact
its viability.
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Sensitivity Analysis Objectives:

1.Identify critical variables: Determine which variables have the

most significant impact on the project's outcome.
2.Assess risk and uncertainty: Evaluate how changes in key
variables affect the project's expected returns and risks.
3.Test assumptions: Verify the validity of assumptions made during
the project evaluation process.
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Types of Sensitivity Analysis:

1.One-way sensitivity analysis: Analyze the impact of changes in a
single variable on the project's outcome.
2.Multi-way sensitivity analysis: Examine the effects of changes in
multiple variables on the project's outcome.
3.Scenario analysis: Evaluate the project's outcome under different
scenarios, such as best-case, worst-case, and most-likely-case
scenarios.
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Steps in Conducting Sensitivity Analysis:

1.Identify key variables: Determine the most critical variables that
impact the project's outcome.
2.Establish a base case: Define a base case scenario using the
expected values of the key variables.
3.Create alternative scenarios: Develop alternative scenarios by
changing the values of the key variables.
4.Evaluate the project's outcome: Calculate the project's expected
returns and risks under each alternative scenario.
5.Analyze and interpret results: Compare the results across different
scenarios and identify the most critical variables that impact the
project's outcome.
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Benefits of Sensitivity Analysis:

 1. Improved decision-making: Enhances decision-makers'
understanding of the project's risks and uncertainties.
 2. Risk management: Helps identify potential risks and develop
strategies to mitigate them.
 3. Flexibility: Allows decision-makers to evaluate different scenarios
and adjust their plans accordingly.
Probability Distribution Approach in Capital Budgeting

 The Probability Distribution Approach is a method used in capital

budgeting to evaluate investment projects under uncertainty.

 It involves estimating the probability distribution of the project's

cash flows or returns, rather than relying on a single-point
estimate.
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Key steps in Probability Distribution Approach

1. Identify uncertain variables: Determine the variables that are
uncertain, such as market demand, prices, or costs.
2. Estimate probability distributions: Assign probability distributions to
each uncertain variable, such as a normal distribution, uniform
distribution, or triangular distribution.
3. Simulate outcomes: Use Monte Carlo simulation or other methods to
generate a large number of possible outcomes for the project's cash
flows or returns.
4. Analyze results: Calculate the expected value, standard deviation,
and other statistics of the project's returns or cash flows.
5. Make decisions: Use the results to evaluate the project's viability,
compare it to other projects, and make informed investment
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Advantages:
1. Better captures uncertainty: Recognizes that uncertain variables can
take on a range of values, rather than relying on a single-point
estimate.
2. Provides a more comprehensive evaluation: Allows for the analysis
of different scenarios, including best-case, worst-case, and most-
likely-case outcomes.
3. Facilitates risk assessment: Enables the calculation of risk metrics,
such as the expected value, standard deviation, and value at risk
(VaR).
Limitations:
1. Requires more data and expertise: Needs accurate estimates of
probability distributions, which can be challenging to obtain.

2. Can be computationally intensive: May require significant

computational resources, especially for complex projects.

3. Difficult to interpret results: Can be challenging to interpret the

results, especially for non-technical stakeholders.
Cost Volume Profit (CVP)
Analysis
 What Is Cost-Volume-Profit (CVP) Analysis?
Cost-volume-profit (CVP) analysis is a method of evaluating the impact that varying
levels of costs and volume have on a company's operating profit.
KEY TAKEAWAYS
 Cost-volume-profit (CVP) analysis is used to find out how changes in variable
and fixed costs impact a firm's profit.
 Companies can use CVP analysis to see how many units they need to sell to
break even (cover all costs) or, alternatively, how many units they need to
sell to reach a certain minimum profit margin.
 CVP analysis can also be used to calculate the contribution margin of a firm's
products; the contribution margin is the difference between total sales and
total variable costs.
 For a business to be profitable, its contribution margin must exceed its total
fixed costs of production.
 Understanding (CVP) Analysis
 Cost-volume-profit (CVP) analysis, also referred to as breakeven analysis,
can be used to determine the breakeven point for different sales volumes
and cost structures.

 The breakeven point is the number of units that need to be sold—or the
amount of sales revenue that has to be generated—to cover the costs
required to make the product.

 CVP analysis can be useful for companies when making short-term

business decisions.

 Running a CVP analysis involves using several equations for price, cost,
and other variables.
 CVP analysis examines the relationship between three key variables:

1. Costs: Fixed costs, variable costs, and total costs.

2. Volume: The quantity of goods or services produced and sold.

3. Profit: The difference between total revenue and total costs

Key Insights from CVP Analysis
1. Break-Even Point (BEP): The point at which total revenue equals
total costs, and the firm neither makes a profit nor incurs a loss.
2. Contribution Margin: The difference between sales revenue and
variable costs, which represents the amount available to cover fixed
costs and generate profit.
3. Margin of Safety: The difference between the expected sales volume
and the break-even sales volume, which represents the firm's ability to
absorb changes in sales volume without incurring losses.
4. Sensitivity Analysis: CVP analysis helps firms understand how
changes in costs, volume, or price affect profitability.
Applications of CVP Analysis
1. Pricing Decisions: CVP analysis helps firms determine the optimal
price for their products or services.

2. Production Planning: CVP analysis helps firms determine the

optimal production level to maximize profitability.

3. Cost Control: CVP analysis helps firms identify areas for cost
reduction and improvement.

4. Investment Decisions: CVP analysis helps investors evaluate the

potential profitability of an investment project.
 Introduction to Variance Analysis
 Variance analysis is a method of assessing the difference between
estimated budgets and actual financial performance.

 It's a quantitative approach that helps businesses maintain better

control over their operations by identifying discrepancies between what
was planned and what occurred.

 This analysis is crucial for pinpointing areas where the business may be
over or underperforming.
 Key Aspects of Variance Analysis
 Summarizing Variances: During a reporting period, all variances are
summed to determine whether the business is over- or underperforming.

 Identifying Trends: Analyzing variances over time helps to identify

significant trends or shifts that may indicate underlying issues.

 Investigating Causes: Once variances are identified, further analysis can

reveal the reasons behind these differences, whether they stem from market
conditions, budgeting standards, or operational inefficiencies.

 Utilizing Automation: Automation tools can assist in efficiently compiling

and analyzing data, allowing for more timely and accurate variance analysis.
 Benefits of Variance Analysis
Improved Planning: Helps managers create more accurate budgets.

Enhanced Control: Provides better control over business operations by

highlighting areas needing attention.

Responsibility Assignment: Clarifies accountability within the

organization.

Monitoring Success: Facilitates monitoring of financial success and

areas for improvement.

Setting Expectations: Assists in setting realistic benchmarks and

expectations.
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 Challenges in Variance Analysis and Solutions
Data Accuracy: The initial data collection had errors, leading to incorrect
variance calculations.
Timeliness: The variance was identified too late, resulting in several
months of overspending.
Complexity: The analysis was complex due to multiple marketing
campaigns running simultaneously.
Understanding Variances: It was difficult to pinpoint which specific
campaigns caused the overspending.
Resource Allocation: The marketing team had limited time to analyze
the variances thoroughly.
Communication: Explaining the findings to senior management took
time due to the complexity of the data.
To address these challenges, the company
took several steps:
1. Implemented automated data collection and validation tools to ensure
accuracy.

2. Conducted monthly variance analysis to identify issues more quickly.

3. Simplified the analysis by focusing on the most significant variances.

4. Used root cause analysis to understand the causes of the variances.

5. Prioritized variance analysis for high-impact campaigns.

6. Created clear, visual reports to communicate findings to stakeholders

effectively.
Thank You
Brita Tamm
502-555-0152
[email protected]
www.firstupconsultants.com