topic 3

• Role of finance in business

  All businesses need money to finance their various activities
• Businesses spend their money on

  • Capital expenditure
  • Revenue expenditure
• Factors to consider when selecting sources of finance

  • Availability
  • Cost of finance (usually from interest charges)
  • Time period of repayment
• Capital expenditure


  Finance spent on fixed assets, i.e. items used repeatedly in the long-term to generate sales revenue
• Revenue expenditure


  Finance spent on the daily running of the business
• Capital expenditure in restaurants


  • Examples to identify
• Revenue expenditure in restaurants

  • Examples to identify
• Change


  Capital expenditure is important for implementing change in organizations
• Sustainability


  Revenue expenditure is vital for the sustainability of organizations
• The consequences of not doing capital expenditure and revenue expenditure can be seen in the examples of failed businesses
• Investment appraisal


  Quantitative (financial) and qualitative (non-financial) approaches to evaluate the costs and benefits of an investment decision
• Failed businesses


  • Borders
  • Kodak
  • Toys R Us
• Approaches to quantitative investment appraisal

  • Payback period
  • Average rate of return
  • Net present value (HL only)
• Borders failed due to inability to invest capital expenditure in e-books and digital music due to mounting debts from operating bricks and mortar stores
• Payback period (PBP)


  The time it takes for an investment project to earn enough profit to repay the cost of the initial investment
• Kodak failed due to reluctance to invest capital expenditure into developing digital cameras
• Payback period formula - worked example

  1. Cost of building hotel ÷ Financial gain per year

  2. Cancun: 100 ÷ (18 ÷ 12) = 66.66 months

  3. Los Cabos: 120 ÷ (24 ÷ 12) = 60 months
• Toys R Us failed due to inability to invest capital expenditure in their own e-commerce platform due to mounting debts from operating bricks and mortar stores
• The rise and fall of Blockbuster

  1. Identify an opportunity for capital expenditure that could have changed the fortunes of Blockbuster

  2. Identify an opportunity for revenue expenditure that could have sustained the success of Blockbuster

  3. With reference to the concepts of change and sustainability, explain why Blockbuster failed
• Cumulative cash flow method - worked example

  1. Step 1: Calculate cumulative net cash flow

  2. Step 2: Identify time between years that cost of investment will be paid back

  3. Step 3: Calculate difference between cost of investment and cumulative net cash flow for calendar year before investment will be paid back
• Blockbuster was once a global leader in video rental, valued at USD$3 billion. However, by 2010, they filed for bankruptcy with almost USD$1 billion in debt
• Advantages of using the PBP

  • Simplest and quickest method
  • Useful for firms with cash flow problems
  • Can see if will break even before replacement
  • Can compare different investment projects
  • Assesses only short-term
• Internal sources of finance

  • Personal funds (for sole traders)
  • Retained profit
  • Sale of assets
• Disadvantages of using the PBP

  • May encourage short-term approach
  • Contribution per month unlikely constant
  • Focuses on time rather than profits
• Average rate of return (ARR)

  Calculates the average profit on an investment project as a percentage of the amount invested
• External sources of finance

  • Share capital
  • Loan capital
  • Overdrafts
  • Trade credit
  • Crowdfunding
  • Leasing
  • Microfinance providers
  • Business angels
• Average rate of return - worked example

  1. Step 1: Calculate total net cashflow

  2. Step 2: Calculate expected profit

  3. Step 3: Enter into ARR formula: (Total returns - Capital cost) ÷ Years of use ÷ Capital cost x 100
• Personal funds (for sole traders)


  The main source of finance for sole traders and for partnerships
• Advantages of using the ARR


  • Enables easy comparisons between projects
• Disadvantages of using the ARR

  • Ignores timing of cash inflows
  • Prone to forecasting errors
  • Calculations based on useful lifespan which may be a guess
• Personal funds (for sole traders)


  • Uses: Capital and revenue expenditure

  Advantages: Zero cost of finance (unless borrowed from friends and family who expect it to be repaid with interest)

  Disadvantages: Amount available is limited to the size of savings owned by the sole trader
• Net present value (NPV)


  Method used to work out the present value of the return on an investment
• Retained profits


  The value of finance that the business keeps (after paying taxes to the government and dividends to its shareholders) to use within the business
• Net present value - worked example

  1. Step 1: Find discount factor for each year

  2. Step 2: Calculate present value of net cash flows

  3. Step 3: Calculate NPV: Sum of present values - Original cost
• Advantages of using NPV

  • More accurate method that takes long-term view
• Retained profits


  • Uses: Capital expenditure, Revenue expenditure (but only in extreme cases when a business is facing a liquidity crisis)

  Advantages: Zero cost of finance (as there are no interest charges)

  Disadvantages: If assets are undesirable (e.g. obsolete technology) or there is no demand, funds cannot be raised
• Sale of assets


  Businesses can sell their unused assets to raise finance
• Disadvantages of using NPV

  • Ignores timing of cash inflows
  • Prone to forecasting errors
  • Calculations based on useful lifespan which may be a guess
• Share capital


  The main source of finance for most limited companies
• Summary of quantitative investment appraisal

  • Payback period: Capital cost ÷ Contribution per month
  • Average rate of return: (Total returns - Capital cost) ÷ Years of use ÷ Capital cost x 100
  • Net present value: Sum of present values - Original cost