FINANCIAL EVALUATION INNOVATION AND NEW PRODUCT DEVELOPMENT

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Roger George
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1 FINANCIAL EVALUATION INNOVATION AND NEW PRODUCT DEVELOPMENT

2 FINANCIAL EVALUATION Our topic includes; Break-Even Analysis Profit-Loss Analysis İncremental Cash Flow Risk Analysis

3 BREAK-EVEN ANALYSIS One of the most common tools used in evaluating the economic feasibility of a new enterprise or product is the break-even analysis. The break-even point is the point at which revenue is exactly equal to costs. At this point, no profit is made and no losses are incurred. Break-even analysis is a simple and valuable forecasting technique. Business can use break-even analysis to: estimate the levels of output they need to produce and sell to make an acceptable return on the time, Money and resources they have risked assess the impact of price changes on profit and sales assess how changes in costs impact on profits determine their margine of safety and what changes in levels of demand they can survive

4 BREAK-EVEN ANALYSIS Break-even analysis is based on categorizing production costs between those which are: Fixed Cost and Variable Cost.

5 BREAK-EVEN ANALYSIS Calculate break-even point numerically, a business needs to know: the level of fixed costs the selling price per unit the variable costs per unit contribution per unit= selling price (per unit) minus variable cost (per unit)

6 BREAK-EVEN ANALYSIS For example; B.E.P is explained in the following example, the case of Best LTD. This company produces and sells quality pens. Its fixed costs amount to 400,000 approximately, whereas each pen costs 12 to be produced. The company sells its products at the price of 20 each.

7 ACTIVITY TIME

8 ACTIVITY TIME There is a simple relationship between break-even and profit. If total output and sales are greater than break-even, then revenue is greater tham cost: thre business makes a profit. If total output and sales are equal to break-even, then revenue equals total costs: the business breaks even. If total output and sales are less than break-even, then revenue is less than total cost: the business makes a loss

9 CONSTRUCTING BREAK-EVEN CHART Company A produces tablets. And, each tablet is sold for $500. And cost of producing per tablet is $275. And fixed cost is $12,000.

10 ANALYSING BREAK-EVEN CHART Break-even level of output: The point at which the total cost line crosses the total revenue line is the break-even point. Reading down from this point can be seen that, to break even, 54 tablets must be sold. Level of profit or loss at each level of output: At levels of output below 54, total costs are greater than total revenue, so the business is maling a loss.the level of loss is represented by the vertical distance between the two lines. The amount of loss can be read off the vertical scale. The level of profit can be found at levels of output above 54 tablets. Margin of safety: The number of units currently being produced above the break-even level is called the margin of safety. For example; if Company A were to produce 100 tablets, the margin of safety would be : Current output - Break-even output = Margin of safety 100 units 54 units 46 units

11 THE EFFECTS OF CHANGING COSTS AND REVENUES ON BREAK-EVEN OUTPUT Change Fixed or variable cost rise Fixed or variable costs fall Sales price rises Sales price falls Impact on Break-Even Total costs also rise, so more units have to be sold to cover costs. The number of units needed to break even increases. Total costs also fall, so fewer units have to be sold to cover cost. The number of units needed to breakeven falls. Each unit produces more revenue, so costs are covered more quickly. The break-even number of units decreases. Each unit sold earns less revenue, so it takes more units to cover costs. The break-even output point increases.

12 PROFIT AND LOSS ANALYSIS The profit and loss account is a component part of the financial situations of any economic entity which synthesizes at the highest level the whole activity developed during the financial year permitting immediate comparisons at least with the indicators achieved during the previous year. The profit and loss account presents a processing and systematization of all income and expenses recorded during the current financial year. The profit and loss account is the financial situation which measures the success and performance of a firm s activity referring to the given period.

13 PROFIT-LOSS ANALYSIS A Profit and Loss (P&L) statement measures a company s sales and expenses during a specified period of time. The function of a P&L statement is to total all sources of revenue and subtract all expenses related to the revenue. It shows a company s financial progress during the time period being examined.

14 PROFIT-LOSS ANALYSIS There are two reasons to prepare a P&L statement. One reason is the P&L statement answers the question, Am I making any money? It is a valuable tool to monitor operations. The second reason to prepare a P&L statement is because it is required by the IRS.

15 PROFIT-LOSS ANALYSIS Reading a P&L is the easiest way to tell if a business has made a profit or loss during a given month or year. The most important figure it contains is net profit this is what is left over after expenses and taxes have been paid.

16 PROFIT-LOSS ANALYSIS Companies typically issue P&Ls monthly. It's customary for the reports to include year to date figures, as well as corresponding year-earlier figures to make comparisons and analysis easier.

17 HOW TO PREPARE A P&L STATEMENT? The data items that you must be able to provide to construct a P&L statement are: Net Sales Cost of Goods Sold Selling and Administrative Expenses Other Income and Other Expense

18 HOW TO PREPARE A P&L STATEMENT? Net Sales Net sales are the total sales during the time period being analyzed minus any allowances for returns and trade discounts. Cost of Goods Sold Cost of goods sold is also called the cost of sales. For retailers and wholesalers it is the total price paid for the products sold during the accounting period. It is just the price of the goods. It does not include selling or administrative expenses.

19 HOW TO PREPARE A P&L STATEMENT? Selling and Administrative Expenses Selling expenses are expenses incurred directly and indirectly in making sales. They include salespeople s salaries, sales office costs, commissions, advertising, warehousing and shipping Administrative expenses are operating expenses not directly associated with the sale of goods. Administrative expenses are commonly considered overhead expenses, and include rent, utilities, telephone, travel and supplies.

20 HOW TO PREPARE A P&L STATEMENT? Other Income and Other Expense These are line items for any unusual income or expense items not directly related to the operations of the business. Other income includes income from interest, dividends,rents, royalties and gains from the sale of capital assets. Other expenses is a line item to record any unexpected losses unrelated to the normal course of business.

21 INCREMENTAL CASH FLOW Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project.

22 POSITIVE INCREMENTAL CASH FLOW A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project. A positive incremental cash flow is a good indication that an organization should spend some time and money investing in the project.

23 EXAMPLE OF INCREMENTAL CASH FLOW ABC International owns a machine that can manufacture 2,000 units per hour. An equipment upgrade can change the maximum capacity of the machine to 3,000 units per hour, which is an incremental increase of 1,000 units. The cost of this upgrade is $200,000, and the profit derived from each unit is $0.10. The machine is currently operated for 40 hours per week.

24 EXAMPLE OF INCREMENTAL CASH FLOW (1,000 units per hour) x $0.10 = $100 per hour incremental cash inflow = ($100 per hour of cash inflow) x (40 hours per week) x (52 weeks per year) = $208,000

25 EXAMPLE OF INCREMENTAL CASH FLOW So the contemplated increase in capacity will yield a net incremental cash flow increase per year of $208,000 The incremental change in cash flow represents a payback period of just over 1 year, which is highly acceptable as long as the upgraded equipment can be expected to operate for longer than the payback period.

26 EXAMPLE OF INCREMENTAL CASH FLOW An alternative way to look at the sample situation is to avoid the $200,000 equipment upgrade and instead run the existing equipment for an additional shift. For example, if two machine operators can be paid $15 per hour to run the machine for an extra shift, this cost is only $62,400 per year, versus incremental cash receipts of $208,000. This alternative is considerably less expensive than the equipment upgrade option, on an incremental cash flow basis.

27 INCREMENTAL CASH FLOW Sunk Cost; is a cost we have already paid or have already incurred the liability to pay. Such a cost cannot be changed by the decision today to accept or reject a project. Put another way, the firm will have to pay this cost no matter what. Based on our general definition of incremental cash flow, such a cost is clearly not relevant to the decision at hand

28 INCREMENTAL CASH FLOW Opportunity Cost; Your firm may have an asset that it is considering selling, leasing, or employing elsewhere in the business. If the asset is used in a new project, potential revenues from alternative uses are lost. These lost revenues can meaningfully be viewed as costs. They are called opportunity costs because, by taking the project, the firm forgoes other opportunities for using the assets.

29 INCREMENTAL CASH FLOW Example for Opportunity Cost Suppose the Weinstein Trading Company has an empty warehouse in Philadelphia that can be used to store a new line of electronic pinball machines. The company hopes to sell these machines to affluent Northeastern consumers. Should the warehouse be considered a cost in the decision to sell the machines?

30 INCREMENTAL CASH FLOW Example for Opportunity Cost The answer is yes. The company could sell the warehouse if the firm decides not to market the pinball machines. Thus, the sales price of the warehouse is an opportunity cost in the pinball machine decision

31 Side Effects Remember that the incremental cash flows for a project include all the changes in the firm s future cash flows. It would not be unusual for a project to have side, or spillover, effects, both good and bad. For example, if the Innovative Motors Company (IMC) introduces a new car, some of the sales might come at the expense of other IMC cars. This is called erosion, and the same general problem could occur for any multiline consumer product producer or seller.in this case, the cash flows from the new line should be adjusted downward to reflect lost profits on other lines.

32 INCREMENTAL CASH FLOW Side Effects; In accounting for erosion, it is important to recognize that any sales lost as a result of our launching a new product might be lost anyway because of future competition. Erosion is only relevant when the sales would not otherwise be lost.

33 INCREMENTAL CASH FLOW Net Working Capital; Normally, a project will require that the firm invest in net working capital in addition to long-term assets. For example, a project will generally need some amount of cash on hand to pay any expenses that arise. In addition, a project will need an initial investment in inventories and accounts receivable

34 INCREMENTAL CASH FLOW Net Working Capital; Some of this financing will be in the form of amounts owed to suppliers (accounts payable), but the firm will have to supply the balance. This balance represents the investment in net working capital. It s easy to overlook an important feature of net working capital in capital budgeting. As a project winds down, inventories are sold, receivables are collected, bills are paid, and cash balances can be drawn down.

35 INCREMENTAL CASH FLOW Net Working Capital; These activities free up the net working capital originally invested. So, the firm s investment in project net working capital closely resembles a loan. The firm supplies working capital at the beginning and recovers it towards the end.

36 INCREMENTAL CASH FLOW Financial Cost; In analyzing a proposed investment, we will not include interest paid or any other financing costs such as dividends or principal repaid, because we are interested in the cash flow.

37 INCREMENTAL CASH FLOW Financial Cost; More generally, our goal in project evaluation is to compare the cash flow from a project to the cost of acquiring that project in order to estimate NPV. The particular mixture of debt and equity a firm actually chooses to use in financing a project is a managerial variable and primarily determines how project cash flow is divided between owners and creditors. This is not to say that financing arrangements are unimportant. They are just something to be analyzed separately.

38 RISK ANALYSIS What is financial risk? Financial risk as the term suggests is the risk that involves financial loss to firms. Financial risk generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more

39 RISK ANALYSIS Types of financial risk

40 RISK ANALYSIS AND RISK ASSESTMENT Risk analysis are the procedures of identification of risk factors and assessing their significance, analysis of the possibilities of undesirable events which can negatively affect the project objectives achievement. Risk analysis includes risk assessment and risk reducing methods or reducing the associated adverse effects. Risk assessment is a risk degree calculation by qualitative or quantitative methods

41 GENERAL PRINCIPLES OF RISK ANALYSIS Time factor startegy Effectiveness of the used methods for risk identification Information reliability Enterprise strategy consideration

42 METHODS OF RISK ANAYSIS Qualitative Risk Determination Quantitative Risk Determination

43 TYPES OF RISKS IN NEW PRODUCT DEVELOPMENT There are two main types of risk in a new product development. These are internal risks and external risks. Internal risk can be divided into financial management, human resources, property management, legislative compliance, corporate governance and housing management External risk depends on a number of factors such as economic risk, funding, regulation, environment, reputation, competition, partnerships and natural disasters

44 RISK ANALYSIS RISK AND REWARD The elements that usually determine the scale of risk or reward are the amount of money that is invested, length of time investment, rate of return or property appreciation, depreciation, fees, taxes, inflation etc While it is natural for the individual and organizations to invest and expect returns it is important the investors make the informed choice to reduce the odds of losing the principle invested

45 HÜSEYİN KAYA ADEM ALİ TÜRKER ESMA ERCAN OKAN ÇILDAN IF YOU HAVE QUESTIONS, HOLLER!

Engineering Economics and Financial Accounting

Engineering Economics and Financial Accounting Unit 5: Accounting Major Topics are: Balance Sheet - Profit & Loss Statement - Evaluation of Investment decisions Average Rate of Return - Payback Period