Investment Evaluation Methods: Finding the Best

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Table of Contents

Executive Summary
Introduction
Cash handling procedures
Cash Control procedures
Cash Flow Budgeting
Capital Budgeting
Conclusion and recommendations
References

Executive Summary

Cash handling and its control, cash flow budgeting, and capital budgeting are routine management processes and tools for running a business efficiently and effectively. Cash is considered susceptive to theft and mismanagement, and therefore its handling process should be theft and embezzlement proof. It is believed that it takes at least two people to embezzle cash. Therefore controls of cash should be so designed that there is segregation of authorization and implementation of cash handling processes. Cash flow budgeting is an estimation of cash receipts and payments for a planned period. Cash budgeting is extremely useful for the purposes of maintaining short term solvency of the entity. Capital budgeting is a decision making process of long term investments. Various methods for evaluating the investments are available, but methods of IRR and net present value have gained creditability as compared to other methods.

Introduction

The purpose of the study is to examine the importance of regular management tools of cash handling procedures, cash control procedures, cash flow budgeting, and capital budgeting in the day to day business functioning of modern business and other entities. An in-depth study has been undertaken to evaluate the functioning of these management tools. The merits of these tools have been brought to the fore in order to recommend the optimum use of these management tools for modern business functions. The detailed study of each management tool follows:

Cash handling procedures

Cash includes currency notes, cheques, debit/ credit card transactions, and money orders. Cash can be mismanaged easily. ‘Cash handling procedures’ involve activities like collection of cash, receipting, depositing and withdrawals of cash from bank, and reconciliation of cash. Business operations undertake activities where cash handling is imminent like, handling petty cash, use of floats, and others. The basic principle of cash handling is to maintain accountability at every stage of cash handling. It is the inadequate procedures and lack of accountability that often paves way for misappropriation of cash. Cash handling procedures should ensure that only small amount of cash remains at the disposal of those are responsible to handle the cash. Such limit can be fixed after assessing the cash transactions in the organization during a period under consideration, and any excess above that limit of cash should be deposited with the bank immediately on exceeding the limit..

Upon receiving cheques and remittance advices from customers from mail, a responsible employee should immediately endorse the cheques and prepare a duplicate listing of cheques received called remittance listing. Remittance advices are separated from the cheques in the mailroom and forwarded to the accounting department to prevent customers’ cheques from being misappropriated before forwarding to cashier for deposit into the bank. A copy of remittance listing should be sent to cashier along with cheques. In order to reduce the risk of diversion of customer receipts by employees, an entity with large volume of customer remittances should encourage on line transfer of remittances. Otherwise the entity may use a bank lockbox facility.

It must be made clear to those receiving the cash that are accountable for cash and cheques that are under their custody.

These days various vending machines are used for dispensing services like photostat copying etc. For collecting cash from these vending machines following rules or procedures need to be adopted:

Keys to vending machines should be kept in safe vault or other secure place.
Two persons should be responsible to open vending machine.Some machines have a meter for counting copies. The responsible person should be asked to take down the reading whenever such machines are opened.
Reading and cash taken out should be recorded in a register kept for the purpose. This register should be signed by both responsible officers.
There should not a fixed time or period to open the vending machine, as this may alert the criminals targeting the machine or the officers responsible to take cash out of the machine.

Similarly there may be safes in offices to keep cash. Cash handling procedures like those mentioned for vending machines are formulated for taking down and recording the cash handled through these safes. In addition to that, keys to safes should not be kept in drawers of the tables of responsible officers. Further cash handling through vending machines or safes should be insured. Whenever there is theft or loss, the matter should always be brought to the higher authorities.

For cash handling at tills at stores and other places, one supervisor and a deputy officer should be made responsible to manage the cash handling. There should always be a record as to which staff member was at till with particular details of time period of his/ her stay at till. New entrant at till should ensure that till is zeroed down before he/ she started his/ her operations. During emergencies the staff handling the till should ensure his/ her attendance at the till in the record register. Cashing up should be done immediately at close of the day or close of the shift. Cash should be withdrawn under the safety of a guard. Two persons should tally the cash with audit roll of the till.

With regard payments of cash to accounts payable, an authorized employee must approve the voucher of payment. Once a cheque is prepared it should be mailed immediately, and the supporting bills and remittance advice, if any, should be stamped ‘paid’, perforated, or otherwise cancelled to prevent resubmission.

Bank account reconciliation should be handled by a responsible officer, say an accounting manager. “This control provides an independent review of both cash receipts and payable cheques processed and detect the removal of cash after it has been entered in the accounting system.” (Steven M. Bragg, page 178)ⁱ

For handling petty cash for small expense and other payments, imperest Petty cash system should be adopted to recoup the prefixed balance in the hand of petty cash cashier.

Cash Control procedures

Cash control procedures requires an efficient internal control system. “Since cash cannot be traced easily, internal control over cash is enhanced by routine review of accuracy of recorded cash transaction and separation of employee duties. These procedures help to prevent theft unless there is collusion among employees.” (Loren A. Nikolai and others, page 318)ⁱⁱ

The cash control procedures is meant for control both over cash receipts and cash payments. Because of its nature, cash is highly susceptible to theft or misappropriation. Accordingly the followings controls should be implemented:

Requesting customers to pay online or by cheques only.
Restrictively endorsing cheques (‘for deposit only’) upon opening the mail
Depositing cash receipts into bank account intact and daily.
Accounting records for receipts should be completed on daily basis
Write offs of uncollectible accounts should be done by an authorized supervisor or controller.
Bank reconciliation should be done by the controller on monthly basis to verify that there were no errors made in recording cash receipts in accounting records.
The functions of cashier(custody of the cash), cash receipts (recording the receipt of cash), and preparing bank reconciliation (comparison) should be segregated

The internal control over cash payment should ensure that payments relates only to the activities of entity only. The internal control of cash payment should have following elements:

The treasure should review and approve the documents for propriety before preparing a cheque for remittance.
Keeping cheques in secure location and limited access to the cheques.
Requiring authorized signatures on cheques, and allowing only authorized signatures on cheques
Mailing cheques to payees immediately after signing.
Duties to authorizing payments for purchases, recording payments, access to cheques, and reconciliation of bank account should be segregated

Cash Flow Budgeting

Cash flow budgeting is preparation of an estimate of cash receipts and cash payment for future given period of time based on the entity’s activities. The basic objective of cash budgeting is to plan out cash outflow on basis of estimated or expected cash inflows. Estimation of cash inflows depends upon expected cash sales, receipts from accounts receivables and other receipts like capital or loan. This may also include receipts on account of sale of assets. Cash outflows are estimated cash payments to accounts payables, payment of regular expenses like salaries, wages, rent, insurances, council charges, vat deposits, corporation taxes, outflow on account of purchases of assets, repayment of loans, withdrawals by the owners, payment of dividends to stakeholders, and others.

Cash inflows are added to beginning bank and cash balances, and then outflows are deducted to arrive at expected ending balances or overdrafts from bank accounts. There is difference in cash flow statement and cash flow budgeting. Cash flow statement is part of financial statements that are prepared at end of accounting period; whereas cash budgeting “is a detailed forecast of expected cash receipts, payments and balances over a planning period.”(Alastair Graham and Brian Coyle, page 32)ⁱⁱⁱ

Capital Budgeting

“Capital budgeting is the process of evaluating and selecting long term investments that are consistent with firm’s goal of maximizing owner’s wealth.” (Lawrence J. Gitman, page 376)^iv The investment decisions are either to reject or accept a proposal. There are different methods whereby capital budgeting proposals can be evaluated. The methods that are normally used include payback method, average rate of return, internal rate of return method, and net present value method.

Average rate of return represents the ratio of average annual profits. The principal virtue of the average rate of return is its simplicity. It makes use of readily available accounting information. Once the average rate of return for a proposal is calculated, it may be compared with a required, or cut off rate of return to determine if the particular proposal should be accepted or rejected. The principal shortcoming of the method is that it is based on accounting income rather than on cash flows and that it fails to take account of timings of cash inflow and outflows. Time value of money is completely ignored. Benefits in the last year are valued the same as benefits in the first year.

Pay back methods tells us the number of years required to recover the capital outlay for proposal.

It is the ratio of the initial fixed investment over the annual cash inflows for the recovery period. If the payback period calculated is less than maximum acceptable payback period, the proposal is accepted; if not, it is rejected. The shortcoming of the payback period method is that it fails to consider cash flows after the payback period. This method is very popular and continues in use, nevertheless, frequently as a supplement to other more sophisticated methods. It does afford management limited insight into the risk and liquidity of a project. The shorter payback period is considered less risky for the project because of its greater liquidity. The company that is cash poor may find the method to be very useful in gauging the early recovery of funds invested. There is some merit to its use in this regard, but the method does not take into account the diversions of possible outcome. Therefore, it cannot be considered an adequate indicator of risk. When the payback method is used it is more appropriately treated as a constraint to be satisfied rather than a profitability measure to be maximized.

Internal rate of return is considered most scientific method as by using IRR the present value of future cash inflows becomes equal to present value of cash outflows. Thereafter the internal rate of return is compared with required rate of return in order to determine whether the proposal should be accepted. This method of acceptance is employed to compare the inter rate of return with a required rate of return, that is also called cut off rate, or hurdle rate. The project is accepted when the internal rate of return exceeds the cut off rate; otherwise the proposal is rejected. When a project is accepted with an internal rate of return in excess of the cut off return, the market price of shares of such an entity increases. This method further gains importance from the fact that it takes into consideration the time value of money; and thus provide a more objective basis for evaluating and selecting investment projects.

The net present value method is also a discounted cash flow approach to capital budgeting, similar to internal rate of return method. Cash flows are discounted to present value using the required rate of return for comparison purposes under this method. When the sum total of present value of cash inflows is equal to or exceeds the present value of cash outflows, the proposal shows the potentials of being accepted. This method endeavors to find out what remains after discounting all cash flows by the rate of return desired by the entity. The principle of this method is the same as is used in the earlier discussed method of internal rate of return. The proposal is accepted when net present value computed as per the required rate of return is positive. Under such circumstances when a firm is taking on a project with a return greater than cut off rate, there are more chances of rising the value of stock of the firm. These methods help an entity in taking capital investment decisions in variety of ways using different techniques.

Sometime there are number of proposals from where to take a decision. In evaluating a group of investment, we must determine whether the proposals are independent of each other. A proposal is mutually exclusive if the acceptance of it precludes the acceptance of one or more other proposals. A contingent proposal depends on the acceptance of one or more other proposals. Capital budgeting tools are valuable decision making tools for modern capital investment ventures.

Conclusion and recommendations

Management tools of cash handling procedures, cash control procedure, cash flow budgeting, and capital budgeting are extremely useful when those are handled as per the requirements of business. Like controls should not be costlier than benefits from such control. It is advisable to apply the most suitable method of capital budgeting as some in comparatively small capital budgets crude methods like average rate of return and payback period are more useful than incurring scientific methods of IRR and net present value. Cash budgeting is always a useful tool irrespective of size of the business activities of the entity. These tools are of immense value to modern businesses.

References

Steven M. Bragg (2009), Accounting Control Best practices, John Wiley and Sons, page 178.

Loren A. Nikolai and others (2009), Intermediate Accounting, Cengage Learning, page 318.

Alastair Graham and Brian Coyle (2000), Cash Flow Forecasting and Liquidity, Lessons Professional Publishing, page 32.

Lawrence J. Gitman (2006), Principles of managerial Finance, Pearson Education, page 376.

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