Financial management deals with the maintenance

Financial management deals with the maintenance

At some stage you have probably bought an asset such as a car, a washing machine or a computer and you may have considered how long you should keep that asset prior to replacing it. If the asset is kept for a longer period its initial cost, less any residual value, is spread over more years which is likely to reduce your cost per year of ownership. However, as the asset ages it is likely to require more and more maintenance and may operate less effectively which will increase your costs per year. Determining the optimal time to replace the asset the optimal replacement cycle is difficult. Indeed I tend to keep my car until such time as I have lost confidence in its ability to get me reliably from A to B or it has deteriorated so much I no longer want to be seen in it!

Strategic financial management

At some stage you have probably bought an asset such as a car, a washing machine or a computer and you may have considered how long you should keep that asset prior to replacing it. If the asset is kept for a longer period its initial cost, less any residual value, is spread over more years which is likely to reduce your cost per year of ownership. However, as the asset ages it is likely to require more and more maintenance and may operate less effectively which will increase your costs per year.

Determining the optimal time to replace the asset the optimal replacement cycle is difficult. Indeed I tend to keep my car until such time as I have lost confidence in its ability to get me reliably from A to B or it has deteriorated so much I no longer want to be seen in it! Companies also face exactly the same asset replacement decisions. The calculation of equivalent annual costs is a tool that can be used to assist in this decision-making process. As we have not been given the residual value after one year of ownership, we cannot calculate an NPV of cost for a one-year replacement cycle.

Hence, our decision here will be between a two- or three-year replacement cycle. NPV of cost — two-year replacement cycle: Here we evaluate all the cash flows associated with buying and keeping the asset for two years. Please note that the normal assumptions with regard to the timings of the cash flows continue to be made. Hence, the maintenance costs are shown at the end of each year, whereas in reality they will arise throughout the year.

One complication that arose in a past question was that the maintenance was an annual overhaul required at each year end rather than ongoing maintenance occurring throughout each year. NPV of cost — three-year replacement cycle: We now evaluate all the cash flows associated with buying and keeping the asset for three years. Whilst there is an element of repetition in these calculations I would still advise using the above simple and logical format or something similar. Although I have seen formats which try to combine the calculations, they are more complex and tend to lead to mistakes being made.

A classic mistake to be avoided is including the residual value after two years in the calculation of the NPV of cost for the three-year replacement cycle. For the three-year replacement cycle, the sale will occur at the end of the three years. Please remember if you buy the asset once you can only sell it once! The two NPVs calculated should not be compared as quite obviously buying and keeping an asset for a longer period is likely to cost more than buying and keeping it for a shorter period as there is less benefit to the owner.

This has proved to be the case here. In order to make a fair comparison we must calculate the equivalent annual costs. Step 2 — For each potential replacement cycle an equivalent annual cost is calculated. The costs calculated in Step 1 are spread over the period for which they will give benefit. Hence, the NPV of cost for the two-year cycle is spread over two years and the NPV of cost for the three-year cycle is spread over three years.

This is done by using annuity factors to turn each NPV of cost into an equivalent annual cost EAC at the end of each year of ownership. Remember if you have equal annual cash flows for a number of years and want to calculate a present value PV you must multiply the annual cash flow by an annuity factor: EAC — two-year cycle: EAC — three-year cycle: While some textbooks will continue to put brackets around these cost figures, I am content to show them as positive as we are describing them as costs.

As the calculated equivalent annual costs are both annual costs, they can be compared to come to a decision. Having worked through an example we should now consider the weaknesses of the approach we have used. These include the following:. Without going into great detail it is worth being aware that a similar technique can be used in other circumstances. These include:. If a company is faced with mutually exclusive projects, where only one out of a number of projects can be accepted, then the general rule is that the company should choose the project that generates the highest NPV as this creates the biggest increase in shareholder wealth.

This is simply a further variation on the equivalent annual cost approach and is demonstrated in the following example. It is anticipated that if either project is chosen it will be possible to repeat it for the foreseeable future. Step 1 — Calculate the NPV for each potential project. This would involve calculating the NPV of each project as normal. I have already done this for us to save time! Step 2 — Calculate the equivalent annual benefit for each potential project. This is calculated using annuity factors in exactly the same way as an EAC is calculated.

For Project B the 4-year annuity factor is used to reflect the four-year life of the project. As Project A has the highest equivalent annual benefit it should be chosen instead of Project B, which has the higher NPV, so long as the project can be repeated for the foreseeable future. Although this topic is a relatively small one within your Financial Management syllabus, it is a topic well worth mastering as when it has been examined in the past those with the necessary knowledge have been able to earn very good marks.

Equally, I would not expect any significant question on this topic to be wholly calculative and hence students should be ready to discuss the reasons for the approach used and the weaknesses or limitations of that approach. Equivalent annual costs and benefits. Equivalent annual costs At some stage you have probably bought an asset such as a car, a washing machine or a computer and you may have considered how long you should keep that asset prior to replacing it.

The equivalent annual cost method involves the following steps: Step 1 — Calculate the net present value NPV of cost for each potential replacement cycle. The decision — The replacement cycle with the lowest equivalent annual cost may then be chosen, although other factors may also have to be considered. This will now be demonstrated and explained further through the use of an example. Calculate the optimal replacement cycle for the machine.

The decision: Weaknesses Having worked through an example we should now consider the weaknesses of the approach we have used. These include the following: Our analysis has ignored the impact of taxation. Both buying an asset and incurring a maintenance cost will cause tax cash flows. While these cash flows could be included they would add to the complexity of the calculation.

Past exam questions have specifically excluded the impact of taxation on the cash flows. Our analysis assumes that we can replace like with like. Our analysis has assumed that the asset can be replaced by exactly the same asset in perpetuity. In reality, this will not be possible as assets are constantly developing. Even if you replace your car with exactly the same model after a number of years the new car will undoubtedly have improvements and other differences to the old one.

In our worked example above, if we were to imagine that the asset was a computer then although the calculated optimal replacement cycle is three years, the difference in cost between the two- and three-year replacement cycles is small. Hence, we might decide to use a two-year replacement cycle as we would then benefit from having a new, more up-to-date computer with more functionality on a more regular basis. Our analysis assumes that we will want to replace like with like.

Additionally the analysis assumes we will want to replace the asset with the same asset in perpetuity. In reality, business needs develop and when it becomes time to replace an asset a company may want to acquire a different asset with different functionality. For instance, a company may want an asset with greater capacity due to growth in their business. You and I face exactly the same issue.

Over my lifetime I have had a variety of different cars as my need has developed — my two-seater sports car proved less than useful when my first child was born! Our analysis has ignored inflation. Different cash flows may suffer from different specific inflation rates and as a result our analysis may not be correct. For instance, the initial cost of assets often inflates quite slowly as manufacturers find more efficient ways of production.

However, maintenance costs often inflate much more quickly as maintenance is often labour-intensive and labour costs often grow quickly. This differential between the inflation rates of different cash flows means that an alternative method, which you are not required to know, should be used. If all the cash flows inflate at one rate then the EAC method can be used with real cash flows and a real cost of capital.

Additional applications of the technique Without going into great detail it is worth being aware that a similar technique can be used in other circumstances. These include: Evaluating the best time to replace an existing asset with a new asset. Deciding between assets which would have the same functionality but have different lives. For instance when you or I are buying a car we could buy a cheaper car of lower quality or a more costly car of higher quality.

It would be unfair to simply compare the costs directly, as the higher quality car is likely to last longer. Equivalent annual benefit If a company is faced with mutually exclusive projects, where only one out of a number of projects can be accepted, then the general rule is that the company should choose the project that generates the highest NPV as this creates the biggest increase in shareholder wealth.

Calculate which project the company should accept. The equivalent annual benefit technique suffers similar weaknesses to the EAC technique. Conclusion Although this topic is a relatively small one within your Financial Management syllabus, it is a topic well worth mastering as when it has been examined in the past those with the necessary knowledge have been able to earn very good marks. Related Links. Student Accountant hub page.

Equivalent annual costs and benefits

Companies profess devotion to shareholder value but rarely follow the practices that maximize it. What will it take to make your company a level 10 value creator? Executives have developed tunnel vision in their pursuit of shareholder value, focusing on short-term performance at the expense of investing in long-term growth. In this article, Alfred Rappaport offers ten basic principles to help executives create lasting shareholder value.

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It is used to plan, control and recover costs expended in providing the IT Services negotiated and agreed to in a service-level agreement SLA. The analysis balances cost against quality and risk to create intelligent, metric-based cost optimization strategies. Balancing is required since cost cutting may not be the best strategy to deliver optimum consumer outputs. ITFM is a discipline based on standard financial and accounting principles, but addresses specific principles that are applicable to IT services, such as fixed asset management, capital management, audit, and depreciation. To provide cost-effective stewardship of the IT assets and resources used in providing IT services.

Financial management for IT services

Your contribution can help change lives. Donate now. Learn more. You've been asked to serve on the Board of a local community-based organization, and you're visiting its offices for the first time. You notice that the floor doesn't seem to have been swept in months, and when the receptionist looks for a piece of paper to write down your name, he can't find one. Participants are milling around, apparently, as you hear from their conversation, because a staff member hasn't shown up for their meeting.

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Ten Ways to Create Shareholder Value

Strategic financial management [1] is the study of finance with a long term view considering the strategic goals of the enterprise. Financial management is nowadays increasingly referred to as "Strategic Financial Management" so as to give it an increased frame of reference. To understand what strategic financial management is about, we must first understand what is meant by the term "Strategic". Which is something that is done as part of a plan that is meant to achieve a particular purpose. Therefore, Strategic Financial Management are those aspect of the overall plan of the organisation that concerns financial managers. This includes different parts of the business plan, for example marketing and sales plan, production plan, personnel plan, capital expenditure, etc. These all have financial implications for the financial managers of an organisation. The objective of the Financial Management is the maximisation of shareholders wealth.

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Comments: 4
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