Accounting

The independence and autonomy of internal audit is a contentious issue in the context of modern business with its given complexities. Three researchers, Joe Christopher, Gerkit Sarens and Philomena Leung have worked together to produce an article entitled, A critical analysis of the independence of the internal audit function evidence from Australia. The stated objective of their study is to analyse critically the freedom of internal audit professionals vis--vis its relationships with management and audit committees. This paper offers a critical evaluation of the deliberations carried out in the said research regarding the role of Internal Audit Executives (IAEs) in Audit Committees (AC) and attempts a detailed analysis on the professed role and influence of IAEs within the corporate framework.

Career paths for audit professionals
Internal audit differs from statutory audit in more sense than one. For one thing, as corroborated by the aforesaid article, statutory auditors comment and report to the shareholders of the company regarding the financial statements provided to them. On the other hand, internal auditors report to the audit committee who is the actual body to whom internal auditors owe allegiance and commitment, and not really to the Board of Directors. But more often than not, it is seen that these Audit Committees sub serve the interests of the Board of Directors and thus their autonomy and independence remains compromised, or even threatened.
Another aspect that this article stresses on is that internal audit is seen as career paths for audit professionals, and it is quite possible that over time, they may reach positions which outgrow aspects of internal audit, and take up broader and wider management responsibilities. At those levels, perhaps internal auditing may not be of critical importance. However, what needs to be borne in mind is that internal audit is a wide ranging function and cannot stay confined to financial statements and record keeping alone.

In large organizations, even non-financial systems can be evaluated through their specific internal audit systems. The fact remains that internal audit often transgresses routine accounting and financial transactions and assumes roles of total corporate accountability that may involve exercising domain concerns in other aspects not really relating to accounting. Internal audit, in its broadest terms also embraces and encompasses installation of norms and procedures in major areas of accountability and also ensure that those accountable align themselves with these predetermined and pre-assessed norms and procedures. Internal audit seeks conformance and adherence to these norms and attempts redressals, whenever digression or violations take place. Therefore, the contention by the authors that internal audit is just a stepping stone to future career growth of ambitious professionals does not seem to be a valid hypothesis. This is especially so when one considers the fact that in all major career cross-roads it is important that internal audit allegiance is rendered, especially in large organizations, where the distinction between ownership and management is distinct and cogent.  However, the article holds a valid point when it purports that the sustenance of divergence between ownership and management is best served by robust internal audit systems. Under such circumstances, it becomes necessary even for the board members and directors, or senior management officials of the company to adhere and be a part of the rules and regulations of the business.

CFOs decide about internal audit budgets and not audit committees
Coming to the next aspect, regarding internal audit budgets, it can be said that the budgets have to be presented by the internal auditors to the Audit Committee. The article under evaluation claims that in the Australian context, the budgets are usually seen and approved by the Chief Finance Officers or an official of that ranking who finally decides about internal audit budgets thus undermining the role of internal audit and even audit committees. However, it needs to be appreciated that the CFO may have to consider the opinion of IAEs and also the AC while recommending the budget and instituting changes in it. Unless this is done, the very exercise of internal audit systems and procedures will be a futile exercise that fails to serve the purpose for which it is conceived. Moreover, one also needs to consider the fact that perhaps the CEO or CFO, especially in a large multiproduct unit, will not have the kind of exposure to the minute details of the business and its workings, while it is possible that the members of internal audit team possess the same. Thus, to a very large extent, top management needs to rely on the recommendations and advice provided by audit committee manned by IECs. Therefore, it becomes apparent that internal auditor and the members of the audit committee, as the article suggests, should be given the leeway of participation while framing financial policies of the company.
           
Thus, it will better serve the interests of the company if the top management considers the opinion and recommendations of the IAE and the AC before approving, disapproving or instituting changes in internal audit budgets. According to the writers, it is believed that internal auditor needs to be seen as partners. (Christopher, Sarens  Leung 2009, p.6). Coming to the third aspect, it is believed that for a proper functioning of internal audit, IAs needs to be seen as partners. While on a broader plane this appears as a constructive approach, since partnerships ingrain a strong affinity and rapport with the corporate unit, a possibility also exists that this may vitiate the independence and autonomy aspect of the internal audit team. Perhaps, as corroborated by the writers, one of the sustaining factors of the internal audit function is its independent, unbiased and free attitude, and this is feared to be compromised, or undermined if the aspect of partnership within corporate governance is sought to be established. The main aspect of objectivity is feared to be reduced, in the event a kind of understanding or partnership with the top management is established, which could reallocate priorities in favour of the management instead of the shareholders. However, it is necessary to seek a deeper understanding under which the use of partnership is sought to be established. In this context, the use of the work partnerships is not considered in its literal sense, but perhaps to convey a sense of affinity and bonding with the organisation. It is meant that by partnering, the internal audit would seek to align itself completely with corporate goals and policies and work together for achieving stakeholders prosperity besides realising the goals and objectives of the corporate. Moreover, it also serves as a platform for working together for strengthening the overall performance of the business unit in all major areas of public and shareholder accountability. It is for achieving common corporate good the article holds, that what matters is The perception of people within the organisation regarding internal auditors as partners (Christopher, Sarens  Leung 2009, p.6).

That being said, it is now necessary to provide further critique of this study, especially with regard to the method of research that has been followed. This study has delved on various research methods for carrying out the research. The main tool is the online questionnaire method. This research study has sought recourse to online questionnaire to a select number of respondents. While a sample size 206 have been considered, the actual number of responses received is only 34, which represents just 16.50 of the total sample. Perhaps one of the major disadvantages of online questionnaire system is that there is no guarantee of response, and the positive benefits of personal interaction is often lacking. Moreover, the mindset of respondents who answer these online questions are not really known, which could have been known in the event of personal interaction.  Non-response bias is also increased when different levels of technical ability are present among the respondents and it becomes a particular problem when response rates are low (Advantages and disadvantages of online questionnaires 2009). Sometimes it is also possible that the respondents may fail to understand the idea behind such online questioning and thus desist from responding. Further, another concern remains that online responses may be poor in quality, contain significant errors and could thus not form part of the survey.

As validated by the writers, this online survey has been confined only to just a select members of IIA, and not to a wider segment. In the Australian context, it can be said that membership into the IIA is neither legally required nor mandatory under auditing laws, and it is quite possible that a large number of trained and competent IA practitioners may be outside the ambit of the IIA. This raises pertinent questions as to the validity and scope of this research study, especially when it is quite possible that a significant portion of the IA professionals in Australia may have been omitted in this study. Thus, to this extent, it may not present the correct state of affairs regarding the independence of IA and how it impinges upon this study.

The next major aspect that needs to be considered is that the respondents are never directly asked whether they are functioning independently or not. The modus operandi that is adopted in this study is to consider the measurements of certain trends examined in these questions that sought to review the independence of internal auditors vis--vis other parties. Thus, it would have been more appropriate if the independence and autonomy aspect of internal audit functions are gleaned through direct questions asked and answers received. Another major drawback of a research of this kind has been that the different levels of threats have been given equal significance which may not be possible under empirical observation.  For instance, it is quite possible that in certain organisations, the influence of CEOs or CFOs in approving internal audit budgets may be lower than in other corporates. The aspect of partnering audit functions will receive greater emphasis in some organisations as compared to others. Besides, in some companies, career growth of IAE may be stifled due to organisational structures and may move along audit lines only. Thus, the aspect of taking internal audit as a career vehicle and not as an end to itself may not be either plausible or tenable.

Impact of legislation on internal auditing
Most organisations in Australia and Europe do pay a great deal of significance to internal audit because of its multifaceted impact on business, and the need for fiscal and accounting discipline advocated by internal audit mechanism. It is also necessary that the dangers of following an inflexible and straightjacket policy needs to be eschewed, and internal audit needs to be progressive minded and development oriented, especially in the changing facets of globalised commerce and business environment. Moreover, it is also necessary that business follow best accounting and auditing practices and also enforce Sarbanes Oxley Laws (wherever applicable) and the implementation of CLERP Act 2004 in the Australian context. CLERP is the acronym for The Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 Under Part 13, a member of the Financial Reporting Panel may issue written summons requiring specified persons to appear before the Panel to give evidence andor produce documents and to attend Panel proceedings unless or until they are excused or released from attendance (Australian securities and investments commission amendment regulation 2004 (no.3) 2004 no.397 2004).

However, in all fairness, it can be said that the concept of internal auditors independence which is the key aspect of this study, needs to be seen in a wider context, especially with regard to career paths of aspiring audit professionals, and also how a strong fundamental knowledge of internal audit can consolidate and improve ones career path in a competitive business environment. It is interesting to learn whether outcomes of the study of perceived threats to internal audit functions is restricted to this Australian study alone, or has a wider impact in other parts of the globe also, it is also necessary to consider that more research needs to be done in order to clearly establish these facts, perhaps on a more globalised scale.

Further research could validate whether results achieved in this study shall be applied in a large framework also.

Moreover, a wider sample population, perhaps not restricted to IAA, but encompassing other professional bodies, is also necessary to be included in order to make studies of this kind more in tune with current realities in this critical field of  professional accounting. Although the ethical guidelines of the professional bodies are updated periodically there have been no radical changes and with the exception of audit committees few of the above recommendations have been implemented (Byrne 2001).

Conclusion
According to the authors of the research paper under critique, the principal objective of the study is to analyse critically the freedom of internal audit professionals vis--vis its relationships with management and audit committees. The results of this survey can be viewed from two perspectives  from the viewpoint of freedom of independent auditors vis--vis management and also from autonomy from the perspective of audit committees. The results of the study are suggestive of the fact that while there are trends for internal auditors to be organisationally placed to maintain independence stature. However, quite often, the management are in a position to assume threatening postures to these assertions. For one thing, independent auditors may need managements assistance for career growth plans and this may have a bearing on their conduct of audit and its results. For another, CEOs and CFO are in a position to influence preparation and approval of budgets, which once again, undermines the status and freedom of internal auditors.

Top management indirectly influences the functioning of IES and viewing them as partners can also be threatening. Coming to audit committees, IAEs could participate in deliberations in such committees and air their views. These AC offer better leeway and response than what the management has propounded. The results of the study conducted by these writers confide that management threats are indeed present and this has been validated by appropriate research. It comes as a matter of hope that the threats posed by management can, to a certain degree, be offset by audit committees. These threats seem to be neutralised by the fact that AC can wield influence and negate management threats. Thus finally, it transpires that this study has, indeed, been able to meet its objectives to a reasonable extent.

Commentary on Financial Ratios

Profitability Ratios

1.
Operating profit margin on ordinary activities Aer lingus -1.33, Ryan Air 20.16
Aer lingus shows a negative margin of 1.33 for the year 2008 this is largely attributable to the rising fuel costs Aer lingus had to face. This year fuel costs rose almost by 58.4.Another reason to the depleting operating profit margins is the decrease in passenger fares, although the number of passengers that traveled with Aer lingus this year has increased but because of the fall in passenger fares the revenue only increased by 5.6.

On the other hand, Ryan air has a better operating profit margin that is mainly because of the difference in sizes of the two companies. Ryan air is Europes largest low fares airline and therefore is a highly attractive to passengers looking for low fares. Ryan air also showed an impressive increase of 20 in the number of passengers that traveled with them as compared to last year. That also increased their revenue by 21 because they did not have to decrease their prices further as their fares are already cheap (Aer lingus plc, 2008).

2.
Operating profit margin including extra ordinary activities  Aer lingus -11.64, Ryan Air 16.84. The operating profit margin including extra ordinary activities has decreased to negative margin of -11.64.This largely due to the cost of exceptional items, these are one-off costs that includes  117.5mln in relation to staff cost restructuring in this year, a 5.9mln relating to a defense of a take over bid by RyanAir plc and some 17.5mln paid under the program for continuous improvement. Whereas, RyaniAir plc again shows a profit margin of 16.84, because they did not incur any major exceptional cost in the year 2008 .Ryan earned a tax gain of  10.6m from the disposal of five aircraft.

3. Net profit margin Aer lingus -7.96, RyanAir 14.38
The net profit margin of Aer lingus has decreased from the previous year, last year they shows a 105.3 m profit after tax but in 2008 they incurred a loss of 107.8m. This is mainly because of the rising fuel costs and heavy cost suffered under net exceptional items. RyanAir has an impressive net profit margin of 14.38, bit has decreased from the last years margin of 19.47.This could be because of the foreign exchange loss suffered of over  56m.

4. Return on Assets Aer lingus -5.45, RyanAir 6.45
This ratio shows Assets utilization with respect to the profit earned for the year. Aer lingus has a negative return its assets because of the loss incurred this year and it also invested big amounts in buying aircraft fleet and also expanding its operations outside Ireland. RyanAir showed an impressive return on its Assets despite investing heavily in buying Boeing aircraft

5. Return on Equity Aer lingus -12.58, RyanAir 15.47
The reason for a negative return margin on equity is that the company incurred loss for the year and it also issued ordinary shares for the year, including bonus shares. RyanAir has a better return on equity than Aer lingus in 2008, because they made a profit this year whereas Aer lingus incurred a loss. RyanAir did not issue any new shares this year in fact they exercised a share buyback of 59.5m ordinary shares.

6. Return on capital employed  Aer lingus 3.41, RyanAir 13.12
Aer lingus shows a positive margin on return on capital employed, because they made a profit of 105m in Earnings before interest and tax, despite the fact they further borrowed in a finance lease this year in long term liabilities. RyanAir showed a return of 13.13 on capital employed mainly because they did not borrow much in long term liabilities and also did not issue any shares this year (Ryan Air Plc, 2008).

Liquidity Ratios

1. Current ratio Aer lingus 1.36 times, RyanAir 4.064 times
Normally a current ratio of 2 times is considered a good one, but 1.36 times is not too bad considering the financial conditions Aer lingus is in. This Aer lingus current liabilities increased tremendously compared to the previous year, whereas the current assets only showed a slight increase. Ryan has an impressive current ratio of 2.06 times which means they have adequate level of current assets to meet their current liabilities.
However, this could also be a negative sign for the company because it may mean the company either has too much capital tied up in cash or it is unable to recover from receivables early enough.

2. Quick ratio Aer lingus 0.12 times, RyanAir 0.97 times
The quick ratio also known as acid test ratio reveals the more realistic picture than the current of companys ability to pay off its current liabilities. The low quick ratio suggests that entity is not able to generate enough cash resources, either because of declining sales or not able to collect receivables quickly enough.

It eliminates the illiquid types of assets like inventory from current assets because inventory is not considered to be as rapidly convertible into cash. Generally the quick ratio should be 11 or higher however this varies widely by industry. Aer lingus has a very low quick ratio of 0.121 it suggests that the company does not have enough liquid assets to cover its current liabilities. The probable reasons include the increase in current portion of finance lease obligation by   63.4million in the year ended 2008.The current liability portion of derivative financial instrument increased from  6.2million to  11.4million in 2008. Another possible reason seems to be that Aer lingus reclassified its financial assets as loans and receivables that were previously recognized as available for sale. As a result its liquid assets were reduced by  9.6million during the year, so the quick ratio was also decreased by the reduction in cash equivalents.

Ryan Air s ratio (0.97) is close to an ideal acid test ratio of 11 it suggests that the company is quickly converting receivables into cash and has faster inventory turnover and cash conversion cycles than Aer lingus. Though Ryan Air still needs to improve its quick ratio to an ideal ratio of 11 or higher to ensure that the company is able to cover its financial obligations.

3. Cash ratio Aer lingus 0.008 times, RyanAir 0.94 times
This ratio determines entitys ability to meet its current liabilities from its cash resources. Aer ingus has a very low cash ratio, indicating that it has a fewer cash resources to meet its current liabilities. T has not been able to receive cash from trade receivables to increase the companys cash reserves. RyanAir has a satisfactory ratio of 0.94 times, indicating that the company can meet its current liabilities from its cash resources.

Gearing Ratios

1. DebtEquity Aer lingus 1.70 times, RyanAir 1.53times
Aer lingus has a better debtequity ratio indicating that the company is less geared and raising finance through further issue of equity rather than borrowing from the lenders. RyanAir has a lower ratio than Aerlingus, mainly because it did not issue any further ordinary shares this year and raised finance through borrowing long term debt (Ryan Air Plc, 2008).

2. Total debt to total assets Aer lingus 62.91, RyanAir 60.46
Ideally this ratio should be around 50, but Aer lingus doesnt have too bad a ratio of total debt to total assets, indicating that the company can safely meet its liabilities from its resources. Ryan Air almost has a slightly better ratio than Aer lingus.

3. DebtCapital Employed Aer lingus 40.17, RyanAir 47.55
This ratio measures the debt the company has a percentage to the capital employed. Aer lingus has a satisfactory level of debt ratio compared to its total capital employed indicating that the company is mainly financing through equity finance. RyanAir has a higher percentage of debt indicating that the company is financing its needs through long term borrowings as it did not issue any further ordinary shares this year. It also had a buyback of 59.5m of its ordinary shares in 2008(Aer lingus plc, 2008).

4. Interest times earned ratio Aer lingus 2 times, RyanAir 6.45 times
This ratio measures how much the company earns in its earnings before interest and tax to cover its interest expense. Aer lingus has a considerably lower ratio indicating that its not earning enough to cover for the interest expense. This is due to the exceptional cost t ha to bear this year which has decreased its earnings before interest and tax. RyanAir has a satisfactory ratio of 6.45 times, which means that it is earning enough to pay off to the lenders.

Efficiency ratio

1. Asset turnover Aer lingus 68.45, RyanAir 44.88
This ratio determines how efficiently the company is utilizing its assets to earn revenue through them. Aer lingus shows an impressive ratio of 68.45 which indicates it is utilizing its assets quite efficiently. RyanAir has a low asset turnover indicating that assets are not being utilized well enough.

2. Account receivables Turnover Aer lingus 17.623 times, RyanAir 79.74 times
This ratio measures how well the company is doing to recover cash from its receivables, Aer lingus has a 17.623 times accounts receivables turnover ration, which indicates that the company is able to recover cash from debtors in time and maintains good credit terms with them.
Ryan Air has a very high ratio, indicating that the company may be allowing too much of credit period to customers to increase revenue. Though offering attractive credit terms to customers to increase sales is a good policy but in the long term it will harm the company in a way that it will not be able to pay off its obligations or finance its activities from its own resources, as a result company will be forced to borrow more loans.

Investor Ratios

1. Earning per share Aer lingus 0.20 euro cents, RyanAir 0.26 euro cents
This ratio shows the profit earned for the each issued stock, Aer lingus incurred a loss this year so thats why it has a negative earning per share. RyanAir made a profit in 2008 but its earnings per share is still lower considering that it did not issue further share and exercised a buyback option of it issued share capital (Aer lingus plc, 2008).

2. Dividend per share Aer lingus 0, RyanAir 0
This ratio measures the amount of dividend that is declared for the shareholders of the company. Both Aer lingus and RyanAir did not pay out any dividend this year to the shareholders. Although, its beneficial for the companies to retain profits which then can be used to fulfill future finance needs of the company but in the long run, not giving dividends to shareholders might damage the investors confidences in the company. And it will make the companys shares less attractive (Ryan Air Plc, 2008).

3. Dividend payout ratio Aer lingus 0, RyanAir 0
This ratio measures the amount of dividend paid out for the earnings per share. As both the companies did not payout any dividends to the investors so both have a zero ratio.

MeritsDemerits of Aer lingus
The above ratio analysis for Aer lingus shows a deteriorating performance for the year 2008 from the previous year. Although some of the factors that hampered the companys financial performance are uncontrollable for the company, like fuel costs which rose tremendously (almost doubled) from the previous year. The economic downturn also played its role in the companys financial problems, which forced the company to reduce its fares.

Almost all of the profitability ratios apart from the return on capital employed show negative margins. The loss which company incurred was due to the exceptional costs of  140.9m that Aer lingus had to bear. Excluding this non-routine exceptional cost, Aer lingus earned a profit of  21.2m it is also indicated by the positive return of 3.41 on capital employed (Aer lingus plc, 2008). Despite of the economic downturn and crisis in aviation industry, Aer lingus managed to increase the number of passengers from the last year, though it was offset by the reduction in travel fares. The Ancillary revenue increased by 37.7 from the last year, cargo revenue showed a slight increase of 5.5 and the other revenue head also increased by 11.5.

The companys liquidity ratios are not too impressive, which may be a risky sign for the company because it means that the company does not have adequate cash or cash equivalent to meet its obligations, it will lower the confidence of the investors and the lenders who might be unwilling to lend in future. The companys gearing ratios seem satisfactory which shows that Aer lingus has not been depending on borrowing debts for its financing needs. The lesser the gearing level a company keeps, the more the confidence investors show in that company.

Company has performed well in achieving impressive efficiency ratios, and is utilizing its assets efficiently. As the company incurred a loss this year, so it could not afford to pay its shareholders any dividends. Aer lingus managed to cut its cost by implementing a third part maintenance contract which saved more than  20.0m in cost in the first half of 2008.

Analysis of statement of Cash Flows for Aer lingus

Judged by the criteria of relevance and reliability, cash flow statements are an extremely useful source of information for the users of accounts. Users would be interested in the survival of the company which is dependent on its ability to generate cash to pay its payables rather than to make a profit. Cash flow statements are very reliable because they are free from subjective allocation of cost to particular accounting periods, and are free from subjective valuation models that dog the reliability of the balance sheet. With a cash flow statement what you see is what you get.

A provisional review of Aer lingus cash flow statement reveals a net increase of  18,266,000 in cash and cash equivalents in the accounting period. At the last year ended 31 December 2007, Aer lingus had a bank overdraft of ( 12,185,000), where as this year they managed to turn that around and had a positive cash and cash equivalent balance of  6,081 at the year ended December 2008. Below is the detailed analysis of how the cash inflows and outflows took place in the year ended 2008.

Operating Activities
Aer lingus payables increased in this year from the last year, which explains one of the reasons for the net cash and cash equivalent increase. Aer Lingus also received an income tax credit of  5,046,000, further increasing its cash balance.

Investing Activities
During the period the company earned a substantial inflow of cash through finance income which also had a positive impact on cash balance at the year end. Total of  54,798,000 interest was earned by the company under finance income, interest income earned on other financial assets of  4,420,000 and amortization of available-for-sale reserve   1,642,000. There was also an exchange gain on cas-.x

When trying to determine the correct discount rate, corporate financiers calculate a weighted average of the cost of each component or source of finance (capital). The Weighted Average Cost of Capital (WACC) is also known as the opportunity cost of capital (i.e., the amount of return that a rational investor requires for an investment of similar risk) (Arnold, 1998).

The WACC is calculated on an after-tax basis, since free cash flows represent cash available to all providers of capital (Damodaran, 2002). It is imperative to note that when calculating free cash flows there is a deduction of national tax charge from the Earnings Before Interest and Tax (EBIT) to determine Net Operating Profit After Tax (NOPAT).

The formula for the WACC of a company with two sources of capital is set out below (Rappaport, 1998)
WACC  (Kd x (1  t)) x (DT)  Ke x (ET)
Where,
Kd Cost of debt
t Tax rate
D Total debt (market value)
E Total equity (market value)
T Debt  Equity (market values)
Ke Cost of equity.

Calculation of Weighted Average Cost of Capital (WACC)

However, most finance textbooks present the Weighted Average Cost of Capital WACC calculation as
WACC  Kdx x (1  t) x D  Ke x E

Where Kd is the cost of debt before taxes, T is the tax rate, D is the percentage of debt on total value, Ke is the cost of equity and E is the percentage of equity on total value. All of them precise (but not with enough emphasis) that the values to calculate D y E are market values. Although they devote special space and thought to calculate Kd and Ke, little effort is made to the correct calculation of market values.

Case Study Vodafone
Generally speaking, calculation of WACC is relatively simple for small organizations (Adler, 1974). However, for a multinational corporation like Vodafone calculating WACC is a tedious job and requires a lot of number crunching. Therefore, some of the small steps in calculating WACC have not been shown in the paper.

The calculation of Vodafones weighted average cost of capital requires 3-step process

Components of Cost of Capital
First, the cost of each kind of capital that the enterprise uses is calculated or inferred, namely debt and equity (Anderson, 2003).

Debt Capital The cost of debt capital is equivalent to actual or imputed interest rate on the companys debt, adjusted for the tax-deductibility of interest expenses. Specifically
The after-tax cost of debt-capital The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in )

Equity Capital Equity shareholders, unlike debt holders, do not demand an explicit return on their capital. However, equity shareholders do face an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with a similar risk profile. Thus, the opportunity cost of equity capital is also inferred (Cumming, 2005).

Capital Asset Pricing Model (CAPM) CAPM says that equity shareholders demand a minimum rate of return equal to the return from a risk-free investment plus a return for bearing extra risk. This extra risk is often called the equity risk premium, and is equivalent to the risk premium of the market as a whole times a multiplier  called beta  that measures how risky a specific security is relative to the total market (Emery, Douglas, Finnerty, and Stove, 1998).

Thus, the cost of equity capital  Risk-Free Rate  (Betatimes Market Risk Premium).

Capital structure
Next, the proportion that debt and equity capital contribute to the entire enterprise is calculated, using the market values of total debt and equity to reflect the investments on which those investors expect to earn a minimum return.

Weighting the Components
Finally, the cost of each kind of capital by the proportion that each contributes to the entire capital structure is weighted. This results into Weighted Average Cost of Capital (WACC), the average cost of each  employed in the business (Harris and Raviv, 1991).

The following is the summary of WACC calculation for Vodafone
DebtEquityTotalPre-tax cost of debt ()3.8Cost of equity ()8.3After-tax cost of debt ()2.8Market value of debt (, MM)500.0

Market value of equity (, MM)76,272.0Enterprise Value (, MM) 76,772.0Percent of enterprise value ()0.7Percent of enterprise value ()99.3Percent of enterprise value ()100.0Weighted Average Cost of Capital (WACC, )8.3 Data Sources www.vodafone.com
Uses of WACC

Profitability Valuation
Economic indicators emerged with the realisation that profitability per se cannot fully measure value because it does not factor in risks. To measure value, returns must also be compared with the cost of capital employed. Using the cost of financing of a company, WACC, it is possible to assess whether value has been created (i.e., when return on capital employed is higher than the cost of capital employed) or destroyed (i.e., return on capital employed is lower than the cost of capital employed).

Value of Operations
The weighted average cost of capital (WACC) blends the required rates of return for debt (kd) and equity (ke) based on their market-based target values (Harvey, 1991). This is useful because the interest tax shield has been excluded from free cash flow (because interest is tax deductible). Since the interest tax shield has value, it must be incorporated in the valuation. Enterprise DCF values the tax shield by reducing the weighted average cost of capital. By calculating free cash flow as if the company were financed entirely with equity, operating performance across companies and over time without regard to capital structure can be compared. By focusing solely on operations, a cleaner picture of historical performance can be developed, and this leads to better forecasting.

Risk Extraction
A companys WACC already reflects its weighted average risk premium. In theory, the value of the weighted average risk premium could be extracted simply by subtracting the risk-free rate from the WACC. In practice, it is better to follow a slightly different procedure because the company cannot actually borrow at the risk-free rate. Instead of subtracting the risk-free rate, the companys expected after-tax borrowing rate is subtracted (Marino and Matsusaka, 2005)

Weighted Average Risk Premium  WACC - Cost of Debt After Tax
For consistency, financial analysts use the same after-tax cost of debt as used in the WACC. This prevents double-counting the companys credit risk premium in the subsequent calculations. The credit risk premium is the additional interest above the risk-free rate that the company must pay to compensate lenders for the possibility that the company might default on its payments to lenders.

Projecting Risk Premium
The risk-adjusted WACC for a project or for its risk class can be obtained simply by adding to the companys expected WACC the difference between the projects risk premium and the companys risk premium

Adjusted WACC  WACC  (Project Risk Premium - Company Risk Premium)
The resulting risk-adjusted WACC provides discount rates reflecting the differing risks of the companys projects.

Limitations of WACC

Complexity
Although applying the weighted average cost of capital is intuitive and relatively straightforward, it comes with some drawbacks. If one discounts all future cash flows with a constant cost of capital, as most analysts do, one is implicitly assuming the company manages its capital structure to a target rate. For example, if a company plans to increase its debt-to-value ratio, the current cost of capital will understate the expected tax shields. Although the WACC can be adjusted for a changing capital structure, the process is complicated.

Assumptions for Weighting System
Calculation of WACC is based on a critical assumption that the firm will in fact raise capital in the proportions specified. Because the firm raises capital marginally to make marginal investments in projects, analysts need to work with the marginal cost of capital for the firm as a whole. This rate depends on the package of funds employed to finance investment projects. In other words, the concern is with new or incremental capital, not with capital raised in the past. For the WACC to represent a marginal cost, the weights employed must be marginal. That is, weights must correspond to the proportions of financing inputs the firm intends to employ.

Adjusting Flotation Costs
Flotation Costs involved in the sale of debt instruments, preferred stock, or common stock affect the profitability of a forms investments. In many cases, the new issue must be priced below the market price of existing financing. In addition, there are out-of-pocket flotation costs. Owing to flotation costs, the amount of funds the firm receives is less than the price at which the issue is sold. The presence of flotation costs in financing requires that an adjustment be made in the evaluation of investment through WACC.

After-Tax Assumptions
Kdx (1-T), the after tax cost of debt, implies that the tax payments coincides in time with the tax accrual. Some firms could present this payment behaviour, but it is not the rule. Only those that are subject to tax withheld from their customers, pay taxes as soon as they invoice their goods or services. Because of this tax assumption and the existence of changing macroeconomic environment, (say, and inflation rates) WACC changes from period to period.

Use of WACC in International Scenario

WACC versus APV
Given the estimates for cost of equity and after-tax cost of debt, the debt and equity weights need to be derived an estimate of the weighted average cost of capital. In emerging markets, many companies have unusual capital structures compared with their international peers. One reason is, of course, the country risk (Masson, 1990). The possibility of macroeconomic distress makes companies more conservative in setting their leverage. Another reason could be anomalies in the local debt or equity markets. In the long run, when the anomalies are corrected, the companies should expect to converge to a capital structure similar to that of their global competitors. One could forecast explicitly how the company evolves to a capital structure that is more similar to global standards. In that case, using APV approach is a more useful option (Plasschaert, 1985).

Selection of Discount Rate
One question that a company investigating a foreign investment in an emerging market should ask is which hurdle rate should be used There are three different types of discount rates. The first method is to use the corporate WACC. Analysts in favour of using one single corporate WACC argue that a multinational organization can be considered as a portfolio of multiple (global) investments and thus each investment can be treated with the same cost of capital, which reflects the companys total aggregated portfolio risks.

The second method is to consider each investment project as a stand-alone investment and value each of them according to a local WACC that reflects the risks of the local country and project. The third method is a middle-of-the-road approach, which recognizes the need to account for the additional sovereign risk factors in the country of the investment in the WACC. This is achieved by simply adding a sovereign risk premium to the corporate WACC as a mark-up.

International capital structure
The key idea is to seek the lowest WACC in whatever currency it is the least, and then use the conversion rule to measure the WACC in the other currency. It is important to use the interest rate on risk-free T-bills for conversion purposes. That allows the costs of capital to be adjusted for different inflationary expectations, as in the Fisher equation. It is appropriate to consolidate all debt and equity at current exchange rates in order to correctly measure the debt-to-equity ratio for global operations.

Specific Risk Adjustments in the WACC
Calculating the WACC in developed markets can be a complicated exercise, but the calculation in emerging market environments is even more demanding. As well as the different and additional risks mentioned, emerging markets are also less developed, liquid and accordingly less efficient. In other words, reliable information for the determination of the WACC will be harder to obtain.

Cost of equity
The first component of the WACC is the cost of equity. In developed markets the capital asset pricing model (CAPM) is mostly applied to estimate the cost of equity of an investment. But CAPM has one significant underlying theoretical assumption, which is that it assumes that markets are fully integrated and efficient. However, there is proof to conclude that emerging markets are not efficient. For fully segmented emerging markets it can even be argued that CAPM is unsuitable compared to WACC for estimating the cost of equity, as the equity prices are not determined by equilibrium situations due to inefficiencies and poor liquidity.

The design of the spreadsheet is important since it presents the information needed by the users. In accounting, spreadsheets are used to keep records needed by the bookkeeper or accountant for data presentation. The importance of spreadsheet can be seen in the increasing number of individuals making use of it for an ease in tracking records.

The spreadsheet is designed in such a way that the users of it, including the beginners, could easily understand what the data presents. Few colors are used so as not to confuse the users. Formulas are embedded in order for the totals to automatically adjust whenever modification is necessary. In table1, the total of the direct cost for building the Econo-Bike will automatically adjust whenever changes in the direct costs are made. Moreover, if changes in the variables are made, the graph will automatically be adjusted to provide the exact conversion of each variable. However, users should retain the formula embedded in the spreadsheet. The formula is the device that made possible the automatic adjustments in the totals. The same procedures are made in all of the tables in the spreadsheet. In table 1 and 2, the number of hours and the rate per hour can be adjusted thus, would also change the amount for each direct labor, further, would also adjust the total cost. In tables 3 and 4, when modifications are made in the number of units produced per year the total direct cost for building each of the product will adjust automatically. In accounting, the quantity of the product is always changing since the quantity depends on the number of products produced, purchased, sold and other related activities performed by the enterprise.

The use of a pie chart is the most appropriate of all the graphs for this case since it provides an ease in knowing which of the factors has the largest fraction in the total cost. Also, the pie as a whole represents the total cost and the cuts made in the pie represents the fraction eaten by the contributors in the total cost such as carbon fibre frames, fork, wheels, components, saddle and handlebars, direct labor (workshop) and direct labor (finishing). The charts are correctly labeled in order for it not to be misleading. The portion of the pie that has the biggest cut is said to be the contributor that contributes the most in the total cost. In the case of table 1 it can be seen that carbon fibre frames has the largest portion in the total cost since it occupies almost one-third of the whole pie. For table 2, wages in quality control department contributes the biggest since it is the portion of the pie that is said to be the biggest.