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Independent Critical Evaluation of a Financial Planning Model UGB317.1

Financial modeling

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IndependentCritical Evaluation of a Financial Planning Model

UGB317.1

Tableof contents page

Financialplan model……………………………………………………………. 3

Riskand uncertainty …………………………………………………………… 3

TheMerchant Navy …………………………………………………………….. 4

Sensitivityanalysis …………………………………………………………….. 5

Incomestatement ……………………………………………………………… 5

Modelingthe sensitivity analysis tool …………………………………………. 6

Observations,Projections and Recommendations …………………………… 8

Strengthsof the sensitivity analysis ……………………………………………. 10

Weaknessesof the sensitivity analysis …………………………………………. 10

CostVolume Profit …………………………………………………………………. 11

OtherAssumptions ………………………………………………………………… 12

Recommendationof application of the model ………………………………….. 12

Conclusion……………………………………………………………………… 13

References/Bibliography ……………………………………………………….. 13

Financial plan model

Financialplanning involves making decisions as to whether the businessundertaking should be continued or stopped altogether. It will giveyou an idea whether or not the business is a viable operation orwhether it will make money or lose money [CITATION How14 p 1 l 1033 ]. Such decisions are alsoreinforced by the use of financial models. Sensitivity analysis isone such model that can easily be applied especially in case ofuncertainty.

Riskand uncertainty

Investmentappraisals and investment decisions will depend on risks anduncertainties of the project to be undertaken. Samuels and Wilkes indescribing risk and uncertainty have stated that Risk is taken tomean a situation in which various outcomes to a decision are possiblebut where the probabilities of the alternative outcomes are known. Uncertainty describes a situation in which there is no suchprobabilistic knowledge or where the information is fragmentary [ CITATION Sam82 l 1033 ]. In uncertain situations, one of the models usedis the sensitivity analysis. It helps in establishing the variablethat is most influential in the project and how the project respondsto other parameters respectively and ultimately identifying thestrengths and weaknesses of the project. The case study on theMerchant Navy Officers Pension Fund will be used to demonstrate howsensitivity analysis can be applied.

TheMerchant Navy Association depends on contributions from themembership and employers, and since these contributions keepfluctuating over time, sensitivity analysis would be a moreappropriate financial tool to be used in determining the strengthsand weaknesses of the project at a given time. The objectivefunction is the contribution towards the fund since the Associationcannot meet its objectives without these contributions.

TheMerchant Navy

Formany years, the shipping industry existed without schemes that aim atbenefiting shipping officers and their families. The Merchant NavyOfficers Pension Fund (MNOPF) was started in 1938 with the aim ofproviding pensions on retirement and protection on death for officersin the United Kingdom mercantile marine as stated in their website [ CITATION mno14 l 1033 ]. MNOPF is divided into two sections the old section and the newsection. The new section was set up after closing the old section in1978. However, the new section also closed up to new membership in1996. Other than having members in the new section or the oldsection, there are members who are also registered in both sectionsand therefore, benefit from both.

Tomeet the obligations of the fund, contributions to the fund are mademainly by the employers of the officers. The fund is used to paybenefits to members on retirement or death, or dependents approved bythe Board of Directors. A summary obtained from their web sitestates that the benefits represent a very long obligation and it isnot possible to know, with certainty, what contributions to the fundare needed to make sure that there will be sufficient money availableto pay the benefits in the future [CITATION mno141 p 14 l 1033 ]. From this therefore, we can confirm that our objective function tobe optimized would be contributions to the fund by employers.

Fromthe case study on the Merchant Navy Officers Pension Fund in 2012downloaded from engaged Investor web site [CITATION eng14 l 1033 ],the following information wasestablished:

&nbsp

Old section (b£)

New section (b£)

Funding position (%)

2008

assets

1.3

2

96

81

active members

&nbsp

1200

&nbsp

&nbsp

Inthis case study, the Chief Executive Officer, Andrew Waring indicatedthat they had a clear journey plan and targeted full settlement ofliabilities within the next 10 years. Therefore, it is clear thatdeficit is a variable that needs to be addressed in decision making. The Association will not meet its objectives if the number ofdefaulters grows with time.

Sensitivityanalysis

Inconducting a sensitivity analysis for the merchant navy, thefollowing are possible parameters that will be considered:

  1. Contributions from employers

  2. Deficit/surplus

  3. Membership

  4. Investments

  5. Time in years

AsPannell puts it, the analysis in this case will be used for decisionmaking and development of recommendations for decision makers [CITATION Pan14 p 2 l 1033 ]. It can also be used inidentifying critical values, thresholds or break-even values wherethe optimal strategy changes identifying sensitive or importantvalues and developing flexible recommendations which depend oncircumstances.

Incomestatement

Theinformation below has been extracted from the Summary Annual Report-2013 of the Merchant Navy Officers Pensions Fund as at 31stMarch 2013 [ CITATION mno142 l 1033 ]. Table 1shows the netincome for the association and this will show us the main asset ofthe group.

Table1: Income statement

&nbsp

old section (m£)

new section (m£)

total (m£)

opening balance as at 31st march 2012

1329.9

2169.2

3499.1

income during the year

90.6

90.6

less

&nbsp

&nbsp

&nbsp

expenses during the year

-90.5

-114.9

-205.4

plus

&nbsp

&nbsp

&nbsp

net return on investment

126.6

261.6

388.2

equals

1366

2406.5

3772.5

Modelingthe sensitivity analysis tool

Contributionsto the pension fund are made by members in the two sections throughtheir employers. Table 2 shows the total number of members on rollat the end of March 2013.

Table2: Membership

&nbsp

old section

new section

both

total

Membership as at 31st march 2013

22096

10125

16786

49009

Inthe case study Farrand quotes Waring, the Chief Executive Officer ofMNOPF saying that the idea behind the MNOPF was to provide aconsistent pension scheme for officers in the merchant navy whochanged employment regularly [CITATION eng14 l 1033 ]. Table 3 gives amounts needed to paythe officers their benefits in 2012 and 2013 financial years.

Table3: Estimated amounts needed to provide benefits

Estimated amount needed to provide benefits

Old section (m£)

New section (m£)

Total(m£)

as at 31st march 2012

1302

2626

3928

as at 31st march 2013

1330

2805

4135

&nbsp

&nbsp

&nbsp

estimated funding level as at 31st march 2013

100%

85%

Paymentof benefits depends on all the funds available at the end of thefinancial year. This will be a surplus if they exceed amounts to bepaid out for benefits and a deficit if the amount to be paid out forbenefits exceeds the total funds available. Table 4 shows the netfunds available from employer contributions and return oninvestments.

Table4: Assets/ total funds at the end of the given financial years

year

assets (m£)

2013

3772.5

2012

3499.1

2011

3305.7

2010

3108.2

2009

2659.2

Theseare values that should be optimized in the operations of the pensionfund. Figure 1 below shows the relationship given by these valuesover a period of five years. As mentioned by Simpson [ CITATION Sim12 l 1033 ],financial models are usually built with the x-axis serving as thetime and the y-axisbreaking down the results by line-item. The sensitivity analysis inthis case has been built on the x,y- plane as shown in figure 1.

Figure1: Relationship between total funds and time in years.

Observations,Projections and Recommendations

Fromthe graph, it is clear that there is a steady increase in total fundscontributed to the merchant navy officers’ pensions fund as timegoes by. The annual increase is approximately £250million.

Ifthis scenario is maintained, then in 2016, it is expected the totalfunds to be collected will be £4500million. The contributions are made from employers and returns frominvestments undertaken by the merchant navy officers’ pensions’fund. Since both, the old section and the new section are closed tonew membership, it means that contributions from employers inrelation to the membership will remain constant or will drop due todeficits. This is on the assumption that there is 100% payment ofcontributions.

However,other employers may fail to remit their contributions in time or someemployers may dissolve their companies hence rendering the employeesjobless and failing to remit their contributions. These conditionswill reduce total contributions to the pension fund hence resultingin a deficit.

Forthe association to meet the deficits, an investment plan should bemooted which can generate income or profits to the group. Suchprofits can then be used to clear the deficits in a given period.

Ofcourse, the deficits will result from the need to meet theobligations of the group in paying benefits to the members. It hasbeen noted that the amount needed to provide benefits has beenincreasing with time. For example, in 2013, the estimated amountneeded to pay for the benefits in the new section was £2805million up from £2626million in the previous year. In the old section, the amount was£1302million in 2012 and increased to £1330million in 2013. At the end of the financial year 2013, the assetsfor the old section were £1366million as opposed to the assets in the new section which stood at£2406.5million. This implies that the old section is able to meet itsobligations in payment of benefits to its members and will have asurplus. But the new section cannot meet payment of benefits to themembers and has a deficit. The estimated funding level for the newsection as at 31stmarch 2013 was 85% as shown in the summary [ CITATION mno142 l 1033 ]. This is the reason why investment plans must be initiated in thefuture to cater for such deficits.

Apossible way of checking on the deficit also is to revise the levelof contributions from the employers so as to meet the deficit. Thiscould be a necessary action if the investment conditions are alsounfavorable.

Thetotal amount needed to pay benefits in both sections was £4135million as at 31stmarch 2013. This shows that there was an overall deficit. If thisamount remains constant for the next three years to 2016, then theassets projected for the year 2016 would be able to cover thebenefits obligations of the pension fund. However, if the estimatedamount needed to pay for benefits increases at the same rate as theincrease in total funds paid, then the pension fund will not be ableto meet its benefits payment obligations. Since the deficits areemanating from the new section, it is recommended that factorscontributing to the shortfalls should be addressed immediately so asto remove the deficit and even generate a surplus. The break evenpoint for the new section can be met by the end of the financial year2014 if the amount to be used for paying benefits remains fairlyconstant.

Strengthsof the sensitivity analysis

Theobservations, projections and recommendations mentioned above arebased on the sensitivity analysis meant to optimize assets orcontributions to the merchant navy officers’ pension fund now andin future. The critical factor in this case is the totalcontribution at the end of each financial year. We are able to usethe graph and the tables to give a projection of the fund in threeyears time from a base of 2013. It is easy to make such observationsusing the sensitivity analysis by considering two aspects at a timeand in this case, it is clear that contributions to the fund aresensitive to changes in other parameters over a given period of time. Consequently, sensitivity analysis is easy to undertake, easy tounderstand, communicate, and apply in financial models and makingdecisions.

Weaknessesof the sensitivity analysis

However,the analysis becomes more complex to analyze and interpret if manyfactors or parameters are considered at a go. This limits theanalysis in scope and makes it more favorable when dealing with oneparameter or several factors grouped together. Samuels and Wilkeshave explained that sensitivity analysis does not make decisions ofitself. It is a practicable procedure that presents derivedinformation in a particular revealing way [CITATION Sam82 p 236 l 1033 ]. Therefore, the decision rests with the management and theimplementers of the project in question.

Cost-Volume-Profitanalysis (CVP)

Inperforming a CVP analysis for the Merchant Navy, the formula requiredwill be as follows:

Totalcosts = managerial costs/fixed costs + expenses + benefits

Totalcontributions = contributions by employer X number of employersregistered

Thebreak even point will be given where there is no surplus or deficitincurred by either of the sections. At this point, the total costwill be equal to the total contributions paid in by employers andtherefore the net income is zero [ CITATION Har14 l 1033 ]. This is also indicated by the point of intersection in the figurebelow.

Itis assumed that all contributions will be paid by employers withoutfail and that other returns on investment are factored in ascontributions to the pension fund.

Figure2 below represents the CVP graph for the old section.

Figure2: CVP graph for the old section of The Merchant Navy

No. of employers

£ Million

Variable costs

Surplus area

Deficit area

Total contributions

Fixed costs

Theadvantage of the CVP is that it is able to give a projection of thegrowth of contributions for the Merchant navy. However, one aspectof the association is considered at a time and in this case it is thenumber of employers and their contributions to the pension fund. Itis assumed that contributions are paid in full but in real lifesituation, we have employers who will default in making theircontributions. A deficit has been realized in the new section asopposed to a surplus of at least £3million in the old section as at the close of the financial period2012. This implies that The Merchant Navy has to incur extra costsfor it to be able to recover deficits created by the new section.

Thedisadvantage of the CVP analysis is that it does not offer solutionsto projected problems from the model, but rather indicate thesituation of the association at a given time.

Asfor the shipping companies affiliated to The Merchant Navy, eachwould have its own CVP analysis drawn but this will not show theoverall contribution of surplus to the pension fund in this casestudy.

OtherAssumptions

Itis also assumed that the project will run for life and is not goingto be stopped in the near future. It is also assumed that employerswill make contributions to the pension fund promptly and no employerwill default. This is the most influential assumption [ CITATION McM141 l 1033 ]of the analyses the sensitivity and the CVP analyses.

Recommendationof application of the model

Sensitivityanalysis is a good financial model and can easily be applied to manysituations. Repeated considerations of the objective function withother parameters either singly or grouped together ultimately yieldsmore accurate results that would allow for better decisions to bemade. When this is combined by other analyses like the CVP analysis,a better picture of the groups financial status is drawn andtherefore, effective decisions can be made by the management.

Conclusion

Financialmodels must be used in financial plans to make informed decisions. Sensitivity analysis should be prioritized in financial modeling butshould be used along with other financial models such the CVPanalysis.

Reference/Bibliography

bpg.com. (n.d.). How to write a financial plan. Retrieved march 3, 2014, from business plans guide website: http://www.business-plans-guide.com/financial-plan.html

Farrand, F. (2011, november 17). Case Study: The Merchant Navy Officers` Pension Fund. Retrieved march 4, 2014, from Engaged Investor: http://www.engagedinvestor.co.uk/case_study_the_merchant_navy-Offi…

Harcourt, H. (n.d.). Cost-Volume-Profit analysis. Retrieved march 11, 2014, from Cliffs notes web site: http://www.cliffsnotes.com/more-subjects/acco..

McMorran, J. (n.d.). Financial modeling and forecasting. Retrieved march 4, 2014, from Postlethwaite &amp Netterville web site: http://www.pncpa.com/admin/files/resources/financial-modeling-and-forecasting.pdf

mnopf. (n.d.). MNOPF summary. Retrieved march 5, 2014, from Merchant Navy Officers Pension Fund web site: http://www.mnopf.co.uk/pdf/49232_MNOPF_Summary_RA_Interactive.pdf

mnopf.co.uk. (n.d.). MNOPF Summary. Retrieved march 5, 2014, from Merchant Navy Officers Pensions Fund web site: http://www.mnopf.co.uk/pdf/49232_MNOPF_Summary_RA_Interactive.pdf

mnopf.co.uk. (n.d.). Welcome to Merchant Navy Officers Pension Fund. Retrieved march 5, 2014, from The Merchant Navy Web site: http://www.mnopf.co.uk

Pannell, D. J. (n.d.). Sensitivity Analysis: strategies, methods, concepts examples. Retrieved march 3, 2014, from dpannell web site: http://www.dpannell.fnas.uwa.edu.au/dpap971f.htm

Samuels, J., &amp Wilkes, F. (1982). Management of Company Finance (3rd Edition). Frome: Butler &amp Tanner Ltd.

Simpson, S. D. (2012, august 10). Financial models you can create with Excel. Retrieved March 4, 2014, from Investopedia web site: http://www.investopedia.com/financial-edge/0812/financial-models…