Chapter 19 Capital Budgeting

Basic Concepts

I. Cash flow

Cash inflow + Cash outflow = Net cash flow

Cash surplus/Cash deficit

II. Time value of money• Affected by inflation

III. Discount rate• The interest rate used in discounting future

cash flow• FV PV

iv. Cost of capital• To determine the attractiveness of a project• Affected by the capital structure of the

company• Example 19.1

Typical Sequence of Preparation of Major BudgetsForecasts

Sales Budget

Production Budget

Selling DistributionCosts Budget

General & Administrative

Expenses Budget

Capital Expenditure

Budget

Research & Development

Budget

MASTER BUDGET ( Budgeted P/L Account & Balance Sheet)

Direct LabourCost Budget

Overhead CostsBudget

Direct MaterialsUsage Budget

Direct PurchasesBudget

Planned this time and deals only with ‘cash’ flows – excluding expenses of Non-cash nature, e.g. depreciation. Consists of estimates of each receipts (e.g. cashPurchases) arising from planned levels of activities and use of resources. Bycomparing anticipated each outflows + inflows, enables management to makenecessary financial arrangement for deficits anticipated or placing cash surplus.

Cash Budget

Capital Budgeting

1. Payback period• The length of time required for the

investment to be recovered• Example 19.2

Payback =InvestmentConstant Inflow

OR

Yr Cash flow

Accumulate cash flow

0 (500) (500)

1 95 (405)

2 95 (310)

3 95 (215)

4 95 (120)

5 95 (25)

6 40 15

7 40

Positive figure or “0”

Example 19.4 – it ignores time value of money

19.5 – it ignores cash flow beyond the payback

period

2. Net Present Value Method

N.P.V. =Present value of all cash inflow +Present value of all cash outflow

If

N.P.V. = 0 indifference

N.P.V. < 0 Project will be rejectedN.P.V. > 0 Project is attractive

PV =FV

(1+r) t

PV of all constant flow = c [1 – 1/(1+r) ]

r

t

Ex. 19.9

3. Average rate of return

Based on the profits of a project (Ex.

19.10)

Case study 1 & 2

Break-even Analysis The level at which TR = TC

Profit = loss = 0$

Q

TR

TC

Loss

Profit

Margin of

safety

Q* = break-even point

Example: FC = $5000, SP = $3, VC = $2

Contribution margin per unit = $ (3 –2)

= $1

= $5,000$(3 –

2)= 5,000 units

= 5,000 * $3 (S.P.)

= $15,000

SP - VCF.C.

B.E.

=

To calculate the quantity at which to achieve target profit the target profit should be added to the F.C. (E.g. target profit $1,000)

Quantity = F.C. + target profitSP – VC

= 5,000 + 1,0003 - 2

= 6,000 units

Exercise: Case study 5

Use & Limitations of B-E analysis