Capital Budgeting and Cash Flow Projection

8/16/2019 Capital Budgeting and Cash Flow Projection

1/21

68 TOPIC 5 CaPITal budgeTIng and Cash flOw PrOjeCTIOn

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Explain the importance of capital budgeting;

2. Identify steps in evaluating a capital budgeting project;3. Evaluate capital budgeting techniques;

4. Disscuss the advantages and disadvantages of each budgetingtechnique; and

5. Analyse the relationship between cash flow estimation and risk andalso inflation.

Topic

5 Capital Budgeting and Cash Flow

Projection

INTRODUCTION

Your company wants to do several projects. As a financial manager, you areassigned to evaluate these projects and submit a report to the board of directors.How will you evaluate these projects to determine their feasibility? To bettercomprehend the technique of project evaluation, it is vital that you, as a financialmanager, understand the meaning of capital budgeting.

In this topic, you will also see how the concept of financial mathematics learnt in

Topic 4 is applied in the evaluation of a financial project.


2/21

TOPIC 5 CaPITal budgeTIng and Cash flOw PrOjeCTIOn 69

Estimation of cash flow is a significant part in capital budgeting. As explainedearlier, capital budgeting is a process of planning the asset spending that is thecash flow expected to be received after a year. Evaluation will be undertaken on

proposals of projects to determine the suitability of those projects to achieve thefirm’s objective. This can be done by using techniques such as accounting rateof return, payback period, discounted payback period, net present value andinternal rate of return.

In making a good decision, accurate cash flow is important because it influencesgreatly the decision to accept or reject a proposed project. Numerous variablesand many workers will be involved in the process of capital budgeting.Projections are not made by the finance department only. Other departmentssuch as the marketing department, production department and human resourcedepartment also make their projections. All data provided by other departments

are compiled by the finance department to make an estimation of cash flow in thecapital budgeting process. Hence, it can be seen how difficult it is to prepare cashflow estimation. It involves numerous variables, cooperation from many peopleand accurate prediction.

A few guidelines on cash flow will be discussed in this topic to help financialmanagers to make more accurate cash flow projection.

5.1

CAPITAL BUDGETING

ACTIVITY 5.1

Explain the importance of cash flow in capital budgeting.

Capital budgeting is a process of planning asset spending, which is the receipt ofcash flow expected after a year. In capital budgeting decisions, a company placesfunds in various types of projects, such as firm expansion project, productiondiversification project, improving cost efficiency project, security project and etc.

Every decision made regarding capital budgeting has significant implicationsto both the cash flow expected to be received by the firm and to the cash flowrisk. This is because the decision on capital budgeting involves investment ofassets that is more than one year. For instance, a company wishes to invest in aproject that has life expectancy of five years. Having invested in that project, it isdifficult for a firm to pullout within this five-year period. At this stage, changesin demand condition, competition and so on may happen. These factors caninfluence the cash flow expected to be received and will affect the firm’s financialperformance. Therefore, it is important for a financial manager to analyse in detaila long-term investment proposal in order to make the best decision for the firm.


3/21


ACTIVITY 5.2

Write three reasons why doing capital budgeting is important.

As mentioned in Topic 1, one of the significant objectives of a firm is to maximiseits wealth. Capital budgeting process is one of the steps to achieve this objective.Thus, capital budgeting is part of a strategic management process.

5.1.1 Te Importance o Capital Budgeting

Capital budgeting involves investment in assets which have life expectancy ofmore than a year. If a project has life expectancy of eight years, it means that afirm will be tied up with that project for eight years. Therefore, it is importantthat a firm makes an accurate projection of the expected return. A mistake inmaking projection whether in terms of asset requirement or expected return willhave a serious impact on the firm’s performance. For example, a firm projectsthat sales will increase in the future. To fulfil the increase in demand, the firm

must invest in new machines and expand its factory now so that the asset isavailable when it is needed. If the projection is correct, the firm will attain profit because tools and outfit are all ready with the capacity to increase productionand fulfil the increase in demand. But if there are mistakes in the projection, suchas demand does not increase as projected, the firm will experience the problem ofreckless spending due to the excessive capacity. This will incur a loss to the firmand if the loss is great, this could lead the firm to bankruptcy.

Capital budgeting is part of the process of strategic management. Decisionregarding capital budgeting of the firm shall point to the strategic direction of thefirm. Regardless whether a firm does a replacement project, expansion project orenvironmental project, all of these projects need capital budgeting.

The timing of an investment project is important. Effective capital budgetingmust take into consideration the time the project is implemented and the qualityof assets invested. If a project takes place when the economy is in inflation, thecapital cost would be higher due to the high interest rate. This will influence thediscount rate used in the analysis of the project’s proposal.


4/21


5.1.2 Evaluation o Capital Budgeting Project

ACTIVITY 5.3

Why is a detailed analysis required for an expansion project comparedto a replacement project?

Assessing capital budgeting proposal involves expenditure. For this reason, afinancial manager may classify projects into various categories to determine thelevel of analysis needed – replacement project, expansion project, security project,environmental project etc.

Normally, a more detailed analysis is required for expansion project compared toan analysis for a replacement project. A large-scale project which requires huge budget will be evaluated more thoroughly than a small-scale project.

5.1.3 Steps in Evaluating Capital Budgeting Project

Evaluation of capital budgeting project involves a number of steps as shown inFigure 5.1.

Figure 5.1: Steps in evaluating capital budgeting project

DeterminingCost of Project

Comparing ofCash

Cash FlowForecasting

Present ValueAcquisition

DeterminingRisk

Choosinga SuitableCapital Cost

The chart in Figure 5.1 can be further explained as:

(a) Determining cost of project Cost of project is the average rate of payment for the use of capital fund for

the operation of that particular capital budgeting project. Cost of project can be influenced by factors such as financing policy and types of investment.Whether a capital budgeting project is accepted or rejected depends mostlyon the discount rate used and this discount rate can be regarded as capitalcost. Capital cost will be discussed in detail in Topic 6.


5/21


(b) Cash Flow Forecasting Estimation of cash flow is an important step in analysing a capital budgeting

project. To make a correct decision, accurate estimation of cash flow is

crucial. Estimation of cash flow is a complicated and difficult step to makedue to the existence of various factors which can influence a project’s cashflow.

This step requires a financial manager to refer to a number of guidelines oncash flow estimation in ensuring that only relevant additional cash flow aretaken into account before making a capital budgeting decision. Guidelinesregarding the estimation of cash flow shall be discussed in depth in thistopic.

(c) Determining Risk

Risk plays a vital role in capital budgeting. Ignoring risk in the analysis ofproposed projects may lead to wrong decision in capital budgeting; andhence will erode the firm’s financial standing.

(d) Choosing a Suitable Capital Cost

Based on cash flow risk, a suitable capital cost will be adopted for thediscounting of cash flow expected to be received.

(e) Present Value Acquisition Cash flow is discounted at present value to get an expected value of the

asset to the firm.

(f) Comparing of Cash The proposed project shall be accepted if present value of cash inflow

is more than cash outflow. On the contrary, the proposed project will berejected if present value of cash inflow is less than cash outflow.

5.1.4 Metods in Evaluating Project

There are a number of evaluation techniques which can be used to determine

whether a project can be accepted or rejected. The evaluation techniques are asfollows: (a) Accounting Rate of Return Accounting rate of return is a traditional method to evaluate a proposed

project in capital budgeting. The equation for accounting rate of return(ARR) is as follows:


6/21


Equation 1

ARR(%) = Net Average Income X 100Average Investment Book Value

Or

Equation 2

ARR(%) =

Net Average Income

X 100Sum of Average Investment Value

Net average income refers to income after depreciation and tax expenditure.

Now look at Example 5.1 that shows how to calculate accounting rate ofreturn and use the figures to determine choice of project.

Example 5.1

The table shows information regarding two projects, A and B. Book value for both projects are RM30,000.

Year 1

(RM)

Year 2

(RM)

Year 3

(RM)

Average

(RM)

Net income of Project A

(after depreciation and tax)

8,000 12,000 16,000 12,000

Net income of Project B

(after depreciation and tax)

16,000 12,000 8,000 12,000

Book value 1st January

31st December

Average

30,000

20,000

25,000

20,000

10,000

15,000

10,000

0

5,000

-

-

15,000


7/21


By using Equation 1, accounting rate of return (ARR) for each project is:

Project B

ARR% =12,000

X 10015,000

= 80%

Project A

ARR% =12,000

X 10015,000

= 80%

By using Equation 2, accounting rate of return (ARR) for each project is:

Project A

ARR% =

12,000

X 10030,000

= 40%

Project A

ARR% =

12,000

X 10030,000

= 40%

To determine whether to accept or reject a proposed project, compare theaccounting rate of return with minimum rate of return required:

(i) Accept a project if ARR is higher than minimum rate of return required;and

(ii) Reject a project if ARR is lower than minimum rate of return required.

If projects compete with one another or overlap each other, we will choose aproject that will give the highest rate of return as long as the project gives ahigher accounting return rate than the required minimum rate of return.

In Example 5.1, both projects A and B are attractive because their accountingrate of return are 80% (by using Equation 1) and 40% (by using Equation2). Both projects A and B will be accepted if the required minimum rate ofreturn is less than 40%.

Based on Example 5.1, project B gives a higher return in year 1 as comparedto project A which gives a higher return in year 3. If we take into calculationthe present value of money, project B will become more attractive ascompared to project A even though both projects give the same accountingrate of return.

One of the advantages of using Accounting Rate of Return (ARR) is, it iseasy to understand and to be used. The concept of income, book value andrate of return is a simple concept to understand by managers.


8/21


The following are the disadvantages of using accounting rate of return(ARR):

(i) It does not take into account the present value of money as seen in

Example 5.1;

(ii) It uses accounting measurement and not cash flow; and

(iii) Different methods of calculation may cause different decisions made.By using equation 1, the project may be accepted but by using equation2 it may be rejected.

(b) Payback Period This is a very simple technique whereby we only have to determine the

period required in order to get back the sum of money invested in the

project. The firm’s management will decide on a payback period; whetherthe project is to be accepted or rejected depends on whether the paybackperiod is longer or shorter than the period set by the management. Theprinciples for payback period are as follows:

(i) Accept the project if the payback period is less than or the same as theperiod decided by the management; and

(ii) Reject the project if the payback period is more than the period decided by the management.

Now, look at Example 5.2 which shows the method of choosing a project

based on payback period.

Example 5.2 Hebat Company is evaluating whether to accept Project A. The investment

required is RM12,000. The total cash flow expected for Project A is asfollows:

YearCash Inflow

(RM)

1 3,000

2 3,000

3 5,000

4 5,000

5 5,000

If Hebat Company sets the payback period to three years, Project A will berejected because the investment payback period exceeds the period set by


9/21


the management. After three years, this project will only give a return ofRM3,000 + RM3,000 + RM5,000 = RM11,000 whereas the cost of investmentis RM12,000.

If Hebat Company sets a payback period of four years, will this project beaccepted? Project A will be accepted because the payback period is less thanthe period set. After three years, the firm will receive a return of RM11,000.Therefore, it still needs RM1,000 to tally the cost of investment of RM12,000.Assuming that cash flow is constant, Hebat Company will take a time of(1,000 ÷ 5,000) 0.2 years to get back the balance of RM1,000. Therefore, thepayback period is 3.2 years compared to the set period of four years.

SELf-ChECk 5.1

Pasti Jaya Company has a project proposal that requires aninvestment of RM100,000. The schedule of cash inflow is as follows:

(a) Calculate the payback period for this project.

Year Cash Inflow (RM)

1 30,000

2 30,000

3 30,000

4 30,000

(b) If the management of the Pasti Jaya Company has decided on apayback period of three years, will this project be accepted?

Now look at Example 5.3.

Example 5.3 Hebat Company has two investment projects proposals: Project A and

Project B. The information on these projects is in the following table:

Assume that Hebat Company sets the payback period to be in three years’time. Based on the technique of payback period, Hebat Company will acceptproject B and reject project A. But is this a good decision?


10/21


Project A Project B

Investment RM12,000 RM12,000

Cash inflow

Year

1 RM3,000 RM3,000

2 RM3,000 RM4,000

3 RM5,000 RM5,000

4 RM5,000 0

5 RM5,000 0

In the payback period technique, Hebat Company does not take intoaccount the cash inflow after the set payback period. Although Project B isable to yield return on the investment in year 3, it will not be able to giveany returns after that. On the contrary, Project A may take a longer periodto yield returns on the investment but it will still produce a cash inflow ofRM5,000 in year 4 and year 5:

Following are the advantages of using the payback period technique:

(i) This is a very easy technique in the project evaluation method. Thecalculation is simple and time needed for making evaluation is short.Thus, the cost of using this technique is low.

(ii) Since this technique is simple and involves low cost, the managementcan use this technique to screen several project proposals and to rejectprojects which are unattractive in terms of payback period return.After that, a detailed evaluation can be undertaken) on the existingproject proposal. With this, the management can save time and cost ofevaluating proposed project.

There are difficulties in projecting cash flow in the long term becauseof the elements of uncertainty. Hence, payback period technique is auseful risk evaluation method.

Based on Examples 5.2 and 5.3, the disadvantages of the payback periodtechnique are as follows:

(i) This technique emphasises on cash inflow in the early years. Whathappens if the payback period is ignored?


11/21


(ii) This technique fails to consider the present value of money because itdoes not do discount cash flow received to present value. Normally,investment involves cash outflow at present and the revenue acquired

in the future. As explained in Topic 4, one ringgit received now is ofhigher value than one ringgit received in the future. If cash inflowis not discounted to the present value, the decision made may beincorrect.

To overcome these disadvantages, the discounted payback periodtechnique can be used. This technique will still determine the periodneeded to get back the sum of money invested but the cash inflow isdiscounted to present value before the decision to accept or reject theproject is made.

(c) Discounted Payback PeriodTo overcome the disadvantages of the payback period technique, discountedpayback period can be used. This technique still determines the periodneeded to get back the sum of money invested but the cash inflow isdiscounted to the present value before the decision to accept or reject theproject is made.

Example 5.4 shows how the technique of discounted payback period is used.

Example 5.4 Referring to Example 5.2 and assuming that the discount rate is 10%, a

discounted payback period schedule can be constructed:

Year Cash Inflow PVIFi=10%

Discounted CashInflow

1 RM3,000 0.9091 2727.3

2 RM3,000 0.8264 2479.2

3 RM5,000 0.7513 3756.5

4 RM5,000 0.6830 3415.5

5 RM5,000 0.6209 3104.5

Referring to the last column in the table, it shows that the total cash flowcollected for the first three years is RM8,963 (RM2,727.20 + RM2,479.20 +RM3,756.50). For the first four years, total cash flow collected is RM12,378(RM8,963 + RM3,415). Since the project investment cost is RM12,000,discounted payback period is three to four years. Therefore, we still needRM3,037 from year 4. Thus, the discounted payback period is:


12/21


Discount all cash flow to the present value

Compare present value of the sum of cash inflow with cash outflow

Accept the project if net present value is positive and rejectit if present value is negative

Based on the information in Example 5.2 for Hebat Company, please look atExample 5.5.

Example 5.5

Year Cash Inflow (RM) Present Value of Cash Inflow (RM)

1 3,000 0.9093 x 3000 = 2727.90

2 3,000 0.8264 x 3000 = 2479.20

3 5,000 0.7514 x 5000 = 3756.50

4 5,000 0.6830 x 5000 = 34155 5,000 0.6209 x 5000 = 3104.50

Total 15483.10

Investment required = RM12,000

No discounting is required on the cost of investment because this sum ofmoney is presently withdrawn.

Discounted payback period years = 3.89 years

Even though this technique takes into consideration the time value of

money, it still does not take into account the cash flow after the paybackperiod.

(d) Net Present Value Net present value of a project is the difference of the present value of all cash

inflow minus the present value of all cash outflow.

To obtain net present value:

30373 + year

3415


13/21


Discount rate used = 10% Net Present Value = The sum of present value of cash inflow – investment cost.

= RM15,483.10 – RM12,000 = RM3,483.10

Accept this project because net present value (NPV) is positive.

Advantages of using the net present value (NPV) technique:

(i) NPV technique takes into consideration present value of money because it discounts cash flow to present value; and

(ii) This technique takes into consideration all money flow for the lifeexpectancy of the project.

Disadvantages of using the net present value (NPV) technique:

(i) In the determination of a suitable discount rate, different discount ratesare used. These will affect present value of returns and as such, willinfluence the management’s decision on a particular project. This can be seen in Topic 4, that is, if a higher discount rate is used, the presentvalue of a sum of money will become smaller. Therefore, choosing asuitable discount rate is quite important for this type of evaluation.

(ii) Since this technique takes into consideration all cash flow of the life

expectancy of the project, projection of cash flow must be accurate. Ifthe projection is not accurate, this can cause a project to be acceptedeven though it ought to be rejected.

If the discount rate given is 10%, use the technique of net present valueto evaluate the proposed project in Self Check 5.1 (Pasti Jaya Company).Would you accept or reject the project? Give reasons.

(e) Internal Rate of Return In the internal rate of return technique, we try to find the interest rate that

equals the present value of the total cash flow with investment cost. Themanagement will decide on a required rate of return from a particularproject. Accepting or rejecting a project depends on the internal rate ofreturn (IRR). Therefore, it is necessary to determine whether IRR is higheror lower than the rate of return which has been set by the management.

We will accept a project if the internal rate of return (IRR) is higher or thesame as the rate of return set by the management. We will reject a projectif the internal rate of return (IRR) is lower than the rate of return set bymanagement.


14/21


15/21


The management requires 12% minimum rate of return for this type ofproject. Based on the above information, calculate the rate of return forproject S.

Answer: For varying cash flow, we have to use the trial and error technique. This

means that we will use one discount rate to determine the net present valueof the project. If the net present value is not equivalent to zero, we will try anew discount rate to determine the net present value.

For a start, we can use the discount rate (i) = 12% (same as capital cost). Withthis rate, net present value of the project can be determined as follows:

Year (1)Cash Flow (RM) (2)PVIFi=12%, n=4

(3) = (1) x (2) Present Value

1 350,000 0.8929 312,515

2 300,000 0.7972 239,160

3 250,000 0.7118 177,950

4 150,000 0.6355 95,325

824,950

Net Present Value = RM824,950 – RM800,000 = RM24,950

Due to the net present value being positive, the discount rate must beincreased. Now, we try with i = 14%.

Year(1)

Cash Flow (RM)

(2)

PVIFi=14%, n=4

(3) = (1) x (2)

Present Value

1 350,000 0.8772 307,020

2 300,000 0.7695 230,850

3 250,000 0.6750 168,750

4 150,000 0.5921 88,815

795,435

Due to the net present value being negative, the discount rate must bereduced. Now, we try with i = 13%.


16/21


Year(1)

Cash Flow (RM)

(2)

PVIFi=13%, n=4

(3) = (1) x (2)

Present Value

1 350,000 0.8850 309,7502 300,000 0.7831 234,930

3 250,000 0.6931 173,275

4 150,000 0.6133 91,995

809,950

Net Present Value = RM809,950 – RM800,000 = RM9,950

Summary

Discount rate (i) Net Present Value 12% RM24,950 13% RM9,950 IRR = ? RM0 14% RM4,565

This means that zero net present value must be between the discount ratesof 13% and 14%. The project’s internal rate of return is the same as 13% + but less than 14%.

It must be reminded that, students must repeat the trial and error calculation(i.e. try a number of different discount rates) until arriving at 2 ranges ofnet present value (one positive and another negative). This ensures thatnet present value equals to zero can be determined. IRR is the discount ratewhich makes the net present value becomes zero:

Advantages of using the internal rate of return technique:

(i) This technique measures rate of return on investment. Rate of returnconcept is easily understood by the management; and

(ii) This technique takes into account present value of money as net present

value technique.

Disadvantages of using the internal rate of return technique:

(i) With regard to certain cash flow, there probably is more than oneinternal rate of return. This will confuse the management in makingdecisions; and

(ii) For competing projects, it is a situation whereby management isrequired to choose only one project, for instance, in a power stationproject, management has a choice between hydro electric, nuclear or


17/21


coal. The internal rate of return technique may give priority to thewrong project.

(iii) The calculation of this technique is quite difficult if there are different

returns during the life of the project.

5.2

GUIDELINES ON CASh fLOWESTIMATION

ACTIVITY 5.4

Based on the project evaluation methods mentioned before, what is the best method you will employ if you are a project manager? What are thecharacteristics you will consider?

SELf-ChECk 5.2

1. Based on the information available in Self-Check 5.1 (Pasti JayaCompany), calculate the internal rate of return for that project.

2. Will you accept or reject the project if the management sets the

required rate of return at 15%? Give your reasons.

As a financial manager, what is the guideline that you will use for the estimationof cash flow in your organisation?

A financial manager has to consider several important guidelines for a moreaccurate cash flow projection in getting better accuracy for capital budgetdecisions. We will discuss these guidelines in the next subtopic.

5.2.1 Based on Cas flow and Not on AccountingProit

Profit is based on accrued concept. For instance, this year’s sale is considereddone and this year’s profit can take into consideration those sales. But, even ifsales happen this year, collection does not necessarily happen in this year too.Therefore, we cannot take into calculation those sales as a cash inflow. Withoutthis cash inflow, the firm’s project may be impeded due to financial difficulties.This applies to any payment made by the company. Sometimes, the firm needsto make a certain payment to another party next year and in the calculation of


18/21


accounting profit, this payment is this year’s cost because service has been givenor merchandise has been supplied by the party concerned. But since paymentneed not be paid this year, cash outflow does not happen and with that, this cash

flow will not be shown this year.

5.2.2 Only Relevant Additional Cas flow isConsidered

Additional cash flow is net cash flow that is related to the investment project.This cash flow will happen if only we accept the project. In determiningadditional cash flow, a few doubts may arise, for instance, sunk cost, opportunitycost and externality. Are these items included as a part of additional cash flow?

(a) Sunk Cost Sunk cost refers to the total cost spent and is not collectable whether a

project is accepted or not. Therefore, a sunk cost cannot be included in theanalysis. For instance, the fee paid to a consultant for conducting a marketresearch. Consultant fees cannot be included in a project analysis becausethis cost has been spent, regardless of whether the project is accepted andthe cost cannot be collected back.

(b) Opportunity Cost Opportunity cost refers to the return which can be acquired from an asset

if the asset is utilised for other usage. For instance, ABC Company has anoffice that can be used as a new branch office or that office can be rented toother people for RM36,000 per year. If ABC Company opens a branch, it willlose the opportunity of having a year’s rent of RM36,000. This opportunitycost must be included in the analysis.

(c) Externality Externality refers to the impact of the project on other departments in the

firm or to the firm’s existing production. For instance, if the firm introducesa new product, this may affect an existing product sale. A financial managershould take into account external impacts when estimating an investmentproject’s cash flow.

ACTIVITY 5.5


19/21


5.3 MAkING DECISIONS ON EXPANSIONPROJECT AND REPLACEMENT PROJECT

ACTIVITY 5.5

Provide one example to describe each of the following items:

1. Sunk cost

2. Opportunity cost

3. Externality

Why is an expansion project more complicated and needs a more detailedanalysis as compared to replacement project? In capital budgeting, two typesof decisions are usually made, which are decisions concerning the followinganalyses:

(a) Replacement project analysis; and

(b) Expansion project analysis.

Usually, analysis of expansion project is more difficult and complex compared

to analysis of replacement project. Analysis of expansion project involvesinvestment in new assets for the purpose of increasing sales and expansionof firm’s market share. Replacement project involves investment to replaceequipments or old assets.

For expansion project, all cash outflow or cost and all cash inflow or revenueneed to be considered. A financial manager must consider the degree of risk aswell as the inflation rate relating to the project when evaluating this particularproject. Evaluating technique such as payback period, net present value and rateof return discussed in this topic can be used to analyse the project.

For replacement project, additional cash flow such as cash received from sale ofold assets or used assets must be calculated. Besides this, the impact of saving ontaxes also needs to be considered.


20/21


5.4 CASh fLOW ESTIMATION AND RISk

What is the relationship between cash flow estimation and risk? Risk measures

variance between real outcome and expected outcome. In capital budgeting,every period is a random variable and cash flow projection may not be accurate.The bigger the variance or the difference between projection of cash flow and realcash flow, the higher the risk will be. In order to make a more accurate analysis, afinancial manager needs to include the degree of risk into capital analysis.

5.5

CASh fLOW ESTIMATION ANDINfLATION

What is the relationship between cash flow projection and inflation? Inflationrefers to increase in the general prices of goods and services. When inflationrate increases, the value of money decreases. If expected inflation rate is notcalculated into the analysis of cash flow projection, the value received isdeflected and inaccurate. As a result, the capital budgeting decision made willnot be accurate and may affect the firm’s financial standing. Due to this, capital budgeting analysis must consider the effects of inflation on cash flow projectionto get a more accurate decision.

The inflation rate expected must be included in the analysis of net present value

to ensure that capital cost takes into consideration the inflation rate. If inflationrate is found to be higher, the discount rate used should be raised. If the inflationrate is low, the discounted rate must be lowered. Please refer to Topic 4 onFinancial Mathematics to revise on discount rate and present value. You should be able to understand the relationship between cash flow estimation and inflationmore clearly after having revised Topic 4.

SELf-ChECk 5.3

1. The _________ the difference between cash flow projection with truecash flow, the more _____________ its risk.

2. In cash flow projection analysis, when the inflation rate is___________, the discount rate used must be increased. Wheninflation rate is ____________, the discount rate used must belowered.

Fill in the blanks.


21/21


SUMMARY

• In this topic, you have learned that capital budgeting involves planningand evaluation of a long-term project as well as the importance of capital budgeting for a firm.

• Several methods of evaluating projects such as accounting rate of return,payback period, discounted payback, net present value and internal rate ofreturn have been explained and examples of calculation for each techniquehave been shown. Besides this, advantages and disadvantages of eachtechnique have also been discussed.

• Cash flow projection is important in the analysis of a proposed investmentproject. A number of guidelines on cash flow projection have been discussed

to help you in making decisions on whether to include the cost.

• Degree of risk of the project and inflation rate are need to be considered whenevaluating a project.

Budgeting technique

Cash floor

Capital budgeting

Inflation

Opportunity cost

Sunk cost

Documents

Capital Budgeting and Cash Flow Projection