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Chapter 19 Capital Budgeting

Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

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Page 1: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

Chapter 19 Capital Budgeting

Page 2: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

Basic Concepts

I. Cash flow

Cash inflow + Cash outflow = Net cash flow

Cash surplus/Cash deficit

Page 3: 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

Page 4: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

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

Page 5: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

Capital Budgeting

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

investment to be recovered• Example 19.2

Payback =InvestmentConstant Inflow

OR

Page 6: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

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”

Page 7: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

Example 19.4 – it ignores time value of money

19.5 – it ignores cash flow beyond the payback

period

Page 8: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

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

Page 9: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

PV =FV

(1+r) t

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

r

t

Ex. 19.9

Page 10: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

3. Average rate of return

Based on the profits of a project (Ex.

19.10)

Case study 1 & 2

Page 11: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

Break-even Analysis The level at which TR = TC

Profit = loss = 0$

Q

TR

TC

Loss

Profit

Margin of

safety

Q* = break-even point

Page 12: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

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.

=

Page 13: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

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

Page 14: Chapter 19 Capital Budgeting Basic Concepts I. Cash flow Cash inflow+Cash outflow = Net cash flow Cash surplus/ Cash deficit

Exercise: Case study 5

Use & Limitations of B-E analysis