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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