Capital Budgeting and Cash Flow Analysis for Project Managers by Derek Hendrikz

Capital Budgeting and Cash

Flow Analysis in Project

Management

derek hendrikzwww.derekhendrikz.com

http://www.derekhendrikz.com/

Copyright © 2014

Derek Hendrikz Consulting

www.derekhendrikz.com



Fundamental Principles of Finance in Project Management





the Cost Benefit principle….



The Cost-Benefit Principle: Obtain clarity about the objective to be attained.

Identify alternative ways in which the objective may be

attained.

Calculate the cost and benefits of each of the alternatives.

Determine the effectiveness of the benefits of each

alternative.

Decide on a criterion or standard to be used against which

the acceptability of an alternative may be weighed.

Take a decision about the most appropriate course of

action.





the Risk Return principle….



The Risk-Return Principle: This principle is a trade-off between risk and return.

The greater the risk, the greater the required rate of

return.

In other words, the return should exceed the risk

involved in any business decision.

Risk is the probability that the actual result of a

decision may deviate from the planned end result

with an associated financial loss or waste in funds.





the Time Value of Money

principle….



The Time Value of Money Principle:

This principle implies that the value of

money today does not equal the value of

money tomorrow.

The basic assumption here is that a person

could increase the value of an amount of

money by investing it and earning interest

on the amount.




Capital Budgeting:

Capital budgeting places emphasis on cash flows associated with projects, rather than on accounting profit figures.

An investment in projects can only add value if its return is greater than the required rate of return.

The return may be best measured in terms of the Net Present Value (NPV) and the Internal Rate of Return (IRR). www.derekhendrikz.com


The Accept-Reject Approach to Evaluating Projects:

This approach involves evaluating

capital expenditure proposals to

determine whether they are acceptable.

If a project does not meet the basic

acceptance criterion, it should be

eliminated from consideration.



The Ranking Approach to Evaluating Projects:

This approach involves ranking projects

on the basis of some predetermined

criterion, such as the rate of return.

The project with the highest return is

ranked first and the project with the

lowest acceptable return, last.



Payback Period:

The payback period is the number

of years required to recover the

initial investment.

To calculate the payback period, you

need to establish when the initial

investment will be covered. www.derekhendrikz.com


Answer to Payback Period Exercise:

The payback period will be 2 years and six months

(time to recover initial investment).

This is calculated by adding the net cash flows of each

year until the initial investment is covered (R350000 +

R650000 + R400000 = (R1400000).

The initial investment is covered during the 3rd year,

with R200000 left. Therefore we assume that the

payback period is covered within the first six months of

the year.



Net Present Value (NPV):

The NPV is calculated by subtracting the initial investment from the present value of the net cash inflows discounted at a rate equal to the firms cost of capital.

If a net present value exceeds zero, then the project can be acceptable, since initial investment (with consideration of time value for money) will be covered. www.derekhendrikz.com


NPV Exercise:

Year: Net Cash Flow: PVIF (12%): PV of Net Cash Flow:

1 R350 000 0.893 R312 550

2 R650 000 0.797 R518 050

3 R400 000 0.712 R284 800

4 R300 000 0.636 R190 800

5 R201 000 0.567 R113 967

Total present value of cash flow: R1 420 167

Less initial investment R1 200 000

NPV R220 167



NPV Exercise with Financial Calculator:

Key In: Press: Calculator Display:

1 200 000 + Cfi -1200000.00

350 000 Cfi 350000.00

650 000 Cfi 650000.00

400 000 Cfi 400000.00

300 000 Cfi 300000.00

201 025 Cfi 201025.00

12 i 12.00

NPV 220 110, 527



Conclusion to NPV exercise:

• After considering the ‘time value for

money’ at a 12% WACC, the return of

project will still exceed the initial

investment.

• The conclusion is therefore that the

project should be accepted.www.derekhendrikz.com


Profitability Index (PI):

Also called the benefit-cost ratio.

The PI measures the present value return per

rand invested, while the NPV approach gives

the difference in rand between the present

value of returns and the initial investment.

The PI is calculated as follows:

PI = Total present values of the present cash flows

Initial investment



Answers Profitability Index (PI) Exercise:

The PI is R1,18.

This implies that for each Rand

invested, the investor will receive

R1,18 back.

Since the return value is more than

R1; the project should be accepted.www.derekhendrikz.com


Internal Rate of Return (IRR):

The IRR is probably the technique

used most often to evaluate

investment alternatives.

If the IRR is greater or equal to the

cost of capital, accept the project,

otherwise reject it.www.derekhendrikz.com


Answers to IRR exercise:

Key In: Press: Calculator Display:

1 200 000 + Cfi -1200000.00350 000 Cfi 350000.00650 000 Cfi 650000.00400 000 Cfi 400000.00300 000 Cfi 300000.00201 025 Cfi 201025.0012 i 12.00

NPV 220 110, 527

IRR 20



Conclusion to IRR exercise:

• The WACC is 12%.

• The IRR is 20%.

• Project should therefore be accepted.



Income Statement Formula…

• Sales less - cost of goods sold = gross profit

• Gross profit - operating expenses = operating profit

• Operating profit - interest expenses = net profit before tax

• Net profit before tax - tax = net profit after tax



Income StatementSales 1 450 000

Opening Inventory 240 000

Purchases 950 000

1 190 000

Closing Inventory 170 000

Cost of Goods Sold 1 020 000

Gross Profit 430 000

Other Expenses 210 000

180 000

Total Expenses 390 000

Net Profit 40 000

Income Statement……



Assets = Owners Equity + Liabilities

Balance Sheet……





Balance Sheet Example……

Assets: Owners’ Equity and Liabilities:

Fixed Assets 1000 Long term debt 300

Current Assets… 500 Current liabilities… 200

• Cash 200 • Accounts payable 100

• Inventory 100 • Short term loans 100

• Debtors 100 Owners Equity 1000

• Movable 100

Total: 1500 Total: 1500



Cash Flow Analysis:

Projected Cash Inflow – Projected Cash Outflow =

Projected Net Cash Flow

(Projected Net Cash Flow + Projected Beginning

Cash Balance) – Projected Short Term Borrowing

= Projected Ending Cash Balance (before

borrowing)

Projected Cash Inflow – Projected Cash Outflow = Projected Net Cash FlowProjected Net Cash Flow + Projected Beginning Cash Balance – Projected Short Term Borrowing = Projected Ending Cash Balance (before borrowing)



Cash Flow Analysis:Projected Cash Inflow – Projected Cash Outflow = Projected Net Cash FlowProjected Net Cash Flow + Projected Beginning Cash Balance – Projected Short Term Borrowing = Projected Ending Cash Balance (before borrowing)

January February March April

Projected Income

Investment 5 000

Brought Forward 10 100 6 700 20 100

Income 10 000 15 000 16 000 9 000

Total Cash on Hand 15 000 25 100 22 700 29 100

Projected Expenses

Equipment 300 300 1 800 0

Labour 3 000 3 200 300 300

Materials 1 600 0 500 1 000

Communication 0 900 0 1 200

Overheads 0 14 000 0 16 000

Total Expenses 4 900 18 400 2 600 18 500

Closing balance: 10 100 6 700 20 100 10 600




Leadership & Management

Capital Budgeting and Cash Flow Analysis for Project Managers by Derek Hendrikz