Basics of financial management Chapter 5

Capital budgeting budget Sum total of investments in interrelated fixed and current assets Characterised by: Cashflows Receipts - expenditure

Calculating cash flow At start of project Cashflow = -investments Cashflow = accounting income + depreciation During project Cashflow = accounting income + depreciation + residual value In the final year

Assessment of capital budgeting projects Average book rate of return On the basis of profitability Pay back period On the basis of cash flow Net present value Internal rate of return Taking into account the time value of money

Average book rate of return Average annual profit ABR = Average invested capital Ignores time value of money Disadvantage

Pay back period Time it takes a project to recover its initial investment from the cumulative cash flow Only partly takes into account the time value of money Does not calculate profitability Disadvantages

Cumulative cash flow Time Start of project

Criteria that take into account the time value of money Discount rate whereby the present value of the expected cash flows equals the initial investment Internal rate of return > weighted average cost of capital  project acceptable Internal rate of return Present value of the expected cash flows NPV > 0  project acceptable Net present value

Interest calculation methods Simple interest Interest calculated on the initial amount only Compound interest Interest calculated on the total initial amount and on the accumulated past interest

Characteristics of assessment criteria ABR Pay back period NPV IRR Measures profitability Yes No Takes into account the time value of money Limited Suitable for assessment of accepting project Suitable for selection of best project

Leasing Nature of agreement Rent Finance Lifetime Financial lease Finance Lifetime of asset Lessee Lessor Operational lease Rent < Lifetime of asset Nature of agreement Lifetime Economic ownership Legal ownership On balance sheet