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 Budgets Forecasts Sales Budget Production Budget Selling Distribution Costs Budget General & Administrative Expenses Budget Capital Expenditure Budget Research & Development Budget MASTER BUDGET ( Budgeted P/L Account & Balance Sheet) Direct Labour Cost Budget Overhead Costs Budget Direct Materials Usage Budget Direct Purchases Budget 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. cash Purchases) arising from planned levels of activities and use of resources. By comparing anticipated each outflows + inflows, enables management to make necessary 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 = Investment Constant Inflow OR

YrCash flow Accumulate cash flow 0(500) 195(405) 295(310) 395(215) 495(120) 595(25) 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. = 0indifference N.P.V. < 0Project will be rejected N.P.V. > 0Project 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 )  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 - VC F.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 profit SP – VC = 5, , =6,000 units

Exercise: Case study 5 Use & Limitations of B-E analysis