bg management accounting chapter 10 4335

Cash flowsCASH OUTFLOW Most projects have at least three types of cash outflows : - They often require an immediate cash outflow in the form of an initial investment in equipment, other

CHAPTER 10

10.1 An overview about capital budgeting

Any decision that involves a cash outlay now to obtain a future return is a capital budgeting decision

Typical capital budgeting decisions include:

1 Cost reduction decisions

2 Expansion decisions

3 Equipment selection decisions

4 Lease or buy decisions

5 Equipment replacement decisions

10.1.1 Typical Capital Budgeting Decision

Capital budgeting tends to fall into two broad categories:

ΠScreening decisions: Does a proposed project meet some present standard of acceptance?

 Preference decisions: Selecting from among several competing courses of action

10.1.2 Cash flows

CASH OUTFLOW

Most projects have at least three types of cash outflows :

- They often require an immediate cash outflow in the form of an initial investment in equipment, other assets, and installation costs

- Some projects require a company to expand its working capital

- Many projects require periodic outlays for repairs and

maintenance and additional operating costs.

10.1.2 Cash flows

CASH INFLOW

Most projects have at least three types of cash inflows :

- A project will normally increase revenues or reduce costs

- Cash inflows are also frequently realized from selling equipment for its salvage value when a project ends

- Any working capital that was tied up in the project can be released for use elsewhere at the end of the project and should be treated as a cash inflow at that time

10.1.3 Time Value of Money

There are 2 types of cash flow:

- Single cash flow: is the cash flow that happens in one

period

- Compound cash flow: is the cash flow that happens

regularly

10.1.3 Time Value of Money

The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows.

Discounting cash flows is a method to translate the

value of future cash flows to their present value

10.2 Methods in analyzing capital budgeting

decisions

• The Payback Period Method (PP)

• The Net Present Value Method (NPV)

• The Internal Rate of Return Method (IRR)

• The Simple Rate of Return Method (SRR)

10.2.1 The Payback Method

The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates

The payback period is expressed in years

10.2.2.The Net Present Value Method

The net present value is the difference between the present value of the cash inflows and the present value of the cash outflows of an investment project

There are 5 steps to apply NPV method

10.2.2.The Net Present Value Method

- Step 1: classify cash flows of the project:

+ Cash outflows include:

Initial investment (including installation costs)

Increased working capital needs

Repair and maintenance

Incremental operating costs

+ Cash inflows:

Incremental revenues

Reduction in cost

Salvage value

Release of working capital

Refund VAT

10.2.2.The Net Present Value Method

- Step 2: Choosing a discount rate

Bases on cost of capital: It is the average rate of return

the company must pay to its long term creditors, shareholders for using their funds

- Step 3: Calculate Cash flow Present Value

Present Value = Cash flow Value X Discount rate

- Step 4: Calculate Net Present Value

NPV = Total cash inflows PV – Total cash Outflows PV

10.2.2.The Net Present Value Method

Step 5: Select projects:

NPV < 0: not acceptable because its return is less than the required rate of return

NPV = 0: acceptable

NPV > 0: acceptable because its return is greater than the required rate of return

10.2.3 Internal Rate of Return Method

• The internal rate of return is the rate of return promised

by an investment project over its useful life.

• It is computed by finding the discount rate that will cause the net present value of a project to be zero.

10.2.3 Internal Rate of Return Method

When using the internal rate of return, the cost of capital acts as a hurdle rate that a

project must clear for acceptance

10.2.4 The Simple Rate of Return

The simple rate of return is the rate of the annual

incremental net operating income generated by a project is divided by the initial investment in the project

SRR = Annual Incremental net operating income

Initial Investment