capital budget & cash budget

7/23/2019 Capital Budget & Cash Budget

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Payback Period =

Initial Investment

Cash Inflow per Period

Payback Period = A +

B

C

In the above formula,

Decision ule

!"amples

Example 1: Even Cash Flows

#olution

Example 2: Uneven Cash Flows

#olution

(cash flows in millions)

$ear Cash %low

& '(&

) )&

* )

hen cash inflows are uneven, weneed to calculate the cumulativenet cash flow for each period andthen use the followin- formula forpayback period.

A is the last period with ane-ative cumulative cash flow/

cumulative cash flow at theend of the period A/

C is the total cash flow durin-the period after A

Both of the above situations areapplied in the followin- e"amples0

Accept the pro1ect only if itspayback period is 2!## than thetar-et payback period0

Company C is plannin- toundertake a pro1ect re3uirin- initialinvestment of 4)&( million0 5hepro1ect is e"pected to -enerate4*( million per year for 6 years0

Calculate the payback period of thepro1ect0

Payback Period = InitialInvestment 7 Annual Cash %low =4)&(8 7 4*(8 = 90* years

Company C is plannin- toundertake another pro1ectre3uirin- initial investment of 4(&million and is e"pected to -enerate4)& million in $ear ), 4) million in$ear *, 4): million in year , 4);million in $ear 9 and 4** million in$ear (0 Calculate the paybackvalue of the pro1ect0



):

9 );

( **

Payback Period

= + <'4))8 7 4);8>

= + <4))8 7 4);8>

? + &0(@? 0(@ years

Disadvanta-esAdvantages of payback periodare.

)0 Payback period is very simpleto calculate0inherent in a pro1ect0 #ince cashflows that occur later in apro1ects life are consideredmore uncertain, payback periodprovides an indication of howcertain the pro1ect cash inflows

are00 %or companies facin- li3uidity

problems, it provides a -oodrankin- of pro1ects that wouldreturn money early0Disadvantages of payback period

are.)0 Payback period does not takeinto account the time value ofmoney which is a seriousdrawback since it can lead to

wron- decisions0 A variation ofpayback method that attemptsto remove this drawback iscalleddiscounted paybackperiod method0

*0 It does not take into account,

the cash flows that occur afterthe payback period0



Cumulative

Cash %low

'(&

'9&

'*6



'))

@

&



#olution

P %actors.

$ear ) = ) 7 <) + )@>) ? &0@96(

$ear * = ) 7 <) + )@>* ? &06)@*

Example 2: Uneven Cash Inflows: An initial investment of 4@,*&thousand on plant and machinery is e"pected to -enerate cash inflows of4,9)) thousand, 49,&6& thousand, 4(,@*9 thousand and 4*,&:(

thousand at the end of first, second, third and fourth year respectively0 Atthe end of the fourth year, the machinery will be sold for 4;&& thousand0Calculate the net present value of the investment if the discount rate is)@0 ound your answer to nearest thousand dollars0



$ear = ) 7 <) + )@> ? &0:&@:

$ear 9 = ) 7 <) + )@>9 ? &0()(@

5he rest of the calculation is summariEed below.

$earFet Cash Inflow

#alva-e alue

5otal Cash Inflow

G Present alue %actor

Present alue of Cash %lows

5otal P of Cash Inflows

H Initial Investment

Fet Present alue

#tren-ths and eaknesses of FP

#tren-ths



Fet present value accounts for time value of money which makes it asounder approach than other investment appraisal techni3ues which donot discount future cash flows such payback period and accountin- rate ofreturn0



eaknesses

Fet present value is even better than some other discounted cash flowstechni3ues such as I0 In situations where I and FP -ive conflictin-decisions, FP decision should be preferred0

FP is after all an estimation0 It is sensitive to chan-es in estimates for

future cash flows, salva-e value and the cost of capital0



!"ample

#olution

Assume that r is )&0

FP at )& discount rate = 4)@,6*

#ince FP is -reater than Eero we have to increase discount rate, thus

FP at ) discount rate = 49,(*)

FP at )9 discount rate = 4*&9

FP at )( discount rate = <4,;6(>

Fet present value does not take into account the siEe of the pro1ect0 %ore"ample, say Pro1ect A re3uires initial investment of 49 million to -enerateFP of 4) million while a competin- Pro1ect B re3uires 4* millioninvestment to -enerate an FP of 4&0@ million0 If we base our decision onFP alone, we will prefer Pro1ect A because it has hi-her FP, but Pro1ectB has -enerated more shareholders wealth per dollar of initial investment

<4&0@ millionJ4* million vs 4) millionJ49 million>0

%ind the I of an investment havin- initial cash outflow of 4*),&&&0 5hecash inflows durin- the first, second, third and fourth years are e"pectedto be 4:(,*&&, 4;:,&&&, 46,)&& and 4((,9&& respectively0

But it is still -reater than Eero we have to further increase the discount

rate, thus



#ince FP is fairly close to Eero at )9 value of r, therefore

I ? )9



) * 4,9)) 49,&6& 4(,@*9

4,9)) 49,&6& 4(,@*9

&0@96( &06)@* &0:&@:

4*,@;&0:@ 4*,;*0&) 4,(990:6

4)&,@@@

H @,*&

4*,(:@ thousand



94*,&:(

;&&

4*,;:(

&0()(@

4),(*;0)



rofitability Inde"

Present alue of %uture Cash %lows

Initial Investment e3uired

Fet Present alue

itial Investment e3uir

!"planation.

Decision ule

=

= ) +

Profitability inde" is actually amodification of the net presentvalue method0 hile presentvalue is an absolute measure<i0e0 it -ives as the total dollarfi-ure for a pro1ect>, the

profibality inde" is a relative

measure <i0e0 it -ives as thefi-ure as a ratio>0



!"ample

Accept a pro1ect if theprofitability inde" is -reaterthan ), stay indifferent if theprofitability inde" is Eero anddont accept a pro1ect if the

profitability inde" is below )0

Profitability inde" is sometimescalled benefit'cost ratio too andis useful in capital rationin-since it helps in rankin-

pro1ects based on their perdollar return0



#olution

Company C is undertakin- apro1ect at a cost of 4(& millionwhich is e"pected to -eneratefuture net cash flows with a

present value of 4:( million0Calculate the profitability inde"0

Profitability Inde" = P of

%uture Fet Cash %lows J Initial

Investment e3uired

Profitability Inde" = 4:(8 J

4(&8 = )0

Fet Present alue = P of Fet%uture Cash %lows H InitialInvestment 3uired

Fet Present alue = 4:(8'4(&8 = 4)(80



5he information about FP andinitial investment can be usedto calculate profitability inde"as follows.

Profitability Inde" = ) + <FetPresent alue J InitialInvestment e3uired>

Profitability Inde" = ) + 4)(8J4(&8 = )0



d



Item Jan Feb March

15,000 -13,500 20,000

Cash Sales 20,000 25,000 30,000

45,000 55,000 70,000

Here is an example ofa cash budget for asmall business:

SMALL BUSINESSASH BU!"E#

$or the three monthsending March %&'

())x

Beginning cashbalance

Expected CashReceipts:

Collection oacco!nts"ecei#able



$the" inco%e 0 0 5,000

&0,000 '',500 125,000

50,000 11,000 5,000

(a)"oll 10,400 10,400 10,400

2,000 2,000 2,000

*d#e"tising 10,000 0 0

Selling expense ',000 &,000 ',000

4,500 4,500 4,500

10,000 10,000 10,000

$the" pa)%ents '00 '00 '00

+3,500 4',500 3&,500

otal cashcollected

Expected cashpa)%ents:

Ra %ate"ials .o"in#ento")/

$the" di"ectexpenses

*d%inist"ati#eexpense

(lant ande!ip%entexpendit!"es

otal cashexpenses



-13,500 20,000 &',500Cash s!"pl!s .o"decit/

capital budget & cash budget

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