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
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):
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
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Cumulative
Cash %low
'(&
'9&
'*6
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'))
@
&
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#olution
P %actors.
$ear ) = ) 7 <) + )@>) ? &0@96(
$ear * = ) 7 <) + )@>* ? &06)@*
Example 2: Uneven Cash Inflows: An initial investment of 4@,*&thousand on plant and machinery is e"pected to -enerate cash inflows of4,9)) thousand, 49,&6& thousand, 4(,@*9 thousand and 4*,&:(
thousand at the end of first, second, third and fourth year respectively0 Atthe end of the fourth year, the machinery will be sold for 4;&& thousand0Calculate the net present value of the investment if the discount rate is)@0 ound your answer to nearest thousand dollars0
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$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
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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
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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
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!"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
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#ince FP is fairly close to Eero at )9 value of r, therefore
I ? )9
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) * 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
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94*,&:(
;&&
4*,;:(
&0()(@
4),(*;0)
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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
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!"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
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#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
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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
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d
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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#
$or the three monthsending March %&'
())x
Beginning cashbalance
Expected CashReceipts:
Collection oacco!nts"ecei#able
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$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
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-13,500 20,000 &',500Cash s!"pl!s .o"decit/