capital budgeting topic on management accounting

2. CAPITAL BUDGETING
 the process of planning expenditures on assets whose cash flows ar
e expected to extend beyond one year.
IMPORTANCE OF CAPITAL BUDGETING
 An erroneous forecast of asset requirements can have serious cons
equences.
 If the firm invest too much, it will incur unnecessarily high depreciat
ion and other expenses.
 if it does not invest enough, two problems may arise.
– its equipment and computer software may not be sufficiently modern to e
nable it to produce competitively.
– If it has inadequate capacity, it may lose market share to rival firms, and re
gaining lost customers requires heavy selling expenses, price reductions, o
r product improvements, all of which are costly.

3. Project Classifications
1. Replacement: maintenance of business
 one category consists of expenditures to replace worn-out or da
maged equipment used in the production of profitable products.
2. Replacement: cost reduction
 includes expenditures to replace serviceable but obsolete equip
ment.
3. Expansion of existing products or markets
 expenditures to increase output of existing products, or to expan
d retail outlets or distribution facilities in markets now being serv
ed, are included here.

4. 4. Expansion into new products or markets
 these are investments to produce a new product or to expand int
o a geographic area not currently being served.
5. Safety and / or environmental projects
 expenditures necessary to comply with government orders, labor
agreements, or insurance policy terms fall into this category
6. Others. This catch-all includes office buildings, parking lots, execut
ive aircrafts, and so on.

5. Example of Methods in Evaluating
Capital Investments
PAYBACK PERIOD
 The length of time required for an investment’s net revenues to cover i
ts cost.
 Defined as the expected number of years required to recover the origi
nal investment, was the first formal method used to evaluate capital b
udgeting projects.
When Periodic Cash Flow is Uniform, Pay Back P
eriod is computed as follows:
Pay Back Period = Net Investments
Annual Cash Returns

6. When the periodic cash flow are not uniform, pay back
period is computed by cumulating the estimated annua
l cash inflows and determining the point in time at whic
h they equal the investment outlay.
Decision Rule:
The Project is desirable when the Pay Back Period is sho
rter than the maximum acceptable pay back period set
by management.
– If PB Period is shorter than the Maximum allowed Period : Accept
– If PB Period is longer than the Maximum allowed Period : reject

7. Illustrative Problem
Determination of payback period: Assume the following cash flows fro two al
ternative investment proposals:
A B .
Net investment in Equipment P150,000 P300,000
Annual Cash Returns:
Yrs 1 to 3 75,000 75,000
Yrs 4 to 5 100,000
Salvage Value of Equipment 15,000 15,000
Economic Life 3 years 5 years
Required: Determine the payback period of the two proposals

8. SOLUTION:
Proposal A:
Payback Period = Net Investment
Annual Cash Returns
= P150,000
P75,000
= 2 years

9. Proposal B:
Payback Period = 3 years (P300,000 - P225,000) X 1year)
P100,000
= 3.75 years
Computations: Annual Cash Returns for 3 years (75,000 X 3) = P225,000
: Cash Return on the 4th year = P100,000

10. Net Cash Flows For Project S & L
Expected After Tax
Net Cash Flows, CFt_
Year (t) Projects S Project L
04 (P 1,000) (P 1,000)
1 500 100
2 400 300
3 300 400
4 100 600
0 1 2 3 4
Project S: _________________________________
-1,000 500 400 300 100
0 1 2 3 4
Project L: _________________________________
-1,000 100 300 400 600
04

11. • Payback Period for Projects S & L
•
• Project S: _________________________________
• Net cash flow -1,000 500 400 300 100
• Cumulative NCF -1,000 - 500 -100 200 300
•
0 1 2 3 4
• Project L: _________________________________
• Net cash flow -1,000 100 300 400 600
• Cumulative NCF -1,000 -900 -600 -200 400

12. • If the P300 of inflows come in evenly during Year 3, then the exact paybac
k period can be found as follows:
•
• Uncovered cost at start of year
• Payback = Year before full recovery + cash flow during year
•
• = 2 + P 100 = 2.33 years
• P 300
• Applying the same procedure to Project L, we find PaybackL =3.33 years. T
he shorter the payback period, the better. Therefore, if the firm required a
payback of three years or less, Project S would be accepted but Project L w
ould be rejected. If the projects were mutually exclusive, S would be ranke
d over L because S has the shorter payback. For example the installation of
a conveyor –belt system in a warehouse and the purchase of a fleet of fork
lifts for the same warehouse would be mutually exclusive projects-accepti
ng one implies rejection of the other.

13. Other Methods
1. Accounting Rate of Return
2. Net Present Value
3. Discounted Rate of Return/Internal Rate of R
eturn

15. Working Capital
 The firm’s total investment in current assets or assets that it e
xpects to be converted into cash within a year or less.
Net Working Capital
 The difference between the firm’s current assets and its curre
nt liabilities.
 Frequently when the term working capital is used, it is actuall
y intended to mean net working capital.

16. Disadvantages of Current Liabilities: The Risk
 The use of current liabilities, or short-term debt, as opp
osed to long-term debt subjects the firm to a greater ris
k of illiquidity for two reasons:
a) short-term debt, due to its very nature, must be repaid or rol
led over more often, and so it increases the possibility that th
e firm’s financial condition might deteriorate to a point wher
e the needed funds might not be available.
b) short-term debt is the uncertainty of interest costs from year t
o year.

17. FINANCING WORKING CAPITAL WITH CURRENT LIABILITIES
Advantages of Current Liabilities: The Return
 Current liabilities offer the firm a more flexible source of financing than do lon
g-term liabilities or equity.
 They can be used to match the timing of a firm’s needs for short-term financin
g.
 The use of long-term debt in this situation involves borrowing for the entire ye
ar rather than for the period when the funds are needed, which increases the
amount of interest the firm must pay.
 This brings us to the second advantage generally associated with the use of sh
ort-term financing: interest cost.
 In general, interest rates on short-term debt are lower than on long-term debt
for a given borrower.

18. Hedging Principle
 The hedging principle can now be stated very succin
ctly : Asset needs of the firm not financed by spontan
eous sources should be financed in accordance with t
his rule: Permanent asset investments are financed w
ith permanent sources, and temporary investments a
re financed with temporary sources.

19. Cash Conversion Cycle
Minimizing working capital is accomplished by
speeding up the collection of cash from sales, i
ncreasing inventory turns, and slowing down t
he disbursement of cash.
Measuring Working Capital Efficiency
The cash conversion cycle, or CCC, is simply th
e sum of days of sales outstanding and days of
sales in inventory less days of payables outsta
nding.

21. Motives for Holding Cash (John Maynard Keynes)
1.the transactions motive
2. the precautionary motive, and
3. the speculative motive

22. 1. Transactions motive
 Balances held for transactions purposes allow the fi
rm to meet cash needs that arise in the ordinary co
urse of doing business.
 The relative amount of cash needed to satisfy
transactions requirements
2. Precautionary motive
 Precautionary balances are a buffer stock of liquid a
ssets.
 This motive for holding cash related to the mainten
ance of balances to be used to satisfy possible, but
as yet indefinite, needs.

23. 3. Speculative motive
Cash is held for speculative purposes in order t
o take advantage of potential profit-making sit
uations

24. CASH MANAGEMENT OBJECTIVES AND DECISIO
NS
The Risk –Return Trade- Off
A company –wide cash-management program
must be concerned with minimizing the firm’s
risk of insolvency.
• Insolvency- situation in which the firm is unab
le to pay its bills on time.

25. COLLECTION AND DISBURSEMENT PROCEDURES
 the efficiency of the firm’s cash-management program can be
enhanced by knowledge and use of various procedures aime
d at
(1) accelerating cash receipts and
(2) improving the methods to disburse cash.
 We will see that greater opportunity for corporate profit impr
ovement lies with the cash receipts side of the funds flow pro
cess, although it would be unwise to ignore opportunities for f
avorably affecting cash- disbursement practices.
Float - the length of time from when a check is written until the
actual recipient can draw upon or use the “good funds”.

26. Managing the Cash Inflow
Mail float
 is caused by the time lapse from the moment a customer mails a remittance ch
eck until the firm begins to process it.
Processing float
 is caused by the time required for the firm to process the customer’s remittan
ce checks before they can be deposited in the bank.
Transit float
 is caused by the time necessary for a deposited check from a customer to clea
r through the commercial banking system and become usable funds to the com
pany.
 Credit is deferred for a maximum of two business days checks that are cleared
through the Federal Reserve System.
Disbursing float
 derives from the fact that the customer’s funds are available in the company’s
bank account until the company’s payment check has cleared through the bank
ing system.

27. Managing the Cash Outflow
 Significant techniques and systems for improving the firm’s management of c
ash disbursements include
(1) zero balance accounts,
(2) payable –through drafts, and
(3) remote disbursing.
 The first two offer markedly better control over company-wide payments, an
d as a secondary benefit they may increase disbursement float. The last tech
nique, remote disbursing, aims solely to increase disbursement float.
Zero Balance Accounts
 A cash-management tool that permits centralized control over cash outflows
but also maintains divisional disbursing authority.

28. Payable – Through Drafts
 Are legal instruments that have the physical appearance of ordinar
y checks but are not drawn on a bank.
 Instead, payable -through drafts are drawn on, and payment is auth
orized by, the issuing firm against its demand deposit account.
 To provide for effective control over field payments.
Electronic Funds Transfer
 Today the extensive use of electronic communication equipment is
serving to reduce float.
 The heart of EFT is the elimination of the check as a method of tran
sferring funds.

30. Accounts Receivable Management
 All firms by their very nature are involved in selling either goods or s
ervices.
 Although some of these sales will be for cash, a large portion will in
volve credit.
 Whenever a sales is made on credit, it increases the firm’s accounts
receivable.
 The importance of how a firm manages its accounts receivable dep
ends on the degree to which the firm sells on credit.
Terms of Sale- Decision Variable
 Identify the possible discount for early payment, the discount perio
d, and the total credit period.

31. Type of Customer – Decision Variable
 Determine the type of customer who is to qualify for trade credit.
 Several costs always are associated with extending credit to less creditwor
thy customers(high-risk firms or individuals).
 First, as the probability of default increases, it becomes more important to
identify which of the possible new customers would be a poor risk.
 When more time is spent investigating the less creditworthy customer, the
costs of credit investigation increase.
Collection Efforts- Decision Variable
 The key to maintaining control over the collection of accounts receivable is
the fact that the probability of default increases with the age of the accou
nt.
 Thus, control of accounts receivable focuses on the control and eliminatio
n of past-due receivables. One common way of evaluating the current situ
ation is ratio analysis.

32. Inventory Management
 The control of the assets used in the production process or produced to be sol
d in the normal course of the firm’s operations.
Raw Materials Inventory
 This includes the basic materials purchased from other firms to be used in the
firm’s production operations.
Work- In-Process Inventory
 Partially finished goods requiring additional work before they become finished
goods.
Finished-Goods Inventory
 Goods on which the production has been completed but that are not yet sold.

33. Inventory- Management Techniques
 essential to the goal of shareholder wealth maximization. To contr
ol the investment in inventory, management must solve two probl
ems:
1. Order Quantity Problem
 Determining the optimal order size for an inventory item given its
usage, carrying costs, and ordering costs.
2. Order point problem
 Determining how low inventory should be depleted before it is re
ordered.

34. Two factors go into the determination of the appr
opriate order points:
1. The procurement or delivery –time stock
 the inventory needed between the order date
and the receipt of the inventory ordered.
2. The safety stock desired

35. Just-In-Time Inventory Control
 Keeping inventory to a minimum and relying on supplie
rs to furnish parts “just in time”.
Single-sourcing
 Using a single supplier as a source for a particular part
or material.