Definition:

What is advantage of accrual method of statement of cash flow:

Allows matching of revenues and expenses in period which they
occur to appropriately measure profits.
What is Financial ratios:
Used to weigh and evaluate operating performance of firm. Measured in
relation to other values. Compares performance record against similar
firms in industry.
What is Ratio analysis:
Ratio analysis provides a basis for evaluating the performance of the firm
and facilitates comparison with other firms, using data from sources such
as Bloomberg, Standard & Poor’s, Value Line Investment Survey, etc.
What is Horizontal analysis:
Horizontal analysis will by calculation with the help of present
amount minus base business the divide to Bare year.
What is leverage;
Use of special force or effects to produce more than normal results from a
given course of action.
What is Leverage in a Business:
The use of fixed charge obligations with the intent of magnifying the
potential return to the firm.
What is Operating Leverage;
The extent to which fixed assets and associated fixed costs are utilized in
the business.
What is Break-even analysis:
A numerical and graphical technique used to determine at what point the
firm will break even.
What is More Conservative Approach:
A firm not willing to accept the additional risk of a higher degree of
operating leverage will only commit to a lower level of fixed costs, and
thus will operate further away from the break-even point.

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What is the Risk Factor:
The risk factor in using financial leverage depends on the firm’s
operations relative to its break-even point and its operating leverage.

What is Cash Break-Even Analysis:

Deducting noncash fixed expenses such as depreciation in the break-even
analysis enables one to determine the break-even point on a cash basis.
Degree of Operating Leverage :
A reflection of the extent fixed assets and fixed costs are utilized in the
business firm. The employment of operating leverage causes operating
profit to be more sensitive to changes in sales.

What is Limitations of Analysis:

The normal assumption in doing break-even analysis is that a linear
function exists for revenues and costs as volume changes.
What is Financial Leverage:
A measure of the amount of debt used in the capital structure of the firm.
What is Impact on Earnings:
Two firms may have the same operating income but greatly different net
incomes due to the magnification effect of financial leverage.
Degree of Financial Leverage:

DFL is the ratio of the percentage change in earnings per share in

response to a percentage change in EBIT.

Limitations to Use of Financial Leverage:

As the firm becomes more highly leveraged and

creditors take on more risk, they will demand higher
interest rates that countermand the benefits of
financial leverage.

Degree of Combined Leverage :

The degree of combined leverage (DCL) is a measure of the

effect on net income as a result of a change in sales. The
DCL is computed similarly to DOL or DFL.

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Controlling Assets—Matching Sales and Production:

When a firm produces more than it sells, inventory rises. When sales rise
faster than production, inventory declines and receivables rise.

Patterns of Financing:
Flexible based on management’s willingness to accept risk.

The Financing Decision:

The term structure of interest rates indicates the relative costs of short- and
long-term financing and is important to the financing decision.

Decision Process:

A-The composition of a firm’s financing of working capital is made within

the risk-return framework.

B-Short-term financing is generally less costly but more risky than long-
term financing. During tight money periods, short-term financing may be
unavailable or very expensive.

C-By applying the probabilities of the occurrence of various economic

conditions, an expected value of alternative financing strategies may be
computed and used as a decision basis.

Toward an Optimum Policy:

An aggressive firm will borrow short term and maintain relatively low
levels of liquidity. Panel 1 in Table 6-11 represents the aggressive firm.

Time Value of Money:

Time value of money used to determine whether future benefits
sufficiently large to justify current outlays.

Future Value—Single Amount:

Measuring value of amount allowed to grow at given interest rate over

period of time.

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Present Value—Single Amount:

A sum payable in the future is worth less today than the stated amount

The formula for the present value is derived from the original formula for
future value.
Future value of an annuity:
Calculated by compounding each individual payment into the
future and then adding up all of these payments.
Capital Budgeting Decision:
Capital budgeting decision involves planning expenditures for project
with minimum period of year or longer and capital expenditure decision
requires. Extensive planning, product design completion, patents
acquired, and capital markets tapped for needed funds Decisions affected
by uncertainties involved. Annual costs and inflows, product life, interest
rates, economic conditions, and technological changes.
Administrative Considerations:
A good capital budgeting program requires steps to be taken in the
decision-making process. Search for and discovery of investment
opportunities.
Accounting Flows versus Cash Flows:
In capital budgeting decisions, emphasis is on cash flows rather than
earnings Depreciation (noncash expenditure) is added back to profit to
determine cash flow generated.
Payback Method:
1. The payback period is the length of time necessary for the sum of the
expected annual cash inflows to equal the cash investment.
Net Present Value (NPV):
1. In this method, the cash inflows are discounted at the firm’s cost of
capital or some variation of that measure.
Internal Rate of Return (IRR):
1. The IRR method requires calculation of the rate that equates the cash
investment with the cash inflows.

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Capital budgeting describes the long-term planning for making and
financing major long-term projects.
1. Identify potential investments
2. Choose an investment.
3. Follow-up or “post audit.”
4.

Discounted-Cash-Flow Models (DCF):

These models focus on a project’s cash in flows and outflows while
taking into account the time value of money. DCF models compare the
value of today’s cash outflows with the value of the future cash inflows.

Net Present Value Model:

The net-present-value (NPV) method computes the present value
of all expected future cash flows using a minimum desired rate of
return.

Applying the NPV Method:

1. Identify the amount and timing of relevant expected cash inflows
and outflows.
2. Find the present value of each expected cash inflow or outflow.
3. Sum the individual present values.

Decision Rules:
1. Managers determine the sum of the present values of all expected
cash flows from the project.
2. If the sum of the present values is positive, the project is desirable.
3. If the sum of the present values is negative, the project is
unattractive.

Internal Rate of Return Model:

The IRR determines the interest rate at which the NPV equals zero.
Payback period Models: (Analyzing Long-Range Decisions)
Payback time, or payback period, is the time it will take to recoup, in the
form of cash inflows from operations, the initial dollars invested in a
project.

Accounting Rate-of-Return Model:

The accounting rate-of-return (ARR) model expresses a project’s return
as the increase in expected average annual operating income divided by
the required initial investment.

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Sensitivity Analysis:
Sensitivity analysis shows the financial consequences that would occur if
actual cash inflows and outflows differ from those expected.

Capital Budgeting and Inflation:

It is the decline in general purchasing power of the monetary unit.

Watch for Consistency:

Consistency can be achieved by including an element for inflation in both
the minimum desired rate of return and in the cash-flow predictions.

Capital Budgeting Decisions

Course Material – Problems and Solutions

Problem 1:
The company will invest $100,000 in a project and average annual
income $50,000. The investment will provide the following inflows:

Year Cash inflow

1 $ 50,000
2 40,000
3 60,000
4 50,000
5 50,000
Total $250,000

Calculate:
1. Net present value at 15% discount factor.
2. Payback period
3. Accounting rate of return.

Note: 15% discount factor (Table A– 3):

Year 15% discount factor

1 0.8696
2 0.7561
3 0.6575
4 0.5718
5 0.4972

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Solution:

1. Calculations of Net present value at 15% discount factor.

Year Cash inflow PV of 15% Discount PV of Cash inflow

Factor
1 $50,000 0.8696 $43,480
2 40,000 0.7561 30,244
3 60,000 0.6575 39,450
4 50,000 0.5718 28,590
5 50,000 0.4972 24,860
Total: $250,000 Total PV of Cash inflow $166,624
Deduct: Initial Investment 100,000
Net Present Value $ 66,624

Capital Budgeting Decision: The calculated value of net present

value is
positive hence the company will invest the money in the project.

2. Calculation of Payback period:

Initial investment $100,000

Cash Cumulative cash
Year
inflow inflow
1 $ 50,000 $50,000
2 40,000 90,000
3 60,000 150,000
4 50,000 200,000
5 50,000 250,000
Total $250,000
Calculations:
Initial investment $100,000
nd
2 year cumulative cash inflow - 90,000
Balance to be receivable $10,000

But 3rd year the company is receiving $60,000

Therefore the payback period is as follows:

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2 years + $10,000 = 0.166 year
$60,000
The Payback period is 2 year + 0.166 = 2.166 years or 26 months

Working note:
2 years x 12 months = 24 months
0.166 year x 12 months =+1. 992 months
Total Months: 25.992 months or 26 months

3. Calculation of Accounting rate of return:

ARR = Average Annual Cash Saving

Initial Investment
= $ 50,000
100,000 = 0.50 or 50%

Capital Budgeting Decisions - Problem and Solution

Discounted Cash Flow Models Problems

Problem: The Muscat Company considering the purchase a machine for

$28,000. It is expected to have a useful life of seven years. The plant
manager estimates the following savings in cash operating costs:
Year Amount
1 $10,000
2 8,000
3 6,000
4 5,000
5 4,000
6 3,000
7 3,000
Total: $39,000
The Muscat Company uses a required rate of return of 16% (PV discount
factor) in its capital budgeting decisions. Calculate discounted cash flow
models:
1. Net present value
2. Payback period
3. Internal rate of return

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 4. Accounting rate of return.
Solution:
1. Calculation of Net Present Value:

Year Cash Savings 16% Discount factor PV of Cash Saving

1 $10,000 0.8621 $8,621
2 8,000 0.7432 5,946
3 6,000 0.6407 3,844
4 5,000 0.5523 2,762
5 4,000 0.4761 1,904
6 3,000 0.4104 1,231
7 3,000 0.3538 1,061
Total: $39,000 Total PV of Cash savings $25,369
Less: Initial Investment 28,000
NPV (-$2,631)

Capital Budgeting Decision: The calculated valued of NPV is negative;

The Muscat company will not purchase the machine.
2. Payback period: Initial Investment = $28,000
Year Cash Savings Cumulative Cash
Savings
1 $10,000 $10,000
2 8,000 18,000
3 6,000 24,000
4 5,000 29,000
5 4,000 33,000
6 3,000 36,000
7 3,000 39,000
Total: $39,000

The initial investment is $28,000.

3 year receiving $24,000
Balance need $4,000
But 4th year company receiving $5,000
Therefore the payback period is as follows:
Payback period = 3 years + $4,000 ÷ $5,000

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 = 3years + 0.8 years
Payback period is 3.8 years or 45.6months
Calculation of Months: 3 years x 12 months = 36 months
0.8 year x 12 = 9.6 months
45.6 months

3. Internal Rate of Return: ( NPV = $0) or Trial and Error Method.

Year Cash 10% PV of 12% PV of

Savings Discount Cash Discount Cash
factor Saving factor Saving
1 $10,000 0.909 $9,090 0.893 $8,930
2 8,000 0.826 6,608 0.797 6,373
3 6,000 0.751 4,506 0.712 4,272
4 5,000 0.683 3,415 0.636 3,180
5 4,000 0.621 2,484 0.567 2,268
6 3,000 0.564 1,692 0.507 1,521
7 3,000 0.513 1,539 0.452 1,356
Total: $39,000 Total PV of $29,334
Cash $27,903
savings - 28,000
Less: Initial 28,000
Investment $1,334 NPV =$0
(-97)
NPV

Interpolations:
IRR = Lower rate + NPV at Lower rate x ( Hr – Lr)
Sum of NPV for Lower rate and higher rate

IRR = 10% + $1,334 x ( 12% - 10 %)

$1,334 + $97

IRR = 10% + $1,334 x 2%

$1,431

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 IRR = 10% + 0.932 x 2 %

IRR = 10% + 0.0186 x100

IRR = 10% + 1.86% = 11.86%

Note: 1. Hr = Higher rate, Lr = Lower rate
2. Here forget ± of -$97
3. 100 = %

4. Accounting Rate of Return:

Accounting Rate of Return= Average Annual Income

Initial investment

$5,571 = 0.19896
$28,000

Accounting Rate of Return is 0.19896 or 19.89% or 20% nearly.

Average Annual Income = Total Cash inflow

No. of years

$39,000
7 years
= $5,571

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