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					The Budget Process
Learning Objectives

        •   Why Budget?
        •   Types of Budgets
        •   Budget Process
        •   Budget Preparation




                                 3
Why Budget?
      If you know where you are going,
      you’re more likely to get there….
 •   Plan
 •   Perform
 •   Evaluate
 •   Report



                                      4
Ch 6: Budgeting and Budgetary Control:

When the organization’s plan for the future is expressed in dollars it is called a budget.

A budget may be:
         part of the organizational planning process;
         a standard against which the organization is controlled;
         a target, at which the organization is aiming.

Budgets may be prepared:
         incrementally (previous year + % increase)
         “zero based” (a fundamental rethinking every year)
         based on previous year, but with challenges to the major assumptions
Exhibit 6.1: The Master Budget:


    Sales forecast/budget                                       changes in receivables


      changes in finished goods inventory


                                            changes in raw material inventory

  Production budget
                                        changes in payables

   Other expense budgets


      BUDGETED                           CASH                        CAPITAL
        INCOME                          BUDGET                       BUDGET
      STATEMENT




                                   BUDGETED BALANCE SHEET
Sales Forecasting:
The budget normally starts with a sales forecast because sales is usually the “limiting
factor”.

A sales forecast may be prepared by:
          professional forecasters (e.g. econometricians);
          sales/marketing staff;
          a committee of informed personnel.

Useful information in preparing a sales forecast includes:
          past data and trends;
          macro-economic factors;
          knowledge of customer preferences;
          knowledge of technological change;
          knowledge of competitors’ plans.
The Budgeting Planning Stage

       • Budgeting is a planning tool
       • A budget needs to tied to the
         organizations goals and objectives
       • A budget can be prepare for :
          – Long Term (5 years)
          – Short Term (1 year)




                                              8
         What are your goals?
• In a piece of paper write down a goal you
  would like to accomplished in the next one to
  four years?




                                                  9
  What is Involved in Preparing the
           Annual Budget
• What is involved?
   – Forecasting sales and profit targets by
     product and service
   – Define human resources needs
   – Plan for introduction of new products or
     services
   – Set time timetable

• Who is involved?
   – Executive Team
   – Department Managers
   – Other employees

                                                10
           The Master Budget
                           • The master budget
• The master budget is a     includes:
  set of budgets that         – Operating budgets
  consolidates an             – Budgeted balance sheet
  organization’s financial    – Cash Budget
  information into            – Capital Expenditure
                                Budget
  budgeted financial
  statements



                                                     11
        Manufacturing Budget
• Operations budget for a manufacturing
  organization include:
  – Sales
  – Production
  – Direct material purchase
  – Direct Labor
  – Manufacturing Overhead
  – Selling and Administrative Expenses


                                          12
Preparation of the Master Budget for a Manufacturing
                    Organization




                                                   13
       Team Work Exercise
• E5




                            14
     Sales Budget


Sales in units
x Selling price
Sales in dollars
                    Next Budgets—
                    Production



                                    15
                Team Work
• Prepare a Sales Budget using Exercise SE4




                                              16
          Production Budget

Sales in units
+ Desired Ending Finished Goods in units
Total Needs in units
-Beginning Finished Goods in units
Production in units          Next Budgets—
                             Material Purchases,
                             Direct Labor, and
                             Overhead!


                                                   17
           Production Budget
Prepare the following production budget for the quarter assuming the
    company maintains finished goods inventory equal to one half of the
    next month's sales. Budgeted sales for April are 7,000 units.




                                                January   February March
Desired sales in units                           5,000     4,000     6,000
Desired ending finished goods inventory          2,000
Desired total units                              7,000
Desired Beginning finished goods inventory       2,500
Production needs                                 4,500




                                                                      18
      Answer
         :
  Prepare the following production budget for the quarter assuming the
  company maintains finished goods inventory equal to one half of the next
  month's sales. Budgeted sales for April are 7,000 units.



                                                January   February March
Desired sales in units                           5,000     4,000     6,000
Desired ending finished goods inventory          2,000     3,000     3,500
Desired total units                              7,000     7,000     9,500
Desired Beginning finished goods inventory       2,500     2,000     3,000
Production needs                                 4,500     5,000     6,500




                                                                        19
     Team Work - More Practice
• Prepare a Production Budget. Exercise SE5.




                                               20
         Direct Material Budget
• Once you know the number of units needed in
  production you could calculate the Materials
  Cost.

• Units x Direct Materials cost
• The total $$ will be used in calculating the
  Cash Budget


                                                 21
Budget Preparation and Teamwork

Materials Budget E7, E8

Labor Budget     E10




                                  22
The Cost of Producing Earrings
Output   FC   VC    TC    MC     AFC   AVC     ATC
  3      50   38     88   —    16.67   12.66   29.33
  4      50   50    100   12   12.50   12.50   25.00
  9      50   100   150   —    5.56    11.11   16.67
 10      50   108   158   8    5.00    10.80   15.80
 16      50   150   200   —    3.13    9.38    12.50
 17      50   157   207   7    2.94    9.24    12.18
 22      50   200   250   —    2.27    9.09    11.36
 23      50   210   260   10   2.17    9.13    11.30
 27      50   255   305   —    1.85    9.44    11.30
 28      50   270   320   15   1.79    9.64    11.42
Chapter 3 – The Economics of Market Allocation




                                             24
            The Cash Budget
• The Cash Budget is a projection of the cash an
  organization will receive and the cash it will
  pay out.




                                               25
    Cash Budgets
Cash Receipts
-Cash Disbursements
Change in Cash
+Beginning Cash
+Borrowings
-Repayments________________
Desired Ending Cash Balance



                              26
Alberta Limited needs a cash budget for the month of November. The following
information is available:

The cash balance on November 1 is $6,000.
  Sales for October and November are $80,000 and $60,000 respectively. Cash
collections on sales are 30 percent in the month of sale, 65 percent in the
following month, and 5 percent uncollectible.
  General expenses are budgeted to be $25,000 for November (depreciation
represents $2,000 of this amount).
  Inventory purchases will total $30,000 in October and $40,000 in
November. Half of the inventory purchases are always paid for in the month of
purchase. The remainder are paid for in the following month.
  Office furniture costing $4,000 will be purchased for cash in November, and
sales commissions are budgeted at $12,000 for November.
  The company must maintain a minimum ending cash balance of $4,000 and
can borrow from the bank in multiples of $100. All loans are repaid after 60
days.

Prepare a cash budget in good form for Alberta Limited for November.

                                                                         27
  Solution
                                  Alberta Limited
                                     Cash Budget
                                      November
Cash receipts (30% of November Sales)              $18,000
                 (65% of October Sales)             52,000
Total Cash Receipts                                $70,000
Cash Payments:
General Expenses ($25,000 - $2000)                 23,000
Purchases (Oct $15,000 + Nov $20,000)               35,000
Office furniture                                              4,000
Sales Commissions                                   12,000
Total Cash Payments                                          $74,000
Change in Cash                                               $4,000)
Beginning Cash                                                6,000
Borrowing                                                      2,000
Repayments                                                       -
Ending Cash                                                  $4,000


                                                                       28
Cash Budgets and Teamwork

                   SE8
                   SE9




                         29
Homework
      P2 in its entirety
     Based on Chapter




                      30
Production Forecasting:
In a “just-in-time” environment production exactly equals sales.

Inventory of finished product allows sales and production are uncoupled, and may be
different amounts, enabling smoothing of cyclical demand (e.g Christmas cards).

         production
–        increase of inventory
+        decrease of inventory
=        sales


Labour forecasting:
This is generally a function of production plans and labour needs in non-production areas.
Cash Forecasting:
Cash forecasting is critical to organizational survival.

          Opening cash balance
+         Total cash received
=         Total cash available


          Total cash received:
                    Cash collections from sales
                    (Sales +/- changes in receivables)

                    + Other cash receipts:
                    (share issues, loans, sale of plant assets)
Cash payments:
        To suppliers for goods purchased
        (cost of goods sold +/- changes in inventory and accounts payable)

         To employees for labour costs

         To other expenses

         Interest & dividends

         Major plant asset purchases

Cash available – cash payments = closing cash balance
Ontario Brewery: Cash Budget: $’000
      Jan Feb Mar         Apr   May Jun  Jul Aug Sep Oct            Nov Dec Year
Sales 500 500 700         700   900 1000 1700 1700 1000 800         800 1700 12000
Collections from sales:
n-1 800 400 400           560   560   720   800   1360 1360 800 640       640 9040
n-2 180 180 90             90   126   126   162    180 306 306 180        144 2070
Other                                                                        nil
Total 980 580 490         650   686   846   962   1540 1666 1106 820      784 11110

Payments:
R.M. 500 500 500 500            500   500   500   500   500   500   500   500   6000
B&K 100 50         50   70       70    90   100   170   170   100    80    80   1130
D&M 100 100 140 140             180   200   340   340   200   160   160   340   2400
G&A 100 100 100 100             100   100   100   100   100   100   100   100   1200
New plant                             200                                        200
Interest & debt repayment                    10   10 10        10    10    10     60
Total 800 750 790 810           850   1090 1050 1120 980      870   850   1030 10990

Net 180     (170) (300) (160) (164) (244) (88) 420 686 236          (30) (246)   120
Start 200    380 210 (90) (250) (414) (658) (746) (326) 360         596 566      200
End 380      210 (90) (250) (414) (658) (746) (326) 360 596         566 320      320
Cash Budgeting:
The cash budget reveals that over the year the cash increases from $200,000 to $320,000.
However there is a cash crisis between May and August, with cash deficit rising to as much as
$746,000.

If you are unaware that there will be a cash crisis you will be totally unprepared to deal with
it.
If you are aware you can take steps to deal with it:

Possible solutions:
          Delay payment for the new plant until the fall;
          Sell short-term investments in the spring;
          Get a short-term bank loan from May to August.

Note this is a temporary problem, so it needs a temporary solution: raising a long-term loan
or issuing new shares would not be appropriate, as these are long-term solutions.
Budgetary Control:
The budget will be used to control operations.

Once the budget is “agreed” it represents a social contract between the parties:
•The budget is accepted by the operatives as being achievable;
•The budget is accepted by management as meeting their needs.

Comparison of budget with the actual results will reveal the extent to which it has, or has
not, been achieved.

Deviations from budget should be investigated:
•To reveal the responsibility area where the problem arose;
•To initiate any corrective action
Budget Preparation
              Budget Topics
•   Defining the budget
•   Getting started
•   Budget sections
•   guidelines




                   University of Houston-Clear Lake   38
     What is the Project Budget?
• Reflects costs of items and activities described
  in the project
• Defines the project narrative with costs
• Justifies the project narrative with costs
• Puts all costs in one place to facilitate review




                  University of Houston-Clear Lake   39
               Why is the Budget
                So Important?
• Generally reviewed before any other part of the
  proposal
• Summarizes the proposal
• Discloses the consistency of the proposal
• A quick way for reviewers to tell if guidelines have
  been followed
• Defines costs for each year of the project



                     University of Houston-Clear Lake    40
            Getting Started:
       Funds Available on Campus
• What do you already have on hand to support
  the project?
  – personnel
  – facilities space
  – supplies
  – equipment
  – travel funds
  – external support


                   University of Houston-Clear Lake   41
              Getting Started:
           External Funds Needed
•   Personnel
•   Space
•   Supplies
•   Equipment
                                              Hint --
•   Travel funds                              Look to the Project
                                              Narrative for project
•   Other                                     needs




                   University of Houston-Clear Lake                   42
              Getting Started
• Funds Needed - Funds Available = Budget
  Proposal

• Create a reasonable budget based on the
  funding you would need to complete the
  project if awarded by the sponsoring agency



                 University of Houston-Clear Lake   43
          Estimate Total Costs
• Give a “best estimate” of your needs
• The Grant Budget helps you determine what
  you want the sponsor to fund and what part
  of the project, if any, UHCL or other agencies
  need to fund
• A fine line between “asking for too much” and
  “asking for too little”


                  University of Houston-Clear Lake   44
            Budget Principles
• Think about the budget when searching for a
  sponsor
• Think about the budget early in the proposal
  development




                 University of Houston-Clear Lake   45
            Budget Principles
• Refer to budget lines frequently in the
  proposal, especially in:
  – Need Statement
  – Objectives
  – Management Plan (especially here)
  – Evaluation Plan
  – Dissemination Plan
  – Continuation Plan


                  University of Houston-Clear Lake   46
            Sections of the Budget
• Direct Costs
   – Personnel (Generally 70%-80% of total)
       • salaries
       • fringe benefits
   – Maintenance and Operation Costs
• Facilities and Administrative Costs (Indirect Costs)
• Total Costs
• Total Matching Costs
• Total Cash + Matching Costs = Total Project Costs


                         University of Houston-Clear Lake   47
               What are F & A
              (Indirect) Costs?
• General Costs that cannot be attributed to any one
  project -- for campus up-keep
• Are negotiated with the Federal Agency DHHS
• UHCL’s current rate:
   – 40% of Modified Total Direct Costs on campus
   – 17% of Modified Total Direct Costs off campus




                    University of Houston-Clear Lake   48
          Sponsor’s Maximum
             Award Limit
• When the sponsoring agency states it will
  award no more than $300,000, what does that
  mean?
  – $300,000 including F&A costs?
  – $300,000 plus F&A costs?
• Review guidelines for maximum award limit
  prior to completing the budget


                  University of Houston-Clear Lake   49
        What is Cost Sharing?
• “. . . that portion of the project or
  program cost not borne by the sponsor . .
  .”
                  OMB Circular A-110




                University of Houston-Clear Lake   50
     To Qualify as Cost Sharing,
     A Cost Must Be . . . (A-110)
• Verifiable from the recipient’s records
• Necessary and Reasonable for
  accomplishment of project objectives
• Allowable under OMB Circular A-21 (Section
  23)
• Un-recovered indirect costs may be included
  only with prior approval of sponsor (usually
  stated in guidelines)


                  University of Houston-Clear Lake   51
              What About A-21?
• A-21 does not mention cost sharing
   – may use same allowable items as funded by sponsor (e.g.,
     personnel, fringes, materials, travel, equipment, space,
     etc.)
• Same rules apply to verifying use of cash from the sponsor:
   – “separately budgeted and accounted for”
   – “internal application of institutional funds”
   – “consistent cost accounting standards are applied”




                       University of Houston-Clear Lake     52
         Reporting Cost Sharing
• A-21 Requirements: All costs must be classified
  consistently regardless of the funding source
• A-110 Requirements: Actual expenditures must be
  verifiable from the recipient’s records
• Sponsor Requirements: Commitments are a
  condition of the award and must be met




                   University of Houston-Clear Lake   53
             Most Common
         Cost Sharing Problems?
• Tendency to over commit
   – PIs generate many proposals, receive fewer awards
   – Offering cost sharing when not required
• Proposals which include no cost sharing
   – Does sponsor expect some institutional cost sharing
     from PI?
   – What do we accumulate and report; how do we
     capture project-related effort?



                     University of Houston-Clear Lake      54
       The Facts on Cost Sharing
• Look for sponsors that do not require cost sharing
  first
• FYI--Two kinds of cost sharing:
   – Cash
   – In-Kind (also know as “non-cash”)
• Use only if sponsor requires
• Meet the minimum required
• Think of in-kind sources first


                    University of Houston-Clear Lake   55
        UHCL Cost Sharing Sources
•   Departmental salaries and fringes
•   Dean or VP
•   Materials and supplies
•   Travel
•   Equipment
•   Internal Grants (during the same award period)
•   Other External Grants (not federally funded)



                      University of Houston-Clear Lake   56
     Sources of Cash Cost Sharing
• Your department--discuss with Department Chair
• Your Dean’s Office
• External partners
• Cannot use an existing external federal award to cash
  cost share in a new federal proposal
• Cannot use money from an award you anticipate
  receiving




                    University of Houston-Clear Lake   57
                  Recapping
                 Cost Sharing
• See Dept. Chair, Dean, and OSP early in proposal
  development if you need cost sharing
• Think of value of non-cash direct and indirect
  infrastructure (UHCL & partners) that can be applied
  first
• Then think of UHCL cash sources
• All sources used must be reasonable and certifiable
  for audit and sponsor



                    University of Houston-Clear Lake     58
               In-Kind (Non-Cash)
•          Cost Sharing Sources**
    Volunteers
      • calculate salaries and fringes
• Space
• Materials
• Travel
• Equipment
• Facilities
**(i.e, outside of UHS)


                           University of Houston-Clear Lake   59
            In-Kind Cost Sharing
• Certifiable non-cash costs not drawn from any
  UHCL account
• Examples:
  – facility space totally dedicated to the project
  – equipment depreciation for items over $500 totally
    dedicated to the project
  – volunteer salaries and fringes
• Add an itemized in-kind cost section
  immediately below the cash cost section

                      University of Houston-Clear Lake   60
            Calculating Salaries
• Determine personnel needed to accomplish project
  objectives and activities
• Obtain current salaries for all personnel from the
  school business coordinator
• Determine the amount of time each person will
  dedicate to the project
• Determine if there are cash or in-kind cost sharing
  requirements from the sponsor’s guidelines



                    University of Houston-Clear Lake    61
            Calculating Salaries
• Determine how much personnel time you want the
  sponsor to fund and how much you want to cost
  share
• Calculate salaries using % release time, or by number
  of estimated days on the project
• Tie the method to project objectives
• Don’t forget about in-kind volunteer help Calculate
  their salaries and put in the in-kind section of the
  project budget


                    University of Houston-Clear Lake   62
              Release Time
• The part of an employee’s contract dedicated
  to the project
• May be funded by
  – Sponsor
  – UHCL
  – Sponsor and UHCL




                 University of Houston-Clear Lake   63
             Calculating Salaries
• For multiple-year projects, figure a 3% Cost of Living
  Allowance increase for each consecutive year of the
  project. UHCL fiscal year is September 1 through
  August 31
   – Disclaimer: 3% increase for each year of grant
     budget is only an estimate
• This standard is university-approved for planning
  grant and contract budgets
• Sponsors award this amount


                     University of Houston-Clear Lake      64
                 Fringe Benefits
• Fringes include:
   – Retirement
   – FICA
   – Unemployment
   – Workers’ compensation
   – Disability
   – Life Insurance
   – Health Insurance
• The OSP can calculate current rates for UHCL employees



                       University of Houston-Clear Lake    65
          Fringe Benefits

• Fringe rates are based on actuals and
  change periodically
• Check with the Office of Sponsored
  Programs for current fringe benefit
  rates.


              University of Houston-Clear Lake   66
              Maintenance and
              Operations Costs
• Operating costs known as M & O are the second part
  of the budget
• Operating costs consist of the costs of the materials,
  travel, equipment, and other costs that enable
  accomplishment of objectives to solve the problem
• Operating costs need to be defined in the itemized
  budget and budget justification




                     University of Houston-Clear Lake   67
       The Proposal Signoff Sheet
•   Project Budget Summary
•   UHCL Cash Cost Sharing Commitments
•   Indicate In-Kind cost sharing
•   Supplemental Pay and/or Summer Pay




                  University of Houston-Clear Lake   68
         The Budget Narrative
• Is a narrative justification of your costs
• Follow the format of your budget
• Describe all costs in terms of UHCL and/or
  standards of the sponsor
• Must be familiar with sponsor’s guidelines
• This is where you “show your work”



                  University of Houston-Clear Lake   69
         Organizing the Proposal
•   Need Statement
•   Goals/Objectives
•   Project Plan
•   Management Plan & Key Personnel
•   Evaluation Plan
•   Dissemination Plan
•   Continuation Plan

                  University of Houston-Clear Lake   70
  Organizing the Proposal (cont.)
• Facilities and Equipment
• Budget and Budget Explanation
• and
  – Abstract
  – Table of Contents
  – Appendices




                   University of Houston-Clear Lake   71
 Review Guidelines for Submission
• The number of copies that should be
  submitted
• How the proposal should be submitted
     • Some proposals are submitted via U.S. mail
     • Some proposals require electronic submission
• When the proposal should be submitted
     • Target date vs. deadline
     • Postmark date
     • Receipt date



                      University of Houston-Clear Lake   72
      Pre-submission Check Off
• Proposal packet has been reviewed for:
  – Content
  – Grammar/Spelling
  – Page numbering/order
• Submit to OSP for review
• Executive Director for OSP approves proposal
• Proposal sent to Provost for signature


                 University of Houston-Clear Lake   73
    Proposal Process Completed
• Next Step?
• Breath a sigh of relief!




                    University of Houston-Clear Lake   74
Capital Budgeting
and Cost Analysis
    Learning Objective 1


Recognize the multiyear focus
    of capital budgeting.
Two Dimensions of Cost Analysis

                 1. A project dimension




          2. An accounting-period dimension



     The accounting system that corresponds to the
     project dimension is termed life-cycle costing.
        Two Dimensions of Cost Analysis

Project D

Project C

Project B

Project A

            2002   2003   2004   2005   2006
     Learning Objective 2


 Understand the six stages of
capital budgeting for a project.
Capital Budgeting

Capital budgeting is the making of long-run
  planning decisions for investments in
          projects and programs.



It is a decision-making and control tool that
 focuses primarily on projects or programs
           that span multiple years.
       Capital Budgeting

        Capital budgeting is a six-stage process:

1. Identification stage                    2. Search stage

            3. Information-acquisition stage

4. Selection stage                     5. Financing stage

          6. Implementation and control stage
Capital Budgeting Example

   One of the goals of Assisted Living is to improve
      the diagnostic capabilities of its facility.


   Management identifies a need to consider the
         purchase of new equipment.


     The search stage yields several alternative
       models, but management focuses on
              one particular machine.
Capital Budgeting Example

    The administration acquires information.

         Initial investment is $245,000.

    Investment in working capital is $5,000.

            Useful life is three years.

        Estimated residual value is zero.

         Net cash savings is $125,000,
      $130,000, and $110,000 over its life.
Capital Budgeting Example

    Working capital is expected to be recovered at
  the end of year 3 with an expected return of 10%.


     Operating cash flows are assumed to occur
               at the end of the year.


   In the selection stage, management must decide
        whether to purchase the new machine.
     Learning Objective 3

Use and evaluate the two main
  discounted cash-flow (DCF)
methods: the net present value
(NPV) method and the internal
 rate-of-return (IRR) method.
          Time Value of Money

Compound Growth,
                                                    Year 5: $1.338
 5 periods at 6%
                                           Year 4: $1.262

                                  Year 3: $1.91

                        Year 2: $1.124

              Year 1: $1.06

        Year 0: $1.00
Discounted Cash Flow


       There are two main DCF methods:




        Net present value (NPV) method




       Internal rate-of-return (IRR) method
Net Present Value Example



 Only projects with a zero or positive
  net present value are acceptable.


 What is the the net present value of
      the diagnostic machine?
       Net Present Value Example

                       Year in the Life of the Project



         0                    1                    2      3

$(250,000)        $125,000 $130,000 $115,000




    Net initial                             Annual cash
   investment                                 inflows
           Net Present Value Example

                                         Net Cash      NPV of Net
 Year        10% Col.       Inflows           Cash Inflows
     1                0.909         $125,000            $113,625
     2                0.826          130,000             107,380
     3                0.751          115,000              86,365
Total PV of net cash inflows                 $307,370
Net initial investment                                   250,000
Net present value of project                      $ 57,370
Net Present Value Example

   The company is considering another investment.

            Initial investment is $245,000.
       Investment in working capital is $5,000.
          Working capital will be recovered.
               Useful life is three years.
          Estimated residual value is $4,000.
         Net cash savings is $80,000 per year.
                Expected return is 10%.
        Net Present Value Example

                                Net Cash                NPV of Net
Years 10% Col. Inflows                  Cash Inflows
1-3        2.487          $80,000                 $198,960
  3        0.751            9,000                    6,759
Total PV of net cash inflows           $205,719
Net initial investment                             250,000
Net present value of project             ($ 44,281)
Internal Rate of Return


               Investment
    = Expected annual net cash inflow
           × PV annuity factor




               Investment
    ÷ Expected annual net cash inflow
           = PV annuity factor
Internal Rate of Return Example

             Initial investment is $303,280.
                  Useful life is five years.
           Net cash inflows is $80,000 per year.



             What is the IRR of this project?


      $303,280 ÷ $80,000 = 3.791 (PV annuity factor)

          10% (from the table, five-period line)
Comparison of NPV and IRR

   The NPV method has the advantage that the end
      result of the computations is expressed in
           dollars and not in a percentage.



          Individual projects can be added.


   It can be used in situations where the required
   rate of return varies over the life of the project.
Comparison of NPV and IRR

     The IRR of individual projects cannot be
       added or averaged to derive the IRR
          of a combination of projects.
Learning Objective 4


Use and evaluate the
 payback method.
 Payback Method

 Payback measures the time it will take to
recoup, in the form of expected future cash
  flows, the initial investment in a project.
Payback Method Example

  Assisted Living is considering buying Machine 1.

          Initial investment is $210,000.

             Useful life is eleven years.

         Estimated residual value is zero.

       Net cash inflows is $35,000 per year.
Payback Method Example

  How long would it take to recover the investment?

            $210,000 ÷ $35,000 = 6 years

           Six years is the payback period.
Payback Method Example

  Suppose that as an alternative to the $210,000
     piece of equipment, there is another one
   (Machine 2) that also costs $210,000 but will
   save $42,000 per year during its five-year life.




           What is the payback period?

           $210,000 ÷ $42,000 = 5 years

     Which piece of equipment is preferable?
Payback Method Example

  Assisted Living is considering buying Machine 3.

          Initial investment is $250,000.

             Useful life is eleven years.

      Cash savings are $160,000, $180,000,
            and $110,000 over its life.


           What is the payback period?
Payback Method Example

  Year 1 brings in $160,000.

              Recovery of the amount
             invested occurs in Year 2.
    Payback Method Example

                  Payback = 1 year

        $ 90,000 needed to complete recovery
+
÷         180,000 net cash inflow in Year 2

                  1 year + 0.5 year
=
          1.5 years or 1 year and 6 months
=
    Learning Objective 5


Use and evaluate the accrual
 accounting rate-of-return
      (AARR) method.
         Accrual Accounting
       Rate-of-Return Method

             The accrual accounting rate-of-return (AARR)
               method divides an accounting measure of
           income by an accounting measure of investment.




                    Increase in expected                        Initial
                       average annual                         required
AARR   =              operating income
                                                  ÷         investment
      Accrual Accounting
Rate-of-Return Method Example

           Initial investment is $303,280.

              Useful life is five years.

        Net cash inflows is $80,000 per year.

                     IRR is 10%.


       What is the average operating income?
      Accrual Accounting
Rate-of-Return Method Example
      Straight-line depreciation is $60,656 per year.

               Average operating income is
              $80,000 – $60,656 = $19,344.


                   What is the AARR?

                          AARR
            = ($80,000 – $60,656) ÷ $303,280
                     = .638, or 6.4%
    Learning Objective 6

Identify and reduce conflicts
  from using DCF for capital
   budgeting decisions and
    accrual accounting for
   performance evaluation.
               Performance Evaluation

                   A manager who uses DCF methods to make capital
                     budgeting decisions can face goal congruence
                             problems if AARR is used for
                               performance evaluation.




                      Suppose top management uses the AARR to
                      judge performance if the minimum desired
                                 rate of return is 10%.



A machine with an AARR of 6.4% will be rejected.
Performance Evaluation

    The conflict between using AARR and
   DCF methods to evaluate performance
   can be reduced by evaluating managers
        on a project-by-project basis.
   Learning Objective 7


    Identify relevant cash
  inflows and outflows for
capital budgeting decisions.
Relevant Cash Flows

Relevant cash flows are expected future cash
  flows that differ among the alternatives.
Relevant Cash Flows

    Net initial investment components

  – cash outflow to purchase investment

     – working-capital cash outflow

 – cash inflow from disposal of old asset
                  Relevant Cash Flow
                   Analysis Example
                   G. T. is considering replacing old equipment.

Old equipment:
Current book value                                    $50,000
Current disposal price                                $ 3,000
Terminal disposal price (5 years)                0
Annual depreciation                                   $10,000
Working capital                                           $ 5,000
Income tax rate                        40%
                     Relevant Cash Flow
                      Analysis Example

Current disposal price of old equipment      $ 3,000
Deduct current book value of old equipment    50,000
Loss on disposal of equipment                          $47,000



                             How much are the tax savings?

                               $47,000 × 0.40 = $18,800
  Relevant Cash Flow
   Analysis Example

           What is the after-tax cash flow from
           current disposal of old equipment?


        Current disposal price           $ 3,000
          Tax savings on loss           18,800
Total                                        $21,800
                    Relevant Cash Flow
                     Analysis Example

New equipment:
Current book value                         $225,000
Current disposal price is irrelevant
Terminal disposal price (5 years)      0
Annual depreciation                        $ 45,000
Working capital                                $ 15,000
                Relevant Cash Flow
                 Analysis Example

                       How much is the net investment
                          for the new equipment?


Current cost                                      $225,000
Add increase in working capital      10,000
Deduct after-tax cash flow from
 current disposal of old equipment   – 21,800
Net investment                                    $213,200
       Relevant Cash Flow
        Analysis Example

       Assume $90,000 pretax annual cash flow from
        operations (excluding depreciation effect).


        What is the after-tax flow from operations?

Cash flow from operations                          $90,000
Deduct income tax (40%)                             36,000
    Annual after-tax flow from operations      $54,000
                     Relevant Cash Flow
                      Analysis Example

                    What is the difference in depreciation deduction?

Annual depreciation
 of new equipment                                            $45,000
Deduct annual depreciation
 of old equipment                                             10,000
Difference                                                              $35,000
   Relevant Cash Flow
    Analysis Example

     What is the annual increase in income tax
            savings from depreciation?


   Increase in depreciation             $35,000
   Multiply by tax rate                     .40
Income tax cash savings
     from additional depreciation       $14,000
          Relevant Cash Flow
           Analysis Example

              What is the cash flow from operations,
                       net of income taxes?


        Annual after-tax flow from operations     $54,000
  Income tax cash savings from
  additional depreciation                                   14,000
Cash flow from operations,
  net of income taxes                                   $68,000
Relevant Cash Flow
 Analysis Example

    G. T. requires a 14% rate of return
            on its investments.


 What is the net present value of the new
 equipment incorporating income taxes?
                  Relevant Cash Flow
                   Analysis Example

                                    Net Cash      NPV of Net
Years 14% Col.               Inflows     Cash Inflows
1-5       3.433              $68,000                $233,444
  5       0.519               10,000                    5,190
Total PV of net cash inflows               $238,636
Investment                                                    213,200
Net present value of new equipment         $ 25,436
Postinvestment Audit

  A postinvestment audit compares the actual
  results for a project to the costs and benefits
 expected at the time the project was selected.



    It provides management with feedback
              about performance.
Strategic Considerations




        Capital investment decisions
         that are strategic in nature
       require managers to consider
        a broad range of factors that
        may be difficult to estimate.

				
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