BUS105 Study Guide

Unit 7: Budgets

7a. Apply the time value of money to capital budgeting decisions

  • How do companies make decisions regarding long term capital investments?
  • What does it mean that a dollar today is worth more than a dollar in the future?
  • For decision making purposes, why is it important that future cash flows be discounted back to their present values?

The process of analyzing and deciding which long-term investments a company should pursue is referred to as making capital budgeting decisions. These decisions will affect the cash flows of a company for many years in the future. Therefore, when capital budgeting decisions are made, care must be taken to ensure that the time value of money is taken into account. 

This idea of time value of money is that a dollar today has more value than a dollar in the future. This is because the sooner I have the dollar, I can invest it and earn a return on it. Thus, the future value of all future cash flows, both inflows and outflows need to be discounted to their present value in order to make informed decisions. 

Capital budgeting decisions are made using time value of money techniques both for whether or not to invest in a given project, as well as when there are multiple competing projects with limited funds available with which to invest, and a firm is trying to decide which project to invest in. 

Review Capital Budgeting and Decision Making.

7b. Evaluate investments using the net present value (NPV), internal rate of return (IRR), and the payback method

  • What methods do companies use in order to evaluate possible capital projects?
  • What is meant by the cost of capital utilized in determining the net present value?
  • What is the advantage of using the internal rate of return method over the net present value method?

There are numerous methods companies employ in capital budgeting decision-making. Two of the more popular ones, both of which use time value of money techniques, are the net present value (NPV) method and the internal rate of return (IRR) method.

In the net present value (NPV) method, all future cash flows are discounted back to today to determine the net present value of the investment. The interest rate used in these calculations is usually the firm's cost of capital. If the NPV for the prospective investment is greater than 0, the project is accepted. If it is less than 0, it is rejected.

In the internal rate of return (IRR) method, a rate of return that generates an NPV of zero is determined. This is known as the internal rate of return (IRR). The IRR represents the time-adjusted rate of return for this investment. The IRR is then compared to a company's required rate of return (also known as the hurdle rate). If the IRR is greater than or equal to the internal rate of return, the investment is accepted. Otherwise, it is rejected. 

A third method used is called the payback method. This method evaluates how long it will take to "pay back", or recover the initial investment. The payback period is the time, stated in years, that it will take to generate enough cash inflows from an investment to cover the cash outflows. Although easier to calculate, this method has significant disadvantages. It doesn't take the time value of money into account at all. It also ignores cash inflows that are to occur subsequent to the payback period.

Review Net Present Value, The Internal Rate of Return, and The Payback Method.

7c. Explain the effects of cash flows, qualitative factors, and ethical issues on long-term investment decisions

  • Why may making decisions based on cash flows possibly be not prudent when the accounting system uses accrual accounting?
  • What are some qualitative factors that may outweigh quantitative factors when making long-term investment decisions?
  • What is an example of an ethical issue that may arise when evaluating long-term investment opportunities?

The methods discussed to evaluate long-term investments focus on cash flows and the timing of cash flows. This differs from financial accounting where the timing of revenues and expenses are based on accrual accounting regardless of cash flows. When making a decision on long-term investments, care must be exercised in recognizing that the cash flows being calculated will likely not match up with the revenues and expenses appearing on a company's income statement. 

The methods discussed in long-term investment decision-making all involve the use of quantitative factors to make decisions. This is used because it allows managers to make informed decisions using data that is observable and measurable. However, there may be other, nonfinancial factors known as qualitative factors that need to be considered as well. For example, an NPV or IRR analysis may lead to the conclusion to not undertake an investment, but there may be some other strategic reason why the company may want to make the investment anyway. 

Finally, all investment decisions may include ethical issues. For example, managers who are evaluated based solely on short-term financial results may consider forgoing an investment opportunity that may have a positive return in the long term since right now it will hurt them. Care must be taken in order to encourage managers to make decisions based on the best interest of the company knowing that they will not be penalized for any side effect that may result because of it. 

Review Other Factors Affecting NPV and IRR Analysis.

7d. Demonstrate the effects of income taxes, working capital, and investment cash outflows on capital budgeting decisions

  • What are the effects that income taxes have on investment opportunities?
  • What is an example of an investment project that will entail multiple cash outflows by a company?
  • Why may cash sometimes be spent early on in an investment project but then returned to the company later in the project?
  • Why is depreciation expense referred to as the depreciation tax shield?

Most companies pay income taxes and must consider the impact on long-term investments that these taxes have on future cash flow. Revenue producing cash inflows and expenses producing cash outflows are adjusted by multiplying the cash flow by (1 – tax rate), such that: 

After-tax revenue cash inflow = Before-tax cash inflow × (1 − tax rate)

After-tax revenue cash outflow = Before-tax cash outflow × (1 − tax rate)

Investment and working capital cash flows are not adjusted because these cash flows do not affect taxable income. Depreciation expense is not itself a cash flow, but it does provide tax savings by lowering net income. The depreciation tax savings cash inflow is equal to depreciation expense × Tax rate. This is often referred to as the depreciation tax shield. 

Most investment proposals will include cash outflows at varying points throughout the life of the project. All of these future cash flows, both inflows and outflows, need to be included when evaluating investment proposals using NPV, IRR, or the payback period methods. Many investments will also include working capital cash flows required to fund items such as inventory and accounts receivable while the investment is being undertaken. Many times, working capital is included as a cash outflow at the beginning of the project, but later in the project will be a cash inflow when the cash is returned back to the company.

Review Additional Complexities of Estimating Cash Flows and The Effect of Income Taxes on Capital Budgeting Decisions.

7e. Explain the components of a master budget and the process for creating a master budget that includes multiple schedules

  • For performance evaluation purposes, why is it important that each division or department of a company have a budget related to their operations?
  • How is a master budget that includes multiple schedules constructed?
  • Why does the process of putting together a master budget begin with a sales budget?

For a manufacturing company, the master budget includes all the budget schedules for all parts of the organization. These can include the sales budget, production budget, direct materials budget, direct labor budget, as well as budgets for manufacturing overhead and selling and administrative expenses. The master budget will also include a budgeted income statement, a capital expenditures budget, a cash budget, and a budgeted balance sheet

The master budget begins with the sales budget as sales projections drive the other budgets. Once the sales budget is set, the production budget is prepared next because the budget preparers now know how much should be produced. This allows them to then create budgets for direct materials and direct labor and manufacturing overhead. Following directly from this all the other budget schedules can be set as well.

Review The Budgeting Process and The Master Budget.

Unit 7 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • budgeted balance sheet
  • budgeted income statement
  • capital budgeting decisions
  • capital expenditures budget
  • cash budget
  • cost of capital
  • depreciation tax shield
  • direct labor budget
  • direct materials budget
  • future value
  • hurdle rate
  • internal rate of return (IRR) method
  • master budget
  • net present value (NPV) method
  • payback method
  • present value
  • production budget
  • required rate of return
  • sales budget
  • time value of money
  • working capital