Introduction to Capital Budgeting

Read this section about making capital budgeting decisions. The discussion discusses the goals of capital budgeting, how to rank investment proposals, assumptions about reinvestment, long- and short-term financing, Payback Method (PM), Internal Rate of Return (IRR), Net Present Value (NPV), and cash flow analysis. When managers and executives make financial decisions to invest limited resources, they use this information to invest more wisely.

Accounting Flows and Cash Flows

Accounting flows are used when transactions occur and documents are produced; cash flow is the movement of money into or out of a business.


LEARNING OBJECTIVE

  • Execute the accounting flow for a company

KEY POINTS

    • Accounting flows involve Journal entries, Ledger accounts and Balancing to present a business's financial position in an Income statement, a Balance sheet and a Cash flow statement.
    • Cash flow is the movement of money into or out of a business, project or financial product.
    • Statement of cash flows includes three parts: Operational cash flows, Investment cash flows and Financing cash flows.

TERM

  • Default risk

    Default risk, also known as credit risk, refers to the risk that a borrower will default on any type of debt by failing to make the obligatory payments.

EXAMPLE

    • For example, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares or raising additional debt finance.


Accounting Flows

When a transaction occurs, a document is produced. Most of the time these documents are external to the business; however, they can also be internal documents, such as inter-office sales. These are referred to as source documents.


Accounting Cycle: The basic cycle from open period to close period.

Basic accounting flows are as followed:

  1. Identify the transaction through an original source document (such as an invoice, receipt, cancelled check, time card, deposit slip, purchase order) which provides the date, amount, description (account or business purpose), name and address of the other party.
  2. Analyze the transaction – determine which accounts are affected, how (increase or decrease), and by how much.
  3. Make journal entries – record the transaction in the journal as both a debit and acredit. Journals are kept in chronological order and may include a sales journal, a purchases journal, a cash receipts journal, a cash payments journal and the general journal.
  4. Post to ledger – transfer the journal entries to ledger accounts.
  5. Trial Balance – a calculation to verify that the sum of the debits equals the sum of the credits. If they don't balance, you have to fix the unbalanced trial balance before you go on to the rest of the accounting cycle.
  6. Adjusting entries – prepare and post accrued and deferred items to journals and ledger T-accounts.
  7. Adjusted trial balance – make sure the debits still equal the credits after making the period end adjustments.
  8. Financial Statements – prepare income statement, balance sheet, statement of retained earnings and statement of cash flows.
  9. Closing entries – prepare and post closing entries to transfer the balances from temporary accounts.

Cash Flows

Cash flow is the movement of money into or out of a business, project or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation. Cash flow can be used, for example, for calculating parameters:

Cash flow is the movement of money into and out of a business, project or financial product.

  • To determine a project's rate of return or value. The time that cash flows into and out of projects is used as inputs in financial models such as internal rate of return and net present value.
  • To determine problems with a business's liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash even while profitable.
  • To be used as an alternative measure of a business's profits when it is believed that accrual accounting concepts do not represent economic realities.
  • To evaluate the 'quality' of income generated by accrual accounting. When net income is composed of large non-cash items it is considered low quality.
  • To evaluate the risks within a financial product, e.g. matching cash requirements, evaluating default risk, re-investment requirements, etc.

Subsets of cash flow in a business's financials include:

  • Operational cash flows: Cash received or expended as a result of the company's internal business activities. It includes cash earnings plus changes to working capital. Over the medium term, this must be net positive if the company is to remain solvent.
  • Investment cash flows: Cash received from the sale of long-life assets, or spent on capital expenditure (investments, acquisitions and long-life assets).
  • Financing cash flows: Cash received from the issue of debt and equity, or paid out as dividends, share repurchases or debt repayments.

Cash flow is a generic term used differently depending on the context. It may be defined by users for their own purposes. It can refer to actual past flows or projected future flows. It can refer to the total of all flows involved or a subset of those.