Capital Budgeting and Cash Flow Analysis for Project Managers by Derek Hendrikz
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Capital Budgeting and Cash
Flow Analysis in Project
Management
derek hendrikzwww.derekhendrikz.com
Copyright © 2014
Derek Hendrikz Consulting
www.derekhendrikz.com
Fundamental Principles of Finance in Project Management
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the Cost Benefit principle….
The Cost-Benefit Principle: Obtain clarity about the objective to be attained.
Identify alternative ways in which the objective may be
attained.
Calculate the cost and benefits of each of the alternatives.
Determine the effectiveness of the benefits of each
alternative.
Decide on a criterion or standard to be used against which
the acceptability of an alternative may be weighed.
Take a decision about the most appropriate course of
action.
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the Risk Return principle….
The Risk-Return Principle: This principle is a trade-off between risk and return.
The greater the risk, the greater the required rate of
return.
In other words, the return should exceed the risk
involved in any business decision.
Risk is the probability that the actual result of a
decision may deviate from the planned end result
with an associated financial loss or waste in funds.
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the Time Value of Money
principle….
The Time Value of Money Principle:
This principle implies that the value of
money today does not equal the value of
money tomorrow.
The basic assumption here is that a person
could increase the value of an amount of
money by investing it and earning interest
on the amount.
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Capital Budgeting:
Capital budgeting places emphasis on cash flows associated with projects, rather than on accounting profit figures.
An investment in projects can only add value if its return is greater than the required rate of return.
The return may be best measured in terms of the Net Present Value (NPV) and the Internal Rate of Return (IRR). www.derekhendrikz.com
The Accept-Reject Approach to Evaluating Projects:
This approach involves evaluating
capital expenditure proposals to
determine whether they are acceptable.
If a project does not meet the basic
acceptance criterion, it should be
eliminated from consideration.
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The Ranking Approach to Evaluating Projects:
This approach involves ranking projects
on the basis of some predetermined
criterion, such as the rate of return.
The project with the highest return is
ranked first and the project with the
lowest acceptable return, last.
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Payback Period:
The payback period is the number
of years required to recover the
initial investment.
To calculate the payback period, you
need to establish when the initial
investment will be covered. www.derekhendrikz.com
Answer to Payback Period Exercise:
The payback period will be 2 years and six months
(time to recover initial investment).
This is calculated by adding the net cash flows of each
year until the initial investment is covered (R350000 +
R650000 + R400000 = (R1400000).
The initial investment is covered during the 3rd year,
with R200000 left. Therefore we assume that the
payback period is covered within the first six months of
the year.
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Net Present Value (NPV):
The NPV is calculated by subtracting the initial investment from the present value of the net cash inflows discounted at a rate equal to the firms cost of capital.
If a net present value exceeds zero, then the project can be acceptable, since initial investment (with consideration of time value for money) will be covered. www.derekhendrikz.com
NPV Exercise:
Year: Net Cash Flow: PVIF (12%): PV of Net Cash Flow:
1 R350 000 0.893 R312 550
2 R650 000 0.797 R518 050
3 R400 000 0.712 R284 800
4 R300 000 0.636 R190 800
5 R201 000 0.567 R113 967
Total present value of cash flow: R1 420 167
Less initial investment R1 200 000
NPV R220 167
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NPV Exercise with Financial Calculator:
Key In: Press: Calculator Display:
1 200 000 + Cfi -1200000.00
350 000 Cfi 350000.00
650 000 Cfi 650000.00
400 000 Cfi 400000.00
300 000 Cfi 300000.00
201 025 Cfi 201025.00
12 i 12.00
NPV 220 110, 527
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Conclusion to NPV exercise:
• After considering the ‘time value for
money’ at a 12% WACC, the return of
project will still exceed the initial
investment.
• The conclusion is therefore that the
project should be accepted.www.derekhendrikz.com
Profitability Index (PI):
Also called the benefit-cost ratio.
The PI measures the present value return per
rand invested, while the NPV approach gives
the difference in rand between the present
value of returns and the initial investment.
The PI is calculated as follows:
PI = Total present values of the present cash flows
Initial investment
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Answers Profitability Index (PI) Exercise:
The PI is R1,18.
This implies that for each Rand
invested, the investor will receive
R1,18 back.
Since the return value is more than
R1; the project should be accepted.www.derekhendrikz.com
Internal Rate of Return (IRR):
The IRR is probably the technique
used most often to evaluate
investment alternatives.
If the IRR is greater or equal to the
cost of capital, accept the project,
otherwise reject it.www.derekhendrikz.com
Answers to IRR exercise:
Key In: Press: Calculator Display:
1 200 000 + Cfi -1200000.00350 000 Cfi 350000.00650 000 Cfi 650000.00400 000 Cfi 400000.00300 000 Cfi 300000.00201 025 Cfi 201025.0012 i 12.00
NPV 220 110, 527
IRR 20
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Conclusion to IRR exercise:
• The WACC is 12%.
• The IRR is 20%.
• Project should therefore be accepted.
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Income Statement Formula…
• Sales less - cost of goods sold = gross profit
• Gross profit - operating expenses = operating profit
• Operating profit - interest expenses = net profit before tax
• Net profit before tax - tax = net profit after tax
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Income StatementSales 1 450 000
Opening Inventory 240 000
Purchases 950 000
1 190 000
Closing Inventory 170 000
Cost of Goods Sold 1 020 000
Gross Profit 430 000
Other Expenses 210 000
180 000
Total Expenses 390 000
Net Profit 40 000
Income Statement……
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Assets = Owners Equity + Liabilities
Balance Sheet……
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Balance Sheet Example……
Assets: Owners’ Equity and Liabilities:
Fixed Assets 1000 Long term debt 300
Current Assets… 500 Current liabilities… 200
• Cash 200 • Accounts payable 100
• Inventory 100 • Short term loans 100
• Debtors 100 Owners Equity 1000
• Movable 100
Total: 1500 Total: 1500
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Cash Flow Analysis:
Projected Cash Inflow – Projected Cash Outflow =
Projected Net Cash Flow
(Projected Net Cash Flow + Projected Beginning
Cash Balance) – Projected Short Term Borrowing
= Projected Ending Cash Balance (before
borrowing)
Projected Cash Inflow – Projected Cash Outflow = Projected Net Cash FlowProjected Net Cash Flow + Projected Beginning Cash Balance – Projected Short Term Borrowing = Projected Ending Cash Balance (before borrowing)
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Cash Flow Analysis:Projected Cash Inflow – Projected Cash Outflow = Projected Net Cash FlowProjected Net Cash Flow + Projected Beginning Cash Balance – Projected Short Term Borrowing = Projected Ending Cash Balance (before borrowing)
January February March April
Projected Income
Investment 5 000
Brought Forward 10 100 6 700 20 100
Income 10 000 15 000 16 000 9 000
Total Cash on Hand 15 000 25 100 22 700 29 100
Projected Expenses
Equipment 300 300 1 800 0
Labour 3 000 3 200 300 300
Materials 1 600 0 500 1 000
Communication 0 900 0 1 200
Overheads 0 14 000 0 16 000
Total Expenses 4 900 18 400 2 600 18 500
Closing balance: 10 100 6 700 20 100 10 600
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