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COMM-2016EL Study Guide - Final Guide: Capital Budgeting, Cash Flow, Net Present Value

Commerce and Administration
Course Code
Kayla Levesque
Study Guide

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Capital Budgeting
In the role of a management accountant, you can help managers make smart financial
decisions. Management accountants are problems solvers, analyzing many investment
opportunities and recommending the best alternative. Capital budgeting is a process used
to determine the impact of future capital purchases. Think of capital as a significant
investment (purchase) that will last years and years. These capital items will contribute to
operations, reduced expenses or increase production.
Capital purchases require large initial investments. Therefore, with any major purchase
you will need to determine the effect on cash flows for many years to follow. These are the
decisions made daily for all types of organizations; educational institutions, government,
not for profit organizations and profitable companies. The overall purpose of utilizing a
capital budgeting model is to determine if your investment has a positive impact to you
today (in the present time).
Capital budgeting decisions compare a possible investment with a continuation of the
status quo. A typical decision is an investment with a more automated production system
to replace an existing system.
There are many models used in capital budgeting but we will only focus the Discounted
Cash Flow Model (DCF). Discounted cash flows, as the name states, discounts (brings back
to the current day) cash inflows and cash outflows that will occur in the future. There are
two variations to DCF, however we will only focus on Net present value (NPV). NPV is an
investment evaluation technique used to determine the present value of future (expected)
cash flows. In order to compute NPV you will need two factors 1) the time period of the
cash flows and 2) the desired rate of return for the investment. The time period is the
number of years into the future you will expect cash flows, the desired rate of return is
always stated as a percentage. If the company is risky (has bad credit) they are exposed to
higher interest rates on debt. You can apply the same concept to the desired rate of return,
if the project is risky the rate of return will be higher. In each analysis do not use
depreciation, remember the DCF model is only concerned with cash flows and since
depreciation is not a cash flow we will ignore it for all discounting of cash flows.
After computing the cash inflows and outflows, if the sum of the all cash flows is positive
the investment is desirable, if the sum is negative than the investment is undesirable. What
does a positive NPV mean? Essentially, the cash inflows over the years will be greater than
your cash outflow today.
When discounting cash flows it is always helpful to prepare a timeline. This will help you
determine the proper factors to apply when computing each present value.
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