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

by Meghan Lever

Department

Commerce and AdministrationCourse Code

COMM-2016ELProfessor

Kayla LevesqueStudy Guide

FinalThis

**preview**shows half of the first page. to view the full**2 pages of the document.**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 î‡²capitalî‡³ 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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