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Mohamed Youssef Lecture 9

**Chapter 11: Capital Budgeting
**

There are 4 method to calculate capital budget

Payback period Accounting Rate of Return (ARR) Traditional method

Net Present Value (NPV) Internal Rate of Return (IRR) Advanced method

A) Traditional Methods i. Payback method ii. Accounting Rate of Return B) Advanced Methods i. Net Present Value ii. Internal Rate of Return Example 1 A company with capital investment $4000 and the project life cycle is 4 years. Y e a r 0 1 2 3 4 Cash inflow 0 5000 6000 6500 7000 Cash outflow (4000) 3500 4000 4200 5000 Total NCF

Net cash flow (NCF) Net Profit If dep.=1000

Acc. NCF (4000) (2500) (500) 1800

(4000) 1500 2000 2300 2000 3800

0 500 1000 1300 1000 3800

Note:

Net profit = NCF- Depreciation For year one Net profit = 5000-3500 = 1500

EX: If Dep / year = 4000/4 = 1000 Income statement for example year 2 will be as follow

Chapter 11

1

Managerial Accounting and control Dr. Mohamed Youssef Lecture 9 Sales Less: Cash Expenses Dep. Net profit Note: 5000 (3500) (1000) 500

•

In the end of the project

Net profit = NCF

To recover all capital investment we need 2 years and 4 month, and this period which we called payback period,. • Payback method

Example: If we have three projects payback period as follow P1 2 year P2 3 year P3 1,5 year The payback period should controlled by company and based on cash flow

• •

Accounting Rate of return (ARR) based on net profit Net Present value and Internal rate of return Arr based on the WACC (Waited average cost of capital) If we have + NPV the project will accept and if we have – NPV the project will reject. For the internal rate of return we use sensitive analysis NPV0 and then we recalculate it with another criteria

Example Year 0 1 2 3 Project 1 (5000) 2000 3000 10000 Project 2 (3000) 6000 3000 1000

By payback method project no. 2 is much better to reduce risk, because the payback period will be 6 month but with project no. 1 the payback period will be 2 years but this method neglect the cash flow after payback period

Chapter 11

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Managerial Accounting and control Dr. Mohamed Youssef Lecture 9 From example 1 required 2 years to collect 3500 from 4000 capital investments and the rest will be 500, this 500 will taken from third year We collect in this year 2300 / 12 = 192 per month So the required months to collect 500 = 500 /192 = 2 months

•

Accounting Rate of return (ARR) We calculate the ARR by two ways

• •

ARR1= (Average net profit / initial investment) ARR2= (Average profit / average capital employment)

Average net profit = net profit / project life cycle For example 1 average net profit = 3800 / 4 = 950 ARR1 = 950 / 4000 = 24% Example If for example we need for a project 4000 $ for machine and 1000 cash and 500 scrap So the average capital employment = (initial investment-scrap) /2 = 5000-500 / 2 =2250 ARR2 = 950/ 2250 =0.42 Presentation (11-4)

PV = TV/ (1+R)n Present value(PV) 1000 10 % Terminal value(TV) 1100 Terminal Value = PV(1+R)n Where R = 10 % N number f years

R is the WACC and called discounted rate 1/ (1+R)n this is called discounted factor

Chapter 11

3

- (10)Evaluation and Control
- (9)Strategy Implementation, Staffing and Directing
- (8) Strategy Implementation, Organizing for Action
- (6)Strategy Formulation, Corporate Strategy
- (5)Strategy Formulation, Business Strategy
- (4) Internal Scanning, Organizational Analysis
- (3)Environmental Scanning and Industry Analysis
- (1)Introducing Strategic Managment
- Mergers and Acquisitions (Hitt)
- Lecture 10
- Managerial Accounting and Control Dr. Mohamed Youssef Lecture 8 Example:
- Managerial Accounting and Control Dr. Mohamed Youssef Lecture 7 Example:
- Managerial Accounting and Control Dr. Mohamed Youssef Lecture 6
- Managerial Accounting and Control Dr. Mohamed Youssef Lecture 5
- Managerial Accounting and Control Dr. Mohamed Youssef Lecture 4 Begin
- Managerial Accounting and Control Dr. Mohamed Youssef Lecture 3 Example:
- Lecture 11
- Lecture 2 accounting
- Lecture 1 accounting

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