Applying Various Capital Budgeting Methodologies

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 INTRODUCTION

To critically analyze the financial viability of a project, managers need to ascertain both

the initial amount to be invested in the project and cash inflows. Initial cash outlay is composed

of the asset cost, plus any other cost associated with its installation so as to make it ready for use

by the firm. On the other hand, cash inflows are considered to be net cash received by the

company after deduction of all expenses as well as the tax then adding back depreciation since it

is deemed to be a non- cash item. Therefore the main aim of this paper is to show the CEO (Mr.

Hillbrandt) how to compute the Cash outflow, cash inflow, and various effects of different

financing options available to the company as well as various expenses that affect cash inflow

and outflows.

Computation of Cash Outflow

This is considered as the initial cash invested by a business in a particular project with an

expectation of generating profit from it. This amount can be obtained through different means

e.g. through Retained earnings as well as through debt finance. If it is achieved through retained

earnings, then the project is considered to be less risky as compared to debt finance. Therefore;

during our computation of Cash outflow, we considered the cost of the machine plus

maintenance cost of inventories giving us $ 2,150,000 as indicated in the Excel worksheet.

Computation of Cash inflow

These are all the cash that are generated from the utilization of initial investment. It is

obtained through deduction of all expenses plus tax expenses the adding back depreciation in all

the years and the salvage value in the last year of the project. After this, an individual is expected

to discount all the cash inflows so as to obtain the present value for each year which will be used
to get the Net present value of the project through deducting the total present value from Initial

cash outflow. Paramasiva,c & Subramanian ,T (2012 Pg. 67 ) Mentioned that according to net

present value method, present value of cash inflow must be more than the present value of cash

outflow.

Paramasiva .c & Subramanian, T (2012 Pg. 9) asserted that financial management involves

the acquisition of required finance to the business concern. Hence; debt capital refers to money

that is obtained from third parties who provide this fund to the company at an interest rate. The

owners of debt capital whether long term or short term are entitled to their fund even if the

company goes into liquidation which is different in the case of shareholders who only receive

payment upon full settlement of all debt owners.

If the company plans on using debt to finance its project, then they will before to adjust the cash

inflows to reflect interest charges since this is part of business expenses which needs to be

deducted from cash flows to obtain Net cash inflow after tax and interest. This will ensure that

the company has been able to fully account for the financial risk associated with debt financing

to arrive at the profit attributable to shareholders only.

Research cost is considered to be part of the initial cost of the project hence any investor

should consider this expense in the computation of initial cash outflow of the company. Failure

to recognize this expense results into understatement of initial cost hence gives a wrong

interpretation of the project's viability.

Rental fee is part of operating expenditures of the firm hence there is a need to recognize this

expense in its computation of net cash inflows. $ 80,000 will be deducted from the operating
profit. Failure to deduct it from the cash inflows results into overstatement of cash inflows

thereby leading to an incorrect financial interpretation by the finance manager.

Conclusion

The firm should not ignore any expense that relates to initial cash outlay as well as those

that affect cash inflows since these expenses help us to arrive at the most viable decision as to

which project firm should invest in. Research expense is part of the initial expense, and the rental

expense is reduced cash inflow of the business.

Firms should minimize the amount of debt capital so as to lower their financial risk in the

market. If they have to utilize debt financing, then they are always required to ensure that they

can increase their output so as to minimized risk. The CEO should, therefore, consider investing

in a project using Equity finance rather than Debt finance.

 Reference

Paramasiva,c & Subramanian ,T (2012 ) Financial management, New age international

publishers.

Ndeda Philip sagwa (2012) Financial Management; CPA revision kit

Paramasivan c. And Subramanian T (2012) Financial Management; New Age International

Publishers

Gupta Kumar Prem, Dr. Hira D.S. and Kamboj Aarti (2008) Introduction to Operations Research

Weetman, P. And Gordon P. (2003) finance and management accounting 3rd Edition Pearson

Education Limited

Chandra Prasanna (2010) finances sense: corporate finance for non- finance executives 4th

edition

Damodaran, Aswath (2007) corporate finance theory and practice 2nd edition