Wk5 Accounting

What is capital budgeting?

A process managers use to choose between long-term investment opportunities that generate cash flows over multiple years.

What are the 3 types of capital investment?

1. OHS (Occupational Health & Safety) 2. Operational 3. Strategic

What is an OHS investment?

An investment required by law or regulation (e.g. installing a fire alarm system). Evaluated on best price/quality.

What is an operational investment?

An investment to enhance operating efficiency or increase revenue (e.g. replacing old equipment). Evaluated using NPV.

What is a strategic investment?

An investment to enhance competitive effectiveness (e.g. expanding into a new country). Evaluated using NPV + qualitative analysis.

What are the 6 steps of capital budgeting?

1. Identify decision alternatives & classify 2. Identify relevant cash flows 3. Apply quantitative analysis 4. Sensitivity analysis 5. Identify qualitative factors 6. Make the decision

What makes a cash flow "relevant" in capital budgeting?

It must (1) arise in the future, AND (2) differ between the decision alternatives.

Give 3 examples of relevant cash OUTFLOWS.

1. Initial investment outlay 2. Future operating costs 3. Project closing/cleanup costs

Give 3 examples of relevant cash INFLOWS.

1. Future revenues 2. Decreased operating costs 3. Residual value of asset at project's end

What is the "initial outlay"?

The purchase price of an asset PLUS any costs to get it into a position ready for use.

What is depreciation?

The amount of economic benefits used up from an asset over one period. It is recognised as an expense in the income statement.

Is depreciation a cash flow?

NO. Depreciation is a non-cash expense — it reduces profit but no money leaves the business each year.

What are the 3 judgements needed to calculate depreciation?

1. Depreciable base (cost − residual value) 2. Useful life of the asset 3. Depreciation method (e.g. straight-line)

What is the depreciable base?

Cost of the asset MINUS its residual value. Formula: Depreciable base = Cost − Residual value

What is residual value?

The estimated value of an asset at the END of its useful life.

What is carrying amount (book value)?

The initial cost of the asset minus all depreciation recorded so far. This is the value shown on the Balance Sheet.

What is the straight-line depreciation formula?

Annual depreciation = Depreciable base ÷ Useful life = (Cost − Residual value) ÷ Useful life

A machine costs $30,000, residual value $3,000, useful life 3 years. What is the annual depreciation?

($30,000 − $3,000) ÷ 3 = $9,000 per year

Under straight-line depreciation, how does the expense change each year?

It stays the SAME every year — that's what "straight-line" means.

What does the carrying amount equal at the END of the asset's useful life?

It equals the residual value (e.g. $3,000 at end of year 3).

What is the core principle behind NPV?

"A dollar today is worth more than a dollar tomorrow." Money now can be invested and grow — so future cash must be discounted back to today's value.

What does NPV stand for and what does it measure?

Net Present Value. It measures whether a project's discounted future cash inflows exceed the initial investment.

What is the NPV formula?

NPV = −Initial investment + Sum of all (Annual net cash flow × Discount factor)

What is a discount factor (Present Value Factor)?

The multiplier that converts a future cash flow into today's value. Formula: PVF = 1 ÷ (1 + r)ⁿ where r = discount rate, n = year number.

If NPV > 0, what should you do?

Invest — the project returns more than it costs in today's money (quantitatively speaking).

If NPV < 0, what should you do?

Do NOT invest — the project destroys value; future cash flows don't cover the initial outlay.

What is a discount rate?

The rate used to convert future cash flows into present value. It reflects the cost of capital / required rate of return.

What is a terminal cash flow?

A one-off cash flow at the END of a project (e.g. selling the asset for its residual value).

When calculating NPV with tax, why do we subtract depreciation first?

To find TAXABLE profit — we need to include depreciation before tax so we calculate the correct tax amount.

After calculating after-tax profit, why do we ADD depreciation BACK?

Because depreciation is NOT a real cash outflow. We add it back to convert accounting profit into actual operating cash flow.

What is the Method 2 cash flow formula (with tax)?

Revenue − Costs − Depreciation = Taxable profit → minus tax = Net profit after tax → plus Depreciation back = Operating Cash Flow

What is a "tax shield" from depreciation?

Because depreciation reduces taxable profit, it reduces the tax you pay. The tax saving = Depreciation × Tax rate.

In Method 1 (depreciation as tax shield), how is operating cash flow calculated?

Net profit after tax (before depreciation) + (Depreciation × Tax rate) = Operating Cash Flow

What are "uneven cash flows"?

When revenue (and therefore cash flows) differs each year, requiring NPV to be calculated year by year rather than using one fixed figure.

For uneven cash flows, what stays constant each year under straight-line depreciation?

The depreciation expense stays the same each year even though revenues vary.

Why is NPV alone insufficient for evaluating STRATEGIC investments?

Strategic investments involve qualitative factors (risk, reputation, competitive threats, staff capability) that cash flows cannot capture.

What does the Strategic Investment Model add to NPV?

A qualitative scoring framework assessing: strategic risk, operational risk, financial risk, regulatory risk, social/environmental impact, and other strategic factors.

Why is the "do not invest" decision risky for strategic investments?

Competitors may take the opportunity instead — so "don't invest" can actually mean losing market share and declining future cash flows.

What happens to the NPV of a strategic investment if you ignore the competitor risk?

It is UNDERSTATED — because the "do not invest" scenario isn't just $0, it's potentially a declining revenue stream.

Name 4 qualitative factors in the Strategic Investment Model.

Any 4 from: strategic risk, operational risk, financial risk, regulatory risk, social impact, environmental impact, alignment with strategy, impact on reputation, core competencies, feasibility of the decision, management capability, competitive advantage.

What is sensitivity analysis in capital budgeting?

Testing how the NPV changes if key assumptions (e.g. revenue, costs, discount rate) turn out to be different from estimates.

What is the difference between current assets and non-current assets?

Current assets: short-term (cash, receivables, inventory). Non-current assets: long-term (property, plant & equipment, investments) — capital budgeting focuses on these.

A project: initial investment $1,400,000; annual net CF $276,000; discount rate 14%; 10 years; terminal CF $400,000. Is NPV positive?

Yes. Total discounted CFs = $1,547,892. NPV = $1,547,892 − $1,400,000 = +$147,892. Invest.

What is the PV factor formula for year n at discount rate r?

PVF = 1 ÷ (1 + r)ⁿ

For Illustration 3: outlay $100,000; revenues vary; costs $30,000/yr; tax 30%; discount 10%. What is annual depreciation?

$100,000 ÷ 4 years = $25,000 per year (no residual value mentioned, so depreciable base = full cost).

What does capital budgeting help managers decide?

Whether to invest in a long-term project AND which option is best when multiple investment opportunities exist.

Who uses capital budgeting analysis in an organisation?

Managers from ALL value-chain areas when pitching for company funds — not just accountants.