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Component 1: Budgeting

The Nature of Budgets A budget is an instrument utilised by management to achieve stated objectives. •

•

Higher Profitability o Limit waste o Improve management decisions Ensure optimal liquidity o Identify best means of financing o Advanced knowledge of future cash requirements

Functions of budgets: • • • • • •

Task assignment, authorisation to act Means of communication Forecasting function Means of co-ordination Means of control Educate managers

Attitude towards budgets: ð ð ð ð

Conflict as a result of conflicting interests Excessive expectations of subordinates (employees) Excessive emphasis of control function No room for own discretion

Management Planning and Control Planning: ü Development of future-oriented objectives ü Drawing up plans quantified in monetary terms to achieve objectives Three types of projections: § § §

Reference projection Desired projection Planned projection

Control: t Observation of differences between financial norms and actual figures t Combined with critical evaluation and reporting ¾ Steps of control: Ø Setting of standards Ø Collection of information; comparing actual performance with standard Ø Analysis and evaluation of performance Ø Corrective action

Cash Budget A cash budget is a tool in the form of a statement which contains an estimate of all the outgoing amounts during a particular future period. Preview of: ¾ Expected cash receipts and payments ¾ Future cash requirements ¾ Periods where financing is required for cash shortages Cash management: • • •

Delay payments; speeding up recoveries Synchronising inflow and outflow of cash Inventory model applied for cash management

Cash Management Negative cash balance (Short-term) o o

Bank overdraft; short term debt Sell marketable securities

Long-term: ð May require adjustment to capital structure ð Additional LT Kv, equity Positive cash balance (Short-term) v Redeem short-term debt v Purchase marketable securities Long-term: §

Investment in non-current assets

Example

The company requires a closing cash balance equal to R10 000. Assume that all cash deficits will be financed by means of short-term loans. Any cash surpluses will first be used to redeem the previous years’ financing. Any additional cash surpluses that may remain can then be utilised to purchase marketable securities.

Solution

Year 1: Obtain ST loan of R40 000 Year 2: Obtain ST loan of R10 000 Year 3: Reduce ST loan by R45 000 Year 4: Reduce ST loan by R5 000 Buy marketable securities of R35 000

Cash Budget Formats General (Compile a Cash Budget) Jan Feb Mar Cash Receipts • Cash (% of sales) • Debtors (% of sales) Total Receipts Cash Payments • Parts • Wages • Overheads • Admin exp. • Interest paid • Income tax • Dividends • Machinery Total Payments Cash Generated (Total Receipts – Total Payments) **** #### Cash Opening Balance (Usually given) Cash Closing Balance **** #### *Cash closing balance from the first month becomes the cash opening balance of the next month.

Minimum Cash Balance, Bank Overdraft and Marketable Securities Jan Cash Generated Cash Opening Balance Available Cash (Cash generated + Cash Opening Balance) Bank Overdraft (If available cash < minimum required balance) Marketable Securities (bought with excess cash) Cash Closing Balance

Minimum Required Balance

Feb

Minimum Required Balance

Mar

Minimum Required Balance

Component 2: Chapter 6 (Estimating Relevant Cash Flows) Large capital investments are usually also necessary for expansion in existing markets or to enter new markets. A business that invests a considerable sum of money in a project does so in the expectation of generating further cash flows that will be sufficient to warrant the large initial investment that is required. Before managers acquire new capital assets, they therefore need to be sure that the investment will yield a positive NPV.

The Different between Profit and Cash Flow • • • •

When the financial feasibility of an investment project is investigated, the focus should be on the project’s cash flow, and not on the profit that results from investing in it. The reason is because the profit represents an accounting item that is calculated based on a set of accounting standards. Profits are calculated for a certain time period; whereas cash flows are determined at a specific point in time. Cash flows provide a clearer picture of the value and timing of a transactions results than profits.

Estimating Relevant Cash Flows It is the cash flow that reflects the change in a business’s overall future cash flows as a direct consequence of accepting a capital investment project. Relevant cash flows are also called incremental cash flows. If a company is evaluating the expansion of its current activities, the company need only consider the cash flows associated with the new project. However, to determine the incremental cash flow for replacement projects, it is first necessary to calculate the company’s current overall cash flow. After this has been calculated, then the company’s expected overall cash flow after the replacement investment has been made should be calculated.

Sunk Costs A sunk cost is a type of cost that has already been incurred in the process of evaluating a capital investment proposal (excluded cost).

Opportunity Costs An opportunity cost refers to the most valuable alternative that would be forgone if a particular investment is undertaken (included cost).

Finance Costs Additional financing costs that arise from accepting a project should be ignored when estimating a capital project’s cash flows.

Inflation and Tax Price changes and the effects of tax should be captured in a manager’s cash flow cost calculation to ensure accurate NPV and internal rate of return values, and to inform sound accept/reject decision making. All incremental cashflows should be shown on an after-tax basis. Company tax: 28%

VAT: 14%

Capital gains tax: 80%

The Components of Project Cash Flows o o o

Initial investment (once off) Operating cash flows (over investment’s life time) Terminal cash flow (at the end)

Calculating the Initial Investment All the costs associated with NOW.

ü Required Information Total up-front costs (the initial investment): ð ð ð ð

The cost of the investment (after tax) Shipping and installation costs Training costs Any change in net working capital (NWC)

ü Steps in Calculating the Initial Investment for an Expansion Project 1. Total cost of the new asset Purchase price (after tax) + shipping and installation costs + training costs + opportunity cost *NB: the cost of the new asset will be shown as negative (-) because it is an initial cash outflow. 2. Initial investment Purchase price + shipping and installation costs + training costs +/- NWC (net working capital)

ü Determining the Net Working Capital Net working capital: net current assets – net current liabilities. Example Inventory Trade Receivables Trade payables Total

Year 1 100 000 50 000 30 000

*Note: ↑ Trade receivables = (outflow)(-) ↑ Inventory = (outflow)(-) ↑ Trade payables = inflow(+)

Year 2 150 000 70 000 60 000

Movement (50 000) (20 000) 30 000 (40 000)

↓ Trade receivables = inflow(+) ↓ Inventory = inflow(+) ↓ Trade payables = (outflow)(-)

Direction (outflow) (outflow) inflow (outflow)

ü Steps in Calculating the Initial Investment for a Replacement Project First calculate the initial investment of the new asset and then calculate the cost associated with the removal of the old asset (New asset – cost of the old asset). 1. The initial investment of the new asset (shown as negative): Purchase price (new asset) + shipping and installation costs + training costs +/- NWC (net working capital) *NB: the cost of the new asset will be shown as negative (-) because it is an initial cash outflow. 2. The total costs associated with the removal of the old asset (shown as positive): After-tax proceeds (old asset) Proceeds from the sale of the old asset (what the asset is sold for, minus removal costs) +/- Tax on the sale of the old asset +/- Change in the net working capital *NB: the amount after-tax proceeds and NWC of the old asset is added to the initial investment of the new asset. *The after-tax proceeds is simply the amount the asset is sold for (minus removal costs) and either add (if a profit is made) or subtract (if a loss is made) the tax amount. i.e. After- tax proceeds = proceeds from the sale of an asset +/- tax amount. 3. Incremental Initial investment for a replacement project: Purchase price (new asset) + shipping and installation costs + training costs +/- NWC (net working capital) *Answer as a negative value + After-tax proceeds (old asset) Proceeds from the sale of the old asset (what the asset is sold for, minus removal costs) +/- Tax on the sale of the old asset + Change in the net working capital (adding back the value of NWC once it is sold)

ü Calculating the Tax Value There are three values that determine the amount of tax: selling price, cost price and the carrying value of an asset. Cost price: the total cost of the asset (including VAT and installation costs) Selling price: what the asset is being sold for minus the removal costs. Carrying value: the cost price of the asset minus the depreciation of that asset thus far. Depreciation = the cost price of the asset ÷ estimated economic life x no. of years it has been in use.

1. Calculating the capital gains tax on an asset: There is a capital gain when the selling price (SP) > cost price (CP) of an asset. i.e. SP = R100 000 CP = R80 000 The profit made is R20 000, which is a capital gain. The capital gains tax would therefore be: 80% x 28% (company tax rate) R20 000 = R4 480 To explain: 80% of the profit is taxable, but it is not the tax amount! The tax amount is the company tax rate x the 80% of the profit that is taxable. If the SP < CP, then capital gains tax would be 0. 2. Calculating the accounting tax on an asset: An accounting profit is made when the selling price (SP) > carrying value (CV) of an asset. i.e. (continuing from above example) SP = R100 000 CV = R50 000 The total profit made is R50 000 (this is not the accounting profit). *BUT, the capital gains tax has to be taken in account: R50 000 (total profit) – R20 000 (capital gain) = R30 000 (accounting profit) The accounting tax of the asset is then calculated based on the accounting profit. R30 000 x 28% = R 8 400

An accounting loss is made when SP < CV, therefore a tax benefit is created. i.e. SP = R100 000 CV = R110 000 The loss that is made is R10 000. The tax is then calculated as follows: -R10 000 x 0.28% = -2 800. The R2 800 will be added to the tax as a tax benefit instead of being subtracted.

Calculating Operating Cash Flows o Operating Cash Flows of an Expansion Project

+

Income Expenses (Cost of sales + operating expenses) EBITDA Depreciation EBIT Taxes NOPAT Depreciation

*After tax loss is subtracted here if given* Annual Operating Cash Flows (AOCF)

o Operating Cash Flows of an Expansion Project The annual operating cash flows are calculated each year. Example: the calculation of the old assets operating cash flows Year

EBITDA

Depreciation

1 2 3 4 5

26 000 24 000 22 000 20 000 18 000

12 000 12 000 12 000 -

EBIT (EBITDA – Depreciation) 14 000 12 000 10 000 20 000 18 000

Tax

3 920 3 360 2 800 5 600 5 040

NOPAT (EBIT – Tax) 10 080 8 640 7 200 14 400 12 960

AOCF

22 080 20 640 19 200 14 400 12 960

The incremental cash flows: the operating cash flows of the new asset – the operating cash flows from the old asset.

Calculating the Terminal Cash Flow The terminal cash flow relates to the end of the project’s lifetime (selling the new and the old asset at the end of the project). The costs associated with years from now.

§ Terminal Cash Flow of an Expansion Project After-tax proceeds (new asset) Proceeds from the sale of the new asset (what the asset is sold for, minus removal costs) +/- Tax on the sale of the new asset +/- Change in the net working capital *NB: add back NWC when selling the asset if it is negative when calculating the initial investment. Subtract NWC if it is positive when calculating the initial investment.

§ Terminal Cash Flow of a Replacement Project New asset:

-

Proceeds Capital gains tax (if loss is made then capital gains tax = 0) Accounting tax (if loss is made then add tax) +/- NWC

Old asset: Proceeds +/- Accounting tax - Capital gains tax +/- NWC Incremental terminal cash flow = terminal cash flow of new asset – terminal cash flow of old asset.

Component 3: Chapter 4 (The Time Value of Money)

Introduction When investors decide to invest their money, some form of return on their investment is usually required. The value of an investment critically depends in the size and timing of the cash flows associated with the investment. Cash flows to be received in the near future are more valuable than ones to be received in the distant future.

Symbols Used in the Course FV = Future value PV = Present value n = number of periods PMT = payment 𝒾 = interest rate per period *NB: clear calculator before use and NEVER put in begin mode.

Interest Rates Simple interest: earned on the principal amount only. Year 1: 10% x R1 000 = R100 Year 2: 10% x R1 000 = R100 Year 3: 10% x R1 000 = R100 Compound interest: interest earned is reinvested together with the principal amount. Year 1: 10% x R1 000 = R100 Year 2: 10% x R1 100 = R110 Year 3: 10% x R1 210 = R121

Investing for a Single Period FV = PV x (1 + 𝒾 )

Investing for More Than One Period FVn = PV0 × (1 + i) n

Semi-annual, Quarterly and Monthly Compounding FVn = PV0 × æç1 + è

i ö ÷ mø

n´ m

m = the number of times interest is compounded per period.

Continuous Compounding The total amount of interest earned increases if interest is compounded more frequently per period.

FVn = PV0 × e i × n e = the base of the natural log (value of 2,7183)

Nominal and Effective Interest Rates The nominal interest rate is the contractual percentage rate of interest charged by a lender or promised by a borrower. The effective annual rate is the annual rate of interest actually paid or earned. m

Effective Annual Rate (EAR) = æç 1 + i ö÷ - 1

è

mø

Present Value and Discounting The amount of money invested today at a given interest rate for a specified period to equal a future amount. PV0 =

FVn

(1 + i ) n *NB: when using FV and PV variables, one must be NEGATIVE.

Valuing Annuities An annuity is a series of equal payments over a specified period of time. An annuity consists of constant payments made at regular intervals. Two types of annuities: • •

Ordinary annuity: payments occur at the end of each period. Annuity due: payments occur at the start of each period.

The Future Value of an Ordinary Annuity The FV of an annuity is the value that a stream of expected or promised future payments will accumulate to after given number of periods at a specific compounded interest. n FVA = PMT × é (1 + i ) -1 ù ú ê i û ë

The Future Value of an Annuity Due The cash-flow stream of an annuity due is similar to that or an ordinary annuity, except that each payment occurs at the beginning of a period rather than the end. n FVA = PMT (1 + 𝒾) × é (1 + i ) -1 ù ê ú i ë û

The Present Value of an Ordinary Annuity The PV of an annuity is the current value of a stream of expected or promised future payments that have been discounted to a single equivalent value today.

The Present Value of an Annuity Due

é1 - (1 + i )- n ù ú PVA = PMT × (1+i) × êêë i úû

Geometric Annuity A geometric annuity is a special type of annuity where the annual payments are not constant, but increase at a constant rate each year.

FV = PMT1 x [

(𝟏#$𝓲)ⁿ$($$(𝟏#𝒈)ⁿ$ 𝓲(𝒈

]

FV = final value of the geometric annuity

PMT1 = the payment at the end of the first year i = the interest earned on the investment g = the constant growth rate in the annual payments n = the period of time over which the payments are made

Arithmetic Annuity An arithmetic annuity is a special type of annuity where the annual payments are not constant, but increase at a constant amount each year.

FV = { PMT1 x [

(𝟏#𝒊)ⁿ$(𝟏 𝒊

𝑮

]} + {( ) x [ 𝒊

(𝟏#𝒊)ⁿ(𝟏 𝒊

– n]}

FV = the final value of the arithmetic annuity PMT1 = the payment at the end of the first year i = the interest earned on the investment G = the constant growth amount in the annual payments n = the period of time over which the investments are made

Perpetuity A perpetuity is an annuity in which the periodic payments begin on a fixed date and continue indefinitely.

1. Ordinary Perpetuity

PV∞ =

PMT i

2. Perpetuity Due

PV∞ =

,-.$/$(0#1) 1

3. Growing Perpetuity

PV∞ = PMT1 i- g *PMT1 is the payment at the end of the first period.

Component 4: Financial Appraisal Methods

Introduction Most investment decisions involve outflows of cash, which result in inflows of cash. • • •

• •

Typically, an investment project involves a relatively large initial investment at the beginning of the project. After the initial investment, a stream of cash inflows and outflows spread over the project lifetime. Finally, provision may also have to be made for cash outflows resulting from additional investments made over the project lifetime. Large cash flows may also be required at the end of the project lifetime. To evaluate the feasibility of investment projects, investment appraisal methods (capitalbudgeting techniques are usually used. Selecting which investment opportunities to pursue and which to avoid is a vital matter to businesses.

Importance of Investment Appraisal Capital budgeting: § § §

Process of identifying and analysing investment opportunities available. Deciding how scare capital resources will be allocated. Company’s should ensure that only value-creating investments are accepted.

Importance of efficient capital budgeting: ü ü ü ü

Investment decisions define the company’s strategic direction. Require long-term investment: capital locked into project. Failure to conduct efficient capital budgeting: result in insufficient production facilities. Capital budgeting involves large amounts of capital: difficult to reverse incorrect investment decision. ü Limited capital available: cannot invest in unprofitable investment opportunities. ü If efficient planning is not conducted: may not be able to find capital required to finance investments.

Steps in the capital budgeting process: 1. Identify all possible investment alternatives. 2. Determine the relevant cash flows associated with investment alternatives. 3. Determine the cost of capital: important to determine if the return earned on projects will exceed company’s cost of capital. 4. Evaluate the projects: appraisal of investment alternatives financial feasibility. 5. Decide if acceptable projects are going to be implemented. 6. Follow up and continuously re-evaluate pro...