Question

IT’S ALL GREEK TO HER

When Regina McDermott opened her auto repair shop, she thought her 15 years of experience with cars was all she would need. To a degree, she was right—within six months, her shop had more work than it could handle, thanks to her widening reputation. At the same time, however, Regina has found it necessary to spend more and more time dealing with financial planning.

Three weeks ago, her accountant came by to discuss a number of finance-related matters. One of these is the need for cash budgeting. “I can work up a cash budget for you,” he explained. “However, I think you should understand what I’m doing so you will realize the importance of the cash budget and be able to visualize your cash inflows and outflows. I think you also need to make a decision regarding the new equipment you are planning to purchase. This machinery is state of the art, but, as we discussed last week, you can buy a number of different types of machinery. You are going to have to decide which is the best choice.”

Regina explained to her accountant that she was indifferent about which equipment to buy. “All of this machinery is good. Perhaps I should purchase the cheapest.” At this point, the accountant explained to her that she could use a number of ways to evaluate this type of decision. “You can base your choice on the payback method—how long it takes to recover your investment in each of these pieces of equipment. You can base it on net present value by discounting future cash flows to the present. Or you can base it on internal rate of return, under which the cash flows are discounted at a rate that makes the net present value of the project equal to zero.”

Regina listened quietly; when the accountant was finished, she said, “Let me think about the various ways of evaluating my capital investment, and I’ll get back to you. Then, perhaps you and I can work out the numbers together.” Her accountant said this sounded fine to him, and he left. Regina began to wish that she had taken more accounting courses while in college. As she explained to her husband, “When the accountant begins to talk, it’s all Greek to me.”

QUESTIONS

1. What is the purpose of a cash-flow budget? What does it reveal? Of what value would it be to Regina?
2. How does the payback method work? How does the net present value method work? How would you explain each of these methods to Regina?
3. How does the internal rate of return method work? How would you explain it to Regina?

Answer 1

As Regima needs to gain knowledge regarding capital budgeting and its various methods to take decisions regarding future buying of machines , I will explain all the questions asked in this regard------:

# Purpose of a cash flow budget

A cash flow budget is an estimation of the inflow and outflow of cash of a business firm over a specific period of time .Its primary purpose is to provide status of the firm' s cash position at any point of time.

# what a cash flow budget reveals

It reveals whether you are able to dpend money on a particular plan keeping in mind the cash flow position of your business.

# Value to Regina regarding cash flow budget

She would be able to know and visualize whether she is able to spend in fixed assets as per her cash flow position.

# Pay back period and its working

Pay back period is a method of capital budgeting which refers to the lenth of time it takes to recover the full cost of the Investment.

Pay back period----- Net Investment of project/ annual cash inflows

The shorter the pay bavk period ,the more attractive Investment plan is.

# Net present value method ( NPV) & its working

It is a method to determine the differenence between present value of inflows and present value of outflows over a period of time .

NPV method helps to analyse the profitability of a project considering the present value of Inflows and outflows

NPV= pv of inflows-- pv of outflows

Higher the NPV ,more attractive the offer is

# Explaining both methods to Regina

Regina must know that only a cheaper Investment plan( cost consideration) is not beneficial to the firm , , it must consider the period of time a plan takes to revover its cost

Similarly,as regards NPV, Regina must know that a rupee earned today is more worth than the rupee earned a few years later. She must vonsider the time value of money while evaluating an investment plan.

# Internal rate of return ( IRR) & its working

It is a discounted cash flow technique which gives a discount rate where net present value or disvounted net cash inflows , is zero.

It is also called the minimum acceptable rate of return which a company must earn to adopt a project.

A present value factor is found by using the following formulae----

PV factor= net Investment/ annual cash inflows

This value is seen in the present value tables corresponding to period of time.

The higher the IRR, the higher the rate of cash flow the firm expects

Explaining the value of IRR to regina

Regina will come to know the Minimum acceptable rate of return which she should expect while investing money on some capital asset.

Hope my explanation would help Regina to understand the importance of capital budgeting techniques while considering an investment plan.