Question

Describe the differences between a flexible budget and a static budget. Use your own example to discuss how to compute and use Net Present Value (NPV), Internal Rate of Return (IRR), and payback period to evaluate a project in capital budgeting.

Answer 1

	Following are the main differences between static and flexible budget:
	1. Nature
	A static budget does not change with the actual volume of the output achieved. A flexible budget is designed to change appropriately with the level of activity attained.
	2. Scope
	A static budget cannot ascertain costs correctly in case of any change in circumstances. Flexible budget can easily ascertain costs in different levels of activities.
	3. Determination Of Cost
	Static budget is prepared under the assumption that all conditions will remain unaltered. Flexible budget is prepared at different levels of activities considering the possible changes in the operational aspect of a business.
	4. Assumptions
	Static budget has a limited application and is ineffective as a tool for cost control. Flexible budget has a wide application as an effective tool for cost control.
	5. Pre-requistes
	Static budget is prepared without classifying the costs according to their variable nature. Flexible budget is prepared by classifying the costs according to their variable nature.
		Example of IRR and NPV
			Proposal A	Proposal B
		Investment, today	$550,000	$275,000
		Useful life	5 years	4 years
		Estimated annual net cash inflows	$150,000	$90,000
		Residual value	$50,000	$0
		Depreciation method	Straight-line	Straight-line
		Discount rate	10%	9%
	(a)	Net Present value calculation	Proposal A	Proposal B
	(i)	Estimated annual net cash inflows	150000	90000
	(ii)	Present value annuity factors	3.790786769	3.239719877
	(iii)	Present value(i)*(ii)	$568,618.02	$291,574.79
	(iv)	Residual value	$50,000	$0
	(v)	Present value Interest factor	0.620921323	-
	(vi)	Present value of residual value(iv)*(v)	$31,046.07	-		Present value of $1 @10%	Year	PVIF
							1	0.909090909
	(vii)	Total present value of cash inflows	$599,664.08	$291,574.79			2	0.826446281
	(viii)	Investment, today	550000	275000			3	0.751314801
		NPV(vii)-(viii)	$49,664.08	$16,574.79			4	0.683013455
							5	0.620921323
		Since, NPV of the Proposal A is more Investment should be made in A.						3.790786769
	(b)	IRR calculation	Proposal A	Proposal B		Present value of $1 @9%	Year	PVIF
							1	0.917431193
		Year	Cash flows	Cash flows			2	0.841679993
		0	($550,000)	($275,000)			3	0.77218348
		1	$150,000	$90,000			4	0.708425211
		2	$150,000	$90,000
		3	$150,000	$90,000				3.239719877
		4	$150,000	$90,000
		5	$200,000
			13.34%	11.72%
		excel formula	IRR(cashflows y0 to y5)	IRR(cashflows y0 to y4)
		Since, IRR of the proposal A is more and greater than required rate of return, proposal A should be opted.
	(b)	Payback period
	i	Initial investment	550000	275000
	ii	Annual cash flow	$150,000	$90,000
	iii	Payback period (i)/(ii) in Years	3.67	3.06
		Since, payback period in Proposal B is less than that of proposal B. Investment should be made in Proposal B.