KEY POINTS

Capital budgeting, which is also called investment appraisal, is the planning process used to determine whether an organization's long term investments, major capital, or expenditures are worth pursuing. Major methods for capital budgeting include Net present value, Internal rate of return,Payback period, Profitability index, Equivalent annuity and Real options analysis. The IRR method will result in the same decision as the NPV method for nonmutually exclusive projects in an unconstrained environment; Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR may select a project with a lower NPV.
TERMS

APT In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds, which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factorspecific beta coefficient. Modified Internal Rate of Return The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some problems with the IRR.

1. he main goal of capital budgeting is to rank projects.

KEY POINTS

Basically, the purpose of budgeting is to provide a forecast of revenues and expenditures and construct a model of how business might perform financially. Capital Budgeting is most involved in ranking projects and raising funds when long-terminvestment is taken into account. Capital budgeting is an important task as large sums of money are involved and a long-term investment, once made, can not be reversed without significant loss of invested capital.

TERMS

Preferred stock Preferred stock (also called preferred shares, preference shares or simply preferreds) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Common stock Common stock is a form of corporate equity ownership, a type of security.
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The purpose of budgeting is to provide a forecast of revenues and expenditures. That is, to construct a model of how a business might perform financially if certain strategies, events, and plans are carried out. It enables the actual financial operation of the business to be measured against the forecast, and it establishes the cost constraint for a project, program, or operation. Budgeting helps to aid the planning of actual operations by forcing managers to consider how the conditions might change, and what steps should be taken in such an event. It encourages managers to consider problems before they arise. It also helps co-ordinate the activities of the organization by compelling managers to examine relationships between their own operation and those of other departments. Other essential functions of a budget include:

To control resources To communicate plans to various responsibility center managers To motivate managers to strive to achieve budget goals To evaluate the performance of managers To provide visibility into the company's performance Capital Budgeting, as a part of budgeting, more specifically focuses on long-term investment, major capital and capital expenditures. The main goals of capital budgeting involve:

Ranking Projects

The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended. (Figure 1)
Raising funds

When a corporation determines its capital budget, it must acquire funds. Three methods are generally available to publicly-traded corporations: corporate bonds, preferred stock, and common stock. The ideal mix of those funding sources is determined by the financial managers of the firm and is related to the amount of financial risk that the corporation is willing to undertake. Corporate bonds entail the lowest financial risk and, therefore, generally have the lowest interest rate. Preferred stock have no financial risk but dividends, including all in arrears, must be paid to the preferred stockholders before any cash disbursements can be made to common stockholders; they generally have interest rates higher than those of corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way to finance capital projects.The Internal Rate of Return is very important. Capital budgeting is an important task as large sums of money are involved, which influences the profitability of the firm. Plus, a long-term investment, once made, cannot be reversed without significant loss of invested capital. The implication of long-term investment decisions are more extensive than those of short-run decisions because of the time factor involved; capital budgeting decisions are subject to a higher degree of risk and uncertainty than are short-run decisions.

Accounting Flows and Cash Flows

Accounting flows are used when transactions occur and documents are produced; Cash flow is the movement of money into or out of a business.
SmartNotes

1. fig. 1

Accounting cycle

The basic cycle from open period to close period.

KEY POINTS

Accounting flows involve Journal entries, Ledger accounts and Balancing to present a business's financial position in an Income statement, a Balance sheet and a Cash flowstatement. Cash flow is the movement of money into or out of a business, project or financial product.

Statement of cash flows includes three parts: Operational cash flows, Investment cash flows and Financing cash flows.
TERMS

Default risk

Default risk, also known as credit risk, refers to the risk that a borrower will default on any type of debt by failing to make the obligatory payments.
EXAMPLES

For example, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares or raising additional debt finance.
FIGURES

1. fig. 2

Cash flow

The movement of money into and out of a business, project or financial product.
Accounting Flows

When a transaction occurs, a document is produced. Most of the time these documents are external to the business; however, they can also be internal documents, such as inter-office sales. These are referred to as source documents. Figure 1
Basic accounting flows are as followed:

1. Identify the transaction through an original source document (such as an invoice, receipt, cancelled check, time card, deposit slip, purchase order) which provides the date, amount, description (account or business purpose), name and address of the other party. 2. Analyze the transaction determine which accounts are affected, how (increase or decrease), and by how much.

3. Make journal entries record the transaction in the journal as both a debit and a credit. Journals are kept in chronological order and may include a sales journal, a purchases journal, a cash receipts journal, a cash payments journal and the general journal. 4. Post to ledger transfer the journal entries to ledger accounts. 5. Trial Balance a calculation to verify that the sum of the debits equals the sum of the credits. If they dont balance, you have to fix the unbalanced trial balance before you go on to the rest of the accounting cycle. 6. Adjusting entries prepare and post accrued and deferred items to journals and ledger T-accounts. 7. Adjusted trial balance make sure the debits still equal the credits after making the period end adjustments. 8. Financial Statements prepare income statement, balance sheet, statement of retained earnings and statement of cash flows. 9. Closing entries prepare and post closing entries to transfer the balances from temporary accounts.
Cash flows

Cash flow is the movement of money into or out of a business, project or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation. Cash flow can be used, for example, for calculating parameters:

To determine a project's rate of return or value. The time that cash flows into and out of projects is used as inputs in financial models such as internal rate of return and net present value. To determine problems with a business's liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash even while profitable. To be used as an alternative measure of a business's profits when it is believed that accrual accounting concepts do not represent economic realities. To evaluate the 'quality' of income generated by accrual accounting. When net income is composed of large non-cash items it is considered low quality. To evaluate the risks within a financial product, e.g. matching cash requirements, evaluating default risk, re-investment requirements, etc.
Subsets of cash flow in a business's financials include:

Operational cash flows: Cash received or expended as a result of the company's internal business activities. It includes cash earnings plus changes to working capital. Over the medium term, this must be net positive if the company is to remain solvent.

Investment cash flows: Cash received from the sale of long-life assets, or spent on capital expenditure (investments, acquisitions and long-life assets). Financing cash flows: Cash received from the issue of debt and equity, or paid out as dividends, share repurchases or debt repayments. Cash flow is a generic term used differently depending on the context. It may be defined by users for their own purposes. It can refer to actual past flows or projected future flows. It can refer to the total of all flows involved or a subset of those. Figure 2

Interest
Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the amount borrowed per period of time, usually one year. The prevailing market rate is composed of: 1. The Real Rate of Interest that compensates lenders for postponing their own spending during the term of the loan. 2. An Inflation Premium to offset the possibility that inflation may erode the value of the money during the term of the loan. A unit of money (dollar, peso, etc) will purchase progressively fewer goods and services during a period of inflation, so the lender must increase the interest rate to compensate for that loss.. 3. Various Risk Premiums to compensate the lender for risky loans such as those that are unsecured, made to borrowers with questionable credit ratings, or illiquid loans that the lender may not be able to readily resell. The first two components of the interest rate listed above, the real rate of interest and an inflation premium, collectively are referred to as the nominal risk-free rate. In the USA, the nominal risk-free rate can be approximated by the rate of US Treasury bills since they are generally considered to have a very small risk.

Simple Interest
Simple interest is calculated on the original principal only. Accumulated interest from prior periods is not used in calculations for the following periods. Simple interest is normally used for a single period of less than a year, such as 30 or 60 days.
Simple Interest = p * i * n

where: p = principal (original amount borrowed or loaned) i = interest rate for one period n = number of periods Example: You borrow $10,000 for 3 years at 5% simple annual interest. interest = p * i * n = 10,000 * .05 * 3 = 1,500 Example 2: You borrow $10,000 for 60 days at 5% simple interest per year (assume a 365 day year). interest = p * i * n = 10,000 * .05 * (60/365) = 82.1917

Compound Interest
Compound interest is calculated each period on the original principal and all interest accumulated during past periods. Although the interest may be stated as a yearly rate, the compounding periods can be yearly, semiannually, quarterly, or even continuously. You can think of compound interest as a series of back-to-back simple interest contracts. The interest earned in each period is added to the principal of the previous period to become the principal for the next period. For example, you borrow $10,000 for three years at 5% annual interest compounded annually: interest year 1 = p * i * n = 10,000 * .05 * 1 = 500 interest year 2 = (p2 = p1 + i1) * i * n = (10,000 + 500) * .05 * 1 = 525 interest year 3 = (p3 = p2 + i2) * i * n = (10,500 + 525) *.05 * 1 = 551.25 Total interest earned over the three years = 500 + 525 + 551.25 = 1,576.25. Compare this to 1,500 earned over the same number of years using simple interest. The power of compounding can have an astonishing effect on the accumulation of wealth. This table shows the results of making a one-time investment of $10,000 for 30 years using 12% simple interest, and 12% interest compounded yearly and quarterly.
Type of Interest Principal Plus Interest Earned

Simple Compounded Yearly Compounded Quarterly

46,000.00 299,599.22 347,109.87

You can solve a variety of compounding problems including leases, loans, mortgages, and annuities by using the present value, future value, present value of an annuity, and future value of an annuity formulas. See the index page to determine which of these is appropriate for your situation.

Rate of Return
When we know the Present Value (amount today), Future Value (amount to which the investment will grow), and Number of Periods, we can calculate the rate of return with this formula:
i = ( FV / PV) (1/n) -1

In the table above we said that the Present Value is $10,000, the Future Value is $299,599.22, and there are 30 periods. Confirm that the annual compound interest rate is 12%. FV = 299,599.22 PV = 10,000 n = 30 i = (299,599.22 / 10,000) 1/30 - 1 = 29.959922 .0333 - 1 = .12

Effective Rate (Effective Yield)

The effective rate is the actual rate that you earn on an investment or pay on a loan after the effects of compounding frequency are considered. To make a fair comparison between two interest rates when different compounding periods are used,

you should first convert both nominal (or stated) rates to their equivalent effective rates so the effects of compounding can be clearly seen. The effective rate of an investment will always be higher than the nominal or stated interest rate when interest is compounded more than once per year. As the number of compounding periods increases, the difference between the nominal and effective rates will also increase. To convert a nominal rate to an equivalent effective rate:
Effective Rate = (1 + (i / n))n - 1

Where: i = Nominal or stated interest rate n = Number of compounding periods per year Example: What effective rate will a stated annual rate of 6% yield when compounded semiannually? Effective Rate = ( 1 + .06 / 2 )2 - 1 = .0609

Interest Rate in Calculations

Time Value of Money calculations always use compound interest. You must adjust the interest rate and the number of periods to be consistent with compounding periods. For example a 6% interest rate compounded semiannually for five years should be entered 3% (6 / 2) for 10 (5 * 2) periods. A calculator expects a 6% interest rate to be entered as the whole number 6 whereas formulas typically use a decimal value of .06.

When analyzing a loan or an investment, it can be difficult to get a clear picture of the loan's true cost or the investment's true yield. There are several different terms used to describe the interest rate or yield on a loan, including annual percentage yield, annual percentage rate, effective rate, nominal rate, and more. Of these, the effective interest rate is perhaps the most useful, giving a relatively complete picture of the true cost of borrowing. To calculate the

effective interest rate on a loan, you will need to understand the loan's stated terms and perform a simple calculation.