BUSINESS FINANCE

Quarter 3
Course Summary

Finance - the science and art of managing money; the study of how people and businesses
evaluate investments and raise capital to fund them.

Budgeting - the act of estimating revenue and expenses over a period of time.

Investments - come in many forms that will generate income or appreciate in the future.

Sources of Funds - people or institutions that will give us the money we need.

Three Basic Questions Addressed by the Study of Finance:

1. What long-term investments should the firm undertake? (capital budgeting decision)
2. How should the firm raise money to fund these investments? (capital structure decision)
3. How can the firm best manage its cash flows as they arise in its day-to-day operations?
(working capital management)

Three Forms of Business Organizations:

Sole Proprietorship - a business owned by a single individual who is entitled to all of the firm’s
profits and is also responsible for all of the firm’s debt. The sole proprietors typically raise money
by investing their own funds and by borrowing from a bank.
Partnership - A business owned by two or more people and operated for profit.
Corporation - An entity created by law owned by shareholders.

Privately-owned Corporations - Privately owned corporations are often owned by family

members whose stocks may not be offered to outsiders unless consent by the family members is
secured
Publicly-listed Companies - owned by unrelated investors and are traded in organized
exchanges like the Philippine Stock Exchange.

Wealth maximization - the overall objective of a shareholder; Shareholders’ wealth is measured

based on the current market price of the corporation’s stocks.

Factors that Influence Market Price

Profit - a measure of the financial performance of a company for a period of time.
Liquidity and leverage - the company’s management of the type and amount of assets and
liabilities that it will hold in the course of its operations.
Dividends - returns on an investment in the form of cash or other properties.

Financial management - deals with decisions that are supposed to maximize the value of
shareholders’ wealth; Managers of a corporation are responsible for making the decisions for the
company that would lead towards shareholders’ wealth maximization.

THE CORPORATE ORGANIZATION STRUCTURE

Shareholders - elect the Board of Directors (BOD). Each share held is equal to one voting right.
Since the BOD is elected by the shareholders, their responsibility is to carry out the objectives of
the shareholders otherwise, they would not have been elected in that position.
Board of Directors - the highest policy making body in a corporation. The board’s primary
responsibility is to ensure that the corporation is operating to serve the best interest of the
stockholders. The following are among the responsibilities of the board of directors:
- Setting policies on investments, capital structure and dividend policies.
- Approving company’s strategies, goals and budgets.
- Appointing and removing members of the top management including the president.
- Determining top management’s compensation.
- Approving the information and other disclosures reported in the financial statements
President (Chief Executive Officer) - The roles of a president in a corporation may vary from one
company to another. Among the responsibilities of a president are the following:
- Overseeing the operations of a company and ensuring that the strategies as approved
by the board are implemented as planned.
- Performing all areas of management: planning, organizing, staffing, directing and
controlling.
- Representing the company in professional, social, and civic activities.

The president cannot manage the company on his own, especially when the corporation has
become too big. To assist him are the vice presidents of different functional areas: finance,
marketing, production and administration. The VP for Finance (or CFO) has the following
functions:

- Financing
- Investing
- Operating
- Dividend Policies

Financing decisions - include making decisions on how to fund long term investments (such as
company expansions) and working capital which deals with the day-to-day operations of the
company (i.e., purchase of inventory, payment of operating expenses, etc.).
Capital structure - refers to how much of your total assets is financed by debt and how much is
financed by equity.
Investing – determining where to put your excess cash to make it more profitable; May either be
short-term or long-term
Operating decisions - deal with the daily operations of the company. The role of the VP for
finance is determining how to finance working capital accounts given two options: Short-term
sources are those that will be payable in at most 12 months, or long-term sources, or those that
mature in longer periods.
Dividend policies - determines when the company should declare cash dividends.

Financial Markets – organized forums in which the suppliers and users of various
types of funds can make transactions directly
Financial Institutions – intermediaries that channel the savings of individuals, businesses, and
governments into loans or investments
Private Placements - the sale of a new security directly to an investor or group of investors.
Public Offering - The sale of either bonds or stocks to the general public.
Financial Instruments – is a real or a virtual document representing a legal agreement involving
some sort-of monetary value; When a financial instrument is issued, it gives rise to a financial
asset on one hand and a financial liability or equity instrument on the other.

THE FINANCIAL SYSTEM

Debt Instruments - generally have fixed returns due to fixed interest rates. Examples are:
- Treasury Bonds and Treasury Bills are issued by the Philippine government. These bonds
and bills have usually low interest rates and have very low risk of default since the
government assures that these will be paid.
- Corporate Bonds are issued by publicly listed companies.
Equity instruments - generally have varied returns based on the performance of the issuing
company. Returns from equity instruments come from either dividends or stock price
appreciation. The following are types of equity instruments:
- Preferred Stock has priority over a common stock in terms of claims over the assets of a
company. This means that if a company were to be liquidated and its assets have to be
distributed, no asset will be distributed to common stockholders unless all the claims of
the preferred stockholders have been given. Moreover, preferred stockholders have also
priority over common stockholders in cash dividend declaration. Dividends to preferred
stockholders are usually in a fixed rate. No cash dividends will be given to common
stockholders unless all the dividends due to preferred stockholders are paid first.
- Holders of Common Stock on the other hand are the real owners of the company. If the
company’s growth is spurring, the common stockholders will benefit on the growth.
Moreover, during a profitable period for which a company may decide to declare
higher dividends, preferred stock will receive a fixed dividend rate while common
stockholders receive all the excess.

Primary Market - Financial market in which securities are initially issued; the only market in which
the issuer is directly involved in the transaction.
Public offering - The sale of either bonds or stocks to the general public.
Private placement - The sale of a new security directly to an investor or group of investors.
Secondary market - Financial market in which preowned securities (those that are not new
issues) are traded
Money market - A financial relationship created between suppliers and users of short-term funds.
Capital market - A market that enables suppliers and users of long-term funds to make
transactions.

FINANCIAL INSTITUTIONS
Commercial Banks - Individuals deposit funds at commercial banks, which use the deposited
funds to provide commercial loans to firms and personal loans to individuals, and purchase debt
securities issued by firms or government agencies.
Insurance Companies - Individuals purchase insurance (life, property and casualty, and health)
protection with insurance premiums. The insurance companies pool these payments and invest
the proceeds in various securities until the funds are needed to pay off claims by policyholders.
Mutual Funds - owned by investment companies which enable small investors to enjoy the
benefits of investing in a diversified portfolio of securities purchased on their behalf by
professional investment managers. When mutual funds use money from investors to invest in
newly issued debt or equity securities, they finance new investment by firms. Conversely, when
they invest in debt or equity securities already held by investors, they are transferring ownership
of the securities among investors.
Pension Funds - Financial institutions that receive payments from employees and invest the
proceeds on their behalf.
Other financial institutions include pension funds like Government Service Insurance System
(GSIS) and Social Security System (SSS), unit investment trust fund (UITF), investment banks, and
credit unions, among others.
Planning - an important aspect of the firm’s operations because it provides road maps for
guiding, coordinating, and controlling the firm’s actions to achieve its objectives; Management
planning is about setting the goals of the organization and identifying ways on how
to achieve them. The goal of maximizing shareholders’ wealth must always be put in mind.

The following criteria may be used for effective planning:

- Specific – target a specific area for improvement.
- Measurable – quantify or at least suggest an indicator of progress.
- Assignable – specify who will do it.
- Realistic – state what results can realistically be achieved, given available resources.
- Time-related – specify when the result(s) can be achieved.

There are two phases of financial planning. Financial planning starts with long term plans which
would then translate to short term plans.

Long-term financial plans

- These are a set of goals that lay out the overall direction of the company.
- A long-term financial plan is an integrated strategy that takes into account various
departments such as sales, production, marketing, and operations for the purpose of guiding
these departments towards strategic goals.
- Those long-term plans consider proposed outlays for fixed assets, research and development
activities, marketing and product development actions, capital structure, and major sources of
financing.
- Also included would be termination of existing projects, product lines, or lines of business;
repayment or retirement of outstanding debts; and any planned acquisitions

Short-term financial plans

Specify short-term financial actions and the anticipated impact of those actions. Part of short-
term financial plans include setting the sales forecast and other forms of operating and financial
data. This would then translate into operating budgets, the cash budget, and pro forma
financial statements

THE PLANNING PROCESS

1. Set goals or objectives - For corporations, long term and short-term objectives are usually
identified. These can be seen in the company’s vision and mission statements. The vision
 statement states where the company wants to be while the mission statement states the
plans on how to achieve the vision.
2. Identify Resources - Resources include production capacity, human resources who will
man the operations and financial resources.
3. Identify goal-related tasks
4. Establish responsibility centers for accountability and timeline
5. Establish the evaluation system for monitoring and controlling - For corporations, the
management must establish a mechanism which will allow plans to be monitored. This
can be done through quantified plans such as budgets and projected financial
statements. The management will then compare the actual results to the planned
budgets and projected financial statements. Any deviations from the budgets should be
investigated.
6. Determine contingency plans - Budgets and projected financial statements are
anchored on assumptions. If these assumptions do not become realities, management
must have alternative plans to minimize the adverse effects on the company

Long term goals - set the direction of the company

Short term goals - are the specific steps or actions that will ultimately reach the company’s long-
term goals

Sales Budget - The most important account in the financial statement in making a forecast is
sales since most of the expenses are correlated with sales. Given the importance of the sales
forecast, the financial manager must be able to support this figure with reasonable assumptions.
The following external and internal factors should be considered in forecasting sales:

If the sales budget is understated, there can be lost opportunities in the form of forgone sales. If it
is too optimistic, the management may decide to unnecessarily increase capacity or hire more
employees and end up with more inventories.

Production Budget - provides information regarding the number of units that should be
produced over a given accounting period based on expected sales and targeted level of
ending inventories.
Required production in units = Expected Sales + Target Ending Inventories – Beginning Inventories

Operations budget - refers to the variable and fixed costs needed to run the operations of the
company but are not directly attributable to the generation of sales.

Cash budget – or cash forecast, is a statement of the firm’s planned inflows and outflows of
cash. It is used by the firm to estimate its short-term cash requirements, with particular attention
being paid to planning for surplus cash and for cash shortages

STEPS IN FORMULATING THE CASH BUDGET

1. Identify how much would be collected in the cash budget period - Sales may be made
in cash or for credit; Cash sales are translated to cash at the point of sale while credit
sales are collected depending on the credit period.
2. Identify other receipts – Add these receipts to the collections from sales to get to total
receipts
3. From the Production Budget, identify how much of the purchases made will be paid by
the company on the cash budget period
4. From the operations budget, identify which expenses will be paid in cash during the cash
budget period.
5. Identify all other cash payments to be made - It is important to recognize that
depreciation and other noncash charges are NOT included in the cash budget
6. Match the receipts and disbursements on the periods they become collectible and
payable, respectively
7. Set a minimum required cash balance - This balance is maintained in case contingencies
arise
8. Evaluate the cash budget - If the net cash flow is above the minimum cash balance, the
company is in excess cash and may consider putting it in short term investments. If it is
below, the company should make a short-term borrowing during that period

Projected financial statements - a tool of the company to set an overall goal of what the
company’s performance and position will be for and as of the end of the year. It sets targets to
control and monitor the activities of the company.

The following reports may be forecasted:

‣ Projected Income Statement
‣ Projected Statement of Financial Position
‣ Projected Statement of Cash Flows

STEPS ON FINANCIAL STATEMENT PROJECTION

1. Forecast sales
2. Forecast Cost of Sales and Operating Expenses
Cost of sales - direct costs associated in the generation of sales
Operation costs - a mix of variable and fixed costs
3. Forecast Net Income and Retained Earnings - to forecast net income, interest expense
and income tax expense should also be considered using the relevant interest and tax
rates. Retained earnings is arrived at by adding projected net income to beginning
retained earnings then deducting dividends to be declared during the year
4. Determine balance sheet items that will vary with sales or whose balances will be highly
correlated to sales
 5. Determine payment schedule for loans
6. Check for other information
7. Determine external funds needed (EFN)
EFN = change in total assets – (change in total liabilities + total change in stockholders’
equity)
8. Determine how external funds needed may be financed

Working capital - the company’s investment in current assets such as cash, accounts receivable,
and inventories.

Net Working capital - the difference between current assets and current liabilities

Operating Cycle - the sum of days of inventory and days of receivables

Days of Inventory - or inventory conversion period or average age of inventories, is the average
number of days to sell its inventory

Days of Sales Outstanding (DSO) - the average time for the company to collect its receivables
Cash Conversion Cycle - also called the net operating cycle, is computed as the operating
cycle less days of payable; It is the length of time it takes for the initial cash outflows for goods
and services purchased (materials, labor, etc.) to be realized as cash inflows from sales (cash
sales and in the collection of receivables).

Days of Payables Outstanding (DPO) - the average number of days for the company to pay its
creditors

SUMMARY

the numerators of the turnovers needed for the computation of cash conversion
cycle are all Income Statement Accounts, while the denominators are all Average Balance
Sheet Accounts.

CORRELATION OF THE OPERATING CYCLE AND NUMBER OF DAYS

Working Capital Management - the administration and control of the company’s working
capital. The primary objective is to achieve a balance between profitability and risk.
THREE TYPES OF WORKING CAPITAL FINANCING POLICIES
1. Maturity-matching working capital financing policy - permanent working capital
requirements should be financed by long-term sources while temporary working capital
requirements should be financed by short-term sources of financing like short-term loans
from banks called working capital loans.
2. Aggressive working capital financing policy - some of the permanent working capital
requirements are financed by short-term sources of financing.
3. Conservative working capital financing policy - some of the temporary working capital
requirements are financed by long-term sources of financing

Permanent Working Capital - the minimum level of current assets required by a firm to carry-on its
business operations given its production capacity or relevant sales range
Temporary working capital - the excess of working capital over the permanent working capital
given its production capacity or relevant sales range

STRATEGIES IN MANAGING THE CASH CONVERSION CYCLE

1. Turn over inventory as quickly as possible without stockouts that result in lost sales
2. Efficiently manage the accounts receivable consistent with the company’s credit
policies and accelerate the collection of receivables
3. Manage mail, processing, and clearing time to reduce them when collecting from
customers and to increase them when paying suppliers
4. Pay accounts payable as slowly as possible without damaging the firm’s credit rating

Cash – the most liquid asset; an important account in the balance sheet that will affect the
liquidity, and solvency of a company. It is also the most vulnerable when it comes to theft,
therefore, a good internal control must be properly implemented to safeguard this asset

Reasons for Holding Cash

Primary Reasons
a. Transactional. This is the cash used for paying expenses such as salaries, utilities, rent and
taxes, among others.
b. Compensating balance. This is the cash held to meet bank requirements such as the minimum
cash balance you maintain for checking accounts and if you have existing loans, banks may
also
require a minimum amount of deposit with them.
- Secondary Reasons
a. Precautionary. This is the cash maintained for emergencies such as the additional cash you
keep during political and economic uncertainties.
b. Speculative. This refers to the cash held by the company to take advantage of opportunities

The Cash Budget

- The cash budget provides information regarding the company’s expected cash receipts and
disbursements over a given period.
- It is useful for identifying future funding requirements or excess cash within a given period. This
allows managers to find possible sources of financing if the cash budget shows cash shortage or
identify appropriate tenors for money market placements for excess cash.
- Normally, a cash budget is prepared for a one-year period broken down into smaller intervals
like months. This allows managers to see the seasonality of the business which affects the cash
flows.
Parts of a Cash Budget:
1. Cash Receipts - include all of a firm’s inflows of cash in a given financial period
2. Cash Disbursements - include all outlays of cash by the firm during a given financial
period

The firm’s net cash flow is found by subtracting the cash disbursements from cash receipts in
each period. Then we add beginning cash to the net cash flow to determine the ending cash
for each period. Finally, we subtract the desired minimum cash balance from ending cash to
find the required total financing or the excess cash balance. If the computed amount is
negative, the company needs financing. Otherwise, the company has excess cash.

Accounts receivable - spring out of the need to sell merchandise; The collectability of accounts
receivables depends largely on the quality of customers. The quality of customers depends on
the standards or credit policies set up and used by an organization.

Credit policies are an integral part of the credit evaluation and there are 5C’s used in credit
evaluation. These are:
Character –the willingness of the borrower to repay the loan
Capacity – a customer’s ability to generate cash flows
Collateral – security pledged for payment of the loan
Capital – a customer’s financial resources
Condition – current economic or business conditions

Inventory Management - involves the formulation and administration of plans and policies to
efficiently and satisfactorily meet production and merchandising requirements and minimize
costs relative to inventories

In a manufacturing company, there are three types of inventories:

Raw materials – these are purchased materials not yet put into production.
Work in process – these are goods and labor put into production but not yet finished.
Finished goods – these are goods put into production and finished. These are ready to be
sold.

ABC Analysis – A classification system used to control inventory wherein:

Inventories classified as “A” are high valued items which should be safeguarded the most.
B items, are average-cost items that should be safeguarded more than C items but not as much
as A items.
C items have low cost and is the least safeguarded.

Financing - To provide funding for a particular need

Possible fund sources for small businesses:

Equity Infusion from investors/business partners
Start-up capital from owner
Loan from a bank
Loan from other financial institutions, etc.
Loan from family members/friends, etc.

Debt Financing - borrowing money from lenders and not giving up ownership.
Equity Financing - the method of raising capital by selling company stock to investors
(stockholders) in exchange of ownership interests in the company.

Liquidity risk - refers to the inability of an investor to buy or sell an asset to avoid financial loss. It
also refers to the inability to meet obligations since assets are tied up with investments or
inventory.

Ratios such as the current ratio and quick ratio measure the institution’s liquidity. There should be
a balance between liquid funds and investments. Too high liquidity ratios will have opportunity
costs since these funds could have been invested to yield earnings. Too low liquidity ratios,
however, may cause the institution to default on payments should emergency situations arise.
Enough liquid assets should be available to meet short term obligations.

Sources of Short-term Funds

Suppliers Credit – refers to the extension of payment due date by suppliers.
Advances from stockholders or other owners – personal funds advanced by a stockholder to a
company that usually requires interest. These usually require little to no interest on advances,
especially if the owner is advancing funds to assist the company in sudden liquidity crisis. This
source, however, is depended on the availability of funds of an individual.
Credit cooperatives – provided lending services to its members. Members usually pay
contributions to the cooperative.
Banks – provides several loan products catering to different types of needs.
Credit Cards – just take note of the high interest rates on this source of funds.
Lending Companies – companies that are dedicated to lending. They usually charge higher
interest than banks but their credit requirements are more lenient compared to banks.
Pawnshops – provides funds in exchange for collateral, usually jewellery, or other items of value.
Informal lending sources (5/6)
Personal network

Factors to consider before availing of short-term funding

Cost (Interest)
• Informal lending sources like 5/6 may be the most expensive.
Availability of short-term funds
• Informal lending sources like 5/6 is most available because there are no formal
requirements to avail of the facility.
Risk
• Whatever the source of fund is, if the company defaults, the lenders may foreclose
some of the company’s properties or even the entire business itself to settle the loan.
Flexibility

• This pertains to the ability of the company to access funds.

• This financial flexibility can be influenced by:
• Nature of the Company’s business
• Leverage ratio
• Stability of operating cash flows
Restrictions (Debt covenants)
• Some lenders like banks may require a minimum deposit balance with their branch for
as long as the loans remain outstanding.
• The bank’s approval may also be secured before cash dividends can be declared.

Sources of Long-term Funds

Equity investors – these are the individuals/corporations which are issued common stock. They
share in the ownership of the company. There are also equity investors who do not have voting
rights in the company but have a share in dividends, usually a fixed percentage. These investors
are issued preferred stock. Holders of preferred shares are first to receive dividends than
common stock holders.
Internally generated funds – not all profits are distributed to stockholders. Most of the profits are
re-invested and used by companies to finance their needs.
Banks – they provide long-term loans, depending on the nature of the need. For example, a 5-
year to 10-year loan may be granted if the purpose of the loan is construction of an office
building.
Bonds – these are debt investments where an investor loans money to an entity which borrows
the funds.
Lending companies – they can also provide long-term loans.

Banks have a portfolio of products that cater to specific needs:

Auto Loan
Housing Loan
Credit Card Loan
Working Capital Loan

Banks are required to verify the identity of their customers to ensure that the funds will not be
used for illegal activities such as, but not limited to, money laundering and terrorist financing.

Importance of the Banking Industry

Provision of Credit and Liquidity – Banks provide credit facilities to borrowers which allow them to
address their liquidity concerns.
Risk Management Services – Banks provide advisory service on asset-liability management and
can also provide recommendations regarding the appropriate financing schemes for a
company’s funding requirement.
Money Remittance – Banks can act as conduits or intermediaries for money remittances.
Economic Development
Channel for Saving and Investment
Promotion of Entrepreneurship

Interest - the cost of holding money. It is the amount charged by the lenders to the
borrowers/users of money, and is usually paid at regular intervals

Simple Interest – the charging interest rate r based on a principal P over T number of years.
Interest = P x r x T

Compound Interest - the interest in the first compounding period is added on the principal

Compounding Frequency - the number of times interest is computed on a certain principal in

one year.

Effective Annual Rate - the actual interest actually paid or earned

Future Value - the amount to which an investment will grow after earning interest.

Present Value - the amount you have to invest today if you want to have a certain amount of
cash flow in the future.

Basic Patterns of Cash Flow

Single Amount (Lump Sum) - a single cash outflow is made and the total receipts will be at a
single future date.
Annuity - periodic stream of equal cash flow at equal time intervals (annually, monthly, etc.).
Ordinary annuity payments are made at the end of each period (usually annually) while for
annuity due, the cash flow occurs at the beginning of each period.
Mixed Stream - unequal periodic cash flows that reflect no particular pattern.

Future Value Formula (Ordinary Annuity):

Present Value Formula (Ordinary Annuity):

Loan - money lent at an interest rate for a certain period of time. Loans are normally secured
from different financial institutions, the most common of which, are banks.
Bond - a form of loan, but can be traded through Philippine Dealing and Exchange (PDEX)
System.

Present Value of a Bond - To calculate the present value or the price of a bond, we need to
combine both the present values of the face value and the annuity payments

When bonds are issued below the face or par value, they are said to be issued at a discount. A
discount occurs when the required rate of return is greater than the nominal rate of return.
When bonds are issued above par, they are said to be issued at a premium. It occurs when the
required rate (effective rate) is below the stated or nominal rate.

Effective Interest Amortization - distinguishes two types of interest rate, the nominal rate or the
stated rate and effective rate or the market rate. When the bond is sold at a discount, the
effective rate is higher than the nominal rate. On the other hand, when the bond is sold at a
premium, the effective rate is lower than the nominal rate.

Using this method, the amortization of bond discount or premium results in periodic interest
expense equal to a constant percentage of the carrying amount of the bonds.

Steps:
1. Calculate the bond interest expense by multiplying the carrying amount of the bonds at
the beginning of the interest period by the effective interest ate.
2. Calculate the bond interest paid (or accrued) by multiplying the face value of the bonds
by the contractual interest rate.
3. Calculate the amortization amount by determining the difference of (1) and (2).
4. Amortization of the discount or premium brings the carrying value/balance to equal the
face value of the bond upon maturity. Bond issue costs (direct loan expenses) are either
added to the carrying value of the bond/loan in case of a premium or subtracted from
the carrying value of the bond/loan in case of a discount.

Straight Line Amortization - provides for an equal amortization of bond premium of discount. The
procedure is simply to divide the amount of the bond premium or discount by the life of the
bonds to arrive at the periodic amortization

Capital Budgeting - The process of evaluating and selecting long-term investments that are
consistent with the firm’s goal of maximizing owners’ wealth.

Long-term investments - result in benefits to accrue to the company in excess of one year

Operating expenses - benefits the company only within the operating period

Capital Budgeting (Steps):

Investment Proposal - Proposals for capital expenditure come from different levels within a
business organization. These are submitted to the finance team for thorough analysis.
Review and Analysis - Financial personnel perform formal review and analysis to assess the
benefits and cost of the investment proposals. These personnel make use of several financial
tools which they see fit in evaluating the project.
Decision Making - Companies usually delegate capital expenditure decisions on the basis of
value limits. The analysis is presented to the proper approving body who will in turn make the
decision on whether to push through with the project or not.
Implementation - Release of funds and start of the project occurs after approval. Large
expenditures are usually released in phases.
Monitoring - Results are monitored and actual cost and benefits are compared with those that
were expected. Action may be required if deviations from the plan are significant in amount.

Required Rate of Return - the minimum expected yield investors require in order to select a
particular investment.
Independent projects - are those whose cash flows are independent of one another. The
acceptance of one project does not eliminate the others from further consideration.
Mutually-exclusive projects - are projects which serve the same function and therefore
compete with one another. The acceptance of one eliminates all other proposals that serve a
similar function from further consideration.

Capital Budgeting Approaches

Accept-Reject Approach - accepts projects which pass a certain criterion
Ranking Approach - the highest-ranking projects will be selected for implementation

Relevant cash flows - include the initial investment, cash inflows from income from the project,
and the expected terminal value of the project, or the expected value of the asset/project at
the end of its economic useful life

Capital Budgeting (Evaluation Techniques)

Payback - measures the amount of time, usually in years, to recover the initial investment.
Net Present Value (NPV) - considers the time value of money and it considers all the cash flows
during the life of the project including the terminal value.

NPV = Present value of cash inflows – present value of cash outflows

Internal Rate of Return (IRR) - the discount rate that equates the NPV of an investment to zero. If
this method is used for capital budgeting analysis, the project’s IRR is compared to the
company’s cost of capital. If the IRR is greater than the cost of capital, the project should be
accepted otherwise, it should be rejected.