CPA Training Video | Capital Budgeting | BEC | By Varun Jain
Miles Education - CPA, CMA, CFA
In this section, we will be discussing capital budgeting and how we can invest our capital by
looking at the potential future cash flows from the investment. It's important to consider the
time value of money, so let's start with the basics of present value, which we covered in
chapter four. For example, let's say I offer you $100 now and $100 a year later.The present
value is the value of money flowing in after a period of time. $100 up to three years is worth
$75 today. The present value of $100 flowing in after one year is worth $91 today. The future
value of $91 today is $100 after one year. Cash flows over five years are worth $379 today.
The present value of an ordinary annuity of $1 for five years at 10% is $3.79, something we
can find in a present value of an annuity table. The effective present value is $3.79, which
we can then multiply by $100.
In an ordinary annuity, we calculate the present value of a cash flow that comes in after a
year. For example, if we had $100 coming in after year one, the present value would be
$0.91.However, in an annuity due or an immediate annuity, the money comes in at the
beginning of the period. The present value of an annuity is the present value of a dollar one
after a certain period of time at a certain interest rate. We use this concept to understand
bonds, leases, pensions, and other series of cash flows.When payments are made at the
beginning of each period, we call it an annuity due. On page twelve, we're looking at the
present value of an annuity in arrears. So, if it's an annuity that is only for one year with a
single cash flow at ten percent, the present value is 0.909.
We are not interested in accounting profit, rather we are interested in cash flows. Let's
consider an example:If sales are $1,000 and expenses, excluding depreciation, interest, and
taxes, are $600, then we need to compare the present value of cash outflows with the
present value of all cash inflows that will occur over the years.Depreciation is not a cash
outflow. It is a non-cash expense. Therefore, if Earnings before interest, taxes, depreciation,
and amortization (EBITDA) is $350, then we focus on cash flows, not accounting
income.Thus, we need to calculate taxes on $350 at 30%. The result is $105, which gives us
Earnings after tax (EAT) of $245.
When it comes to capital budgeting, there are four techniques that are usually considered:
Right investment plus increase in working capital Right disposal of assets plus recovery of
working capital Discounted payback method (to cover up for the disadvantage of the other
two methods) Loess three years people easy method (which gives a good starting point on
how good the investment is). The discounted payback method is often used to account for
time value. The simple formula highlights the initial investment divided by after-tax net cash
inflows to give an estimate of how long it would take to get back the initial investment. This
method is easy to use but can be modified for more accurate results. For example, in some
cases, the cash flow may be the same every year, allowing for a more straightforward
Miles Education - CPA, CMA, CFA
In this section, we will be discussing capital budgeting and how we can invest our capital by
looking at the potential future cash flows from the investment. It's important to consider the
time value of money, so let's start with the basics of present value, which we covered in
chapter four. For example, let's say I offer you $100 now and $100 a year later.The present
value is the value of money flowing in after a period of time. $100 up to three years is worth
$75 today. The present value of $100 flowing in after one year is worth $91 today. The future
value of $91 today is $100 after one year. Cash flows over five years are worth $379 today.
The present value of an ordinary annuity of $1 for five years at 10% is $3.79, something we
can find in a present value of an annuity table. The effective present value is $3.79, which
we can then multiply by $100.
In an ordinary annuity, we calculate the present value of a cash flow that comes in after a
year. For example, if we had $100 coming in after year one, the present value would be
$0.91.However, in an annuity due or an immediate annuity, the money comes in at the
beginning of the period. The present value of an annuity is the present value of a dollar one
after a certain period of time at a certain interest rate. We use this concept to understand
bonds, leases, pensions, and other series of cash flows.When payments are made at the
beginning of each period, we call it an annuity due. On page twelve, we're looking at the
present value of an annuity in arrears. So, if it's an annuity that is only for one year with a
single cash flow at ten percent, the present value is 0.909.
We are not interested in accounting profit, rather we are interested in cash flows. Let's
consider an example:If sales are $1,000 and expenses, excluding depreciation, interest, and
taxes, are $600, then we need to compare the present value of cash outflows with the
present value of all cash inflows that will occur over the years.Depreciation is not a cash
outflow. It is a non-cash expense. Therefore, if Earnings before interest, taxes, depreciation,
and amortization (EBITDA) is $350, then we focus on cash flows, not accounting
income.Thus, we need to calculate taxes on $350 at 30%. The result is $105, which gives us
Earnings after tax (EAT) of $245.
When it comes to capital budgeting, there are four techniques that are usually considered:
Right investment plus increase in working capital Right disposal of assets plus recovery of
working capital Discounted payback method (to cover up for the disadvantage of the other
two methods) Loess three years people easy method (which gives a good starting point on
how good the investment is). The discounted payback method is often used to account for
time value. The simple formula highlights the initial investment divided by after-tax net cash
inflows to give an estimate of how long it would take to get back the initial investment. This
method is easy to use but can be modified for more accurate results. For example, in some
cases, the cash flow may be the same every year, allowing for a more straightforward
