THE BASICS OF FINANCIAL
MANAGEMENT
Rien Brouwers MSc. & Wim Koetzier MSc.
Third Edition | Noordhoff Uitgevers
Part 2 Finance
Chapters 5-9
IMPORTANT:
Grey text is not a requirement to learn for the MAN5 Exam (BUas)
, 5 Capital budgeting
5.1 Capital budgeting and cash flow
- Capital budgeting = investing of capital in assets – focused on size and composition
- New investment plan: consider possibility, profitability, possible contribution and business
objectives
Only after decision to execute the plan, method of financing should be investigated
- Replacement investments = keep production capacity at the same level
- Expansion investments = increase production capacity
- When considering if an investment is useful, all additional investments should also be considered
- Investment project = sum of all related investments (fixed and current assets)
When executed: series of cash outflows – for purchases and replacements
Assessment project focused on cash flow: cash inflow should cover cash outflow
- Cash flow = difference between cash inflows and cash outflows (inflows minus outflows)
- Not focused on profit (sales minus costs) – since value of money can differ over time
Main difference profit/cash flow: costs that do not result in cash outflows (e.g. depreciation)
- Time value of money = money available at the present is worth more than the money in the future
- Opportunity costs = missing revenue due to receiving money later
- Weighted average cost of capital = average cost at which a company can attract capital
Determines time preference, investment must be equal to weighted average cost of capital
- Disinvestment: capital invested in assets that becomes available, often the residual value
Creates extra cash flow in the last year of the investment project
- Cash flow = Period profit after tax + depreciation – investments + disinvestments
Must be sufficient to meet obligations to capital providers, pay dividend and interest creditors
5.2 Assessment based on period profit
- Profitability = profit divided by average invested capital
Differs per year, investment project: average profit / average invested capital of whole period
Average invested capital = (initial invested capital + residue value at end) / 2
- Accounting rate of return (ARR) = calculated profitability of an investment project
Must be larger than the weighted average cost of capital – the higher, the better
5.3 Assessment based on cash flow
- Payback period = duration of earning back the investment: cash outflow + cash inflow = 0
In years/months/weeks/days – the shorter, the better
Only considers the time value of money in a limited way, does not consider profitability
Focused on liquidity and easy to calculate
5.4 Assessment based on cash flow, considering time value of money
1) Financial arithmetic = to compare different moments in time, using interest calculations
- Simple interest = interest calculated on the original amount, no interest on interest itself
- Compound interest = calculated on the original amount and on interest already due
- Future value = the value of capital at a future moment (e.g. original amount + interest after # years)
- Present value = current value of amount due in the future ( € 45,286.54
)
Discount rate: interest rate used to calculate a present value (1.02)
5
Want €50,000 in 5 years, 2% compound interest: € 50,000/1.02 =€ 45,286.54
2) Net present value method = calculates the net present value of the expected cash flows
MANAGEMENT
Rien Brouwers MSc. & Wim Koetzier MSc.
Third Edition | Noordhoff Uitgevers
Part 2 Finance
Chapters 5-9
IMPORTANT:
Grey text is not a requirement to learn for the MAN5 Exam (BUas)
, 5 Capital budgeting
5.1 Capital budgeting and cash flow
- Capital budgeting = investing of capital in assets – focused on size and composition
- New investment plan: consider possibility, profitability, possible contribution and business
objectives
Only after decision to execute the plan, method of financing should be investigated
- Replacement investments = keep production capacity at the same level
- Expansion investments = increase production capacity
- When considering if an investment is useful, all additional investments should also be considered
- Investment project = sum of all related investments (fixed and current assets)
When executed: series of cash outflows – for purchases and replacements
Assessment project focused on cash flow: cash inflow should cover cash outflow
- Cash flow = difference between cash inflows and cash outflows (inflows minus outflows)
- Not focused on profit (sales minus costs) – since value of money can differ over time
Main difference profit/cash flow: costs that do not result in cash outflows (e.g. depreciation)
- Time value of money = money available at the present is worth more than the money in the future
- Opportunity costs = missing revenue due to receiving money later
- Weighted average cost of capital = average cost at which a company can attract capital
Determines time preference, investment must be equal to weighted average cost of capital
- Disinvestment: capital invested in assets that becomes available, often the residual value
Creates extra cash flow in the last year of the investment project
- Cash flow = Period profit after tax + depreciation – investments + disinvestments
Must be sufficient to meet obligations to capital providers, pay dividend and interest creditors
5.2 Assessment based on period profit
- Profitability = profit divided by average invested capital
Differs per year, investment project: average profit / average invested capital of whole period
Average invested capital = (initial invested capital + residue value at end) / 2
- Accounting rate of return (ARR) = calculated profitability of an investment project
Must be larger than the weighted average cost of capital – the higher, the better
5.3 Assessment based on cash flow
- Payback period = duration of earning back the investment: cash outflow + cash inflow = 0
In years/months/weeks/days – the shorter, the better
Only considers the time value of money in a limited way, does not consider profitability
Focused on liquidity and easy to calculate
5.4 Assessment based on cash flow, considering time value of money
1) Financial arithmetic = to compare different moments in time, using interest calculations
- Simple interest = interest calculated on the original amount, no interest on interest itself
- Compound interest = calculated on the original amount and on interest already due
- Future value = the value of capital at a future moment (e.g. original amount + interest after # years)
- Present value = current value of amount due in the future ( € 45,286.54
)
Discount rate: interest rate used to calculate a present value (1.02)
5
Want €50,000 in 5 years, 2% compound interest: € 50,000/1.02 =€ 45,286.54
2) Net present value method = calculates the net present value of the expected cash flows
