FMA 101 Topic 9 – Capital Budgeting Cash Flows Assignment Answers

 

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FMA 101 LEARNING OUTCOMES

After completing this topic, you should be able to:

  • List and discuss the three major cash flow components.
  • Explain the meaning of relevant cash flows and distinguish between expansion versus replacement decisions, sunk costs and opportunity costs.
  • Determine the initial investment associated with a proposed capital expenditure taking into account all the relevant factors that determine the initial investment amount.
  • Identify and determine the relevant operating cash inflows associated with capital expenditure taking into account all the relevant factors that can influence the proposed capital expenditure.
  • Identify and determine the terminal cash flow associated with a proposed capital expenditure taking into account all the relevant factors that can influence the proposed capital expenditure.

 

READING FMA 101 Topic 9 :

Before continuing with this topic, please read the following:

  • Gitman et al. (2015: Chapter 11)

Please make sure that you also read this study guide carefully as it contains additional information that is not in the prescribed textbook.

 

The key concepts that you must focus on are:

  • relevant cash flows
  • the major cash flow components
  • expansion decisions versus replacement decisions
  • sunk costs and opportunity costs
  • international capital budgeting
  • foreign direct investments

 

 

CAPITAL BUDGETING

Capital budgeting refers to financial planning for the acquisition of capital assets in an organisation. Capital assets include land and buildings, purchasing, adding to or replacing equipment, furniture and fittings, vehicles, plant and machinery, computers, research and development to develop new products or services, investments in automation, robotics or artificial intelligence, mergers with other entities, acquisitions and similar capital expenditure opportunities.

 

The capital expenditure budget, also referred to as CAPEX, refers to the capital budget in organisations.

 

It is expected of you to understand the basic terminology used in the context of capital budgeting. You must be able to describe, define and distinguish between concepts such as:

  • relevant cash flows and incremental cash flows
  • the three major cash flow components (initial investment, operating cash flows and the terminal cash flow)
  • expansion decisions and replacement decisions
  • sunk costs and opportunity costs

You must be able to explain the importance of each of the above concepts for the capital investment decision.

 

 

THE RELEVANT CASH FLOWS

You must be able to explain what a relevant cash flow means and identify, describe and distinguish between the different categories of relevant cash flows that form part of the capital budget process.

 

You should take note of Figure 11.4 in the prescribed textbook that illustrates and explains the different categories of relevant cash flows and how they are calculated.

 

You should be able to explain the differences between expansion decisions and replacement decisions.

 

You need to study and understand how each of the three major cash flow components are determined in a replacement of assets scenario. The procedures are demonstrated in Figure 11.2 of the prescribed textbook.

 

You should be able to explain the differences between sunk costs and opportunity costs.

 

Students generally find it difficult to distinguish between sunk costs and opportunity costs. Study Example 11.1 in the prescribed textbook to overcome this challenge.

 

Exclude the section on international capital budgeting and long-term investments for purposes of assignments and preparation for examinations.

 

 

FINDING THE INITIAL INVESTMENT

The key concepts that you must focus on are:

  • the installed cost of a new asset
  • the after-tax proceeds from the sale of an asset
  • the tax value of an asset
  • basic tax rules relating to the sale of an asset
  • the change in net working capital

 

The purchase price of the new asset refers to the initial investment amount. Take note of the fact that the South African Revenue Service (SARS) has very definitive views as to what it deems to be the acquisition cost of an asset. It is, therefore, advisable to consider the initial investment amount in terms of what SARS allows, as taxation is also brought into play when doing capital expenditure budgeting.

 

The following paragraphs provide a summary of the views of SARS. Take note that you should reaffirm such views at the time of preparing capital budgets, as SARS might make changes from time to time.

 

The cost of an asset is the cost that in the opinion of the Commissioner (of Revenue) a person (or business) would have incurred on the direct acquisition of the asset, including the direct costs of installation or erection, had he acquired it under a cash transaction at arm’s length on the date the transaction for the acquisition was in fact concluded.

 

 

Under the same rule, finance charges incurred under a suspensive sale do not form part of the cost of an asset. Similarly, pre-production interest, interest on money borrowed to finance the acquisition of an asset prior to it being brought into use, may not be added to the value of the asset. The cost of installing or erecting an asset can include shipping and delivery charges for purposes of determining the cost of an asset.”

 

You must, therefore, make quite sure of the different cost aspects that are allowed to form part of the new asset as well as the old asset to be disposed of, should such a situation occur. The more accurate such costs are determined, the better the capital expenditure budget preparation and decision-making will be.

 

 

Table 11.1 in the prescribed textbook illustrates how the initial investment of an asset is calculated, taking into consideration:

  • the installed cost of a new asset
  • the after-tax proceeds from the sale of an existing asset
  • the tax effect on the sale of such an asset
  • any changes in working capital

 

You need to study Table 11.1 in the prescribed textbook very carefully to ensure that you will be able to determine the initial investment amount of a capital expenditure decision.

 

You also need to carefully study Example 11.2 in the prescribed textbook. This example demonstrates and explains how the tax value of an asset is calculated.

 

You need to study Example 11.3 and Tables 11.2 and 11.3 in the prescribed textbook very carefully. This example explains and demonstrates the tax treatment of the sale of an asset in terms of three different scenarios. These scenarios are:

  • selling the asset for more than its tax value
  • selling the asset for less than its tax value
  • selling the asset for its tax value

 

The changes that may take place in the net working capital of an entity because of the acquisition of any new assets and/or the disposal of any existing assets are critical considerations when making a capital expenditure. The manner in which any such changes in net working capital are determined is very well demonstrated and explained in Example 11.4 and Table 11.3 in the prescribed textbook. You need to study both the example and the content of the table very well to ensure that you will be able to determine changes in net working capital resulting from capital expenditure decisions.

 

Study Example 11.5 in the prescribed textbook carefully, as this example summarises and demonstrates how the initial investment amount is determined by taking into consideration the installed costs of a new asset, the proceeds from the sale of an existing asset and the changes occurring in the net working capital as a result of the acquisition of the new asset and the disposal of an existing asset.

 

 

FMA 101 FINDING THE OPERATING CASH INFLOWS

The key concepts that you must focus on are:

  • proceeds from the sale of an asset
  • taxes on the sale of an asset
  • changes in net working capital

 

The terminal cash flow component is the final component to be determined in the capital budgeting process. You must be able to calculate this amount in the case of a sale of assets or in the event that there is no asset to sell. You must also be able to calculate the effect of taxes (if applicable) on the terminal cash flow and the final terminal cash flow value of a capital item.

 

The procedure to determine the terminal cash flow at the end of the life of a project is thoroughly explained and illustrated in Table 11.8 in the prescribed textbook as well as in Example 11.8 in the prescribed textbook.

 

You must study both the content of the table and the information presented in the example very well to ensure that you are able to competently determine the terminal value of a project given the relevant data and information.

 

 

SUMMARISING THE RELEVANT CASH FLOWS

You must be able to prepare a cash flow analysis summary using a set of information provided and calculate the relevant cash flows that can be used for purposes of making a capital budget decision.

 

Refer to Examples 11.9 and 11.10 presented and demonstrated in the prescribed textbook as examples of how such a summary must be prepared and documented.

 

 

ADDITIONAL SOURCES TO ACCESS FMA 101 Topic 9

Access the following websites to broaden your understanding of capital budgeting cash flows in the context of financial management:

  • Cash flows in capital budgeting: https://youtu.be/D8IJKl8sGsM, accessed 5 March 2020.
  • https://youtu.be/X6HvKl             rLY, accessed 5 March 2020.

 

 

FMA 101 Topic 9 SELF-ASSESSMENT EXERCISES

At the end of this chapter, there is a series of different self-test problems, warm- up exercises, problems and a more comprehensive case study. You should attempt to answer these questions, perform the calculations and use them to practise and re-enforce your learning and understanding. You may submit any of your answers to the lecturer for assessment and feedback.

 

SBS also shares copies of previous exam papers with you during the semester. The questions in these exam papers are very good examples of what you are expected to know and be able to do having studied and mastered the content of chapter 11 of the prescribed textbook and having followed the guidance provided in this topic.

 

 

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