Capital Budgeting Decison

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Revised Fall 2012

Key Terms and Concepts to Know
Basic Concepts  The statement of cash flows highlights the major activities that impact cash flows and hence, affect the overall cash balance.  Cash flows are important because they finance operations, pay bills, pay employees, pay dividends, repay loans and make investments.  The statement analyzes the changes in the non-cash balance sheet from the perspective of whether the changes provided or used cash. In other words, the analysis seeks to explain the change in the cash balance by looking at the changes in the other balance sheet account.  The term cash on the statement of cash flows refers broadly to both currency and cash equivalents such as certificates of deposit or money market instruments. Net income is not cash flow  Net income is revenues less expenses  Cash flows are the increases and decreases in the cash balance  Cash does not always flow in the same accounting period as revenue is earned and/or expenses are incurred. This is why accrual basis accounting uses accounts such as accounts receivable and accounts payable to account for the difference in timing between revenue or expanse and cash inflows or outflows. Organizing the statement of cash flows  The statement of cash flows is organized into three sections that report cash flows resulting from: o operating activities o investing activities o financing activities  The statement of cash flows also has a fourth section for analyzing cash. Cash Flows from Operating Activities: Direct vs. Indirect Methods  The section can be prepared using one of two methods: o Direct method o Indirect method.  The two methods will always report the same amount of net cash provided by operating activities.

Revised Fall 2012

Key Topics to Know
Statement Layout
The cash flow statement is consists of four sections: three sections which analyze the changes in the accounts other than cash during the period and one section which summarizes the activity in cash for the period:  Operating activities generate cash inflows and outflows related to revenue and expense transactions, i.e., net income. This section includes all of the income statement accounts as well as most current asset and current liability accounts.  Investing activities generate cash inflows and outflows related to acquiring or disposing of noncurrent assets such as property, plant, and equipment, long-term investments, and loans to another entity.  Financing activities generate cash inflows and outflows related to borrowing from and repaying principal to creditors and transactions with stockholders.  The fourth section is Cash which adds the net cash flows from each of the three activities sections to calculate the net change in cash for the period. The net change in cash is then added to the beginning balance for cash to determine the ending balance in cash which must match the balance for cash reported on the balance sheet. Example #1: For each of the following items, indicate whether it would appear in the operating, investing, or financing activities section of the statement of cash flows or is not reported in one of these three categories. Assume the indirect method is used for reporting. a) Revenue – expenses b) Collection of a cash dividend c) Payment of a dividend previously declared d) Purchase of land in exchange for a long-term note payable e) Issued common stock for cash f) Sale of equipment for cash g) Purchase of a patent for cash h) Sales of a short-term investment for cash i) Collection of an account receivable j) Issuance of a stock dividend Operating ________ ________ ________ Investing ________ ________ ________ Financing None ________ ________ ________ ________ ________ ________

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