BUDGETING ANALYSIS

Ronald W. Spahr

Professor and Chair, Department of Finance, Insurance and Real Estate Fogelman College of Business and Economics

University of Memphis, Memphis, TN 38152-3120

Office phone: (901) 678-1747 or 5930, Fax: (901) 678-0839

spahr@memphis.edu

January 10, 2011

FINANCIAL FORECASTING AND CAPITAL

BUDGETING ANALYSIS

Course Description

This course covers fundamental concepts and techniques of financial forecasting and financial analysis including time value of money, cost of capital, capital investment decisions, product costing and lease-buy analysis.

Course Outline

I.Time Value of Money ....................................................................................4

A.Present Value and Future Value

1. Discrete Compounding

2. Compound Interest Tables

3.Continuous Compounding

4.Effective Annual Rate

5.Calculations Involving Fractional Years

B.Annuities

1.Ordinary Annuities (Annuities in Arrears)

2.Annuities Due

3.Deferred Annuities

4.Continuous Payment Annuities

5.Perpetuities

6.Calculations Involving Fractional Years

7. Amortization Schedules

II. Break-Even Analysis and Financial Forecasting 20

III.Cost of Capital........................................................................................23

A.Component Costs

B. Concept of Weighted Average Cost of Capital (WACC)

IV.Capital Budgeting....................................................................................31

A.Definitions

1.Conventional vs. Nonconventional Cash Flows

2.Independent, Mutually Exclusive, Contingent, Competitive

and Complementary Projects

B.Decision Rules for Project Evaluation/Comparison

1.Net Present Value (NPV)

3. Payback Period

C.Estimation of Cash Flows

1.Incremental Cash Flows

2.Sunk Costs

3.Opportunity Costs

4.After-Tax Cash Flows

5.Financing Costs

6. Inflation: Real vs. Nominal Cash Flows

D. Annual Equivalent Cost

1. Capital Recovery Cost

E.Product Costing

1.Level Production

V. Lease versus Purchase Decision55

I. TIME VALUE OF MONEY

PRESENT VALUE AND FUTURE VALUE

Methods of computing interest:

1. simple interest: you do not earn interest on your interest

2. compound interest: you do earn interest on your interest

Example:You deposit $100 in a bank account. Compute the account balance after three years assuming:

a.8% simple interest

Year BOY BalanceInterestEOY Balance

1$100.00 $8.00 $108.00

2$108.00 $8.00 $116.00

3$116.00 $8.00 $124.00

b.8% interest compounded annually

Year BOY BalanceInterestEOY Balance

1$100.00 $8.00 $108.00

2$108.00 $8.64 $116.64

3$116.64 $9.33 $125.97

c.8% interest compounded quarterly

Qtr BOQ BalanceInterestEOQ Balance

1$100.00 $2.00 $102.00

2$102.00 $2.04 $104.04

3$104.04 $2.08 $106.12

....

....

....

12$124.34 $2.49 $126.83

Computing Future Value (FV) of a Lump Sum Under Annual Compounding

notation:r = nominal annual interest rate

basic principle:Think of the term (1+r) as a multiplicative growth factor; i.e., each year the account balance grows by a multiplicative factor of (1+r); this implies that over an n-year period the account balance grows by a factor of (1+r)n.

FV formula:Let C denote a single lump sum cash flow in dollars; the future value after n years is: FV = C(1+r)n

t=0 n=(years)

________________________

C t

FV = C(1+r)n

Computing Present Value (PV) of a...