Baker, J.J. & Baker, R.W., Budgets

Static budgets are used to make sales, revenue, and expense forecasts for companies with predictable expense and sales patterns. Expense and revenue figures in static budgets do not change, regardless of the actual level of activity. Very often, therefore, there are deviations between actual amounts and budgeted amounts — this difference is referred to as static budget variance.

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In this case: budgeted sales (output) = 25,000 (2500 @ \$10)

Actual sales (output) = (24,550) (2445 @ \$10)

Static budget variance = \$450

Net revenues = actual procedures done x budgeted cost

= \$24,550

Net expenses = \$1.85x 2455

= \$4,546

Revenues — expenses = \$24,550 – \$4,546

= \$20,004

Part Two

There are four major methods of reporting cash flows and evaluating the profitability of capital projects:

The Payback Method: this technique determines the profitability of a project based on the amount of time it would take to generate adequate cash flows to recoup the initial investment cost. The shorter the amount of time taken to recover the same, the more profitable a project is (Graham & Smart, 2011).

The Average Rate of Return: the ARR determines a project’s viability by totaling its generated cash flows over the years of investment, and dividing the same by the number of years.

The Net Present Value: this technique determines a project’s viability based on the discounted sum of cash flows generated from it over its life course (Finance Formulas, 2014). A positive NPV indicates that a project is profitable and should be adopted; moreover, the higher the NPV, the more profitable a project is.

The Internal Rate of Return: the IRR is used to compare competing capital projects. It is defined as the discount rate at which NPV is equal to zero. The higher the level of IRR yielded by a project, the more profitable it is.

The net present value (NPV) technique is most appropriate for this scenario, given that no comparisons are being made to choose the best out of multiple alternatives. The NPV calculation has been presented in the table below.

NPV = sum of discounted net cash flows — initial cost of investment

PV Year 1 = 500,000/(1.05) = \$476, 190

PV year 2 = 500,000/(1.052) = \$453,515

PV year 3 = 500,000/(1.053) = \$431,919

PV year 4 = 500,000/(1.054) = \$411, 351

PV year 5 = 500,000/(1.055) = \$391, 763

Salvage value at the end of year 5: \$1,500,000 – \$100,000 (salvage value at the end of year 10)

= \$1,400,000

Depreciation per year = \$1,400,000/10 = \$140,000

Accumulated depreciation at the end of year 5 = \$140,000 x 5 = \$700,000

Salvage value at the end of year 5 = \$1,500,000 – \$700,000 = \$800,000

Present value of salvage value at the end of year 5 = \$800,000/(1.055) = \$626, 821

year 1

year 2

year 3

year 4

year 5

Net cash flows

500,000

500,000

500,000

500,000

500,000

Present value (PV)

476, 190

453,515

431,919

411,351

391,763

Total PV (year 1 to 5)

476, 190

929, 705

1,316,624

1,772,975

2,164,758

PV of salvage value

626,821

Subtotal 2,791,559

NPV = -\$2,000,000 + \$2,791,559

= \$791,559

Interpretation: the MRI project yields a positive net present value, implying that it is a viable investment opportunity, and the company ought to adopt it.

References

Finance Formulas. (2014). Net Present Value. Finance Formulas. Retrieved 1 October 2014 from http://www.financeformulas.net/Net_Present_Value.html

Graham, J. & Scott, S. (2011). Introduction to Corporate Finance: What Companies Do (3rd ed.).Mason, OH: Cengage Learning.