Importance Of Cash Budget, Contribution Margin Ratio And Net Present Value In Financial Decision Making

Cash Budget

The financial budget made to calculate budget cash inflows and cash outflows for a specific period of time is known as cash budget. With the help of cash budget, the closing balance of cash can also be ascertained. It helps in determining excessive cash or shortage of cash that is expected during the period (Weygandt, Kimmel and Kieso, 2009). By preparing cash budget and making the use of information derived from it, managers can take decisions accordingly. Such as, if there are chances of cash shortage in future, then managers can take steps accordingly like changing the credit policy. Similarly, if excessive cash will be there then, plans like making investments and repayments can be made (Crosson and Needles, 2013). Cash budget of Student Enterprises for the quarter ending 31 March 2018 is as follows:

Cash Budget
For the Quarter ending 31 March 2018
	Quarter 1
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Beginning cash balance	79,550
Add: cash receipts
Cash Sales	162,624
Receipts from accounts receivables	145,640
Receipt of loan	28,500
Total receipts	336,764
Less: Cash payments
Office furniture purchased	27,176
Administrative expenses	24,816
Wages	85,020
Prepayments	9,295
Payments of accounts payable	93,104
Total cash payments	239,411
Cash surplus/(deficit)	97,353
Closing cash balance	176,903

2. The difference between total sales and total variable cost is known as contribution. The contribution then divided by sales and expressed as a percentage, is known as contribution margin ratio. The total margin generated is basically the total earnings made by an enterprise used to pay fixed expenses and earn profits (Heisinger, 2009). The margin should be high and must be sufficient to cover all the fixed costs and administrative overheads. The method can be used in determining the selling price in specific situations. It can also be useful in identifying the impact on profits due to changes in sales (Rajasekaran, 2010). Formula for calculating contribution margin ratio is:

Contribution Margin = (Sales-Variable costs) ÷ Sales 

Part A

Contribution margin ratio for Printers

Particulars	Printers
	$
Contribution (Sales-variable cost)	836,000
Sales	3,096,000
Contribution margin ratio	27.00

Contribution margin ratio for faxes

Particulars	Faxes
	$
Contribution (Sales-variable cost)	530,000
Sales	1,595,000
Contribution margin ratio	33.23

Contribution margin ratio in total

Particulars	Total
	$
Contribution (Sales-variable cost)	1,366,000
Sales	4,691,000
Contribution margin ratio	29.12

Break even sales is that amount of revenue at which a firm earns zero profit. The point where the sales and total cost are same. BEP sales exactly covers the basic fixed cost of the business including all the variable costs associated with the sales. It is useful for the managers as it gives an idea about the break even sales level, at which minimum sales are required to be generated during a period in order to avoid the losses (Rich, et.al. 2011). To calculate BEP sales, following formula is used:

BEP sales = Fixed costs ÷ Average contribution margin ratio

Particulars	Total
	$
Fixed costs
Direct Fixed costs	770,000
Common Fixed Costs	202,000
Total contribution margin ratio	29.12
Break even Sales	3,337,959.00

Student Industries sells IT equipment, specialising in printers and Faxes. The break even sales for the company is $3,337,959. It is calculated by dividing the total of direct fixed costs and common fixed costs with total contribution margin ratio. This BEP sale will be apportioned to each of the item in their sales ratio respectively. The sales ratio of printers and faxes is 0.66 and 0.34 respectively.

Contribution Margin Ratio

For Printers, BEP sales is $2,203,010.25 which means the management is required to generate this much of sales in order to cover the fixed cost associated with this product.

For faxes, BEP sales is $1,134,948.76 that is required to made by the management during the given period of time, for covering up all the fixed costs associated with the product.

Particulars	Printers	Faxes
Sales	3,096,000	1,595,000
Total Sales	4,691,000	4,691,000
Sales ratio	0.66	0.34
Break even sales	2,203,010.25	1,134,948.76
Total Break even sales	3,337,959.00	3,337,959.00

3. Net present value method which is also known as discounted cash flow method is most commonly used capital budgeting technique used to determine the profitability of an investment proposal. The method takes into account the time value of money and provides a basis to take decision regarding accepting or rejecting a particular project. NPV is a simple accounting difference between the present values of cash inflow and present values of cash outflow. It may be positive, negative and zero. Generally, a project having high NPV is considered to be more desirable (Bierman and Smidt, 2012).

NPV being positive

When the PV of cash inflows are greater than PV of cash outflows, then net present value will be positive and it will be okay to accept the project (Baker and English, 2011).

If the PV of cash outflow is greater than PV of cash inflows, then NPV is said to be negative. It will be better to avoid making investment in the project having negative NPV

NPV is said to be zero when the cash inflows are equal to cash outflows. This will be a no profit situation and the company can accept or reject the proposal.

Part A

Calculation of NPV at rate of 11%  

Years	Cash inflows	[email protected]%	Present values
0	-124,000	1	-124000
1	54,600	0.900900901	49,189.19
2	49,600	0.811622433	40,256.47
3	44,600	0.731191381	32,611.14
4	52100	0.658730974	34,319.88
		NPV ($)	32,376.68

Part B

Calculation of NPV at rate of 15%   

Years	Cash inflows	[email protected]%	Present values
0	-124,000	1	-124000
1	54,600	0.869565217	47,478.26
2	49,600	0.756143667	37,504.73
3	44,600	0.657516232	29,325.22
4	52100	0.571753246	29,788.34
		NPV ($)	20,096.55

The above parts A and B shows the calculations of Net present value of a project at different rates of return. If the funds are earned at the rate of 11%, then NPV will be $32,376.68 and if the funds are earned at rate of 15%, then NPV will be $20,096.55. Both the NPVs are positive and the company can invest in purchasing the machine. As it is said that, project with high NPV will be more desirable to be accepted so at rate of 11%, NPV is more as compare to that of at 15%. Hence, it is advisable to the company to use funds in purchase of the machine and earning the return at 11%.

Part D

Years	Cash inflows	Cumulative Cash inflow
0	-124,000
1	54,600	54,600
2	49,600	104,200
3	44,600	148,800
4	52100	200,900
	Payback period	2.38

The payback period is known as the time taken by an investment proposal in recouping the initial investment. It is another technique of capital budgeting used for evaluating investment proposals. If the project take much longer to recover the initial outlay, then it will be better to reject the proposal. Similarly, if the payback period is shorter that means the project is able to recover the outflow faster and should be accepted (Damodaran, 2010).In part D, undiscounted payback period is calculated which is 2.38 years. This is more than the required payback period of two years. On the basis of this, it is advisable to the management to ignore the investment in this project as the period is higher than the required one.

But the calculated payback period is undiscounted and is not reliable. If discounted one is calculated, then it will be within the requirements and company can invest in this project. As the project have positive and high NPV and the discounted payback period will be as per the requirements, then it will be advisable that management must invest in this proposal.

References

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2009. Managerial accounting: Tools for business decision making. John Wiley & Sons.

Baker, H.K. and English, P., 2011. Capital budgeting valuation: Financial analysis for today’s investment projects (Vol. 13). John Wiley & Sons.

Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge

Crosson, S.V. and Needles, B.E., 2013. Managerial accounting. Cengage Learning.

Damodaran, A., 2010. Applied corporate finance. John Wiley & Sons.

Heisinger, K., 2009. Essentials of managerial accounting. Cengage Learning.

Rajasekaran, V., 2010. Cost Accounting. Pearson Education India.

Rich, J., Jones, J., Heitger, D.L., Mowen, M. and Hansen, D., 2011. Cornerstones of Financial and Managerial Accounting. Cengage Learning.