Grob Capital Budgeting with Financial Plans

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1 Grob Capital Budgeting with Financial Plans

2 Heinz Lothar Grob Capital Budgeting with Financial Plans An lntroduction SPRINGER FACHMEDIEN WIESBADEN GMBH

3 Heinz Lotbar Grob is professor of General Business Infonnatics at the University of Muenster, Gennany. His current research interests include Invesunent Controlling and Computer Assisted Learning. Translated from Gennan by Thomas D. Jeitschko Die Deutsche Bibliothek- CIP-Einheitsaufnahme Grob, Heinz Lotbar : Capital budgeting with financial plans : an introduction I Heinz Lothar Grob. [Aus dem Dt. von Thomas D. Jeitschko]. Einheitssacht.: Einführung in die Investitionsrechnung <engl.> ISBN ISBN (ebook) DOI / Copyright Springer Fachmedien Wiesbaden 1993 Originally published by Gabler Verlag, Wiesbaden in 1993 No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means: electronic, magnetic tape, mechanical, photocopying, recording or otherwise, without permission in writing from tl1e publisher. Word processing and Iayout: Carmen Sieking ISBN

4 Acknowledgements I would like to thank the many people who have assisted me in the development of this book. In particular, I thank Thomas D. Jeitschko for the translation from German. His care and his creativity, while treating the language with great ease, were very impressive. Many thanks to Stefan Kooths who has done the first groundwork and the last proof-reading. I am also grateful to Christian Treichel for developing the program (VOFI) with me. Meanwhile, VOFI is being used successfully in the USA. Also thanks to Jörg Henneböle for the editing work and to my secretary, Carmen Sicking, who always interpreted and typed the handwriting without complaint. Finally, I owe my thanks to the editor, Reinhold Roski, for his cooperation. H einz Lothar Grob

5 Preface Long-term decision making is a vitally important management task to an enterprise. Capital Budgeting serves as the methodical basis to quantify the monetary consequences of these decisions. "Introduction to Capital Budgeting with Financial Plans" deals with financial planning. The material thus brought forward competes with the traditional methods of capital budgeting such as present value, annuity, intemal rate of retum, or the payback period. Financial planning has a clear advantage in that all presumptions made to support the traditional methods are brought out into the open. The slogan could be: "Explicate the implications!" The advantage of the concept is that it can be easily elaborated, while still remaining simple to comprehend. This is done by applying a spreadsheet method: Visualization Of Financial lmplications - VOFI. The technique ist as old as calculations of interest on a day-to-day basis. Hence critical comments regarding difficult computations are outdated when working with visualized plans. The book is a fictitious case study. In an easily accessible linguistic style, the Faustian struggle of a manager and bis advisor is traced through the contemplation of an investment decision. The reader - who plays an active part in the case study - follows the path from the simplest static approaches to the more sophisticated time-adjusted techniques, and finally leams to appreciate the visualized (computeraided) financial plans which include taxes. While doing so, the reader not only leams the interpretive function of visualized plans in disclosing hidden assumptions of the traditional methods, but also gets to know them as an instrument of investment controlling in their own right - as do the other participants of the case study.

6 Contents 1 lntroduction to an Almost Emßess Case Study 1 2 Capital Budgeting of a Single Investment Project Conventional Methods of Capital Budgeting 5 VOFI-case section 1 Static vs. Time-adjusted Methods of Preinvestment Analysis 5 VOFI-case section 2 Estimation of Specific Data 9 VOFI-case section 3 Consolidation of the Series of Payments with the Help of Conventional Methods of Capital Budgeting 17 VOFI-case section 4 A Computer Program for Conventional Capital Budgeting 33 VOFI-case section 5 Transformation of the Series of Payments with Varying Payments into an Equivalent Series of Payments and Consolidating it to Conventional Target Figures 36 VOFI-case section 6 A Computer Program for Tabulating Annuity Factors, Present V alue of Annuity Factors, and Terminal Value of Annuity Factors 43 VOFI-case section 7 Mathematical Foundations of Static Profit Comparisons 44

7 2.2 The Method of Visualized Financial Planning Visualization of Financial Implications (VOFI) 50 VOFI-case section 8 First Encounter with VOFI Visualized Financial Plans as Models of Explication 62 VOFI-case section 9 lnterpreting Present Value 62 VOFI-case section 10 lnterpreting the Annuity 69 VOFI-case section 11 lnterpreting the Payback Period 73 VOFI-case section 12 A Special Property of the Constant Discount Rate 78 VOFI-case section 13 Interpreting the Interna! Rate of Return 80 VOFI-case section 14 The Philosopher's Folly 92 VOFI-case section 15 The Final Phenomenon Visualized Financial Plans as Decision Models 97 VOFI-case section 16 The Break-Through 97 VOFI-case section 17 Terminal Value and Initial Value with Manifold Conditions on the Financial Market 98

8 VOFI-case section 18 Concept of Withdrawal with Manifold Conditions on the Financial Markets VOFI for Determining Reference Nurobers 106 VOFI-case section 19 The VOFI-Payback Period 106 VOFI-case section 20 VOFI-Indices of Probability 109 VOFI-case section 21 Effective Interest on Loans 118 VOFI-case section 22 New Data on Loan Terms Capital Budgeting of Mutually Exclusive Projects Conventional Methods 124 VOFI-case section 23 Implications of the Present and Terminal Value Con~epts 124 VOFI-case section 24 Implications of the Annuity Method 128 VOFI-case section 25 Implications of the Interna! Rate of R.!turn Capital Budgeting with VOFI 140 VOFI-case section 26 Explicating through VOFI 140

9 4 Selected Topics of Capital Budgeting Interpretation the Discount Rate 142 VOFI-case section 27 Unmasking a Dazzling Parameter Visualization of Financial lmplications via Linear Programming 155 VOFI-case section 28 The LP-Wheel Optimizing the Operating Life 162 VOFI-case section 29 The New Decision Parameter The Problem of Uncertainty 179 VOFI-case section 30 Lowest-Price Limit 179 VOFI-case section 31 More Critical Values Visualization of Financial and Taxation Implications 188 VOFI-case section 32 From VOFI to the New & Improved VOFI: VOFATI 188 VOFI-case section 33 Graphie Presentation 197

10 6 Decision and Control 202 VOFI-case section 34 The Investment Decision 202 VOFI-case section 35 The Forecast Error 205 VOFI-case section 36 Capital Spending Control 212 VOFI-case section 37 The Software Decision 219 VOFI-case section 38 Another Decision 224 Appendices Bibliography Symbols Index

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