There are three main components necessary for creating a cash budget.

They are:
1. Time period
2. Desired cash position
3. Estimated sales and expenses

1. Time Period
The first decision to make when preparing a cash budget is to decide the period of time for which
your budget will apply. That is, are you preparing a budget for the next three months, six months,
twelve months or some other period?
2. Cash Position
The amount of cash you wish to keep on hand will depend on the nature of your business, the
predictability of accounts receivable and the probability of fast-happening opportunities (or
unfortunate occurrences) that may require you to have a significant reserve of cash.
You may want to consider your cash reserve in terms of a certain number of days sales. Your
budgeting process will help you to determine if, at the end of the period, you have an adequate
cash reserve.
3. Estimated Sales and Expenses
The fundamental concept of a cash budget is estimating all future cash receipts and cash
expenditures that will take place during the time period. The most important estimate you will
make, however, is an estimate of sales. Once this is decided, the rest of the cash budget can fall
into place.
If an increase in sales of, for example, 10 percent, is desired and expected, various other accounts
must be adjusted in your budget. Raw materials, inventory and the costs of goods sold must be
revised to reflect the increase in sales. In addition, you must ask yourself if any additions need to
be made to selling or general and administrative expenses, or can the increased sales be handled
by current excess capacity? Also, how will the increase in sales affect payroll and overtime
expenditures?

Example of a Cash Budget

The following is an example of a cash budget for the 90 days provided below for the XYZ
Company.
CASH BUDGET FOR 90 DAYS
Beginning cash balance
Add:
Estimated collections on accounts receivable
Estimated cash sales
Deduct:
Estimated payments on accounts payable
Estimated cash expenses
Contractual payments on long-term debt
Quarterly dividend
Estimated ending cash balance

$ 320,000
750,000
250,000
$1,320,000
$ 800,000
150,000
150,000
50,000
$1,150,000
$ 170,000

Cost of capital:
a firm financial policy regarding the sources of finances it plans to use and the particular mix in
which they will be used governs its use of debt and equity financing cost of capital represents the
firms cost of financing and is the minimum rate of return that a project must earn to increase
firms values. The particular mixer of debt is equity thats the firm utilizes can impact the firms
cost of capital.
Cost of preferred stock: the cost of preferred stock (Kp) is the ratio of the preferred stock
dividend to the firms net proceeds from the sale of the preferred stock.
Cost of common stock: the cost of common stock is the return required on the stock by investors
in the market place. There are two forms of common stock financing.
Retained earning
New issues of common stock

Ke=di/po+ g

CAPM: capital asset pricing model (CAPM) provides a basis for determining the investor
expected or required rate of return form investing in common stock.
CAPM is a statement of the relationship between expected returns and risks in which risk is
determined by the systematic risk (beta) for the risky asset. The expected return s equal to the
sum of the risk free rate of interest and a risk premium equal to the product of beta and the
market risk premium.
1. The market depends on three things,
2. The risk free rate (rf)
3. The systematic risk of the common stock return relative to the market as a whole or the
stocks beta ()
The market risk premium which is equal to the differences in the expected rate of return for the
product as a whole. That is expected rate of return for the average security minus the risk free
rate, (km-kf)
Using the CAPM model, the investors required rate can be written in follows,
Equation

What is cash budget? Why cash budget is needed?

Cash budget is an important tool in the hands of financial management for the planning and
control of the working capital to ensure the solvency of the firm. It can be used as a tool for
analyzing the revenues and costs of a company or individual.
The importance of cash budget may be summarized as follow:(1) Helpful in Planning.
Cash budget helps planning for the most efficient use of cash. It points out cash surplus,
or deficiency at selected point of time and enables the management to arrange for the

(2)

(3)

(4)

(5)
(6)

(7)

(8)

deficiency before time or to plan for investing the surplus money as profitable as possible
without any threat to the liquidity.
Forecasting the Future needs.
Cash budget forecasts the future needs of funds, its time and the amount well in advance.
It, thus, helps planning for raising the funds through the most profitable sources at
reasonable terms and costs.
Maintenance of Ample cash Balance.
Cash is the basis of liquidity of the enterprise. Cash budget helps in maintaining the
liquidity. It suggests adequate cash balance for expected requirements and a fair margin
for the contingencies.
Controlling Cash Expenditure.
Cash budget acts as a controlling device. The expenses of various departments in the firm
can best be controlled so as not to exceed the budgeted limit.
Evaluation of Performance.
Cash budget acts as a standard for evaluating the financial performance.
Testing the Influence of proposed Expansion Programme.
Cash budget forecasts the inflows from a proposed expansion or investment programme
and testify its impact on cash position.
Sound Dividend Policy.
Cash budget plans for cash dividend to shareholders, consistent with the liquid position of
the firm. It helps in following a sound consistent dividend policy.
Basis of Long-term Planning and Co-ordination.
Cash budget helps in co-coordinating the various finance functions, such as sales, credit,
investment, working capital etc. it is an important basis of long term financial planning
and helpful in the study of long term financing with respect to probable amount, timing,
forms of security and methods of repayment.

Valuing Common Stock

Common stock is not so easy to value. The cash flows are not stable or easily identified. One
simple model that is sometimes used to value common stock is the Gordon Dividend Valuation
Model.
D1
ks g

P0 =
where:
ks =
g=

D1 =

Dividends Year 1
Investors' Required Rate of Return
Growth Rate in Dividends
D1 would be calculated by multiplying current dividends by (1 + g).
For example, price a share of common stock with current dividends of $5, a dividend growth rate
of 3% if the investors' required rate of return is 15%.
P0 =

5.15
.15 .03

= $42.92

D1 was found by multiplying the current dividends of $5 by 1.03 (1 + .03).