Capital Budgeting and Cash Flow Analysis

1. 9 Capital Budgeting and Cash Flow Analysis

2. Introduction • This chapter discusses capital budgeting and capital expenditures. • It deals with the financial management of the assets on a firm’s balance sheet.

3. Capital Budgeting • The process of planning for purchases of assets whose returns are expected to continue beyond a year • Capital Expenditure • A cash outlay expected to generate a flow of future cash benefits for more than a year. • Capital budgeting decisions can be the most complex decisions facing management.

4. Expand an existing product line Working capital Merger and acquisition Enter a new line of business Replacement Advertising campaign R&D Education and training Capital Expenditure Decisions Check out a successful project: http://www.barcode-system.com/book.htm

5. Cost of Capital • Firm’s overall cost of funds • Investors’ required rate of return • Provides a basis for evaluating capital investment projects

6. How Projects Are Classified • Independent • Acceptance or rejection has no effect on other projects. • Mutually Exclusive • Acceptance of one automatically rejects the others. • Contingent • Acceptance of one project is dependent upon the selection of another.

7. Mutually Exclusive Projects • Purchase new machine • Purchase used machine • Rent machine • Repair old machine

8. Most companies have a limited amount of dollars available for investmentFunds constraint Capital Rationing

9. Basic Framework for Capital Budgeting • Expand output until marginal revenue equals marginal cost • Invest in the most profitable projects first • Continue accepting projects as long as the rate of return exceeds the MCC

10. Capital Budgeting Problems • All projects may not be known at one time • Changing markets, technology, and corporate strategies can make current projects obsolete and make new ones profitable. • Difficulty in determining the behavior of the MCC • Estimates of CFs have varying degrees of uncertainty.

11. Capital Budgeting Process • Step 1 • Generating proposals • Step 2 • Estimating CFs • Step 3 Ch 9 • Evaluating alternatives and selecting projects • Step 4 Ch 9 • Reviewing prior decisions

12. Classify Investment Projects • Growth opportunities • Cost reduction opportunities • Required to meet legal requirements • Required to meet health & safety standards

13. Estimating CFs • On an incremental basis • On an after-tax basis • Include indirect effects • Exclude sunk costs • Opportunity costs of resources

14. Cash Flow Information • American Cash Flow Institute • http://acfi-online.com/ • American Cash Flow Association • http://acfa-cashflow.com/

15. Step 1 Cost plus installation and shipping Plus Step 2 Increases in net working capital Minus Step 3 Net proceeds from sale of existing assets Plus or minus Step 4 Taxes associated with the above sale Equals NINV Remember to check out the tax consequences Estimating the NINV

16. NINV for a Multiple-period Investment • The NINV for a multiple-period investment is the PV of the series of outlays discounted at the firm’s cost of capital.

17. Computing Net Cash Flows

18. Tax Consequences at the End of a Project’s Life

19. Ethical Issues: Biased CF Estimates • Overestimate the revenues • Underestimate the costs • Reduce CF estimates to a level below the “most likely outcome”