Copyright ©2003 South-Western/Thomson Learning Chapter 8 Capital Budgeting and Cash Flow Analysis

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

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.

Capital Expenditure Decisions Expand an existing product line Working capital Refunding Leasing Merger and acquisition Enter a new line of business Replacement Advertising campaign R&D Education and training Check out a successful project:

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

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.

Mutually Exclusive Projects Purchase new machine Purchase used machine Rent machine Repair old machine

Capital Rationing Most companies have a limited amount of dollars available for investment Funds constraint

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

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.

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

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

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

Cash Flow Information American Cash Flow Institute – American Cash Flow Association –

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

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.

Computing Net Cash Flows

Tax Consequences at the End of a Project’s Life Case 1Sale = book valueNo tax consequences Case 2Sale < book valueTax savings = marginal tax rate x amount of loss Case 3Sale > book valueGain x marginal tax rate Case 4Sale > costGain + capital gain x marginal tax rate

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