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Capital Budgeting and Cash Flow Analysis

9. 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.

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Capital Budgeting and Cash Flow Analysis

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  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”

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