CAPITAL BUDGETING AND CASH FLOW ANALYSIS

OBJECTIVES:

The principles of estimating cash flows and their application.

The identification and estimation of net investment and net cash flows.

Key terms

Cost of Capital the cost of funds supplied to it and used to finance investments made by
a company.

How projects are classified

a. Independent Projects- whose acceptance or rejection is independent of the

acceptance or rejection of other projects

b. Mutually Exclusive Projects- one where acceptance of such a project means

rejecting others, even though the latter standing alone may pass muster as good
investments

c. Contingent Projects- dependent projects; the choice of one investment

necessitates undertaking one or more other investment

Availability of Funds
- Capital rationing is the act of placing restrictions on the amount of new
investments or projects undertaken by a company.

Capital budgeting- the process of planning and controlling for purchases of assets whose
cash flows are expected to continue beyond one year.

Four key steps in the Capital Budgeting Process

1. Generating investment project proposals

2. Estimating cash flows

3. Evaluating alternatives and selecting projects to be implemented

4. Reviewing a projects performance after it has been implemented and post-auditing

performance after termination

Generating investment project proposals

Classifying Investment Projects

Projects Generated by Growth Opportunities

 Projects Generated by Cost Reduction Opportunities

Projects Generated to meet Legal Requirements and Health and Safety Standards

Project Size and the Decision making Process

Principle of Estimating Cash Flows

Cash Flows should be measured on an incremental basis.

Cash Flows should be measured on an after-tax basis.

Sunk Cost should not be considered when evaluating a project.

The value of resources used in a project should be measured in terms of their

opportunity costs.

Net Investment
- Projects initial net cash outlay, which is the outlay at time 0.

NET INVESTMENT = the cost of acquiring new asset plus installation cost
+
Increase in Working Capital
-
Net Proceeds
+/-
Taxes associated with acquiring the new asset/ sale of the old asset

Net (Operating) Cash Flow

- Operating cash flow is a measure of the amount of cash generated by a
company's normal business operations.

Asset Expansion Projects

- A project that requires a firm to invest funds in additional assets in order to
increase sales (or reduce costs).

Asset Replacement Projects

- Involve retiring one asset and replacing it with a more efficient asset.