Capital Budgeting And Cash Flow Analysis Introduction - Financial Management

This is the first of several chapters that explicitly deal with the financial management of the assets on a firm’s balance sheet. In this and the following two chapters we consider the management of long -term assets.

Capital budgeting

is the process of planning for purchases of assets whose returns are expected to continue beyond one year.A capital expenditure is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than one year. It is distinguished from a normal operating expenditure, which is expected to result in cash benefits during the coming 1-year period. (The choice of a 1-year period is arbitrary, but it does serve as a useful guideline.)

Several different types of outlays may be classified as capital expenditures and evaluated using the framework of capital budgeting models, including the following:

  • The purchase of a new piece of equipment, real estate, or a building in order to expand an existing product or service line or enter a new line of business
  • The replacement of an existing capital asset, such as a drill press
  • Expenditures for an advertising campaign
  • Expenditures for a research and development program
  • Investments in permanent increases of target inventory levels or levels of accounts receivable
  • Investments in employee education and training
  • The refunding of an old bond issue with a new, lower-interest issue
  • Lease-versus-buy analysis
  • Merger and acquisition evaluation

Total investments or capital expenditures of all industries in the United States during 2002 exceeded $1.1 trillion. Capital expenditures are important to a firm both because they require sizable cash outlays and because they have a long -range impact on the firm’s performance. The following example illustrates the magnitude and long-term impact of capital expenditures for an individual company.

In June 2002, Ford Motor Company announced plans to invest $5 billion to $6 billion in Volvo, its Swedish luxury -car subsidiary that it had purchased for $6.5 billion in 1999.1 The bulk of the funds invested were to be used to build up to five new or redesigned midsize vehicle models. Also, part of the capital invested was to be used to expand its manufacturing facilities in Sweden and Belgium in order to be able t produce up to 600,000 units per year, compared with the 425,000 units it produced in 2001. These capital expenditures were being made despite a weak economy, a loss of $5.45 billion by Ford in the previous year, and a 15 percent drop in Volvo’s U.S. sales during the first five months of 2002, compared with the previous year. Despite these concerns, Ford had confidence in Volvo’s new products and the long-term health of the economy and the company.

A firm’s capital expenditures affect its future profitability and, when taken together, essentially plot the company’s future direction by determining which products will be produced, which markets will be entered, where production facilities will be located, and what type of technology will be used. Capital expenditure decision making is important for another reason as well.

Specifically, it is often difficult, if not impossible, to reverse a major capital expenditure without incurring considerable additional expense. For example, if a firm acquires highly specialized production facilities and equipment, it must recognize that there may be no ready used -equipment market in which to dispose of them if they do not generate the desired future cash flows.

For these reasons, a firm’s management should establish a number of definite procedures to follow when analyzing capital expenditure projects. Choosing from among such projects is the objective of capital budgeting models.


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