The capital budgeting process is concerned primarily with the estimation of the cash flows associated with a project, not just the project’s contribution to accounting profits. Typically, a capital expenditure requires an initial cash outflow, termed the net investment. Thus it is important to measure a project’s performance in terms of the net (operating) cash flows it is expected to generate over a number of future years.
Figure shows the estimated cash flows for a particular project. After an initial net investment of $100,000, the project is expected to generate a stream of net cash inflows over its anticipated 5-year life of $50,000 in year 1; $40,000 in year 2; $30,000 in year 3; $25,000 in year 4; and $5,000 in year 5. This type of project is called a conventional or normal project.
Illustration of Estimated Cash Flows for a Normal Capital Investment Project
Nonnormal or nonconventional projects have cash flow patterns with either more than one or no sign change. Table illustrates the cash flow patterns for three sample projects. Projects X and Y can cause some analytical problems, as we shall see in the discussion of the internal rate of return criterion in the following chapter. Project X might require that certain equipment be shut down and rebuilt in year 3, and Project Y could be an investment in a mining property, with the negative cash flow in year 5 representing abandonment costs associated with closing down the mine after its mineral wealth has been depleted.
Finally, Project Z, which generates negative cash flows over the entire life of the investment, such as an investment in pollution control equipment, can be difficult to evaluate using the decision- making criteria developed in the next chapter.
Regardless of whether a project’s cash flows are expected to be normal or nonnormal, certain basic principles should be applied during their estimation, including the following:
A firm may also have to provide for further working capital increases as sales increase over the life of the project. These additional working capital requirements should be included in the yearly net cash flows as outflows.However, as the project winds down, net working capital balances decline; these should be included as inflows when determining yearly cash flows. Other indirect effects may occur when one division of a firm introduces a new product that competes directly with a product produced by another division. The first division may consider this product desirable, but when the impact on the second division’s sales is considered, the project may be much less attractive.
For example, in the Ford capital expenditure decision discussed earlier in the chapter, the company should consider the impact of the increased output of Volvos on the demand for Ford’s other luxury -car brands —namely, Lincoln and Jaguar.
Sample Cash Flow Patterns for Nonnormal Projects
Because sunk costs cannot be recovered, they should not be considered in the decision to accept or reject a project. For example, in 2004, the Chemtron Corporation was considering constructing a new chemical disposal facility. Two years earlier, the firm had hired the R.O.E. Consulting Group to do an environmental impact analysis of the proposed site at a cost of $500,000.
Because this $500,000 cost cannot be recovered whether the project is undertaken or not, it should not be considered in the accept –reject analysis taking place in 2004. The only relevant costs are the incremental outlays that will be made from this point forward if the project is undertaken.
costs. Opportunity costs of resources (assets) are the cash flows those resources could generate if they are not used in the project under consideration. For example, suppose that the site Chemtron is considering to use for its disposal facility has been owned by the firm for some time. The property originally cost $50,000, but a recent appraisal indicates that the property could be sold for $1 million.
Because Chemtron must forgo the receipt of $1 million from the sale of the site if the disposal facility is constructed, the appropriate opportunity cost of this piece of land is $1 million, not the original cost of $50,000. These five principles of cash flow estimation may be applied to the specific problem of defining and calculating a project’s net investment and net cash flows.
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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