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 • Capital Budgeting is the process of planning for purchases of assets whose returns are expected to continue beyondone year.
Capital Budgeting • Capital Expenditure • A cash outlay expected to generate a flow of future cash benefits for more than one year. • A normal operating expenditure expected to result in cash benefits during the coming one-year period. (The choice of a one-year period is arbitrary, but it does serve as a useful guideline.)
Capital Budgeting • Capital budgeting decisions can be the most complex decisions facing management. • Several different types of outlays may be classified as capital expenditures and evaluated using the framework of capital budgeting models. (See next several slides.)
Types of Capital Expenditure • 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 drill press • Expenditures for an advertising campaign
Types of Capital Expenditure • 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
Types of Capital Expenditure • The refunding of an old bond issue with a new, lower-interest issue • Lease-versus-buy analysis • Merger and acquisition evaluation
Capital Expenditure Decisions • 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.
Capital Expenditure Decisions • A firm’s capital expenditures affect its future profitability and, when taken together, essentially plot the company’s future direction by determining the following things: • which products will be produced • which markets will be entered • where production facilities will be located • what type of technology will be used
Capital Expenditure Decisions • 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.
Capital Expenditure Decisions • 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.
Capital Expenditure Decisions • 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.
Cost of Capital • A firm’s cost of capital is defined as the cost of the funds supplied to it. It is also termed the required rate of return because it specifies the minimum necessary rate of return required by the firm’s investors.In this context, the cost of capital provides the firm with a basis for choosing among various capital investment projects.
How Projects Are Classified • Independent Projects • Acceptance or rejection of one project has no effect on other projects from consideration. • For example, a firm may want to install a new telephone communications system in its headquarters and replace a drill press during approximately the same time. In the absence of a constraint on the availability of funds, both projects could be adopted if they meet minimum investment criteria.
How Projects Are Classified • Mutually Exclusive Projects • Acceptance of one project automatically rejects the others. Because two mutually exclusive projects have the capacity to perform the same function for a firm, only one should be chosen. • For example, BMW was faced with deciding whether it should locate its U.S. manufacturing complex in Spartanburg, S.C., or at one of several competing North Carolina sites. It ultimately chose the Spartanburg site; this precluded other alternatives.
How Projects Are Classified • Contingent Projects • Acceptance of one project is dependent upon the adoption of one or more other projects. • When a firm is considering contingent projects, it is best to consider together all projects that are dependent on one another and treat them as a single project for purposes of evaluation. • For example, a decision by Nucor to build a new steel plant in North Carolina is contingent upon Nucor investing in suitable air and water pollution control equipment.
Capital Rationing • When a firm has adequate funds to invest in all projects that meet some capital budgeting selection criterion, the firm is said to be operating without a funds constraint.
Capital Rationing • Many times firms limit their capital expenditures, not because of a funds constraint but because of limited managerial resources needed to manage the project effectively. • Frequently, however, the total initial cost of the acceptable projects in the absence of a funds constraint is greater than the total funds the firm has available to invest in capital projects.
Most companies have a limited amount of dollars available for investmentFunds constraint Capital Rationing
Basic Framework for Capital Budgeting • According to economic theory, a firm should operate at the point where the marginal cost of an additional unit of output just equals the marginal revenue derived from the output. Following this rule leads to profit maximization.
Basic Framework for Capital Budgeting • A firm’s marginal revenue is the rate of return earned on succeeding investments. • A firm’s marginal cost may be defined as the firm’s marginal cost of capital (MCC), that is, the cost of successive increments of capital acquired by the firm.
Basic Framework for Capital Budgeting • Figure 8.1 illustrates a simplified capital budgeting model. This model assumes that all projects have the same risk. The projects under consideration are indicated by lettered bars on the graph.
Basic Framework for Capital Budgeting • Project A requires an investment of $2 million and is expected to generate a 24 percent rate of return. • Project B will cost $1 million ($3 million minus $2 million on the horizontal axis) and is expected to generate a 22 percent rate of return, and so on.
Basic Framework for Capital Budgeting • The projects are arranged in descending order according to their expected rates of return, in recognition of the fact that no firm has an inexhaustible supply of projects offering high expected rates of return. This schedule of projects is often called the firm’s investment opportunity curve (IOC).
Basic Framework for Capital Budgeting • Typically, a firm will invest in its best projects first—such as Project A—before moving on to less attractive alternatives.
Basic Framework for Capital Budgeting • The MCC schedule represents the marginal cost of capital to the firm.
Basic Framework for Capital Budgeting • Note that the schedule increases as more funds are sought in the capital markets. The reasons for this including the following: • Investors’ expectations about the firm’s ability to successfully undertake a large number of new projects • The business risk to which the firm is exposed because of its particular line of business
Basic Framework for Capital Budgeting • The firm’s financial risk, which is due to its capital structure • The supply and demand for investment capital in the capital market • The cost of selling new stock, which is greater than the cost of retained earnings
Basic Framework for Capital Budgeting • The basic capital budgeting model indicates that, in principle, the firm should undertake Projects A, B, C, D, and E, because the expected returns from each project exceed the firm’s marginal cost of capital.
Basic Framework for Capital Budgeting • Unfortunately, however, in practice, financial decision making is not this simple. Some practical problems are encountered in trying to apply this model, including the following (the following four slides):
Basic Framework for Capital Budgeting • At any point in time, a firm probably will not know all of the capital projects available to it. In most firms, capital expenditures are proposed continually, based on results of research and development programs, changing market conditions, new technologies, corporate planning efforts, and so on.
Basic Framework for Capital Budgeting • Thus, a schedule of projects similar to Figure 8.1 will be probably be incomplete at the time the firm makes its capital expenditure decisions.
Basic Framework for Capital Budgeting • The shape of the MCC schedule itself may be difficult to determine. (The problems and techniques involved in estimating a firm’s cost of capital are discussed in Chapter 11.)
Basic Framework for Capital Budgeting • In most cases, a firm can only make uncertain estimates of a project’s future costs and revenues (and, consequently, its rate of return). Some projects will be more risky than others. The riskier a project is, the greater the rate of return that is required before it will be acceptable. (This concept is considered in more detail in Chapter 10.)
Basic Framework for Capital Budgeting: Summary • Invest in the most profitable projects first. • Continue accepting projects as long as the rate of return exceeds the MCC. • Expand output until marginal revenue equals marginal cost.
Capital Budgeting Process • Step 1 • Generating capital investment project proposals • Step 2 • Estimating cash flows
Capital Budgeting Process • Step 3 Ch 9 • Evaluating alternatives and selecting projects to be implemented • Step 4 Ch 9 • Reviewing a project’s performance after it has been implemented, and post-auditing its performance after its termination
Classify Investment Projects • Growth opportunities • Cost reduction opportunities • Required to meet legal requirements • Required to meet health & safety standards
Classify Investment Projects • Projects Generated by Growth Opportunities: • Assume that a firm produces a particular product that is expected to experience increased demand during the upcoming years. If the firm’s existing facilities are inadequate to handle the demand, proposals should be developed for expanding the firm’s capacity.
Classify Investment Projects • These proposals may come from the corporate planning staff group, from a divisional staff group, or from some other sources.
Classify Investment Projects • Because most existing products eventually become obsolete, a firm’s growth is also dependent on the development and marketing of new products. This involves the generation of research and development investment proposals, marketing research investments, test marketing investments, and perhaps even investments in new plants, property, and equipment.
Classify Investment Projects • Projects Generated by Cost Reduction Opportunities: • Just as products become obsolete over time, so do plants, property, equipment, and production processes. Normal use makes older plants more expensive to operate because of the higher cost of maintenance and downtime (idle time).
Classify Investment Projects • In addition, new technological developments may render existing equipment economically obsolete. These factors create opportunities for cost reduction investments, which include replacing old, obsolete capital equipment with newer, more efficient equipment.
Classify Investment Projects • Projects Generated to Meet Legal Requirements and Health and Safety Standards: • These projects include investment proposals for such things as pollution control, ventilation, and fire protection equipment. In terms of analysis, this group of projects is best considered as contingent upon other projects.
Classify Investment Projects • To illustrate, suppose USX wishes to build a new steel plant in Cleveland, Ohio. The decision will be contingent upon the investment in the amount of pollution abatement equipment required by state and local laws. Thus, the decision to invest in the new plant must be based upon the total cost of the plant, including the pollution abatement equipment, and not just the operating equipment alone. In the case of existing facilities, this type of decision making is sometimes more complex.
Classify Investment Projects • For example, suppose a firm is told it must install new pollution abatement equipment in a plant that has been in operation for some time. The firm first needs to determine the lowest cost alternative that will meet these legal requirements. “Lowest cost” is normally measured by the smallest present value of net cash outflows from the project. Then management must decide whether the remaining stream of cash flows from the plant is sufficient to justify the expenditure. If it appears as though it will not be, the firm may consider building a new facility, or it may decide simply to close down the original plant.
Principles of Estimating CFs • The capital budgeting process is concerned primarily with the estimation of the cash flows associated with a projects, not just the project’s contribution to accounting profits.
Principles of Estimating CFs • 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.
Principles of Estimating CFs • The project expected to generate a stream of net cash inflows over its anticipated life is called a normal or conventional project.