HANDOUTS ON FUNDAMENTALS OF
3) Any decision that involves an
FINANCIAL MANAGEMENT 1 (For Classroom
Discussion)
(Ms. Carmelita U. de Guzman, CPA, MGM)
Chapter 12: Capital Budgeting and
Estimating Cash Flows
(Reference: Van Horne and John M.
Wachowicz, Fundamentals of Financial
Management, 13th edition)
(refer to the powerpoint presentation of
Chapter 11: The Basics of Capital
Budgeting
(Reference: Brigham, Eugene,
Fundamentals of Financial Management,
12th edition)
Chapter 28: Basics of Capital
Budgeting
(Reference: Cabrera, Ma. Elenita
Balatbat, Financial Management
(Principles and Applications, vol. 2) 2015
edition)
1. Introduction
a) Capital budgeting question is
probably the most important issue in
corporate finance because the fixed
assets define the business of the firm.
b) Business firms possess a huge
number of possible investments. Each
possible investment is an option
available to the firm. Some options are
valuable, others are not. The essence of
successful financial management is
learning to identify and decide which
potential business ventures are worth
undertaking.
c) Capital budgeting is also essential
because asset expansion typically
involves substantial expenditures and
before a firm can spend a large amount
of money, it must have the funds
available and large amounts of money
are not available automatically.
2. Capital Budgeting Process a system
of interrelated steps for making long-
term investment decisions.
a) Step 1. Generating Project
Proposals
(a.1) A firms sustained growth and even
its ability to remain competitive and to
survive depends upon a constant flow of
ideas for new products, ways to making
existing products better and ways to
produce output at a lower cost.
(a.2) A well-managed firm therefore, will
go to great lengths to develop good
project proposals.
(a.
outlay now in order to obtain a future
return is a capital budgeting decision,
which includes the following:
(1) Replacement decisions to continuous
current
operations consist of expenditures to
replace worn-out or damaged equipment
required in the production of profitable
) products.
(2) Replacement to effect cost reduction
includes expenditures to replace still
serviceable but obsolete equipment and
thereby to lower costs. Such decisions
are discretionary and may be deferred for
later action and a fairly detailed analysis
is generally required.
(3) Expansion into new products or
markets relate to new products or
geographic areas which involve strategic
decisions that could change the
fundamental nature of the business; or
considering acquisition of a new plant
warehouse or other facility to increase
capacity and sales. Decision is generally
made at the top level of management.
(4) Expansion of existing products or
markets expenditures to increase
output of existing products to expand
distribution/retail outlets in markets
being currently served. Decision is
likewise made at a higher level within the
firm.
(5) Equipment selection decisions
relate to decisions whether several
available machines should be purchased
or leased.
(6) Safety and/or environment projects
expenditures necessary to comply with
government orders, labor agreements or
insurance policy terms.
(7) Mergers where one firm buys
another firm.
(8) Other projects includes items such
as office buildings, parking lots, car
plans, etc.
(a.4) Categories of Capital Investment
Decisions
(1) Independent capital investment
projects or Screening decisions relate
to whether a proposed project is
acceptable (whether it passes a present
hurdle). These are projects which are
evaluated individually and reviewed
against predetermined corporate
standards of acceptability resulting in an
accept or reject decision. For
example, a company may have a policy
1
of accepting projects only if they promise
a return of at least 15% on the
investment. The required rate of return
is the minimum rate of returns a project
must yield to be acceptable. Examples
are: investment in long-term assets such
as property, plant and equipment; new
product development; undertaking a
large scale advertising campaign;
introduction of a computer; corporate
acquisitions, such as purchase of shares
in subsidiaries or affiliates.
(2) Mutually exclusive capital
investment projects or Preference
decisions relate to selecting from
among several acceptable alternatives.
The project to be acceptable must pass
the criteria of acceptability set by the
company and be better than the other
investment alternatives. For example, a
company may be considering several
different equipment to replace an
equipment on the assembly line. The
choice of which equipment to purchase is
a preference decision. Other examples
are: replacement against renovation of
equipment or facilities; rent or lease
against ownership of facilities; manual
bookkeeping system against
computerized system; preventive
maintenance against periodic overhaul of
machineries; purchase of machinery from
an outside supplier against assembly of
the machinery by the companys own
staff.
b) Step 2. Collecting Relevant
Information about
Opportunities
Capital budgeting is a dynamic
process because the firms changing
environment may affect the desirability
of current or proposed investment.
Information is needed throughout the
entire capital budgeting process to
ensure that the process is operating
effectively.
c) Step 3. Estimating Cash Flows
(c.1) Deriving accurate estimates of cash
flows is the most important and most
difficult step in the entire capital
budgeting process. Estimating cash
flows is important because no step later
in the process can overcome inaccurate
or unreliable information generated by
this step.
(c.2) Net cash flow is the difference
between inflows and outflows of cash
that result from a firm undertaking a
2
project. Only incremental after-tax cash
flows are relevant. Historical costs
arising from past decisions are sunk costs
and therefore cannot affect future
alternatives.
(c.3) Cash flows of a project fall into
three categories:
(1) Net Initial Investment the net initial
cash outlay needed to acquire a specific
investment project. Most capital projects
require a significant initial outlay before
they generate cash inflows. The net
investment is calculated by subtracting
any initial cash inflows that occur in
placing an asset into service from the
amount of the initial cash outflows
required by the project.
(2) Net Operating Cash Flows or Returns
the incremental changes in a firms
cash flows that result from investing in a
project. Net operating cash flows may
vary over the projects life and the timing
of these varying flows may also vary
during the year. However, operating
cash flows are generally assumed to
occur at the end of a given year. The
cash returns are the inflows of cash
expected from a project reduced by the
cash cost that can be directly attributed
to the project.
(3) Net Terminal Cash Flow -
d) Step 4. Evaluating Project
Proposals
(d.1) Capital investments are evaluated
under certainty or risk.
(1) Under Certainty the exact values
associated with the investment, such as
the cash flows and the required of
return, are known in advance. In
practice, few financial variables are
known in advance with absolute
certainty.
(2) Under risk variables required for
evaluating investment proposals are not
certain and involve a margin of error.
(d.2) There are numerous techniques
that may be used to evaluate both
individual and multiple projects under
conditions of certainty and risk. Most of
these techniques employ time value of
money concepts in order to account for a
projects cash flows over time.
e) Step 5. Selecting Projects
(e.1) In theory, the firm should invest in
new projects up to the point where the
rate of return from the last project is
equal to the firms marginal cost of
capital.
(e.2) In practice, many factors,
quantitative as well as qualitative, should
be given consideration before the final
decision is made as to the selection of a
particular investment. This will include
among others, relationship of this
opportunity to other aspects of the
company operations and long-term goals,
the timing of the cash flows, the
availability of funds for investment
purposes, the impact on the financial
structure of the company, social impact
of the opportunity, and legal
ramifications.
(e.3) The final selection of projects
depends on three major factors:
(1) Project type : Capital expenditure
decisions may be classified as
independent and mutually exclusive.
(1.a) Independent project one having a
distinct function. Acceptance or rejection
of an independent project does not
necessarily preclude other projects from
consideration.
(1.b) Mutually exclusive project an
alternate way of performing the same
function as other projects under
consideration. Acceptance of a mutually
exclusive project eliminates the other
alternatives from further consideration.
(2) Availability of funds: Unlimited funds
allow a firm to operate with no
constraints on its capital expenditures. A
firm with no capital constraints should
accept all projects that meet its selection
criteria.
(2.a) Capital rationing occurs when a
firm places an upper limit on its capital
expenditures. This limit on the size of
the total capital budget is often self-
imposed. The dominant cause of a
budget constraint is a debt limit imposed
by internal management.
(2.b) Under capital rationing, a firm may
not maximize shareholders wealth
because it may reject profitable projects
(projects whose expected rate of return
exceeds the required rate of return).
(2.c) A firm that rations funds should
allocate the funds in a way that
maximizes long-run return within the
budget constraints.
(3) Decision criteria: These are
established to rank projects and to
provide a cutoff point for capital
expenditures. Frequently there are more
proposals for projects than the firm is
able or willing to finance.
3
(3.a) Ranking techniques are used to
select the best subset of acceptable
projects from a larger set that cannot be
fully funded.
(3.b) Projects are often ranked according
to a prescribed hurdle rate of minimum
acceptable rate of return. Hurdle rates
reflect the projects riskiness; common
measures include the firms cost of
capital (the required rate of return of
investors who provide funds to the firm);
opportunity cost (the rate of return on
the firms best alternative investment
available), or some risk-adjusted rate.
(e.4) Capital budgeting techniques
provide a useful quantitative basis for
project selection. However, other factors
in addition to the economic appraisal of
an investment must be considered.
Qualitative factors such as personal
preferences of decision makers, ethics,
and social responsibility, also serve as
inputs in the selection process.
(e.50 Once the final projects are
selected, they must be combined into a
capital budget, which is a plan of
expenditures for fixed assets.
f) Step 6. Implementing and
Reviewing Projects
(f.1) The decision to accept or reject a
proposed project must be communicated
to its originator and to others in the firm.
Acceptable projects must then be
implemented in a timely and efficient
manner.
(f.2) The implementation stage involves
developing formal procedures for
authorizing the expenditures of funds for
capital projects.
(f.3) The review stage involves analyzing
projects that have been adopted in order
to determine if they should be continued,
modified, or terminated.
(f.4) After a project is completed, post-
audit is conducted in which comparisons
are made between earlier estimates and
actual data. Review of past decisions
may provide a basis for improving
managements ability to evaluate
subsequent investment alternatives.
3. Capital Budgeting Risk
a) Forecasting risk or estimation risk is
the possibility that a bad decision will be
made because of errors in the projected
cash flows.
b) Risk should be considered in
evaluating capital budgeting projects in
both informal and formal ways. These
approaches cannot remove risk, but they
can provide a means of dealing with it in
a rational manner.
c) Methods of estimating and measuring
risk
(c.1) Scenario Analysis The basic form
of what-if analysis is called scenario
analysis. This approach involves the
determination of what happens to NPV
(net present value) estimates when we
ask what-if questions.
(c.2) Sensitivity Analysis is the process
of changing one or more variables to
determine how sensitive a projects
returns are to these changes. It is useful
for pointing out where forecasting errors
will do the most damage but does not tell
us what to do about possible errors.
(c.3) Simulation Analysis a combination
of scenario and sensitivity analysis. It let
all the items vary at the same time.
(c.4) Beta Estimation -

4. Inflation and Capital Budgeting