CAPITAL BUDGETING AND

ESTIMATING CASH FLOWS

 After studying this material you should be able to

 Cash flows from operations is the cash flow generated by business activities,
including sales of goods and services. Operating cash flow reflects tax payments, but
not financing, capital spending, or changing in net working capital

 Capital budgeting -The process of identifying, analyzing, and electing investment

projects whose returns (cash flows) are expected to extend beyond one year
 ESTIMATING CASH FLOWS
The cash flow statement reflects the movement of cash within an enterprise during a
specific period

The financial health of a firm depends on its ability to generate sufficient amounts of
cash to pay its creditors, employees, suppliers, and owners - only cash can be spent !!!!

Depreciation expense requires no cash outlay - the entire cash outflow related to
a depreciable asset occurs at the time the asset is purchased

The difference between current assets and current liabilities is known as net
working capital, but financial managers often refer to the difference simply
(but imprecisely) as working capital

The value of a firm’s assets is always equal to the combined value of the
liabilities and the value of the equity, the cash flows received from the firm’s assets (that is,
its operating activities), CF(A) must equal the cash flows to the firm’s creditors, CF(B),
and equity investors, CF(S):

CF(A) = CF(B) + CF(S)


Cash flows from operating
activities
The most common source of cash
for a company. It involves buying
and selling of inventory, receipts
from debtors, payments to
creditors and the paying of
expenses
Inflows:
 Money received from sales
 Money received from
other incomes
Outflows:
Money paid for expenses
Money paid for tax
CASH FLOW STATEMENT
Cash Flow Statement
Cash flows from
investing activities
Cash changes as a result of
buying and selling of
tangible/fixed assets and any
changes in investments (i.e.,
fixed deposits)
Inflows:
 Money received from the
sale of assets
 Fixed deposits maturing
Outflows:
Money paid for replacing
tangible/fixed assets
Money paid for buying new
assets
Investing in fixed deposits
Cash flows from
financing activities
Cash changes as a result of
obtaining financing and
paying off loans/issuing of
shares
Inflows:
 Money received from issuing shares
 Money received from obtaining
loans
Proceeds from new stock issue or
from long-term debt sales
Outflows:
Money used for repaying loans
Repurchase of stock
Money paid for dividends
 CASH FLOW FROM OPERATING ACTIVITIES

 Cash flow results from the firm’s normal activities in producing and selling goods and services

To calculate cash flow from START COMPANY

operating activities we start with Cash flow from operating activities [2013]
net income. Then we add back [RON in millions]
noncash expenses and adjust for Net income 86
changes in current assets and
Depreciation 103
liabilities
Change in assets and liabilities
Accounts receivable -24
Notes payable will be included
in the financing activities Inventories 11
section Accounts payable 16

Accrued expense 18

Notes payable – the amount of Other -8

principal due on a formal written Cash flow from operating activities 202
promise to pay (loans from banks)
 CASH FLOW FROM INVESTING AND FINANCING ACTIVITIES

START COMPANY
Cash flow from investing activities Cash flow from investing activities[2013]
involves changes in capital assets: [RON in millions]
acquisition of fixed assets and sales of Acquisition of fixed assets -198
fixed assets (i.e., net capital
expenditures) Sales of fixed assets 25
Cash flow from investing activities -173

START COMPANY
Cash flow from financing activities [2013]
[RON in millions]
Retirement of long-term debt -73
Cash flow from financing – cash
Proceeds from long-term debt sales 86
flows to and from creditors and
owners include changes in equity and Change in notes payable -3
debt
Dividends -43
Repurchase of stock -6
Proceeds from new stock issue 43
Cash flow from financing activities 4
 START COMPANY
STATEMENT OF Statement of Cash Flows [2013], [RON in millions]
CONOLIDATED Operations

CASH FLOWS Net income 86

Depreciation 103
Changes in assets and liabilities
The statement of cash flows
in the addition of cash flows Accounts receivable -24
from operations, cash flows Inventories 11
from investing activities, and Accounts payable 16
cash flows from financing
Accrued expenses 18
activities. When we add all
the cash flows together, we Other -8
get the change in cash on Total cash flow from operations 202
the balance sheet
Investing activities
Acquisition of fixed assets -198
Sales of fixed assets 25
Total cash flow from investing activities -173
Interest paid should really
go under financing Financing activities
activities. The reason is Change in notes payable -2
that interest is deducted
Dividends -12
as an expense when net
income is computed Repurchase of stock -6
Total cash flow from financing activities -20
Change in cash (on the balance sheet) 9
 THE CASH FLOW PROCESS FOR A FIRM

Raise Funds (Cash)

1. External
 Owners Acquire Assets
 Creditors 1. Long-term
2. Internal Used to 2. Working capital
 Cash flow from
operations Used to
 Liquidation of assets
Product and Sell
Used to
Products/Services
1. Funds for reinvestment 1. Services provided or inventories
2. Funds to distribute to owners converted to cash sales and
and creditors Results to accounts receivable
2. Accounts receivable collected and
converted to cash
 CAPITAL BUDGETING

 Capital budgeting – the process of planning for purchases of assets whose cash
flows are expected to continue beyond 1 year

 A capital expenditure is a cash outlay that is expected to generate a flow of future

cash benefits lasting longer than 1 year (e.g., the replacement of an existing capital
asset)

 A firm’s cost of capital is the cost of the funds supplied to it. The required rate of
return is the minimum necessary rate of return required by the firm’s investors

 Depreciation is defined as the systematic allocation of the cost of an asset over more
than 1 year. The annual depreciation expenses recorded for a particular asset is an
allocation of its original cost and does not represent a cash outlay

 As a result, a company’s annual depreciation expense is added to earnings after

taxes in calculating after-tax cash flow
 CAPITAL BUDGETING

 PROJECT TYPES

 Independent projects – an independent project is one whose acceptance or rejection

does not directly eliminate other projects from consideration

 Example, a firm may want to install a new communication system in its

headquarters and replace a drill press during approximately the same time.

 Mutually exclusive projects is one whose acceptance precludes the acceptance of one
or more alternative proposals.

 !!! Because two mutually exclusive projects have the capacity to perform the
same function for a firm, only one should be chosen

 Contingent projects is one whose acceptance is dependent on the adoption of one or

more other projects.

 Example, a decision to build a new bakery is contingent investing in suitable air

and water pollution control equipment