PowerPoint to accompany Chapter 8 Capital Budgeting & Cash Flow Principles Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Learning Goals:  Understand what motivates capital expenditure.  Understand the steps in the capital budgeting process.  Define basic capital budgeting terminology.  Discuss relevant features of capital projects.  Calculate the initial and terminal amounts associated with a proposed capital expenditure.  Find the relevant operating cash inflows using the income statement format and the formula method.  Determine the terminal cash flow associated with a proposed capital expenditure. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition The Capital Budgeting Decision Making Process  Capital Budgeting: the process of evaluating and selecting long term investments consistent with the firm’s goal of maximising owner wealth.  Capital Expenditure: an outlay of funds by the firm that is expected to produce benefits over a period of time greater than one year.  Operating Expenditure: an outlay of funds resulting in benefits being received within one year. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Cash Flow Patterns Page 347. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Relevant Cash Flows  The incremental after tax cash outflow and resulting subsequent inflows associated with a proposed capital project.  Incremental Cash Flows: the additional cash inflows and outflows expected from a proposed capital project. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Cash Flow Components • The cash flows of any project having a conventional cash flow pattern will have three components: 1. Initial Investment: the relevant cash outflow at time zero. 2. Annual Operating Net Cash Inflow: the incremental annual after-tax net cash inflows resulting from implementation during a project’s life. 3. Terminal Cash Flow: the after tax non-operating cash flow occurring in the final year of the project. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Cash Flow Components Page 348. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Issues When Using Relevant Cash Flows In Capital Budgeting  Interest and other financing costs are not included in projected annual cash flow calculations.  Opportunity and sunk costs are often mishandled or ignored.  International capital budgeting must consider political and currency risks. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Issues When Using Relevant Cash Flows In Capital Budgeting  Identifying cash flows for replacement decisions is more complex than for expansion decisions. Page 349. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Finding The Initial Investment Installed cost of new asset - After tax proceeds from sale of old asset +/- Change in net working capital = Initial investment . Chapter 8 Capital Budgeting & Cash Flow Principles Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9 781 4425 181 93/. 9 781 4425 181 93/ Gitman et al / Principles of Managerial Finance / 6th edition Cash Flow Components • The cash flows of any project having a conventional cash