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