The specific cash flows that should be considered in a capital budgeting decision

Glossary

Chapter 10

base (most likely)

caseAn analysis in which all of the input variables are set at their most likely values.

best–case scenarioAn analysis in which all of the input variables are set at their best reasonably forecasted values.

beta (market) riskThat part of a project’s risk that cannot be eliminated by diversification; it is measured by the project’s beta

coefficient.

corporate (within–

firm) risk

Risk that does not take into consideration the effects of stockholders’ diversification; it is measured by a project’s

effect on the firm’s earnings variability.

exchange rate riskThe uncertainty associated with the price at which the currency from one country can be converted into the

currency of another country.

expansion projectA project that is intended to increase sales.

externalitiesThe effect accepting a project will have on the cash flows in other parts (areas) of the firm.

incremental cash

flowThe change in a firm’s net cash flow attributable to an investment project.

incremental

operating cash

flows

The changes in day–to–day cash flows that result from the purchase of a capital project and continue until the

firm disposes of the asset.

initial investment

outlayThe incremental cash flows associated with a project that will occur only at the start of a project’s life.

Monte Carlo

simulation

A risk analysis technique in which probable future events are simulated on a computer, generating a probability

distribution that indicates the most likely outcomes.

opportunity costThe return on the best alternative use of an asset; the highest return that will not be earned if funds are invested in

a particular project.

political riskThe risk of expropriation (seizure) of a foreign subsidiary’s assets by the host country or of unanticipated

restrictions on cash flows to the parent company.

project required

rate of return, rprojThe risk–adjusted required rate of return for an individual project.

pure play methodAn approach used for estimating the beta of a project in which a firm identifies companies whose only business

is the product in question, determines the beta for each firm, and then averages the betas to find an

approximation of its own project’s beta.

relevant cash

flowsThe specific cash flows that should be considered in a capital budgeting decision.

repatriation of

earningsThe process of sending cash flows from a foreign subsidiary back to the parent company.

replacement

analysisAn analysis involving the decision as to whether to replace an existing asset with a new asset.

risk–adjusted

discount rate

The discount rate (required rate of return) that applies to a particular risky stream of income; it is equal to the

risk–free rate of interest plus a risk premium appropriate to the level of risk associated with a particular project’s

income stream.

scenario analysisA risk analysis technique in which “bad” and “good” sets of financial circumstances are compared with a most

likely, or base case, situation.

sensitivity

analysis

A risk analysis technique in which key variables are changed and the resulting changes in the NPV and the IRR

are observed.

stand–alone riskThe risk an asset would have if it were a firm’s only asset; it is measured by the variability of the asset’s expected

returns.

sunk costA cash outlay that already has been incurred and that cannot be recovered regardless of whether the project is

accepted or rejected.

terminal cash flowThe net cash flow that occurs at the end of the life of a project, including the cash flows associated with (1) the

final disposal of the project and (2) returning the firm’s operations to where they were before the project was

accepted.

worst–case

scenarioAn analysis in which all of the input variables are set at their worst reasonably forecasted values.

Since capital budgeting describes the process by which all companies make decisions on their capital projects, it is not unusual for some fairly sophisticated techniques to be employed in its execution. Regardless of this, capital budgeting relies heavily on just a few basic principles.

Capital budgeting typically adopts the following principles:

• decisions are based on cash flows, not accounting concepts such as net income;
• the timing of cash flows is critical;
• cash flows are based on opportunity costs. A comparison is made between the incremental cash flows that occur with investment and without the investment;
• cash flows are analyzed on an after-tax basis. Taxes have to be fully reflected in capital budgeting decisions;
• the financing costs are ignored. Financing costs are already reflected in the required rate of return and therefore including them again in the cash flows and the discount rate would lead to double counting; and
• the capital budgeting cash flows are not the same as accounting net income.

Capital Budgeting Concepts

In addition to the basic capital budgeting principles outlined above, there are several concepts that capital managers should be aware of in the capital budgeting process. These include:

• sunk costs: these are costs that have already been incurred;
• opportunity cost: this refers to what a resource is worth if it is put to its next-best use;
• incremental cash flow: this is the cash flow that is realized because of a decision;
• externality: this refers to the ripple effect of an investment. If possible, these effects should be part of the investment decision. Cannibalization is one example of an externality. This occurs when an investment results in customers and sales moving away from another part of a company.
• conventional cash flow versus non-conventional cash flow: a conventional cash flow pattern has an initial cash outflow followed by a series of cash inflows. Conversely, a non-conventional cash flow pattern is one in which the initial cash outflow is not followed by cash inflows only. Instead the cash flows can flip from positive to negative again (or even change signs several times).

Question

Which of the following statements is most likely accurate?

1. In capital budgeting, only pre-tax cash flows should be considered.
2. The timing of cash flows is crucial to the capital budgeting process.
3. A non-conventional cash flow pattern is one that has an initial cash outflow followed by a series of cash inflows.

Solution

The correct answer is B.

Capital budgeting analysts make an extraordinary effort to detail precisely when cash flows occur.

A is incorrect because cash flows are analyzed on an after-tax basis; taxes have to be fully reflected in capital budgeting decisions.

C is incorrect because a conventional cash flow pattern (not a nonconventional cash flow pattern) is the one which has an initial cash outflow followed by a series of cash inflows.

What kind of cash flow is relevant for capital budgeting decisions?

What is considered a capital budgeting decision?

How are cash flows estimated for capital budgeting?

Why cash flow is important in capital budgeting?