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Subject 2. Basic Principles of Capital Budgeting

Capital budgeting decisions are based on incremental after-tax cash flows discounted at the opportunity cost of capital. Assumptions of capital budgeting are:

  • Capital budgeting decisions must be based on cash flows, not accounting income.

    Accounting profits only measure the return on the invested capital. Accounting income calculations reflect non-cash items and ignore the time value of money. They are important for some purposes, but for capital budgeting, cash flows are what are relevant.

    Economic income is an investment's after-tax cash flow plus the change in the market value. Financing costs are ignored in computing economic income.

  • Cash flow timing is critical because money is worth more the sooner you get it. Also, firms must have adequate cash flow to meet maturing obligations.

  • The opportunity cost should be charged against a project. Remember that just because something is on hand does not mean it's free. See below for the definition of opportunity cost.

  • Expected future cash flows must be measured on an after-tax basis. The firm's wealth depends on its usable after-tax funds.

  • Ignore how the project is financed. Interest payments should not be included in the estimated cash flows since the effects of debt financing are reflected in the cost of capital used to discount the cash flows. The existence of a project depends on business factors, not financing.

Important capital budgeting concepts:

  • A sunk cost is a cash outlay that has already been incurred and which cannot be recovered regardless of whether a project is accepted or rejected. Since sunk costs are not increment costs, they should not be included in the capital budgeting analysis.

    For example, a small bookstore is considering opening a coffee shop within its store, which will generate an annual net cash outflow of $10,000 from selling coffee. That is, the coffee shop will always be losing money. In the previous year, the bookstore spent $5,000 to hire a consultant to perform an analysis. This $5,000 consulting fee is a sunk cost; whether the coffee shop is opened or not, the $5,000 is spent.

  • Incremental cash flow is the net cash flow attributable to an investment project. It represents the change in the firm's total cash flow that occurs as a direct result of accepting the project.

    • Forget sunk costs.
    • Subtract opportunity costs.
    • Consider side effects on other parts of the firm: externalities and cannibalization.
    • Recognize the investment and recovery of net working capital.

  • Opportunity cost is the return on the best alternative use of an asset or the highest return that will not be earned if funds are invested in a particular project. For example, to continue with the bookstore example, the space to be occupied by the coffee shop is an opportunity cost - it could be used to sell books and generate a $5,000 annual net cash inflow.

  • Externalities are the effects of a project on cash flows in other parts of a firm. Although they are difficult to quantify, they should be considered. Externalities can be either positive or negative:

    • Positive externalities create benefits for other parts of the firm. For example, the coffee shop may generate some additional customers for the bookstore (who otherwise may not buy books there). Future cash flows generated by positive externalities occur with the project and do not occur without the project, so they are incremental.

    • Negative externalities create costs for other parts of the firm. For example, if the bookstore is considering opening a branch two blocks away, some customers who buy books at the old store will switch to the new branch. The customers lost by the old store are a negative externality. The primary type of negative externality is cannibalization, which occurs when the introduction of a new product causes sales of existing products to decline.

    Future cash flows represented by negative externalities occur regardless of the project, so they are non-incremental. Such cash flows represent a transfer from existing projects to new projects, and thus should be subtracted from the new projects' cash flows.

  • Conventional versus non-conventional cash flows.

    • A conventional cash flow pattern is one with an initial outflow followed by a series of inflows.

    • In a non-conventional cash flow pattern, the initial outflow can be followed by inflows and/or outflows.

Some project interactions:

  • Independent versus mutually exclusive projects. Mutually exclusive projects are investments that compete in some way for a company's resources - a firm can select one or another but not both. Independent projects, on the other hand, do not compete for the firm's resources. A company can select one or the other or both, so long as minimum profitability thresholds are met.

  • Project sequencing. How does one sequence multiple projects over time, since investing in project B may depend on the result of investing in project A?

  • Unlimited funds versus capital rationing. Capital rationing occurs when management places a constraint on the size of the firm's capital budget during a particular period. In such situations, capital is scarce and should be allocated to the projects most likely to maximize the firm's aggregate NPV. The firm's capital budget and cost of capital must be determined simultaneously to best allocate the firm's capital. On the other hand, a firm can raise the funds it wants for all profitable projects simply by paying the required rate of return.

Study notes from a previous year's CFA exam:

2. Basic Principles of Capital Budgeting