Financial Management FIN_3701_Summary

Study Unit 01 - CAPITAL BUDGETING AND CASH FLOW PRINCIPLES Capital budgeting: Process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximising owner wealth. Capital expenditure: Outlay of funds with expected benefits over a period of time greater than one year. Operating expenditure: Outlay of funds with expected benefits received within one year. Reasons for capital expenditure: Expansion of operations (most common motive) Replacement or renewal (in maturity stage) Other purposes (advertising, R&D) Steps in the capital budgeting process: 1. Proposal generation 2. Review and analysis 3. Decision making 4. Implementation 5. Follow-up Two Types of projects that needs financing: 1. Independent projects: Unrelated and independent cash flows. Acceptance of one does not eliminate the other from considerations. 2. Mutually exclusive projects: Have the same function. Acceptance of one eliminates the need for other option. Example: Expanding plant OR buying another company (same purpose) If firms have UNLIMITED FUNDS all independent project that will deliver an acceptable return can be accepted. Most firms operate under CAPITAL RATIONING with only a fixed budget for capital expenditure. TWO approaches: Accept-Reject: Evaluating capital expenditure proposals to determine if they meet the firm’s minimum acceptance criterion. Used when the firm has unlimited funds. Ranking: Screen projects according to predetermined measures + rank from first to last. Only acceptable projects should be ranked. Conventional cash flow pattern: Initial outflow followed by a series of inflows. Unconventional cash flow patterns: Initial outflow is followed by a series of inflows and outflows. Relevant cash flows: Inflows and Outflows related to a specific projects or investment decision. Major cash flow components: 1. Initial investment 2. Operating cash flow 3. Terminal cash flow (does not include operating cash flow in the last year)  All projects have at least the first two components