Preparation of capital budgets
The process for evaluating and selecting long-term investments that are consistent with the company's goal of maximizing the wealth of the owners.
Capital expenditure
A disbursement of funds that the company makes with the expectation that it will provide benefits for a period of time greater than one year.
Current expenditure
A disbursement of funds that generates benefits that they receive over a period of one year.
Capital budgeting process
Five different but related steps to know if: creation of proposals, review and analysis, decision-making, execution and follow-up.}
Independent projects
Projects whose cash flows are not related to or are independent of each other; acceptance of one does not mean elimination of others.
Mutually exclusive projects
Projects that compete with each other in such a way that accepting one eliminates the others from being considered.
Annuity
A stream of equitable annual cash flows.
Mixed stream
A series of cash flows exhibiting any pattern other than that of an annuity.
Relevant cash flows
The cash outflow (investment) and the resulting incremental after-tax inflows relate to the proposed capital expenditure.
Incremental cash flows
The additional cash flows (outflows or inflows) that are expected as a result of a proposed capital expenditure.
Reasons for capital expenditures
Capital expenditures are made for many reasons. The basic reasons are to expand, replace or renovate fixed assets to obtain some other tangible benefit over an extended period.
Conventional and unconventional patterns of cash flows
A conventional cash flow pattern consists of an initial outflow followed only by a series of inflows. For example, a business could spend $ 10,000 today and as a result it would expect to receive equitable annual cash inflows of $ 2,000 each year for the next 8 years.
An unconventional cash flow pattern is one in which an initial outflow is not followed by just a series of inflows; For example, the purchase of a machine that requires an initial cash outflow of $ 20,000 and generates cash inflows of $ 5,000 per year for four to years. In the fifth year after purchase, a cash outflow of $ 8000 is required to service the machine after which it generates cash inflows of $ 5000 per year for five years.
Main components of cash flows
In any project, cash flows that exhibit a conventional pattern include three basic components:
1) an initial investment.
2) operating cash inflows.
3) terminal cash flow.
All projects (expansion, replacement or renovation) have the first two components. However, some lack the final component, that is, the terminal cash flow.
Sunk costs and opportunity costs
Sunk costs are cash disbursements that have already been made (that is, past disbursements) and therefore have no effect on cash flows relevant to the current decision. As a result, sunk costs should not be included in a project's incremental cash flows. Opportunity costs are cash flows that could result from the most appropriate alternative use of an asset that is owned; therefore, they represent cash flows that are not produced by the use of said asset in the proposed project. For this reason, any opportunity cost should be included as a cash outflow when determining the incremental cash flows of a project.
