Chapter 10 & Chapter 11
10.1 Overview of capital budgeting
Capital budgeting: is the process of identifying, evaluating and implementing a firm’s long-term
investment opportunities
Identify investments that will enhance a firm’s competitive advantage and increase shareholder
wealth
Capital budgeting decisions involve a large up-front investment followed by a series of smaller cash
inflows
Poor capital budgeting decision can ultimately result in bankruptcy
Variety of long-term investment decisions, but mostly involve the investment in fixed assets (PPE)
o These assets are often referred to as earning assets
Motives for capital expenditure
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 by the firm resulting in benefits received within one year
Fixed-asset outlays are capital expenditure, but not all capital expenditures are classified as fixed
assets
Basic motives for capital expenditures are to expand operations, to replace or renew fixed assets,
or to obtain some other, les tangible benefit over a long period
Steps in the process
Capital budgeting process:
1. Proposal generation
Proposals for new investment projects are made at all levels within a business organisation
and are review by finance personnel
2. Review and analysis
Financial managers perform formal review and analysis to assess the merits of investment
proposals
3. Decision-making
Firms typically delegate capital expenditure decision making on the basis of rand limits
Generally, the board of directors must authorise expenditures beyond certain amounts
Plant managers are often given authority to make decisions necessary to keep the
production line moving
4. Implementation
Following approval, expenditures are made and projects implemented
Expenditures for a large project often occur in phases
5. Follow-up
Results are monitored
Actual costs and benefits are compared with those that were expected
o Action may be required if outcomes differ from projected ones
Step 2 and 3 take up majority of the time and effort
, Step 5 is important but is often ignored
Basic terminology
Independent versus mutually exclusive projects
Independent projects:
o Projects whose cash flows are unrelated to (or independent of) one another
o The acceptance of one does not eliminate the others from further consideration
o Projects do not compete with firm’s resources
o A company can select on, or the other, or both – so long as they meet minimum profitability
thresholds
Mutually exclusive projects:
o Projects that compete with one another so that the acceptance of one eliminates from
further consideration of all other projects that serve a similar function
o A firm can select one or another but not both
o Projects compete in some way for a company’s resources
Unlimited funds versus capital rationing
Unlimited funds:
o If a firm has unlimited funds (or it can raise as much money as it neds by borrowing or
issuing stock) for making investments, then all independent projects that provide greater
returns than some specified level can be accepted and implemented
Capital rationing:
o Firm only have a given amount of funds available to invest in potential investment projects
at any given time
o Numerous projects will compete for these funds
Accept-reject versus ranking approaches
Accept-reject approach:
o Involves the evaluation of capital expenditure proposals to determine whether they meet
the firm’s minimum acceptance criteria
o Can be used when the firm has unlimited fuds, as a preliminary step when evaluating
mutually exclusive projects, or in situation when capital must eb rationed
Ranking approach:
o Involves ranking of capital expenditure on the basis of some predetermined measure, such
as the rate of return
o Projects with the highest return are ranked first
o Only acceptable projects should be ranked
o Ranking is useful in selecting the ‘best’ of a group of mutually exclusive projects and in
evaluating projects with a view of capital rationing
11.1Relevant cash flows
To evaluate capital investment alternatives, we must focus on incremental cash flows
Incremental cash flows: Additional cash flows (initial outflow and subsequent inflows) expected to
result from a proposed capital expenditure
o Effect on the firm’s other investments must be considered
10.1 Overview of capital budgeting
Capital budgeting: is the process of identifying, evaluating and implementing a firm’s long-term
investment opportunities
Identify investments that will enhance a firm’s competitive advantage and increase shareholder
wealth
Capital budgeting decisions involve a large up-front investment followed by a series of smaller cash
inflows
Poor capital budgeting decision can ultimately result in bankruptcy
Variety of long-term investment decisions, but mostly involve the investment in fixed assets (PPE)
o These assets are often referred to as earning assets
Motives for capital expenditure
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 by the firm resulting in benefits received within one year
Fixed-asset outlays are capital expenditure, but not all capital expenditures are classified as fixed
assets
Basic motives for capital expenditures are to expand operations, to replace or renew fixed assets,
or to obtain some other, les tangible benefit over a long period
Steps in the process
Capital budgeting process:
1. Proposal generation
Proposals for new investment projects are made at all levels within a business organisation
and are review by finance personnel
2. Review and analysis
Financial managers perform formal review and analysis to assess the merits of investment
proposals
3. Decision-making
Firms typically delegate capital expenditure decision making on the basis of rand limits
Generally, the board of directors must authorise expenditures beyond certain amounts
Plant managers are often given authority to make decisions necessary to keep the
production line moving
4. Implementation
Following approval, expenditures are made and projects implemented
Expenditures for a large project often occur in phases
5. Follow-up
Results are monitored
Actual costs and benefits are compared with those that were expected
o Action may be required if outcomes differ from projected ones
Step 2 and 3 take up majority of the time and effort
, Step 5 is important but is often ignored
Basic terminology
Independent versus mutually exclusive projects
Independent projects:
o Projects whose cash flows are unrelated to (or independent of) one another
o The acceptance of one does not eliminate the others from further consideration
o Projects do not compete with firm’s resources
o A company can select on, or the other, or both – so long as they meet minimum profitability
thresholds
Mutually exclusive projects:
o Projects that compete with one another so that the acceptance of one eliminates from
further consideration of all other projects that serve a similar function
o A firm can select one or another but not both
o Projects compete in some way for a company’s resources
Unlimited funds versus capital rationing
Unlimited funds:
o If a firm has unlimited funds (or it can raise as much money as it neds by borrowing or
issuing stock) for making investments, then all independent projects that provide greater
returns than some specified level can be accepted and implemented
Capital rationing:
o Firm only have a given amount of funds available to invest in potential investment projects
at any given time
o Numerous projects will compete for these funds
Accept-reject versus ranking approaches
Accept-reject approach:
o Involves the evaluation of capital expenditure proposals to determine whether they meet
the firm’s minimum acceptance criteria
o Can be used when the firm has unlimited fuds, as a preliminary step when evaluating
mutually exclusive projects, or in situation when capital must eb rationed
Ranking approach:
o Involves ranking of capital expenditure on the basis of some predetermined measure, such
as the rate of return
o Projects with the highest return are ranked first
o Only acceptable projects should be ranked
o Ranking is useful in selecting the ‘best’ of a group of mutually exclusive projects and in
evaluating projects with a view of capital rationing
11.1Relevant cash flows
To evaluate capital investment alternatives, we must focus on incremental cash flows
Incremental cash flows: Additional cash flows (initial outflow and subsequent inflows) expected to
result from a proposed capital expenditure
o Effect on the firm’s other investments must be considered
