INTERNATIONAL CAPITAL BUDGETING
I: THE BASICS OF CAPITAL BUDGETING
1. WHAT IS CAPITAL BUDGETING?
Capital budgeting may be defined as the process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year. Capital budgeting involves the following: * Generating investment project proposals consistent with the firm’s strategic objectives * Estimating after-tax incremental operating cash flows for the investment projects * Evaluating Project incremental cash flows
* Selecting Projects based on value-maximizing acceptance criterion * Reevaluating implemented projects continually and performing post-audits for completed projects.
2. GENERATING INVESTMENT PROJECT PROPOSALS
Investment project proposals can stem from a variety of sources. For the purpose of analysis, projects may be classified into one of the following categories: (i) New Products or Expansion of Existing Project
(ii) Replacement of equipment or buildings
(iii) Research and Development
(v) Safety and/or environmental projects
For a new product, the proposal usually originates in the marketing department. A proposal to replace a piece of equipment with a more sophisticated model, however, usually arises from the production area of the firm.
3. ESTIMATING AFTER-TAX INCREMENTAL OPERATING CASH FLOWS
One of the most important tasks in capital budgeting is estimating future cash flows for a project. In evaluating a capital budget project we are concerned only with those cash flows that results directly from the project. These cash flows, called incremental cash flows, represents changes in the firm’s total cash flows that occur as a direct result of accepting or rejecting the project. Basic Characteristics of the Relevant Project Flows
* Incremental (not total) flows
* Cash (not accounting income) flows. Since cash, not accounting income is central to all decisions of the firm, we express the benefit we expect to receive from a projection terms of cash flows rather than income flows. * Operating (not financing) flows. For each investment we used to provide information on operating as opposed to financing cash flows. Financing flows such as interest payments, principal payments, and cash dividends are excluded from our cash flow analysis.
Basic Principles that must be adhered to in estimating the after tax incremental operating cash follows: Ignore Such Costs:
These are unrecovered past outlays which, since they cannot be recovered, should not affect present actions on future decisions. Include Opportunity Costs:
Opportunity cost may be defined as what is lost by not taking the next-best investment alternative. For instance if we allocate plant space to a project and this space can be used for something else, its opportunity cost must be included in the project’s evaluation. Include project driven changes in working capital net of spontaneous changes in current liabilities Consider effects of inflation
Calculating the Incremental Cash Flows
It is helpful to place project cash flows into three categories based on timing: (i) Initial Cash outflow (= the initial net cash investment) (ii) Interim Incremental net Cash Flows (= those net cash flows occurring after the initial cash investment but not including the final period’s cash flows). (iii) Terminal Year Incremental Net Cash Flow (This period’s cash flows is singled out for special attention because a particular set of cash flows often occurs at project termination) Basic Format For Determining Initial Cash Outflow
Cost of New Asset(s)