Interview Questions

Capital Budgeting and Cash Flow Analysis

Key Chapter Concepts

  1. Capital budgeting is the process of planning for purchases of assets whose cash flows are expected to continue beyond one year.
  2. The cost of capital is defined as the cost of funds supplied to a firm. It represents the required rate of return a firm must earn on its investments and thus is an important input in the capital budgeting process.
  3. There are four key steps in the capital budgeting process:
    a. Generating investment project proposals
    b. Estimating cash flows
    c. Evaluating alternatives and selecting projects to be implemented
    d. Reviewing a project’s performance after it has been implemented and postauditing its performance after termination
  4. Investment projects can be generated by growth opportunities, by cost reduction opportunities, and to meet legal requirements and health and safety standards.
  5. The initial outlay required to implement a project is called the net investment. It includes
    a. The installed cost of the assets
    b. Plus any initial net working capital requirements
    c. Less any cash inflows from the sale of replacement assets
    d. Plus or minus the tax consequences associated with the sale of existing assets and/or the purchase of new assets.
  6. The net operating cash flow from a project is equal to the change in net operating earnings after tax plus the change in depreciation minus the change in net working capital investment requirements associated with the adoption of a project. In the last year of a project’s life, this net cash flow definition may have to be modified to reflect the recapture of the accumulated net working capital investment and any after -tax salvage value received.
  7. The economic viability of a project can be affected by special tax considerations, such as the use of accelerated depreciation methods like the Modified Accelerated Cost Recovery System (MACRS) of depreciation.

Capital Investment Opportunities During a Business Downturn:The Case of Cleveland Cliffs Inc.

Financial Challenge

When the economy enters a period of low or negative economic growth, many firms cut back on the capital investments they had planned to make. With low or no growth in demand for their products, many firms postpone expansions. During business downturns, other firms become strapped for cash and look to sell off surplus assets so that they can acquire the cash that will be needed to survive the downturn. Still others are forced to enter bankruptcy proceedings and often liquidate assets as part of that process.

It is in times like these, such as late 2001 and early 2002, that opportunities present themselves to firms that are well positioned with strong balance sheets and ample cash balances.

In some cases, the acquisition of another firm’s assets may be driven by the fact that the assets being acquired may be a better strategic fit for the acquiring firm than for the seller. For example, in late 2001 Mead Corporation sold its Western Graphics poster-making unit to Rose Art Industries (the second largest maker of crayons).

Rose aims to dominate the art -and-crafts market in the United States. Similarly, Eaton Corporation recently sold its air- conditioning business unit to Parker-Hannifin. Eaton wanted to exit the air -conditioning business, whereas Parker-Hannifin, armed with $825 million in cash, wanted to grow this sector of its business.

In other cases, the acquisitions represent moves of desperation by firms that are short of cash. Under these circumstances,“fire-sale” prices can be found by those with abundant liquid resources. For example, in 2001, Cleveland Cliffs Inc., a firm that controls half of the nation’s iron-ore production, used the business downturn and the financial woes of many steel producers to pick up additional iron mines at bargain prices. Nearly a third of Cleveland Cliffs’ customers were in bankruptcy proceedings in late 2001, and many of these firms have ownership interests in iron mines that they were willing to unload.

WHX (parent company of Wheeling-Pittsburgh Steel), for example, agreed to sell Cleveland Cliffs its 12.5 percent share in a Michigan mine for no cash. Cleveland Cliffs merely had to assume the debt on the mine. Similar acquisitions of mining properties owned by bankrupt Bethlehem Steel and bankrupt LTV were also in the works. Cleveland Cliffs has been successful in cutting its costs, reducing the tax on the production from these mines, and securing other concessions from the states where they operate in exchange for commitments to keep the mines open.This cost -cutting was an essential element of the financing of these acquisitions. Cleveland Cliffs now considers every iron -ore mine owned by U.S. steelmakers to be for sale, and was aggressively pursuing them during the period of the business downturn and cash flow problems for the nation’s steelmakers.

Other companies have used the weak business climate as an opportunity to acquire strategic resources and bargain prices. For example, Kinder Morgan Energy Partners LP spent about $500 million on acquisitions during 2001. During 2001, American Greetings Corporation paid $35 million to buy its biggest online competitor, BlueMountain. A few years ago, Excite@Home, which entered Chapter 11 bankruptcy proceedings, had paid $780 million to acquire BlueMountain.

Acquisitions such as these offer some important lessons. First, liquidity provides a company with opportunities to acquire assets at very favorable prices during times of weak business conditions. Strong firms set the stage for further growth by making bargain purchases during business downturns. Second, there is usually a price at which the assets in even the weakest industries (such as iron -ore mines) can make good economic sense. Cleveland Cliffs’ strategy of picking up iron -ore mine assets at bargain prices speaks to this. Regardless of the economic conditions, financial managers need to scrutinize all major capital investments to determine whether they are likely to contribute to the creation of shareholder value.

The analysis of capital investments (that is, projects having economic lives extending beyond one year in time) is a key financial management function. Each year, large and small firms spend hundreds of billions of dollars on capital investments. These investments chart the course of a company’s future for many years to come.Therefore, it is imperative that capital investment analysis be performed correctly. This chapter develops the principles of capital investment analysis —with an emphasis on the estimation of cash flows from a project. Chapter considers appropriate decision criteria in the capital budgeting process that will maximize shareholder wealth.

Introduction

This is the first of several chapters that explicitly deal with the financial management of the assets on a firm’s balance sheet. In this and the following two chapters we consider the management of long -term assets.

Capital budgeting

is the process of planning for purchases of assets whose returns are expected to continue beyond one year.A capital expenditure is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than one year. It is distinguished from a normal operating expenditure, which is expected to result in cash benefits during the coming 1-year period. (The choice of a 1-year period is arbitrary, but it does serve as a useful guideline.)

Several different types of outlays may be classified as capital expenditures and evaluated using the framework of capital budgeting models, including the following:

  • The purchase of a new piece of equipment, real estate, or a building in order to expand an existing product or service line or enter a new line of business
  • The replacement of an existing capital asset, such as a drill press
  • Expenditures for an advertising campaign
  • Expenditures for a research and development program
  • Investments in permanent increases of target inventory levels or levels of accounts receivable
  • Investments in employee education and training
  • The refunding of an old bond issue with a new, lower-interest issue
  • Lease-versus-buy analysis
  • Merger and acquisition evaluation

Total investments or capital expenditures of all industries in the United States during 2002 exceeded $1.1 trillion. Capital expenditures are important to a firm both because they require sizable cash outlays and because they have a long -range impact on the firm’s performance. The following example illustrates the magnitude and long-term impact of capital expenditures for an individual company.

In June 2002, Ford Motor Company announced plans to invest $5 billion to $6 billion in Volvo, its Swedish luxury -car subsidiary that it had purchased for $6.5 billion in 1999.1 The bulk of the funds invested were to be used to build up to five new or redesigned midsize vehicle models. Also, part of the capital invested was to be used to expand its manufacturing facilities in Sweden and Belgium in order to be able t produce up to 600,000 units per year, compared with the 425,000 units it produced in 2001. These capital expenditures were being made despite a weak economy, a loss of $5.45 billion by Ford in the previous year, and a 15 percent drop in Volvo’s U.S. sales during the first five months of 2002, compared with the previous year. Despite these concerns, Ford had confidence in Volvo’s new products and the long-term health of the economy and the company.

A firm’s capital expenditures affect its future profitability and, when taken together, essentially plot the company’s future direction by determining which products will be produced, which markets will be entered, where production facilities will be located, and what type of technology will be used. Capital expenditure decision making is important for another reason as well.

Specifically, it is often difficult, if not impossible, to reverse a major capital expenditure without incurring considerable additional expense. For example, if a firm acquires highly specialized production facilities and equipment, it must recognize that there may be no ready used -equipment market in which to dispose of them if they do not generate the desired future cash flows.

For these reasons, a firm’s management should establish a number of definite procedures to follow when analyzing capital expenditure projects. Choosing from among such projects is the objective of capital budgeting models.


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