Chapter 8 - Pearson Learning Solutions

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$College of Marin Study Guide for Math 95 A,B - Pearson Learning ...$

326 PART THREE Long-Term Investment DecisionsFIGURE 8.1Conventional Cash FlowTime line for a conventionalcash flow patternCash Inflows0$2,000$2,000$2,000$2,000$2,000$2,000$2,000$2,000Cash Outflows123 4 5End of Year678$10,000conventional cashflow patternAn initial outflow followedonly by a series of inflows.nonconventional cashflow patternAn initial outflow followedby a series of inflows andoutflows.Conventional versus Nonconventional Cash Flow PatternsCash flow patterns associated with capital investment projects can be classified asconventional or nonconventional. A conventional cash flow pattern consists ofan initial outflow followed only by a series of inflows. For example, a firm mayspend $10,000 today and as a result expect to receive equal annual cash inflows(an annuity) of $2,000 each year for the next 8 years, as depicted on the timelinein Figure 8.1. 1 A conventional cash flow pattern that provides a mixed stream ofcash inflows is depicted in Figure 8.3.A nonconventional cash flow pattern is one in which an initial outflow is followedby a series of inflows and outflows. For example, the purchase of amachine may require an initial cash outflow of $20,000 and may generate cashinflows of $5,000 each year for 4 years. In the fifth year after purchase, an outflowof $8,000 may be required to overhaul the machine, after which it generatesinflows of $5,000 each year for 5 more years. This nonconventional pattern isillustrated on the time line in Figure 8.2.Difficulties often arise in evaluating projects with nonconventional patternsof cash flow. The discussions in the remainder of this chapter and in <strong>Chapter</strong> 9are therefore limited to the evaluation of conventional cash flow patterns.FIGURE 8.2NonconventionalCash FlowTime line for anonconventionalcash flow patternCash InflowsCash Outflows0$5,000 $5,000$5,000 $5,0001 2 3 45$5,000 $5,000$5,000 $5,000 $5,0006 7 8 9 10$20,000$8,000End of Year1. Arrows rather than plus or minus signs are frequently used on time lines to distinguish between cash inflows andcash outflows. Upward-pointing arrows represent cash inflows (positive cash flows), and downward-pointingarrows represent cash outflows (negative cash flows).2008935971Principles of Managerial Finance, Brief Fifth Edition, by Lawrence J. Gitman. Copyright © 2009 by Lawrence J. Gitman. Published by Prentice Hall.
CHAPTER 8 Capital Budgeting Cash Flows 327REVIEW QUESTIONS8–1 What is capital budgeting? Do all capital expenditures involve fixedassets? Explain.8–2 What are the key motives for making capital expenditures? Discuss, compare,and contrast them.8–3 What are the five steps involved in the capital budgeting process?8–4 Differentiate between the members of each of the following pairs of capitalbudgeting terms: (a) independent versus mutually exclusive projects;(b) unlimited funds versus capital rationing; (c) accept–reject versus rankingapproaches; and (d) conventional versus nonconventional cash flowpatterns.LG3relevant cash flowsThe incremental cash outflow(investment) and resultingsubsequent inflows associatedwith a proposed capitalexpenditure.incremental cash flowsThe additional cash flows—outflows or inflows—expectedto result from a proposedcapital expenditure.initial investmentThe relevant cash outflowfor a proposed project attime zero.8.2 Relevant Cash FlowsTo evaluate capital expenditure alternatives, the firm must determine the relevantcash flows. These are the incremental cash outflow (investment) and resultingsubsequent inflows. The incremental cash flows represent the additional cashflows—outflows or inflows—expected to result from a proposed capital expenditure.As noted in <strong>Chapter</strong> 3, cash flows rather than accounting figures are used,because cash flows directly affect the firm’s ability to pay bills and purchase assets.The remainder of this chapter is devoted to the procedures for measuring therelevant cash flows associated with proposed capital expenditures.Major Cash Flow ComponentsThe cash flows of any project having the conventional pattern can include threebasic components: (1) an initial investment, (2) operating cash inflows, and (3)terminal cash flow. All projects—whether for expansion, replacement or renewal,or some other purpose—have the first two components. Some, however, lack thefinal component, terminal cash flow.Figure 8.3 depicts on a time line the cash flows for a project. The initialinvestment for the proposed project is $50,000. This is the relevant cash outflowFIGURE 8.3Cash Flow ComponentsTime line for major cashflow componentsOperatingCash InflowsTerminalCash Flow$25,000$5,000 $7,000 $8,000 $8,000 $10,000$4,000 $6,000 $7,000 $8,000 $9,0000123456789102008935971$50,000InitialInvestmentEnd of YearPrinciples of Managerial Finance, Brief Fifth Edition, by Lawrence J. Gitman. Copyright © 2009 by Lawrence J. Gitman. Published by Prentice Hall.
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