2. Basic Principles of Capital Budgeting

b. describe the basic principles of capital budgeting;

## c. explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing;

Are capital budgeting decisions based on accounting income or cash flows? Why? - Capital budgeting decisions must be based on cash flows, not accounting income - Cash flow timing is critical because money is worth more the sooner you get it. Also, firms must have adequate cash flow to meet maturing obligations.

For capital budgeting, are expected future cash flows measured on a before-or-after-tax basis? Expected future cash flows must be measured on an after-tax basis. The firm’s wealth depends on its usable after-tax funds.

What is a sunk cost? A sunk cost is a cash outlay that has already been incurred and which cannot be recovered regardless of whether a project is accepted or rejected.

What is incremental cash flow? Incremental cash flow is the net cash flow attributable to an investment project. It represents the change in the firm’s total cash flow that occurs as a direct result of accepting the project.

What is opportunity cost? Opportunity cost is the return on the best alternative use of an asset or the highest return that will not be earned if funds are invested in a particular project.

What are positive externalities? Positive externalities create benefits for other parts of the firm.

What are negative externalities? What is the primary type of negative externality? - Negative externalities create costs for other parts of the firm. - Cannibalization is the primary type of negative externality

What is a conventional vs non-conventional cash flow? - A conventional cash flow pattern is one with an initial outflow followed by a series of inflows. - A non-conventional cash flow pattern has an initial outflow which can be followed by inflows and/or outflows.

What is an independent vs mutually exclusive project? - Mutually exclusive projects are investments that compete in some way for a company’s resources - a firm can select one or another but not both. - Independent projects, on the other hand, do not compete for the firm’s resources.

What is capital rationing? Capital rationing occurs when management places a constraint on the size of the firm’s capital budget during a particular period. In such situations, capital is scarce and should be allocated to the projects most likely to maximize the firm’s aggregate NPV.