Principles of Managerial Finance

CHAPTER 8 Capital Budgeting Cash Flows 359

accept–reject approach
The evaluation of capital
expenditure proposals to
determine whether they meet the
firm’s minimum acceptance
criterion.

ranking approach
The ranking of capital expendi-
ture projects on the basis of
some predetermined measure,
such as the rate of return.

conventional cash flow pattern
An initial outflow followed only
by a series of inflows.

nonconventional
cash flow pattern
An initial outflow followed by a
series of inflows andoutflows.

capital rationing
The financial situation in which
a firm has only a fixed number of
dollars available for capital
expenditures, and numerous
projects compete for these
dollars.

0

$10,000

End of Year

Cash Inflows

Cash Outflows^8

$2,000

7

$2,000

6

$2,000

5

$2,000

4

$2,000

3

$2,000

2

$2,000

1

$2,000

FIGURE 8.1

Conventional Cash Flow
Time line for a conventional
cash flow pattern

2. Arrows rather than plus or minus signs are frequently used on time lines to distinguish between cash inflows and
   cash outflows. Upward-pointing arrows represent cash inflows (positive cash flows), and downward-pointing
   arrows represent cash outflows (negative cash flows).

be accepted. Typically, though, firms operate under capital rationing instead.

This means that they have only a fixed number of dollars available for capital

expenditures and that numerous projects will compete for these dollars. Proce-

dures for dealing with capital rationing are presented in Chapter 10. The discus-

sions that follow here and in the following chapter assume unlimited funds.

Accept–Reject versus Ranking Approaches

Two basic approaches to capital budgeting decisions are available. The accept–

reject approachinvolves evaluating capital expenditure proposals to determine

whether they meet the firm’s minimum acceptance criterion. This approach can

be used when the firm has unlimited funds, as a preliminary step when evaluating

mutually exclusive projects, or in a situation in which capital must be rationed. In

these cases, only acceptable projects should be considered.

The second method, the ranking approach,involves ranking projects on the

basis of some predetermined measure, such as the rate of return. The project with

the highest return is ranked first, and the project with the lowest return is ranked

last. Only acceptable projects should be ranked. Ranking is useful in selecting the

“best” of a group of mutually exclusive projects and in evaluating projects with a

view to capital rationing.

Conventional versus Nonconventional Cash Flow Patterns

Cash flow patterns associated with capital investment projects can be classified as

conventionalor nonconventional.A conventional cash flow patternconsists of

an initial outflow followed only by a series of inflows. For example, a firm may

spend $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 time line

in Figure 8.1.^2 A conventional cash flow pattern that provides unequal annual

cash inflows is depicted in Figure 8.3 on page 361.

Anonconventional cash flow patternis one in which an initial outflow is fol-

lowed by a series of inflowsandoutflows. For example, the purchase of a machine