Principles of Managerial Finance

360 PART 3 Long-Term Investment Decisions

relevant cash flows
The incremental cash outflow
(investment) and resulting subse-
quent inflowsassociated with a
proposed capital expenditure.

incremental cash flows
The additionalcash flows—
outflows or inflows—expected
to result from a proposed capital
expenditure.

0

$20,000

End of Year

Cash Inflows

Cash Outflows

5

$8,000

10

$5,000

9

$5,000

8

$5,000

7

$5,000

6

$5,000

4

$5,000

3

$5,000

2

$5,000

1

$5,000

FIGURE 8.2

Nonconventional
Cash Flow
Time line for a nonconven-
tional cash flow pattern

LG3

may require an initial cash outflow of $20,000 and may generate cash inflows of

$5,000 each year for 4 years. In the fifth year after purchase, an outflow of $8,000

may be required to overhaul the machine, after which it generates inflows of

$5,000 each year for 5 more years. This nonconventional pattern is illustrated on

the time line in Figure 8.2.

Difficulties often arise in evaluating projects with nonconventional patterns

of cash flow. The discussions in the remainder of this chapter and in Chapters 9

and 10 are therefore limited to the evaluation of conventional cash flow patterns.

Review Questions

8–1 What is capital budgeting?Do all capital expenditures involve fixed

assets? Explain.

8–2 What are the key motives for making capital expenditures? Discuss, com-

pare, 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 capi-

tal budgeting terms: (a) independent versus mutually exclusive projects;

(b) unlimited funds versus capital rationing; (c) accept–reject versus rank-

ing approaches; and (d) conventional versus nonconventional cash flow

patterns.

8.2 The Relevant Cash Flows

To evaluate capital expenditure alternatives, the firm must determine the relevant

cash flows.These are the incremental cash outflow (investment) and resulting

subsequent inflows.The incremental cash flowsrepresent the additionalcash

flows—outflows or inflows—expected to result from a proposed capital expendi-

ture. As noted in Chapter 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

the relevant cash flows associated with proposed capital expenditures.