Earnings and Cash Flow

EARNINGS AND CASH FLOW

The nature and characteristics of capital investment decisions warrant a careful analysis of investment alternatives . A set of systematic capital budgeting procedures is necessary to ensure that all capital investment proposals are evaluated considering the organization 's goals and policies so that the best alternative is undertaken . The importance of a systematic process is highlighted by the difficulty of evaluating capital investment proposal since it involves the future . As such , many methods or techniques are developed and used to provide decision makers an educated and rational choice

in the midst of the future 's uncertainty

The capital budgeting process may vary among firms , but they usually go through the basic stages of the process . In the first phase , different departments submit their capital project proposals along with the preparation of the master budget plan . In doing so , the costs and benefits are estimated , considering the corporate criteria set . This is quite strenuous since projects involve estimation that encompasses a number of years . As a rule of thumb , the longer the time for the realization and recovery of the investment , the more risky the project is . Once the project proposals are gathered , they are evaluated in the light of the firm 's goals and policies . This is the stage where both quantitative and qualitative factors are put into play . Upon approval the capital budget is prepared that may look as a simple as a list of all approved projects or as complex as the inclusion of detailed descriptive data about each . Finally , projects are reevaluated periodically to determine if the projects are still in line with the original expectations . The firm can learn two important things in this stage . First , errors committed would serve as a learning point in making realistic predictions and secondly , it gives the firm the chance to compare existing projects with alternative capital investment opportunities

The overarching justification for pushing through with a capital investment is its effect on the firm as a whole . Since the firm would lay a considerable amount of money on a project , it should recover the investment through the project 's net cash inflow . The type of project dictates the type of annual cash inflow . For replacement of existing but old machinery for instance , cash inflow could be the savings on avoidable repair costs of the old machinery . For a project characterized by a significant improvement in business processes , cash inflow normally includes the additional income the new project would contribute . The same can be said for an expansion project such as an introduction of a new product line , in addition to the strategic affect on the business as a whole . Whether the effect is savings or additional income , the yield of a successful capital investment would ultimately affect the firm 's periodic business performance . If the net income is high , and on the presumption that minimally , return on equity increases

In making capital investment decisions , quantitative evaluation methods are usually employed . This can be grouped into two...