5 - Valuation of Cash Flows and Capital Budget Allocation

Summary

INTRODUCTION

Capital budgeting is an investment decision to be taken by a firm or a company as to whether a project should be undertaken or not. Every capital budgeting decision that a firm takes will change the volume of the cash receipts and payments of the firm. For instance, suppose a firm is considering introducing a new product. Then in order to ensure that the new product occupies a significant position in the market, it is necessary that the product is advertised and distributed properly. This will involve a sequence of cash outflows from the firm in terms of payment for advertising, service for distribution, transportation cost etc. If the product is a substitute of an already available product in the market, then there may be additional expenditures like the one for quality packaging. The firm, of course, will start receiving cash inflows from the sale of the product after a certain period. A bank loan is one way of financing the expenditure of the project. Alternatively, a highly significant number of stocks can be issued to finance the expenditure partly or fully. This will mean that the same amount of equity is to be distributed among an increased number of shareholders. The organization would need to consider the impact of an additional loan on the overall cost of financing the projects.