FINA Text BK - MODULE 07 - Cap cshfl

FINA Text BK - MODULE 07 - Cap cshfl - MODULE 07 CAPITAL...

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07: Page 1 of 28 MODULE 07 CAPITAL BUDGETING 1. ESTIMATING CASH FLOWS This module starts you on your mastery of capital budgeting. You’ll get a brief overview of capital budgeting, then move into estimating the cash flows used in the process. Ranking and selecting capital investments require management to forecast cash flows over many years. Errors in forecasting have serious results because of the large size and long life. Consider the experience of companies in the oil industry as an example of the importance of capital investments. After the Arab oil embargo of 1973, the oil business enjoyed the strongest boom in its history. It lasted until the end of 1981. The posted price of OPEC (Organization of Petroleum Exporting Countries) crude oil peaked at $34 a barrel. After a price collapse, the price of oil reached $80 per barrel in 2006 and $146 per barrel in 2008, and then another collapse. U.S. oil companies made large capital investments while oil prices rose, financing investments with bonds, bank loans, issues of new shares of common stock, and earnings retained. The oil industry erred in the past like many others have erred. Managers forecast cash flows based on their expectations of increasing oil prices. Most oil companies in the 70s and 80s and in 2008 started large, ambitious projects because of the high profits and seemingly permanent nature of cash flows. The economic bubble burst each time as a glut of oil forced OPEC to cut prices. A precipitous decline in oil company profits and cash flow followed. Capital investments that seemed profitable in the 70s and 80s based on oil prices of $34 a barrel were failures at $17 a barrel. Some companies went bankrupt. And many teetered on the brink with cash flows barely above the level required to service debt. When Iraq invaded Kuwait in 1990, optimism spread throughout the industry, and again companies overestimated cash flows. The resulting capital investments led to overcapacity and yet another period of depressed earnings and cash flows. With oil prices in 2008 around $140 per barrel range, the industry again embarked on a capital-investment binge to expand capacity and production. Here we go again? Oil companies share a common failing: Management makes incorrect forecasts of cash flows because the estimates are based on animal spirits, excess exuberance about future prospects. That’s a problem because oil companies are unable to cut expenses or sell assets to generate cash when cash flows decline below expected levels. Lenders and investors are unwilling to advance more loans to companies on the brink of bankruptcy. The result is widespread declines in stock prices and increases in bankruptcies. Financial managers have the challenging task of analyzing capital investment proposals and recommending action for the company to take. To help you understand this process, the module begins with estimating investment cash flows. It then considers operating cash flows and terminal cash flow at the end of a proposed project's expected life. When you finish this module, you will be able to do
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This note was uploaded on 05/10/2010 for the course FINA 3770 taught by Professor Chandy during the Fall '08 term at North Texas.

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FINA Text BK - MODULE 07 - Cap cshfl - MODULE 07 CAPITAL...

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