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Operating expenses are short-term expenses where the benefits are enjoyed in the same period as the expense are incurred.Capital expenses involve obtaining the major productive asset:  a company will pay a substantial amount today to obtain the equipment, technology or other resource and will use this asset as part of the production process over several years. Capital Budgeting Process is a formal way for managers to guide their capital expenditure decisions. This process consists of six steps or phases.Net Present Value (NPV):A dollar measure of the impact of a project on the company’s wealth.  It uses the opportunity cost to bring all of the project’s incremental cash flows back to the present and then compares inflows to outflows to see if the project is acceptable.Internal Rate of Return (IRR):  The rate of return earned on a project.  To make a decision managers must compare the IRR to the opportunity cost.  They should only accept the project if it earns (IRR) more than should be expected (RRR) given other projects of equivalent risk. Profitability Index (PI):A ratio that calculates the relative wealth created per dollar invested.  It uses the same inputs–present values of inflows and present value of outflows–used for NPV but shows managers the relative wealth created rather than the total wealth created.  This specialized, relative measure has some specialized applications.  Payback calculates the amount of time it takes for a project to “payback” its initial investment.  The shorter the payback period the quicker the company gets its initial investment back and begins to see a profit.  Managers set the maximum payback period they will accept.  Projects with payback periods shorter than this maximum will be acceptable; projects exceeding this project will be rejected. average accounting return is the rate of return earned on a project. It is calculated by comparing the average net income earned by a project to the cost of the project, measured by the average book value. In a way similar to Payback, managers will set a minimum AAR.  If the project earns more than this specified rate, it is accepted.  If the ARR is less, the project will be rejected.  While useful for some purposes the AAR is not based on future cash flows, and does not use the opportunity cost.  It is thus of limited use in making decisions about the future Economically independent projects are ones where making one choice is independent of other choices.  Managers can accept all projects that are wealth-increasing.Mutually exclusive projects are projects where choosing one project precludes the adoption of other projects.  Managers must rank these projects by some criteria and select the best project

.Capital rationing: The case where funds are limited to a fixed dollar amount and must be allocated among competing projects.  Managers need a method of ranking projects, or portfolio of projects, by their desirability and selecting the higher-ranked projects until their funds are fully committed.Soft rationing: Limits on investments are made by managers for better control of the firm.Hard rationing: Funds are not available and managers must choose the best set of projects given their capital constraints.Divisible projects: A company may take on a portion of a project and get proportional benefits from the project.Indivisible projects:  A company may adopt a project in its entirety or not, but cannot take a portion of a project Incremental Cash Flows After Taxes (ICFAT) are the periodic cash outflows and inflows that occur if, and only if, an investment project is accepted.  Incremental cash flow focuses on the project, not the company as a whole.Economic interdependencies:  Adopting a project would change the cash flows in other parts of the company.Synergy:  The positive effect where adopting the project would increase the cash flows from existing operations.Erosion:  The negative effect where adopting the project would decrease the cash flows from existing operations.Sunk costs:  Costs that have already been incurred.  As such they would not be affected by the capital budgeting decision and are thus not incremental cash flows.Revenue enhancing project:   These projects introduce a new product, improve an existing product, or involve other aspects to increase sales, such as a major marketing campaign.Cost reduction project:  These projects focus on reducing costs.  Outsourcing of business functions or production, improving supply chains, employing machine learning lead to lower costs and thus higher income.Corporate Social Responsibility project:  The ExxonMobil project is an example of corporations contributing to society.  While the corporation’s function in society is to efficiently produce goods and services, corporations are expected to be good citizens.  These projects do help society, and also enhance the reputation of the company.Regulatory requirements project:  Governments regulate economic activity to protect society from harmful effects.  The most cost-effective way to handle toxic waste from a production process is to dump it into Lake Lady Bird.   These projects are undertaken because they are required.  Free cash flow (FCF)/Cash flow from assets:  The amount of cash generated by a company that is available to distribute to the firm’s creditors and owners.

Operating cash flow is earnings before interest plus depreciation minus taxes.   And, it’s important to remember that these cash flows have not yet occurred–we estimate what they would be if the project were to be adopted.  Capital spending is the cash that must be invested in the project’s capital assets to produce the projected operating cash flow!   Any operating cash flow that must be invested in productive assets is not available for the company’s security holders, so the projected capital expenditures must be subtracted from the operating cash flow. Additions to Net Working Capital are investments in the project’s short-term assets.   A project may require investments in such items as accounts payable and inventory.   Some operating cash flow may have to be invested in these short-term assets and is thus not available (free) to be paid to the security holders Capital spendingis the cash that must be invested in the project’s capital assets.  Operating cash flow is earnings before interest plus depreciation – taxes.   In capital budgeting OCF measure the cash flows from operating the project, but does not include the cash flows related to capital spending or changes in NWC.Initial cash flows:  Expenditures that are undertaken to obtain assets and begin a capital budgeting project.Direct expendituresare those directly connected with obtaining the capital asset. Indirect expenditures, which result from our decision to purchase the asset, should also be included at the project’s inception. Operating cash flows:  Cash flows received from the operating of the capital budgeting project.Terminal cash flows:  Cash flows incurred in closing down a capital budgeting project. Fiat money:  Money issued by a government that is not backed by a physical commodity such as gold or silver.  Specie money:  A metallic money that possesses intrinsic value and is naturally limited in supply.Inflation:  A decrease in the purchasing power of a unit of a currency.Deflation:  An increase in the purchasing power of a unit of a currency.Nominal interest rate:An interest rate that is not adjusted for inflation.Real interest rate:An interest rate reflecting the real change in purchasing power of a currency.Inflation premium:   The extra rate of return required by investors to compensate them for the loss of purchasing power of the currency. Cost of capital: The minimum rate of return required by investors to undertake a capital budgeting project Product decision: The managerial decision that identifies the customers the firm will seek to serve and determine their needs.Production decision:  The managerial decision that designs the products offered to customers.  

Financing decision:  The managerial decision that determines the mix of financial securities–bonds and stocks–that will provide the capital needed to finance the project. Variable Costs: Costs that vary with the level of production. Fixed costs:  Costs that do not vary with the level of production Leverage:The use of fixed costs to magnify changes in rates of return. Operating leverage: The use of fixed operating costs to magnify an increase in sales into a larger percent increase in operating profit and NOI. Financial leverage:The degree to which a firm uses debt in its capital structure.  As interest payments are generally fixed, the more a firm uses debt, the more its net income will change with a change in sales. Break-even analysis: Analysis of the level of sales at which a project would earn zero profit: At the break-even point revenues exactly equal costs.Unlevered firm:A company that uses only equity in its capital structure.Levered firm:A company that uses both debt and equity in its capital structure.Weighted Average Cost of Capital (WACC): The weighted average cost of a firm’s common equity, preferred stock, and debt.  Used as the discount rate for capital budgeting decisions. Expansion project:  A project that increases the scale of the company’s operations.Pure Play firm:  A firm concentrated in a particular industry or operation.Pure play method:Uses a publicly traded firm’s rate of return as the discount rate for a capital budgeting project that has the same operating characteristics as the pure-play firm.