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Study Unit 10 Investment Decisions

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SU- 10.1 – The Capital Budgeting Process Definition – Planning and controlling investment for long-term projects. Capital budgeting unlike other considerations will affect the company for many periods going forward. Predicting the need for future capital assets is one of the more challenging task, which can be affected by: Inflation Interest rates Cash availability Market demands Production capacity is a key driver Applications for capital budgeting Buying equipment Building facilities Acquiring a business Developing a product of product line Expanding into new markets

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SU- 10.1 – The Capital Budgeting Process Consider the tax consequences All decisions should be done on an after tax basis Considered costs Avoidable cost – May be eliminated by ceasing or improving an activity. Common cost – Shared by all options and is not clearly allocable. Deferrable cost – May be shifted to the future. Fixed cost – Does not very within relevant range. Imputed cost – May not have a specific cash outlay in accounting Incremental cost – Difference in cost of two options. Opportunity cost – Maximum benefit forgone based on next alternative. Relevant cost – Vary with action. Constant cost don’t affect decision. Sunk – Cannot be avoided. Weighted-average Cost of Capital – Hurdle rate

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SU- 10.1 – The Capital Budgeting Process Stages in Capital Budgeting Identification and definition - Id What is the strategy? Definition – Define the projects – Revenue, costs, and cash flow Most difficult stage Search – Each investment to be evaluated be each function of the firms value chain. Information-acquisition – Costs and benefits of the projects are enumerated. Selection – Increase shareholder value. NPV, IRR.. Financing – Debt or equity Implementation and monitoring – Feedback and reporting

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SU- 10.1 – The Capital Budgeting Process Investment Ranking Steps Determine Net Investment Costs – Gross cash requirement less cash recovered from trade or sale of existing assets, adjusted for taxes Calculating estimated cash flows – Capture increase in revenue, decrease costs Comparing cash-flows to Net Investment Costs – Evaluate the benefit. Ranking investments – NPV, IRR, Payback Other considerations Book Rate of Return – Always use cash flow Relevant cash flows Net initial investment – New equipment cost, W/C requirements, after tax disposals Annual net cash flows – After tax cash collections for operations, depr tax savings. Project termination cash flows – After tax disposal, W/C recovery Inflation – Raises hurdle rate. Post-audits – Deterrent of bad projects. Questions 5 – 7 on page 414

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SU – 10.2 Discounted Cash flow Analysis Time Value of Money Concepts – A dollar received in the future is worth less than today. Present Value (PV) – Value today of future payment Future Value (FV) – Future value of an investment today. Annuities – equal payments at equal intervals Ordinary annuity (in arrears) Annuity due (in advance) – PV & FV is always greater than ordinary annuity Hurdle rate – WACC or Shareholder’s opportunity cost of capital Net Present Value (NPV) – Project return in $$ Internal Rate of Return (IRR) – Project return in %

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SU – 10.2 Discounted Cash flow Analysis Cash flows and discounting NPV = Cash flow 0 Cash flow 1 Cash flow 2 (1 + r) 0 (1 + r) 1 (1 + r) 2 IRR shortcomings - Directional changes of cash flows Mutually exclusive projects Varying rates of return Multiple investments Comparing Cash flow Patterns – Pg 399 + +

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SU – 10.2 Discounted Cash flow Analysis NPV vs IRR comparison Reinvestment rate NPV assumes the cash flow can be reinvested at projects discount rate. Independent projects: NPV and IRR give same accept/reject decision if projects are independent. All acceptable independent projects can be undertaken. Mutually exclusive projects. Cost of one greater than other Timing, amounts, and direction of cash flow are different Different useful lives IRR provides 1 rate, NPV can be used with multiple rates. Multiple investments. NPV is adaptable, IRR is not. IRR assumes cash flow is reinvested at IRR rate. NPV assumes reinvestment in the desired rate of return. NPV and IRR are most sound decision making tools for wealth maximization. NPV profile – Page 401 Select greatest NPV over greatest IRR

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SU – 10.3 Payback and discounted payback Payback period = Number of years to pay for itself. Pro - Simple Cons - No consideration for time value of money. Does not consider cash flow after payback period. Payback and constant cash flows vs variable cash flows Discounted payback method Pro – More conservative yet still simple Con – Does not consider cash flow after payback period. Other payback methods Bailout payback = Considers salvage value Payback reciprocal (1 divided by payback) estimate of IRR Breakeven time = Time require for discounted cash flows to = 0.

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SU 10.4 Ranking investment projects Why should we rank investment projects Capital rationing Methods Profitability index = NPV / Net Investment Internal capital markets – Internal funding Linear programming – Technique for optimizing resource allocation.

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SU 10.5 Comprehensive Example Page 405

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SU 10.6 Risk Analysis and real options in Capital Investments Risk analysis – Attempt to measure the variability of future returns from proposed investment. Informal method – NPV is calculated and reviewed. Risk-adjusted discount rates – Adjust rate of return upwards as project becomes more risky. Certainty equivalent adjustments- from Utility theory – the point where you are indifferent to a choice between a certain sum of money and the expected value of a risky sum. Simulation analysis – Computer is used to generate many results based upon various assumptions. Pilot plants Sensitivity analysis – An iterative process of recalculated returns based on changing assumptions.

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SU 10.6 Risk Analysis and real options in Capital Investments Real (managerial or strategic) options Value of a real option – The difference between the projects NPV with the option vs. without the option. Usually more valuable the later it is exercised. Types of real options: Abandonment (Put option) Follow-up investment Wait and Learn (call option) Flexibility option – vary an input Capacity option – vary an output New geographical markets New product option – follow on products

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