VI-Economic Evaluation of Facility Investments 1. Project Life Cycle and Economic Feasibility 2.Basic Concepts of Economic Evaluation 3.Costs and Benefits.

Slides:



Advertisements
Similar presentations
Capital Budgeting.
Advertisements

INVESTMENT ANALYSIS OR CAPITAL BUDGETING. What is Capital Budgeting? THE PROCESS OF PLANNING EXPENDITURES ON ASSETS WHOSE RETURN WILL EXTEND BEYOND ONE.
TOPIC 3 Investment Appraisal.
Hawawini & VialletChapter 7© 2007 Thomson South-Western Chapter 7 ALTERNATIVES TO THE NET PRESENT VALUE RULE.
Capital Budgeting: To Invest or Not To Invest  Capital Budgeting Decision –usually involves long-term and high initial cost projects. –Invest if a project’s.
Capital Investment Analysis
COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and.
B280F Introduction to Financial Management
T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization 9.1Net Present Value 9.2The Payback Rule 9.3The Average.
CAPITAL BUDGETING TECHNIQUES
Capital Budgeting Net Present Value Rule Payback Period Rule
Net Present Value and Other Investment Criteria
Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 10 Capital Budgeting Techniques.
Chapter Fourteen Capital Investment Decisions COPYRIGHT © 2012 Nelson Education Ltd.
Contemporary Engineering Economics, 4 th edition, © 2007 Effects of Inflation on Project Cash Flows Lecture No. 45 Chapter 11 Contemporary Engineering.
Project Appraisal, Capital Rationing, Taxation and Inflation
CHAPTER 12 THE CAPITAL BUDGETING DECISION Capital Expenditures Decision §CE usually require initial cash outflows in hope of future benefits or cash.
4. Project Investment Decision-Making
CAPITAL BUDGETING AND LEASING Chapter 4. Investment The addition of durable assets to a business Disinvestment is the withdrawal of durable assets from.
1 Capital investment appraisal. 2 Introduction As investments involve large resources, wrong investment decisions are very expensive to correct Managers.
© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter Nine.
Chapter 1.
Unit 3 - Cash Flow Forecasting
Strategic Business Planning for Commercial Producers.
Strategic Business Planning for Commercial Producers Investment Analysis: What Investments Should I Make?
Advanced Engineering Economy Contemporary Engineering Economics, 5th edition, © 2010.
AEC 422 Fall 2014 Unit 2 Financial Decision Making.
4 C H A P T E R Capital Investment Decisions.
Chapter 3 – Opportunity Cost of Capital and Capital Budgeting
FOOD ENGINEERING DESIGN AND ECONOMICS
Steve Paulone Facilitator Financial Management Decisions The financial manager is concerned with three primary categories of financial decisions:  1.Capital.
Project Planning and Capital Budgeting
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 11 Capital Budgeting.
Hawawini & VialletChapter 71 ALTERNATIVES TO THE NPV RULE.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license.
8- 1  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capital Budgeting Chapter 8.
CAPITAL BUDGETING INITIAL INVESTMENT PLANNING HORIZON TERMINAL VALUE REQUIRED RATE OF RETURN NET CASH FLOWS.
1 Capital Budgeting Capital budgeting - A process of evaluating and planning expenditure on assets that will provide future cash flow(s).
$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 10-1 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Capital.
Lecture No. 37 Chapter 11 Contemporary Engineering Economics Copyright © 2010 Contemporary Engineering Economics, 5th edition, © 2010.
Capital Budgeting The Capital Budgeting Decision Time Value of Money Methods of Capital Project Evaluation Cash Flows Capital Rationing The Value of a.
CHAPTER 11 EVALUATING PROJECTS WITH THE BENEFIT / COST RATIO METHOD $$$ $
Capital Budgeting MF 807 Corporate Finance Professor Thomas Chemmanur.
Chapter 10 Choices Involving Time Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written.
$$ Entrepreneurial Finance, 4th Edition By Adelman and Marks PRENTICE HALL ©2007 by Pearson Education, Inc. Upper Saddle River, NJ Capital Budgeting.
Learning Goals Understand the key capital expenditure motives and the steps in the capital budgeting process. Define basic capital budgeting terminology.
Warren Reeve Duchac Accounting 26e Capital Investment Analysis 26 C H A P T E R human/iStock/360/Getty Images.
Chapter 8 Capital Asset Selection and Capital Budgeting.
13-1 Agenda for 30 July (Chapter 9) Assessment of various commonly used methods for deciding how capital is to be allocated. Net Present Value (NPV) The.
20-1 HANSEN & MOWEN Cost Management ACCOUNTING AND CONTROL.
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing,
1 Developing Project Cash Flow Statement Lecture No. 23 Chapter 9 Fundamentals of Engineering Economics Copyright © 2008.
Amity School Of Business 1 Amity School Of Business BBA Semister four Financial Management-II Ashish Samarpit Noel.
FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab.
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Capital Budgeting Chapter 11.
Needles Powers Crosson Financial and Managerial Accounting 10e Capital Investment Analysis 24 C H A P T E R © human/iStockphoto ©2014 Cengage Learning.
Chapter Inflation and Capital Investment Analysis
Copyright © Houghton Mifflin Company. All rights reserved.1 Financial & Managerial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson.
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith.
Capital Budgeting Techniques. Capital budgeting is the process of evaluating capital projects, projects with cash flows over more than one year. The four.
Effects of Inflation on Project Cash Flows
INVESTMENT ANALYSIS OR CAPITAL BUDGETING
Inflation and Its Effects on Project Cash Flows
Chapter 9 Impairment of Assets.
Capital Budgeting 2 2.
7 Capital Budgeting Decisions–Part I
Chapter 6 Principles of Capital Investment
Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Managerial Accounting 2002e
Presentation transcript:

VI-Economic Evaluation of Facility Investments 1. Project Life Cycle and Economic Feasibility 2.Basic Concepts of Economic Evaluation 3.Costs and Benefits of a Constructed Facility 4.Interest Rates and the Costs of Capital 5.Investment Profit Measures 6.Methods of Economic Evaluation 7.Depreciation and Tax Effects 8.Price Level Changes: Inflation and Deflation 9.Uncertainty and Risk 10.Effects of Financing on Project Selection 11.Combined Effects of Operating and Financing Cash Flows 12.Public versus Private Ownership of Facilities 13.Economic Evaluation of Different Forms of Ownership

6.1 Project Life Cycle and Economic Feasibility Facility investment decisions represent major commitments of corporate resources and have serious consequences on the profitability and financial stability of a corporation. In the public sector, such decisions also affect the viability of facility investment programs and the credibility of the agency in charge of the programs. It is important to evaluate facilities rationally with regard to both the economic feasibility of individual projects and the relative net benefits of alternative and mutually exclusive projects.

6.1 Project Life Cycle and Economic Feasibility Four major aspects of economic evaluation will be examined: –The basic concepts of facility investment evaluation, including time preference for consumption, opportunity cost, minimum attractive rate of return, cash flows over the planning horizon and profit measures. –Methods of economic evaluation, including the net present value method, the equivalent uniform annual value method, the benefit-cost ratio method, and the internal rate of return method. –Factors affecting cash flows, including depreciation and tax effects, price level changes, and treatment of risk and uncertainty. –Effects of different methods of financing on the selection of projects, including types of financing and risk, public policies on regulation and subsidies, the effects of project financial planning, and the interaction between operational and financial planning.

6.2 Basic Concepts of Economic Evaluation A systematic approach for economic evaluation of facilities consists of the following major steps: –Generate a set of projects or purchases for investment consideration. –Establish the planning horizon for economic analysis. –Estimate the cash flow profile for each project. –Specify the minimum attractive rate of return (MARR). –Establish the criterion for accepting or rejecting a proposal, or for selecting the best among a group of mutually exclusive proposals, on the basis of the objective of the investment. –Perform sensitivity or uncertainty analysis. –Accept or reject a proposal on the basis of the established criterion.

6.3 Costs and Benefits of a Constructed Facility The basic principle in assessing the economic costs and benefits of new facility investments is to find the aggregate of individual changes in the welfare of all parties affected by the proposed projects. The changes in welfare are generally measured in monetary terms, but there are exceptions, since some effects cannot be measured directly by cash receipts and disbursements.

6.3 Costs and Benefits of a Constructed Facility Examples include the value of human lives saved through safety improvements or the cost of environmental degradation. The difficulties in estimating future costs and benefits lie not only in uncertainties and reliability of measurement, but also on the social costs and benefits generated as side effects. Furthermore, proceeds and expenditures related to financial transactions, such as interest and subsidies, must also be considered by private firms and by public agencies.

6.4 Interest Rates and the Costs of Capital Constructed facilities are inherently long-term investments with a deferred pay-off. The cost of capital or MARR depends on the real interest rate (i.e., market interest rate less the inflation rate) over the period of investment. As the cost of capital rises, it becomes less and less attractive to invest in a large facility because of the opportunities foregone over a long period of time.

6.5 Investment Profit Measures A profit measure is defined as an indicator of the desirability of a project from the standpoint of a decision maker. A profit measure may or may not be used as the basis for project selection. Since various profit measures are used by decision makers for different purposes, the advantages and restrictions for using these profit measures should be fully understood.

6.5 Investment Profit Measures There are several profit measures that are commonly used by decision makers in both private corporations and public agencies. Each of these measures is intended to be an indicator of profit or net benefit for a project under consideration. Some of these measures indicate the size of the profit at a specific point in time; others give the rate of return per period when the capital is in use or when reinvestments of the early profits are also included –Net Future Value and Net Present Value –Equivalent Uniform Annual Net Value –Benefit Cost Ratio –Internal Rate of Return –Adjusted Internal Rate of Return –Return on Investment –Payback Period

6.6 Methods of Economic Evaluation Net Present Value Method Net Future Value Method Net Equivalent Uniform Annual Value Method Benefit-Cost Ratio Method Internal Rate of Return Method

6.7 Depreciation and Tax Effects For private corporations, the cash flow profile of a project is affected by the amount of taxation. In the context of tax liability, depreciation is the amount allowed as a deduction due to capital expenses in computing taxable income and, hence, income tax in any year. Thus, depreciation results in a reduction in tax liabilities.

6.8 Price Level Changes: Inflation nad Deflation In the economic evaluation of investment proposals, two approaches may be used to reflect the effects of future price level changes due to inflation or deflation. The differences between the two approaches are primarily philosophical and can be succinctly stated as follows: –The constant dollar approach. The investor wants a specified MARR excluding inflation. Consequently, the cash flows should be expressed in terms of base-year or constant dollars, and a discount rate excluding inflation should be used in computing the net present value. –The inflated dollar approach. The investor includes an inflation component in the specified MARR. Hence, the cash flows should be expressed in terms of then-current or inflated dollars, and a discount rate including inflation should be used in computing the net present value.

6.9 Uncertaninty and Risk Since future events are always uncertain, all estimates of costs and benefits used in economic evaluation involve a degree of uncertainty. Probabilistic methods are often used in decision analysis to determine expected costs and benefits as well as to assess the degree of risk in particular projects.

6.10 Effects of Financing on Project selection Selection of the best design and financing plans for capital projects is typically done separately and sequentially. Three approaches to facility investment planning most often adopted by an organization are: –Need or demand driven: Public capital investments are defined and debated in terms of an absolute "need" for particular facilities or services. With a pre-defined "need," design and financing analysis then proceed separately. Even when investments are made on the basis of a demand or revenue analysis of the market, the separation of design and financing analysis is still prevalent. –Design driven: Designs are generated, analyzed and approved prior to the investigation of financing alternatives, because projects are approved first and only then programmed for eventual funding. –Finance driven: The process of developing a facility within a particular budget target is finance-driven since the budget is formulated prior to the final design. It is a common procedure in private developments and increasingly used for public projects.

6.11 Combined Effects of Operating and Financing Cash Flows A general approach for obtaining the combined effects of operating and financing cash flows of a project is to make use of the additive property of net present values by calculating an adjusted net present value.

6.12 Public versus Private Ownership of Facilities In recent years, various organizational ownership schemes have been proposed to raise the level of investment in constructed facilities. For example, independent authorities are assuming responsibility for some water and sewer systems, while private entrepreneurs are taking over the ownership of public buildings such as stadiums and convention centers in joint ventures with local governments. Such ownership arrangements not only can generate the capital for new facilities, but also will influence the management of the construction and operation of these facilities. In this section, we shall review some of these implications.

6.13 Economic Evaluation of Different Forms of Ownership While it is difficult to conclude definitely that one or another organizational or financial arrangement is always superior, different organizations have systematic implications for the ways in which constructed facilities are financed, designed and constructed. Moreover, the selection of alternative investments for constructed facilities is likely to be affected by the type and scope of the decision- making organization.