CHAPTER 4
The investment decision
Introduction
• What should financial managers do to maximise shareholders’
wealth?
• Make wise investment, financing and dividend decisions
•
Which activities will the enterprise get involved in ?
• Building new factory
• New machine in production process
• Development of new product
• Take-over of another company
• Identify and evaluate all profitable investment projects
• Only accept those that add to creation of shareholder wealth
Investment decisions
• It is expensive
• LT survival depends on the ability to invest in financially feasible
projects
• Negative ST effects
• Wrong decisions can lead to failure of business
• It is difficult and expensive to correct a mistake
• It has a LT impact on competitiveness and profitability
• Need to maintain competitive advantage:
• Technological developments
• New product development
• Changing market trends
Introduction: Capital vs Financial Investment
• Capital investment:
• Productive utilisation of capital to purchase productive assets
• Financial investment:
• Transfer of surplus funds to financial intermediaries, who
transfer it to 3rd parties
Introduction: Steps in the investment decision
1. Identification
2. Evaluation of alternatives
3. Decision-making
4. Implementation
5. Follow-up evaluation
Introduction: Steps in the investment decision
• Incremental Cash Flow
• Only the additional cash flow that the acceptance of the
project will contribute to the existing cash flow
• Differs in regard to expansion and replacement projects
• Expansion project – only the cash flows of the project
• Replacement project – difference between existing cash
flows and expected cash flows from project
INVESTMENT CONCEPTS: Incremental cash flow
Definitions
Expansion
VS
What is the impact of a
new/extra project?
Company
Replacement
What is the impact of
replacing an existing
asset?
Company
Asset
Replace with a new
asset
Example – incremental cash flow (Pg 55)
A printing company intends to double their current production.
Two alternatives are considered.
First option: an existing printing press will be sold, and replaced with
a newer model. It is expected that the enterprise’s annual cash inflow
will increase from R400 000 to R600 000 as a result of the
transaction.
Second option: The purchase of an additional printing press that will
be used in conjunction with the existing one. The expected annual
cash inflow associated with the new printing press amounts to R150
000.
Incremental cash in flow option 1 = (600 000 - 400 000)
= 200 0000
Incremental cash in flow option 2 = 150 000
Definitions
• Sunk Costs
• Cash flows that occurred in the past
• Cash flows have no influence on the cash flow of current
project
• Examples :
• Feasibility studies
• Environmental impact assessments
• NOT included in investment calculations
Definitions
• Opportunity Costs
• Cost associated with the acceptance of one alternative
over another
• The cost of an opportunity forgone
• Include in investment decision
• See example on page 56
Types of projects
• Independent
• The selection of one project does not exclude the selection of
others
• Has no effect on cash flows of other project
• Mutually exclusive
• Acceptance of one project will result in rejection of all others
• Complimentary – positive effect on cash flows from existing
projects
• Substitute – negative effect on cash flows from existing projects
Example Page 57
Assume that an enterprise needs to make a decision between the following two
investment options:
Option A: entails the manufacturing of a new product range, and will result in an
annual cash inflow of R500 000. The new products, however, will compete with the
enterprise’s existing products, and it is expected that the existing cash inflow will
decrease by R150 000.
Relevant cash inflow associated with Option A amounts to:
= 500 000 - 150 000
= R350 000
Option B: entails the extension of the enterprise’s activities to another branch of
industry. The expected cash inflow due to the extension amounts to R300 000. Since
some of the enterprise’s existing products will also be used in the new branch of
industry, it is also expected that the existing cash inflow will increase by R100 000.
Relevant cash inflow associated with Option B amounts to:
= 300 000 + 100 000
= R400 000
Cash Flow Diagram
Terminal
cash inflow
Initial
investment
- 200 000
0
25 000
25 000
25 000
25 000
1
2
3
4
50 000
25 000
5
Annual
cash
inflows
Types of cash flow streams
Conventional cash stream:
Unconventional cash stream:
Annuity:
Mixed cash stream
Cash flow calculations
• Initial investment
• Periodic cash flows from operations
• Terminal cash flow
Periodic cash flows
Terminal
flow
Initial
investment
Terminal cash
cashflow
Initial investment
• All cash flows at beginning of project – positive and negative
Components :
• Opportunity cost
• Any other relevant costs
• Installed cost of new asset (All costs to ensure that the new
asset is operational)
• Purchase price (- discount if applicable) PLUS transport,
preparation of plant, installation cost, VAT (if not included)
Initial investment
• Net working capital requirement
• Required to support operating activities
• Increase or decrease in working capital components
• Inventory, trade receivables and trade payables might
increase /decrease
• Focus on impact on cash flow
Example Page 59: Beauty Box Ltd
Example Page 59: Beauty Box Ltd - answers
Periodic cash flows
Cash flows during the lifespan of a project/asset
1. After-tax operating cash flow
• Profit vs Cash flow
• After-tax cash flow
• Finance cost – leave out of calculation (included in WACC)
• Depreciation – not a cash flow item - add back to profit
2. Changes in net working capital – any annual changes in net
working capital requirement
3. Additional investments (e.g. upgrades)
4. Any cash flows as a result of complimentary / substitute
projects
Example Page 61
Terminal cash flows
• Final cash flow at the end of a project lifetime
• Both positive and negative
• Two components:
• After-tax sales proceeds of the asset
• Selling price minus relevant costs
• Tax implications – capital gains and accounting profit/loss
• Reversal of changes in working capital
• Cumulative working capital investment over project
lifetime must be reversed
Rand value
Net proceeds
Carrying value
Total profit
If Net proceeds is less than the initial installed cost of the asset
Initial cost
Net proceeds
R 100 000
R 80 000
Carrying value
R 40 000
Total profit
=
Accounting profit
23
Tax on accounting profit = Accounting profit x tax rate (28%)
Rand value
Net proceeds
Carrying value
Total profit
If Net proceeds is more than the initial installed cost of the asset
Net proceeds
R 120 000
Carrying value
R 40 000
Initial cost
R 100 000
Total profit
24
Capital gain
Accounting profit
• Capital gain x 80% x 28%
Inclusion rate
Tax rate
Example: ABC Ltd Page 62/63
27
Example: ABC Ltd Page 62/63
After-tax cash flow Beauty Box ANSWER
After-tax cash flow Beauty Box ANSWER
After-tax cash flow Beauty Box ANSWER
SUMMARY of cash flow diagram for Beauty Box
-1 550 000
549 000
549 000
549 000
549 000
461 000
549 000
0
1
2
3
4
5
32