Study Unit 10
Investment Decisions
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:
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Inflation
Interst rates
Cash availability
Market demands
• What are the applications for capital budgeting?
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Buying equipment
Building facilities
Acquiring a business
Developing a product of product line
Expanding into new markets
Continue
SU- 10.1 – The Capital Budgeting
Process
• Consider the tax consequences
• All decisions should be done on an after tax basis
• Considered costs
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Avoidable cost
Common cost
Deferrable cost
Fixed cost
Imputed cost
Incremental cost
Opportunity cost
Relevant cost
Sunk
Weighted-average
Continued
SU- 10.1 – The Capital Budgeting
Process
• Stages in Capital Budgeting
• Identification
• Search
• Information-acquisition
• Selection
• Financing
• Implementation and monitoring
Continued
SU- 10.1 – The Capital Budgeting
Process
• Investment Ranking Steps
• Det. Net Investment Costs
• Calculating est. cash flows
• Comparing cash-flows to Net Investment Costs
• Ranking investments
• Other considerations
• Book vs. cash accounting
• Relevant cash flows
• Net initial investment
• Annual net cash flows
• Project termination cash flows
• Inflation
• Post-audits
Questions 5 – 7 on page 414
SU – 10.2 Discounted Cash flow Analysis
• Time Value of Money
• Concepts
• Present Value (PV)
• Future Value (FV)
• Annuities – equal payments at equal intervals
• Ordinary annuity (in arrears)
• Annuity due (in advance) – PV & FV is always greater than ordinary
annuity
• Hurdle rate
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
Continued
SU – 10.2 Discounted Cash flow Analysis
• Cash flows and discounting
NPV =
Cash flow0
(1 + r)0
Cash flow1
(1 + r)1
• IRR shortcomings •
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Directional changes of cash flows
Mutually exclusive projects
Varying rates of return
Multiple investments
• NPV vs IRR comparison
Cash flow2
(1 + r)2
SU – 10.3 Payback and discounted
payback
• Definition of Payback
• Payback and constant cash flows vs variable cash flows
• Discounted payback method and other payback methods
SU 10.4 Ranking investment projects
• Why should we rank investment projects
• Methods
• Profitability index
• Internal capital markets
• Linear programming
SU 10.5 Comprehensive Example
• Page 405
SU 10.6 Risk Analysis and real options in
Capital Investments
• Risk analysis
• Real (managerial or strategic) options