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
Interest rates
Cash availability
Market demands
• Production capacity is a key driver
• 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
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 – 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
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
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
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 %
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
• Comparing Cash flow Patterns – Pg 399
+
Cash flow2
(1 + r)2
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.
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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
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.
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.
SU 10.5 Comprehensive Example
• Page 405
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.
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:
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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