Study Unit 10

1. Study Unit 10 Investment Decisions

2. 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

3. 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

4. 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

5. 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

6. 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 %

7. SU – 10.2 Discounted Cash flow Analysis • Cash flows and discounting NPV = Cash flow0 Cash flow1 Cash flow2 (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 + +

8. 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

9. 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.

10. 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.

11. SU 10.5 Comprehensive Example • Page 405

12. 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.

13. 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