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2/2 Warm-up

2/2 Warm-up. You have suddenly been turned into a “business angel” Describe what you are and your role in business finance. Explain how you would evaluate an investment opportunity. 2/3 Warm-up. Summarize the following; Quantitative factors considered by the sharks.

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2/2 Warm-up

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  1. 2/2 Warm-up • You have suddenly been turned into a “business angel” • Describe what you are and your role in business finance. • Explain how you would evaluate an investment opportunity.

  2. 2/3 Warm-up • Summarize the following; • Quantitative factors considered by the sharks. • Qualitative factors considered by the sharks.

  3. Business Financing Capital Investment Decisions (Capital Expenditures) • Sources of Finance • Managing Working Capital • (Revenue Expenditures)

  4. Investment Appraisal • Identify consequences from an investment • Incremental cash flows • Apply method to appraise an investment • Analyze the results of these calculations • Make Investment Decision

  5. Investment Appraisal • What is an investment? • Capital Expenditure (Cap-Ex) = spending $ today with expectation of earning a return in the future • Return on Investment (ROI) = profit generated from the investment • What is Investment Appraisal? • Evaluating the impact (financial costs & benefits) of an investment project • Deciding whether or not to undertake the investment project based on its projected costs & benefits

  6. Impact of Investment Project • Incremental cash flows resultingfrom the investment decision • any and all changes in the business’s future cash flows that are a direct consequence of making the investment decision • Stand-alone Principle – isolate the project’s cash flows and evaluate • evaluate the investment’s cash flows against the costs to acquire it.

  7. Identifying Incremental Costs Included Ignored Sunk Costs – costs incurred & cannot be recovered Financing Costs – interest, dividends, or repaying loans • Working Capital Changes – increased investment (cash, stock, etc.) • Opportunity Cost – the benefit given up when using a resource • Side Effects – spillover effects from an investment (good or bad)

  8. 2/8 Warm-up • Describe the process for evaluating Capital Expenditure projects. • Explain the difference between Payback Period and Average Rate of Return for evaluating investment projects.

  9. Investment Appraisal Methods Payback Period Average Rate of Return (ARR) Average annual profit earned as % of amount initially invested Estimate of investment’s worth over its useful life • Time needed to recover the cost of an investment • When does cumulative sum of cash inflows = cost of investment?

  10. Calculating Payback PeriodCumulative Cash Flow Method Construction of a new sports complex will cost $1,000,000 Projected Net Cash Flows Cumulative Cash Flow + $0 = $210,000 (1) + $210,000 = $560,000 + $560,000 = $1,040,000 + $1,040,000 = + $1,490,000 (2) Amount of financing needed in final year. (3) Calculate average monthly cash flow in final year (3) Number of Months in Final Year Financing Needed / Avg Monthly Cash Flow = # Months

  11. Payback Period (in months) • How Used to Evaluate? • Shorter payback = better investment • Advantages • simple & quick • helps businesses w/ cash flow problems • compare projects • less prone to forecasting errors • Disadvantages • ignores benefits received after payback • Focuses on time, not profit

  12. Average Rate of Return Construction of a new sports complex will cost $1,000,000 Projected Net Cash Flows (1) Total Inflow Total $1,490,000 (2) Project Profit - Project Profit = Total Cash Inflow Investment - $1,000,000 $1,490,000 = $490,000 (3) Avg Annual Profit / Project Profit Years = Avg Annual Profit $490,000 / 4 = $122,500 ARR (%) / = Avg Annual Profit Investment (4) Avg Rate of Return $122,500 / $1,000,000 = 12.25%

  13. Average Rate of Return (ARR) • How used to Evaluate? • Compare the ARR for different projects (higher the better) • Compare the ARR with base interest rate • Adequately being compensated for project’s risk? • Advantages • Easy to compare different projects • Disadvantages • Prone to errors (forecasting for long-term investments) • Ignores time value of money • Must know the useful life span of investment

  14. Qualitative Investment AppraisalFactors Other Than Numbers • Predictions about the future • Business Objectives other than profit • Amount of Risk business can tolerate • State of Economy • Effect of project on Corporate Image • Effect on Human Relations, will project damage (or improve) employee morale? • Random event risk (Exogenous shocks)

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