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Capital Investment

Capital Investment. Lecture Outline. Define Capital Budgeting. Explain the importance of Capital Budgeting. Examine the method of implementing and managing long term projects. Discuss the advantages/disadvantages of the various analysis techniques. Time Value of Money.

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Capital Investment

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  1. Capital Investment

  2. Lecture Outline • Define Capital Budgeting. • Explain the importance of Capital Budgeting. • Examine the method of implementing and managing long term projects. • Discuss the advantages/disadvantages of the various analysis techniques.

  3. Time Value of Money • Would you rather have $1,000 today or $1,000 in five years time? Answer: $1,000 Today • $1,000 can be invested today and if it earns 10% interest each year for the next 5 years it will accumulate to $1,610. • $1,000 today will also buy more than $1,000 in five years time.

  4. Time Value of Money • $1 today is worth more than $1 in the future because of two factors: 1. Interest rates 2. Inflation

  5. Time Value of Money (45,000) 20,000 20,000 20,000 0 1 2 3 (years) • Would you invest $45,000 now if you were to receive a return of $20,000 every year for the next three years

  6. Time Value of Money We cannot simply say: Cash Inflow 60,000 Less Cost 45,000 Gain 15,000 • Money has a time value. $20,000 in one years time is worth more than $20,000 in three years time.

  7. Time Value of Money • As cash flows for each year have a different inherent value, they cannot be simply added together. • Therefore we need to convert the annual cash flows into a common scale so that they can be added together. The common scale we use is called Present Value.

  8. Time Value of Money (45,000) 20,000 20,000 20,000 0 1 2 3 • In calculating present value we convert (discount) all the annual cash flows into today’s dollars (ie what is $20,000 in two years time worth in today’s dollars).

  9. Time Value of Money • It’s the same basic principle you follow when you have different currencies. $A 100 = $A 100 $US100 = $A142 $HK100 = $A 26 $A268

  10. Time Value of MoneyLump Sum • A lumps sum refers to a one off amount (ie what is the present value of $100 received in five years time). Present Value = Future Value (1 + i)n Where; i: The interest rate n: Number of years

  11. Present ValueLump Sum • If the interest rate is 10%, what is the PV of $161 received in five years time? ? $161 0 1 2 3 4 5

  12. Solution Present Value = Future Value (1 + i)n Present Value = 161 (1.10)5 Present Value = $100

  13. Practice Question • Using an interest rate of 12%, what is the PV of $15,000 received in seven years time? ? $15,000 0 1 2 3 4 5 6 7

  14. Solution Present Value = Future Value (1 + i)n Present Value = 15,000 (1.12)7 Present Value = $6,785.24

  15. Present ValueAnnuity Annuity • Constant stream of cash flows (ie cash flow received each year of a projects life). PV =FV1 + FV2 + FV3 (1 + i) (1 +i)2 (1 + i)3

  16. Present ValueAnnuity • Would you invest $45,000 now if you were to receive a return of $20,000 every year for the next three years. Use an interest rate of 8%.

  17. Present ValueAnnuity PV = 20,000 + 20,000 + 20,000 (1.08) (1.08)2 (1.08)3 PV = 18,518 + 17,146 + 15,877 PV = $51,541 Gain = 51,541 – 45,000 Gain = 6,541

  18. Practice Question • If the interest rate is 10%, how much would the government need to invest today to fund a road safety program costing $5m every year for the next three years? PV =FV1 + FV2 + FV3 (1 + i) (1 +i)2 (1 + i)3

  19. Solution PV = 5,000,000 + 5,000,000 + 5,000,000 (1.10) (1.10)2 (1.10)3 PV = 4,545,454 + 4,132,231 + 3,756,574 PV = $12,434,259

  20. Present Value of an AnnuityEqual Annual Cash Flows • If the net cash flows are the same each year: PV = NCFi]n Where: NCF: Net Annual Cash Flow i: Interest calculated each compounding period. n: Number of repayments throughout life of loan/investment.

  21. Solution PV = NCFi]n PV = 5,000,00010%]3 PV = 5,000,000 x 2.4869 PV = $12,434,500

  22. Capital Budgeting • The planning and financing of capital investments such as: • Replacement of Equipment • Enhancement of Production Facilities • Establishing a New Retail/Production Site.

  23. Importance of Capital Budgeting • Capital investments usually have the following characteristics. • High Cost (relative to the size of the entity) • Decision will extend well into the future. • Difficult to reverse decision.

  24. Capital Budgeting Process Step One • Calculate the net annual cash flows. Step Two • Apply one of the four evaluation techniques • The Payback Method • Net Present Value • Internal Rate of Return • Accounting Rate of Return

  25. Step OneCalculating Net Annual Cash Flows • Estimate life of the project/asset. • Estimate cash inflows for each year • Additional sales • Residual value • Cost savings • Estimate cash outflows for each year • Cost of the project/asset • Higher wages, training costs, higher electricity cost • Net Cash Flow = Inflow - Outflow

  26. Analysis TechniquesPayback Method The Payback Method • Measures the time it will take the net annual cash flows generated by the investment to recover the cost of the original investment. • To Calculate (assuming net cash flows are the same each year): Initial Cost of Investment = ? Years Net Annual Cash flows

  27. Analysis TechniquesPayback Method • The project is acceptable if the payback period is less than a pre-determined period of time. • The shorter the payback period the lower the risk of the investment.

  28. Analysis TechniquesPayback Method Benefits • Simple to use and understand. • Provides a rough estimate of risk (ie earlier cash flows are less risky than later ones). • Firms experiencing cash shortages may need to recover investments quickly.

  29. Analysis TechniquesPayback Method Limitations • Ignores the time value of money. • Payback method ignores cash flows after the point at which the initial cash outlay has been received. • Discriminates against projects with long gestation periods: • Environmental Technology • Robotic Equipment

  30. Analysis TechniquesNet Present Value (NPV) Step 1 • Calculate the present value of the net annual cash flows. Step 2 • Calculate the present value of the cost of the project/asset. Step 3 • NPV = Answer to Step 1 – Answer to Step 2

  31. Analysis TechniquesNet Present Value • If NPV ≧ 0 : Project is acceptable • The amount of any positive NPV represents the immediate increase in the entity’s wealth that will result from accepting the project.

  32. Analysis TechniquesNet Present Value Benefits • The time-value of money is considered. • The entire life of the project is included in the analysis.

  33. Qualitative Factors • Qualitative factors must also be taken into consideration before a capital investment is made. Examples of qualitative factors include: • Increase in the quality of the product. • Introduction of labour saving machinery may be deferred due to union opposition. • Higher ranked projects may require greater resources ie more labour or management supervision.

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