13 Investment Decisions Flashcards
CAPITAL BUDGETING
Definition of
Identifying, analyzing, selecting LONG TERM projects.
OPPORTUNITY COST
The MAXIMUM benefit forgone by using a scarce resource for a purpose and not the
NEXT BEST PURPOSE
Possible uses of CAPITAL BUDGETING
B.E.E.P
Buying equipment or facilities
business, equipment, expand new markets, product/product line new
Capital Budgeting
General Considerations
Accurate forecasts of future changes in demand required to have necessary capacity for increased demand, without excess when demand slackens
Need planning because of changes to capital markets, interest rates, inflation money supply (CIIM)
TAX Consequences must be considered
RELEVANT COSTS
- Relevant costs DIFFER among alternatives
a. They are AVOIDABLE and can be ELIMINATED by CEASING an activity or IMPROVING a process.
b. INCREMENTAL COST: increase in TOTAL cost by selecting one cost over another
IRRELEVANT COSTS
-do NOT VARY between alternatives
SUNK COSTS: occurred in PAST, CANNOT BE CHANGED.
COMMITTED COSTS: incurred in FUTURE because of PAST DECISIONS (FUTURE LEASE PAYMENTS)
STAGES OF CAPITAL BUDGETING
a. IDENTIFICATION and DEFINITION
b. SEARCH
c. INFORMATION - ACQUISITION
d. SELECTION
e. FINANCING
f. IMPLEMENTATION and MONITORING
CAPITAL BUDGETING
a. IDENTIFICATION and DEFINITION
Identify/Define the projects/programs need to achieve objectives
CAPITAL BUDGETING
b. SEARCH
POTENTIAL projects preliminary evaluation by reps throughout value chain.
Dismal REJECTED, others PASSED ON for FURTHER EVALUATION
CAPITAL BUDGETING
c. INFORMATION-ACQUISITION
for PROJECTS THAT PASSED
- Costs/Benefits enumerated
- QUANTITATIVE financial measures looked at
- —INVESTMENT and PERIODIC CASH FLOW
QUALITATIVE AND QUANTITATIVE identified and addressed
-e.g. training on new equipment
-e.g. uncertainty about technological development, demand, govt regulation,
economic conditions
CAPITAL BUDGETING
d. SELECTION
a. employ a SELECTION MODEL (NPV, IRR)
and NON-FINANCIAL measures
b. Projects that will increase SHAREHOLDER VALUE the most are selected
CAPITAL BUDGETING
e. FINANCING
SOURCE identified
from:
- issuing DEBT
- COMPANY OPERATIONS
- selling STOCK
CAPITAL BUDGETING
f. IMPLEMENTATION and MONITORING
- projects must be kept ON SCHEDULE and WITHIN BUDGET
- also, if unforeseen problems/opportunities have arisen
STEPS IN RANKING INVESTMENTS
a. determine the asset COST or NET INVESTMENT
b. calculate ESTIMATED CASH FLOWS
c. RELATE CASH FLOW BENEFITS to their COST
d. RANK the investments
NET INVESTMENT
- NET outlay or
- GROSS outlay minus RECOVERED from SALE or TRADE
**ADJUSTED FOR TAXES
***INCREASES in NET WORKING CAPITAL treated as a COST (increase in RECEIVABLES or INVENTORIES) that will be RECOVERED at the END OF THE PROJECT
CALCULATE ESTIMATED CASH FLOWS
- PERIOD by PERIOD
- NET CASH FLOW is the benefit (Revenues or Savings) versus COST
- ECONOMIC LIFE: period over which benefits of investment expected to be received (NOT THE PHYSICAL/TECHNICAL LIFE OF THE ASSET)
HURDLE RATE
MINIMUM RATE OF RETURN on a project investor will accept
- riskier project = higher hurdle rate
- lower DISCOUNT RATE = Lower HURDLE RATE
- DO NOT use CURRENT RATE OF RETURN as HURDLE RATE. Can REJECT projects that should be accepted.
CAPITAL BUDGETING
RELEVANT CASH FLOWS (steps)
a. NET INITIAL INVESTMENT
b. Annual NET cash flows
c. Depreciation TAX SHIELD
d. PROJECT TERMINATION cash flows.
* ***Don’t forget this!
NET INITIAL INVESTMENT:
a. Initial COST of equipment
b. Initial WORKING CAPITAL REQUIREMENTS
c. AFTER TAX proceeds from disposal of old equipment
ANNUAL CASH FLOWS
a. AFTER TAX collections (excluding depreciation tax effect.
b. DEPRECIATION TAX SHIELD
PROJECT TERMINATION cash flows
a. AFTER Tax PROCEEDS
B. WORKING CAPITAL RECOVERED !!!!!!!
(UNTAXED!!!)
DEPRECIATION TAX SHIELD
DEPRECIATION EXPENSE x Tax Rate
***SALVAGE VALUE is NEVER CONSIDERED
CAPITAL BUDGETING
INFLATION
Because with inflation, future dollars are worth less. So, hurdle rate is higher.
Higher rate of return is required.
Capital Budgeting
Post Audits should be done
Serve as a CONTROL MECHANISM, to deter managers from suggesting unprofitable investments
- Unfavorable actual to forecast may mean INACCURATE FORECASTS/IMPLEMENTATION PROBLEMS
- individuals who supplied inaccurate forecasts should have to explain
- AVOID EARLY ANALYSIS, misleading if analysis before all cash flows known
QUALITATATIVE (NOT FINANCIAL)
BUDGET CONSIDERATIONS
- Effects on the ENVIRONMENT
- ADDITIONAL JOBS created
- a project with early losses or that has lower gain than alternatives may fit with companies overall growth strategy
Risk Analysis TECHNIQUES
-Risk Analysis measures likelihood of variability of future returns
TECHNIQUES
a. Informal Method: NPV’s are compared at desired rate of return. If the projects have similar NPV’s, THE LESS RISKY PROJECT IS CHOSEN (MUTUALLY EXCLUSIVE, Only one can be chosen)
B. RISK Adjusted Discount Rates: ***The discount rate is generally the companys COST OF CAPITAL.
-when the investment is MORE or LESS risky the DISCOUNT RATE is ADJUSTED.
INCREASED for Riskier
DECREASED for less Risky
-IRR: the IRR may be less than the company’s cost of capital, but accepted.
IRR more than cost of capital and rejected. due to risk
Certainty Equivalent Adjustments:
comes from UTILITY THEORY. indifferent to a certain sum of money and risky investment
Simulation Analysis:
- Refines standard PROBABILITY THEORY
- COMPUTER generates examples under DIFFERENT ASSUMPTIONS
Sensitivity Analysis:
Forecasts many NPV’s under changing assumptions. Large change in NPV means it is SENSITIVE and my be More Risky. Basically an ITERATIVE process.
Scenario Analysis:
Profitability analyzed under different assumptions.
Monte Carlo Simulation:
Generates Probability DISTRIBUTION of all possible outcomes.
Risk Analysis REAL OPTIONS
S.A.D.E VGN (VeGaN)
Mgt should be able to tell what Real Options are embedded in project.
- Abandonment
- Delay
- Expand
- Scale Back
- Vary Inputs Option
- Geographical Area New
- New Product
- Abandonment: SELLING the assets or REDEPLOYING in another project. Accepted when Abandonment Value EXCEEDS NPV of Future Cash Flows.
- Postpone: the option to delay without losing the opportunity.
3.
Real Options (Changes available to a project)
S.A.V.E VGN (VeGaN)
- Scale Back: Shrink a project back after Implementation.
- Abandon: Sell or Redeploy Assets. OK when Abandon Value exceeds NPV of FUTURE CASH FLOWS.
- Vary Inputs: example: switching fuels
- Vary Outputs: example raise/lower production due to economic changes
- Expand: option to Expand project after implementation.
- Geographical New: example one where NPV is negative but follow up promising
- New Product Option: unprofitable but Next Gen or Complementary product is profitable.
- *adding Real Options is INEXPENSIVE, potential Risk Reduction is great.
- *The Real Option is more valuable>
- later it is excercised
- more Variable underlying risk
- HIGHER level of INTEREST RATES
