Capital Investemnt Decisions Flashcards
Considerations
Life span
Cash flows
Time value of money
5 stages of capital budgeting
Indemnification Information acquisition Predictions Choose among alternatives Implementation and control
Alternative methods of choosing
Discounted cash flow methods - Net Present Value -internal rate of return Payback Accounting rate of return
Analysis
NPV is greater than zero so project is acceptable
Need to consider non-financial factors
- flexibility
- quality
- impact on customers
- impact on competition
Comparison of NPV and IRR
- NPV is expressed in money and not in percentage
- With NPV individual project’s can be added to see the effect of accepting a combination of projects
- NPV can be used in situations where the required rate of return varies over the life of the project
- The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects
Sensitivity analysis
- can be used by managers to examine how a result will change if the predicted financial outcomes are not achieved or if an underlying assumption changes
- can take various forms
- helps managers focus on those factors that are most sensitive
- the use of probabilities for different cash flow outcomes can readily be incorporated
- Real options approach to investment analysis - cash flows are discounted after considering options such as waiting for investment, abandoning temporarily ….depending on certain outcomes
Relevant cash flows
Relevant CF are expected future cf that differ among the alternatives
Capital investment projects typically have three major categories of cash flows - net initial investment, cash flow from operations, cash flow from terminal disposal of assets and recovery of working capital
Depreciation is irrelevant in DCF analysis because it is a non-cash allocation of costs.
Payback
Payback measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project.
An example of uniform cash flows and analyzing the financial aspects of projects.
= net initial investment/uniform increase in annual cash flows.
Accounting rate of return method
Divides an accounting measure of income by an accounting measure of investment.
Also called return on investment.
The ARR method is similar to the IRR method in that both methods calculate a rate of return percentage
While the ARR calculates return using operating income numbers are considering accruals, the IRR method calculates return on the basis of cash flows and the time value of money.
Qualitative factors to consider when reviewing a capital budgeting system:
1) predicting the full set of benefits and costs (both financial and non-financial)
2) Recognising the full time horizon of the project,
3) Performance evaluation and the selection of projects.
ARR is low because:
The investment increases the denominator and, as a result of depreciation, also reduces the numerator operating income in the ARR computation.
Optimal decision made using a DCF method
Will not report good operating income results in the project’s early years on the basis of the ARR
The conflict between using ARR and DCF methods
To evaluate performance can be reduced by evaluating managers on a project by project basis.
Income tax considerations
Although depreciation is a non-cash expense it is a deductible cost for calculating tax outflow.
Taxes saved as a result of depreciation deductions increase cash flows in discounted cash-flow computations.
Post investment audit
Compares the actual results for a project to the costs and benefits expected at the time the project was selected.
It provides management with feedback about performance
Intangible assets
Intangible assets are critical to most organisations
These assets have the potential to yield net cash inflows many years into the future
Top management can use a capital budgeting tool, such as NPV, to summarise the difference in the future net cash inflows from an intangible asset at two different points in time.
Real rate of return
Rate of return required to cover return and investment risk.
Nominal rate of return
Rate of return required to cover return, investment risk and inflation. The rates of return earned on the financial markets are nominal rates because they compensate investors for both risk and inflation. I
Nominal approach
Predict cash inflows and outflows in nominal monetary units and use a nominal rate as the required rate of return
Real approach
Predict cash inflows and outflows in real monetary units and use a real rate as the required rate of return.
Identification stage
Distinguish which types of capital expenditure projects are necessary to accomplish organisational goals. An organisations strategy could be increase revenues by targeting new products or customers. Nike makes significant investments in product innovation and design in hoping to develop the next generation of high-quality sportswear. Or another company might set out to reduce costs by improving productivity and efficiency.
Information acquisitions stage
In order to consider the predicted costs and predicted consequences of alternative capital investments. Information both quantitative and qualitative should be collected from all parts of the value chain to evaluate alternative projects. In Honda the firms too managers and the company’s marketing managers produce potential revenue numbers and suppliers for prices etc. Lower level managers are alex to validate the data provided and to explain the assumptions underlying them. Goal is to encourage open and honest communication that results in accurate estimates so that the correct investment decisions are made.
Make predictions
Forecast all potential cash flows attributable to the alternative projects at this stage. A new project generally requires a firm to make substantial initial overlay of capital. Investing in new projects requires the firm to forecast its cash flows several years into the future. BMW estimates yearly cash flows and sets its investment budget accordingly using a 12 year planning horizon. But there is uncertainty associated with these predictions. Managers may be tempted to introduce biases into projections in order to derive the outcome to their preferred choice.
Choose among alternatives
Managers determine which investment yields the greatest benefit and the least cost to the organization. Using the quantitative information obtained in the predictions the firm uses any one of the severs capital budgeting methodologies to determine which project best meets organizational goals.
Stage 5: implementation and control stage
To put the project in motion and monitor performance. As the project is implemented the company must evaluate whether capital investments are being made as scheduled and within the budget.
Important for a company to abandon projects that are performing poorly relative to expectations.
Capital budgeting process also influenced by:
Behavioral, organizational and political factors and the ability of individual managers to sell their own projects to senior management is often pivotal in the acceptance or rejection of projects
Discounted cash flow
Measure the expected future inflows and outflows of a project as if they occurred now so that they can be compared in an appropriate way.
Discounted cash flow methods recognize that the use of money has an opportunity cost. Key feature is the time value of money because the dcf methods explicitly and routinely weight cash flows by the time value of money they are often considered as better methods for long run decisions.
Depreciation is not deducted in DCF analysis because the expense entails no cash outflow.
NPV is calculated
Using the required rate of return which is the minimum acceptable rate on investment. It is the rerun that the organization could expect to receive elsewhere for an investment of comparable risk.
NPV method calculates the expected net monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time.
Only positive ones are acceptable because the return from project exceeds the cost of capital
Internal rate of return
Discount rate at which the present value of expected cash inflows from a project equals the PV of expected cash outflows of the project.
Comparison of NPV and IRR methods
NPV method is a value not a percentage.
You can add the NPV’s of individual independent projects to estimate the effect of accepting a combination of projects.
You can use NPV in situations where the required rate of return varies over the life of a project.
IRR method is prone to indicating unclear decisions when mutually exclusive projects with unequal lives of unequal levels of initial investment = irr method implicitly assumes that the project cash flows can be reinvested at the company’s required rate of return.
But managers find the percentage return computed in IRR easy to understand and compare.
