Capital Investment Decision Flashcards
Capital Expenditures
Involve large amts of money
Not regularly recurring
Commit a firm to a long term action
Large cash inflows and outflow over a number of years
External Pressures
Effects of competition, demand, and technology
Internal pressures
Firms cost structure and managements’ expectations
Types of investments
Replacement
Cost reduction
Expansion
New products
Budgeting decision steps
- Ideas for project are developed
- Projects are classified
- Expected future cash flows are estimated (estimate investment and cash inflows)
- Risk is appraised
- Financial value is analyzed
- Post-audit (compare real results with predicted)
Borrowing is only worthwhile if:
return exceeds cost
Lending is only worthwhile if:
Return is at least equal to that which can be obtained from alternative opportunities
How is the interest rate determined?
Receipt of money is preferred sooner rather than later
Risk of capital sum not being repaid
Inflation
Define Future value
A dollar in hand today is worth more than a dollar to be received in the future because you could invest it and earn interest now.
Future Value =
Amount to be invested X (1 + interest rate)
Present Value =
Amount received / (1 + interest rate)
Future Value of an investment =
PV (1 + interest rate)^years)
PV of an investment =
FV/(1+ rate)^years
OR FV*(PVIFi,n) where the PVIFi,n is from a chart
Define Net PV
Difference between the present value of the inflows and the present value of the outflows
Required Rate of Return
Rate of return that an investment must earn to be financially attractive
Should be equal to the cost of capital (debit and equity)
