capital investment decisions Flashcards
what does a financial manager do
- corporate finance and capital markets
- investment decisions
- financial risk management
- liquidity and cash management
give a brief overview of investment decisions
project evaluation
cost of capital
- equity
- preference shares
- debt
what is the capital investment decision
the decision to invest cash now for the prospect of a greater return in the future
possible motivations for investments
expansions
innovations
minimising the cost of production
sustainability developments
investing in the downturn
how may technology innovations affect the world
- AUGMENT the capacity for workers
- GENERATE tasks
- SUBSTITUTE for human labour
- TRANSFER responsibility to consumers
what is the decision making process
- prepare an outline for the proposed investment
- conduct early screening of opportunities to assess alignment with strategic objectives
- evaluate the opportunity - net present value analysis
- conduct sensitivity/scenario analysis
- evaluate funding availability
- review and monitor
what is opportunity cost
expected rate of return that shareholders could have obtained by investing in financial assets
what is the green book
guidelines for policies, programmes and projects
central government guidance on appraisal and evaluation
what is NPV model
net present value model is the most appropriate model for investment decision making - it comes from the fundamental model valuation where value is the present value of expected future cash flows
what does NPV model take into account
risk and the time value of model by looking at expected cash flows discounted at the opportunity cost of capital
what is the ideal NPV
ideally accept all projects where NPV>0
what issues arise from NPV formula
issues over what to include for Rt (time period t expected incremental net cash flow)
issues over whether to discount/ how much the rate should be (i)
what are the important steps for using NPV rule for capital investment decisions
- estimate expected future cash flows
- determine the cost of capital
- computer NPV and conduct sensitivity analysis
what does expected incremental cash flows =
cash flow if projected accepted - cash flow if not
what do u include in expected incremental cash flows
- taxes
- all incremental affects (impact on rest of business)
- cash flows that come after sales
- change in working capital
- salvage value of any assets
what do u exclude in expected incremental cash flows
- sunk costs
- allocated overheads
- depreciation - unless permitted for tax purposes
- debt interest
what is capital allowances?
the amount the company is allowed to claim against taxable profit. it is claimed on assets purchased for the project
what is sensitivity analysis
where factors are changed to try take into account of potential surprise events
enables the determination of crucial determinants of success
what are the types of analysis
scenario analysis
break-even analysis
benefit cost ratio
what is scenario analysis
can accommodate interrelated variable through looking at consequences of different scenarios
what is break even analysis
determines how far scales could fall before NPV turns negative for example
what is benefit cost ratio
may be estimates for public sector investments
what are RIOs
real investment options -
NPV analysis for investment appraisal involves a single accept/reject decision (STATIC NPV)
in reality there is flexibility over decisions during the life of the project
what are the types of RIOs
- wait and learn before investing : option to DEFER
- abandon project : option to ABANDON
- expand the project : option to EXPAND
- change the project to vary production or output methods: option to SWITCH
how may ignoring RIOs at evaluation stage affect the valuation
may mean the project is undervalued in the RIOs are ‘in the money’
total value of the project =
static NPV + option premium (value of RIOs)
how do financial managers try to quantify the value of RIO
by using models
- black Scholes model
- binomial model
- related to binomial model –> decision tree analysis
what is the black Scholes option pricing model
model used for pricing call options
five factors impact an option value:
1. share price
2. exercise price
3. risk free rate of interest
4. volatility of underlying assets
5. time to maturity
what is the binomial option pricing model
a model that assumes that there are two outcomes in any given time period, each is assigned a probability and expected values are then generated
used to value option to continue/expand or option to abandon
useful for mapping out project when learning/decision takes place over time - decision tree analysis
what are spot rates
rates for immediate exchange of currency, they may be an average of the quoted rates available
what are forward rates
rates available for exchange of currency at a specified date in the future
what can forward rates give an indication of
whether a currency is expected to appreciate or depreciate
what is interest rate parity
the relative difference in interest rates equals the relative difference between forward and spot exchange rates
in other words the foreign rate of interest covered for exchange risk should be the same as the home rate of interest
does the interest rate parity hold in practice
it did until 2007-2009 financial crisis then was persistently violated for some time after 2009 partly due to leverage restriction on some banks
what is expectations theory
E (spot rate) = forward rate
the forward rate is equal to the expected future spot rate
does expectations theory hold in practice
the forward rate does tend to both over state and understate the spot rates
on average the rates are almost identical - the consequence for the financial manager is that forward rates can be used to predict future spot rates
what is purchasing power parity
the expected difference in inflation equals the expected change in the exchange rate
prices of goods generally must be the same across countries
does purchasing power parity hold in practice
large differences in inflation rates are generally accompanied by an offsetting change in the exchange rate (concerns expected not values)
what is the link between interest rates and inflation rates
differences in expected interest rates reflect the differences in expected inflation rates i.e real rates are the same
why shouldn’t you borrow in currencies that appear to change low interest rates
low rates may reflect the fact that investors expect inflation to be low and the currency to appreciate
when can interest rates and currency exposures be important to a firm
if they have
- debt or loans in different countries
- international sales
- production sourced internationally
- customers from other countries
how can exchange rate exposure be divided
transaction exposure – as a result of a specific transaction
economic exposure – more general exposure
translation exposure – through translation of financial statements
what are the two methods of evaluating international investment opportunities
- working with foreign cost of capital
- working with home cost of capital
how do you evaluate international investment opportunities using foreign cost of capital
a. estimate foreign after-tax expected cash flows
b. discount at the foreign rate cost of capital to give a foreign rate NPV
c. multiply the NPV by the current spot rate to give NPV in this home currency
how do you evaluate international investment opportunities using home cost of capital
a. estimate foreign after tax expected cash flows
b. translate these to the home currency using the forward rate
c. discount at the home rate cost of capital
what other factors should be consider when evaluating International decisions
- tax planning
- political risk
how my the UK double tax treaty benefit u
may be able to claim exemption or partial relief from UK withholding tax on certain types of UK income
what is political risk
risk of an unanticipated action by governments or the court after the investment has been made
what should you do when investing in a country with high political risk
- shorter lived investments could be considered if there are doubts about realising future cash flows
- financing could be sought or guaranteed by world bank or a consortium of banks
