Chapter 7 - Making Capital Investment Decisions Flashcards
What is the focus of capital budgeting?
What changes of assets need to be done?
Why are investment decisions of importance to a business?
- Large amounts of resources are often involved
- Relatively long timescales tend to be involved
- It is often difficult and/or expensive to bail out of an investment once it has been undertaken
What are the three methods for evaluating investment opportunities?
- Payback period (PP)
- Net present value (NPV)
- Internal rate of return (IRR)
What characterises the Payback period method?
It is the time it takes for an investment to be repaid by the net cash inflows from the project. For a project to be accepted its payback period must be no longer than a set maximum payback period. If there are many competing projects, the one with the shortest PP should be chosen. PP method emphasises liquidity.
What are some problems with the payback period method?
- It does not take into account the timing of cash flows, only when it is fully repaid
- It ignores cash flows arising after the payback period
- Ignores risk areas such as changes in demand
- Does not concern wealth maximisation for owners
- There is no objective basis for determining the maximum payback period.
NPV is a model that provides us with…
…logical allowance for the timing of all costs and benefits of an investment opportunity. The time value of money is considered since we discount cash flows. NPV is the only method that directly connects output to owner’s wealth.
What are three reasons for why amounts of money change in value?
- Interest lost. Making an investment means that we are deprived of interest we would have received by keeping the money in a bank account.
- Risk. Things may not turn out as expected. Higher risk = require higher returns.
- Inflation.
How do we discount future cash flows?
Sum of cash flow / (1+r)^n
where r is the cost of capital and n is how many years in the future the cash flow occurs.
What investments should be made according to the NPV method?
All investments that have a positive NPV (greater than or equal to 0) when all future cash flows are discounted and added. If there are many competing projects, the one with the highest NPV should be selected.
What characterises the IRR method?
Cash flows are discounted and IRR shows the discount rate that produces NPV = 0. For projects to be accepted they must meet a minimum IRR requirement. If there are many competing projects, the one with the highest IRR should be selected. The IRR does however not take into account the scale of the investment.
What are some practical points to be aware of when evaluating investments?
- Past costs should be ignored.
- Common future costs should be ignore, since only costs that vary with the decision should taken into account.
- Opportunity costs arising from foregone benefits should be taken into account
- Taxation should be considered, since investments can result in a tax shield
- We assume year-end payments
What are the five stages that managers must consider in investment decision making?
- Determine investment funds available.
- Identify profitable project opportunities. Scanning environment.
- Evaluate the proposed project.
- Approve the project.
- Monitor and control the project. Often larger projects or random samples because it is time-consuming.
What are two ways to deal with uncertainty in investment evaluations?
- Sensitivity analysis. Change one parameter at a time.
- Scenario analysis. Change all parameters at once. Best case, normal case, worst case scenarios.
What are three generic ways to create value in the business when we know NPV?
i: Work to get cash inflows earlier (time value of money), everything else equal = higher NPV
ii: Work to get cash outflows later (time value of money), everything else equal = higher NPV
iii: Work to reduce the risks in the cashflows/project (cost of capital will be lower and hence NPV
higher)
