Session 5-6: Strategic investment decisions

Question 1

What should be the structure of investment decisions?

Answer 1

Question 2

What does Incrumentalism mean?

Answer 2

‘Incrementalism’ = many small projects

Question 3

What are typical concerns people make in investment appraisals?

Answer 3

1) Failure to identify alternatives correctly
2) Too much weight given to short term productivity declines
3) Historically: excessive discount rates applied ( long-term benefits penalized)

Question 4

What are the 5 rules for relevant cash flows?

Answer 4

Question 5

We are going to look at an example of equipment replacement at Mavis ( Shank,1996, MAR) Basically Mavis main customer has an order but it will require mavis to change its production process, so we are going to calculate NPV of this.
Firstly, what are the relevant cash flows?

Answer 5

Question 6

What is the net cash flow for year one

1) what are the 4 cash flows we have to work out?

Answer 6

The 4 cash flows which are important are:

1) inital capital outlay ( cash outflow) - Always include in a cash flow q.
2) Dispoal of old machine ( cash inflow)
3) 10% investment tax credit ( we don’t know if this will always be the case but check)
4) Tax savings from loss/gain in disposal.

Question 7

Now actually work out the cash flows? for t = 0

Answer 7

1) Capital outlay = (680,000)
2) Disposal of old machine ( 240,000)
3) 10% investment tax credit ( if you read q its on the new paid capital) so 10% of 680,000.
4) You have tax savings from selling the old machine ( as originally you would be paying tax on that but your not paying no more.
4 manual lathes = NBV - dispoal price ( cost - AD) - disposal price(market value) = (590,000-114,000) - 240,000 = 236,000. ( this is a loss on dispoal as NBV>dispoal price.
236,000 ( this loss would be taxed so you add it back on) x 46% = 108,560, which is cash inflow.

Question 8

As Mavis is changing a cheaper machine for a more expensive one, what does it mean for taxation?

Answer 8

Incuremental taxation = ( incrumental profits - incurmental capital allowance) * tax rate.
Capital allowance is the percentage of asset book value dedcutible from taxable profits, in asset replacement decisions we look at incrumental depreciation to calculate any change in capital allowance. So capital allowance = depreication.

Question 9

Workout mavis incrumental taxation from (t=1 to 12)

Answer 9

Incuremental profits made in the year is the savings of labour cost + cost savings from maintence, supplies and power)
2 shifts x 4 operators x 8h x 5d x 52 w = 16,640 DLH in a year with old machines. then you find 75% of this because you only need 1 worker rather than 4 = 12480.
So DLH saved = $124800 ( $10 per labour our)
$124800 + 20000 = $144800 additional taxable profits per year.

Question 10

Now tell me the net cash flows for t=1 to 12?

Answer 10

Savings in labour cost ( 4 operators we calculated from last slide)
+ savings in supplies. maintence and power
+ additional taxes paid ( extra, from switching from a cheaper to a more expensive machine).

Question 11

We are going to look at the final cash flow t =12, What do we need to consider?

Answer 11

Terminal value:
1) CFs from t=1 to t=11
2) Disposal of new machine
3) Foregone dispoal of old machines ( opportunity cost of selling the 4 mannual lathes)
(No changes in deprecation in the final year and no loss on disposal therefore no tax implication)

Question 12

Now actually work out the cash flow for the last year t =12?

Answer 12

Question 13

What are the 4 main methods for investment appraisal?

Answer 13

1) NPV
2) IRR
3) ARR
4) PAYBACK PERIOD.

Question 14

What is the present value of an annutiy?

Answer 14

Question 15

Now lets Lets say the discount rate was 10%, 20% and 30% calculate the NPV?

Answer 15

Question 16

What is IRR and what is decsion rule?

Answer 16

An equivalent way of stating the NPV criterion: accept if the expected
return on investment is higher than the opportunity cost of capital.

Question 17

With IRR, what do we use, what was the case for Mavis?

Answer 17

Trial and error so in Mavis case

Question 18

We could potentially use quadratic formula to calculate IRR? ( tba)

Answer 18

FG

Question 19

What are problems with iRR?

Answer 19

Multiple IRRs
No IRR
does not capture size of project

Question 20

What is a negative of NPV but what is are 2 positives? ?

Answer 20

NEGATIVE = depends on setting a required rate r

Question 21

What does Payback period mean?

Answer 21

Payback period = time t needed to recover initial investment

Question 22

What is payback period?

Answer 22

Here 252,516 is meant to be swapped around

Question 23

What are benefits the payback period?

Answer 23

– Rule of thumb, easy to understand
– Useful if:
• Distant cash flows highly uncertain
• Preliminary phase, initial screening

Question 24

What are drawbacks of IRR?

Answer 24

Limitations:
– how is t* established?
– ignores time value of money/opportunity cost of capital
– Ignores CFs beyond t*
• More concerned with cash management in the short
or medium term

Question 25

What is Accounting rate of return?

Answer 25

Income divided by investment ( ROI)
If ARR > required rate of return r, then accept
– Need to establish r = benchmark
• Between 2 projects, choose project with highest ARR

Question 26

Calculate Accounting rate of return?

Answer 26

Question 27

What is an advantage and 2 disadvantages of ARR?

Answer 27

Advantage:
• Based on information readily available (financial
statements)
Disadv’s : Affected by chosen accounting methods (e.g.
depreciation)
- Also Time value of money ignored

Question 28

From a purely financial point of you, the 4 methods used to evaluate investment appraisal, what can we say?

Answer 28

From a purely quantitative perspective, the machine replacement is extremely
favourable!

Question 29

The new automated technology seems promising given the
growing demand for products for oil exploration…
– but if one looks more closely at how the new machine
operates, some concerns may be raised, regarding what….
What 6 qualitative factors do we need to consider?

Answer 29

Question 30

What does flexibility mean here for mavis?

Answer 30

The new machine causes a loss of flexibility because you only jobs requiring all four combined operations, thus potentially changing its
product mix in favour of more complex products.
Thus risk of downtime (time when you relax and do not do very much)

Question 31

What does Quality and customer value for mavis?

Answer 31

Are these more complex machined products necessarily increasing customer value?
- For example: is manual customisation a source of competitive advantage for Mavis?

Question 32

What does Strategy pursued mean for Mavis?

Answer 32

Mavis = small firm: can it succeed in the automated technology segment of the market?
Is the company aiming to achieve cost leadership or product differentiation?
- Given small size, cost leadership is unlikely to be feasible
(requires economies of scale).

Question 33

What does Labour and skills mean here for Mavis?

Answer 33

Moving to automation implies a shift in key competencies
• How quickly can operators learn to use the new
machine?
• What are the consequences of firing 6 employees at
once, in a firm which is possibly employing no more than
60?

Question 34

What does supply chain mean for qualitiative analysis?

Answer 34

1) is Mavis running the risk of becoming a captive supplier, too dependent on Buckeye?
2) Thus, the new machine may cause Mavis to lose both
buyer power and seller power within the supply chain

Question 35

What does Performance measurement mean here for Mavis?

Answer 35

loss on disposal of $236,000 Recognising such loss implies acknowledging a mistake made 3 years ago.