Strategic Investment Decision (Session 11-12) Flashcards
Capital Budgeting
Capital budgeting is a process
that managers use when they
choose among strategic
investment opportunities
Why is capital budgeting decision important?
Capital budgeting decisions affect
cash flows in future years which
introduces an important concept,
the time value of money, which
refers to the idea that a dollar
received today is worth more
than a dollar received in the
future.
Examples of relevant cash outflows
- Initial investment outlay
- Future operating costs
- Project closing and cleanup costs
Examples of relevant cash inflows include:
- Future revenues
- Decreased operating costs
- Salvage value of assets at project’s end
Methods that consider the time value of money (discounted cash flow methods):
- Net present value (NPV) method
- Internal rate of return (IRR) method
Methods that do not consider the time value of money
- Payback method
- Accrual Accounting rate of return method
Future Value
The amount received in the future, for a given
number of years at a given interest rate, for a
given investment today.
Present value:
The value in today’s dollars of a sum received in
the future.
NPV Method
The NPV of a project is the sum of the project’s discounted cash flows
NPV analysis is often used to…
screen projects as to whether they are
acceptable.
After the screening, acceptable projects may be ranked according to their…
profitability index
Profitability index
Profitability Index = PV of cash inflows / PV of investment cash outflows
The discount rate is…
the interest rate that is used across time to
reduce the value of future dollars to today’s dollars.
Many decision-makers simply…
set the discount rate at the organization’s weighted average cost of capital (WACC)
Internal Rate of Return (IRR) Method
The IRR method determines the discount rate necessary for the present
value of the discounted cash flows to be equal to the investment (solve for
the discount rate at which a project’s NPV equals zero)
The IRR is the…
The IRR is the interest rate (X %) at which:
Initial investment = NPV of cash inflows.
Break-Even Rate of Return
Payback Method
- The payback method computes the number of years before the initial
investment is recovered. - If cash inflows are the same each year and the project has only one initial
outlay, the payback period is computed as
Why is the payback method widely used?
Because of its simplicity
Why is the payback method flawed?
the payback method is flawed because it ignores the time
value of money. It ignores cash flows that occur after the payback period.
What should be done when using the payback method?
If used at all, the payback method should be used in conjunction with
the NPV or IRR methods to help assess project risk.
Accrual Accounting Rate of Return Method
- The accrual accounting rate of return (AARR) is the expected
increase in average annual operating income as a percentage of the
initial increase in required investment.
Why is the AARR widely used?
This method is widely used because financial accounting
information is readily available. It ignores the time value of money.
Qualitative factors often influence strategic investment decisions…
- the effects of the decision on the company’s reputation,
- the effects on the quality of the company’s products and services,
- the effects on the company’s community
- the effects on the environment
- After a capital budgeting decision is made, a post-investment audit should be
performed to assess the decision process.
Accountants often…
Accountants often prepare analyses of projects that align with an organization’s
strategic plans.
After a project has been accepted, accountants and managers…
After a project has been accepted, accountants and managers monitor its progress
and compare actual performance to the capital budget expectations.
Three structural design levers
- Work units - groupings of employees by functions or markets
- Span of control – who reports to whom
within the organization - Span of accountability – what
performance measures are employees
accountable for (to their superiors)
What is the span of control?
The span of control refers to the
scope of people or other
resources over which an
individual is given decision-
making authority, and for which
he or she is held accountable.
The range of a span of control
A span of control can range from
narrow to wide
Individuals at the top of an organization’s hierarchy often have…
Wide spans of control
Individuals at the bottom of an organization’s hierarchy often have…
narrow spans of control
Centralized Decision-Making
When decision-making is centralized, the right to make or authorize
decisions lies within top levels of management.
Decentralized Decision-Making
When decision-making is decentralized, the rights and responsibilities for
decision-making permeate all levels of the organization.
Responsibility Accounting
Responsibility accounting is the process of assigning authority and
responsibility to managers of sub-units, and then measuring and evaluating
their performance.
Under responsibility accounting, managers are…
Under responsibility accounting, managers are held responsible only for
factors over which they have control.
Four common types of responsibility centers are…
o cost centres
o revenue centres
o profit centres
o investment centres.
Cost centers
Managers of cost centers have responsibility only for managing the center’s costs. These managers may only have responsibility for some of the
centre’s costs and not for others.
Many support departments are cost centres, for example:
- Human resource department
- Accounting department
Revenue Centers
Managers of revenue centers have the responsibility for generating
revenues. Revenue center managers are held responsible for the volume
of sales. These managers usually have the authority to determine the prices of
goods sold.
Many customer-facing departments are revenue centers… such as…
- Marketing department
- Sales department
Profit Centers
Managers of profit centers have the responsibility for generating
revenues and controlling costs. These managers usually have the authority to determine prices, the sales
mix of goods sold, and the inputs used.
Any department that has revenue and cost within its department can be a profit center, such as…
Manufacturing division which sells to
other internal or external parties
Investment Centers
Managers of investment centers have the responsibility for generating
revenues and controlling costs. They also are usually responsible for some
return on investment metric. These managers usually have the same authority as do profit center
managers, in addition to the authority to make asset acquisition and
disposition decisions.
Example of an investment center
A manufacturing division with a manager allowed to purchase large
machinery and perhaps build more factory space is an example of an
investment center.
Performance Evaluation of Investment Centers
- Return on investment (ROI) is the ratio of operating income to average operating assets.
- Residual income measures the dollar amount of profits in excess of
a required rate of return. - Economic value added (EVA) is a variation of residual income that
incorporates a number of adjustments to reduce the disadvantages
produced by residual income.
What is ROI?
Return on investment (ROI) is the ratio of operating income to
average operating assets.
What does residual income measure?
Residual income measures the dollar amount of profits in excess of
a required rate of return.
What is an Economic value added (EVA)
Economic value added (EVA) is a variation of residual income that
incorporates a number of adjustments to reduce the disadvantages
produced by residual income.
Structural Design Levers
Three structural design levers:
1) Work Units
2) Span of Control
3) Span of Accountability
Structural Design Levers
- Work units
groupings of employees by
functions or markets
Structural Design Levers - Span of Control
Span of control – who reports to whom within
the organization
Structural Design Levers
Span of accountability – what performance
measures are employees accountable for (to
their superiors)
What is the purpose of using the 3 levers to organize?
To influence the span of attention!
Span of attention
- domain of activities within a manager’s field of
view - defines what a manager will care to gather info
about and influence - can be narrow or broad
- comes from within individual managers (not top-
down like the span of control and span of
accountability)
Motivating Performance with Compensation
- Organizations use compensation contracts that provide incentives for
employees to increase the value of the organization. - These contracts include cash-based bonuses, stock options, and other
types of bonuses based on stock prices. - Earnings and growth targets are often set as goals in these
compensation packages.
o But, how does one measure the performance of employees?
How does one measure performance?
1) One way is to focus on financial measures only
2) Currently, emphasis on a mix of financial and non-financial performance measures
What is a balanced scorecard?
It is a strategic performance management system (tool)
Balanced scorecard helps management…
Helps management in clarifying company’s
strategy and translating it into actions
Balanced scorecard encompassess…
Encompasses financial and non-financial
measures
Balanced Scorecards includes four perspectives, which are:
- Financial
- Customer
- Internal
- People
