value from investment decisions Flashcards
capital budgeting process
- generation of investment proposals
- evaluation/selection
- management of capex during implementation of chosen projects
- control/audit
evaluation/selection
- identify/forecast relevant cash flows
- establish suitable investment decision rules
- apply rules to select best project
independent projects
no effects from implementation of one on:
- implementation of another
- their cashflows
dependent projects/dependencies
- budget constraints
- cash flow effects
- mutually exclusive projects
budget constraints
- eg R&D expenditure shuts down other projects
- best to select projects within budget so overall NPV is maximised
- profitability index (PV/cost) good to rank projects
- doesn’t work perfectly as there can be better project combinations that get same NPV for lower cost, even if PI high
cash flow effects
eg new products will affect sales of old product
mutually exclusive projects
- use of the same finite resource
- eg empty lot can only be built on once
rules/measures for investment decisions
- payback period
- net present value
- internal rate of return
payback period
- how long until initial investment is recovered
- ignores time value of money
- project accepted if payback period is less than threshold, often 2-3 years
- for short-medium term, and small-scale projects
net present value
present value of future cash flows LESS initial cost/investment
- measures value created by project
-accept when NPV > 0
- reject when NPV < 0
internal rate of return
- which discount rate makes NPV = zero/how high can rate be that NPV is still positive
- provides margin of error
- NOT for un-standard cashflows and projects of different scales
- reflects risk of project for investors
- should exceed cost of capital so that NPV positive
- IRR estimates cost of capital that an individual business can handle without NPV being negative, hence internal rate
non-standard cash flows
- projects with long time to build
- intermittent, large CAPEX
- substantial shut-down costs
- can have >1 IRR
- discount rates in between show positive NPVs
repeat purchases/different timelines
investment decision criterion that measures net benefit/cost per period over useful lifetime of an investment that needs to be replaced repeatedly - Equivalent Annual Annuity (EAA)
repeat purchases/EAA assumption
you will be able to replace investment with identical item at same cost
repeat purchases/EAA considerations
- required life - how long planning to use
- replacement cost - maybe more expensive
- technological obsolescence/speed of innovation - new alternatives
