Week 10 Everything Flashcards
Capital investment decisions
Investment decisions are strategic decisions with long-term effects. Managers develop strategies from entity’s vision and core competencies. These strategies are aimed at entity’s overall purpose, which usually includes long term profitability. Capital budgeting proposals are analysed as if they were stand-alone projects.
Investment decisions are strategic decisions with long-term effects
Can be classified as regulatory (investment required by regulations), strategic (investment takes the company in a new direction – more next week); or operational (required for the day-to-day running of the business)
Capital budgeting
Capital budgeting is a process managers use to choose among investment opportunities that have cash flows over a number of years. Appraisal involves an understanding of the classes or categories of capital investment projects is required.
Capital investment categories
Regulatory Investments to comply with regulatory, safety, health and environmental requirements
Operational capital investment decisions
Strategic capital investment decisions
Steps for addressing capital budgeting decisions
Identify decision alternatives and classify project
Identify relevant cash flows
Apply the appropriate quantitative analysis techniques
Perform sensitivity analysis
Identify and analyse qualitative factors
Consider quantitative and qualitative information and make a decision
Identify decision alternatives and classify project
Regulatory, operational or strategic?
Apply the appropriate quantitative analysis techniques
NPV is most suitable for operational investments
Identify and analyse qualitative factors
Very important with strategic investments
Relevant cash flows must
arise in the future, and differ among decision alternatives
Examples of relevant cash outflows
Initial investment outlay
Future operating costs
Project closing and cleanup costs
Examples of relevant cash inflows
Future revenues
Decreased operating costs
Salvage value of assets at project’s end
Quantitative analysis methods
Capital budgeting objective is to increase long-term value of the entity which affect future cash flows. Therefore, time value of money is an important factor
Therefore, time value of money is an important factor
Present value is the value in today’s dollars of a sum received in the future
Future value is the amount received in the future for a given number of years at a given interest rate for a given investment today
Note: some regulatory investments do not require analysis using
Note: some regulatory investments do not require analysis using time value of money as they are required by law and are generally evaluated by price and fit for purpose (i.e. fire pumps)
Methods that consider time value of money
Net present value (NPV) method
Internal rate of return (IRR) method
Methods that do not consider time value of money
Payback method
Accrual accounting rate of return method (i.e. ROI)
NPV method
NPV method determines whether an entity would be better off investing in a project based on the net amount of discounted cash flows for the project. Useful for operational investments. Only partially useful for strategic investments.
Present value of a series of cash flows
NPV Formula
15/5/19
Uncertainties and sensitivity analysis
General rule is accept project if NPV > 0
Discount rate
The discount rate is the interest rate that is used across time to reduce the value of future dollars to today’s dollars. This is often set at an entity’s weighted average cost of capital (WACC). But this ignores variations in risk among projects. A higher (lower) discount rate is appropriate for projects having higher (lower) risk. Tendency to ‘load up’ the discount rate (e.g. use 12% instead of 10%) to deal with inherent risk can penalise strategic investments (or those with cash flows that come later in the project).
Income taxes and the net present value method
Income taxes affect cash flow and therefore capital budgeting decisions. Most cash flows affect taxes in the year they occur, but initial investment often provides a depreciation tax shield over a number of years. Depreciation is not a cash flow and shouldn’t be included in cash flow calculations but is required to determine tax related cash flows in NPV methods. Must also consider tax implications on gains or losses on terminal values
Depreciation is not a cash flow and shouldn’t be included in cash flow calculations but is required to determine tax related cash flows in NPV methods
i.e. calculate net profit before tax (and after depreciation) for tax determination then and add back depreciation
