Week 11 Everything Flashcards
Capital investment categories
Regulatory Investments
Operational capital investment decisions
Strategic capital investment decisions
Regulatory Investments
comply with regulatory, safety, health and environmental requirements;
often mandatory expenditure for operations to continue
Operational capital investment decisions
made for operational purposes, for example replacement or upgrade of equipment
discretionary expenditure to continue the status quo of operational activities
Strategic capital investment decisions
deviates from normal operations (i.e. new products; new acquisitions; new geographical locations)
involves greater risk and often greater outlay of funds
Steps for addressing capital budgeting decisions
Identify decision alternatives and classify project
-Regulatory, operational or strategic?
Identify relevant cash flows
Apply the appropriate quantitative analysis techniques
-NPV on its own is not suitable for strategic investments
Perform sensitivity analysis
Identify and analyse qualitative factors
-Very important with strategic investments
Consider quantitative and qualitative information and make a decision
Strategic Investments and cash flow uncertainties
Estimating cash flows for projects involving new products or services is more difficult than for replacement of existing products and services. Revenues must sometimes be based on a market that currently does not exist resulting in estimation errors. Individuals providing information about the future cash flows are likely to have a vested interest in the project’s acceptance and are more likely to estimation bias.
Individuals providing information about the future cash flows are likely to have a vested interest in the project’s acceptance and are more likely to estimation bias.
form estimates that favour project
fail to identify all possible project costs
Long timeframes reduce ability to anticipate
Ability to accurately estimate cash flows decreases as forecast moves further into future
Long timeframes reduce ability to anticipate:
customer tastes
changes in technology
productivity
competition
availability of resources
changes in regulations
Factors affecting the discount rate:
Interest rates
Inflation
Riskiness of project
Length of time for capital projects increases uncertainty in relation to these factors
Caution when using NPV with strategic investments
When quantifying the multi-faceted ‘strategic’ benefits the hard-to-quantify benefits may be conservatively estimated. Synergies might not be quantified or disregarded. Uncertainty in cash flow predictions results in company preference for shorter payback periods.
DCF analysis presumes “do not invest” = continuation of current cash flow stream. If companies do not invest in strategic opportunities they cannot assume they will maintain existing business. Strategic opportunities may be taken up by competitor. In this way the “Do not invest” decision = declining cash flow stream
Needs to be factored into analysis, otherwise NPV of strategic investment is understated
Strategic investments involve larger outlays, longer payback periods
Larger outlays with longer payback periods the benefits that commonly come later in the cash flow stream are penalised by DCF and NPV methods
Benefits such as higher quality, shorter lead times, broader product range are difficult to quantify
Strategic investments often capitalise on synergies and it is often hard to identify incremental investment effect
Improving capital budgeting
Be aware of the different types of investments and when NPV results needs to be carefully scrutinised. Sensitivity analysis can help managers evaluate how NPV results would change with variations in input data. Spreadsheets allow easy variation of discount rates and cash flows. Other underlying assumptions including difficult to quantify strategic benefits (may be ranked instead). Allows decision makers to consider results of other scenarios.
