week 3 Flashcards
what is investment project?
The term investment project is interpreted very broadly to include any proposal to outlay cash in the expectation that future cash inflows will result
capital expenditure management involves the
planning and control of expenditures incurred in the expectation of deriving future economic benefits in the form of cash inflows
capital expenditure process involves
- generation of investment proposals
- evaluation and selection of those proposals
- approval and control of capital expenditures
- post-completion audit of investment projects.
investment proposals: Investment ideas or projects:
¡simple upgrades of equipment,
¡replacing inefficient exiting equipment,
¡plant expansions,
¡new product development,
¡bidding for commercial contracts,
¡entering new markets. or
¡corporate takeovers.
types of invesment projects
what are independent investments?
¡Projects that can be considered and evaluated in isolation from other projects.
¡This means that the decision on one project will not affect the outcomes of another project
- technically feasible to undertake one of the projects, irrespective of the decision made about the other project(s).
- The net cash flows from each project must be unaffected by the acceptance or rejection of the other project(s).
what are mutually exclusive investments?
¡Alternative investment projects, only one of which can be accepted.
¡For example, a piece of land is used to build a
factory, which rules out an alternative project of
building a warehouse on the same land.
methods of project evaluation include
Methods of project evaluation include:
- Payback period
- Net present value (NPV)
- Internal rate of return (IRR)
- Benefit–cost ratio (profitability index)
simple project evaluation methods
payback period
payback period, a non discounted cash flow method,
The amount of time required for an investment to generate cash flows to recover its initial cost.
simple project evaluation methods
payback period
when is an investment acceptable?
An investment is acceptable if its calculated payback is less than some maximum acceptable payback period
.
pros of payback period
- Easy to understand/simple
- Adjusts for uncertainty of later cash flows.
- knowledge of how soon funds in the project will be recouped provides managers with info to facilitation cash budget preparation –> better liquidity management
disadvantages of payback period
- Time value of money (timing of all cash inflows and outflows) and risk ignored.
- arbitrary determination of acceptable payback period.
- Ignores cash flows after the point net cash flows = intial outlay, thus, discriminates long term projects and projects that generate large cash flow later
advantages of benefit cost ratio
¡Includes time value of money
¡Easy to understand
¡Does not accept negative estimated NPV investments
¡Biased towards liquidity
disadvantages of benefit cost ratio
- May reject positive NPV investments
- Arbitrary determination of acceptable payback period
- Ignores cash flows beyond the cutoff date
- Biased against long-term and new products
what are discounted cash flow methods
Discounted cash flow (DCF) methods involve the process of discounting a series of future net cash flows to their present values.
DCF methods include:
¡The net present value method (NPV).
¡The internal rate of return method (IRR).
projects should be accepted if
they increase shareholders’ wealth
postive NPV represents
the immediate increase in the company’s wealth that will result from accepting the project—that is, a positive net present value means that the project’s benefits are greater than its cost, with the result that its implementation will increase shareholders’ wealth
If a company implements a project that has a positive net present value, the company will be
more valuable/better off than before it undertook the project, and therefore, other things being equal, the total market value of the company’s shares should increase immediately by the same amount as the net present value of the new project.
what is the internal rate of return
The internal rate of return for a project is the rate of return that equates the present value of the project’s net cash flows with its initial cash outlay.
IRR is the discount rate (or rate of return) at which the net present value is zero.
decision rule for IRR
The IRR is compared to the required rate of
return (k).
If IRR > k the project should be accepted.
If the required rate of return is the minimum return that investors demand on investments then, other things being equal, accepting a project with an internal rate of return greater than the required rate should result in an increase in the price of the company’s shares.
¡Situations where the IRR rule and NPV rule may be in conflict:
nDelayed Investments
nNonexistent IRR
nMultiple IRRs
Hence, the number of cash flow sign reversals corresponds to
maximum, but not necessarily the actual, number of internal rates of return.
. IRR measures
the average return of the investment and the sensitivity of the NPV to any estimation error in the cost of capital
IRR rule and mutually exclusive investments: differences in scale
¡If a project’s size is doubled, its NPV will double. This is not the case with IRR. Thus, the IRR rule cannot be used to compare projects of different scales.
For independent investments, both the IRR and NPV methods of investment evaluation lead to
the same accept/reject decision, except for those investments where the cash flow patterns result in either multiple internal rates of return or no internal rate of return. In other words, if a project has an internal rate of return greater than the required rate of return, the project will also have a positive net present value when its cash flows are discounted at the required rate of return—that is, NPV > 0 when r > k, NPV < 0 when r < k, and NPV = 0 when r = k
describe normal cases of mutuallly exclusive projects and extreme
the expected benefits from one project are affected by a decision to accept or reject another project.
In the extreme case, where the expected cash flows from a project will completely disappear if another project is accepted, or it is technically impossible to undertake the proposed project if another project is accepted
e.g. choice of one equipment leads to rejection of another
one of the problems of IRR
it can be affected by changing the timing of the cash flows, even when the scale is the same.
describe economic value added as a method of project evaluation
ndifference between the project’s accounting profit (or operating CFs) and the required return on the capital invested in the project.
how can EVA be improved?
improved by increasing accounting profit (or CF) or by reducing capital employed.
what is EVA given by
what does EVA show?
addition to the company’s wealth created by the investment.
real option analysis
management choices are often known as
real options
limitations of NPV analysis
the approach treats projects as now-or-never prospects—whereas we know that in reality managers often have significant flexibility in how they manage a project (including when to begin it)
In addition, NPV is limited to a yes-or-no analysis; for example, it implicitly gives no recognition to the fact that, after a project has begun, managers may intervene in the project as circumstances develop.
how can the limitations of NPV be overcome?
by real options analysis
what are real options
the flexibility that a manager has in choosing whether to undertake or abandon a project or change the way a project is managed
they can choose how to implement a project and manage an ongoing project
examples of real options
options to
¡delay investment
¡expand operations
¡abandon operations.
calculation of payback period takes into account
Calculation of the payback period takes into account only the net cash flows up to the point where they equal the investment outlay.
Consider two projects, A and B, where project A has a net present value (NPV) of $100 and project B has an NPV of $50. If both projects are independent, which project should be accepted?
both as they are both positive, so they both add value to the firm and increase shareholders’ wealth
the difference in ranking is caused by differences in
any difference in the magnitude or timing of the cash flows may cause a difference in the ranking of investment projects using the internal rate of return and net present value methods.
2 most popular project evaluation methods
NPV and internal rate of return
when there are mutually exclusive project with NPV and IRRs that differ, what do you do?
At a required rate of return of 10 per cent, both investments are worth undertaking, but if a choice has to be made between the two investments, then investment B with the larger net present value is to be preferred. This is because B adds more to the company’s value than A. The net present value method will ensure that the value of the company is maximised, whereas the use of the internal rate of return method will not ensure that result.
