Cap Budgeting - 1 Long-Term Investment Decisions

Cap Budgeting - 1

Long-Term Investment Decisions

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IMPORTANCE OF LONG-TERMINVESTMENT ANALYSIS

Commitment of large amounts of resources

Long period of risk– Capital assets often mean technological risk– Strategic considerations– Exit barriers

• Time value of money considerations• Important analytical tool• Not the primary consideration of analysis

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Before we let you buy that newmachine you wanted, we want to know what return we are going to get out of it?

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LONG-TERM INVESTMENT ANALYSIS

vs. CAPITAL BUDGETING“Capital Budgeting”

Planning for long-term investment decisions regarding capital assets (facilities) including considerations

for financing the investment

“Long-term Investment Analysis”

Planning for ALL TYPES of long-term investment decisions,regardless of whether capital assets are involved

The major difference is that long-term investment analysisis a broader “strategic” consideration

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CAPITAL INVESTMENTDECISION MODELS

Non-discounted cash flow models– Payback period– Accounting rate of return

Discounted cash flow models– Internal rate of return– Net present value

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PAYBACK METHOD

Payback period = length of time needed to recover the initial investment in the asset

Cash outflow for investmentAnnual net cash benefit

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PAYBACK METHOD

Possible reasons for use:– Help evaluate risks associated with

uncertain future cash flows– Minimize impact of an investment on

liquidity– Help control risk of obsolescence– Relatively simple

Limitations– Ignores time value of money– Ignores total profitability of the project

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NET PRESENT VALUE(NPV)

NET PRESENT VALUE(NPV)

This model is the most widely recommended approach to capital budgeting since it specifically considers the time value of money and provides a basis for valuing the firm

Net Present Value = PV Cash Inflows - PV Cash Outflows

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NET PRESENT VALUE(NPV)

Decision criteria:– If NPV > 0, a return in excess of the cost of

capital has been earned, and the project is acceptable

– If NPV < 0, a return less than the cost of capital has been earned, and the project is unacceptable

Reinvestment assumptionAll cash flows generated by the project are

immediately reinvested at the cost of capital

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COST OF CAPITAL

The weighted average of the returns expected by the different parties contributing funds (debt and equity). The weights are determined by the proportion of funds provided by each source.

It is sometimes known as the

“hurdle rate.”

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INTERNAL RATE OF RETURN(IRR)

The interest rate that results in the present values of the cash outflows equaling the present value of the cash inflows.

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INTERNAL RATE OF RETURN(IRR)

Decision criteria:– If the IRR > Cost of capital, the project

is acceptable– If the IRR < Cost of capital, the project

is not acceptable

Reinvestment assumptionCash inflows from the project are

immediately reinvested to earn the IRR

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DISCOUNTED CASH FLOW ANALYSIS

Strengths– Cash flows vs. Accrual income– Time value of money is considered– Incorporation of financing costs

Limitations– Accuracy of cash flow projections– Possible misapplications of DCF analysis– Ability to determine “cost of capital”– Difficulty of estimating opportunity costs– Lack of integration of qualitative factors

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DISCOUNTED CASH FLOWSSpecific Items

Initial and subsequent investments Taxable cash flows

– Revenues– Expenses

Deductible noncash expenses (Depreciation, etc.)

Residual (salvage) values– Existing assets– Assets at termination of project– Tax considerations (gains or losses)

Working capital investments

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AFTER-TAX CASH FLOWS

Rule for taxable cash benefits (1-tax rate) x cash receipt = After-tax cash flow

Example: Increased sales or reduced costs

Rule for taxable cash expenses (1-tax rate) x cash payment = After-tax cash flow

Example: Labor costs

Rule for tax shield for noncash expenses (tax rate) x noncash expense = tax shield (cash inflow)

Example: Depreciation on equipment

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AFTER-TAX CASH FLOWSContinued

Rule for sale of assets

Proceeds from sale (+/-) Tax book value = Taxable gain/loss

Taxable gain/loss x Tax rate = Net tax effect

Proceeds from sale (+/-) Net tax effect = Net cash flow from sale of asset

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Strategic Considerations

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Justifying capital expenditures in a new manufacturing

environment

CAD/CAM

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Capital expenditures in a new manufacturing environment

Traditional investment analysis tools may not be adequate to make these type decisions. The day-to-day operating impact (tactical) may not be the key factor in making a decision. Less tangible benefits may be the deciding factor in whether or not to invest in new technology.

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EXAMPLES OF INTANGIBLES

Competitive advantage– Producing a product or providing a service

that competitors cannot Quality

– Improving the quality of a product by reducing the potential to make mistakes

Process simplification– Enhanced production capabilities

Reduced time to produce – Reducing the cycle time needed to make a

product or provide a service

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Capital investment decisions have potential pitfalls

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WHAT TO DO?

Consider the opportunity cost of not making an investment

Give full consideration to costs that may be hidden

Don’t set the barriers to strategic investment too high

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Find the hidden costs

warrantycosts

Trainingcosts

Cost offaulty

assumptions

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POST-IMPLEMENTATION AUDITS

An opportunity to re-evaluate a past decision to purchase a long-term asset by comparing expected and actual inflows and outflows

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POST-IMPLEMENTATION AUDITS Benefits

POST-IMPLEMENTATION AUDITS Benefits

By comparing estimates with results, planners can determine why their estimates were incorrect and can avoid making the same mistakes in the future

Rewards can be given to those who make good capital budgeting decisions

If the audit is not done, there are no controls on planners who might be tempted to inflate the benefits in order to get their projects approved

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Don’t throw good money after bad