Chapter 8 Long-Term (Capital Investment) Decisions.

Chapter 8

Long-Term (Capital Investment) Decisions

Topics to be Discussed

Introduction

Focus on Cash Flow

Screening and Preference Decisions

Discounted Cash Flow Analysis

Internal Rate of Return

Introduction

Capital Investment Decisions

Which do I purchase?

What is the return on the investment?

What are the qualitative costs and benefits?

What are the quantitative costs and benefits?

Focus on Cash Flow

Long-term investment decisions require a consideration of the time and value of money.

The time value of money is based on the concept of a dollar received (paid) today being worth more (less) than a dollar received (paid) in the future.

Focus on Cash Flow

Original investment

Repairs and maintenance

Extra operating costs

Incremental revenues

Cost reductions in operating expenses

Salvage value

Release of working capital at the end

What cash flows should I consider??


Screening decisions involve deciding if an investment meets some predetermined company standard.

Preference decisions involve choosing between alternatives.


Should old equipment be replaced with new?

Should a new delivery vehicle be purchased or leased?

Should a manufacturing plant be expanded?

Should a new retail store be opened?

Typical Problems


Increase production

Increase sales

Reduce costs

make a higher quality product

Provide better customer serviceIdentify

Objectives


Quantitative analysis of the options using tools that recognize the time value of money

Qualitative analysis

Identify and Analyze Available Options


Step 4

Select the best option

Discounted Cash Flow Analysis

Key Concept

The time value of money is considered in capital investment decisions using one of two techniques: the Net Present Value (NPV) method or the Internal Rate of Return (IRR) method.

Discounted Cash Flow Analysis Net Present Value

The Cost of Capital represents what the firm would have to pay to borrow (issue funds) or raise funds through equity (issue stock) in the financial marketplace. In NPV, the discount rate serves as a hurdle rate or a minimum required rate of return.

What do I use for a discount rate?


Key ConceptIf the present value of cash flows is greater than or equal to the present value of cash outflows (the NPV is greater than or equal to zero), the investment provides a return at least equal to the discount rate (the minimum required rate or return) and the investment is acceptable.


Cost: $50,000

Net increase in cash flows (Revenues-Expenses): $14,000 for six years

No salvage value

MRR = 12% and use for discount rate

Should B&R purchase a new refrigerated delivery van?


Cash Flow

Initial Investment

Annual Cash Income

Net Present Value

Year

Now

1-6

Amount

$(50,000)

14,000

12% Factor

1.0000

4.1114

Present Value

$(50,000.00)

57,559.60

$7,559.60

Because the NPV is positive, the delivery van should be purchased.


Key Concept

The internal rate of return (IRR) is the actual yield or return earned by an investment.

The IRR is the discount rate that makes the NPV = 0.


IRR can be found by using a NPV table, financial calculator or Excel.

When determining whether to accept a project, you must also consider the impact of uncertainty on the decision.

Changes in assumptions about future revenue and costs are likely to affect the decision.

More Topics

Screening versus Preference Decisions

The Impact of Taxes on Capital Investment Decisions

The Impact of Uncertainty on Capital Investment Decisions

The Impact of the New Manufacturing Environment on Capital Investment Decisions

The Payback Method

Screening vs Preference Decisions

Invest inProject

Decisionon what

method touse

NPV

NPV> 0

Consider allqualitative factorsin the decisions

ProjectRejected

NO NO

YES YES

IRR

IRR > cost of capital

ProjectRejected

Screening vs Preference Decisions

Profitability Index (PI): Calculated by dividing the present value of the cash flow by the initial investment.

A PI greater than 1.0 means that the NPV is positive and the project is acceptable.


Nonprofit organizations such as hospitals, museums, churches, and other organizations are structured as organizations exempt from federal and state income taxes.


Profit-making companies must pay income taxes on any taxable income earned.


Key Concept

Taxes are a major source of cash outflows for many companies and must be taken into consideration in time value of money.


Pause and ReflectWhy isn’t the original purchase price of $50,000 for the delivery van adjusted for the impact of income tax?

Extended Example

Amber Valley is considering installing another chair lift for a new undeveloped area that would expand the amount of area available for skiing.

The options are to put in a double, triple or quadruple chair life to carry two, three or four skiers on each chair.

Extended Example

Pause and Reflect

What qualitative factors should Amber Valley consider in its decision?


One way to adjust for risk is to increase the cost of capital used in the NPV calculations.

How do I try to adjust for uncertainty?


What if the number of skiers did not increase at the rate that was projected? Will the acquisition of the new lift still result in a sufficient return of and on investment?

Uncertainty

Sensitivity Analysis: Used to highlight decisions that may be affected by changes in expected cash flows. Use what-if analysis to determine how sensitive capital investment decisions are to changes (number of skiers per day).

The Impact of the New Manufacturing Environment on Capital Investment

Decisions

Automating a process is more extensive and expensive than just purchasing a piece of equipment. Other expenses include:

Software needed

Training of personal and complementary machines

Processes needed


Decisions

Benefits of automating production processes:

Decrease labor costs

Increase in the quality of the finished product

Increased speed of production process

Increased reliability of the finished product

An overall reduction in the amount of inventory


Decisions

Key Concept

Analyzing the cost and benefits of investments in automated and computerized design and manufacturing equipment and robotics can be very difficult and requires careful consideration of both quantitative and qualitative factors.

The Payback Method

The length of time needed for a long-term project to recapture or pay back the initial investment.

Payback Period =Original Investment

Net Annual Cash Inflows

The Payback Method

Key Concept

The payback method can be useful as a fast approximation of the discounted cash flow methods when the cash flows follow similar patterns.

Appendix

Time Value of Money and Decision Making

Future Value

Present Value

Annuities

Time Value of Money and Decision Making

The present value of cash flows is the amount of future cash flows discounted to their equivalent worth today. So how do we find the present value?

If I receive cash at different times, how do I determine the time value of money?

Future Value

The time value of money is the result of the ability of money to earn interest over time.

Future Value is what $1 today will be worth in the future including interest.

Simple Interest is interest on the invested amount only.

Compound Interest is interest of the invested amount plus interest on previous interest earned but not withdrawn.

Future Value

How much will this $100 be worth three years from now if I invest it at 4%?

Year 1$100 @ 4%

$104

Year 2$104 @4%

$108.16

Year 3$108.16 @ 4%

$112.19

Future Value

FV = PV (1 + r)n

FV = Future Value

PV = The $ Amount Invested Today

r = Interest Rate

n = Number of Time Periods

Future Value

Future value can be calculated by using

The formula

FV tables

Hand-held calculators

Computers

Present Value

If I need $112.19 three years from now, and I can invest at 4%, how much do I have to invest now?

$112.191.04

$108.16

$108.161.04

$104.00

$104.001.04

$100.00

Present Value

FV

(1+r)nPV =

FV = Future Value

r = Interest Rate

n = Time Period

Present Value

Present Value can be calculated using

Formula

Tables

Hand-held calculators

Computers

Present Value

Key Concept

More frequent compounding increases future values and decreases present values.

Present Value

Pause and Reflect

Why does a 50% increase in return from 8% to 12% result in almost a 100% increase in future value (from $20,000 to $40,000)?

Annuities

An annuity is a series of cash flows of equal amount paid or received at regular intervals. Common examples include mortgage and loan payments.

The present value of an ordinary annuity is the amount invested or borrowed today that will provide for a series of withdrawals or payments of equal amount for a set number of periods.

End of Chapter 8

With practice, you can figure out how to determine the time value of money.

Chapter 8 Long-Term (Capital Investment) Decisions.

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Transcript of Chapter 8 Long-Term (Capital Investment) Decisions.