Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

14Strategic Issues In

Making Investments Decisions

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Investment Decisions

Investments are major decisions that have long-term Investments are major decisions that have long-term consequences beyond current consumption.consequences beyond current consumption.

Two effects of time on a decision and its outcomes Two effects of time on a decision and its outcomes distinguish an investment decision:distinguish an investment decision:

1.1. The decision commits resources for a lengthy period of The decision commits resources for a lengthy period of time, and this commitment usually prevents taking time, and this commitment usually prevents taking another future opportunityanother future opportunity

2.2. Management’s flexibility to modify an investment as time Management’s flexibility to modify an investment as time and information unfold can affect alternative decisions.and information unfold can affect alternative decisions.

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Learning Objective 1

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Strategic InvestmentsA A strategic investmentstrategic investment is a choice among is a choice among

alternative courses of action and the allocation alternative courses of action and the allocation of resources to those alternatives most likely of resources to those alternatives most likely

to succeed after considering . . .to succeed after considering . . .

1)1) changes in natural, social, and economic changes in natural, social, and economic conditions, andconditions, and

2)2) actions of competitors.actions of competitors.

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Learning Objective 2

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Information about External Events

External Information Organization's

Financial Records

Interviews with Knowledgeable

Individuals Publicly Available

information Uncontrollable future events

Past financial records have limited usefulness for predicting future events if the organization has never operated in a similar environment

Company personnel who can think creatively might identify future events. Experienced consultants also can be excellent sources of future events.

News, government, foundation, and industry analyses can be excellent sources of future events

Likelihood of future events' occurrence

Past financial records have limited usefulness for predicting future odds if the organization has never operated in a similar environment.

Experienced consultants and company personnel can estimate odds, but individuals are notoriously weak at this task.

News, government, foundation, and industry analyses can be excellent sources of the likeliness of future events.

Sources and Usefulness of External InformationSources and Usefulness of External Information

Group brainstorming methods and Group brainstorming methods and decision-support software may help decision-support software may help identify the range of future events.identify the range of future events.

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Likelihood of Future Events’ Occurrence

Sensitivity AnalysisSensitivity AnalysisForecasts the effects of Forecasts the effects of a likely change in each a likely change in each

future, relevant event on future, relevant event on investment outcomes.investment outcomes.

Scenario AnalysisScenario AnalysisForecasts the effects of Forecasts the effects of likely combinations of likely combinations of

future events on future events on investment outcomes.investment outcomes.

Expected Value AnalysisSummarizes the combined effects of relevant future

events on decision outcomes, weighted by the probability or odds of the events’ occurrence.

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Expected Value Analysis

Relevant Future Event Probability of

Occurrence Annual market growth = 8% 30%Annual market growth = 4% 40%Annual market growth = 2% 30%Total probability 100%

The management of Matrix, Inc. is in the process of accessing the probability of market growth for their

product. The following consensus has been reached:

ExpectedExpectedMarketMarketGrowthGrowth

= (8% = (8% × .30) + (4% × .30) + (4% × .40) + (2% × .30)× .40) + (2% × .30)

E[market growth] = 2.4% + 1.6% + .6% = E[market growth] = 2.4% + 1.6% + .6% = 4.6%4.6%

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Internal Information

Internal information Organization's

financial records

Interviews with knowledgeable

individuals Publicly available

information Effect of future events on investment costs and benefits

Account or regression analysis of financial records might be useful to predict costs or benefits if expected future activities are similar to recent experience.

Consultants can bring knowledge of other organizations' experiences with similar events. Company personnel can apply others' experiences and perform engineering analysis to predict costs and benefits.

Descriptions of other organizations' experiences with similar events can be helpful for predicting future costs and benefits.

Sources and Usefulness of Internal InformationSources and Usefulness of Internal Information

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Discounted Cash Flow Analysis A method of comparing alternative

investments Combines estimates of present and

future cash outflows and inflows associated with each investment

Discounts the cash flows to account for the opportunity costs of committing funds

Differs from payback period methods: DCF Includes all cash flows throughout

the life of the investment DCF always discounts the cash flows

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Investment Cash FlowsEstimate separately 3 types of cash flows:1) Investment cash flows

a) Asset acquisition (and disposal of old asset)b) Tax effect from disposal of old assetc) Tax credit arising from the new acquisition

2) Periodic operating cash flowsa) Receipts from operations b) Cost savings that occur (including tax savings)c) Operating expenses

3) Cash flows from termination of investment

Next, an illustration of these cash flows, courtesy of ShadeTree Roasters.

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Investment Cash Flows The entire purchase is made in cash at the end of year

0 (i.e. at start of the investment period) The equipment will be depreciated by the straight-line

method over 4 years, and there are no salvage values Operating income will increase because of higher

sales and savings in energy costsShadeTree Roasters - Investment in New Equipment

Data InputNew equipment cost, inc ludinginstallation and training $200,000Salvage value of new equipment -New equipment useful life 4 yearsSalvage value of old equipment -Annual inc rease in contrib. margin $30,000Annual energy cost savings $40,000Income tax rate 40%Discount rate 8%

● Income tax rate is 40% (for effect of depreciation)● Future cash flows are discounted at 8% per year

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Investment Cash FlowsInvestment analysis End of yearInitial cash flows for year: 0 1 2 3 4 Investment cost (200,000) Proceeds from old equipment -Annual operating income items Inc rease in contribution margin 30,000 30,000 30,000 30,000 Energy cost savings 40,000 40,000 40,000 40,000 Deprec iation expense (50,000) (50,000) (50,000) (50,000)Change in operating income 20,000 20,000 20,000 20,000Tax on change in income (8,000) (8,000) (8,000) (8,000)After-tax change in operating income 12,000 12,000 12,000 12,000Add back deprec iation expense 50,000 50,000 50,000 50,000After-tax operating cash flow 62,000 62,000 62,000 62,000

• Assume that cash flows are the same in each year.• Note that depreciation expense is used only to estimate the tax savings. The expense itself is not a cash flow.• These net cash flows must be discounted to get the investment’s net present value.

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Choice of a Discount Rate The discount rate is an estimate of the

opportunity cost of making this investment instead of some other.

If the rate chosen is too high, some profitable investments will be rejected.

If the rate chosen is too low, some marginal investments will be approved too easily.

Suggested discount rates: A risk-free rate (e.g., Treasury bond rate) Long-term market return on equities The rate chosen should allow for price inflation

%

(1+r)^(-n)

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Cash to be received in the future has a cost. Alternative investments and price inflation

reduce the value of those cash flows in current monetary terms (present value).

That is why the cash flows are discounted, normally using a constant discount rate.

Assume annual cash flows of $10,000 and a discount rate of 8%. Every dollar received one year from now has a present value of ($1)*(1.08-1)=$0.926. After two years a dollar has a present value of $0.857.

Discounting Future Cash Flows$10,000 $10,000 $10,000 $10,000

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Net Present Value

Compute the present value of each cash inflow and outflow.

Sum all the present values to get the net present value (NPV).

If the NPV of the investment is greater than zero, the project promises returns greater than the opportunity rate.

The next slide calculates the NPV of the ShadeTree Roasters investment proposal.

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Net Present Value

Investment analysis End of yearInitial cash flows for year: 0 1 2 3 4 Investment cost (200,000) Proceeds from old equipment -Annual operating income items Increase in contribution margin 30,000 30,000 30,000 30,000 Energy cost savings 40,000 40,000 40,000 40,000 Deprec iation expense (50,000) (50,000) (50,000) (50,000)Change in operating income 20,000 20,000 20,000 20,000Tax on change in income (8,000) (8,000) (8,000) (8,000)After-tax change in operating income 12,000 12,000 12,000 12,000Add back deprec iation expense 50,000 50,000 50,000 50,000After-tax operating cash flow 62,000 62,000 62,000 62,000Disposal valuePresent value fac tors 1.000 0.926 0.857 0.794 0.735Discounted cash flows (200,000) 57,407 53,155 49,218 45,572Net present value 5,352$ Note: =sum(b26:f26)

The proposal estimates an NPV of $5,352. So the present valueof the net cash inflows during four years exceeds the $200,000 initial investment.

So do we go ahead?

I vote Yes!

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Payback Period Managers may want to know how soon they

will recover an initial investment. This method counts the time that will pass

before the projected cash inflows equal the initial cash expenditure.

The payback period method complements the discounted cash flow method, though the result may be different.

In the ShadeTree Roasters example: Divide the initial investment of $200,000 by the

annual contribution margin of $62,000. The payback period is 3.23 years.

Often the cash flows are not discounted.

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Internal Rate of Return This percentage is calculated together

with the investment’s net present value. An investment’s IRR is the discount rate

that would create an NPV of zero for the investment.

So, if the NPV is greater than zero, then the IRR will be greater than the discount rate.

In the case of ShadeTree Roasters, the proposed investment would have an IRR of 9.2%, higher than the required return of 8%.

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Learning Objective 3

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Forecasts of Investment InformationThe management of ShadeTree Roasters has gathered the

following information concerning a potential investment.

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Forecasts of Investment InformationForecast and Net Present Value – No Major CompetitorForecast and Net Present Value – No Major Competitor

$50,000,000 $50,000,000 × 1.046 = $52,300,000× 1.046 = $52,300,000

$10,460,000 $10,460,000 × 35% = $3,661,000× 35% = $3,661,000

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Forecasts of Investment InformationForecast and Net Present Value – No Major CompetitorForecast and Net Present Value – No Major Competitor

$699,000 $699,000 × 40% = $279,600× 40% = $279,600

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Forecasts of Investment InformationForecast and Net Present Value – No Major CompetitorForecast and Net Present Value – No Major Competitor

=NPV(.08,F15:N15)+D15

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Forecasts of Investment InformationForecast and Net Present Value – With Major CompetitorForecast and Net Present Value – With Major Competitor

The major competitor does not enterThe major competitor does not enterthe market until the second year.the market until the second year.

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Forecasts of Investment InformationForecast and Net Present Value – With Major CompetitorForecast and Net Present Value – With Major Competitor

=NPV(.08,F15:N15)+D15

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Expected Value Analysis Decision Tree

NPVCompetitor Outcome E[NPV]

40% (4,965,809)$ (1,986,324)$ 60% 2,012,498 1,207,499

100% (778,825)$

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Value of Deferring Irreversible DecisionsLet’s assume that ShadeTree Roasters wants to Let’s assume that ShadeTree Roasters wants to

consider waiting one year to see if its major consider waiting one year to see if its major competitor decides to enter the market.competitor decides to enter the market.

All other information remains the same. Let’s All other information remains the same. Let’s look at our analysis now.look at our analysis now.

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Wait One Year, With No Major Competitor

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Learning Objective 4

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Wait One Year, With a Major Competitor

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Defer Decision One YearFirst Second NPV Best

decision Probability Competitor? decision outcome choice

Expand (4,139,865)$ No40% Yes

Don't expand -$ YesDon't decide

Expand 2,618,754$ Yes60% No

Don't expand -$ No

E[NPV] = $ 1,571,252

($0 ($0 × .40) + ($2,618,754 × .40) + ($2,618,754 × .60) = $1,571,252× .60) = $1,571,252

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Value of the Option to Wait

Under common investment conditions, the net Under common investment conditions, the net present value that we calculated in our analysis present value that we calculated in our analysis is is incorrectincorrect. We did not consider the situation . We did not consider the situation

where ShadeTree entered the market but where ShadeTree entered the market but terminated the project after one yearterminated the project after one year when a when a major competitor may enter the same market. major competitor may enter the same market.

Though ShadeTree would not recover its Though ShadeTree would not recover its investment (which is a sunk cost), it may be investment (which is a sunk cost), it may be

less costly to terminate after one year than to less costly to terminate after one year than to continue operations in the market. This analysis continue operations in the market. This analysis

is referred to as real option value.is referred to as real option value.

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Learning Objective 5

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Real Option Value Decision TreeSecond NPV Best

Decision now Choice Prob Competitor? decision outcome choice

Continue (5,662,762)$ No40% Yes

Terminate (4,093,148)$ YesExpand

Continue 2,925,012$ YesExpand now or not 60% No

Terminate (4,093,148)$ NoDon't expand -$

E[NPV, expand now] = [$(4,093,138) E[NPV, expand now] = [$(4,093,138) × .40] + [$2,925,012 × .40] + [$2,925,012 × .60]× .60]

E[NPV, expand now] = E[NPV, expand now] = $117,752$117,752

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Value of the Option to WaitIf ShadeTree postpones its If ShadeTree postpones its

decision to expand for one year decision to expand for one year and then expands into the new and then expands into the new

market, we calculate the market, we calculate the expected net present value to be:expected net present value to be:

$1,571,252$1,571,252

If ShadeTree expands now and If ShadeTree expands now and continues operations, we continues operations, we

calculate the expected net calculate the expected net present value to be:present value to be:

$117,752$117,752

Postpone one year 1,571,252$ Expand now 117,752 Expected value of waiting 1,453,500$

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Learning Objective 6

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Legal and Ethical Issues in Strategic Investment Analysis

Trade unions, regulators, investors, non-government organizations and some business executives have

succeeded in influencing United States laws and recent Organisation for Economic Cooperation and

Development guidelines that prohibit bribery and other corrupt practices by multination companies.

Such acts are designed to Such acts are designed to discourage companies from illegally discourage companies from illegally

obtaining information about the obtaining information about the intentions of competitors.intentions of competitors.

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Internal Ethical Pressures

1.1. Bias from personal commitment to an Bias from personal commitment to an investment project.investment project.

2.2. Fear of loss of prestige, position, or Fear of loss of prestige, position, or compensation from a failed investment.compensation from a failed investment.

3.3. Greed and intentional behavior to Greed and intentional behavior to defraud an organization or its defraud an organization or its stakeholders.stakeholders.

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Role of Internal Controls and Audits

o Hiring practices -- performing background and Hiring practices -- performing background and reference checks.reference checks.

o Investment reporting and reviews -- periodic Investment reporting and reviews -- periodic progress reporting to see if the investment is progress reporting to see if the investment is meeting stated goals.meeting stated goals.

o Codes of ethics -- educate and support employees Codes of ethics -- educate and support employees who want to behave ethically.who want to behave ethically.

o Internal audits -- examinations of operations, Internal audits -- examinations of operations, programs, and financial results performed by programs, and financial results performed by independent investigators.independent investigators.

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End of Chapter 14