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Cap Budgeting - 1
Long-Term Investment Decisions
Cap Budgeting - 2
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
Cap Budgeting - 3
Before we let you buy that newmachine you wanted, we want to know what return we are going to get out of it?
Cap Budgeting - 4
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
Cap Budgeting - 5
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
Cap Budgeting - 6
PAYBACK METHOD
Payback period = length of time needed to recover the initial investment in the asset
Cash outflow for investmentAnnual net cash benefit
Cap Budgeting - 7
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
Cap Budgeting - 8
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
Cap Budgeting - 9
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
Cap Budgeting - 10
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.”
Cap Budgeting - 11
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.
Cap Budgeting - 12
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
Cap Budgeting - 13
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
Cap Budgeting - 14
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
Cap Budgeting - 15
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
Cap Budgeting - 16
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
Cap Budgeting - 17
Strategic Considerations
Cap Budgeting - 18
Justifying capital expenditures in a new manufacturing
environment
CAD/CAM
Cap Budgeting - 19
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.
Cap Budgeting - 20
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
Cap Budgeting - 21
Capital investment decisions have potential pitfalls
Cap Budgeting - 22
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
Cap Budgeting - 23
Find the hidden costs
warrantycosts
Trainingcosts
Cost offaulty
assumptions
Cap Budgeting - 24
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
Cap Budgeting - 25
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
Cap Budgeting - 26
Don’t throw good money after bad