Long-Term (Capital Investment) Decisions Chapter 9 Long-Term (Capital Investment) Decisions

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 value of money. The time value of money is based on the concept that a dollar received today is worth more than a dollar received in the future.

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?

Discounted Cash Flow Analysis The time value of money is considered in capital investment decisions by using one of two techniques: the net present value (NPV) method or the internal rate of return (IRR) method.

Net Present Value If the present value of cash inflows 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.

Internal Rate of Return 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.

Screening and Preference Decisions Screening decisions involve deciding if an investment meets some predetermined company standard. Preference decisions involve choosing between alternatives.

Screening and 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.

The Impact of Taxes on Capital Investment Decisions Taxes are a major source of cash outflows for many companies and must be taken into consideration in calculations of the time value of money.

The Impact of Uncertainty on Capital Investment Decisions How do I try to adjust for uncertainty? One way to adjust for risk is to increase the cost of capital used in the NPV calculations.

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

Net Annual Cash Inflows The Payback Method The payback period is the length of time needed for a long-term project to recapture or pay back the initial investment. Original Investment Net Annual Cash Inflows Payback Period =

Appendix: Present and Future Value The time value of money is the result of the ability of money to earn interest over time. Present Value is a $1 future cash flow discounted to its equivalent worth today 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 on the invested amount plus interest on previous interest earned but not withdrawn