Business Investment Analysis Chapter 9

Business Investment Analysis Capital Budgeting or Capital Expenditure Analysis Application of our Theory of Value (DCF): Forecast future “incremental” FCF (operating definition) The operating cost is called the cost of capital.

Business Investment Analysis A typical business investment has a “no growth” pattern. Company grow because they make individual investment, but individual investment does not grow.

Business Investment Analysis if NPV ≥ 0 (measure of wealth creation) - objective #1. This investment creates wealth for financial asset holders and shareholders in particular and should be undertaken (regardless of the source of financing: Borrowing Share issue Combination)

Business Investment Analysis 4 types of depreciation (presumed equal): Financial reporting (depreciation) Depreciation for tax purposes (CCA) Economic depreciation – reduced ability of the real asset (or business investment) to produce cash flow, if company does nothing. Maintenance capital expenditure (MCAPX vs. CAPX)

Business Investment Analysis If: or NPV ≥ 0 or IRR ≥ Cost of Capital or Payback period ≤ Benchmark Payback period is the # of years to recover an investment with incremental FCF or Then, this is a “good investment” .

Business Investment Analysis There are 3 cases where you must use IRR with care : The IRR rule must be reverted for “disinvestment” There may exist multiple IRR. Rare, generally, but common for natural resources & energy investment. Rule of thumb: The # of IRRs is equal to the # of sign in cash flows changes. The IRR can have difficulty in identifying better or worse investment from a mutually exclusive set.