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 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 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

Screening and Preference Decisions Increase production Increase sales Reduce costs make a higher quality product Provide better customer service Identify Objectives

Screening and Preference Decisions Quantitative analysis of the options using tools that recognize the time value of money Qualitative analysis Identify and Analyze Available Options

Screening and Preference Decisions 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?

Discounted Cash Flow Analysis Net Present Value Key Concept If 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.

Discounted Cash Flow Analysis Net Present Value 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?

Discounted Cash Flow Analysis Net Present Value 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.

Internal Rate of Return 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.

Internal Rate of Return 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 on what method to use NPV IRR NPV > 0 IRR > cost of capital YES YES Invest in Project NO NO Consider all qualitative factors in the decisions Project Rejected Project Rejected

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.

The Impact of Taxes on Capital Investment Decisions Nonprofit organizations such as hospitals, museums, churches, and other organizations are structured as organizations exempt from federal and state income taxes.

The Impact of Taxes on Capital Investment Decisions Profit-making companies must pay income taxes on any taxable income earned.

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

The Impact of Taxes on Capital Investment Decisions Pause and Reflect Why 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?

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.

The Impact of Uncertainty on Capital Investment Decisions 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

Benefits of automating production processes: Decrease labor costs The Impact of the New Manufacturing Environment on Capital Investment 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

The Impact of the New Manufacturing Environment on Capital Investment 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. Original Investment Net Annual Cash Inflows Payback Period =

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 Year 1 $100 @ 4% $104 How much will this $100 be worth three years from now if I invest it at 4%? 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 $112.19 1.04 $108.16 If I need $112.19 three years from now, and I can invest at 4%, how much do I have to invest now? $108.16 1.04 $104.00 $104.00 1.04 $100.00

Present Value FV (1+r)n PV = 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.