Chapter 8 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 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??

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?

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 revenues and costs are likely to affect the decision.

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

Screening vs. Preference Decisions Invest in Project Decision on what method to use NPV NO YES IRR IRR < cost of capital NPV>0 Reject Project Reject Project Consider all qualitative factors in the decision

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

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 personnel and complementary machines Processes needed

The Impact of the New Manufacturing Environment on Capital Investment Decisions Benefits of automating production processes: Decreased 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 Payback Method The length of time needed for a long-term project to recapture or pay back the initial investment. Payback Period = Original Investment Net Annual Cash Inflows

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 on the invested amount plus interest on previous interest earned but not withdrawn.

Future Value How much will this $100 be worth three years from now if I invest it at 4%? Year 1 4% $104 Year 2 $ Year 3 4% $112.19

Future Value FV = PV (1 + r) n FV = Future Value PV = The $ Amount r = Interest Rate n = Number of Time Periods

Present Value If I need $ three years from now, and I can invest at 4%, how much do I have to invest now? Year 3 $ $ Year 2 $ $ Year 1 $ $100.00

Present Value FV (1+r) n PV = FV = Future Value r = Interest Rate n = Time Period

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.