1. Long-Term Investment Decisions

2. IMPORTANCE OF LONG-TERM INVESTMENT 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

3. Before we
let you buy that new
machine you wanted, we want to know what return
we are going to get
out of it?

4. LONG-TERM INVESTMENT ANALYSIS vs. 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 analysis
is a broader “strategic” consideration

5. CAPITAL INVESTMENT DECISION MODELS
Non-discounted cash flow models
Payback period
Accounting rate of return
Discounted cash flow models
Internal rate of return
Net present value

6. Cash outflow for investment Annual net cash benefit
PAYBACK METHOD
Payback period = length of time needed to recover the initial investment in the asset
Cash outflow for investment
Annual net cash benefit

7. PAYBACK METHOD Possible reasons for use: Limitations
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

8. NET PRESENT VALUE (NPV)
PV Cash Inflows -  PV Cash Outflows
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

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 assumption
All cash flows generated by the project are immediately reinvested at the cost of capital

10. It is sometimes known as the
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.”

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.

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 assumption
Cash inflows from the project are immediately reinvested to earn the IRR

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

14. DISCOUNTED CASH FLOWS Specific 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

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

16. AFTER-TAX CASH FLOWS Continued
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

17. Strategic Considerations

18. Justifying capital expenditures in a new manufacturing environment
CAD/CAM

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.

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

21. Capital investment decisions have potential pitfalls

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

23. Find the hidden costs Cost of warranty faulty costs assumptions
Training
costs

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

25. 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

26. Don’t throw good money after bad