Cap Budgeting — 1 Long-Term Investment Decisions

Cap Budgeting - 1 Long-Term Investment Decisions

Cap Budgeting - 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

Cap Budgeting - 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?

Cap Budgeting - 4 LONG-TERM INVESTMENT ANALYSIS vs. CAPITAL BUDGETING “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

Cap Budgeting - 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

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

Cap Budgeting - 7 PAYBACK METHOD § Possible reasons for use: – 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

Cap Budgeting - 8 NET PRESENT VALUE (NPV) Net Present Value = 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

Cap Budgeting - 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

Cap Budgeting - 10 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. ”

Cap Budgeting - 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.

Cap Budgeting - 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

Cap Budgeting - 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

Cap Budgeting - 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

Cap Budgeting - 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

Cap Budgeting - 16 AFTER-TAX CASH FLOWS Continued § Rule for sale of assets v Proceeds from sale (+/-) Tax book value = Taxable gain/loss v Taxable gain/loss x Tax rate = Net tax effect v Proceeds from sale (+/-) Net tax effect = Net cash flow from sale of asset

Cap Budgeting - 17 Strategic Considerations

Cap Budgeting - 18 Justifying capital expenditures in a new manufacturing environment CAD/CAM

Cap Budgeting - 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.

Cap Budgeting - 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

Cap Budgeting - 21 Capital investment decisions have potential pitfalls

Cap Budgeting - 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

Cap Budgeting - 23 Find the hidden costs warranty costs Training costs Cost of faulty assumptions

Cap Budgeting - 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

Cap Budgeting - 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

Cap Budgeting - 26 Don’t throw good money after bad