CMA Part 2 Financial Decision Making Study Unit 10 Investment Decisions Adrien Dubourg, CMA
SU- 10.1 The Capital Budgeting Process Definition Planning and controlling investment for long-term projects. Capital budgeting unlike other considerations will affect the company for many periods going forward long-term, multiple accounting periods, relatively inflexible once made. Predicting the need for future capital assets is one of the more challenging task, which can be affected by: Inflation Interest rates Cash availability Market demands Production capacity is a key driver
SU- 10.1 The Capital Budgeting Process Applications for capital budgeting Buying equipment Building facilities Acquiring a business Developing a product of product line Expanding into new markets Important to correctly forecast future changes in demand in order to have the correct capacity. Planning is crucial to anticipate changes in capital markets, inflation, interest rates and money supply.
SU- 10.1 The Capital Budgeting Process Consider the tax consequences All decisions should be done on an after tax basis Considered costs in Capital Budgeting Avoidable cost May be eliminated by ceasing or improving an activity. Common cost Shared by all options and is not clearly allocable. Deferrable cost May be shifted to the future. Fixed cost Does not very within relevant range. Imputed cost May not have a specific cash outlay in accounting Incremental cost Difference in cost of two options.
SU- 10.1 The Capital Budgeting Process Opportunity cost Maximum benefit forgone based on next alternative, including that of the stockholders (which also establishes the firms hurdle rate). Relevant cost Vary with action. Constant cost don t affect decision. Sunk Cannot be avoided. Weighted-average Cost of Capital Weighted average of the interest cost of debt (net of tax) and the costs (implicit or explicit) of the components of equity capital to be invested in long-term assets. It is also the hurdle rate.
SU- 10.1 The Capital Budgeting Process Stages in Capital Budgeting Identification and definition - Id What is the strategy? Definition Define the projects Revenue, costs, and cash flow Most difficult stage Search Each investment to be evaluated be each function of the firms value chain. Information-acquisition Costs and benefits of the projects are enumerated. Quantitative financial factors have highest priority Nonfinancial measures (quantitative and qualitative) Selection Increase shareholder value. NPV, IRR.. Financing Debt or equity Implementation and monitoring Feedback and reporting
SU- 10.1 The Capital Budgeting Process Investment Ranking Steps Determine Net Investment Costs Gross cash requirement less cash recovered from trade or sale of existing assets, adjusted for taxes Investment required includes funds to provide for increases in working capital, i.e. additional receivables and inventories. Calculating estimated cash flows Capture increase in revenue, decrease costs Net cashflow period by period from investment Economic life of the investment Depreciable life Comparing cash-flows to Net Investment Costs Evaluate the benefit. Continued
SU- 10.1 The Capital Budgeting Process Ranking investments NPV, IRR, Payback Other considerations Book Rate of Return GAAP NI from Investment Book Value of Investment Also called accrual accounting rate of return Don t use accrual accounting numbers, instead use cash flow Reason Net Income are affected by company s choices of accounting methods Also, do not compare project book rate to company s book rate of return for investments which could be distorted Continued
SU- 10.1 The Capital Budgeting Process Relevant cash flows Net initial investment» New equipment cost» Working capital requirements,» After tax disposals proceeds Annual net cash flows» After tax cash collections for operations» Depreciation tax savings Project termination cash flows» After tax disposal» Working capital recovery See example on page 393
SU- 10.1 The Capital Budgeting Process Other Considerations Inflation Raises hurdle rate. Post-audits Deterrent of bad projects.» Actual to expected cashflow» Identify sources of unrealistic estimates» Avoid premature evaluations of projects» Non-quantitiative benefits
SU 10.1 Practice Question 1 The relevance of a particular cost to a decision is determined by A Riskiness of the decision. B Number of decision variables. C Amount of the cost. D Potential effect on the decision.
SU 10.1 Practice Question 1 Answer Correct Answer: D Relevance is the capacity of information to make a difference in a decision by helping users of that information to predict the outcomes of events or to confirm or correct prior expectations. Thus, relevant costs are those expected future costs that vary with the action taken. All other costs are constant and therefore have no effect on the decision.
SU 10.1 Practice Question 2 Answer Lawson, Inc., is expanding its manufacturing plant, which requires an investment of $4 million in new equipment and plant modifications. Lawson s sales are expected to increase by $3 million per year as a result of the expansion. Cash investment in current assets averages 30% of sales; accounts payable and other current liabilities are 10% of sales. What is the estimated total investment for this expansion? A B C D $3.4 million. $4.3 million. $4.6 million. $5.2 million.
SU 10.1 Practice Question 2 Answer Correct Answer: C The investment required includes increases in working capital (e.g., additional receivables and inventories resulting from the acquisition of a new manufacturing plant). The additional working capital is an initial cost of the investment, but one that will be recovered (i.e., it has a salvage value equal to its initial cost). Lawson can use current liabilities to fund assets to the extent of 10% of sales. Thus, the total initial cash outlay will be $4.6 million {$4 million + [(30% 10%) $3 million sales]}.
SU 10.1 Practice Question 3 What is the net cash outflow at the beginning of the first year that Dickins should use in a capital budgeting analysis? A $(170,000) B $(180,000) C $(192,000) D $(210,000)
SU 10.1 Practice Question 3 Answer Correct Answer: D Delivery and installation costs are essential to preparing the machine for its intended use. Thus, the company must initially pay $210,000 for the machine, consisting of the invoice price of $180,000, the delivery costs of $12,000, and the $18,000 of installation costs.
SU 10.2 Discounted Cash flow Analysis Time Value of Money Concepts A dollar received in the future is worth less than today. Present Value (PV) Value today of future payment Future Value (FV) Future value of an investment today. Annuities equal payments at equal intervals Ordinary annuity (in arrears) Annuity due (in advance) PV & FV is always greater than ordinary annuity See examples on page 394 through 396
SU 10.2 Discounted Cash flow Analysis Hurdle rate Goal is for companies discount rate to be as low as possible. WACC or Shareholder s opportunity cost of capital. The lower the firm s discount rate, the lower the hurdle the company must clear to achieve profitability Net Present Value (NPV) Project return in $$ See example on 397
SU 10.2 Discounted Cash flow Analysis Internal Rate of Return (IRR) Project return in % IRR shortcomings - + + Directional changes of cash flows Mutually exclusive projects Varying rates of return Multiple investments
SU 10.2 Discounted Cash flow Analysis Cash flows and discounting NPV = Cash flow 0 Cash flow 1 Cash flow 2 (1 + r) 0 (1 + r) 1 (1 + r) 2 Comparing Cash flow Patterns Pg 399
SU 10.2 Discounted Cash flow Analysis NPV vs IRR comparison Reinvestment rate NPV assumes the cash flow can be reinvested at projects discount rate. Independent projects: NPV and IRR give same accept/reject decision if projects are independent. All acceptable independent projects can be undertaken. Mutually exclusive projects. Cost of one greater than other Timing, amounts, and direction of cash flow are different Different useful lives IRR provides 1 rate, NPV can be used with multiple rates. Multiple investments. NPV is adaptable, IRR is not. IRR assumes cash flow is reinvested at IRR rate. NPV assumes reinvestment in the desired rate of return. NPV and IRR are most sound decision making tools for wealth maximization. NPV profile Page 401 Select greatest NPV over greatest IRR
SU 10.2 Practice Question 1 The net present value (NPV) method of investment project analysis assumes that the project s cash flows are reinvested at the A B C D Computed internal rate of return. Risk-free interest rate. Discount rate used in the NPV calculation. Firm s accounting rate of return.
SU 10.2 Practice Question 1 Answer Correct Answer: C The NPV method is used when the discount rate is specified. It assumes that cash flows from the investment can be reinvested at the particular project s discount rate.
SU 10.2 Practice Question 2 The net present value of a proposed investment is negative; therefore, the discount rate used must be A Greater than the project s internal rate of return. B Less than the project s internal rate of return. C D Greater than the firm s cost of equity. Less than the risk-free rate.
SU 10.2 Practice Question 2 Answer Correct Answer: A The higher the discount rate, the lower the NPV. The IRR is the discount rate at which the NPV is zero. Consequently, if the NPV is negative, the discount rate used must exceed the IRR.
SU 10.2 Practice Question 3 Dr. G invested $10,000 in a lifetime annuity for his granddaughter Emily. The annuity is expected to yield $400 annually forever. What is the anticipated internal rate of return for the annuity? A Cannot be determined without additional information. B 4.0% C 2.5% D 8.0%
SU 10.2 Practice Question 3 Answer Correct Answer: B The correct answer is 4.0%. $10,000 = $400 IRR; IRR = 0.040 = 4.0%.
SU 10.3 Payback and discounted payback Payback period = Number of years to pay for itself. Pro - Simple Cons - No consideration for time value of money. Does not consider cash flow after payback period. Payback and constant cash flows vs variable cash flows See example on page 402
SU 10.3 Payback and discounted payback Discounted payback method is used to overcome the payback methods disregard for time value of money Pro More conservative yet still simple Con Does not consider cash flow after payback period. See example on page 403
SU 10.3 Payback and discounted payback Other payback methods Bailout payback = Considers salvage value Payback reciprocal (1 divided by payback) estimate of IRR Breakeven time = Time require for discounted cash flows to = 0. Alternative is to consider the time required for the present value of the cumulative cash inflows to equal the present value of all the expected future cash flows
SU 10.3 Practice Question 1 Which one of the following methods for evaluating capital projects is the useful from an investment analysis point of view? A B C D Accounting rate of return. Internal rate of return. Net present value. Payback.
SU 10.3 Practice Question 1 Answer Correct Answer: A The accounting, or book, rate of return is an unsatisfactory means of evaluating capital projects for two major reasons. Because the accounting rate of return uses accrual-basis numbers, the calculation is subject to such accounting judgments as how quickly to depreciate capitalized assets. Also, the accounting rate of return is an average of all of a firm s capital projects; it reveals nothing about the performance of individual investment choices.
SU 10.3 Practice Question 2 The payback reciprocal can be used to approximate a project s A B C D Profitability index. Net present value. Accounting rate of return if the cash flow pattern is relatively stable. Internal rate of return if the cash flow pattern is relatively stable.
SU 10.3 Practice Question 2 Answer Correct Answer: D The payback reciprocal (1 payback) has been shown to approximate the internal rate of return (IRR) when the periodic cash flows are equal and the life of the project is at least twice the payback period.
SU 10.4 Ranking investment projects Why should we rank investment projects Capital rationing Reasons include lack of financial resources, control estimation bias, and unwillingness to issue new equity (to raise new capital)
SU 10.4 Ranking investment projects Methods Profitability index = NPV / Net Investment See example on page 404 Internal capital markets Internal funding Linear programming Technique for optimizing resource allocation.
SU 10.4 Practice Question 1 The profitability index approach to investment analysis A B C D Fails to consider the timing of project cash flows. Considers only the project s contribution to net income and does not consider cash flow effects. Always yields the same accept/reject decisions for independent projects as the net present value method. Always yields the same accept/reject decisions for mutually exclusive projects as the net present value method.
SU 10.4 Practice Question 1 Answer Correct Answer: C The profitability index (excess present value index) of an investment is the ratio of the present value of the future net cash flows (or only cash inflows) to the net initial investment. It is a variation of the net present value (NPV) method and facilitates the comparison of different-sized investments. Because it is based on the NPV method, the profitability index will yield the same decision as the NPV for independent projects. However, decisions may differ for mutually exclusive projects of different sizes.
SU 10.4 Practice Question 2 The method that divides a project s annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment is the A Internal rate of return method. B Accounting rate of return method. C Payback method. D Net present value (NPV) method.
SU 10.4 Practice Question 2 Answer Correct Answer: B The accounting rate of return uses undiscounted net income (not cash flows) to determine a rate of profitability. Annual after-tax net income is divided by the average carrying amount (or the initial value) of the investment in assets.
SU 10.4 Practice Question 3 The technique that measures the estimated performance of a capital investment by dividing the project s annual after-tax net income by the average investment cost is called the A B C D Bail-out payback method. Internal rate of return method. Profitability index method. Accounting rate of return method.
SU 10.4 Practice Question 3 Answer Correct Answer: D The accounting rate of return (also called the unadjusted rate of return or book value rate of return) measures investment performance by dividing the accounting net income by the average investment in the project. This method ignores the time value of money.
Page 405 SU 10.5 Comprehensive Example
SU 10.6 Risk Analysis and real options in Capital Investments Risk analysis Attempt to measure the variability of future returns from proposed investment. Informal method NPV is calculated and reviewed. Risk-adjusted discount rates Adjust rate of return upwards as project becomes more risky. Certainty equivalent adjustments- from Utility theory the point where you are indifferent to a choice between a certain sum of money and the expected value of a risky sum. Simulation analysis Computer is used to generate many results based upon various assumptions. Pilot plants Sensitivity analysis An iterative process of recalculated returns based on changing assumptions.
SU 10.6 Risk Analysis and real options in Capital Investments Real (managerial or strategic) options Value of a real option The difference between the projects NPV with the option vs. without the option. Usually more valuable the later it is exercised. Types of real options: Abandonment (Put option) Follow-up investment Wait and Learn (call option) Flexibility option vary an input Capacity option vary an output New geographical markets New product option follow on products
SU 10.6 Practice Question 1 Sensitivity analysis, if used with capital projects, A B C D Is used extensively when cash flows are known with certainty. Measures the change in the discounted cash flows when using the discounted payback method rather than the net present value method. Is a what-if technique that asks how a given outcome will change if the original estimates of the capital budgeting model are changed. Is a technique used to rank capital expenditure requests.
SU 10.6 Practice Question 1 Answer Correct Answer: C After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis, which is a trial-and-error method used to determine the sensitivity of the estimates used. For example, forecasts of many calculated NPVs under various assumptions may be compared to determine how sensitive the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may drastically alter the NPV, suggesting that the risk of the investment may be excessive.
SU 10.6 Practice Question 2 When the risks of the individual components of a project s cash flows are different, an acceptable procedure to evaluate these cash flows is to A B C D Divide each cash flow by the payback period. Compute the net present value of each cash flow using the firm s cost of capital. Compare the internal rate of return from each cash flow to its risk. Discount each cash flow using a discount rate that reflects the degree of risk.
SU 10.6 Practice Question 2 Answer Correct Answer: D Risk-adjusted discount rates can be used to evaluate capital investment options. If risks differ among various elements of the cash flows, then different discount rates can be used for different flows.
SU 10.6 Practice Question 2 Sensitivity analysis is used in capital budgeting to A B C D Estimate a project s internal rate of return. Determine the amount that a variable can change without generating unacceptable results. Simulate probabilistic customer reactions to a new product. Identify the required market share to make a new product viable and produce acceptable results.
SU 10.6 Practice Question 3 Answer Correct Answer: B After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis, which is a trial-and-error method used to determine the sensitivity of the estimates used. For example, forecasts of many calculated NPVs under various assumptions may be compared to determine how sensitive the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may drastically alter the NPV, suggesting that the risk of the investment may be excessive.