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1

**Capital Investment Decision
**

Revision

• Purpose • Methods

2

**The Investment Decision
**

• The objective of the corporation is to Maximise Shareholders Wealth • To do this we need to invest in those projects that will give the correct rate of return for the risk involved • To do this we need to be able to

3

**The Investment Decision
**

1. Identify suitable investment opportunities 2. Decide on the best selection method 3. Identify the cash flows that will be generated by those investments 4. Discount them at the correct cost of capital 5. Choose the best one or ones from those available

4

Capital Investment Decision The ideal selection method will • Select the project that maximises shareholders wealth • Consider all cash flows • Discount the cash flows at the appropriate market determined opportunity cost of capital • Will allow managers to consider each project independently from all others 5 .

NPV is the Net Present Value of a stream of cash flows discounted at the correct cost of capital for the degree of risk inherent in realising those cash flows NPV is best but what do companies use and why? 6 • . Internal rate of return is the discount rate that will give a Net Present Value of 0. Accounting Rate of Return IRR.Capital Investment Decision • • • • Methods for evaluating projects Payback ARR.

The NPV is positive only for discount rates that are less than 14%. the internal rate of return (IRR).1 NPV of FFF’s New Project The graph shows the NPV as a function of the discount rate. 7 . Given the cost of capital of 10%.Capital Investment Decision Figure 6. the project has a positive NPV of $100 million.

Capital Investment Decision • We know that the NPV is the best method because. • The reinvestment rate assumption • Value additivity • Differences in scale • Multiple IRRs 8 .

000.Capital Investment Decision • Why not IRR and does it have a use? 1. Delayed Investments The Bonzo Dog DoDah Band are offered USD2. They calculate that they will need three years to make the recording and that they will have to give up earnings in each of those years of USD 1. Should they do it? ACFL1 9 .000.000.000 today from a rich investor to make a new vinyl LP.

000 1.999.434 That’s close enough ACFL1 10 . What is the IRR? With a wild stabbing guess say 23.000.000.656. What is the opportunity cost of capital? Say 6% • 2nd question.000.2338)2 (1.000.Capital Investment Decision • 1st question.532.2338)3 .000 – 1.917 .000 – 1.855 = -810.1.2338 (1.504 .000 – 1.38% +2.

06)3 .06) -2.000 (1.000 -1.839.000.889.000 – 1.000.000.000 – 1.996 .630 Can we explain what is going on here? ACFL1 11 .673.022 = -943.396 So what should they do? (1.Capital Investment Decision • But using 6% as the cost of capital + 2.06)2 (1.000.

000 . What is the combined NPV? Answer = 787.509 = 1.686 and 855.000 + 650.1.195 As combined flows = 1.000 +650.000.000 At 10% and now combine them.000 + 350.000 +650.000 + 350.643.193 12 .1.000 +650.000.643.Capital Investment Decision • Value Additivity Try working out the NPV for the following .000 +650.000 +650.

000.000 +650.IRR = 39% -1.300.2.IRR = 49% .000 + 1.000.000.Capital Investment Decision -1.300.000 + 350.000 +1.IRR = 43.000 +650.000 .000.5% 13 .000 + 350.000 .000.000 +1.000 +650.000 +650.000 .000 + 650.000 +650.000 + 1.

Capital Investment Decision • Issues of scale • What would you prefer A return of 50 % or one of 20% ? an NPV of 50 or an NPV of 500? Depends for the IRR but you would prefer the higher NPV 14 .

1200 1.4049 PV +1201 446 399 356 Double the scale IRR still 12% -2402 +1000 +1000 +1000 PV +2402 893 797 712 ACFL1 15 .Advanced Corporate Finance • Project A with IRR of 12% -1201 + 500 + 500 + 500 PVF 1.2544 1.

16 .4 B&DeM In this case. invalidating the IRR rule. Star should make the investment. If the opportunity cost of capital is either below 4. there is more than one IRR.Capital Investment Decision Figure 6.723% or above 19.619%.

Management Education. Managers prefer % figures => IRR. Short-term compensation schemes => Payback (Levy 200 –203. Payback simple to calculate. Pike 1985 pg 49). ARR Managers don’t understand NPV/ Complicated Calculations. its NPV But………. Some Reasons for usage of wrong techniques. Behavioural Factors (see later section on Behavioural Finance!!) Increase in Usage of correct DCF techniques: Computers.Capital Investment Decision • • • • So. 17 • • • • • • .

Capital Investment Decision • How do we decide when resources are constrained? We need to maximise NPV which may mean not going for the project with the highest NPV. • Why would resources be constrained? This could be due to Capital Rationing ACFL1 18 . rather the combination of projects that gives the highest total NPV.

07 C 70 75 .80 B 80 75 1.93 *PI = Profitability Index = Value Created Resource Consumed ACFL1 19 .Capital Investment Decision • 150million to invest • Three projects Project NPV Investment PI* A 100 125 .

bright Bath Students There are never enough 20 .Capital investment Decision • What about other scarce resources? • E.g.

Capital Investment Decision • Profitability Index = Value created Resource consumed = NPV RC Bath Students Project A B C D E NPV 30 35 20 15 12 100 150 70 80 28 Headcount PI .43 21 .18 .3 .23 .28 .

28 .42 .18 28 128 198 Broken the budget 22 .30 .Capital Investment Decision A mere 200 students are available Project E A C B D NPV 12 30 20 35 15 Headcount Headcount PI Cumulative requirement 28 100 70 150 80 .23 .

Capital Investment Decision • Try this one 380 tonnes of scarce material Project A B C D E NPV 50 20 45 15 35 Mats Usage Mats PI 180 70 120 75 100 23 .

Capital Investment Decision • What do you notice? • So? Now Moving on 24 .

Taxes/tax losses .Opportunity costs . incremental cash flows .Capital Investment Decision • Remember We have to look at all the relevant.Depreciation .Working capital .Cannibalisation 25 .

8 million pa 5 million to be spent on design and engineering 10 million on software 7.000 pa at 260 per unit = 26 million Cost of production is 110 per unit = 11M Gross profit 15 million pa Operating expenses = 2. units 100.5 million equipment depreciated over 5 years on straight line basis 26 .Capital Investment Decision • • • • • • • Illustrations using examples from B&DeM New project.

Capital Investment Decision Table 7.1 HomeNet’s Incremental Earnings Forecast (Spreadsheet) 27 .

Capital Investment Decision • Points to make so far 1 Tax losses 2 Depreciation 3 Interest cost Now Opportunity cost 28 .

Capital Investment Decision • New lab will be housed in existing space. What should the cost be? • Well what are the alternative uses? • Suppose could rent for 200.000 pa for years 1 to 4 then this is a foregone income of 200.4) 29 .000 x (1-.

5 m 30 .Capital Investment Decision • Cannibalisation 25 % of the sales of the new product will come from existing sales of a similar product.500.25 x 100 = 2.25 x 60 (cost per unit) = 1. How do we account for this? Lost revenue at price of 100 per unit 100.000 x .000 x .000 But there will be lower cost of sales 100.

Capital Investment Decision • Table 7.2 HomeNet’s Incremental Earnings Forecast Including Cannibalization and Lost Rent 31 .

Net working capital 32 . • So far looked at sales and costs just need to add a couple of things in. Depreciation (which you are already familiar with 2.e.Capital Investment Decision • Need to work out the Free Cash Flow i. 1. the effect of the project on the company’s cash.

Capital investment Decision Table 7.3 Calculation of HomeNet’s Free Cash Flow (Including Cannibalization and Lost Rent) 33 .

Capital Investment Decision Table 7.5 Computing HomeNet’s NPV (Spreadsheet) 34 .

multiple .constant growth 35 .Capital Investment Decision • • • • Anything else? Timing of cash flows Liquidation/salvage value Terminal Value .

03 36 .000.10 ..000 = 30.000 .000.10 2) Suppose expect to grow at 3% pa thereafter Then PV at end year five of future cash flows is 3.857.000.143 . If cost of capital is 10% then PV at end year 5 of future cash flows is 3.000.000.000 = 42.Capital Investment Decision Terminal value • Constant Growth 1) Year 5 free cash flow is 3.

Capital Investment Decision • Break even analysis Using the IRR to give a feel for the ‘margin of safety’ ref the cost of capital • Sensitivity analysis • Scenario analysis 37 .

9 Best.and Worst-Case Parameter Assumptions for HomeNet 38 .Capital Investment Decision Sensitivity Analysis Table 7.

Under the initial assumptions. Also shown are the breakeven levels for each parameter.0 million.and Worst-Case Parameter Assumptions Green bars show the change in NPV under the best-case assumption for each parameter. HomeNet’s NPV is $5. 39 . red bars show the change under the worst-case assumption.Capital Investment Decision Figure 7.1 HomeNet’s NPV Under Best.

10 Scenario Analysis of Alternative Pricing Strategies 40 .Capital Investment Decision Scenario Analysis Table 7.

0 million.2 Price and Volume Combinations for HomeNet with Equivalent NPV The graph shows alternative price per unit and annual volume combinations that lead to an NPV of $5. 41 . Pricing strategies with combinations above this line will lead to a higher NPV and are superior.Capital Investment Decision Figure 7.

Capital Investment Decision • Summary • Investments should add to shareholder wealth • NPV is the correct method • Incremental free cash flows • Forecasting cash flows 42 .

Advanced Corporate Finance • Before moving on to other aspects of using the NPV approach we should consider EVA or Economic Value Added. ‘The cash flows of a project less a capital charge that reflects the opportunity cost of the capital invested as well as any capital consumed’ How does it differ from NPV? ACFL1 43 .

Advanced Corporate Finance • Basically NPV gives the return of a project over a period of time while EVA focuses more on the individual time segments within the overall period but will give the same result ACFL1 44 .

286 .35 .375 .Capital Investment Decision Project C E B A D NPV 45 35 20 50 15 Mats PI (NPV per T) .277 .200 Tonnes Used 120 100 70 180 75 Cumulative tonnes used 120 220 290 470 45 .

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