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Chapter 12 Strategic Investment Decisions. Key Topics: Strategic Investment Decisions Net present value (NPV) analysis with and without inflation) Other methods for strategic investment decisions Qualitative factors Sensitivity analysis. Strategic Investment Decisions.
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Chapter 12 Strategic Investment Decisions Key Topics: • Strategic Investment Decisions • Net present value (NPV) analysis with and without inflation) • Other methods for strategic investment decisions • Qualitative factors • Sensitivity analysis
Short-Term Decisions • Tend to be non-routine • Effect operations over the next several months to one year • Examples
Long-Term Decisions • Usually involve large investments • Project life is greater than 1 year • Usually incorporate the time value of money • Examples
Alternative Methods • NPV (accountants’ favorite) • IRR (sometimes finance folks like this one) • Payback (often used in other countries) • Accrual accounting rate of return (not useful for project decision making)
NPV • Time line • Investment • Cash inflows less cash outflows • Discount cash flows • Compare to investment NPV = - investment + discounted cash flows
NPV Analysis Investment rules based on NPV: • If the NPV is positive, accept the project. • When choosing among various projects, choose the one with the highest NPV or the highest profitability index. Assumptions: • All cash flows are certain (they are actually uncertain) • Cash can be borrowed or loaned at the same interest rate, and that rate is constant from period to period (not very realistic).
IRR Initial investment = NPV of cash inflows = CF * (PVFA ?years, ?%) Solve for the PVFA factor and then check tables to identify rate.
Payback • Divide investment amount by annual return if cash flows are uniform • Subtract annual returns from investment and keep track of the number of times you have to subtract (that’s the number of years it will take)
Accrual Accounting Rate of Return Accounting income/investment amount
NPV With Taxes • First calculate tax cash flows -Include depreciation (tax shield) • Then calculate incremental cash flows -Exclude depreciation (not a cost)
NPV With Taxes Stellar Stadium Seats Stellar Stadium Seats (SSS) is bidding on a contract to supply 10,000 stadium seats to the local university each year for five years. The specifications for the seats require that they withstand body weights up to 300 lbs. in both sitting and standing positions. SSS engineers have designed a seat that should satisfy university specifications, but development costs were $53,000. If SSS wins the contract, the firm would have to invest an additional $600,000 in manufacturing equipment that has no salvage value. The average cost of producing a seat would be about $25. This includes $7 for materials, $1 for labor, $5 for variable factory overhead, and $12 for depreciation on the equipment. SSS uses straight-line depreciation for purposes of computing taxable income. The firm’s tax rate is 30%. SSS can earn 10% after taxes on other projects. A. What is the net present value of the contract if the price per seat is set at $30? B. What would be the minimum acceptable price per seat?
Capital Budgeting and Inflation Inflation can be defined as the decline in the general purchasing power of the monetary unit, the dollar in the U.S. An annual inflation rate as low as 5% can result in sizable losses in purchasing power over a period of time. There are two types of interest rates that concern us in analyzing inflation: 1) Real rate of interest. This rate is made up of two elements: A. A risk-free element, the “pure” rate of interest that is paid on long-term government bonds and B. A business-risk element, the “risk” premium above the pure rate that is demanded for undertaking risks 2) Nominal rate of interest. This rate is made up of: A. The real rate of interest and B. An inflation element.
Real and Nominal Approaches There are two internally consistent approaches to capital budgeting problems that incorporate inflation. • Real Approach: Predict cash inflows and outflows in real monetary units and use a real discount rate • Nominal Approach: Predict cash inflows and outflows in nominal units and use a nominal discount rate. If cash inflows and outflows are valued in real terms and a nominal discount rate is used, the approach is internally inconsistent. This creates a bias against the adoption of many worthwhile capital investment projects. The discounted present value of cash inflows will be understated when this error is made. • Because U.S. tax rules restrict depreciation to the amount of an asset’s purchase price in nominal dollars at the time of purchase, the tax savings each year will be in nominal dollars.
Depreciation Effects 1) If depreciation cash flows are to be discounted under the real method, they need to be discounted for inflation before they are discounted using the real discount rate. 2) If instead, the nominal method is used, any real cash flows are inflated, depreciation is already valued in nominal dollars, so no adjustments are made, and the nominal discount rate is used.
Sensitivity Analysis Many factors can be manipulated through a “what -if” sensitivity analysis. When spreadsheets are set up appropriately, the discount rate, cash flows, salvage values, and any underlying assumptions can be varied. This provides managers with an immediate measure of the financial effect of differences between forecasts and subsequent outcomes
