MAC 2

Long range decisions involving opportunities to invest in new assets or projectsAmong the most important decisions made by managersPlace large amounts of resources at risk for long periods of timeAffect the future development of the firmDecision making process is called Capital Budgeting*Capital Investment Decisions

Two types:Independent projects (Mutually exclusive projects)If accepted or rejected, do not affect the cash flows of other projectsCompeting projectsAcceptance of one alternative precludes the acceptance of another*Capital Budgeting

Managers must decide whether or not a capital investment will:Earn back its original outlayProvide a reasonable returnCovering the opportunity cost of the funds investedTo make a capital investment decision, managers must: Make estimates of the quantity and timing of after-tax cash flowsAssess the risk of the investmentConsider the impact of the project on the firms profits

*Capital Budgeting

Managers must:Set goals and priorities set for capital investmentsEstablish basic criteria for acceptance or rejection of proposed investmentsTwo types of methods:Nondiscounting modelsDo not consider time value of moneyTwo methodsPayback periodAccounting rate of return (ARR)Discounting modelsUse time value of moneyTwo methodsNet present value (NPV)Internal rate of return (IRR)Most companies use both types of methods*Making Capital Investment Decisions

=*DefinitionOriginal investment / Annual cash flowPayback period

Measures the return on a project in terms of income as opposed to using cash flowFormula:*Accounting Rate of ReturnAverage income / Initial investmentAccounting Rate of Return=Average income is not the same as cash flowsFormula:Add net income for each year of the project and divide by the number of years

=*DefinitionAverage Net Income / Initial InvestmentAccounting Rate of Return

Difference between the present value of the cash inflows and outflows associated with a projectMeasures the net cash flows of the projectSize of the positive NPV measures the increase in value of the firm resulting from an investmentTo use NPV method, a required rate of return must be definedMinimum acceptable rate of return *Net Present Value (NPV)

If NPV is positive:Rate of return on the investment is greater than the required rate of returnInvestment, the minimum rate of return, and a return in excess of profit are all recoveredInvestment is acceptableIf NPV is zero:Rate of return on the investment is exactly the required rate of returnInvestment and the minimum rate of return are recoveredDecision maker will be ambivalent regarding acceptance or rejection*Evaluating Net Present Value (NPV)

If NPV is negative:Rate of return on the investment is less than the required rate of returnInvestment cost may or may not be recovered, and the minimum rate or return is not recoveredInitial investment should be rejected*Evaluating Net Present Value (NPV)

Interest rate that sets the projects NPV to zeroFormula:*Internal Rate of Return (IRR)Can be found using trial and error, or Using PV tablesCompared to required rate of returnIf IRR > Required rate of returnProject is deemed acceptableIf IRR < Required rate of returnProject is rejectedI = CFt / (1 + i)t

*DefinitionInternal Rate of ReturnDiscount factor = Investment / Annual Cash Flow

Follow-up analysis of project once it is implementedShould be completed by independent partyOften internal audit staffCompares:Actual benefits to estimated benefitsActual operating costs to estimated costsEvaluates the overall outcome of the investmentProposes corrective action if needed*Post Audit of Capital Projects

By evaluating profitability and cash flows, firms ensure that assets are used wiselyManagers held accountable for results of capital investment decisionsMore likely to make decisions in the best interest of the firmFeedback is gained and used in future decision making*Benefits of a Postaudit

CostlyLimitations:Assumption driving original analysis may often be invalidated by changes in the actual operating environmentAccountability must be qualified:By the impossibility of foreseeing every possible eventuality*Drawbacks of a Postaudit

Net Present Value (NPV) and Internal Rate of Return (IRR) can produce different resultsNPV Assumes that each cash flow received is reinvested at the required rate of returnMeasures cash flow profitability in absolute termsIRR Assumes that each cash flow is reinvested at the computed IRRMeasures cash flow profitability in relative termsNPV consistently selects the project which maximizes the firms wealth*Mutually Exclusive Projects

Assess the flow pattern for each projectCompute the net present value (NPV) for each projectIdentify the project with the greatest NPV*Steps in Selecting Best Project

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