long-term investment decisions by p.rai87@gmail

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Long-Term InvestmentDecisions



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 considerationsImportant analytical toolNot the primary consideration of analysis



LONG-TERM INVESTMENT ANALYSISVS. CAPITAL BUDGETING

³Capital Budgeting´

Planning for long-term investment decisions regarding

capital assets (facilities) including considerationsfor financing the investment

³Long-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 analysisis a broader ³strategic´ consideration



CAPITAL INVESTMENTDECISION MODELS

´ Non-discounted cash flow models« Payback period« Accounting rate of return

´ Discounted cash flow models« Internal rate of return« Net present value



PAYBACK METHOD´ Possible reasons for use:

« Help evaluate risks associated with uncertain futurecash 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



NET PRESENT VALUE

(NPV)

NET PRES ENT VALUE

(NPV)

This model is the most widely recommendedapproach to capital budgeting since it specificallyconsiders the time value of money and provides abasis for valuing the firm

Net Present Value =7 PV Cash Inflows - 7 PV Cash Outflows



NET PRESENT VALUE

(NPV)´ Decision criteria:

« If NPV > 0, a return in excess of the cost of capitalhas been earned, and the project is acceptable

«

If NPV < 0, a return less than the cost of capital hasbeen earned, and the project is unacceptable

´ Reinvestment assumptionAll cash flows generated by the project are immediately

reinvested at the cost of capital



COST OF CAPITAL´

The weighted average of the returns expected bythe different parties contributing funds (debtand equity). The weights are determined by theproportion of funds provided by each source.

It is sometimes known as the

´hurdle rate .µ



INTERNAL RATE OF RETURN(IRR)

´ The interest rate that results in the

p resent values of the cash outflowsequaling the p resent value of thecash inflows .



GIVEN THE (PERIOD, CASH FLOW) PAIRS(N , C N ) WHERE N IS A POSITIVE INTEGER,THE TOTAL NUMBER OF PERIODS N , ANDTHE NET PRESENT VALUE NPV, THEINTERNAL RATE OF RETURN IS GIVEN

BY R IN:



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 assumptionCash inflows from the project are immediately

reinvested to earn the IRR



DISCOUNTED CASH FLOW

ANALYSIS´ Strengths« 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 capitalµ«

Difficulty of estimating opportunity costs« Lack of integration of qualitative factors



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



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 flowExample: Labor costs

´ Rule for tax shield for noncash expenses(tax rate) x noncash expense = tax shield (cash inflow)

Example: Depreciation on equipment



AFTER-TAX CASH FLOWSCONTINUED

´ Rule for sale of assets

Proceeds from sale (+/-) Tax book value =

Taxable gain/loss

Taxable gain/loss x Tax rate = Net tax effect

Proceeds from sale (+/-) Net tax effect =

Net cash flow from sale of asset



StrategicConsiderations



J USTIFYING CAPITAL EXPENDITURES IN ANEW MANUFACTURING ENVIRONMENT

CAD/CAM



CAPITAL EXPENDITURES IN A NEWMANUFACTURING ENVIRONMENT

´ Traditional investment analysis tools

may not be adequate to make these typedecisions. The day-to-day operating impact (tactical) may not be the key factor

in making a decision. Less tangiblebenefits may be the deciding factor inwhether or not to invest in newtechnology.



EXAMPLES OF INTANGIBLES

´ Competitive advantage« Producing a product or providing a service that

competitors cannot´ Quality

« Improving the quality of a product by reducing thepotential 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



CAPITAL INVESTMENT DECISIONS

HAVE POTENTIAL PITFALLS



WHAT TO DO?

´ Consider the opportunity cost of not making aninvestment

´

Give full consideration to costs that may behidden´ Don·t set the barriers to strategic investment

too high



FIND THE HIDDEN COSTS

w arra tyc sts

Trai ic sts

Co st of

f aultyassumpti on s



POST-IMPLEMENTATION AUDITS

´ An o pp ortunity to re-evaluate a p ast decision top urchase a long-term asset by com p aring ex p ected and actual inflows and outflows



POST-IMPLEMENTATION AUDITSBENEFITS

POST-IMPLEMENTATION AUDITSBENEFITS

´ B y comparing estimates with results, plannerscan determine why their estimates wereincorrect and can avoid making the samemistakes in the future´ Rewards can be given to those who make goodcapital budgeting decisions

´ If the audit is not done, there are no controls onplanners who might be tempted to inflate thebenefits in order to get their projects approved



DON¶T THROW GOOD MONEYAFTER BAD



BIBLIOGRAPHY

PRINCIPLE OF MANAGERIAL FINANCE ² LAWRENCE J. GITMAN

FINANCIAL MANAGEMENT ² I.M. PANDEY

FUNDAMENTALS OF FINANCIAL MANAGEMENT ² R.P.RUSTAGI

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