CHAPTER 12: STRATEGIC INVESTMENT DECISIONS Cost Management, Canadian Edition © John Wiley & Sons,...

CHAPTER 12: STRATEGIC INVESTMENT DECISIONS

Cost Management, Canadian Edition

© John Wiley & Sons, 2009Chapter 12: Strategic Investment Decisions

Cost Management, Cdn Ed, by Eldenburg et alSlide # 1

Learning Objectives

© John Wiley & Sons, 2009

Chapter 12: Strategic Investment DecisionsCost Management, Cdn Ed, by Eldenburg et al

Slide # 2

• Q1: How are strategic investment decisions made?

• Q2: What cash flows are relevant for strategic investment decisions?

• Q3: How is net present value (NPV) analysis performed and interpreted?

• Q4: What are the uncertainties and limitations of NPV analysis?• Q5: What alternative methods (IRR, payback, and accrual accounting rate of return) are used for long-term decision making?

• Q6: What additional issues should be considered for strategic investment decisions?

• Q7: How do income taxes affect strategic investment decision cash flows?

• Q8: How are the real and nominal methods used to address inflation in NPV analysis (Appendix 12A)


Cost Management, Cdn Ed, by Eldenburg et al Slide 3

Q1: How are strategic investment decisions

made?

Process for Making Strategic

Investment Decisions



Slide # 4

• The process used to compare and analyze long-term investment projects is called capital budgeting.

• The capital budgeting process includes the following stages:– Identify decision alternatives.– Identify relevant cash flows.– Apply the appropriate quantitative

techniques.– Perform sensitivity analysis.– Identify and analyze qualitative factors.– Consider quantitative and qualitative factors

and make a decision.

Capital Budgeting Quantitative Techniques



Slide # 5

• Methods that do not consider the time value of money:– Payback method– Accounting rate of return method

• Methods that consider the time value of money:– Net present value (NPV) method– Internal rate of return (IRR) method



Q2: What cash flows are relevant for strategic investment decisions?

Relevant Cash Flows in Capital Budgeting



Slide # 7

• Relevant cash flows occur in the future and are different across the alternatives.

• Examples of relevant cash outflows include:– Initial investment outlay– Future operating costs– Project closing and cleanup costs

• Examples of relevant cash inflows include:– Future revenues– Decreased operating costs– Salvage value of assets at project’s end



Q3: How is net present value (NPV) analysis

performed and interpreted?

Net Present Value (NPV) Analysis



Slide # 9

• The NPV of a project is the sum of the project’s discounted cash flows:

n

tt

t=0

Expected cash flowNPV =

1 r, where

• t = year of the project’s life in which cash flow occurs

• n = life of the project• r = discount, or hurdle rate• If a project’s NPV > 0, it is acceptable

NPV Analysis and Project Ranking



Slide # 10

• NPV analysis is often used to screen projects as to whether they are acceptable.

• After screening, acceptable projects may be ranked according to their profitability index.

Profitability index =

Present value of benefitsPresent value of costs

• The profitability index allows for rankings of projects of various sizes.

NPV ExampleJoseph Leasing is considering an investment in a new apartment building. The Lindie Lane building will cost $450,000 and the net annual cash inflows are expected to be $45,000 for 7 years. At the end of the 7th year, Joseph expects to be able to sell Lindie Lane building for $400,000. Joseph demands a minimum required rate of return of 8% on all investments. Assume all cash inflows occur at the end of each year. Compute the NPV of the Lindie Lane building. Is it an acceptable investment?



PV of cash inflows:Annuity of cash inflows:

$45,000 x PV annuity factor of 5.206 $234,270Sale of building:

$400,000 x PV of $1 factor of 0.583 233,200467,470

PV of cash outflows:Initial investment 450,000

NPV $17,470

Yes,the NPV > 0,

so the investment is

acceptable

NPV ExampleJoseph Leasing is also looking at the purchase of a lot with a double-wide trailer on it. The cost is $65,000 and the expected net cash inflows are $6,800 per year for 10 years. At the end of the 10th year, Joseph expects to be able to sell the lot and trailer for $45,000. Compute the NPV of the trailer investment. Is it an acceptable investment?



Yes, the NPV > 0,

so the investmen

t is acceptabl

e

PV of cash inflows:Annuity of cash inflows:

$6,800 x PV annuity factor of 6.710 $45,628Sale of lot and trailer:

$45,000 x PV of $1 factor of 0.463 20,83566,463

PV of cash outflows:Initial investment 65,000

NPV $1,463

NPV ExampleCompare the two investments for Joseph using the profitability index, and describe to him what the index means. Which investment (or both) should he make?



The Lindie Lane

yields a slightly

greater PV for each invested

dollar than does the trailer.

Profitability index

Lindie Lane building:PV of cash inflows 467,470PV of cash outflows 450,000

Trailer:PV of cash inflows 66,463PV of cash outflows 65,000

= 1.0388

= 1.0225

If Joseph has sufficient capital, he should invest in both unless he has alternatives that have even greater

profitability indices.



Q4: What are the uncertainties and limitations of NPV

analysis?

Limitations of NPV Analysis



Slide # 15

• The uncertainty about future cash flows increases the further the cash flow is in the future. Many factors have an impact such as customer tastes, changes in technology and competition

• Other uncertainties exist such as the life of the project, cost of the initial investment and factors which may impact the discount rate.• Individuals providing information about the future cash flows are likely to have a vested interest in the project’s acceptance.



Q5: What alternative methods (IRR, payback, and accrual accounting

rate of return) are used for long-term decision

making?

Internal Rate of Return (IRR) Method



Slide # 17

• The IRR method computes the discount rate required to set the NPV to zero.

• For projects with equal annual cash inflows where the only cash outlay is the initial investment, the IRR can be determined by computing the PV of an annuity factor and solving for the interest rate.

PV of an annuity factor

=Initial investment

Annual cash inflow

• Then the discount rate is found by locating the column for the PV factor, given n.

IRR ExampleGraham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Assume the cost savings are realized at the end of the year. Graham requires a 10% rate of return on all new investments. Compute the IRR for the proposed machine. Should Graham purchase the machine?



Since the machine’s IRR exceeds Graham’s minimum rate of return, the machine is an acceptable investment,

but of course should still be compared to other, potentially better, investments.

5.650=$100,000

$17,700

Locate the 5.65 factor in the present value of an annuity table, using n = 10 years and note that it is found in the 12% column, so the IRR = 12%.

Payback Method



Slide # 19

• The payback method computes the number of years before the initial investment is recovered.

• If cash inflows are the same each year and the project has only one initial outlay, the payback period is computed as:

Payback period in years =

Initial investmentAnnual cash inflow

• For projects where annual cash inflows are not equal, the payback period is computed by merely counting the years required before the initial investment is recovered.

Payback Method



Slide # 20

• The payback method is widely used because of its simplicity.

• However, the payback method is flawed because:– It ignores the time value of money.– It ignores cash flows that occur after the

payback period.

• If used at all, the payback method should be used in conjunction with the NPV or IRR methods to help assess project risk.

Payback Method ExampleGraham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Compute the payback period for the proposed machine.



Notice that the payback period is the same as the PV factor computed in the IRR example.

5.650 years=$100,000$17,700

Payback Method ExampleCophil, Inc. is considering the purchase of a new machine. There are two alternatives, and the cash flow information is given below. Compute the payback period for each and comment on your findings.



The payback method shows Machine B to be preferable to Machine A, but ignores the large cash inflows of

Machine A that occur after the payback period.

The payback period for Machine B is 2 years. The

payback period for Machine A is 3.5 years

($60,000 covered after 3 years, and $40,000 is ½ of

year 4’s cash inflow).

Machine A Machine B0 ($100,000) ($100,000)1 $10,000 $50,0002 $20,000 $50,0003 $30,0004 $80,0005 $80,0006 $80,000

Cash FlowTime period

Accrual Accounting Rate of Return Method



Slide # 23

• The accrual accounting rate of return computes the project’s rate of return using operating income in place of cash flows.

• This method is widely used because the financial accounting information is readily available, but it is flawed because it ignores the time value of money.

Accrual accounting

rate of return

Operating income Annual cash inflow

=

Accrual Accounting Rate of Return

Method ExampleBlanche Manufacturing is considering the purchase of a new machine. The cost is $100,000 and it is expected to last 5 years and have no salvage value. The machine is expected to generate cost savings of $32,000 per year. Ignoring income tax effects, compute the accrual accounting rate of return for this investment.



Annual cost savings $32,000

Annual depreciation expense ($100,000/5 years)20,000

Effect on annual operating income $12,000Accrual

accounting rate of return

$12,000$100,000

= = 12%



Q6: What additional issues should be considered for

strategic investment decisions?

Additional Considerations in Strategic Investment

Decisions



Slide # 26

• Qualitative issues that may arise in capital budgeting include:– the effects of the decision on the company’s

reputation,– the effects on the quality of the company’s

products and services,– the effects on the company’s community,

and– the effects on employees.• After a capital budgeting decision is made, a post-investment audit should be performed to assess the decision process.



Q7: How do income taxes affect strategic investment

decision cash flows?

Income Tax Considerations



Slide # 28

• All cash flows should first be converted to an after-tax amount.

• The tax savings that result from the capital cost allowance (CCA) deduction is called the CCA tax shield. All capital assets are eligible for CCA deductions

Income Tax Considerations• CCA deductions are as allowed by Canada

Revenue Agency (CRA)• CCA rates dictate the maximum CCA that can be

deducted on a firm’s tax return each year• Rates use a declining balance method and are

applied to the opening balance of undepreciated capital cost (UCC) for each asset class

• CCA claimed in any given year reduces the deductions that can be used in future years

• Due to significant capital costs of some projects, CCA deductions can be a critical factor in determining whether a project will generate a positive return



Slide # 29

CCA tax shield formula

The tax savings that are provided by CCA can be calculated with the following formula:

PV of tax savings: Investment * Tax Rate* CCA Rate

CCA Rate + RRRX1 + 0.5 * RRR1 + RRR



Slide # 30



Q8: How are the real and nominal methods used to address inflation in NPV analysis (Appendix 12A)

Inflation and NPV Analysis



Slide # 32

• When the purchasing power of the dollar declines over time, it is known as inflation.

• The real rate of interest does not consider changes in the purchasing power of a dollar.

• The nominal rate of interest is the rate that investors demand when inflation is taken into consideration in their decisions.

Inflation and NPV Analysis



Slide # 33

• The risk-free rate is the rate of interest that is paid on long-term government bonds.

• The risk premium is the additional rate of return investors demand to compensate them for taking risk.

• The risk premium increases for riskier investments.

• The real rate of interest is the nominal rate plus the risk premium demanded for that investment.

Nominal and Real Methods of

NPV Analysis


Slide # 34

• The real and nominal rates of interest are related as follows:

• Nominal future cash flows are real cash flows inflated to future dollars:

Nominal rate of interest

= (1 + real rate) x (1 + inflation rate)

- 1

Nominal cash flow = Real cash flow x (1 + i)t,

wherei = rate of inflation, and t = the number of time periods in the future

the cash flow occurs© John Wiley & Sons, 2009

Nominal and Real Methods of

NPV Analysis



Slide # 35

• In the real method of NPV analysis, future cash flows are state in real dollars (without considering changes in the purchasing power of the dollar) and a real rate of interest is used as the discount rate.

• In the nominal method of NPV analysis, future cash flows and the terminal project value must be inflated to future dollars and a nominal rate of interest is used as the discount rate.

Copyright

Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.


Slide 36Chapter 12: Strategic Investment Decisions

Cost Management, Cdn Ed, by Eldenburg et al

Date post:	14-Dec-2015
Category:	Documents
Upload:	elfrieda-norman
View:	232 times
Download:	2 times

CHAPTER 12: STRATEGIC INVESTMENT DECISIONS Cost Management, Canadian Edition © John Wiley & Sons,...

Documents