Making Inv Dec

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Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved . McGraw-Hill/Irwin

14Strategic Issues In

Making Investments

Decisions


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Investment Decisions

Investments are major decisions that have long-term consequences beyond current consumption.

Two effects of time on a decision and its outcomes

distinguish an investment decision:1. The decision commits resources for a lengthy period of

time, and this commitment usually prevents takinganother future opportunity

2. Managements flexibility to modify an investment as timeand information unfold can affect alternative decisions.


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Learning Objective 1


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Strategic Investments

A strategic investment is a choice amongalternative courses of action and the allocationof resources to those alternatives most likely

to succeed after considering . . .

1) changes in natural, social, and economicconditions, and

2) actions of competitors.


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Information about External Events

External InformationOrganization's

Financial Records

Interviews withKnowledgeable

IndividualsPublicly Available

informationUncontrollable futureevents

Past financial recordshave limited

usefulness for predicting futureevents if theorganization hasnever operated in asimilar environment

Company personnelwho can think

creatively mightidentify future events.Experiencedconsultants also canbe excellent sourcesof future events.

News, government,foundation, and

industry analyses canbe excellent sourcesof future events

Likelihood of futureevents' occurrence Past financial recordshave limitedusefulness for predicting future oddsif the organizationhas never operated ina similar

environment.

Experiencedconsultants andcompany personnelcan estimate odds ,but individuals arenotoriously weak atthis task.

News, government,foundation, andindustry analyses canbe excellent sourcesof the likeliness of future events.

Sources and Usefulness of External Information

Group brainstorming methods anddecision-support software may helpidentify the range of future events.


7/41Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved . McGraw-Hill/Irwin

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Likelihood of Future Events

Occurrence

Sensitivity Analysis Forecasts the effects of a likely change in each

future, relevant event oninvestment outcomes.

Scenario AnalysisForecasts the effects of likely combinations of

future events oninvestment outcomes.

Expected Value AnalysisSummarizes the combined effects of relevant future

events on decision outcomes, weighted by theprobability or odds of the events occurrence.



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Expected Value Analysis

Relevant Future EventProbability of Occurrence

Annual market growth = 8% 30%

Annual market growth = 4% 40%Annual market growth = 2% 30%Total probability 100%

The management of Matrix, Inc. is in the process of

accessing the probability of market growth for their product. The following consensus has been reached:

ExpectedMarketGrowth

= (8% .30) + (4% .40) + (2% .30)

E[market growth] = 2.4% + 1.6% + .6% = 4.6%



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Internal Information

Internal informationOrganization's

financial records

Interviews withknowledgeable

individualsPublicly available

informationEffect of future eventson investment costs

and benefits

Account or regressionanalysis of financial

records might beuseful to predict costsor benefits if expected futureactivities are similar to recent experience.

Consultants can bringknowledge of other

organizations'experiences withsimilar events.Company personnelcan apply others'experiences andperform engineeringanalysis to predictcosts and benefits.

Descriptions of other organizations'

experiences withsimilar events can behelpful for predictingfuture costs andbenefits.

Sources and Usefulness of Internal Information



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Discounted Cash Flow Analysis

A method of comparing alternativeinvestmentsCombines estimates of present andfuture cash outflows and inflows

associated with each investmentDiscounts the cash flows to accountfor the opportunity costs of committing funds

Differs from payback p er iod methods:DCF Includes all cash flows throughoutthe life of the investmentDCF always discounts the cash flows



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Investment Cash FlowsEstimate separately 3 types of cash flows:1) Investment cash flows

a) Asset acquisition (and disposal of old asset)b) Tax effect from disposal of old assetc) Tax credit arising from the new acquisition

2) Periodic operating cash flowsa) Receipts from operationsb) Cost savings that occur (including tax savings)c) Operating expenses

3) Cash flows from termination of investment

Next, an illustration of these cash flows, courtesy of ShadeTree Roasters.



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Investment Cash FlowsThe entire purchase is made in cash at the end of year

0 (i.e. at start of the investment period)The equipment will be depreciated by the straight-linemethod over 4 years, and there are no salvage valuesOperating income will increase because of higher

sales and savings in energy costsShadeTree Roasters - Investment in New Equipment

Data InputNew equipment cost, includinginstallation and training $200,000Salvage value of new equipment -New equipment useful life 4 yearsSalvage value of old equipment -Annual increase in contrib. margin $30,000Annual energy cost savings $40,000Income tax rate 40%Discount rate 8%

Income tax rate is40% (for effect of depreciation)

Future cash flowsare discounted at8% per year



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Investment Cash FlowsInvestment analysis End of year

Initial cash flows for year: 0 1 2 3 4

Investment cost (200,000)Proceeds from old equipment -

Annual operating income items

Increase in contribution margin 30,000 30,000 30,000 30,000

Energy cost savings 40,000 40,000 40,000 40,000

Depreciation expense (50,000) (50,000) (50,000) (50,000)

Change in operating income 20,000 20,000 20,000 20,000

Tax on change in income (8,000) (8,000) (8,000) (8,000)

After-tax change in operating income 12,000 12,000 12,000 12,000

Add back depreciation expense 50,000 50,000 50,000 50,000

After-tax operating cash flow 62,000 62,000 62,000 62,000

Assume that cash flows are the same in each year. Note that depreciation expense is used only to estimate

the tax savings. The expense itself is not a cash flow. These net cash flows must be discounted to get the

investments net present value.



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Choice of a Discount Rate

The discount rate is an estimate of theopportunity cost of making this investmentinstead of some other.If the rate chosen is too high, some profitableinvestments will be rejected.If the rate chosen is too low, some marginalinvestments will be approved too easily.Suggested discount rates:

A risk-free rate (e.g., Treasury bond rate)Long-term market return on equitiesThe rate chosen should allow for price inflation

%

(1+r)^(-n)



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Cash to be received in the future has a cost.Alternative investments and price inflation

reduce the value of those cash flows incurrent monetary terms (present value).That is why the cash flows are discounted,normally using a constant discount rate.

Assume annual cash flows of $10,000 and a discountrate of 8%. Every dollar received one year from nowhas a present value of ($1)*(1.08 -1)=$0.926. After twoyears a dollar has a present value of $0.857.

Discounting Future Cash Flows$10,000 $10,000 $10,000 $10,000



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Net Present Value

Compute the present value of each cash inflowand outflow.Sum all the present values to get the net

present value (NPV).If the NPV of the investment is greater thanzero, the project promises returns greater thanthe opportunity rate.

The next slide calculates the NPV of theShadeTree Roasters investment proposal.



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Net Present Value

Investment analysis End of year Initial cash flows for year: 0 1 2 3 4

Investment cost (200,000)Proceeds from old equipment -

Annual operating income itemsIncrease in contribution margin 30,000 30,000 30,000 30,000Energy cost savings 40,000 40,000 40,000 40,000Depreciation expense (50,000) (50,000) (50,000) (50,000)

Change in operating income 20,000 20,000 20,000 20,000Tax on change in income (8,000) (8,000) (8,000) (8,000)After-tax change in operating income 12,000 12,000 12,000 12,000Add back depreciation expense 50,000 50,000 50,000 50,000After-tax operating cash flow 62,000 62,000 62,000 62,000

Disposal valuePresent value factors 1.000 0.926 0.857 0.794 0.735Discounted cash flows (200,000) 57,407 53,155 49,218 45,572Net present value 5,352$ Note: =sum(b26:f26)

The proposal estimates an NPV of $5,352. So the present value

of the net cash inflows during four years exceeds the$200,000 initial investment.

So do

we goahead?

I vote Yes!



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Payback PeriodManagers may want to know how soon theywill recover an initial investment.This method counts the time that will passbefore the projected cash inflows equal theinitial cash expenditure.The payback period method complements thediscounted cash flow method, though theresult may be different.In the ShadeTree Roasters example:

Divide the initial investment of $200,000 by theannual contribution margin of $62,000. Thepayback period is 3.23 years.Often the cash flows are not discounted.



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Internal Rate of ReturnThis percentage is calculated together with the investments net present value. An investments IRR is the discount ratethat would create an NPV of zero for theinvestment.So, if the NPV is greater than zero, thenthe IRR will be greater than the discountrate.

In the case of ShadeTree Roasters, theproposed investment would have anIRR of 9.2%, higher than the requiredreturn of 8%.



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Forecasts of Investment InformationThe management of ShadeTree Roasters has gathered the

following information concerning a potential investment.


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Forecasts of Investment InformationForecast and Net Present Value No Major Competitor

$50,000,000 1.046 = $52,300,000

$10,460,000 35% = $3,661,000


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$699,000 40% = $279,600


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=NPV(.08,F15:N15)+D15


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Forecasts of Investment InformationForecast and Net Present Value With Major Competitor

The major competitor does not enter the market until the second year.


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Forecasts of Investment InformationForecast and Net Present Value With Major Competitor

=NPV(.08,F15:N15)+D15


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Expected Value Analysis Decision Tree

NPVCompetitor Outcome E[NPV]

40% (4,965,809)$ (1,986,324)$60% 2,012,498 1,207,499

100% (778,825)$


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Value of Deferring IrreversibleDecisions

Lets assume that ShadeTree Roasters wants toconsider waiting one year to see if its major

competitor decides to enter the market.

All other information remains the same. Letslook at our analysis now.


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Wait One Year, With No MajorCompetitor


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Wait One Year, With a MajorCompetitor


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Defer Decision One Year

First Second NPV Bestdecision Probability Competitor? decision outcome choice

Expand (4,139,865)$ No40% Yes

Don't expand -$ YesDon't decide

Expand 2,618,754$ Yes60% No

Don't expand -$ No

E[NPV] = $ 1,571,252

($0 .40) + ($2,618,754 .60) = $1,571,252


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Value of the Option to Wait

Under common investment conditions, the netpresent value that we calculated in our analysisis incorrect . We did not consider the situation

where ShadeTree entered the market but

terminated the project after one year when amajor competitor may enter the same market.Though ShadeTree would not recover its

investment (which is a sunk cost), it may beless costly to terminate after one year than to

continue operations in the market. This analysisis referred to as real option value.


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Real Option Value Decision TreeSecond NPV Best

Decision now Choice Prob Competitor? decision outcome choice

Continue (5,662,762)$ No40% Yes

Terminate (4,093,148)$ YesExpand

Continue 2,925,012$ YesExpand now or not 60% No

Terminate (4,093,148)$ NoDon't expand -$

E[NPV, expand now] = [$(4,093,138) .40] + [$2,925,012 .60]

E[NPV, expand now] = $117,752


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Value of the Option to WaitIf ShadeTree postpones its

decision to expand for one year and then expands into the new

market, we calculate theexpected net present value to be:

$1,571,252 If ShadeTree expands now and

continues operations, wecalculate the expected net

present value to be:$117,752

Postpone one year 1,571,252$Expand now 117,752

Expected value of waiting 1,453,500$

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Legal and Ethical Issues in StrategicInvestment Analysis

Trade unions, regulators, investors, non-governmentorganizations and some business executives have

succeeded in influencing United States laws and recentOrganisation for Economic Cooperation and

Development guidelines that prohibit bribery and other corrupt practices by multination companies.

Such acts are designed todiscourage companies from illegally

obtaining information about theintentions of competitors.

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Internal Ethical Pressures

1. Bias from personal commitment to aninvestment project.

2. Fear of loss of prestige, position, or compensation from a failed investment.

3. Greed and intentional behavior todefraud an organization or itsstakeholders.

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Role of Internal Controls and Audits

o Hiring practices -- performing background andreference checks.

o Investment reporting and reviews -- periodicprogress reporting to see if the investment is

meeting stated goals.o Codes of ethics -- educate and support employees

who want to behave ethically.

o Internal audits -- examinations of operations,programs, and financial results performed byindependent investigators.

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End of Chapter 14

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