Welcome to our presentation

Prepared to: sifat kamallecturer dpt. Business studies

prepared by :Md: jahangir alam UG 01-24-10-024

ANUP KUMAR SARKAR UG01-24-10-003 RAKIB AHMED UG01-24-10-037

3

The Investment Decision

The objective of the corporation is to Maximise Shareholders Wealth

To do this we need to invest in those projects that will give the correct rate of return for the risk involved

To do this we need to be able to

4

The Investment Decision

1. Identify suitable investment opportunities2. Decide on the best selection method3. Identify the cash flows that will be

generated by those investments4. Discount them at the correct cost of

capital5. Choose the best one or ones from those

available

5

Capital Investment DecisionThe ideal selection method will Select the project that maximises

shareholders wealth Consider all cash flows Discount the cash flows at the

appropriate market determined opportunity cost of capital

Will allow managers to consider each project independently from all others

Capital Investment Decision The process of making a capital

investment decision involves these steps: Identification of a project Definition of a project and screening Analysing and accepting Implementation Monitoring Post audit

Capital investment decission how effect in business

Capital investment projects are some of the most important financial expenditures made by a business owner because they involve large amounts of money and projects that last more than a year and often several years. Making a poor capital investment decision can have a disastrous effect on a business firm and even cause business bankruptcy because it will cost so much money

8

Capital Investment Decision Methods for evaluating projects Payback ARR, Accounting Rate of Return IRR. Internal rate of return is the discount

rate that will give a Net Present Value of 0. NPV is the Net Present Value of a stream

of cash flows discounted at the correct cost of capital for the degree of risk inherent in realising those cash flows

NPV is best but what do companies use and why?

9

Capital Investment Decision We know that the NPV is the best

method because; The reinvestment rate assumption Value additivity Differences in scale Multiple IRRs

10ACFL1 10

Capital Investment Decision Why not IRR and does it have a use?1. Delayed Investments The Bonzo Dog DoDah Band are offered

USD2,000,000 today from a rich investor to make a new vinyl LP. They calculate that they will need three years to make the recording and that they will have to give up earnings in each of those years of

USD 1,000,000. Should they do it?

11

Capital Investment Decision

Issues of scale What would you prefer A return of 50 % or one of 20% ? an NPV of 50 or an NPV of 500?

Depends for the IRR but you would prefer the higher NPV

12

Capital Investment Decision So, its NPV But………. Some Reasons for usage of wrong techniques. Managers prefer % figures => IRR, ARR Managers don’t understand NPV/ Complicated

Calculations. Payback simple to calculate. Short-term compensation schemes => Payback

(Levy 200 –203, Pike 1985 pg 49). Behavioural Factors (see later section on Behavioural

Finance!!) Increase in Usage of correct DCF techniques: Computers. Management Education.

13ACFL1 13

Capital Investment Decision How do we decide when resources are

constrained? We need to maximise NPV which may mean not going for the project with the highest NPV, rather the combination of projects that gives the highest total NPV.

Why would resources be constrained?This could be due to Capital Rationing

14

Capital investment Decision

What about other scarce resources? E.g. bright Bath Students There are never enough

15

Capital Investment Decision Remember We have to look at all the relevant,

incremental cash flows - Taxes/tax losses - Opportunity costs - Depreciation - Working capital - Cannibalisation

16

Capital Investment Decision Points to make so far 1 Tax losses 2 Depreciation 3 Interest costNow Opportunity cost

17

Capital Investment Decision Need to work out the Free Cash Flow i.e. the effect of the project on the

company’s cash. So far looked at sales and costs just

need to add a couple of things in. 1. Depreciation (which you are already

familiar with 2. Net working capital

18

Capital Investment Decision Anything else? Timing of cash flows Liquidation/salvage value Terminal Value - multiple - constant growth

19

Capital Investment Decision Break even analysis Using the IRR to give a feel for the

‘margin of safety’ ref the cost of capital

Sensitivity analysis Scenario analysis

20

Capital Investment Decision

Summary Investments should add to

shareholder wealth NPV is the correct method Incremental free cash flows Forecasting cash flows

21ACFL1 21

Advanced for business Before moving on to other aspects of

using the NPV approach we should consider EVA or Economic Value Added.

‘The cash flows of a project less a capital charge that reflects the opportunity cost of the capital invested as well as any capital consumed’

How does it differ from NPV?

22ACFL1 22

Advanced Corporate Finance Basically NPV gives the return of a

project over a period of time while EVA focuses more on the individual time segments within the overall period but will give the same result

These are some of the factors which affect capital investment decisions:

The outlook of the management Opportunities which are created by

technological changes Strategy of the competitor Cash flow budget Fiscal Incentives Market Forecast Other non-economic factors

These motives would explain clearly as to why capital investment decisions are extremely important for an organization

Expansion: Capital investment decisions are aimed at the expansion of operation levels.

Replacement: Post the period of maturity, when the growth of a firm slows down, the firms; worn out or outdated assets need to be replaced, like machinery, vehicles, equipment, etc.

Renewal: As a substitute to replacing, renewal might involve rebuilding, retrofitting or overhauling an existent asset..