Key Topics:

1
Chapter 12 Strategic Investment Decisions

• Key Topics
• Strategic Investment Decisions
• Net present value (NPV) analysis with and without
  inflation)
• Other methods for strategic investment decisions
• Qualitative factors
• Sensitivity analysis

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Strategic Investment Decisions
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Short-Term Decisions

• Tend to be non-routine
• Effect operations over the next several months to
  one year
• Examples

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Long-Term Decisions

• Usually involve large investments
• Project life is greater than 1 year
• Usually incorporate the time value of money
• Examples

5
Alternative Methods

• NPV (accountants favorite)
• IRR (sometimes finance folks like this one)
• Payback (often used in other countries)
• Accrual accounting rate of return (not useful for
  project decision making)

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Timeline for New Projects
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Replace Old Equipment
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NPV

• Time line
• Investment
• Cash inflows less cash outflows
• Discount cash flows
• Compare to investment
• NPV - investment discounted cash flows

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NPV Analysis

• Investment rules based on NPV
• If the NPV is positive, accept the project.
• When choosing among various projects, choose the
  one with the highest NPV or the highest
  profitability index.
• Assumptions
• All cash flows are certain (they are actually
  uncertain)
• Cash can be borrowed or loaned at the same
  interest rate, and that rate is constant from
  period to period (not very realistic).

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IRR

• Initial investment NPV of cash inflows CF
  (PVFA ?years, ?)
• Solve for the PVFA factor and then check tables
  to identify rate.

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Payback

• Divide investment amount by annual return if cash
  flows are uniform
• Subtract annual returns from investment and keep
  track of the number of times you have to subtract
  (thats the number of years it will take)

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Accrual Accounting Rate of Return

• Accounting income/investment amount

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Alternative Methods No Taxes or Inflation
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NPV With Taxes

• First calculate tax cash flows
• -Include depreciation (tax shield)
• Then calculate incremental cash flows
• -Exclude depreciation (not a cost)

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NPV With Taxes

• Stellar Stadium Seats
• Stellar Stadium Seats (SSS) is bidding on a
  contract to supply 10,000 stadium seats to the
  local university each year for five years. The
  specifications for the seats require that they
  withstand body weights up to 300 lbs. in both
  sitting and standing positions. SSS engineers
  have designed a seat that should satisfy
  university specifications, but development costs
  were 53,000.
• If SSS wins the contract, the firm would have
  to invest an additional 600,000 in manufacturing
  equipment that has no salvage value. The average
  cost of producing a seat would be about 25.
  This includes 7 for materials, 1 for labor, 5
  for variable factory overhead, and 12 for
  depreciation on the equipment.
• SSS uses straight-line depreciation for
  purposes of computing taxable income. The firms
  tax rate is 30. SSS can earn 10 after taxes on
  other projects.
• A. What is the net present value of the
  contract if the price per seat is set at 30?
• B. What would be the minimum acceptable price
  per seat?

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Capital Budgeting and Inflation

• Inflation can be defined as the decline in the
  general purchasing power of the monetary unit,
  the dollar in the U.S. An annual inflation rate
  as low as 5 can result in sizable losses in
  purchasing power over a period of time.
• There are two types of interest rates that
  concern us in analyzing inflation
• 1) Real rate of interest. This rate is made up
  of two elements
• A. A risk-free element, the pure rate of
  interest that is paid on long-term government
  bonds and
• B. A business-risk element, the risk premium
  above the pure rate that is demanded for
  undertaking risks
• 2) Nominal rate of interest. This rate is made
  up of
• A. The real rate of interest and
• B. An inflation element.

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Real and Nominal Approaches

• There are two internally consistent approaches
  to capital budgeting problems that incorporate
  inflation.
• Real Approach Predict cash inflows and outflows
  in real monetary units and use a real discount
  rate
• Nominal Approach Predict cash inflows and
  outflows in nominal units and use a nominal
  discount rate.
• If cash inflows and outflows are valued in real
  terms and a nominal discount rate is used, the
  approach is internally inconsistent. This
  creates a bias against the adoption of many
  worthwhile capital investment projects. The
  discounted present value of cash inflows will be
  understated when this error is made.
• Because U.S. tax rules restrict depreciation to
  the amount of an assets purchase price in
  nominal dollars at the time of purchase, the tax
  savings each year will be in nominal dollars.

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Depreciation Effects

• 1) If depreciation cash flows are to be
  discounted under the real method, they need to be
  discounted for inflation before they are
  discounted using the real discount rate.
• 2) If instead, the nominal method is used, any
  real cash flows are inflated, depreciation is
  already valued in nominal dollars, so no
  adjustments are made, and the nominal discount
  rate is used.

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Capital Budgeting Problem With Taxes and Inflation
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Sensitivity Analysis

• Many factors can be manipulated through a what
  -if sensitivity analysis. When spreadsheets are
  set up appropriately, the discount rate, cash
  flows, salvage values, and any underlying
  assumptions can be varied. This provides managers
  with an immediate measure of the financial effect
  of differences between forecasts and subsequent
  outcomes