LongTerm Capital Investment Decisions

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Chapter 8

• Long-Term (Capital Investment) Decisions

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Topics to be Discussed
Introduction Focus on Cash Flow Screening and
Preference Decisions Discounted Cash Flow
Analysis Internal Rate of Return
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Introduction
Capital Investment Decisions Which do I
purchase? What is the return on the
investment? What are the qualitative costs and
benefits? What are the quantitative costs and
benefits?
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Focus on Cash Flow
Long-term investment decisions require a
consideration of the time and value of money. The
time value of money is based on the concept of a
dollar received (paid) today being worth more
(less) than a dollar received (paid) in the
future.
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Screening and Preference Decisions
Screening decisions involve deciding if an
investment meets some predetermined company
standard. Preference decisions involve choosing
between alternatives.
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Screening and Preference Decisions
Should old equipment be replaced with new? Should
a new delivery vehicle be purchased or
leased? Should a manufacturing plant be
expanded? Should a new retail store be opened?
Typical Problems
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Discounted Cash Flow Analysis
Key Concept The time value of money is considered
in capital investment decisions using one of two
techniques the Net Present Value (NPV) method or
the Internal Rate of Return (IRR) method.
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Discounted Cash Flow Analysis Net Present Value
The Cost of Capital represents what the firm
would have to pay to borrow (issue funds) or
raise funds through equity (issue stock) in the
financial marketplace. In NPV, the discount rate
serves as a hurdle rate or a minimum required
rate of return.
What do I use for a discount rate?
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Discounted Cash Flow Analysis Net Present Value
Key Concept If the present value of cash flows is
greater than or equal to the present value of
cash outflows (the NPV is greater than or equal
to zero), the investment provides a return at
least equal to the discount rate (the minimum
required rate or return) and the investment is
acceptable.
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Discounted Cash Flow Analysis Net Present Value
Cost 50,000 Net increase in cash flows
(Revenues-Expenses) 14,000 for six years No
salvage value MRR 12 and use for discount rate
Should BR purchase a new refrigerated delivery
van?
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Discounted Cash Flow Analysis Net Present Value
Cash Flow Initial Investment Annual Cash
Income Net Present Value
Year Now 1-6
Amount (50,000) 14,000
12 Factor 1.0000 4.1114
Present Value (50,000.00) 57,559.60 7,559.60
Because the NPV is positive, the delivery van
should be purchased.
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Internal Rate of Return
Key Concept The internal rate of return (IRR) is
the actual yield or return earned by an
investment. If NPV 0, then IRR Required Rate
of Return.
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Screening vs Preference Decisions
Decision on what method to use
NPV
IRR
YES
YES
Invest in Project
NO
NO
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Screening vs Preference Decisions
Profitability Index (PI) Calculated by dividing
the present value of the cash flow by the initial
investment. A PI greater than 1.0 mean that the
NPV is positive and the project is acceptable.
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The Impact of Taxes on Capital Investment
Decisions
Profit-making companies must pay income taxes on
any taxable income earned.
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The Impact of Taxes on Capital Investment
Decisions

• Key Concept
• After Tax Cash Flows
• Pretax Cash Inflow (1-T)
• Pretax Cash Outflow (1T)
• Depreciation (T)

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The Impact of Uncertainty on Capital Investment
Decisions
One way to adjust for risk is to increase the
cost of capital used in the NPV calculations.
How do I try to adjust for uncertainty?
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The Impact of Uncertainty on Capital Investment
Decisions
What if the number of skiers did not increase at
the rate that was projected? Will the acquisition
of the new lift still result in a sufficient
return on investment?
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Uncertainty
Sensitivity Analysis Used to highlight decisions
that may be affected by changes in expected cash
flows. Use what-if analysis to determine how
sensitive capital investment decisions are to
changes (number of skiers per day).
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The Payback Method
The length of time needed for a long-term project
to recapture or pay back the initial investment.
Original Investment Net Annual Cash Inflows
Payback Period
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The Payback Method
Key Concept The payback method can be useful as a
fast approximation of the discounted cash flow
methods when the cash flows follow similar
patterns.
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Appendix
Time Value of Money and Decision Making Future
Value Present Value Annuities
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Time Value of Money and Decision Making
The present value of cash flows is the amount of
future cash flows discounted to their equivalent
worth today.
If I receive cash at different times, how do I
determine the time value of money?
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Present Value
FV (1r)n
PV
FV Future Value r Interest Rate n Time
Period
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Present Value
Present Value can be calculated
using Formula Tables Hand-held calculators Compute
rs
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End of Chapter 8