unit i part 2

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U N I T I S T R A T E G I C F I N A N C I A L M G T

Investment decisions /Corporate

strategy & high technologyinvestments.1


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Investment decisions

y Capital budgeting is vital in marketing decisions.

y Decisions on investment, which take time to mature,have to be based on the returns which that

investment will make.y Unless the project is for social reasons only, if the

investment is unprofitable in the long run, it isunwise to invest in it now.

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Chapter objectives

y This chapter is intended to provide:y An understanding of the importance of capital

budgeting in marketing decision makingy An explanation of the different types of investment

projecty An introduction to the economic evaluation of

investment proposals

y The importance of the concept and calculation of netpresent value and internal rate of return in decision

makingy The advantages and disadvantages of the payback

method as a technique for initial screening of two ormore competing projects

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expenditures

y A capital investment project can be distinguishedfrom current expenditures by two features:

y a) such projects are relatively large

b) a significant period of time (more than one year)elapses between the investment outlay and thereceipt of the benefits..

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A systematic approach to capital budgeting

y a) the formulation of long-term goals

y b) the creative search for and identification of newinvestment opportunities

y c) classification of projects and recognition ofeconomically and/or statistically dependentproposals

y d) the estimation and forecasting of current andfuture cash flows

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Cont

y e) a suitable administrative framework capable oftransferring the required information to the decisionlevel

y f) the controlling of expenditures and carefulmonitoring of crucial aspects of project execution

y g) a set of decision rules which can differentiateacceptable from unacceptable alternatives is

required.y The last point (g) is crucial and this is the subject of

later sections of the chapter.

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The classification of investment projects

y a) By project size

y Small projects may be approved by departmentalmanagers. More careful analysis and Board of

Directors' approval is needed for large projects of,say, half a million dollars or more.

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yb) By type of benefit to the firm

y an increase in cash flow a decrease in risk

an indirect benefit (showers for workers, etc).

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y c) By degree of dependence

y mutually exclusive projects (can execute project Aor B, but not both)

complementary projects: taking project A increasesthe cash flow of project B. substitute projects: taking project A decreases thecash flow of project B.

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y d) By degree of statistical dependence

y Positive dependence Negative dependence

Statistical independence.

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y e) By type of cash flow

y Conventional cash flow: only one change in thecash flow sign

y e.g. -/++++ or +/----, etc

y Non-conventional cash flows: more than onechange in the cash flow sign,

y e.g. +/-/+++ or -/+/-/++++, etc.

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proposals

y The analysis stipulates a decision rule for:

y I) accepting orII) rejecting

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Investment projects

y The time value of money

y Recall that the interaction of lenders with borrowerssets an equilibrium rate of interest. Borrowing is only

worthwhile if the return on the loan exceeds the costof the borrowed funds. Lending is only worthwhile ifthe return is at least equal to that which can beobtained from alternative opportunities in the same

risk class.

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The interest rate received by thelender is made up of:

y i) The time value of money: the receipt of money ispreferred sooner rather than later. Money can be used to earnmore money. The earlier the money is received, the greaterthe potential for increasing wealth. Thus, to forego the use ofmoney, you must get some compensation.

y ii) The risk of the capital sum not being repaid. Thisuncertainty requires a premium as a hedge against the risk,hence the return must be commensurate with the risk beingundertaken.

y iii) Inflation: money may lose its purchasing power overtime. The lender must be compensated for the decliningspending/purchasing power of money. If the lender receivesno compensation, he/she will be worse off when the loan isrepaid than at the time of lending the money.

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PV / NPV

y Exercise Present valuey i) What is the present value of $11.00 at the end of one year?

ii) What is the PV of $16.10 at the end of 5 years?y b) Net present value (NPV)y The NPV method is used for evaluating the desirability of investments or

projects.y where:y Ct = the net cash receipt at the end of year t

Io = the initial investment outlayr = the discount rate/the required minimum rate of return on investmentn = the project/investment's duration in years.

y The discount factor r can be calculated using:y Decision rule:y If NPV is positive (+): accept the project

If NPV is negative(-): reject the project

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NPV (eg )

y Year Cash Flow ($)

y 0 $ 800y 1 $400

y 2 $400y 3 $400y 400y PV = $400(0.9091) + $400(0.8264) + $400(0.7513)y = $363.64 + $330.56 + $300.52y = $994.72y NPV = $994.72 - $800.00y = $194.72

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IRR

y ) The internal rate of return (IRR)y Refer students to the tables in any recognised published source.y The IRRis the discount rate at which the NPV for a project equals

zero. This rate means that the present value of the cash inflows forthe project would equal the present value of its outflows.

y The IRRis the break-even discount rate.y The IRRis found by trial and error.y where r = IRRy IRRof an annuity:y where:y

Q (n,r) is the discount factorIo is the initial outlayC is the uniform annual receipt (C1 = C2 =....= Cn).

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IRR

y Example:

y What is the IRRof an equal annual income of $20per annum which accrues for 7 years and costs $120?

y = 6y From the tables = 4%

y Economic rationale for IRR:

y

If IRR

exceeds cost of capital, project is worthwhile,i.e. it is profitable to undertake.

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y Find the IRRof this project for a firm with a 20%cost of capital:

y YEAR CASH FLOW

y 0 10000

y 1 8000

y 2 6000

y a) Try 20%b) Try 27%c) Try 29%

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Net present value vs internal rate of return

y Independent vs dependent projects

y NPV and IRRmethods are closely related because:

y i) both are time-adjusted measures of profitability,

andii) their mathematical formulas are almost identical.

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b) NPV vs IRR: Dependent projects

y Agritex is considering building either a one-storey(Project A) or five-storey (Project B) block of offices on aprime site. The following information is available:

y Initial Investment Outlay /Net Inflow at the Year

Endy Project A -9,500 11,500

y Project B -15,000 18,000

y Assume k = 10%, which project should Agritexundertake?

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The payback period (PP)

y The CIMA defines payback as 'the time it takes thecash inflows from a capital investment project toequal the cash outflows, usually expressed in years'.

When deciding between two or more competingprojects, the usual decision is to accept the one withthe shortest payback.

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Disadvantages of the payback method:

y It ignores the timing of cash flows within the paybackperiod, the cash flows after the end of payback periodand therefore the total project return.

y It ignores the time value of money. This means that it

does not take into account the fact that $1 today is worthmore than $1 in one year's time. An investor who has $1today can either consume it immediately or alternativelycan invest it at the prevailing interest rate, say 30%, toget a return of $1.30 in a year's time.

y It is unable to distinguish between projects with thesame payback period.

y It may lead to excessive investment in short-termprojects.

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Advantages of the payback method:

y Payback can be important: long payback meanscapital tied up and high investment risk. The methodalso has the advantage that it involves a quick,

simple calculation and an easily understood concept.

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The accounting rate of return - (ARR)

y The ARRmethod (also called the return on capitalemployed (ROCE) or the return on investment (ROI)method) of appraising a capital project is to estimate

the accounting rate of return that the project shouldyield. If it exceeds a target rate of return, the projectwill be undertaken.

y Note that net annual profit excludes depreciation.

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Disadvantages:

y It does not take account of the timing of the profits froman investment.

y It implicitly assumes stable cash receipts over time.

y

It is based on accounting profits and not cash flows.Accounting profits are subject to a number of differentaccounting treatments.

y It is a relative measure rather than an absolute measure

and hence takes no account of the size of the investment.y It takes no account of the length of the project.

y it ignores the time value of money.

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The payback and ARR methods in practice

y It is a particularly useful approach for ranking projects wherea firm faces liquidity constraints and requires fast repaymentof investments.

y It is appropriate in situations where risky investments are

made in uncertain markets that are subject to fast design andproduct changes or where future cash flows are particularlydifficult to predict.

y The method is often used in conjunction with NPV or IRRmethod and acts as a first screening device to identify projects

which are worthy of further investigation.y it is easily understood by all levels of management.

y It provides an important summary method: how quickly willthe initial investment be recouped?

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What Does Sensitivity Analysis Mean?

y

A technique used to determine howdifferent values ofan independent variablewill impact a particular

dependent variable under a given set of assumptions.This technique is used within specific boundaries thatwill depend on one or more input variables, suchas the effect that changes in interest rateswill have ona bond's price.

Sensitivity analysis is a way to predict the outcome of adecision if a situation turns out to be different comparedto the key prediction(s).

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Sensitivity analysis

y Sensitivity analysis is very useful when attempting todetermine the impact the actual outcome of aparticular variable will have if it differs from what

was previously assumed. By creating a given setof scenarios, the analyst can determine howchanges in one variable(s) will impactthe target variable.

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SIMULATION METHOD

y Monte Carlo methods (or Monte Carloexperiments) are a class ofcomputationalalgorithms that rely on repeated random sampling tocompute their results. Monte Carlo methods are

often used in simulating physical and mathematicalsystems. Because of their reliance on repeatedcomputation ofrandom or pseudo-random numbers,these methods are most suited to calculation by a

computer and tend to be used when it is unfeasibleor impossible to compute an exact result with adeterministic algorithm.[1]

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unit i part 2

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