...MBA7001 Accounting for Decision-Makers Week 6 Lecture – Capital Investment Appraisal Slide 10.2 Chapter 10 Making capital investment decisions LEARNING OUTCOMES CHAPTER 10: Investment Appraisal Methods You should be able to: Explain the nature and importance of investment decision making First hour – 23.11.11 Identify the four main investment appraisal methods found in practice •Payback •ARR Use each method to reach a decision on a particular investment opportunity Discuss the attributes of each of the methods 1 Atrill and McLaney, Accounting and Finance for Non-Specialists, 7th Edition, © Pearson Education Limited 2011 Investment Appraisal Investment appraisal methods used in practice Investment appraisal – the process of appraising the potential investment projects. Assessment of the level of expected returns earned for the level of expenditure made. Estimates of future costs and benefits over the project’s life. 3 • Every business would like to do everything • But it all costs • Capital expenditure on new projects or purchases (fixed assets) needs to be planned • Capital is always rationed Scenario: • Your business wishes to expand its product line • It is considering Products A and B but it can only afford to do one. • How does it decide? What main factors affect the investment decision • How much will it cost ? Investment appraisal methods used in practice • How much will I get back ? • When will I get the income ? • 4 main techniques available ranging from ...
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...discounted cash flow (DCF) calculations used for making capital budgeting decisions. NPV and IRR lead to the same decisions with investments that are independent. With mutually exclusive investments, the NPV method is easier to use and more reliable. Introduction To this point neither of the two discounted cash flow procedures for evaluating an investment is obviously incorrect. In many situations, the internal rate of return (IRR) procedure will lead to the same decision as the net present value (NPV) procedure, but there are also times when the IRR may lead to different decisions from those obtained by using the net present value procedure. When the two methods lead to different decisions, the net present value method tends to give better decisions. It is sometimes possible to use the IRR method in such a way that it gives the same results as the NPV method. For this to occur, it is necessary that the rate of discount at which it is appropriate to discount future cash proceeds be the same for all future years. If the appropriate rate of interest varies from year to year, then the two procedures may not give identical answers. It is easy to use the NPV method correctly. It is much more difficult to use the IRR method correctly. Accept or Reject Decisions Frequently, the investment decision to be made is whether to accept or reject a project where the cash flows of the project do not affect the cash flows of other projects. We speak of this type of investment as being an...
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...IFAC Board Exposure Draft November 2012 Comments due: February 28, 2013 Professional Accountants in Business International Good Practice Guidance Project and Investment Appraisal for Sustainable Value Creation IFAC’s mission is to serve the public interest by: contributing to the development of high-quality standards and guidance; facilitating the adoption and implementation of high-quality standards and guidance; contributing to the development of strong professional accountancy organizations and accounting firms and to high-quality practices by professional accountants, and promoting the value of professional accountants worldwide; and speaking out on public interest issues. The PAIB Committee serves IFAC member bodies and professional accountants worldwide who work in commerce, industry, financial services, education, and the public and not-for-profit sectors. Its aim is to promote and contribute to the value of professional accountants in business. To achieve this objective, its activities focus on: increasing awareness of the important roles professional accountants play in creating, enabling, preserving, and reporting value for organizations and their stakeholders; and supporting member organizations in enhancing the competence of their members through development and sharing of good practices and ideas. Copyright © November 2012 by the International Federation of Accountants (IFAC). For copyright, trademark, and permissions information, please see page...
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...Capital Budgeting 2 Capital Budget Processes and Techniques Investment decisions impact the long-term success or failure of a company. The capital budgeting theory assumes that the primary goal of a firm’s shareholders is to maximize firm value. The process of analyzing and prioritizing investment opportunities is capital budgeting. Capital budgeting involves three basic steps of identifying potential investments, analyzing the set of investment opportunities that will create shareholder value, and implementing and monitoring the investment projects that a firm should undertake. Managers need analytical tools to help them make the best investment decisions for their firm. This paper will explore six different methods of evaluating investment projects and their advantages and disadvantages. The six methods are the payback period, discounted payback period, net present value, profitability index, internal rate of return, and modified internal rate of return, which method is most used in business, and issues related to capital budgeting. Capital Budgeting 3 Payback Period The first capital budgeting method is the payback period. The payback period is the amount of time it takes for a given project’s cumulative net cash inflows to recoup the initial investment (Graham, Smart & Megginson, 2010, p. 235). A company will determine...
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...METHODS OF EVALUATING CAPITAL INVESTMENTS Non-discounted cash flow methods * Payback period * Payback reciprocal * Payback bail-out period * Accounting rate of return Discounted cash flow methods * Net present value * Present value index (profitability index) * Annualized net present value or Equivalent annual annuity * Present value/discounted payback * Internal rate of return * Modified internal rate of return Methods that consider risk * Breakeven Cash Inflow * Risk-Adjusted Discount Rates * Certainty Equivalents * Simulation * Sensitivity and Scenario Analysis * Probability Trees I. Non-discounted cash flow techniques: A. Payback period (payoff/payout period) – measures the length of time required to recover the initial investment Decision rule: Accept if payback < required maximum payback Reject if payback > required maximum payback 1. Even cash flows Payback Period = Net Investment Annual CFAT 2. Uneven cash flows Payback Period = point where the cumulative cash flows equal the net investment Advantages: 1. easy to compute and understand 2. used to measure degree of risk associated with a project 3. generally, the longer the payback period, the higher the risk 4. used to select projects...
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... Chapter 1 The Overall Process Capital Expenditures Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase of new equipment, expansion of production facilities, buying another company, acquiring new technologies, launching a research & development program, etc., etc., etc. Capital expenditures often involve large cash outlays with major implications on the future values of the company. Additionally, once we commit to making a capital expenditure it is sometimes difficult to backout. Therefore, we need to carefully analyze and evaluate proposed capital expenditures. The Three Stages of Capital Budgeting Analysis Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. We are trying to answer the following question: Will the future benefits of this project be large enough to justify the investment given the risk involved? It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or...
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...University, Iceland Examiner: Dr. Rögnvaldur Sæmundsson Associate Professor, Reyjavík University, Iceland. ii Abstract The way companies value their investment opportunities has changed in recent years. With changing market conditions companies are constantly confronted with investment decisions that are increasingly uncertain. Known investment analysis such as net present value and decision tree analysis increasingly undervalue investment opportunities as they lack the flexibility and ability to modify projects when new information is available. A method based on financial option valuation has become the basis for a new technique to value high risk investment opportunities. It is based on valuation in the risk-neutral world and therefore eliminates investors’ attitude to risk. Real option analysis can capture the value of this increased flexibility, which previous methods have not been able to, such as the option to defer, abandon, expand or default a project. These options can be exercised when new information arrives and therefore provide an opportunity to put a floor on project loss. Use of binomial option pricing model gives managers a whole range of possibilities in analyzing the flexibility and to value the uncertainty in their investments. In this thesis the disadvantages of net present value and decision...
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...CAPITAL BUDGETING FOR MULTINATIONALS 13.1 INTRODUCTION Although the original decision to undertake an investment in a particular foreign country may be the outcome of combination of strategic, behavioural and economic considerations, choice of a specific project within a particular product-market posture calls for evaluation of its economic feasibility. For this purpose, capital budgeting exercise has to be done. A firm should deploy funds in a project if the marginal revenue obtained there from exceeds the marginal cost. For an MNC, capital budgeting involves economic analysis of the firm's direct investment opportunities. Whatever be the motive for Direct Foreign Investment (DFI), an MNC's very survival and sustainable competitive position depends on its ability to identify and choose the most profitable investment opportunity. Capital budgeting technique provides the mechanism to identify opportunities and evaluate their economic viability. This is why MNCs evaluate international projects by using capital budgeting techniques. Proper use of capital budgeting techniques can help the firm in identifying the international projects worthy of implementation from those that are not. 13.2 FUNDAMENTALS OF EVALUATING FOREIGN PROJECTS Once a firm has compiled a list of prospective investments, it uses capital budgeting techniques to select from among them that combination of projects that maximizes the firm's value to shareholders. The theoretical framework involved in evaluation...
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...techniques are used to evaluate possible investment opportunities and to determine which of these opportunities will generate the best return to the firm’s shareholders. Therefore, it is vital for the firm if they wish to continue receiving funds from shareholders to employ the best techniques available when analysing which investment opportunities will give the best return. There are two types of project appraisal techniques: non-discounted cash flows and discounted cash flows. The Net Present Value and internal rate of return, examples of discounted cash flows, are in use in many large corporations and regarded as more effective than the traditional techniques of payback and accounting rate of return. In this paper, I will examine the use of the Net Present Value, and the provisions it makes for specific cases, such as unequal lives and mutually exclusive projects. Then I will conclude with the technique that has been proved the best for investment appraisal through the analysis and comparison of project appraisal techniques. The Net Present Value (NPV) method is used by 75% of firms when deciding on investment projects. The reasons for its wide use is that firstly, the NPV rule takes into account the time value of money, meaning that it recognises that a pound today is worth more than a pound tomorrow as the pound today can be invested to start earning interest immediately. Secondly, NPV depends solely on the forecasted cash flows from the project and the opportunity cost...
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...on the risk of the investment 3. Provides a crude measure of liquidity Disadvantages 1. No concrete decision criteria to indicate whether an investment increases the firm's value 2. Ignores cash flows beyond the payback period 3. Ignores the time value of money 4. Ignores the risk of future cash flows Discounted Payback Period Advantages Disadvantages 1. No concrete decision criteria that indicate whether the investment increases the firm's 1. Considers the time value of money value 2. Considers the riskiness of the project's 2. Requires an estimate of the cost of capital in order to calculate the payback cash flows (through the cost of capital) 3. Ignores cash flows beyond the discounted payback period Net Present Value Advantages 1. Tells whether the investment will increase he firm's value 2. Considers all the cash flows 3. Considers the time value of money 4. Considers the risk of future cash flows (through the cost of capital) Disadvantages 1. Requires an estimate of the cost of capital in order to calculate the net present value. 2. Expressed in terms of dollars, not as a percentage. Profitability Index Advantages Disadvantages 1. Tells whether an investment increases the firm's value 1. Requires an estimate of the cost of capital in 2. Considers all cash flows of the project order to calculate the profitability index 3. Considers the time value of money 4. Considers the risk of future cash flows 2. May not give the...
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...ID 752. Chapter 1 The Overall Process Capital Expenditures Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase of new equipment, expansion of production facilities, buying another company, acquiring new technologies, launching a research & development program, etc., etc., etc. Capital expenditures often involve large cash outlays with major implications on the future values of the company. Additionally, once we commit to making a capital expenditure it is sometimes difficult to backout. Therefore, we need to carefully analyze and evaluate proposed capital expenditures. The Three Stages of Capital Budgeting Analysis Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. We are trying to answer the following question: Will the future benefits of this project be large enough to justify the investment given the risk involved? It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will...
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...long-term investments which produce a return equal to greater than the investments required rate of return. Thus, the purpose of this topic is to provide you with the knowledge and skills needed to identify, analyze and make capital or long-term investments (also known as Capital Budgeting) which are equal to or greater than the investments required rate of return. The Focus of this Topic The focus of this topic is for you to learn how to: 1. predict future cash flows from “ownership” investments, 2. calculate the present value of those cash flows, 3. compare the present value to the current purchase price of that investment, and 4. make an investment decision which attempts to maximize owner wealth. * While you can learn the steps in the process, it is important to remember that predicting future cash flows from ownership investments is difficult at best and depends on your ability to make reasonable and accurate assumptions about the future and how it will affect those cash flows. While numbers don’t “lie,” assumptions may, so keep in mind that your numbers are based your the accuracy of your underlying assumptions. * Ultimately, your job is to use your experience and judgment to make good assumptions about the investment’s future cash flows, and based on the assumptions and analysis, develop a course of action that allows you to maximize owner wealth. Independent Versus Mutually Exclusive Investments * Independent Investments (projects...
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...Pittsburgh Capital Budgeting: Investment Criteria BUSFIN 1030 Introduction to Finance Capital Budgeting Decisions Examples of decisions addressed: 1. What products should the firm sell? 2. In what markets should the firm compete? 3. What new products should the firm introduce? Roles of managers: 4. Identify and invest in products and business acquisitions that will maximize the current market value of equity. 5. Learn to identify which products will succeed and which will fail. The capital markets will send the firm signals about how well it is doing. Net Present Value (NPV) The net present value is the difference between the market value of an investment and its cost. [pic] NPV is a measure of the amount of market value created by undertaking an investment project. The interest rate, r, will reflect the risk of the cash flows. Finding the market value of the investment 6. Use discounted cash flow valuation (calculate present values). 7. Compute the present values of future cash flows Net Present Value Rule (NPV): An investment should be accepted if the net present value is positive and rejected if the net present value is negative. Positive NPV projects create shareholder value. Using NPV The marketing department of your firm is considering whether to invest in a new product. The costs associated with introducing this new product and the expected cash flows over the next four years...
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...Introduction Capital Budgeting is a process that allows businesses to assess whether their investment decisions like purchasing a new plant, constructing a new building, or engaging in a new venture is profitable enough to pursue. (Investopedia. 2015) When making crucial investment decisions, capital budgeting gives businesses a more informed way of deciding. This is because investment decisions are weighed in terms of the cash flows over the duration of the new venture or investment. This way, a company can have more visibility in terms of monitoring its cash flows for every period. Consequently, businesses can make an initial evaluation of pushing through a certain project or not. This is what makes capital budgeting very useful since companies...
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...Capital budgeting is a process that involves making of investment decision by company from one or a series of investment projects to identify the most worthwhile projects for undertaking. A company’s capital investment usually focuses:- • Expansion in existing market • Develop new products or entering new market • Purchase new building / plants • Replacement or improvement on existing equipment Capital budgeting decision is vital for any company because it always involved: • Large investment – capital budgeting decision usually involve large investment of funds but mostly there is a shortage of funds at every firm. Hence the funds and the resources need to be controlled by the firm • Irreversible nature- once the decision for acquiring a permanent assets is taken, it becomes very difficult to dispose of these assets with the incurring heavy cost • Long term effect on profitability- Not only the present earning of the firm is affected but the future growth and profitability also depend upon investment decision taken today, any unsound decision made can lead to a downfall tomorrow Capital budgeting is a complex process as it involved decision relating to the investment of current funds for the benefit to be achieved in the future but future is always uncertain. The 5 step process in capital budgeting decision is: I. Identified investment opportunities- investment proposal or projects normally was initiated by a firm’s management or staffs in line with the corporate...
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