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Long Term Investment Decisions

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					Long-Term Investment
      Decisions
IMPORTANCE OF LONG-TERM
INVESTMENT ANALYSIS

   Commitment of large amounts of resources

   Long period of risk
       Capital assets often mean technological risk
       Strategic considerations
       Exit barriers

•   Time value of money considerations
    •   Important analytical tool
    •   Not the primary consideration of analysis
 LONG-TERM INVESTMENT ANALYSIS
 VS. CAPITAL BUDGETING
                   “Capital Budgeting”

  Planning for long-term investment decisions regarding
    capital assets (facilities) including considerations
                for financing the investment

            “Long-term Investment Analysis”

Planning for ALL TYPES of long-term investment decisions,
    regardless of whether capital assets are involved

The major difference is that long-term investment analysis
         is a broader “strategic” consideration
             CAPITAL INVESTMENT
              DECISION MODELS

   Non-discounted cash flow models
     Payback period
     Accounting rate of return



   Discounted cash flow models
     Internalrate of return
     Net present value
                  PAYBACK METHOD

   Payback period = length of time needed to recover
    the initial investment in the asset



                Cash outflow for investment
                  Annual net cash benefit
                 PAYBACK METHOD
   Possible reasons for use:
       Help evaluate risks associated with uncertain future
        cash flows
       Minimize impact of an investment on liquidity
       Help control risk of obsolescence
       Relatively simple

   Limitations
       Ignores time value of money
       Ignores total profitability of the project
            NET PRESENT VALUE
                  (NPV)
          Net Present Value =
 PV Cash Inflows -  PV Cash Outflows



This model is the most widely recommended
approach to capital budgeting since it specifically
considers the time value of money and provides
a basis for valuing the firm
                  NET PRESENT VALUE
                        (NPV)
   Decision criteria:
       If NPV > 0, a return in excess of the cost of capital
        has been earned, and the project is acceptable
       If NPV < 0, a return less than the cost of capital has
        been earned, and the project is unacceptable

   Reinvestment assumption
    All cash flows generated by the project are immediately
       reinvested at the cost of capital
               COST OF CAPITAL
   The weighted average of the returns expected
    by the different parties contributing funds (debt
    and equity). The weights are determined by the
    proportion of funds provided by each source.



      It is sometimes known as the
               “hurdle rate.”
        INTERNAL RATE OF RETURN
                  (IRR)

 Theinterest rate that results in the
 present values of the cash outflows
 equaling the present value of the
 cash inflows.
GIVEN THE (PERIOD, CASH FLOW) PAIRS (N, CN)
WHERE N IS A POSITIVE INTEGER, THE TOTAL
NUMBER OF PERIODS N, AND THE NET PRESENT
VALUE NPV, THE INTERNAL RATE OF RETURN IS
GIVEN BY R IN:
              INTERNAL RATE OF RETURN
                        (IRR)
   Decision criteria:
       If the IRR > Cost of capital, the project is acceptable
       If the IRR < Cost of capital, the project is not
        acceptable


   Reinvestment assumption
    Cash inflows from the project are immediately
      reinvested to earn the IRR
DISCOUNTED CASH FLOW ANALYSIS
   Strengths
       Time value of money is considered
       Incorporation of financing costs
   Limitations
       Accuracy of cash flow projections
       Possible misapplications of DCF analysis
       Ability to determine “cost of capital”
       Difficulty of estimating opportunity costs
       Lack of integration of qualitative factors
            DISCOUNTED CASH FLOWS
                SPECIFIC ITEMS
   Initial and subsequent investments
   Taxable cash flows
       Revenues
       Expenses
   Deductible noncash expenses (Depreciation, etc.)
   Residual (salvage) values
       Existing assets
       Assets at termination of project
       Tax considerations (gains or losses)
   Working capital investments
                  AFTER-TAX CASH FLOWS
   Rule for taxable cash benefits
    (1-tax rate) x cash receipt = After-tax cash flow
    Example: Increased sales or reduced costs

   Rule for taxable cash expenses
    (1-tax rate) x cash payment = After-tax cash flow
    Example: Labor costs

   Rule for tax shield for noncash expenses
    (tax rate) x noncash expense = tax shield (cash inflow)
    Example: Depreciation on equipment
                 AFTER-TAX CASH FLOWS
                      CONTINUED
   Rule for sale of assets

       Proceeds from sale (+/-) Tax book value =
           Taxable gain/loss

       Taxable gain/loss x Tax rate = Net tax effect

       Proceeds from sale (+/-) Net tax effect =
            Net cash flow from sale of asset
Strategic
Considerations
JUSTIFYING CAPITAL EXPENDITURES IN A NEW
      MANUFACTURING ENVIRONMENT




 CAD/CAM
       CAPITAL EXPENDITURES IN A NEW
        MANUFACTURING ENVIRONMENT


      Traditional investment analysis tools
    may not be adequate to make these type
    decisions. The day-to-day operating
    impact (tactical) may not be the key factor
    in making a decision. Less tangible
    benefits may be the deciding factor in
    whether or not to invest in new
    technology.
          EXAMPLES OF INTANGIBLES
   Competitive advantage
       Producing a product or providing a service that
        competitors cannot
   Quality
       Improving the quality of a product by reducing the
        potential to make mistakes
   Process simplification
       Enhanced production capabilities
   Reduced time to produce
       Reducing the cycle time needed to make a product or
        provide a service
CAPITAL INVESTMENT DECISIONS HAVE
        POTENTIAL PITFALLS
                WHAT TO DO?

 Consider the opportunity cost of not making an
  investment
 Give full consideration to costs that may be
  hidden
 Don’t set the barriers to strategic investment
  too high
FIND THE HIDDEN COSTS




            warranty           Cost of
             costs              faulty
                             assumptions




                  Training
                   costs
        POST-IMPLEMENTATION AUDITS


   An opportunity to re-evaluate a past decision to
    purchase a long-term asset by comparing
    expected and actual inflows and outflows
      POST-IMPLEMENTATION AUDITS
               BENEFITS

By comparing estimates with results, planners
can determine why their estimates were
incorrect and can avoid making the same
mistakes in the future
Rewards   can be given to those who make good
capital budgeting decisions
Ifthe audit is not done, there are no controls
on planners who might be tempted to inflate the
benefits in order to get their projects approved
DON’T THROW GOOD MONEY AFTER
BAD
            BIBLIOGRAPHY
PRINCIPLE OF MANAGERIAL FINANCE – LAWRENCE J. GITMAN

        FINANCIAL MANAGEMENT – I.M. PANDEY

FUNDAMENTALS OF FINANCIAL MANAGEMENT – R.P.RUSTAGI