Investment Decisions

• Relevant Cash Flows for NPV Analysis

  A) Disposal

  B) Tax

  C) Disposal

  D) Investment

  E) Working Capital

  F) Revenue

  G) Costs

  H) EBIT

  I) CF

  J) Disposal

  K) Working Capital

  
• Relevant Cash Flow Rules for Investment

  1. Undo effects of accrual accounting (e.g. depreciation)
  2. Find relevant cash flows
  3. Consider opportunity costs
  4. Ignore sunk costs
  5. Ignore the costs of financing
• Examples of Relevant Flows include Disposal Value, cash flows from Operations, Tax Effects and Opportunity Costs of Replacement
• Examples of Irrelevant Flows include Net Book Values, Depreciation and Revenues (if they are the same for both alternatives)
• One key issue with overlooking long-term benefits is that managers will prefer to choose projects that are more profitable in the short term, in the interest of personal ambitions (bonuses or promotions) since their performance is evaluated yearly.
• New technologies and innovation often appear unfavourable if analysed only through financial lenses:

  • There is a failure to identify alternatives correctly.
  • Managers tend to favour incrementalism, taking on many small projects rather than taking on the risk of one large project. This is largely due to too much weight given to the concern of short-term productivity declines, which overlooks potential long-term investments.
  • Many benefits can be intangible at the time of the appraisal of innovation.
  • Historically, excessive discount rates have been applied, overlooking long-term benefits.
• Qualitative factors that need to be considered when investing include:

  • Flexibility - can the investment adapt to complex/different products
• Qualitative factors that need to be considered when investing include:

  • Quality - are more complex investments increasing customer value (significant if manual customisation is a key source of competitiveness)
• Qualitative factors that need to be considered when investing include:

  • Pursued Strategy - is the investment aligned with the company’s strategy (e.g. cost leadership vs product differentiation)
• Qualitative factors that need to be considered when investing include:

  • Labour & Skills - how quickly can workers learn to use the new capital
• Qualitative factors that need to be considered when investing include:

  • Supply Chain - will investing in a new production process make the company more reliant on their customers?
• Net Present Value is the amount by which a project’s return exceeds the required rate of return.
• Internal Rate of Return is the discount rate at which the net present value of a project is equal to zero.
• The Payback Period Method is the time needed to recover the initial investment
• The riskier the investment, the shorter the required Payback Period is
• An advantage of NPV is that it takes the size of the project into account
• An advantage of NPV is that it can be used even if different discount rates are used in different time periods
• A disadvantage of NPV is that it depends on setting an arbitrary required rate
• An advantage of IRR is that it does not depend on setting an arbitrary required rate
• A disadvantage of IRR is that it does not capture the size of the project
• A disadvantage of IRR is that it becomes ambiguous if r changes over time
• Payback Period = Net initial investment / Annual increase in CFs
• An advantage of the Payback Period is that it is easy to understand
• An advantage of the Payback Period is that it is useful if distant cash flows are highly uncertain
• A disadvantage of the Payback Period is that the cutoff point is an arbitrary value
• A disadvantage of the Payback Period is that the Time Value of Money & Opportunity Cost of Capital are ignored
• A disadvantage of the Payback Period is that it ignores cash flows beyond t* (only works for short term projects)
• Accounting Rate of Return = Operating Profit / Investment
• An advantage of ARR is that it is based on readily available information (financial statements)
• An advantage of ARR is that it allows managers to see how investments will affect future accounting results
• A disadvantage of ARR is that it is affected by chosen accounting methods (e.g. depreciation)
• A disadvantage of ARR is that it ignores the size of the project