Topic 9

• Capital budgeting


  The process of making investment decisions for major, long-term projects
• Disney's capital budgeting decision

  • Investing $17.5 million to build Disneyland park in California in 1955
• Capital budgeting decisions

  • They are critical in defining a company's business
  • They frequently consist of smaller investment decisions that define a business strategy
  • Successful investment decisions lead to the development of managerial expertise and capabilities that influence the firm's choice of future investments
• Typical capital budgeting process

  1. Phase I: The firm's management identifies promising investment opportunities

  2. Phase II: The investment opportunity's value-creating potential is thoroughly evaluated
• Types of capital investment projects

  • Revenue enhancing investments (such as introducing a new product line)
  • Cost-reducing investments (such as replacing old equipment with more efficient equipment)
  • Mandatory investments that are a result of government mandates (such as investments to meet safety and environmental regulations)
• Net present value (NPV)


  The difference between the present value of cash inflows and the cash outflows. NPV estimates the amount of wealth that the project creates.
• NPV decision criteria

  Investment projects should be accepted if the NPV of the project is positive and should be rejected if the NPV is negative
• Calculating an investment's NPV

  1. Cash flow for Year 1

  2. Cash flow for Year 2

  3. Cash flow for Year n

  4. Cash flow for Year 0

  5. Net present value
• Profitability index (PI)

  A cost-benefit ratio equal to the present value of an investment's future cash flows divided by its initial cost
• PI decision criteria

  If PI is greater than one, the NPV will be positive and the investment should be accepted<|>When PI is less than one, which indicates a bad investment, NPV will be negative and the project should be rejected
• Internal rate of return (IRR)


  The discount rate that results in a zero NPV for the project
• IRR decision criteria

  Accept the project if the IRR is greater than the required rate of return or discount rate used to calculate the net present value of the project and reject it otherwise
• Payback period


  The number of years needed to recover the initial cash outlay required to make the investment
• Limitations of payback period

  • It ignores the time value of money
  • It ignores cash flows that are generated by the project beyond the end of the payback period
  • It utilizes an arbitrary cutoff criteria
• Internal Rate of Return (IRR)


  The discount rate that makes the NPV equal to zero
• Payback Period


  The number of years required to recover the initial cash outlay out of project future cash flows
• Limitations of Payback Period Criterion

  • It ignores the time value of money
  • It ignores cash flows that are generated by the project beyond the end of the payback period
  • It utilizes an arbitrary cutoff criterion
• Discounted Payback Period

  The number of years required to recover the initial cash outlay out of project discounted future cash flows
• Net Present Value (NPV)

  The present value of expected cash inflows minus the present value of expected cash outflows
• Profitability Index (PI)

  The present value of expected future cash flows divided by the initial cash investment
• The Wealth of Nations was written in 1776
• When analysing markets, a range of assumptions are made about the rationality of economic agents involved in the transactions
• Rational


  (in classical economic theory) economic agents are able to consider the outcome of their choices and recognise the net benefits of each one
• Rational agents will select the choice which presents the highest benefits
• Producers act rationally by

  Selling goods/services in a way that maximises their profits
• Workers act rationally by

  Balancing welfare at work with consideration of both pay and benefits
• Marginal utility

  The additional utility (satisfaction) gained from the consumption of an additional product
• If you add up marginal utility for each unit you get total utility
• Polymers


  Molecules made from a large number of monomers joined together in a chain
• Synthetic polymers

  • nylon
  • polyethylene
  • polyester
  • Teflon
  • epoxy
• Enzymes

  • They increase the rate of chemical reactions without themselves being consumed or permanently altered by the reaction
  • They increase reaction rates without altering the chemical equilibrium between reactants and products
• As temperature increases

  The rate of reaction increases
• Romelo's Restaurants is considering a project with the following expected cash flows:
• Calculate the project's NPV, Profit Index and Discounted Payback Period
• NPV = −$150m + $90m/(1.12) + $70m/(1.12)2 + $90m/(1.12)3 + $100m/(1.12)4
• NPV = −$150,000,000 + $80,357,143 + $55,803,571+ $64,060,222 + $63,551,808
• NPV = $113,772,744
• P.I = Present Value of Future Cash Flows / Initial Outlays
• P.I = $263,772,744 / $150,000,000
• P.I = 1.76