Capital Investments Theory And Practice Notes

Lecture 2: Capital Investments (Theory and Practice) Summary * Introduction * Theory of capital investment decisions * Practice of capital investment decisions * The role of the institutional context Introduction * What are the key changes that occur when moving from short-term to long-term decisions? * Relevant costs and revenues change * More options and alternatives * Strategic considerations become prominent * Financial consequences of the decision are felt for many years and are usually irreversible * Need to consider the time value of money * Need to work under conditions of uncertainty * What has management accounting got to do with capital budgeting? * Information supply ? Financial and non-financial ? Ex-ante and ex-post ? Internal and external * Planning (decision making) for investment projects ? Ex-ante project selection * Control of investment projects ? Ex-post performance assessment, project audit Key Points * Short-term vs. long-term decisions * MA role in capital budgeting * Time value of money * WACC * Relevant cash flows * DCF/NPV valuation * Limitations of NPV * Capital rationing * Profitability index * IRR * Payback method * ROI/Accounting rate of return * Capital investment decisions * Institutions and capital investment decisions Definitions * Capital rationing = When capital is limited and the firm may be unable to undertake all available projects whose NPV>0 * Costs of financing = Cost of debt and equity implicitly included in the discount rate * External rationing = Limited ability to raise capital Theory of Capital Investment Decisions Time Value of Money * Internal rationing = budget ceilings * * Investments are thought of as time trade-offs ? Forgoing present wealth (consumption) to obtain greater future wealth (consumption) ? Investment appraisal = Evaluating consumption opportunities occurring at different points in time ? Use PV for comparability * Opportunity cost of capital = r ? Opportunity cost of capital = minimum acceptable rate of return (the hurdle rate) ? The return that could be expected from alternative projects of comparable risk Determining the opportunity cost of capital ? External funding sees r as the cost of borrowing ? Internal + external funding: sees r as WACC ? WACC = Weighted average cost of debt and equity capital * Investment appraisal = Evaluating consumption opportunities occurring at different points in time * NPV = Amount by which a project's return exceeds required rate of return r i.e. the increase in shareholders' wealth * Opportunity cost of capital = minimum acceptable rate of return (the hurdle rate) * Sunk costs = costs already incurred, do not change among alternatives * WACC = Weighted average cost of debt and equity capital Formulae * # # Depends on: ? Capital structure? Relevant Cash Flows * We must consider which cash flows are relevant to the capital investment decision * What are the relevant cash flows? ? We focus on cash # 'Undo' the effects of accruals accounting ? e.g. depreciation # Only cash can be investment ? Find incremental cash flows # Future CF with project vs. without project ? Consider opportunity costs # No cash effects # Cash forgone for not undertaking the next best alternatives ? We ignore sunk costs # Sunk costs = costs already incurred, do not change among alternatives ? We ignore costs of financing # Costs of financing = Cost of debt and equity implicitly included in the discount rate Example demonstrating relevant cash flows vs. irrelevant cash flows Course Notes Page 7 * * * ARR = Income / Investment 

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