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Capital Investments Theory And Practice Notes

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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

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* ARR = Income / Investment

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