Lecture 2: Capital Investments (Theory and Practice)
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
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
