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Investment Decisions
Investments are major decisions that have longterm consequences beyond current consumption.
Two effects of time on a decision and its outcomes distinguish an investment decision: 1. The decision commits resources for a lengthy period of time, and this commitment usually prevents taking another future opportunity 2. Managements flexibility to modify an investment as time and information unfold can affect alternative decisions.
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Learning Objective 1
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Strategic Investments
A strategic investment is a choice among alternative courses of action and the allocation of resources to those alternatives most likely to succeed after considering . . . 1) changes in natural, social, and economic conditions, and 2) actions of competitors.
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Learning Objective 2
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Group brainstorming methods and decision-support software may help identify the range of future events.
News, government, foundation, and industry analyses can be excellent sources of the likeliness of future events.
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Forecasts the effects of a likely change in each future, relevant event on investment outcomes.
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Internal Information
Sources and Usefulness of Internal Information
Internal information Effect of future events on investment costs and benefits Organization's financial records Account or regression analysis of financial records might be useful to predict costs or benefits if expected future activities are similar to recent experience. Interviews with knowledgeable individuals Consultants can bring knowledge of other organizations' experiences with similar events. Company personnel can apply others' experiences and perform engineering analysis to predict costs and benefits. Publicly available information Descriptions of other organizations' experiences with similar events can be helpful for predicting future costs and benefits.
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A method of comparing alternative investments Combines estimates of present and future cash outflows and inflows associated with each investment Discounts the cash flows to account for the opportunity costs of committing funds Differs from payback period methods:
DCF Includes all cash flows throughout the life of the investment DCF always discounts the cash flows
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3) Cash flows from termination of investment Next, an illustration of these cash flows, courtesy of ShadeTree Roasters.
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$40,000
40% 8%
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Assume that cash flows are the same in each year. Note that depreciation expense is used only to estimate the tax savings. The expense itself is not a cash flow. These net cash flows must be discounted to get the investments net present value.
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The discount rate is an estimate of the opportunity cost of making this investment instead of some other. If the rate chosen is too high, some profitable investments will be rejected. If the rate chosen is too low, some marginal investments will be approved too easily. Suggested discount rates:
A risk-free rate (e.g., Treasury bond rate) Long-term market return on equities The rate chosen should allow for price inflation
(1+r)^(-n)
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$10,000
$10,000
$10,000
Cash to be received in the future has a cost. Alternative investments and price inflation reduce the value of those cash flows in current monetary terms (present value). That is why the cash flows are discounted, normally using a constant discount rate.
Assume annual cash flows of $10,000 and a discount rate of 8%. Every dollar received one year from now has a present value of ($1)*(1.08-1)=$0.926. After two years a dollar has a present value of $0.857.
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Compute the present value of each cash inflow and outflow. Sum all the present values to get the net present value (NPV). If the NPV of the investment is greater than zero, the project promises returns greater than the opportunity rate. The next slide calculates the NPV of the ShadeTree Roasters investment proposal.
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So do we go ahead?
I vote Yes!
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Payback Period
Managers may want to know how soon they will recover an initial investment. This method counts the time that will pass before the projected cash inflows equal the initial cash expenditure. The payback period method complements the discounted cash flow method, though the result may be different. In the ShadeTree Roasters example:
Divide the initial investment of $200,000 by the annual contribution margin of $62,000. The payback period is 3.23 years. Often the cash flows are not discounted.
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This percentage is calculated together with the investments net present value. An investments IRR is the discount rate that would create an NPV of zero for the investment. So, if the NPV is greater than zero, then the IRR will be greater than the discount rate. In the case of ShadeTree Roasters, the proposed investment would have an IRR of 9.2%, higher than the required return of 8%.
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Learning Objective 3
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=NPV(.08,F15:N15)+D15
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The major competitor does not enter the market until the second year.
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=NPV(.08,F15:N15)+D15
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$ $
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All other information remains the same. Lets look at our analysis now.
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Learning Objective 4
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Learning Objective 5
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E[NPV, expand now] = [$(4,093,138) .40] + [$2,925,012 .60] E[NPV, expand now] = $117,752
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$1,571,252
If ShadeTree expands one nowyear and Postpone continues operations, Expand now we calculate the expected net Expected value of waiting present value to be:
$ 1,571,252 117,752 $ 1,453,500
$117,752
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Learning Objective 6
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Such acts are designed to discourage companies from illegally obtaining information about the intentions of competitors.
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o Codes of ethics -- educate and support employees who want to behave ethically.
o Internal audits -- examinations of operations, programs, and financial results performed by independent investigators.
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End of Chapter 14
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