Investment decisions /Corporate

strategy & high technology

investments.
1

UNIT I STRATEGIC FINANCIAL MGT

 Investment decisions
2

Capital budgeting is vital in marketing decisions.

 Decisions on investment, which take time to mature,
have to be based on the returns which that
investment will make.
Unless the project is for social reasons only, if the
investment is unprofitable in the long run, it is
unwise to invest in it now.
 Chapter objectives

This chapter is intended to provide:

· An understanding of the importance of capital budgeting
in marketing decision making
· An explanation of the different types of investment project
· An introduction to the economic evaluation of investment
proposals
· The importance of the concept and calculation of net
present value and internal rate of return in decision making
· The advantages and disadvantages of the payback method
as a technique for initial screening of two or more
competing projects
 Capital budgeting versus current expenditures

A capital investment project can be distinguished

from current expenditures by two features:
a) such projects are relatively large
b) a significant period of time (more than one year)
elapses between the investment outlay and the
receipt of the benefits..
 A systematic approach to capital budgeting
5

a) the formulation of long-term goals

b) the creative search for and identification of new
investment opportunities
c) classification of projects and recognition of
economically and/or statistically dependent
proposals
d) the estimation and forecasting of current and
future cash flows
 Cont…
6

e) a suitable administrative framework capable of

transferring the required information to the decision
level
f) the controlling of expenditures and careful
monitoring of crucial aspects of project execution
g) a set of decision rules which can differentiate
acceptable from unacceptable alternatives is
required.
The last point (g) is crucial and this is the subject of
later sections of the chapter.
 The classification of investment projects

a) By project size

Small projects may be approved by departmental
managers. More careful analysis and Board of
Directors' approval is needed for large projects of,
say, half a million dollars or more.
 The classification of investment projects
8

b) By type of benefit to the firm

· an increase in cash flow
· a decrease in risk
· an indirect benefit (showers for workers, etc).
 The classification of investment projects
9

c) By degree of dependence

· mutually exclusive projects (can execute project A
or B, but not both)
· complementary projects: taking project A increases
the cash flow of project B.
· substitute projects: taking project A decreases the
cash flow of project B.
 The classification of investment projects
10

d) By degree of statistical dependence

· Positive dependence
· Negative dependence
· Statistical independence.
 The classification of investment projects
11

e) By type of cash flow

· Conventional cash flow: only one change in the
cash flow sign
e.g. -/++++ or +/----, etc
· Non-conventional cash flows: more than one
change in the cash flow sign,
e.g. +/-/+++ or -/+/-/++++, etc.
 The economic evaluation of investment proposals

12

The analysis stipulates a decision rule for:

I) accepting or
II) rejecting
 Investment projects
13

The time value of money

Recall that the interaction of lenders with borrowers
sets an equilibrium rate of interest. Borrowing is
only worthwhile if the return on the loan exceeds the
cost of the borrowed funds. Lending is only
worthwhile if the return is at least equal to that
which can be obtained from alternative opportunities
in the same risk class.
 The interest rate received by the
lender is made up of:
14

i) The time value of money: the receipt of money is preferred

sooner rather than later. Money can be used to earn more money.
The earlier the money is received, the greater the potential for
increasing wealth. Thus, to forego the use of money, you must get
some compensation.
ii) The risk of the capital sum not being repaid. This
uncertainty requires a premium as a hedge against the risk, hence
the return must be commensurate with the risk being undertaken.
iii) Inflation: money may lose its purchasing power over time.
The lender must be compensated for the declining
spending/purchasing power of money. If the lender receives no
compensation, he/she will be worse off when the loan is repaid
than at the time of lending the money.
 PV / NPV
15

Exercise Present value

i) What is the present value of $11.00 at the end of one year?
ii) What is the PV of $16.10 at the end of 5 years?
b) Net present value (NPV)
The NPV method is used for evaluating the desirability of investments or projects.
where:
Ct = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on investment
n = the project/investment's duration in years.
The discount factor r can be calculated using:
Decision rule:
If NPV is positive (+): accept the project
If NPV is negative(-): reject the project
 NPV (eg )
16

Year
 Cash Flow ($)

0
 $ 800
1$400

2 $400

3 $400

400

PV = $400(0.9091) + $400(0.8264) + $400(0.7513)

= $363.64 + $330.56 + $300.52

= $994.72

NPV = $994.72 - $800.00

= $194.72

 IRR
17

) The internal rate of return (IRR)

Refer students to the tables in any recognised published source.
· The IRR is the discount rate at which the NPV for a project equals
zero. This rate means that the present value of the cash inflows for the
project would equal the present value of its outflows.
· The IRR is the break-even discount rate.
· The IRR is found by trial and error.
where r = IRR
IRR of an annuity:
where:
Q (n,r) is the discount factor
Io is the initial outlay
C is the uniform annual receipt (C1 = C2 =....= Cn).
 IRR
18

Example:
What is the IRR of an equal annual income of $20
per annum which accrues for 7 years and costs $120?
= 6
From the tables = 4%
Economic rationale for IRR:
If IRR exceeds cost of capital, project is worthwhile,
i.e. it is profitable to undertake.
 19

Find the IRR of this project for a firm with a 20%

cost of capital:
YEAR CASH FLOW

0 10000
1 8000
2 6000
a) Try 20%
b) Try 27%
c) Try 29%
 Net present value vs internal rate of return

20

Independent vs dependent projects

NPV and IRR methods are closely related because:
i) both are time-adjusted measures of profitability,
and
ii) their mathematical formulas are almost identical.
 a) NPV vs IRR: Independent projects

21

Independent a project: Selecting one project does

not preclude the choosing of the other.
With conventional cash flows (-|+|+) no conflict in
decision arises; in this case both NPV and IRR lead
to the same accept/reject decisions.
 b) NPV vs IRR: Dependent projects

22

Agritex is considering building either a one-storey (Project

A) or five-storey (Project B) block of offices on a prime
site. The following information is available:
Initial Investment Outlay /Net Inflow at the Year
End
Project A -9,500 11,500

Project B -15,000 18,000

Assume k = 10%, which project should Agritex undertake?

 The payback period (PP)

23

The CIMA defines payback as 'the time it takes the

cash inflows from a capital investment project to
equal the cash outflows, usually expressed in years'.
When deciding between two or more competing
projects, the usual decision is to accept the one with
the shortest payback.
 Disadvantages of the payback method:

24

· It ignores the timing of cash flows within the payback period,

the cash flows after the end of payback period and therefore
the total project return.
· It ignores the time value of money. This means that it does
not take into account the fact that $1 today is worth more than
$1 in one year's time. An investor who has $1 today can either
consume it immediately or alternatively can invest it at the
prevailing interest rate, say 30%, to get a return of $1.30 in a
year's time.
· It is unable to distinguish between projects with the same
payback period.
· It may lead to excessive investment in short-term projects.
 Advantages of the payback method:

25

· Payback can be important: long payback means

capital tied up and high investment risk. The method
also has the advantage that it involves a quick,
simple calculation and an easily understood concept.
 The accounting rate of return - (ARR)

26

The ARR method (also called the return on capital

employed (ROCE) or the return on investment (ROI)
method) of appraising a capital project is to estimate
the accounting rate of return that the project should
yield. If it exceeds a target rate of return, the project
will be undertaken.
Note that net annual profit excludes depreciation.
 Disadvantages:

27

· It does not take account of the timing of the profits

from an investment.
· It implicitly assumes stable cash receipts over time.
· It is based on accounting profits and not cash flows.
Accounting profits are subject to a number of different
accounting treatments.
· It is a relative measure rather than an absolute measure
and hence takes no account of the size of the investment.
· It takes no account of the length of the project.
· it ignores the time value of money.
 The payback and ARR methods in practice

28

· It is a particularly useful approach for ranking projects where a

firm faces liquidity constraints and requires fast repayment of
investments.
· It is appropriate in situations where risky investments are made in
uncertain markets that are subject to fast design and product
changes or where future cash flows are particularly difficult to
predict.
· The method is often used in conjunction with NPV or IRR method
and acts as a first screening device to identify projects which are
worthy of further investigation.
· it is easily understood by all levels of management.
· It provides an important summary method: how quickly will the
initial investment be recouped?
 What Does Sensitivity Analysis Mean?
29

 

A technique used to determine how different values of an
independent variable will impact a particular
dependent variable under a given set of assumptions. This
technique is used within specific boundaries that will depend
on one or more input variables, such as the effect that
changes in interest rates will have on a bond's price.

Sensitivity analysis is a way to predict the outcome of a

decision if a situation turns out to be different compared to
the key prediction(s).
 Sensitivity analysis
30

Sensitivity analysis is very useful when attempting to

determine the impact the actual outcome of a
particular variable will have if it differs from what
was previously assumed. By creating a given set
of scenarios, the analyst can determine how
changes in one variable(s) will impact
the target variable. 
 SIMULATION METHOD

31

Monte Carlo methods (or Monte Carlo

experiments) are a class of computational
algorithms that rely on repeated random sampling to
compute their results. Monte Carlo methods are often
used in simulating physical and mathematical
systems. Because of their reliance on repeated
computation of random or pseudo-random numbers,
these methods are most suited to calculation by a
computer and tend to be used when it is unfeasible or
impossible to compute an exact result with a
deterministic algorithm.[1]
32