Strategic Issues In Making Investments Decisions

1. 14 Strategic Issues In Making Investments Decisions

2. Investment Decisions Investments are major decisions that have long-term consequences beyond current consumption. • Two effects of time on a decision and its outcomes distinguish an investment decision: • The decision commits resources for a lengthy period of time, and this commitment usually prevents taking another future opportunity • Management’s flexibility to modify an investment as time and information unfold can affect alternative decisions.

3. Learning Objective 1

4. 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 . . . • changes in natural, social, and economic conditions, and • actions of competitors.

5. Learning Objective 2

6. Group brainstorming methods and decision-support software may help identify the range of future events. Information about External Events Sources and Usefulness of External Information

7. Likelihood of Future Events’ Occurrence Sensitivity AnalysisForecasts the effects of a likely change in each future, relevant event on investment outcomes. Scenario AnalysisForecasts the effects of likely combinations of future events on investment outcomes. Expected Value AnalysisSummarizes the combined effects of relevant future events on decision outcomes, weighted by the probability or odds of the events’ occurrence.

8. ExpectedMarketGrowth = (8% × .30) + (4% × .40) + (2% × .30) Expected Value Analysis The management of Matrix, Inc. is in the process of accessing the probability of market growth for their product. The following consensus has been reached: E[market growth] = 2.4% + 1.6% + .6% = 4.6%

9. Internal Information Sources and Usefulness of Internal Information

10. Discounted Cash Flow Analysis • 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 DCF

11. Investment Cash Flows Estimate separately 3 types of cash flows: • Investment cash flows • Asset acquisition (and disposal of old asset) • Tax effect from disposal of old asset • Tax credit arising from the new acquisition • Periodic operating cash flows • Receipts from operations • Cost savings that occur (including tax savings) • Operating expenses • Cash flows from termination of investment Next, an illustration of these cash flows, courtesy of ShadeTree Roasters. DCF

12. Investment Cash Flows • The entire purchase is made in cash at the end of year 0 (i.e. at start of the investment period) • The equipment will be depreciated by the straight-line method over 4 years, and there are no salvage values • Operating income will increase because of higher sales and savings in energy costs • Income tax rate is • 40% (for effect of • depreciation) • Future cash flows • are discounted at • 8% per year

13. Investment Cash Flows • 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 • investment’s net present value.

14. Choice of a Discount Rate % • 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 DCF (1+r)^(-n)

15. Discounting Future Cash Flows $10,000$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.

16. Net Present Value • 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. DCF

17. Net Present Value The proposal estimates an NPV of $5,352. So the present value of the net cash inflows during four years exceeds the $200,000 initial investment. I vote Yes! So do we go ahead?

18. 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. DCF

19. Internal Rate of Return • This percentage is calculated together with the investment’s net present value. • An investment’s 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%. I R R

20. Learning Objective 3

21. Forecasts of Investment Information The management of ShadeTree Roasters has gathered the following information concerning a potential investment.

22. $50,000,000 × 1.046 = $52,300,000 $10,460,000 × 35% = $3,661,000 Forecasts of Investment Information Forecast and Net Present Value – No Major Competitor

23. $699,000 × 40% = $279,600 Forecasts of Investment Information Forecast and Net Present Value – No Major Competitor

24. Forecasts of Investment Information Forecast and Net Present Value – No Major Competitor =NPV(.08,F15:N15)+D15

25. The major competitor does not enterthe market until the second year. Forecasts of Investment Information Forecast and Net Present Value – With Major Competitor

26. Forecasts of Investment Information Forecast and Net Present Value – With Major Competitor =NPV(.08,F15:N15)+D15

27. Expected Value Analysis Decision Tree

28. Value of Deferring Irreversible Decisions Let’s assume that ShadeTree Roasters wants to consider waiting one year to see if its major competitor decides to enter the market.All other information remains the same. Let’s look at our analysis now.

29. Wait One Year, With No Major Competitor

30. Learning Objective 4

31. Wait One Year, With a Major Competitor

32. ($0 × .40) + ($2,618,754 × .60) = $1,571,252 Defer Decision One Year

33. Value of the Option to Wait Under common investment conditions, the net present value that we calculated in our analysis is incorrect. We did not consider the situation where ShadeTree entered the market but terminated the project after one year when a major competitor may enter the same market. Though ShadeTree would not recover its investment (which is a sunk cost), it may be less costly to terminate after one year than to continue operations in the market. This analysis is referred to as real option value.

34. Learning Objective 5

35. Real Option Value Decision Tree E[NPV, expand now] = [$(4,093,138) × .40] + [$2,925,012 × .60] E[NPV, expand now] = $117,752

36. Value of the Option to Wait If ShadeTree postpones its decision to expand for one year and then expands into the new market, we calculate the expected net present value to be:$1,571,252 If ShadeTree expands now and continues operations, we calculate the expected net present value to be:$117,752

37. Learning Objective 6

38. Legal and Ethical Issues in Strategic Investment Analysis Trade unions, regulators, investors, non-government organizations and some business executives have succeeded in influencing United States laws and recent Organisation for Economic Cooperation and Development guidelines that prohibit bribery and other corrupt practices by multination companies. Such acts are designed to discourage companies from illegally obtaining information about the intentions of competitors.

39. Internal Ethical Pressures • Bias from personal commitment to an investment project. • Fear of loss of prestige, position, or compensation from a failed investment. • Greed and intentional behavior to defraud an organization or its stakeholders.

40. Role of Internal Controls and Audits • Hiring practices -- performing background and reference checks. • Investment reporting and reviews -- periodic progress reporting to see if the investment is meeting stated goals. • Codes of ethics -- educate and support employees who want to behave ethically. • Internal audits -- examinations of operations, programs, and financial results performed by independent investigators.

41. End of Chapter 14