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## PowerPoint Slideshow about 'Valuation of Capital Investments' - johana

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Capital Investments

- Like common stock cash flows, payments from investments in capital are not determined
- Investments are the foremost decision of the management of the firm
- The firm’s investment decisions should maximize shareholders’ wealth

Investment Decision Rules

- Discussion based on Chapter 6 (not assigned)
- Corporate practice is not always good practice and some common rules are wrong
- Payback period = time to recover investment, e.g $100 tool saving $50/year has two-year payback period
- Average (accounting) return = Average Income/Average investment, e.g $50/year income and $100 tool with two year life implies $50/(($100+0)/2 = 100% return

Payback Period andAverage Accounting Return

- Payback period ignores future cash flows with possibly large present value. We can see the effect of this in the “Simple Present Value Factors”
- Timing of cash flows critical in present value analysis
- Accounting rate of return does not consider timing of cash flows at all

Investment Valuations in Finance

- Estimate future cash flows and current costs
- Choose a discount rate or calculate internal rate of return
- Accept project if net present value > 0 or internal rate > hurdle rate
- Other criteria (payback period, average accounting return) are wrong
- Use of net present value recommended

Internal Rate of Return

- Internal rate of return (IRR) is that discount rate which make NPV = 0
- Tricky in application, users must be wary of problems in computation and interpretation
- Assumptions make IRR dangerous
- Mathematical properties make interpretation of IRR hard or impossible
- Net present value is the best method to evaluate investments

Capital Budgeting impliesLimitated Funds for Investment

- Why are funds limited?
- What is suggested if NPV > 0 projects are rejected?
- What is real corporate world like and what does that suggest about project screening?
- Profitability index can be useful:

Objective is to Maximize Value

- PI > 1 means NPV > 0
- Initial Investment*(PI-1) = NPV since NPV=PVCF – C dividing each side by C
- Rank PIs and take maximum combination of NPVs withing budget constraint
- Easily programmed for large-firm administration

Maximizing NPV using PIs withCapital Budgeting

- Assume capital budget of $10 million
- Have six projects as follows:
- Project Cost PI
- A $2 Million 1.5
- B 4 “ 1.4
- C 5 “ 1.3
- D 3 “ 1.05
- E 2 “ .90
- F Flexible 1.00
- How to maximize NPV with budget contraints?

Topics in Investment Analysis

- Estimating incremental cash flows, i.e. cash flows due to the investment decision
- Importance of including net working capital
- Inflation effects on cash flows and the choice of real or nominal discount rates
- Analyzing components the present value of cash flows
- Comparing projects with unequal lives

Cash Flow Estimation

- Cash flows from operations
- Increase or decrease in sales
- Increase or decrease in costs
- Change in depreciation and taxes
- Other cash flows from the decision
- Changes in investment in working capital
- Changes in fixed assets or required maintenance cycles
- Initial cash flows from the investment

Estimate the Cash Flows

- Baldwin Example (pp. 200-206)
- Inputs into cash flows
- Question 7.1
- The Best Company example (question 7.2)
- Scott Investors (question 7.21)
- What are sources of value?

Inflation Effects

- Inflation means future revenues are inflated in terms of current purchasing power
- Two ways of dealing with inflation
- Discount rate includes an inflation allowance (most common since market rates are nominal rates)
- Deflate projected revenues and costs to convert to current dollars and discount using real risk-adjusted discount rate
- Steady or predictable versus varying inflation

Components of Present Values

- Components of cash flows from investment may have different risks
- Tax-shield from depreciating original cost is risk free if the firm will certainly be paying taxes but tax savings are in inflated dollars
- Investment costs are usually current and are not discounted, but not always true
- Operating cash flow risk depends on project

Replacement and Unequal Lives

- If different acceptable machines must be replaced at different intervals or have different periodic lumpy costs like major maintenance over longer time periods, they must be made comparable to choose best
- Two methods are used to compare
- Replacement chain - compare a cost cycle
- Equivalent annual cost - treat as annuities

For Next Class

- Read Chapter 3
- Review the “Financial Statement Analysis and Assumptions for Valuation” and compare to Chapters 2 and 3
- Review old midterms and bring questions to optional review session

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