Week 10 Everything

Question 1

Capital investment decisions

Answer 1

Investment decisions are strategic decisions with long-term effects. Managers develop strategies from entity’s vision and core competencies. These strategies are aimed at entity’s overall purpose, which usually includes long term profitability. Capital budgeting proposals are analysed as if they were stand-alone projects.

Question 2

Investment decisions are strategic decisions with long-term effects

Answer 2

Can be classified as regulatory (investment required by regulations), strategic (investment takes the company in a new direction – more next week); or operational (required for the day-to-day running of the business)

Question 3

Capital budgeting

Answer 3

Capital budgeting is a process managers use to choose among investment opportunities that have cash flows over a number of years. Appraisal involves an understanding of the classes or categories of capital investment projects is required.

Question 4

Capital investment categories

Answer 4

Regulatory Investments to comply with regulatory, safety, health and environmental requirements

Operational capital investment decisions

Strategic capital investment decisions

Question 5

Steps for addressing capital budgeting decisions

Answer 5

Identify decision alternatives and classify project

Identify relevant cash flows

Apply the appropriate quantitative analysis techniques

Perform sensitivity analysis

Identify and analyse qualitative factors

Consider quantitative and qualitative information and make a decision

Question 6

Identify decision alternatives and classify project

Answer 6

Regulatory, operational or strategic?

Question 7

Apply the appropriate quantitative analysis techniques

Answer 7

NPV is most suitable for operational investments

Question 8

Identify and analyse qualitative factors

Answer 8

Very important with strategic investments

Question 9

Relevant cash flows must

Answer 9

arise in the future, and differ among decision alternatives

Question 10

Examples of relevant cash outflows

Answer 10

Initial investment outlay

Future operating costs

Project closing and cleanup costs

Question 11

Examples of relevant cash inflows

Answer 11

Future revenues

Decreased operating costs

Salvage value of assets at project’s end

Question 12

Quantitative analysis methods

Answer 12

Capital budgeting objective is to increase long-term value of the entity which affect future cash flows. Therefore, time value of money is an important factor

Question 13

Therefore, time value of money is an important factor

Answer 13

Present value is the value in today’s dollars of a sum received in the future

Future value is the amount received in the future for a given number of years at a given interest rate for a given investment today

Question 14

Note: some regulatory investments do not require analysis using

Answer 14

Note: some regulatory investments do not require analysis using time value of money as they are required by law and are generally evaluated by price and fit for purpose (i.e. fire pumps)

Question 15

Methods that consider time value of money

Answer 15

Net present value (NPV) method

Internal rate of return (IRR) method

Question 16

Methods that do not consider time value of money

Answer 16

Payback method

Accrual accounting rate of return method (i.e. ROI)

Question 17

NPV method

Answer 17

NPV method determines whether an entity would be better off investing in a project based on the net amount of discounted cash flows for the project. Useful for operational investments. Only partially useful for strategic investments.

Question 18

Present value of a series of cash flows

NPV Formula

Answer 18

15/5/19

Question 19

Uncertainties and sensitivity analysis

Answer 19

General rule is accept project if NPV > 0

Question 20

Discount rate

Answer 20

The discount rate is the interest rate that is used across time to reduce the value of future dollars to today’s dollars. This is often set at an entity’s weighted average cost of capital (WACC). But this ignores variations in risk among projects. A higher (lower) discount rate is appropriate for projects having higher (lower) risk. Tendency to ‘load up’ the discount rate (e.g. use 12% instead of 10%) to deal with inherent risk can penalise strategic investments (or those with cash flows that come later in the project).

Question 21

Income taxes and the net present value method

Answer 21

Income taxes affect cash flow and therefore capital budgeting decisions. Most cash flows affect taxes in the year they occur, but initial investment often provides a depreciation tax shield over a number of years. Depreciation is not a cash flow and shouldn’t be included in cash flow calculations but is required to determine tax related cash flows in NPV methods. Must also consider tax implications on gains or losses on terminal values

Question 22

Depreciation is not a cash flow and shouldn’t be included in cash flow calculations but is required to determine tax related cash flows in NPV methods

Answer 22

i.e. calculate net profit before tax (and after depreciation) for tax determination then and add back depreciation