COMM 308chapter 13: Capital Budgeting, Risk Considerations, and Other Special Issues Flashcards
(53 cards)
Capital expenditures
a firm’s investments in long-lived asset (can be tangible and intangible)
usually involve large amounts of money
the decisions are frequently irrevocable
Capital budgeting
the process by which a firm makes capital expenditure decisions
the process steps by which a firm makes capital expenditure decisions (capital budgeting)
(1) identifying investment alternatives
(2) evaluating these alternatives
(3) implementing the chosen investment decisions
(4) monitoring and evaluating the implemented decisions
how can securities reflect capital expenditure decisions?
if they messed up, people will know and will not think that investing in these companies is a good decision
security price decreases
Michael Porter’s five critical factors that determine the attractiveness of an industry
the five forces
entry barriers
the threat of substitutes
the bargaining power of buyers
the bargaining power of suppliers
rivalry among existing competitors
according to Michael Porter, what do firms have little control over after inception?
the attractiveness of the industry they are in
according to Michael Porter, what do firms have total control over?
over the manner in which they strive to create a competitive advantage within their industry
according to Michael Porter, what can firms do to obtain competitive advantage?
- Cost leadership: strive to be a low-cost producer
or
- Differentiation: offer “differentiated” products
Cost leadership: strive to be a low-cost producer
viable for firms that are able to take advantage of economies of scale, proprietary technology, or privileged or superior access to raw materials
investment outlays should be made in accordance with a firm’s potential advantage
Differentiation: offer “differentiated” products
Firms can provide products that are differentiated from others in several ways
–> The most obvious is to have a product that is itself unique by virtue of its physical or technological characteristics
–> However, firms can also differentiate their products by providing customers with unique delivery alternatives or by establishing a marketing approach that distinguishes their products from those of their potential competitors
Porter suggests that it is difficult to sustain a competitive advantage once one has been created, what must companies keep doing then?
companies must continually plan (and invest) strategically
Bottom-up analysis
based on the idea that a firm is simply a set of capex decisions
an investment strategy in which capex decisions are made in isolation, without considering general industry and economic trends or whether the firm should continue in this particular business
involves probabilities and estimates
Equipment replacement is a typical bottom-up analysis or top-down analysis?
why?
a typical bottom-up analysis
an engineer estimates the savings that will be realized by replacing one piece of equipment with another
A financial analyst then translates these savings into financial parameters to determine whether the replacement savings are worth the cost of the equipment
at no point does the engineer or the financial analyst consider whether the firm should continue in this business
top-down analysis
focuses on strategic decisions about which industries or products the firm should be involved in
looking at the overall economic picture
involves uncertainty which can’t be calculated using probabilities
In looking at bottom-up versus top-down analysis, what stays the same?
the capital budgeting framework
In looking at bottom-up versus top-down analysis, what is different?
the quality of the estimates
discounted cash flow (DCF) methodologies
techniques for making capex decisions that are consistent with the overriding objective of maximizing shareholder wealth
involves estimating future cash flows and comparing their discounted values with investment outlays required today
they are technically identical to the approaches used to evaluate bonds and preferred and common shares
The payback period method
defined as the number of years required to fully recover the initial cash outlay associated with a capital expenditure
we use a cutoff date
provides a useful intuitive measure of how long it takes to recover an investment and is sometimes used as an informal measure of project risk
shorter or longer payback periods are better?
shorter payback periods
how can the payback period method measure risk?
the quicker a firm recovers its investment outlay, the less risky the project is
drawbacks of the payback period method
- it disregards the time and risk value of money, because it treats a dollar of cash flow received in year 3 the same as those received in year 1, and so on
- the payback period does not account for the cash flows received after the cutoff date, which could be substantial for some long-lived projects
- the choice of the cutoff date is somewhat arbitrary and may vary from one firm to the next
The discounted payback period method
alleviates the first shortcoming of the payback period by accounting for the time value of money
the number of years required to fully recover the initial cash outlay in terms of discounted cash flows
Shorter periods are better, and projects with discounted payback periods before the cutoff date will be accepted
drawbacks of the discounted payback period method
ignores cash flows beyond the cutoff date
the cutoff date is somewhat arbitrary
The net present value (NPV) of a project
defined as the sum of the present value (PV) of all future after-tax incremental cash flows generated by an initial cash outlay, minus the present value of the investment outlays
the present value of the expected cash flows net of the costs needed to generate them
it is like the Real Estate class, if you can use excel, do it
