Week 5 - Strategic investment decisions

Question 1

Define r = opportunity cost of capital (hurdle rate)

Answer 1

1. The minimum acceptable rate of return
2. The return that could be expected from alternative projects of comparable risk

Question 2

Incrementalism

Answer 2

Companies tend to prefer taking on many small projects over time (eg. prototypes) rather than favouring a large project/change - resistance
- might delay the co. from catching up with changes in the environment, affecting the biz as a whole
- might not add up to same result
- might end up being more costly

Question 3

Key examples for…
4 for RELEVANT cash flows
5 for IRRELEVANT cash flows

Answer 3

Relevant cash flows
1. Disposal value
2. Cost savings
3. Tax effects
4. Opportunity costs of replacement

Irrelevant cash flows
1. NBV
2. Depreciation
*3. Decrease in OH allocated: not relevant for firm as a whole (no alternative uses of floor space freed up)
4. Financing costs
5. Revenues (if the same for both alternatives)

Question 4

Capital allowance

Incremental taxation formula

Answer 4

Capital allowance = % of asset book value deductible from taxable profit
- in asset replacement decisions, look at INCREMENTAL depreciation to calculate any CHANGE in capital allowance

(Incremental profits - incremental capital allowance) * tax rate

Question 5

NPV vs IRR - 4 considerations (3 pros for NPV)

*From Sourdough case,
A central problem of NPV calculations are the MANY ASSUMPTIONS to make w.r.t the future.
eg. even if our cash flows are secured through agreements, what happens if the customer goes bankrupt?

Answer 5

1. NPV takes into account the SIZE of a project; IRR does not
2. NPV can be used even if diff. rates r used in diff. time periods; IRR is ambiguous in case of unconventional cash flows or if r CHANGES OVER TIME
3. NPV has more REALISTIC reinvestment assumptions (CFs reinvested at r); IRR makes an unrealistic assumption of reinvestment at r* = IRR
4. NPV depends on EXOGENOUS rate r (con); IRR uses an ENDOGENOUS rate (pro)

Question 6

Payback period/method

Answer 6

= time t needed to recover initial investment
= Net initial investment / Annual increase in CFs

The riskier the investment, the shorter the required t*

Question 7

2 benefits & 3 limitations of Payback method

Answer 7

Benefits
1. rule of thumb, easy to understand
2. useful if:
– distant cash flows highly uncertain
– preliminary phase, initial screening

Limitations
1. how is t* established? (arbitrariness)
2. ignores TIME VALUE OF MONEY / opportunity cost of capital
3. ignores CFs beyond t*
– more concerned with cash management in the SHORT or MEDIUM TERM

Question 8

Accounting rate of return (aka ROI) & decision rule

Answer 8

= Income / Investment
usually,
= Average annual increase in OPERATING PROFIT / AVERAGE investment over project’s life OR NET INITIAL investment

Accept if ARR > required rate of return r
- need to establish r = benchmark. (But how to know if the benchmark is appropriate or not? can be rate of return from other comparable projects)
- Between 2 projects, choose project w/ highest ARR

Question 9

2 pros & 2 cons of Accounting rate of return + 2 other issues

Answer 9

Pros
1. Based on information readily available (financial statements)
2. Gives managers an idea of how investments will affect future accounting results

Cons
1. Affected by chosen accounting methods, eg. DEPRECIATION
2. Ignores SIZE {& time value of money}

Other issues
1. ARR often used for PERFORMANCE MEASUREMENT
- Managers tempted to make decisions using the same rule by which they will be evaluated, ie. ARR and not NPV
- even if NPV is used, managers are tempted to prefer projects which perform better in terms of SHORT TERM PROFITABILITY
» Need to evaluate managers BY PROJECT & look at project results rather than overall accounting results

2. Required rate of return r for the WHOLE FIRM may be lower than the ARR of a business unit
   - any ARR in between causes GOAL INCONGRUENCE

Question 10

What is the issue if a large proportion of a positive NPV investment comes from an old machine? Include 2 acct. examples

Answer 10

eg. relies on DISPOSAL of old machine, the TAX SAVING on loss from disposal

• If the old machine is at the end of its useful life with NO DISPOSAL value, the NPV of the investment would be much lower.

Question 11

Qualitative analysis / strategic factors - 6 possible areas of concern (ref. to equipment replacement at Mavis)

*see slides for all details

Answer 11

1. Flexibility
2. Quality/customer value
   - Source of competitive advantage?
   - Potential reduction of Mavis’ ROLE in the value chain
3. Strategy pursued
   - Cost leadership or product differentiation?
   - Vertical INTEGRATION may not be a feasible option as flexibility seems a key-attribute in this competitive environment
4. Labour and skills
   - Shift in key-competencies
   - Can staff quickly learn to use new machine?
   - Consequences of firing employees
5. Supply chain
   - May lose both BUYER POWER & SELLER POWER within the supply chain
   ie. risk of becoming a captive supplier too dependent on buyer, & dependent on its major suppliers and quality
6. Performance measurement
   - Loss on disposal = substantial erosion of current profitability
   - Implications of acknowledging a mistake made 3 years ago?

Question 12

What does ‘Opportunity cost of old machine’ represent?

Answer 12

The foregone disposal of old machine

Question 13

From the Sourdough case,
6 additional strategic considerations in favour of the investment of the new machine

Answer 13

1. NPV > 0 (Investment looks promising in financial terms)
2. Technology can further improve EFFICIENCY (technological advantage)
3. Maybe new we can generate a new customers base if we deliver good quality
   
   • might be able to EXPAND to other MARKETS
4. Good if aligned with a cost leadership strategy
5. Decrease in financial vulnerability and uncertainty? {STEADY STREAM of cash inflows}
6. Organisational change?
   - might be utilising IDLE CAPACITY

Question 14

From the Sourdough case,
6 additional strategic considerations against the investment of the new machine

Answer 14

1. Purchase decision is coupled with a major shift in strategy (DEPENDENCY upon new customer)
2. Capital is bound within the organisation (is the restaurant reliable?)
3. What about the general economic environment?
4. Predictability of future cash flows? Calculations feasible?
   eg. what would happen if the restaurant decided after some time to source bread from another producer that is able to provide standard bread at lower cost?
   + there is an implicit ASSUMPTION that the revenues from the existing customer base will remain the SAME once the new machine is in operation.
5. Reputational risk (How will our customers react if we enter mass production?)
   
   • operating in 2 diff. segments of the market with 2 diff. strategies (high quality, small batches, product differentiation VS one big customer, lower quality, larger batches, standard products) - risk of SENDING inconsistent SIGNALS of QUALITY to customers
6. Loss of at least some FLEXIBILITY
   - could have harmful impact on quality & morale of the master baker & employees, endangering the LOYALTY of current customers
   - may lose more money than expected as the production of larger batches may involve using MORE RESOURCES & POWER than they are used to.
   - Also, the bakers may not be used making orders of such high volume & may require an ADJUSTMENT PERIOD