Week 10 chapter notes

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University of Toronto Scarborough
Financial Accounting
Liang Chen

Chapter 12 Strategic Investment Decisions Notes Evaluating the Quality of a Decision-Making Aid Importance of Assumptions N higher-quality decision aids make use of higher-quality techniques and help managers make better decisions in uncertainty N evaluating assumptions is an important part of deciding whether a particular analysis method provides high-quality information Capital Budgeting N some strategic budgets involve choosing among potential long-term investment projects N capital budgeting Æ process for choosing among investment opportunities that have cash flows occurring over a number of years N 2 categories for opportunities: developing or expanding products or services; and replacing or reorganizing assets or services N time value of money (TVM) Æ concept that a dollar received today is worth more than a received in the future Decision Alternatives N organizations identify new projects, products, and services through a variety of methods N individuals, teams, and whole departments are responsible for identifying future investment opportunities N organizational strategies are reflected in long-term decisions about products, services, and acquisitions of new business segments N at times organizational strategy requires consideration of new product lines or business segments to expand organizational scope Relevant Cash Flows (a) Develop or Expand Products or Services (b) Decision to Replace or Reorganize Assets, Products, or Services Net Present Value Method N future value Æ amount to be received in the future, calculated for a given number of years at a given interest N present value Æ value in today’s dollars of an amount to be received in the future, calculated for number of years at interest Present Value of a Series of Cash Flows N net present value (NPV) method Æ capital budgeting method that determines whether an organization would be better off investing in a project based on the net amount of discounted cash flows for the project t = time period (year), n = life of the project, r = discount rate N the expected cash flows include the initial investment, incremental operating cash flows, and terminal cash flows N if the NPV is positive, the project is generally considered acceptable because it is expected to increase the organization’s value Net Present Value of a Project N profitability index Æ ratio of the present value of the benefits to the present value of the costs of a capital budgeting opportunity N profitability index = present value of cash inflows / present value of investment cash outflows www.notesolution.com N profitability index and NPV method always accept and reject the same project, but index allows managers to rank order projects N it provides a simple way to identify which projects are expected to earn higher returns Identifying a Reasonable Discount Rate N discount rate Æ interest rate that is used across time to reduce the value of future dollars to today’s dollars N weighted average cost of capital (WACC) Æ weighted average after-tax rate for the costs of the various sources of long-term financing such as debt and stock; sometimes used as the discount rate in capital budgeting N if a project involves little risk, then a lower discount rate might be appropriate N conversely, a higher discount rate is appropriate for projects having higher risk Uncertainties and Sensitivity Analysis N the general rule when performing NPV analysis is to accept the project if NPV is greater than zero N there are many assumptions built into this general rule, including cost of the initial investment, timing and dollar amounts of incremental revenues and costs, terminal values, project life, and appropriate discount rate N there are also many uncertainties involved including cash flow, project life and discount rate, and estimation bias N sensitivity analysis helps managers evaluate how their NPV results would change with variations in the input data Internal Rate of Return N internal rate of return (IRR) Æ capital budgeting method that determines the discount rate necessary for the present value of the discounted cash flows to be equal to the investment (i.e., the discount rate at which the project’s NPV equals 0) Payback Method Uniform Cash Flows N payback method Æ capital budgeting method that measures the amount of time required to recover the initial investment N number of years to pay back the investment = initial investment / annual incremental operating cash flow Non-Uniform Cash Flows N because the cash flows are non-uniform each year, the payback period can be found by calculating the cumulative incremental operating cash flows until the initial investment amount has been fully recovered N the number of years needed to cover the initial investment is the payback period Advantages and Disadvantages of the Payback Method N the payback method has some important disadvantages N it does not incorporate TVM—future cash flows are not discounted to reflect opportunity cost of using funds for other projects N this method does not value the cash flows that are received after the investment has been recovered N in addition, it imposes an arbitrary cut-off period, which favours projects with shorter payback periods N however, the payback method is used extensively as it is easy to calculate and easy to understand N in addition, payback is sometimes used with NPV or IRR when meaningful estimates of relevant cash flows are lacking because the project or product is so new that it provides no historical data for reference Accrual Accounting Rate of Return Method N accrual accounting rate of return (AARR) Æ capital budgeting method that measures the expected increase in average annual operating income as a percent of the initial increase in investment Advantages and Disadvantages of the Accrual Accounting Rate of Return Method N the AARR method presents several problems—first, it ignores the time value of money N amortization is deducted from numerator, but full investment amount is denominator, so investment is essentially counted twice N the AARR method is frequently used to evaluate division or department performance because the financial information is readily available, but it is not an appropriate method for evaluating long-term investment Other Considerations for Strategic Investment Decisions Qualitative Factors N qualitative factors often influence strategic investment decisions—sometimes these factors cannot be quantified, and other times numerical estimates would be so uncertain that decision makers would find them useless N estimating the future cash flows from implementing an enter
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