MGAB03H3 Chapter Notes -Nominal Interest Rate, Risk Premium, Tax Shield

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9 Jan 2011
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Chapter 12 Strategic Investment Decisions Notes
Evaluating the Quality of a Decision-Making Aid
Importance of Assumptions
x higher-quality decision aids make use of higher-quality techniques and help managers make better decisions in uncertainty
x evaluating assumptions is an important part of deciding whether a particular analysis method provides high-quality information
Capital Budgeting
x some strategic budgets involve choosing among potential long-term investment projects
x capital budgeting Æ process for choosing among investment opportunities that have cash flows occurring over a number of years
x 2 categories for opportunities: developing or expanding products or services; and replacing or reorganizing assets or services
x time value of money (TVM) Æ concept that a dollar received today is worth more than a received in the future
Decision Alternatives
x organizations identify new projects, products, and services through a variety of methods
x individuals, teams, and whole departments are responsible for identifying future investment opportunities
x organizational strategies are reflected in long-term decisions about products, services, and acquisitions of new business segments
x 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
x future value Æ amount to be received in the future, calculated for a given number of years at a given interest
x present value Æ value in todays 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
x 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
x the expected cash flows include the initial investment, incremental operating cash flows, and terminal cash flows
x 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
x profitability index Æ ratio of the present value of the benefits to the present value of the costs of a capital budgeting opportunity
x profitability index = present value of cash inflows / present value of investment cash outflows
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Document Summary

Relevant cash flows (a) develop or expand products or services (b) decision to replace or reorganize assets, products, or services. Present value of a series of cash flows. N profitability index and npv method always accept and reject the same project, but index allows managers to rank order projects it provides a simple way to identify which projects are expected to earn higher returns. 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.

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