Lecture Notes on Capital Investment Decisions

Exam Preparation & Upcoming Schedule

• Three lectures remaining (including today).

• Final exam is approaching.

• Aim to pass the primary exam to avoid additional exams during the winter holiday.

Online Quiz Details

• Online quiz next week.

• A whole week to complete the quiz.

• Quiz duration: 60 minutes.

• Covers topics 5, 6, 7, and 8.

Lecturer's Experience & Exam Difficulty

• Initial quizzes often have good results.

• Lecturers may increase the difficulty of subsequent quizzes and exams.

• Rationale: To differentiate students and identify top performers.

• No fixed quota for failing students; passing depends on meeting standards.

Concerns & Final Exam Format

• Worry: Early quiz results may give a false sense of simplicity.

• Online quizzes/exams might involve external help, which is not a concern.

• Final exam: closed book.

• Plain formula sheet will be provided.

• Final exam design is complete.

• Strategy: Mix of simple, medium, and complex questions.

Advice for Exam

• If struggling with initial questions, remain calm and proceed to other questions.

• Methods required for the exam have been covered in tutorials, quizzes, and exams.

Announcement

• Announcement regarding the quiz to be made soon.

• Quiz next week.

Capital Investment Decisions

• Today's Topic: Capital Investment Decisions.

• Last week: Methods for capital budgeting.

Methods Learned Last Week

• NPV (Net Present Value)

• IRR (Internal Rate of Return)

• Payback Period

• Index (considered similar to NPV)

Exam Implications

• Different types of questions related to NPV, IRR, and payback in the final exam.

• Theory questions on the differences between NPV and IRR.

• Long calculation questions to determine NPV and IRR for decision-making.

Today's Focus: Cash Flow Estimatio

• Estimating cash flows from time zero to the project's end.

• Cash flow types:

  • Initial cost/outlay (time zero)

  • Ongoing cash flows (during investment period)

  • Terminal cash flows (project completion)

• Calculate NPV after carefully calculating all cash flows.

• Cost of capital/discount rate given this week, calculation next week.

Project Types & Considerations

• Project Types: Expansion and replacement.

• Cash flow handling varies by project type.

• Projects with unequal lives: special treatment needed.

Important Points Before Cash Flow Calculation

• Focus on Cash Flows: Capital budgeting decisions must be based on cash flows.

  • Example: Selling coffee for 4 generates 4 in cash flows.

  • Example: Paying 5,000 in salaries is a cash outflow.

• Accounting Numbers vs. Cash Flows: Information often comes from accounting numbers.

  • Accounting uses accrual basis (payables, receivables).

  • Depreciation is a key concern.

Depreciation Explained

• Depreciation: Allocating the cost of a long-term asset over its useful life.

  • Cash outflow occurs at time zero (when asset is bought).

  • Accounting rules spread the cost over the asset's life.

  • Depreciation is a non-cash item.

• Non-Cash Items: Generally excluded, but consider if they affect cash items.

  • Depreciation affects profit, which affects tax, which is a cash item.

Tax Implications

• More depreciation leads to less profit, resulting in less tax paid.

• After-Tax Cash Flows: Only consider after-tax cash flows.

Cash Flow Timeline

• Project timeline (e.g., four years).

• Three cash flow types:

  • Initial Outlay

  • Operating Cash Flow (OCF - net cash flows, inflows - outflows)

  • Terminal Cash Flow (end of project)

Initial Outlay Details

• Equipment, land costs (lump sum).

• Initial development costs (delivery, installation).

Ongoing Cash Flows Details

• Incremental revenues minus incremental costs equals profit.

• Pay taxes on profit to get operating cash flows.

Incremental Focus

• Focus on incremental/differential cash flows.

• Purpose: To earn additional revenue/profits or reduce costs.

• Types of Projects:

  • Profit-seeking: additional cash inflow.

  • Cost-reducing: cash inflow from reduced costs.

• Independent projects: incremental cash flows sufficient.

• Mutually exclusive/replacement projects: more complex.

Terminal Value Details

• Selling equipment at the end of the project.

• Selling price might not equal book value (due to depreciation).

• Book Value: Accounting value of the asset after depreciation.

Tax Implications for Selling Price

• Selling price > book value: Capital gain, pay tax.

• Selling price < book value: Recognize a loss, tax saving (cash inflow).

Working Capital

• Add at the beginning, deduct at the end.

• Example: Retail shop buying PC components for inventory (1,000,000).

• Cash transforms to inventory, then back to cash when sold.

Time Value of Money

• Even if cash returns, time value of money matters.

• Saving 1,000,000 in the bank yields approx. 4% return (40,000).

• Working capital included to calculate the time value of money.

Opportunity Costs

• Example: Company A owns vacant land for 50 years.

• Opportunity Cost: Potential revenue from selling or renting the land if not used for the project.

• Include opportunity cost in the project cost.

Sunk Costs

• Definition: Costs that cannot be recovered regardless of the project decision.

• Example: Paying 50,000 for a feasibility study.

• Do NOT include sunk costs in project cost calculation.

• Cost should be taken into account, the decision to conduct the project creates consequences.

Working Capital (Revisited)

• Cash transformed to inventory, receivables, payables.

• Time value of money is the consideration.

Externalities/Cannibalization

• Positive and negative externalities.

Negative Externalities

• Example: Coca-Cola introducing a new flavor.

• New flavor might attract customers from existing Coke products, reducing old product revenue.

• Accounted for as a loss to existing product revenue.

Positive Externalities

• Example: Apple introducing Apple Music.

• Selling iPhones increases Apple Music subscriptions.

• New product improves the sales of existing products.

• Positive benefit to the existing product.

Financing Costs

• Excluded from cash flow calculations.

• Example: Borrowing 10,000,000 and paying interest.

• Interest is not deducted from incremental revenue.

• Financing costs are accounted for next wek during the discount rate.

After-Tax Cash Flows (Revisited)

• Important to consider.

Allocated Costs

• Overhead costs (e.g., electricity) are allocated to different projects.

• Example: Building with divisions A, B, C, rent $1,200,000

Scenario 1: New division D in vacant space

• Rent remains 1,200,000. Accounting might allocate 300,000 to each of the four divisions, A,B,C, and D.

• Include to evaluate a project.

• Focus only on whether a difference is created.

• No increase in rent, don't allocate.

• The 300,000 that will be assigned to Division D is a sunk cost.

Scenario 2: New division D increases rent to 1,400,000

• Allocate the incremental cost of 200,000 to division D.

Project Types: Expansion vs. Replacement

Expansion

• Deciding whether to do more of something.

• Only one decision necessary.

Replacement

• Deciding whether to replace an old machine with a new one.

• Determine whether the the change could create a difference.

• Calculate different numbers to determine, there's no initial conclusions.

Cash Flows: Initial, Terminal, Operating

Initial

• Purchase of equipment.

• Sale of old equipment (for replacement projects).

• Initial development costs, working capital.

Ongoing

• Incremental revenue minus incremental costs yields profit.

• Pay taxes to determine Operating cash flow.

Key Income Statement

• Operating Revenue

• Incremental Operating costs (fixed & variable). Fees. Including overhead.

• Depreciation (non-cash)

  = EBT (Earnings Before Taxes)

• Income Tax

• =Net Income

• Add back depreciation. Adding all the expense of the revenue and expense of each product.

• =Operating Cash Flow