Investment Decision and Capital Budgeting
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Transcript of Investment Decision and Capital Budgeting
8/8/2019 Investment Decision and Capital Budgeting
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&
Capital Rationing
8/8/2019 Investment Decision and Capital Budgeting
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What is Capital Investment?· Long Term commitment of scares resources
Why is Capital Investment Decision Important?· Generation of future income
How to evaluate Capital Investments?
· Time value methods
Effects of Capital Rationing· T es of Decisions and Constraints
Effects of Taxation and Inflation·
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1) Compounding & Discounting Formula=
i = Interest Ratet = Time PeriodF = Final Sum
ompoun ng scount ngF = P(1+i)^t P = F / (1+i)^t
2 Assum tions initial setProject independenceSimple investmentDiscount rate is known
Complies with maximizing NPW
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Investment Decision / Appraisal
3) "Common Sense" Decision Rules
Investment Initial Net Cash Proceeds
Proposal Outlay Year 1 Year 2A 10,000 10,000
, , ,
C 10,000 3,762 7,762D 10,000 5,762 5,762
· Assume A&B and C&D are mutually exclusive
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Investment Decision / Appraisal
3) "Common Sense" Decision Rules
Investment Initial Net Cash Proceeds
Proposal Outlay Year 1 Year 2A 10,000 10,000
, , ,
C 10,000 3,762 7,762D 10,000 5,762 5,762
· Assume A&B and C&D are mutually exclusive
then larger amount in return better.Select B
Rule 2 C&D if same outlay, and return,en ear er re urn s e er.
Select D
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Ca ital Rationin arise because of limited resourcesDecision NOW affects FUTURE, but FUTURE depends on decision NOW
Types of Capital Rationing problemso = x erna cons ra n s
(2) Hard = Internal Constraints(a) Control issuesb Political issues
Single Period ConstraintsMany project single year
Accept project based on :(a) Benefit Cost Ration (NPV/Outlay)
(b) Profitability Index (PV of Benefit/PV of Outlay)
(c) LP method
Multiple Period ConstraintsMany projects over many years
No clear cut answer BUT :(a) Dynamic Programming
(b) Other
simulation
models
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Reasons why Capital Rationing occurs
prices are depressed
Restrictions on bank lending due to government controls
The costs associated with making a small equity issue may be too great
more loans
Limitation of methods usedAssumption of divisible projects
No account of risk of ro ect and attitude towards risk b com an and shareholders Interdependencies between projects are difficult to establish
L near re at ons ps are usua y assume , a ract on o a pro ect s ta en o we may not get the same proportion of benefits and cost
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ITEMS / TIME PERIOD 1 ...... n
Cash SalesDebtor PaymentsSale of Fixed AssetsNew Share Issue / Capital
Calculating
New Loans
Realized Investments
TOTAL INCOME X
EXPENDITURE / PAYMENTSCash PaymentsCreditor PaymentsWages & Salaries
en a esHeating & LightingInterest PaymentsDividendsLoan Repayment
TaxationPurchase of Fixed Assets
TOTAL EXPENDITURE Y
NET CASH FLOW X Y
Open Cash Balance (b/f)Close Cash Balance (c/f)
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Decision Criteria
1) What decision rules can we use? this creates wealth and should be adopted
< c) If two or more actions satisfy Rule a
but are mutually exclusive, adopt action
which generates greatest NPW
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Calculate the variance for each period of each year
Squaring the Variance, and finding the deviations from theexpected returns for each year
Find E(NPV) average value for each year and discount by theinterest rate (cost of capital) and deduct outlay
Find SD(NPV) for each year by discounting the variance with
the interest rate (cost of capital) BUT by (1+i)^2t
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Inflation Effects
What is inflation?"An increase in monetary units to obtain the same benefit"
Types of inflationSpecific (Price changes)General Purchasin Power Chan es
Money Terms = General Inflation Rate · Real Rate of Interest
ec s :(1) Decrease in real after tax returns
DepreciationShorter a back
(2) Inflation BiasC & H Survey 1976
Under investment
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Taxation Effects
Taxationa) Impact on Cash Flow
c) Impact on Perceived Risk