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TOPIC ELEVEN

LONG-TERM DECISION MAKING


Lecturer: Masud Muhammad

CHAPTER COVERAGE
At the end of this topic, you should be able to:
Explain capital investment;
Apply various capital investment appraisal techniques;
Examine the effects of inflation and taxation in capital investment
appraisal;
Identify risks and uncertainty, sensitivity analysis and capital rationing;
and nalyse ethical issues and other qualitative factors in long-term
decision making.

11. INTRODUCTION
Managers often make decisions involving an investment today with the hope
to get returns in the future. All of investments require significant initial capital
or fund outlay with the hope of getting a return of extra cash flows in the
future.
These significant investment decisions in projects that have long-term
implications and benefits are known as capital budgeting or capital
investment decisions. There could be many potential projects but the
availability of funds is a major constraint. Therefore, managers must
thoroughly evaluate and choose projects with the highest future returns.

11.1 CAPITAL INVESTMENT


APPRAISAL TECHNIQUES
Generally, any decision that requires an outlay (initial investment) now in
expectation of future benefit or return is a capital budgeting decision. Below
are some examples of capital budgeting or investment decisions, which
demand thorough and well thought planning.
(a) Lease or purchase decision Whether a new machine should be leased
or purchased;
(b) Expansion decision Whether a new building, warehouse or any facility
should be acquired to increase capacity and sales;
(c) Equipment replacement decision Whether outdated machine should
be replaced now or later; and
(d) Cost-reduction decision Whether a new piece of equipment should be
acquired to reduce costs.

APPRAISAL TECHNIQUES (Cont.)


The capital investment decisions would involve planning, setting targets and
priorities, arranging financing and using a set of criteria for making the
selection of long-term assets and commitments.
Poor capital investment decisions can be very costly because they affect the
long-run profitability of a company since huge amounts of resources are
invested and at risk for long period of time.
(a) Accounting rate of return;
(b) Discounted payback;
(c) Internal rate of return; and

(d) Payback;
(e) Net present value;
(f) Profitability index.

11.1.1 Accounting Rate of Return (ARR)


Accounting rate of return (ARR) is also known as the return on investment,
simple rate of return and the return on capital employed. The formula for
computing ARR is
ARR = Average annual profit or Average income / Average
investment
ARR measures the return on a project in terms of income or profit instead of
cash flows.
Income or profit is different from cash flows because the computation of
income statement uses the accrual basis.
Discuss the advantages and disadvantages of ARR.

11.1.2 Payback
The payback method is very popular, widely used, and can be considered as the
easiest and most straightforward method. Payback period refers to the time
required for a firm to recover its original investment.
Consider the following two capital investments A and B. Both projects require
the same amount of initial investment of RM300,000 and have a 4-year life. The
expected cash flows for A and B are as follows.
Investment

Year 1

Year 2

Year 3

RM80,000 RM80,000 RM140,000

RM150,000

RM100,000

Year 4
RM100,000

RM50,000 RM100,000

Calculate the Payback period for two projects, suggest the best option and
discuss the pros and cons.

11.1.3 Discounted Payback


In order to overcome a deficiency of the payback model with regard to the
time value of money, we may adjust the computation of the payback period
by using cash flows that are discounted first to their present values. This
adjustment on the cash flows is referred to as adjusted or discounted
payback method.

11.1.4 Net Present Value


(NPV)

NPV
measures the profitability of an investment by looking at the difference
in the present value of the cash inflows and outflows associated with the
capital investment.
NPV = (PV of cash inflows PV of cash outflows) Investment Outlay
NPV = PV of net cash flows - Investment Outlay

- I0

Net Present Value (NPV)


Calculate the Net Present Value of the following investment at 10% cost of
capital. Discuss the advantages and disadvantages of this method of
appraisal.
Project A
Cash flows
Investment

(100,000)

Year 1

22,727

Year 2

20,660

Year 3

18,783

Year 4

27,320

Year 5

31,045

Year 6

28,225

Year 7

25,660

11.1.5 Internal Rate of


Return (IRR)
Similar to NPV, internal rate of return considers the time value of money. The
internal rate of return is the interest (represented by i or K) rate or the
discount rate (also known as discounted rate of return) that will make the
NPV of an investment zero.
At this point, the present value of cash receipts is equal to the present value
of cash outlays. In other words, IRR specifies the maximum cost of capital
that can be committed to finance a capital investment without negatively
affecting the value to the shareholders.

11.1.6 Profitability Index


In some scenarios, there are several potential projects with positive NPVs but
there are limited funds available to finance those projects. Thus, we need to
rank and prioritise the projects according to their profitability. How do we
rank potential capital investments? One way to do it is by ranking them
according to their NPVs. Alternatively, we may rank them by their profitability
index.
Profitability index is computed as follows:
Profitability Index = Present value of project / Investment outlay
Calculate the profitability index
of these projects.

Projec Investme
ts
nt

PV of Cash inflows

150,000

245,000

100,000

190,000

90,000

150,000

11.2 CAPITAL RATIONING


Although sometimes a company has many potential capital investment
projects with positive NPVs, whether the company can take up all the projects
is subject to availability of funds to finance those investments. There are
situations where funds are limited or insufficient to finance all projects.
Management may impose a budget ceiling (for various reasons), limiting the
amount of funds available for investments in any particular period.
Companies may set such policies upon all capital investments that are
financed by internal funds. This internal limitation on fund availability is
referred to as soft capital rationing.
Funds may also be insufficient or limited due to external constraints, such as
difficulty in getting funds from the financial markets. Then this situation is
called as hard capital rationing.

CAPITAL RATIONING (Cont.)


The company have
allocated RM50 million
fund for capital
investment for the
period.
Rank the projects based
on NPV and Profitability
Index and suggest the
best combination.
Discuss the advantages
and disadvantages and
possible consequences.

11.3 EFFECTS OF INFLATION


How does inflation affect capital investment decisions?
Fundamentally, inflation affects both the future cash flows and the required
return on the investment, which is the discount rate
In terms of cash flows, expected inflation may increase your future cash flows
but it does not mean you are better off, and your purchasing power will
remain the same.
Nominal cash flow = Real cash flow (1 + Expected inflation rate) n
(1 + nominal rate of return) = (1 + real rate of return) ( 1 + expected rate
inflation)

EFFECT OF TAXATION

EFFECT OF TAXATION (Cont.)

EFFECT OF TAXATION (Cont.)


The company has collected the following data for further analysis:
Cost of equipment

RM1,500,000

Required working capital

RM 600,000

Estimated annual cash inflows from sales

RM1,000,000

Estimated annual cash expenses

RM 550,000

Cost of road repairs in year 6

RM 200,000

Salvage value of the equipment in 10 years

RM 500,000

Assume the company ceases after 10 years, and thus the business will be
closed that year. The equipment would then be sold at its salvage value. The
companys after tax cost of capital is 12% and its tax rate is 25%. The
company uses the straight line method, assuming no salvage value for
computing tax-shield purposes.

11.4 RISK AND UNCERTAINTY, AND


SENSITIVITY ANALYSIS
Making investment decisions entails careful analysis and evaluation because
various types of investments carry different degrees of risk and uncertainty.
Studies of past returns show that investors require higher expected returns
for investing in risky securities, and the safest investment has the lowest
average rate of return.
This relationship is described in a model called capital asset pricing model
(CAPM). The relationship between expected returns and risk (measured in
terms of beta) is represented by a sloping line, called the security market
line. This security market line can be used to establish the expected return on
any security.

CAPM
Consider the following example to calculate the expected return on these
investments

Sensitivity Analysis:
These variables include estimated cost of capital (the i), estimated life of the
project (the n), estimated initial outlay (the I), and estimated stream of cash
flows that can be broken up into selling price, sales volume, and operating
costs.

11.5 ETHICAL ISSUES AND OTHER


QUALITATIVE FACTORS IN LONG-TERM
DECISION MAKING
Managers can make sound capital investment decisions after considering
quantitative factors like the NPV, IRR, and profitability index, as well as the
qualitative factors. Nevertheless, sometimes managers may not make
investment decisions in the best interest of the company. What might cause
or motivate managers to do that?
Modifying figures for getting approval
Pressure over short-term results
Myopic Behaviour

11.5.1 Other Qualitative


Factors
Despite those quantitative measurements like NPV, payback period and IRR,
qualitative factors are equally important when making capital investment
decisions. Some of the qualitative factors include company culture, ethics,
safety and environmental concerns
Environmental Considerations
Ethical Concerns
Company Culture
Balance between cost and quality
Image and reputation

SUMMARY