Boland

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• Boland
• WHO

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• 6/1 AUTONOMOUS GROUP LEARNING (AGL)
  
• NO. 6 - DISCOUNTED CASH FLOW FOR CAPITAL
  INVESTMENT ANALYSIS
• PART II

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• 6/1 AUTONOMOUS GROUP LEARNING (AGL)
  
• NO. 6 - DISCOUNTED CASH FLOW FOR CAPITAL
  INVESTMENT ANALYSIS
• PART II

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1.0 REVIEW OF PART I AND SHORT QUIZ
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2.0 PROGRAM LEARNING
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3.0 LECTURE - EFFECTS OF TAX ON CIA
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6/132c 3. 0 LECTURE - EFFECTS OF TAX ON
CIA 3.1 INCOME TAX Tax payable and tax
"shields" affect the timing of the
cash flows in the CIA Cash Profile. Gross
savings I 000 are reduced by 40 tax,
to make savings of 600 after tax.
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6/132d 3.2
DEPRECIATION (a) Cost of a fixed asset is a
capital expenditure it is allocated
as depreciation expense over the working
life (horizon) of the asset. (b) For
simplicity we use "straight line depreciation"
but other methods are equally
applicable. (c) Depreciation is not a cash flow
after Year 0 but provides a tax shield
in Years 1 - 10.
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6/132e 3.2
DEPRECIATION (d) Annual depreciation depends
upon the tax law!! (e) When the new machine
replaces an existing machine the
relevant depreciation in the cash
flow is New machine (say 1000/5)
200 Less Existing machine (say 600/5)
120 Incremental depreciation
80
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6/133 3.3 TAX SHIELDS If
equipment is sold or scrapped, any loss is a
relief for tax purposes. Thus, if equipment with
a book value of 200 is sold for nothing, there is
a book loss which provides a tax
shield immediately of 40 tax shield 40 x 200
80 cash inflow. The loss on disposal is reduced
by any terminal value thus if a book value of
200 is sold for 200, there is no profit or loss
and thus no tax shield.
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6/134 3.4 OVERALL EFFECT OF TAX SHIELD
ON CASH INFLOW Cash inflow
after tax is computed as follows Saving
100 Less
Incremental Depreciation 20 Taxable
Income 80 Tax _at_ 40
of 80 48 Add Incremental
Depreciation 20 Cash flow after tax
68
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6/134 3.4 OVERALL EFFECT OF TAX SHIELD
ON CASH INFLOW or
alternatively Saving
100 Less Tax _at_ 40
40
60 Add Incremental
depreciation tax shield 20 _at_ 40
8 Cash flow after tax
68 Note Both methods
provide the same result savings 100 less tax of
32 cash flow after tax of 68.
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6/135 3.5 TAX SHIELD ON BOOK LOSSES Where
equipment is scrapped any book loss provides a
tax shield now (year 0). The advantage of the tax
shield in year 0 instead of over the remaining
life of the machine is a time advantage Examples
1 2 3 Net Book
Value 100 100 100 Terminal Value
- 20 100 Book Loss 100
80 - ___ ___
___ Tax Shield on loss _at_ 40 40 32
- Add Terminal Value -
20 100 Total benefit now which reduces the
investment in the new machine 40
52 100
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6/136 3.6 PROBLEMS OF DIFFERENT WORKING
LIVES Difficult to compare mutually exclusive
projects with different horizons (i. e. 20 years
or 15 years). Simple solution is to choose the
shorter horizon (15 years) and introduce a
Terminal Value for the longer project (20 years)
as a cash inflow in year 15. Alternatively use
the "Yield" method and to identify the best
return. Other theoretical methods may be too
complicated or require difficulty assumptions.
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6/137 3. 7 QUANTITATIVE AND NON-QUANTITATIVE
FACTORS N
NQ D Quantify for rigorous analysis but
consider also the NQ factors. If the Q is poor
we may still invest conversely even good Q, we
may still decide not to invest. Need a range of
Qs to test the sensitivity of results
to different assumptions try different -
discount rates - horizons - terminal values -
levels of cash flow NOTE Horizon is the _at_e
assumption.
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6/138 3.8 APPROACH TO CIA (a) DICH -
Decision Investment
Cash Flow
Horizon and Terminal Values (b) AA (Alternative
Analysis) and PFD (Provision for
Disaster). (c) Cash Profile Actual cash to
present value cash. (d) Measures of investment
Payback, Net Present Value,
Profitability Index and Yield.
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6/138a 3.8 APPROACH TO CIA (e) NQ
factors. (f) Decision !!! NOTE NQ factors and
sound business judgement are keys to
effective CIA - DCF is just a tool.
Remember "Cash Flows must ring the cash
register do dont polish the peanuts
concentrate on the coconuts ... "
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6/139 3.9a DEPRECIATION Strainght line
method 100 20 20 20 20
20 Diminishing balance method 100 30
21 15 10 7
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6/140 3.9b ANNUAL AFTER TAX CASH
FLOW APPROACH I APPROACH II Savings -
Cash In 100 Savings - Cash
In 100 Depreciation 20 Tax 40
40 Taxable Income 80
60 Tax 40 - Cash
Out 32 Depn tax shield
20 X 40
8 Sub total
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Depeciation
20 Cash Flow after tax 68
68
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6/141 3. 9c TERMINAL VALUES AND TAX SHIELDS
1 2
3 Old Machine Net Book Value 100 100 100 Terminal
Value 80 80 0 Book
Loss 20
60 100 Tax Shield - 40
8 24 40 Terminal Value
80 40 0 Reduction of new investment 88
64 40
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6/142 3.9d COMPARING DIFFERENT WORKING
LIVES Machine A 10 years
Machine B 15 years - take a
cut off at 10 years
and take a terminal value

and a tax shield
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6/143 3.9e DICH ANALYSIS PFD
DICH
AA Cash Profiles
After Tax
Measures of Investment
NQ Factors
DECISION
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6/144 3.9f CIA DECISIONS
Q NQ D
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4.0 CASE STUDY
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5.0 LECTURE - ON THE CASE
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6/145 5.0 LECTURE - SCOTT MORTON
COMPANY 5.1 STORY OF THE CASE hree years ago
SMC bought four machines with a 15 year working
life, for use on a major contract held by the
company for the previous 10 years. Now consider
replacing them with one automatic machine for 180
000 with a possible 15 year horizon, financing
the cost mai from the bank. Is financing
relevant to CIA? General Manager justifies the
investment by payback and SRI. Should the
company buy the automatic machine now?
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6/146 5.2 GENERAL MANAGERS
JUSTIFICATION (a) No, not justified by payback
and SRI alone fails to consider "time
value of money", terminal values, tax
shields and the effect of fixed
costs. (b) Alternatives available - Buy the
machine now and scrap 4 old machines - Buy the
machine now and scrap 3 old machines - Buy the
machine later - Buy another machine - Don't buy
anything - Lease - Overhaul the old
machine - Subcontract the work - Give up the
contract
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6/147 5. 3 NQ FACTORS AND
PFD (a) The following NQ factors are
relevant - Overall manufacturing
policy - Labour problems - Reliability - Supplier
relationships - Materiality - Better machines
later, etc.
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6/147a 5. 3 NQ FACTORS AND PFD (b)
Provision for the following possible
disasters - Automatic machine may become
obsolete - Machine may break down - Contract may
change - be unprofitable or not
renewed - Labour savings amy not be
realized - Quality control and labour
problems - Start-up delays - More capacity needed
(keep one old machine?)
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6/147b 5. 3 NQ FACTORS AND PFD (b)
Provision for the following possible disasters
but on the other hand - Greater
capacity than three machines - Avoid labour
troubles - Provide many NQ benefits - Have a long
life - And OVERALL may be strategically necessary
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6/148 5.4 RELEVANT
DATA (a) Bank loan not relevant - merely
financing not CIA problem (really!
) (b) Terminal value of old machine 60 000
reduces the new mac investment from
180 000 to 120 000 net. (c) Loss on scrapping
the old machine (120 000 - 60 000) 60
00 provides a tax shield of 40 - 24
000 which reduces the gross investment
from 120 000 to net investment of 96 000.
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6/148a 5.4 RELEVANT
DATA (d) Floor space savings are fixed costs -
not relevant since no cash flow (does
not "ring the cash register".' (e)
Horizon. Initially try 15 years but reduce it
due to risk. Try 7 years as more
reasonable estimate.
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6/149 5.5 INCREMENTAL DEPRECIATION AND
CIA WORKSHEET Relevant
depreciation is the (additional)
incremental depreciatio as follows New
machine 180 000 15 years 12 000 p. a. Old
machine 120 000 12 years 10 000 p. a.
Incremental depreciation 2 000 p. a.
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6/149a 5.5 INCREMENTAL DEPRECIATION AND
CIA WORKSHEET CIA Wor
ksheets show following results Horizon
Horizon 15 years 7 years Gross Payback 3
years 3 years NPV 15 -3 PI 1.1
1.0 Yield 18 15 NOTE
Yield not substantially changed due to tax shield
on book loss in year 7 since Tax Law only
allows depreciation tax shield of 1/15 annually
for 15 years.
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6/150 5.6 PLAN OF ACTION (a) Do
not buy the machine now. (b) Justification. Aut
omatic machine achieves yield of only 15 at a 7
year horizon yet old machine lasted only 3 years.
High risk of project due to possible
obsolescence, breakdown and contract failure.
Better alternative available?
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6/150a 5.6 PLAN OF
ACTION (c) Search alternative machines or delay
decision until long term contract is
signed or possibly lease the machine
or sub-contract. (d) Set up a CIA system to
consider all alternatives and to do a
PFD before making a decision. NOTE NPV of -3
is not SIGNIFICANT - TREAT IT
AS O!
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6/151 5.7 LEARNING POINTS (a)
Bank loans for financing equipment are not
relevart to the investment
problem! (b) New investment is reduced by the
terminal value of old
machine. (c) Book loss on old equipment provides
a tax shield to reduc the new
investment. (d) New investment much achieve the
required Yield after tax.
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6/151a 5.7 LEARNING POINTS (e)
Depreciation is a non-cash expense relevant
for tax purposes. (f) Depreciation tax
shield on the taxable cash flow is
only for the incremental depreciation based on
the tax law. (g) Horizon is the key
assumption - don't forget terminal
values and tax shields on book losses! (h)
Test CIA using different assumptions to produce
a range of computations.
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6/151b 5.7 LEARNING
POINTS i) DICH followed by Cash Profile and
Measures of Investment. (i) Q NQ
D but NQ is the key! (k) Compute figures in 000s
(thousands! big assumptions do not
justify small figures - avoid
"fraudulent pseudo accuracy". (1) Don't let the
figures make the decision - they
merely support good business judgement. (m) Seek
not merely a good investment opportunity
but the best alternative to achieve required
objectives.
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6/152 5.8b LEARNING PATTERNS
BENEFIT OF SCRAPPING OLD MACHINE NOW
Terminal Values
TV 60 TV 60 Book Value
Book 4 0 120

Loss TAX
SHIELD 84 NOTE Only
incremental depreciation is relevant in the
annual cash flow.
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6/153 5.8 LEARNING PATTERNS
SAVINGS AFTER TAX METHOD 1 Savings
30 Savings 30 Incremental Deprec
iation 2 Tax
12 Taxable savings 28
18 Tax 40 11
Depn. Sub-total 17
Tax Shield 1 Add back depn. 2 Cash
flow AT 19
19
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6/154 5.8 LEARNING PATTERNS
NQ FACTORS HORIZON
NQ - Technical
15 yrs. Machine?
Technology? - Economic ?
Breakdown? - Contract
I yr. Labour?
Product
Contract
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6/155 5.8 LEARNING PATTERNS
MEASURES OIF INVESTMENT PB
SRI PI NPV YIELD
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6/156 5.8 LEARNING PATTERNS
CIA DECISION Yield
PB Assumptions NQ Factors AA? PFD? Decision
by Management
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6/157 5.8 LEARNING PATTERNS
GRAPHICAL METHODS YIELD
try different DRs ...
DR 10 DR 20
DR 30
HORIZON - YEARS
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6/158 5.8 LEARNING PATTERNS
GRAPHICAL METHODS YIELD
seek the minimum life to achieve
the required DR ...

HORIZON - YEARS
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6.0 BILL BROWN
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7.0 PROGRAM LEARNING
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8.0 LECTURE - CAPITAL BUDGETING SYSYEMS
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6/159 8.0 LECTURE - CAPITAL BUDGETING
SYSTEMS 8.1 THE SYSTEMATIC
APPROACH (a) Search (b) Long range planning and
short range capital budgets. (c) Research and
analysis - determine relevant data. (d) Criteria
- set basis for Go or No Go decision. (e) Audit
- systematic comparison of project estimates
and subsequent reality. Basis for
reviewing past decisions and making
new ones. Psychological effect upon
managers making new estimates.
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6/159a 8.0 LECTURE - CAPITAL BUDGETING
SYSTEM 8.1 THE SYSTEMATIC
APPROACH (f) Disinvestment policy -
important! (g) System of forms and procedures
(Controller' s job! NOTE Distinguish
"investment" problems (what to invest in) from
"financing" problems (how to finance investments)!
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6/160 8. 2 LONG RANGE
PLAN For CIA in the framework of a long planning
horizon we need (a) Forecast of general
economic activity. (b) Projection of the firm's
physical sales volume. (c) Forecasting of the
facilities and personnel needed. (d) Projection
of routine machine replacement (best
analysed by operational research
techniques). (e) Ranking of major projects
including plans to deal with long run
changes in the economy or the
Organisation.
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6/161 8. 3 SHORT RANGE CAPITAL
BUDGET - Forces managers to look ahead and
plan. - Forces top management to look at cash
flow, earnings, depreciation
allowances and dividend
policy. - Should accomplish (a) tie
in with a long range capital budget.
(b) forecast of cash flows for each investment
project. - Fits projects into
a general framework, consistent with
the company objectives.
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6/162 8.4 RISK Involved in
all projects - never certainty! Never good data
- valid assumptions. Approach to risk in
CIA (a) Use conservative estimates. (b) Use
higher IOR'S. (c) Use probability and "expected
value" techniques. (d) Use shorter
horizons. (e) Use graphical methods to show
sensitivity of measures of investment
to underlying assumptions. NOTE See HBR article
on the Hertz Model using probability
and the computer.
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8/163 8. 5 APPROACH TO "LEASE OR BUY"
PROBLEMS Complex problem with no "correct" DCF
solutions! BUY - NPV of the cost to buy is
Original Investment less the PV of the tax
shield. LEASE - NPV of the cost to lease is PV
of the after tax lease payments. Determine Cash
Profiles at various discount rates and
assumptions. Don't believe the results too
easily!! Sophisticated analysis is not
justified for poor data. NQ factors are the key!
If short of cash ... we lease!
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6/164 8. 6 CRITICISM OF CIA
MEASURES (a) Payback and SRI ignore time value
of money. (b) Payback ignores all cash flows
after payback period. (c) All measures involve
assumptions about re-investing annual
proceeds. (d) Yield does not indicate size of
projects whereas NPV does (e) To
communicate to management use YIELD and
PAYBACK.
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6/165 8.7 PROBLEM OF ASSUMPTIONS All
CIA depends upon assumptions. Prepare high, low
and expected assumptions. Key assumption is
HORIZON! Use CIA techniques appropraite to the
data. Normally compute all data in thousands -
dont polish peanuts!!. Set the assumptions
and then do AA, PFD, Cash Profile, Measures of
Investment, NQ factors, Decision and
Audit. NOTE Watch out for your personal EI
(Emotional Investment) in a poor alternative!
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6/166 8.8 DICH D -
Decision and Criteria I - Investment C - Cash
flow after tax H - Horizon and terminal values
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6/167 8. 9 MANIPULATION CIA
data may be manipulated like any other
accounting data. To "improve" the DCF return, we
may reduce investment or increase savings
shorten time of savings or increase horizon
reduce tax -rate or increase terminal values
deduct irrelevant salvage values combine
projects ands cover a bad one with a good
one! Insist that CIA assumptions be stated and
justified be sure they are valid and always seek
alternative assumptions. CIA sets the shape of
the company for years ahead we must get it
"right".
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6/168 8.10 CIA AND PROFIT
NOW Invest "now for benefit later" but don't
ignore effect of "irrelevant losses" on the
actual profits this year. Choose a mix of
investments that provides both short term and
long term profit for the company. CIA book
losses may not be relevant cash flow but they
may be too big to ignore in their effect on
the current year net profit!!
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6/169 8.11 CAPITAL BUDGETING SYSTEM Long
Range Short Range Planning
Capital Budget (5 years) Search
Analysis
Criteria Decision Audit Forms
Possible Procedures Disinvestment
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6/170 8.11 PROVIDING FOR
RISK HORIZONS
GRAPHS ESTIMATES HIGH -
LOW
SENSITIVITY HURDLE RATES
ANALYSIS PROBABILITIES
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6/171 8.11 APPROACH TO LEASE v BUY CASH
PROFILES - ACTUAL, BOR, IOR SENSITIVITY
AND NQ FACTORS DISNTINGIUISH - FINANCIAL v
OPERATING LEASE
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6/172 8.11 ASSUMPTIONS GOOD ASSUMPTIONS ARE
THE KEY TO CIA WHICH IS EFFICIENT -
DOING THINGS RIGHT AND EFFECTIVE -
DOING THE RIGHT THINGS
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6/173 8.1l DICH Good DICH
involves Assumptions AA Cash Profiles - Real
Money into PV Money Measure s of Investment - PB,
NPV, PI, YIELD Q NQ D PFD to
give Ranges of Decision, for Management
Intuition
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6/174 8.ll CIA
MANIPULATION How to turn an estimated yield of
8 into the required hurdle rate of 15 M
Investment? Savings? Horizon? Volumes?
Terminal Values? Tax Rates? Combination with a
"good" project? Alternatively - justify it
by Law or Policy or Expense it!!
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9.0 CASE STUDY
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10.0 LECTURE ON THE CASE
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6/175 10.0 LECTURE - CAPE CHEMICAL
CO. 10.1 STORY OF THE CASE Company needs
increased product X701 provided either by
purchase or investment in new machine. Factory
manager' s analysis indicates acceptable investmen
t of 42 against Controller yield of
10. General Manager wants to know what to do
about the Capital Budgeting System and this
project.
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6/176 10. 2 CAPITAL BUDGETING
SYSTEM Company needs proper system since CIA
involves key major expenditures over long time
periods system must relate projects not to
short term but to long term planning one year
budgets are only useful as part of a long term
plan. Suggest (a) Measures of Investment - DCF
essential for analysis of major
projects compute results in 000's
only.
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6/176a 10. 2 CAPITAL BUDGETING
SYSTEM (b) Planning - set up Total Business
Plan for 5 years, researc ing the
environment, setting policies, key
decisions and an budgets. Replan every year for
5 years ahead ensure tha system
motivates a creative search for new
CIA projects. (c) Hurdle Rate - set minimum
acceptance rate for CIA projec to
ensure improvement of long term
profitability of the firm rate should be
"Average Cost of Capital" or different
(high rates to allow for risk.
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6/176b 10. 2 CAPITAL BUDGETING
SYSTEM (d) Ranking projects systematically
only after Q and NQ factor have been
considered. Use yield and Payback as
major criteria for the 'IQ (e) Search-for new
projects to provide both the short term
and long term profitability for the
company. (Do AA and PFD regularly).
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6/177 10. 3 AUDIT CIA
post-completion audits are vital to (a) Check
out the capital investment estimates against
reality. (b) Check original
assumptions. (c) Improve future CIA.
74
6/178 10.4 CONTROLLERS ROLE IN
CIA Controller' s role is mainly
to (a) Devise and install a capital budgeting
system which relates project proposals
to long term planning. (b) Give
technical advice to managers submitting
projects. (c) Educate managers in CIA. (d) Check
out CIA proposals. (e) Make post completion
audits of CIA projects. (f) Help to develop a
creative approach toward CIA
throughout the company.
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6/179 10.5 COMPUTERS Simple standard
computer packages available for CIA. Keep all
data simple! ! Don't believe the computer too
easily! Make alternative computations for each
project using various assumptions. NOTE Beware
of garbage! Discounted garbage! And even
worse, computerised discounted garbage! (CIA
based on wrong assumptions. )
76
6/180 10. 6 ALTERNATIVES AND CRITICISM
OF FACTORY MANAGERS
COMPUTATION (a) Many alternatives available
buy, do not buy, delay buying, buy
product, lease equipment, don't expand,
work double shift, etc. (b) Several errors in
the assumptions and method -
Depreciation is not a cash flow - relevant only
for tax shield. -
Calculation does not include DCF. -
Relevant production is 100 000 not 600
000. (c) Lease v. buy analysis could also be
made.
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6/181 EQUIPMENT DECISION AND
JUSTIFICATION (a) Q facvtor - CIA
Worksheet shows the the equipment is
not justified Payback
3 years Net Present Value
-1 Profitability Index
.8 Yield /-
10 (standard 15) (b) NQ factors - better
alternatives probably available (AA),
horizon may be less than 7 years, possible
quality problem etc, (PFD). (c) Subject to
NQ factors DO NOT BUY the equipment
now seek a better alternative.
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6/182 10.8 LEARNING
POINTS (a) Need for rigorous capital budgeting
system which relates projects and
capital budgets to long term
planning. (b) One year capital budget must be
related to long term plan. (c) Search
and audit are vital parts of the capital
budgeting system. (d) Post-completion audits
of projects essential for many reasons.
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6/182a 10.8 LEARNING
POINTS (e) Controller's responsibilities are
not' purely financial must design a
capital budgeting system for a
creative environmen (f) Q NQ D.
Mainly NQ! (g) Computers very useful for CIA if
based on valid assumptions. (h) Only
relevant cost and volumes should be
included in CIA.
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6/182b 10.8 LEARNING
POINTS (i) Depreciation is still not a
relevant cash flow. (j) Assumptions of costs and
prices may be wrong - verify underlying
assumptions and seek alternatives. (k)
All valid CIA computations must include income
tax. (1) Return on investment must be
DCF to be valid (SRI is not valid.)
81
6/182c 10.8 LEARNING
POINTS (m) Projects ranked by Yield and
Payback but decision depends mainly
on management judgement (NQ) not
Q.' (n) Watch for manipulation of the
numbers! (o) Do AA and PFD for all CIA
projects. (p) Keep the CIA numbers simple -
complex numbers not jutified by broad
assumptions.
82
6/183 10.9 LEARNING PATTERNS BUDGETIN
G SYSYEMS CIA not only for Project Analysis
But also for Long term planning
Short term capital budgets Procedures for
Search, Analysis, Ranking Decision,
Audit and Disinvestment.
83
6/184 10.9 LEARNING PATTERNS
RANKING FOR SELECTION RANK
PROJECTS BY PB, PI, YIELD BUT NOT BY NPV
OR SRI ...
84
6/185 10.9 LEARNING PATTERNS
CONTROLLER FUNCTIONS Creative
Cash Flows Capital
Future Profits System EVA SVA
CREATIVE ENVIRONMENT
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6/186 10.9 LEARNING PATTERNS
CIA COMPUTERS WIDER
RANGE WIDER ...
COMPUTERISED OF GOOD
RANGE OF
CIA ASSUMPTIONS
RESULTS NOTE Q NQ still equals D
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6/187 10.9 LEARNING PATTERNS
SETTING HURDLE RATE E AVERAGE COST OF CAPITAL
IS MINIMUM "HURDLE'L RATE D KEY
MANAGEMENT DECISION! NOTE Should change over
time!
87
6/188 10.9 LEARNING PATTERNS
ASSUMPTIONS
RELEVANT CASH FLOWS VOLUMES COSTS
CONTRIBUTIONS
88
6/189 10.9 LEARNING PATTERNS
CAPITAL INVESTMENT DECISIONS THE
CAPITAL BUDGETING SYSTEM CIA,
Q, NQ, DCF, AA, PFD MANAGEMENT JUDGEMENT
INTUITION DECISIONS
89
11.0 QUIZ - JUST FOR FUN
90
12.0 SUMMARY LECTURE FOR PART II
(WELL DONE!!!)
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6/190 12.0 SUMMARY LECTURE FOR PART
II 12.1 LEARNING OBJECTIVES (a) Understand the
language and concepts of DCF for
Capital Investrnent Analysis (CIA). (b) Develop
confidence in applying modern DCF
techniques to practical business
problems. (c) Appreciate the need for a creative
capital budgeting system for long term
planning of capital investment
involving search, analysis and
audit. (6) Communicate effectively with
technical and specialist
staff. (e) Motivate further study in the
fitture..
92
6/191 12.2 WORK
COMPLETED Language and concepts AA and
PED Measures of Investment - before tax and
after tax. Capital budgeting systems
93
6/192 12.3 CIA DECISIONS Key
decisions - large amounts - long time
periods. Cornmitment of funds Year 0 for benefit
years 1-20. Justification - law, policy and
economics. Importance (a) Future of company
depends on sound CIA. (b) Needs highest level of
managernent judgement and complex
skills. (c Magnitude, timing and wisdom of CIA
ensures long-term survival of the
firm.
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6/193 12.4 CASH PROFILE Reduce investment
to cash Profile years 0-20. Relevant costs and
savings. Ignore sunk and fixed
costs1 Contribution (not net profit). Depreciati
on for tax shield only. Cash Proflie is the KEY!
95
6/194 12.5 SELECTING DISCOUNT
RATES Key management decision. Need to
research the "Average Cost of Capital" to
determine the hurdle discount rate (DR). Policy
decision. Changes over time and possibly changes
by project. Company guidelines - General
Motors 20 AT - Sears Roebuck 10-15
AT - US Steel 8 AT
96
6/195 12.6 MEASURES OF CAPITAL
INVESTMENT (a) Measures and Standards - NPV -
Positive money PT - Positive 1 Yield - Above
TOR (b) NPV and Yield assume theoretically that
cash flow can be reinvested annually at
the same rate (c) Assumptions can be manipulated
to give any desired result -be
realistic - use a range - be
scepticall
97
6/196 12.7 PROVIDING FOR
RISK Conservative estimates of cash
flovi. High - low - expected values. Higher
IOR. Shorter horizons. Low TV'S.
98
6/197 12.8 SOPHISTICATED METHODS Materialit
y - work in COO's (K). Reality of
assumptions. Mathematical possibilities. Multipl
e measures. Graphical methods to show
sensitivity of the results to changes in
assumptions. Hertz model using computers and
"probability and expected value'1 techniques.
99
6/198 12.9 DICH D - Decisio
n and Criteria I - Investment C - Cash
Flpw H - Horizon and Terminal Value Foliowed by
Cash Profile, Measures of Investment, NQ Factors
and Decisions. NOTE Dont forget Alternative
Analysis, PFD, Emotional Investment,
Coconuts and Peanuts.
100
6/199 12.10 DISINVESTMENT (a) Exis
ting projects may produce ketter earnings
if sold (disinvested) rather than
retained. (b) Disinvestment is so often
psychologically difficult because of
EI. (c) Criteria should be the same
10k. (d) Specialised assets may have more value
to others than the first
owner. (e) Accounting book values do not
indicate Opportunity Cost of assets!
101
6/200 12.11 SYSTEMS Search ) Analysis )
Long term planning Criteria ) Short term capital
budgets Decision ) Audit )
102
6/201 12.12 FORMS AND
PROCEDURES (a) Controls and procedures provide
special forms for analysis.
evaluation and approval. (b) Training is
essential for technical and human
problems. (c) Good capital budgeting
systems require control and
enthusiasm based on the "spirit" rather than
the letterof the rules - outgrowth of
general environment of the
firm. (d) Need a creative approach to CIA.
103
6/202 12.13 BALANCED APPROACH TO
CAPITAL BUDGEflNG Promoting CIA
projects neyer depends purely on the
quantitative measures. Management must take
a balanced approach (a) Replacement Decisions
- where the company seeks cost savings
and the data is fairly accurate. (b) Expansion
Decisions - where the company seeks to
increase earnings from existing products.
104
6/202a 12.13 BALANCED APPROACH TO
CAPITAL BUDGEflNG (c) Product Line
Decisions - where the company seeks to
respond to competitive pressures and to
develop new product lines and volumes. (d)
Strategic Decisions - cannot be quantified
easily but are nevertheless vital to the
long term success of the company - MOST
IMPORTANT DECISIONS! NOTE No substitute for
sound business judgement and
intuition!!
105
6/203 12.14
OVERALL (a) CIA decisions are key decisions for
large amounts for long time periods,
upon which the Company's survival
depends. (b) CIA techniques are only an aid to
good business intuition but we must
avoid prejudice, therefore always do
AA and PFD early enough to avoid
Emotional Investment, in an alternative which
may not be the best available (c) Com
pany's capital budgeting system helps
managernent to select a portfolio of capital
investments that provide both short term
and long term profitability, EVA, SVA
and cash flow.
106
6/204 12.15 LEARNING PATTERNS APPROACH
TO RISK Conservative estimates Shorter
horizons High DR Low TVs Low expected cash flows
107
6/205 12.15 LEARNING PATTERNS
SYSTEMS Search Analysis Criteria Decision Audi
t Search etc. etc .
108
6/206 12.15 LEARNING PATTERNS
DICH DICH - CP - MOI AA PFD EI Q NQ
D
109
6/207 12.15 LEARNING PATTERNSI BALANCED
APPROACH Expansion Decisions CIA - Replacement
and Product Line Decisions Strategic
Decisions SOUND BUSINESS JUDGEMENT
110
CONCLUSIONS
111
6/208 12.16 CONCLUSiONS (a) C
IA is useful for practical decision-making
because it sharpens business intuition
as to which major projects should be
undertaken. (b) CIA is a systematic analysis
which explores the sensitivity of
projects to different assumptions and
seeks all alternatives.
112
6/208 12.16 CONCLUSiONS (c)
CIA must fit strategy it must be part of long
term planning choose not just
individual projects, but a portfolio of
investment opportunities. (d) Capital Budgeting
System should provide CIA with
appropriate forms, procedures, and post decision
audits.
113
6/208 12.16 Conclusions (e) So
phisticated methods of CIA using probability,
expected values, dispersion. MOnte Carlo
methods, decision trees, computers,
etc. are only as good as the
underlying assumptions. (f) Approach -
Examine.all alternatives. - Get
major figures right. Re-check assumptions.
- Smell the results - if they don't
smell right, do them again (or
get someone else to do them! )
114
6/208 12.16 Conclusions (g) Don
't be too conservative. If you keep that old
machine too long you are probably paying
for the new. one - without getting the
benefit of it!'1 (h) Remember shareholders and
management do not have the same goals
management is more concerned with cash
flow. (I) Payback does indicate when
cash will be available again for new
opportunities. However, quick payback
alone may reject good long term
investment opportunities.
115
6/208 12.16 Conclusions (j)
Provide for risk - political, economic,
technical and business the Manager must
feel responsible for his judgement of the
experts and the ASSUMPTIONS - even when
with the best of intentions - they turn
out .to be wrong!! (k) Don't plan Only for
the long term future - watch the effect
on profits this year too.'
116
6/208 12.16 Conclusions (l)
DCF is to be used for large amounts over long
time periods so don't "polish peanuts",
however emotionally satisfying that may
sometimes be. (m) CIA is no substitute but
only an aid to CREATIVE FINANCIAL
MANAGEMENT, and GOOD BUSINESS JUDGEMENT in
selecting a "Portfolio"of projects for
both short and long term profitability, cash
flow, EVA and SVA.
117
6/208 12.16 Conclusions
REPEATING . THE KEY MESSAGE... (l) DCF is to
be used for large amounts over long time
periods so don't "polish peanuts", however
emotionally satisfying that may sometimes
be. (m) CIA is no substitute but only an aid
to CREATIVE FINANCIAL MANAGEMENT, and
GOOD BUSINESS JUDGEMENT in selecting a
"Portfolio"of projects for both short
and long term profitability, cash flow,
EVA and SVA..
118
FINAL NOTES
119
FINAL NOTES THIS
ENDS OUR PROGRAM. WE HOPE IT HAS INSPIRED
YOU TO DEVELOP YOUR SKILLS BY PRACTICAL
APPLICATION. WE THANK YOU FOR YOUR
INTEREST AND HARD WORK.
120
FINAL NOTES KEEP
THE GLOSSARY HANDY AS A DAILY REFERENCE FOR CIA
LANGUAGE AND CONTINUE YOUR STUDIES. FOR ANY
HELP NEEDED robertboland_at_wanadoo.fr PROVIDES A
24 HOUR SERVICE WE HOPE YOU REALLY ENJOYED
THE AGL EXPERIENCE AND WILL CALL ON US FOR
FURTHER TRAINING IN THE EXCITING FIELD OF FINANCE
AND ACCOUNTING.