The Investment Decision

Finance Week 3 The Asset Investment, Valuation Decision

Gavin Kretzschmar1,
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Accounting and Finance Group

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University of Edinburgh
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MBA 2010-2011 - Higgins Ch 7

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Capital Budgeting

The future of a company lies in the investments it makes today. Investment project proposals are the responsibility of all managers in the organization. Capital budgeting is the nancial evaluation of project proposals. Weigh outlay today vs. expected future benets. DCF Discounted cash ow analysis is the backbone of modern academic nance. DCF is used to evaluate cash ow streams whose costs and/or benets extend beyond the current year.

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Figures of Merit Three-step procedure

Estimate the relevant cash ows. Calculate a gure of merit for the investment, summarizing the investments economic worth. Compare the gure of merit to an acceptance criterion.

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Payback Period and Accounting Rate of Return

The payback period is the amount of time the company must wait before recouping its original investment. - The piers payback period is 5 1/3 = 40/7.5. Accounting rate of return (arr) is the ratio of annual average cash ow to total cash outow. The piers arr = 21.1% = [(7.5 x 9 + 17)/10]/40.

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Issues

The payback period ignores cash ows after payback, and also ignores the time value of money. - The payback period is sometimes useful as a rough guide to project risk. The arr ignores the timing of cash ows.

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Compounding and Discounting

The future value received in a year, from $1 invested today at 10%, is $1.10. The present value of $1.10 to be paid in a year when the interest rate is 10% is $1. With compounding, the future value received in 2 years, from $1 invested today at 10%, is $1.21 = 1 x 1.1 x 1.1. In reverse, the present value of $1.21 to be paid in two years when the interest rate is 10% is obtained by dividing the 1.21 by 1.12.

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Interpretation

The discount rate is the interest rate and the term is called a discount factor - derived using the WACC If a company has cash on hand, the discount rate reects the companys opportunity cost of capital. If a company raises the cash externally, the discount rate measures the investors opportunity cost of capital.

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Equivalence and NPV

Two cash ow streams with the same present value can be transformed into each other. Net present value is the present value of the future expected cash ows minus the initial investment. NPV measures the amount of value creation. Decline negative NPV projects, and accept non-negative NPV projects.

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Benet-Cost Ratio

BCR = PV of cash inows divided by PV of cash outows. The BCR is also known as the protability index. IRR The internal rate of return (IRR) is "the" discount rate that makes the PV of a stream of cash ows equal to zero. Loosely speaking, the IRR can be regarded as the rate of return associated with the cash ows.

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Applications and Extensions

Bond valuation. Par value of $1,000. Coupon rate of 8%. Maturity is 9 years. Required return is 7%. PV = $1,065.15.

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IRR of Perpetuity

A paid per year into perpetuity, when required return is r. P = A/r. r = A/P

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Mutually Exclusive Alternatives and Capital Rationing

Situation there is more than one way to accomplish an objective, and the investment problem is to select the best alternative. When investments are independent, all three gures of merit NPV, IRR, BCR - will generate the same investment decision.

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Capital Rationing
Capital rationing exists when the decision maker has a xed investment budget that is not to be exceeded. Task is to rank the opportunities according to their investment merit. Capital rationing can alter the ranking of alternative independent investments. IRR in Perspective IRR has more intuitive appeal than NPV and BCR. IRR can sometimes allow the decision maker to sidestep the question of what is the right discount rate for the investment. At the same time, there might be multiple values for IRR, or no IRR at all. IRR might be invalid for analyzing mutually exclusive alternatives under capital rationing.

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Determining the Relevant Cash Flows

Two principles. Cash ow principle: time stamp cash ows, recording them when they actually occur. With-without principle: record only cash ow differences that occur because an investment is made as opposed to not made.

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Example

MBA Example

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Financing Costs

Financing costs refer to any dividend, interest, or principal payments associated with nancing an investment. The standard procedure is to reect the cost of money into the discount rate and ignore nancing costs. This issue comes up again in the next chapter.

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A Decision Tree

Figure 7A-2 provides a capsule summary of the key points involved in capital budgeting.

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Overview

Markets and instruments - Case The nancing decision - and capital structure (WACC) This week the Investment decision - we need to work on calculation skills. Case cover the WACC example - get into the calculations and calculators!

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The Objective in Decision Making

In traditional corporate nance, the objective in decision making is to maximize the value of the rm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efcient, the objective is to maximize the stock price. All other goals of the rm are intermediate ones leading to rm value maximization, or operate as constraints on rm value maximization.

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Picking the Right Projects: For the Firm - Investment Analysis First Principles

Invest in projects that yield a return greater than the minimum acceptable hurdle rate (we have a few tools that need to learn to use - PB - DPB - NPV - IRR) The hurdle rate should be higher for riskier projects and reect the nancing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash ows generated and the timing of these cash ows; they should also consider both positive and negative side effects of these projects.

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Picking the Right Projects: For the Firm - Investment Analysis First Principles

Choose a nancing mix that minimizes the hurdle rate and matches the assets being nanced. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics. Objective: Maximize the Value of the Firm

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The Basics of Capital Budgeting

Dealing with problem areas Working Capital Sunk Costs Cannibalization Excess capacity Capital Rationing - how many projects?

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Capital Budgeting

A project, with a life of four years, has the following projected cash ow: Investment in an oileld Cash ow projection $000 Receipts Payments Year 1 100 500 Year 2 150 50 Year 3 200 60 Year 4 450 150

What is the payback period, discounted payback period, net present value (NPV) and internal rate of return (IRR) of the project assuming a cost of capital of 10%?

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Capital Budgeting

Investment in an oileld $500 Cash ow Cumulative cash ow Discounted cash ow Cumulative Discounted cash ow Year 1 (400) (400) (364) (364) Year 2 100 (300) 83 (281) Year 3 140 (160) 105 (176) Year 4 300 140 205 29

Payback occurs after 3.53 year, discounted payback after 3.86 years.

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Capital Budgeting

Cash ows $000 Receipts Payments Cash ow

1 Discount factor 10% (1+0.1)t Discounted cash ow

Year 1 100 500 (400) 0.9091 (364)

Year 2 150 50 100 0.8264 83

Year 3 200 60 140 0.7513 105

Year 4 450 150 300 0.6830 205

Net Present Value NPV = 29.082

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Capital Budgeting

Cash ows $000 Receipts Payments Cash ow

1 Discount factor 14% (1+0.14)t Discounted cash ow

Year 1 100 500 (400) 0.8772 (351)

Year 2 150 50 100 0.7695 77

Year 3 200 60 140 0.6750 95

Year 4 450 150 300 0.5921 178

Net Present Value NPV = 1.8

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