Investment Decisions Flashcards
Week 7 & 8
What are the two horizons of managerial decision-making?
- ST operational decisions (Pricing, Advertising, Output)
- LT strategic decisions (Growth, Investment decisions, Financing)
What are some examples of Long-term strategic decisions?
- Capital Investment, new products, market-entry, technological adaptation, Expenditure on R&D and HC, M&A
What is Capital Budgeting? How does it differ from Capital Expenditure?
- Capital Budgeting is the process of planning for/evaluating capital expenditure
- Capital Expenditure is the cash outflow designed to generate a flow of future cash benefit
- Capital expenditure is costly and tough to reverse
When should a firm choose whether to invest?
- If future return > MCk, this means that the firm should invest
- It is important to compare the Investment Opportunity Curve (downward) VS MCk Curve (upward)
What are the steps of Capital Budgeting?
- Generate alternative capital investment project
- Estimate cash flows for project proposal
- Evaluate and choose investment projects to implement
- Review investment project and check said assumptions
Elaborate on generating alternative capital investment project
- Proposals come from management/workers/shareholders
- All investment projects are Long-Term
- Proposal screening from chiefs/managers/presidents
What should be included and excluded in the calculation for investment?
- Basic calculation of what to include/exclude (all measured in opportunity cost)
- INCLUDE: incremental cash flow, externalities, CFAT
- EXCLUDE: sunk-costs, Non-incremental overheads
How can you evaluate a project?
- Typically, the project initially outflows and then inflows incremental
- Need to compare cash at different times which is tough
- Two methods of NPV and IRR
What is the NPV? Give the equation for NPV and PV and when firms know when to accept/reject the project
- NPV is the present value, discounted at the cost of capital (K) [differs between firms] of the streams of Net Cash Flow minus the net investment
- PV = Σ[At / (1+K)^t] where At is an unequal payment
- NPV = Σ[NCF / (1+K)^t] - NINV
- If NPV >0, accept the project
What is the IRR? Give the equation for IRR and when firms know when to accept/reject the project
- IRR is the discount rate that equates the PV with the Net Investment i.e. NPV = 0
- Using NPV = 0, the IRR is the r in the equation
- If IRR>k, Accept the project
What is the comparison between NPV and IRR?
- Come to the same conclusion (NPV>0 and r>k are the same thing)
- In the case of mutually exclusive projects, they may give different values
- NPV > IRR because IRR doesn’t account for magnitudes of projects
What is the equation for ARR and when firms know when to accept/reject the project
- ARR = [Average annual profits after tax] / [initial investment of projects]
- Accept if ARR>k
- Based on accounting income, not cashflows
- Doesn’t take into account inflow & outflow timing
What is the Payback Period? Give the equation and when firms know when to accept/reject the project
- Payback Period is based on the length of time required to recover the cost of an investment
- PP = [Initial Investment of a Project] / [Annual Cashflow]
- Accept if PP < Maximum Acceptable PP (Defined by the firm)
- Popular but it doesn’t consider cashflows or timings of flows
What is Capital Rationing? What is used to rank bundles within the Capital budget?
- How to ration available capital among competing potentially successful projects
- These can be ranked using the profitability ratio
- PR = 1 + NPV/NINV
- You cannot exceed capital funds constraints
What is the Cost of Capital?
- How much a firm has to pay for the capital it uses to finance new investment
- The minimum rate of return that must be earned for new investment
- This is determined by the capital market
- Related to risk of new investment, existing assets and firm’s capital structure
What are the two major sources of investment? How are these financed?
- EXTERNAL: Debt and Equity
- INTERNAL: Cash flow
What is the equation for the cost of debt?
- Ki = Kd(1-T)
Ki is after tax K, Kd is before tax K and T is MRT
What are the equations for cost of equity? What does it depend on?
- The type of Model (DVM Vs CAPM)
- Ke = D1/V0 + g
D1 is the shareholders dividends at the end, V0 is the value of the stock at the start, g is the growth rate
- Ke = D1/V0 + g
- This comes from the sum of a geometric progression, where D1 = A, Ke = ‘1’ and g = r
- Ke = rf + β(Rm-rf)
What is the equation for the Weighted average cost of Capital (WACC)?
- Kc = [E/D+E] Ke + [D/D+E] Kd
What is Capital Structure?
- The composition of debt & equity in total investment financing
What is leverage? How can leverage be calculated and what are the other names it can be called?
- Leverage is the combination of debt & equity is used to maximise the firm’s value
- AKA Debt-to-Equity ratio, Capital Gearing
- Leverage = D/E
What are the advantages of financing with debt?
- Cheaper (r<D), especially when r is low
- Less risky for investors (lenders)- debt holders get paid first in the event of default
- Low effective costs, interest payments are tax-deductible
- Lower costs of issuing & administration
- Allows company to retain ownership (no stocks/shares)
What are the disadvantages of financing with debt?
- High borrowing can risk inability to meet repayments
- Shareholders are exposed to more risk than just business
- Rational shareholders will expect greater compensation
What are the five theories of Capital Structure?
- Modigliani-Miller Theory
- Traditional Theory
- Trade-off Theory
- Pecking order Theory
- Agency costs Theory
What is the Modigliani-Miller Theory? What are some of the drawbacks and assumptions? How does this come to the conclusion?
- There are no ‘frictions’ [transactional costs, taxes, costless info, symmetric info]
- This means that Kc and the value of the firm remain constant, regardless of the degree of leverage
- This is because total investment value depends on its underlying profitability and risk; if leverage increases, risk moves between D and E
- The model is unrealistic and was refuted by empirical evidence (was then used to include tax)
- Debt is seen as better
What is Traditional Theory? What are some of the drawbacks and assumptions?
- Assumes there is an optimal capital structure and that the firm can increase its value through leverage
- If CS is only equity, Ke=Kc
- When debt increases, Ke increases, but Kc falls until point x
- However, when leverage increases, this brings greater risk-> investors need Ke because Ke and Ki rise, Kc rises and a firm’s value declines
- Firms want to be at x (optimal level) where Kc is minimised and Vg [Company Value] is maximised
What is Trade-Off Theory? What are the conclusions that can be drawn?
- Assumes that a firm trades off between benefits and costs of debt and equity financing to optimise capital structure
- BENEFITS: Tax benefits of Debt
- COSTS: Bankruptcy costs and stress of cost of debt
- Trade-off between benefits and costs (rewards vs risk)
What is Pecking Order Theory? What are some of the drawbacks and assumptions?
- Based on asymmetric information between managers and shareholders
- Firms prefer internal financing to external
- In the necessity case of external financing, debt is prefered to equity (no divorce of ownership)
- Myers (1984) counteracted this:
- Managers are assumed to know better than investors
- Investors believe managers think the firm is overvalued- managers take advantage
- Investors may place a lower value to equity
What is Agency Costs Theory?
- Based on the principle/agent theory, where the shareholder can abuse the manager because of asymmetric information
- Agency cost= financial loss due to asymmetric information
- As debt:equity ratio increases, so does manager risk
- Management has the incentive to destroy a firms value through empire building & perks- increased leverage imposes financial discipline
What is Country Risk Analysis? Who measures it?
- CRA is the risk of investing/lending in a country
- This could be from changes in business environment that may adversely affect profits
- CRA is included in the risk-premium of required rate of return and is connected to cross-border investment
- Credit risk rating agencies (e.g. Moody’s) and Political risk agencies (e.g. Economist Intelligence Unit) can measure these things
How do you account for Country Risk?
- Insurance against the risk
- Detailed analysis of risk factor
- Scenario Planning
What is Cost Benefit Analysis? How should the project be evaluated?
- Used to assess the consequences of a particular program expenditure or policy change
- Objective to maximise social welfare
- Issues arise as to how to measure costs/benefits and how to determine the discount rate
- Accept the programme if the PVbenefits/PVcosts > 1 [can use NPV/IRR]
- For expansion, look if MB>MC
What is the decision-making process for Cost-Benefit analysis?
- Determine the objective to be maximised
- Consider constraints on decisions
- Costs & Benefits that should be considered
- Select criterion to determine acception
- Select appropriate discount rate
What does CBA say about Pareto efficiency?
- Assumes ‘Potential’ Pareto improvement
- Kaldor-Hicks criterion: A change is desirable if those better off in principle compensate those who are made worse-off
- Hence there is a net gain
What are some of the Constraints for CBA?
- Physical- land, technology
- Legal/administrative- laws, hiring quality people
- Political/Social- Culture, Moderation of what is the best
- Financial/Distributional- Losers cannot be too harmed
How can Costs/Benefits be categorised?
- Direct Benefits (Crops from a new irrigation system)
- Direct Costs (Capital Costs)
- Indirect Costs/Benefits (Affects 2nd parties)
- Intangibles (QoL, aesthetics)
- Tough to measure, so approximations are used
What is the social rate of discounting?
- The discount rate to be used when evaluating a project
- Potential for bias, objectors want a high rate
- The discount rate is the function of allocation of resources between public & private sectors
What is Cost-Effective analysis? What are the two theories?
- Due to difficulty estimating, this asks what are the alternatives to reach the goal
- How can the goal be reached most efficiently?
- Least cost: Identify least expensive method
- Objective-level: Estimate the cost of achieving several performance level of the same objective
