Strategic financial decision
making
Capital budgeting and investment
decisions
Decision tools
- NPV
- IRR
- Payback
- Profitability index
Key ingredients of NPV
Wat is a strategic financial decision
2 Important financial decisions managers face:
- investment decisions (i.e., how to allocate capital) = “how to raise
money”
- financing decisions (i.e., how to pay for investment and expenses by
using a (global) set of alternatives, D/E?) = “how to spend money”
Example of a financial decision: whether to take up a new investment in a
particular industry of country.
Goal of a corporation:
Managers are expected to make decisions that will maximize the firm
value for firm’s shareholders.
Modern view:
… maximize value for all stakeholders (e.g., employees, suppliers,
community)
Finance decisions are influenced by other business discipline functions
- marketing = to expand f.e. your business to another country
- management = they know about the entire resources of the
business, and they know f.e. if there is enough money for an extra
decision.
- accounting and information systems
What is capital budgeting
,Capital budgeting is the process of analyzing investment opportunities
and deciding which ones to accept.
A capital budget list is a list of all investments that a firm plans to
undertake during the next period. It is a list of decisions we might take or
not.
Common methods to decide which projects to select:
• Net present value (NPV)
• Internal rate of return (IRR)
• Payback period
• Profitability index
Investment decisions: does it matter?
In this lesson we are the “making investment decision”.
Net present value (NPV) analysis
We do a NPV-analysis to understand whether we schould accept the
project or not.
Managers increase shareholders’ wealth by accepting all projects that are
worth more than they cost.
Accept all projects with a positive value
How do you calculate this value?
Net present value of future cash flows that are affected by the
investment decision
What is the value of the project?
Step 1: is to calculate the value of the project.
Step 2: compare the costs to the present value of the project
Costs = present value of the cash outflows
Benefits = present value of the cash inflows
,Formula
𝐶0 = Initial Cash Flow (is most of the time negative)
𝐶𝑙 = Cash Flow at time 1
𝐶2 = Cash Flow at time 2
𝐶𝑡 = Cash Flow at time t
𝑡 = Time period of the investment
𝑟 = (Opportunity) cost of capital
Example 1: net present value of an investment opportunity
Problem:
You have been offered the following investment opportunity:
if you invest $1,000 today, you will receive $500 at the end of each of
the next three years.
If you could otherwise earn 10% per year on your money, should you
undertake the investment opportunity?
- Opportunity cost = “r” in the formula = 10% in this example
Solution:
We denote the upfront investment as a negative cash flow (because it is
money we need to spend) and the money we receive as a positive cash
flow.
To decide whether we should accept this opportunity, we compute the
NPV by computing the present value of the stream:
NPV = -1.000 + (500/1,10) + (500/1,102) + (500/1,103) = €243,43
Since the NPV is positive, we accept this project!
Perpetuities and annuities
Perpetuities (oneindige looptijd)
When a constant cash flow will occur at regular intervals forever it is called
a perpetuity.
If an investment goes to perpetuity, you will receive each year cashflows
(infinitively). The present value of the perpetuity = C/r.
, Annuities (vast bedrag elke maand maar wel een bepaalde LT)
When a constant cash flow will occur at regular intervals for a finite
number of N periods, it is called an annuity.
If an investment goes to annuity, we wille receive the same amount every
year but we wille stop at year “n”.
The present value of the annuity =
Growing perpetuity
Assume you expect the amount of your perpetual payment to increase at
a constant rate, g.
If an investment goes to growing perpetuities, our cashflows are growing
to grow compared to the cashflows of the previous years.
The present value of a growing perpetuity = C / (r – g)
Growing annuity
The present value of a growing annuity with the initial cash flow c, growth
rate g, and interest rate r is defined as:
“N” in the formula is the last Period.
NPV and Stand-alone projects
Consider a take-it-or-leave-it investment decision involving a single,
stand-alone project for Fredrick’s Feed and Farm (FFF).
The project costs $250 million and is expected to generate cash flows of
$35 million per year, starting at the end of the first year and lasting
forever.
- Cash inflow = 35
- Investment outflow or cash outflow at year 0 = 250
The NPV of the project is calculated as: -250 + (35/r)
The NPV is dependent on the discount rate (r)!
making
Capital budgeting and investment
decisions
Decision tools
- NPV
- IRR
- Payback
- Profitability index
Key ingredients of NPV
Wat is a strategic financial decision
2 Important financial decisions managers face:
- investment decisions (i.e., how to allocate capital) = “how to raise
money”
- financing decisions (i.e., how to pay for investment and expenses by
using a (global) set of alternatives, D/E?) = “how to spend money”
Example of a financial decision: whether to take up a new investment in a
particular industry of country.
Goal of a corporation:
Managers are expected to make decisions that will maximize the firm
value for firm’s shareholders.
Modern view:
… maximize value for all stakeholders (e.g., employees, suppliers,
community)
Finance decisions are influenced by other business discipline functions
- marketing = to expand f.e. your business to another country
- management = they know about the entire resources of the
business, and they know f.e. if there is enough money for an extra
decision.
- accounting and information systems
What is capital budgeting
,Capital budgeting is the process of analyzing investment opportunities
and deciding which ones to accept.
A capital budget list is a list of all investments that a firm plans to
undertake during the next period. It is a list of decisions we might take or
not.
Common methods to decide which projects to select:
• Net present value (NPV)
• Internal rate of return (IRR)
• Payback period
• Profitability index
Investment decisions: does it matter?
In this lesson we are the “making investment decision”.
Net present value (NPV) analysis
We do a NPV-analysis to understand whether we schould accept the
project or not.
Managers increase shareholders’ wealth by accepting all projects that are
worth more than they cost.
Accept all projects with a positive value
How do you calculate this value?
Net present value of future cash flows that are affected by the
investment decision
What is the value of the project?
Step 1: is to calculate the value of the project.
Step 2: compare the costs to the present value of the project
Costs = present value of the cash outflows
Benefits = present value of the cash inflows
,Formula
𝐶0 = Initial Cash Flow (is most of the time negative)
𝐶𝑙 = Cash Flow at time 1
𝐶2 = Cash Flow at time 2
𝐶𝑡 = Cash Flow at time t
𝑡 = Time period of the investment
𝑟 = (Opportunity) cost of capital
Example 1: net present value of an investment opportunity
Problem:
You have been offered the following investment opportunity:
if you invest $1,000 today, you will receive $500 at the end of each of
the next three years.
If you could otherwise earn 10% per year on your money, should you
undertake the investment opportunity?
- Opportunity cost = “r” in the formula = 10% in this example
Solution:
We denote the upfront investment as a negative cash flow (because it is
money we need to spend) and the money we receive as a positive cash
flow.
To decide whether we should accept this opportunity, we compute the
NPV by computing the present value of the stream:
NPV = -1.000 + (500/1,10) + (500/1,102) + (500/1,103) = €243,43
Since the NPV is positive, we accept this project!
Perpetuities and annuities
Perpetuities (oneindige looptijd)
When a constant cash flow will occur at regular intervals forever it is called
a perpetuity.
If an investment goes to perpetuity, you will receive each year cashflows
(infinitively). The present value of the perpetuity = C/r.
, Annuities (vast bedrag elke maand maar wel een bepaalde LT)
When a constant cash flow will occur at regular intervals for a finite
number of N periods, it is called an annuity.
If an investment goes to annuity, we wille receive the same amount every
year but we wille stop at year “n”.
The present value of the annuity =
Growing perpetuity
Assume you expect the amount of your perpetual payment to increase at
a constant rate, g.
If an investment goes to growing perpetuities, our cashflows are growing
to grow compared to the cashflows of the previous years.
The present value of a growing perpetuity = C / (r – g)
Growing annuity
The present value of a growing annuity with the initial cash flow c, growth
rate g, and interest rate r is defined as:
“N” in the formula is the last Period.
NPV and Stand-alone projects
Consider a take-it-or-leave-it investment decision involving a single,
stand-alone project for Fredrick’s Feed and Farm (FFF).
The project costs $250 million and is expected to generate cash flows of
$35 million per year, starting at the end of the first year and lasting
forever.
- Cash inflow = 35
- Investment outflow or cash outflow at year 0 = 250
The NPV of the project is calculated as: -250 + (35/r)
The NPV is dependent on the discount rate (r)!
