Capital Investment Policy
1.Lecture 1
1.1 What is “Capital Investment Policy”?
Harvard business review seeks to answer the question on what a good investment policy
is as follows:
- One or more criteria by which to measure the relative economic attributes of
investment alternatives.
- Decision rules for selecting “acceptable” investments.
- In the short run, it should indicate which investments should be chosen to achieve
the financial objectives of the corporation.
- In the long run, it should serve as a basis for identifying or developing investment
alternatives that are likely to match the policies selected.
In practice a company must answer two broad questions, which we will find out are generally
intertwined:
- What investments should it make?
- How should it pay for these investments?
1.2 The Financial Goal of the Corporation
The goal of a firm is decided by its owner, in the case of a corporation it is decided by
shareholders. A management team is hired to act on behalf of the owner(s) or shareholders.
Two problems may arise due to this structure:
- Definition of goals: What if shareholders disagree among each other?
- Implementation of shareholders‘ goals: Separation of ownership and control may
lead to agency conflicts.
Regardless of independent shareholder wishes, they can assign one common goal to their
management team: to maximise the current market value of shareholders’ investments in the
firm. By doing so they will accumulate wealth which they can use to achieve their personal
goals. Please note: Maximising Shareholder Value ≠ Maximising Profits => increasing short
term profits could inhibit future payoffs due to lack of present investments, in a mature
company: continuous investment might not add shareholder value, even though profits are
increasing. Which option is the most appropriate will be dictated by the hurdle rate or cost of
capital (recall last year's course: bedrijfsfinanciering) of an investment. This opportunity cost
is partly determined by the risk of said investment. However manager’s private interests
could interfere with their interest in maximising shareholder value thus leading to what we
call an agency problem which can lead to agency costs: these being the cost incurred by
the shareholders due to having to monitor and/or constrain a manager or due to the
manager’s lack of effort which causes a loss of value.
,1.3 Investment Decisions & Present Value
The goal when evaluating investments is obviously to choose the most valuable project!
Recall the present value rule, net present value rule and the rate of return rule.
The rest of this segment is entirely recapitulation of core concepts from Bedrijfsfinanciering,
therefore not worth discussing again. Please see ppt if additional information is needed.
Please note!!! Regardless of our preferences for cash today versus cash in the future, we
should always maximise NPV first! Presuming we can borrow at the risk-free interest rate.
1.4 Alternative Decision Rules
Again recapitulation so I will summarise briefly
Note: these alternative methods are not as accurate as the NPV but are often easier to use
and are therefore chosen over the far superior and more accurate alternative.
Internal rate of return: a project's IRR is the interest rate that equals the NPV to zero. This
method is the most popular alternative and usually leads to a correct result. We will accept
the project if the calculated IRR is greater than the cost of capital. The difference in the IRR
and the cost of capital is the highest estimation error that may occur that would not impact
the original decision. However
- The IRR method cannot distinguish the difference between lending or borrowing
money.
- It also struggles when there are multiple IRR’s for a given problem: the amount of
different IRR’s is the amount of times the sign of the cash flow changes during the
projects' lifespan. This means that also the NPV’s sign changes that many times and
we must therefore be cautious when choosing which interval of IRR to use.
- The IRR also doesn't take a project's scale into account which can cause issues
when we’re deciding between mutually exclusive projects.
- If interest rates vary during the course of a project then the IRR becomes quite
complex, the NPV-method however doesn’t change in complexity.
- Sometimes there isn’t even a real solution to a problem using the IRR, we cannot
make a decision based on an imaginary number.
Payback method: payback period is the amount of time it takes to recover or pay back the
initial investment. If the payback period is less than a pre-specified length of time, you accept
the project. Otherwise, you reject the project. It is used by many companies because of its
simplicity. However, it does not generally give a reliable decision since it ignores the time
value of money.
,1.5 Efficient Capital Markets & No-Arbitrage Pricing
Idem as previous paragraph
Efficient capital market: are meant to approximate the real world. Most implications of
assuming efficient capital markets hold if there are some investors who face no taxes, no
transaction costs, etc. It is presumed that there is no differential information. In efficient
markets it is impossible to “outsmart” the market.
Arbitrage: an arbitrage opportunity occurs when it is possible to make a profit without taking
any risk or making any investment. Efficient markets do not exhibit arbitrage opportunities.
Law of One Price: if equivalent investment opportunities trade simultaneously in different
efficient markets, they must trade for the same price in both markets. This also implies that
portfolios are valued as the sum of the included securities.
Unless the price of a security is equal to its NPV then there is an arbitrage opportunity which
will force the price up or down until it reaches said NPV, this is called the No Arbitrage Price.
This means that in a perfect capital market a financial investment will always have a NPV
equal to 0. These are different from real investments which will still be able to have positive
or negative NPV’s. This means that the only way to make money in the stock market (more
than a fair, risk adjusted return) is to know more than others (insider trading), if everyone
expects a stock to grow then that will be reflected in the price. Even if we introduce
transaction costs the price will not deviate further than the cost of said transaction.
X. Complementary material: interests
All seen in BeFi and/or BaFi: will only note useful information.
Effective Annual Rate (EAR): the interest we will effectively receive, taking k-periods of
compounding into account.
Annual Percentage Rate (APR): the interest rate over the year, not taking the compounding
effect into consideration: if 𝑖 is the rate over 𝑘 periods then 𝐴𝑃𝑅 = 𝑘. 𝑖.
𝑘
=> Conversion: 𝐸𝐴𝑅 = (1 + 𝐴𝑃𝑅/𝑘) − 1.
𝑃
To calculate a loan payment: 𝐶 = 1 1 𝑁 with 𝑃 being the initial loan.
𝑟
(1−( 1+𝑟 ) )
Real and Nominal interest rates conversion: (1 + 𝑟𝑟𝑒𝑎𝑙)(1 + 𝑖𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛) = 1 + 𝑟𝑛𝑜𝑚.
𝑟−𝑖
=> 𝑟𝑟𝑒𝑎𝑙 = 1+𝑖
.
Don't forget! Discount real cash flows with the real interest rate and discount nominal cash
flows with the nominal interest rate.
, X. Complementary material: valuation multiples
Method of Comparables (Comps): estimate the value of the firm based on the value of other,
comparable firms or investments that we expect will generate very similar cash flows in the
future.
Valuation Multiple: a ratio of a firm's value to some measure of the firm’s scale or cash flow.
Example: The Price-Earnings Ratio: P/E Ratio = Share price divided by earnings per share.
Limitations:
- When valuing a firm using multiples, there is no clear guidance about how to adjust
for differences in expected future growth rates, risk, or differences in accounting
policies.
- Comparables only provide information regarding the value of a firm relative to other
firms in the comparison set.
=> discounted cash flows methods take more variables into account such as a companies
own discount rate which in itself takes many risk factors into account. This method is
therefore more accurate than valuation through multiples.
2.Lecture 2
Profitability index: when a firm’s resources are constrained then it may have other
investment priorities, f.e. How to use their available resources as optimally as possible. In
𝑁𝑃𝑉
this case we’ll evaluate the profitability index of each investment: 𝑃𝐼 = 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑑
.
However, 2 conditions must be satisfied: The set of selected projects must exhaust all
capital/resources and there is only one resource constraint.
2.1 Portfolio and CAPM Theory
Portfolio theory: we assume that investors only care about a portfolio’s mean return and its
variance and moreover that an investor can invest in many securities. The volatility of an
“efficient” portfolio cannot be lowered without lowering its expected return, if this isn’t the
case then it’s the case of an inefficient portfolio. Note!: correlation has no effect on the
expected return of a portfolio, it only impacts the volatility! Therefore if stocks are perfectly
correlated, the diversification effect will be non-existent. The lower the correlation the greater
the diversification effect will be. We can long or short stocks as well, if we long a stock we
can view it as going above 100% because we’re adding on top of what we own and if we
short it can be viewed as going below 0% (we are selling an asset we don’t own). If we add
more stocks to the portfolio, even if putting all our money in just that stock would be
inefficient, that does not mean that there isn’t an effective diversification to be made! An
efficient frontier will form showing us what the efficient sets are. => you cannot do worse by
having more investment opportunities. If a portfolio is not in the efficient frontier then that
portfolio has a diversifiable risk.
1.Lecture 1
1.1 What is “Capital Investment Policy”?
Harvard business review seeks to answer the question on what a good investment policy
is as follows:
- One or more criteria by which to measure the relative economic attributes of
investment alternatives.
- Decision rules for selecting “acceptable” investments.
- In the short run, it should indicate which investments should be chosen to achieve
the financial objectives of the corporation.
- In the long run, it should serve as a basis for identifying or developing investment
alternatives that are likely to match the policies selected.
In practice a company must answer two broad questions, which we will find out are generally
intertwined:
- What investments should it make?
- How should it pay for these investments?
1.2 The Financial Goal of the Corporation
The goal of a firm is decided by its owner, in the case of a corporation it is decided by
shareholders. A management team is hired to act on behalf of the owner(s) or shareholders.
Two problems may arise due to this structure:
- Definition of goals: What if shareholders disagree among each other?
- Implementation of shareholders‘ goals: Separation of ownership and control may
lead to agency conflicts.
Regardless of independent shareholder wishes, they can assign one common goal to their
management team: to maximise the current market value of shareholders’ investments in the
firm. By doing so they will accumulate wealth which they can use to achieve their personal
goals. Please note: Maximising Shareholder Value ≠ Maximising Profits => increasing short
term profits could inhibit future payoffs due to lack of present investments, in a mature
company: continuous investment might not add shareholder value, even though profits are
increasing. Which option is the most appropriate will be dictated by the hurdle rate or cost of
capital (recall last year's course: bedrijfsfinanciering) of an investment. This opportunity cost
is partly determined by the risk of said investment. However manager’s private interests
could interfere with their interest in maximising shareholder value thus leading to what we
call an agency problem which can lead to agency costs: these being the cost incurred by
the shareholders due to having to monitor and/or constrain a manager or due to the
manager’s lack of effort which causes a loss of value.
,1.3 Investment Decisions & Present Value
The goal when evaluating investments is obviously to choose the most valuable project!
Recall the present value rule, net present value rule and the rate of return rule.
The rest of this segment is entirely recapitulation of core concepts from Bedrijfsfinanciering,
therefore not worth discussing again. Please see ppt if additional information is needed.
Please note!!! Regardless of our preferences for cash today versus cash in the future, we
should always maximise NPV first! Presuming we can borrow at the risk-free interest rate.
1.4 Alternative Decision Rules
Again recapitulation so I will summarise briefly
Note: these alternative methods are not as accurate as the NPV but are often easier to use
and are therefore chosen over the far superior and more accurate alternative.
Internal rate of return: a project's IRR is the interest rate that equals the NPV to zero. This
method is the most popular alternative and usually leads to a correct result. We will accept
the project if the calculated IRR is greater than the cost of capital. The difference in the IRR
and the cost of capital is the highest estimation error that may occur that would not impact
the original decision. However
- The IRR method cannot distinguish the difference between lending or borrowing
money.
- It also struggles when there are multiple IRR’s for a given problem: the amount of
different IRR’s is the amount of times the sign of the cash flow changes during the
projects' lifespan. This means that also the NPV’s sign changes that many times and
we must therefore be cautious when choosing which interval of IRR to use.
- The IRR also doesn't take a project's scale into account which can cause issues
when we’re deciding between mutually exclusive projects.
- If interest rates vary during the course of a project then the IRR becomes quite
complex, the NPV-method however doesn’t change in complexity.
- Sometimes there isn’t even a real solution to a problem using the IRR, we cannot
make a decision based on an imaginary number.
Payback method: payback period is the amount of time it takes to recover or pay back the
initial investment. If the payback period is less than a pre-specified length of time, you accept
the project. Otherwise, you reject the project. It is used by many companies because of its
simplicity. However, it does not generally give a reliable decision since it ignores the time
value of money.
,1.5 Efficient Capital Markets & No-Arbitrage Pricing
Idem as previous paragraph
Efficient capital market: are meant to approximate the real world. Most implications of
assuming efficient capital markets hold if there are some investors who face no taxes, no
transaction costs, etc. It is presumed that there is no differential information. In efficient
markets it is impossible to “outsmart” the market.
Arbitrage: an arbitrage opportunity occurs when it is possible to make a profit without taking
any risk or making any investment. Efficient markets do not exhibit arbitrage opportunities.
Law of One Price: if equivalent investment opportunities trade simultaneously in different
efficient markets, they must trade for the same price in both markets. This also implies that
portfolios are valued as the sum of the included securities.
Unless the price of a security is equal to its NPV then there is an arbitrage opportunity which
will force the price up or down until it reaches said NPV, this is called the No Arbitrage Price.
This means that in a perfect capital market a financial investment will always have a NPV
equal to 0. These are different from real investments which will still be able to have positive
or negative NPV’s. This means that the only way to make money in the stock market (more
than a fair, risk adjusted return) is to know more than others (insider trading), if everyone
expects a stock to grow then that will be reflected in the price. Even if we introduce
transaction costs the price will not deviate further than the cost of said transaction.
X. Complementary material: interests
All seen in BeFi and/or BaFi: will only note useful information.
Effective Annual Rate (EAR): the interest we will effectively receive, taking k-periods of
compounding into account.
Annual Percentage Rate (APR): the interest rate over the year, not taking the compounding
effect into consideration: if 𝑖 is the rate over 𝑘 periods then 𝐴𝑃𝑅 = 𝑘. 𝑖.
𝑘
=> Conversion: 𝐸𝐴𝑅 = (1 + 𝐴𝑃𝑅/𝑘) − 1.
𝑃
To calculate a loan payment: 𝐶 = 1 1 𝑁 with 𝑃 being the initial loan.
𝑟
(1−( 1+𝑟 ) )
Real and Nominal interest rates conversion: (1 + 𝑟𝑟𝑒𝑎𝑙)(1 + 𝑖𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛) = 1 + 𝑟𝑛𝑜𝑚.
𝑟−𝑖
=> 𝑟𝑟𝑒𝑎𝑙 = 1+𝑖
.
Don't forget! Discount real cash flows with the real interest rate and discount nominal cash
flows with the nominal interest rate.
, X. Complementary material: valuation multiples
Method of Comparables (Comps): estimate the value of the firm based on the value of other,
comparable firms or investments that we expect will generate very similar cash flows in the
future.
Valuation Multiple: a ratio of a firm's value to some measure of the firm’s scale or cash flow.
Example: The Price-Earnings Ratio: P/E Ratio = Share price divided by earnings per share.
Limitations:
- When valuing a firm using multiples, there is no clear guidance about how to adjust
for differences in expected future growth rates, risk, or differences in accounting
policies.
- Comparables only provide information regarding the value of a firm relative to other
firms in the comparison set.
=> discounted cash flows methods take more variables into account such as a companies
own discount rate which in itself takes many risk factors into account. This method is
therefore more accurate than valuation through multiples.
2.Lecture 2
Profitability index: when a firm’s resources are constrained then it may have other
investment priorities, f.e. How to use their available resources as optimally as possible. In
𝑁𝑃𝑉
this case we’ll evaluate the profitability index of each investment: 𝑃𝐼 = 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑑
.
However, 2 conditions must be satisfied: The set of selected projects must exhaust all
capital/resources and there is only one resource constraint.
2.1 Portfolio and CAPM Theory
Portfolio theory: we assume that investors only care about a portfolio’s mean return and its
variance and moreover that an investor can invest in many securities. The volatility of an
“efficient” portfolio cannot be lowered without lowering its expected return, if this isn’t the
case then it’s the case of an inefficient portfolio. Note!: correlation has no effect on the
expected return of a portfolio, it only impacts the volatility! Therefore if stocks are perfectly
correlated, the diversification effect will be non-existent. The lower the correlation the greater
the diversification effect will be. We can long or short stocks as well, if we long a stock we
can view it as going above 100% because we’re adding on top of what we own and if we
short it can be viewed as going below 0% (we are selling an asset we don’t own). If we add
more stocks to the portfolio, even if putting all our money in just that stock would be
inefficient, that does not mean that there isn’t an effective diversification to be made! An
efficient frontier will form showing us what the efficient sets are. => you cannot do worse by
having more investment opportunities. If a portfolio is not in the efficient frontier then that
portfolio has a diversifiable risk.
