Capital investment policy samenvatting
Lecture 1
What is capital investment policy?
- Any investment policy must embody 2 components:
o One or more criteria by which to measure the relative economic attributes of
investment alternatives
▪ Welke criteria je gebruikt om alternatieve met elkaar te vergelijken
o Decision rules for selecting acceptable investement
▪ Hoe je beste kiest
- Purpose:
o A consistent and adequate investement policy has a double function:
▪ 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
o => is een soort communicatie middle
- The corporate finance perspective:
o Any company must answer 2 questions:
▪ What investment should it make?
• What real assets should it buy?
▪ How should it pay for these investments?
• What securities and other assets should it sell?
o Investments policies focus on question 1, but we will see that question 1 and 2 are
generally not independent
The financial goal of the corporation
What is a company?
- Company = group os projects
o Role of management is to choose the best projects
- Project = a series of cash flows
o Cash inflows = revenue
o Cash outflows = initial investments and expenses
- Cash flow = an amount of money paid at a specific time
o Cash inflow = positive amount
o Cash outflow = negative amount
Where do the company objectives come from?
- The goal of a firm is determined by the firm’s owners
o For a company, by its shareholders
- Management hired ta act on behalf of the owners/shareholders
o Day-to-day operations
- 2 problems:
o Definition of goals: what if shareholders disagree among each other?
o Implementation of shareholders’ goals: separation of ownership and control may
lead to agency conflicts
1
,The financial goal of the corporation
- All shareholders – independent of their individual preferences – can agree to assign one
objective to the manager:
o Maximize the current market value of shareholders’ investment in the firm
- With functioning financial markets, wealth can then be put to whatever purpose each
shareholder wants
o If you want money now, you sell your shares
o If you want money later, you keep your shares, and let them grow
- Example:
o Consider 2 investors with entirely different preferences:
▪ Assume both currently have €100 000
▪ A wants to save for the future, G wants to spent now
▪ If the interest rate is 10%, A would have €110 000 to spend in a year
o Financial markets allow A and G to transfer consumption over time
▪ Assume both have €110 000 at their disposal in 1 year
▪ A would be happy, G could borrow and spend €100 000 today
- Example 2:
o Suppose A and G have a friend (F) who starts a company and offers them a certain
payment of €121 000 next year if the invest their €100 000 today:
▪ A is happy: gets €121 000 instead of €110 000 tomorrow
▪ G is happy: can borrow €110 000 instead of €100 000 today
• Als je €121 000 naar vandaag brengt krijg je €110 000
o The success of F’s company is in the interest of A and G despite their different
consumption preferences
2
, - It is key that financial markets are well-functioning and competitive, and that all shareholders
have equal access
- Suppose G could not easily borrow against future returns:
o G would want to consume as much as possible now and thus push for higher
dividends/lower investment/… today
▪ Dan groeit bedrijf minder, maar krijgt ze wel hoger dividend
o A would push in the apposite direction and try to invest as much as possible to
maximize resources available for consumption tomorrow
o If both were shareholders in the same firm, the overall objectives would be
impossible to determine
- Careful: maximizing shareholder value ≠ maximizing profits
o increasing current profits by cutting back on LT investments may impair LT value
o not paying dividends and reinvesting additional cash in a mature company might
increase profits but not shareholder value
- Example: paying dividends VS investing:
o Suppose Tesla considers launching a new electric car and has set aside the necessary
cash
o Options: go ahead with the launch or pay cash to shareholders
o Suppose the launch is about as risky as the US stock market and that the stock
market offers a return of 10%.
o If the new car generates a return of 20% shareholders would be happy for Tesla to
launch; if it generates 5%, they prefer the cash
o Minimum rate of return at which shareholders would be happy with the launch and
not demand their money back: 10%
o This rate is also called hurdle rate or cost of capital; it is an opportunity cost as it
depends on shareholders’ outside options
o To remember: the appropriate opportunity cost depends on the risk of the proposed
investment
Implementing shareholder goals
- In perfect markets, maximizing shareholder value is an objective that all shareholders can
agree on. This makes it possible to delegate the management of the company to a hired
manager
- But: Managers’ private interests might not be aligned with the shareholders’ objective (job
security, bonuses, …); such diverging objectives cause agency problems
- Agency costs arise when managers do not maximize firm value or when shareholders incur
costs to monitor & constrain managers
- Suppose the return on A and G’s investment in F’s company would depend on F’s
commitment
- Once the company is funded, F might realize that networking with business partners may
lead to a well-paying and less stressful job
- For F it could be worthwhile to spend time networking even if this reduces her commitment
to (& thus the value of) her company
- A and G’s investment would lose value but enforcing F’s commitment may be costly
3
, Summary
- Shareholders with heterogeneous preferences can agree on maximizing company value as an
objective for the firm they own
- ⇒ The goal of the corporation is to maximize shareholder value
- A capital investment policy is a strategy for value creation
- Agency costs may arise because the implementation of the policy is delegated to a manager,
who may have diverging objectives
Investment decisions & present value
Investment decisions
- We are interested in corporate investment decisions because they are a way of creating value
for shareholders
- The goal is to choose “the most valuable” projects
- How do we decide whether projects add value for shareholders?
o And how do we know how much value they add?
- Example:
o You can pay €3.5M today to construct a building in 1 year
▪ The interest rate r to borrow around €3.5 M for 1 year is 10%
▪ The building will be worth €4.0 M next year
▪ Question: Is it profitable to build this structure?
o Need to make cash flows comparable:
▪ Present value (PV) of future cash flow: C1 / (1+r) = 4..1 = €3.64
▪ Future Value (FV) of current cash flow: C0 x (1 + r) = 3.5 x 1.1 = €3.85
▪ We call r the discount rate and 1/(1+r) the discount factor
Investments decision rules
- 3 rules:
o Present Value rule: Invest if PV = 𝑐1 /(1+r) > cost of investment = 𝑐0
▪ In our example, PV = €3.64, cost = e3.5, so invest
o Net Present Value rule: Invest if NPV = 𝑐𝑜 + 𝑐1 /(1+r) > 0
▪ In our example, NPV = €0.14 > 0, so invest
o Rate of Return rule: Invest if Rate of Return = Profit / Investment > r
▪ In our example, return = (4.0 – 3.5) / 3.5 = 14.3% > 10%, so invest
- Common principle: a project adds value if its return is higher than the return of comparable
alternative investments (hurdle rate, cost of capital)
PV with multiple cash flows
- The present value (PV) of a cash flow C1 one year from today is:
𝑐1
o PV = 1+𝑟
- The PV of a cash flow 𝑐𝑡 in year t is:
𝑐𝑡
o (1+𝑟) 𝑡
- The PV of a stream of cash flows 𝑐1 , 𝑐2 , …, is:
𝑐1 𝑐2 𝑐𝑡
o PV = 1+𝑟 + (1+𝑟) 2 + …. + (1+𝑟)𝑡
4
Lecture 1
What is capital investment policy?
- Any investment policy must embody 2 components:
o One or more criteria by which to measure the relative economic attributes of
investment alternatives
▪ Welke criteria je gebruikt om alternatieve met elkaar te vergelijken
o Decision rules for selecting acceptable investement
▪ Hoe je beste kiest
- Purpose:
o A consistent and adequate investement policy has a double function:
▪ 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
o => is een soort communicatie middle
- The corporate finance perspective:
o Any company must answer 2 questions:
▪ What investment should it make?
• What real assets should it buy?
▪ How should it pay for these investments?
• What securities and other assets should it sell?
o Investments policies focus on question 1, but we will see that question 1 and 2 are
generally not independent
The financial goal of the corporation
What is a company?
- Company = group os projects
o Role of management is to choose the best projects
- Project = a series of cash flows
o Cash inflows = revenue
o Cash outflows = initial investments and expenses
- Cash flow = an amount of money paid at a specific time
o Cash inflow = positive amount
o Cash outflow = negative amount
Where do the company objectives come from?
- The goal of a firm is determined by the firm’s owners
o For a company, by its shareholders
- Management hired ta act on behalf of the owners/shareholders
o Day-to-day operations
- 2 problems:
o Definition of goals: what if shareholders disagree among each other?
o Implementation of shareholders’ goals: separation of ownership and control may
lead to agency conflicts
1
,The financial goal of the corporation
- All shareholders – independent of their individual preferences – can agree to assign one
objective to the manager:
o Maximize the current market value of shareholders’ investment in the firm
- With functioning financial markets, wealth can then be put to whatever purpose each
shareholder wants
o If you want money now, you sell your shares
o If you want money later, you keep your shares, and let them grow
- Example:
o Consider 2 investors with entirely different preferences:
▪ Assume both currently have €100 000
▪ A wants to save for the future, G wants to spent now
▪ If the interest rate is 10%, A would have €110 000 to spend in a year
o Financial markets allow A and G to transfer consumption over time
▪ Assume both have €110 000 at their disposal in 1 year
▪ A would be happy, G could borrow and spend €100 000 today
- Example 2:
o Suppose A and G have a friend (F) who starts a company and offers them a certain
payment of €121 000 next year if the invest their €100 000 today:
▪ A is happy: gets €121 000 instead of €110 000 tomorrow
▪ G is happy: can borrow €110 000 instead of €100 000 today
• Als je €121 000 naar vandaag brengt krijg je €110 000
o The success of F’s company is in the interest of A and G despite their different
consumption preferences
2
, - It is key that financial markets are well-functioning and competitive, and that all shareholders
have equal access
- Suppose G could not easily borrow against future returns:
o G would want to consume as much as possible now and thus push for higher
dividends/lower investment/… today
▪ Dan groeit bedrijf minder, maar krijgt ze wel hoger dividend
o A would push in the apposite direction and try to invest as much as possible to
maximize resources available for consumption tomorrow
o If both were shareholders in the same firm, the overall objectives would be
impossible to determine
- Careful: maximizing shareholder value ≠ maximizing profits
o increasing current profits by cutting back on LT investments may impair LT value
o not paying dividends and reinvesting additional cash in a mature company might
increase profits but not shareholder value
- Example: paying dividends VS investing:
o Suppose Tesla considers launching a new electric car and has set aside the necessary
cash
o Options: go ahead with the launch or pay cash to shareholders
o Suppose the launch is about as risky as the US stock market and that the stock
market offers a return of 10%.
o If the new car generates a return of 20% shareholders would be happy for Tesla to
launch; if it generates 5%, they prefer the cash
o Minimum rate of return at which shareholders would be happy with the launch and
not demand their money back: 10%
o This rate is also called hurdle rate or cost of capital; it is an opportunity cost as it
depends on shareholders’ outside options
o To remember: the appropriate opportunity cost depends on the risk of the proposed
investment
Implementing shareholder goals
- In perfect markets, maximizing shareholder value is an objective that all shareholders can
agree on. This makes it possible to delegate the management of the company to a hired
manager
- But: Managers’ private interests might not be aligned with the shareholders’ objective (job
security, bonuses, …); such diverging objectives cause agency problems
- Agency costs arise when managers do not maximize firm value or when shareholders incur
costs to monitor & constrain managers
- Suppose the return on A and G’s investment in F’s company would depend on F’s
commitment
- Once the company is funded, F might realize that networking with business partners may
lead to a well-paying and less stressful job
- For F it could be worthwhile to spend time networking even if this reduces her commitment
to (& thus the value of) her company
- A and G’s investment would lose value but enforcing F’s commitment may be costly
3
, Summary
- Shareholders with heterogeneous preferences can agree on maximizing company value as an
objective for the firm they own
- ⇒ The goal of the corporation is to maximize shareholder value
- A capital investment policy is a strategy for value creation
- Agency costs may arise because the implementation of the policy is delegated to a manager,
who may have diverging objectives
Investment decisions & present value
Investment decisions
- We are interested in corporate investment decisions because they are a way of creating value
for shareholders
- The goal is to choose “the most valuable” projects
- How do we decide whether projects add value for shareholders?
o And how do we know how much value they add?
- Example:
o You can pay €3.5M today to construct a building in 1 year
▪ The interest rate r to borrow around €3.5 M for 1 year is 10%
▪ The building will be worth €4.0 M next year
▪ Question: Is it profitable to build this structure?
o Need to make cash flows comparable:
▪ Present value (PV) of future cash flow: C1 / (1+r) = 4..1 = €3.64
▪ Future Value (FV) of current cash flow: C0 x (1 + r) = 3.5 x 1.1 = €3.85
▪ We call r the discount rate and 1/(1+r) the discount factor
Investments decision rules
- 3 rules:
o Present Value rule: Invest if PV = 𝑐1 /(1+r) > cost of investment = 𝑐0
▪ In our example, PV = €3.64, cost = e3.5, so invest
o Net Present Value rule: Invest if NPV = 𝑐𝑜 + 𝑐1 /(1+r) > 0
▪ In our example, NPV = €0.14 > 0, so invest
o Rate of Return rule: Invest if Rate of Return = Profit / Investment > r
▪ In our example, return = (4.0 – 3.5) / 3.5 = 14.3% > 10%, so invest
- Common principle: a project adds value if its return is higher than the return of comparable
alternative investments (hurdle rate, cost of capital)
PV with multiple cash flows
- The present value (PV) of a cash flow C1 one year from today is:
𝑐1
o PV = 1+𝑟
- The PV of a cash flow 𝑐𝑡 in year t is:
𝑐𝑡
o (1+𝑟) 𝑡
- The PV of a stream of cash flows 𝑐1 , 𝑐2 , …, is:
𝑐1 𝑐2 𝑐𝑡
o PV = 1+𝑟 + (1+𝑟) 2 + …. + (1+𝑟)𝑡
4
