Capital Investment Policy
1. The Investment Decision
1. Decision within corporate finance
There are three important (inter-related) decisions in corporate finance:
o The investment decision(allocate resources to projects)
Dixit and Pindyck (1994): “The act of incurring an immediate cost in the
expectation of future rewards”.
Invest only when expected return > minimum acceptable return (‘required
return’)
Returns come from free cash flows(leveraged=after all financing
charges are done)(after all net working capital etc has been
accounted and diminshed)
The required return (k) reflects the project’s 1) activity risk and 2)
financial risk
Hurdle rate(alternative)
Discounting unleveraged cashflow at the WACC
In most business, no opposite outcomes as value maximalization of
shareholders and the firm as a whole looks similar
o The financing decision(raise funds)
- What is the optimal mix of equity and debt in a firm?
- What is the optimal composition of the equity and the debt?
- What is the optimal maturity structure of the debt?
Choose a financial structure that contributes to firm value maximization, i.e.
a low WACC and leads to the proper selection of projects
o The dividend decision(distribution)
How much of the realized profits (‘earnings’) should be paid out to the firm’s
shareholders?
If dividends are retained, the share price will increase ↔ signaling
function of dividends
A large dividend now, means a smaller in the future
→→ Investment, financing and dividend decisions are highly inter-related:
o Investments + equity payments (dividends) + debt payments (interest + principal)
o =
o internally generated cash flows + externally raised funds (equity + debt)
2. Objectives of the investment decision
Maximization of the value of the firm
o The management of a firm serves best the interests of its shareholders when
maximizing firm value, at least when the firm is not in financial distress
o Consider the following one-period model:
The economy consists of one company, held by multiple (N) shareholders
1
, One euro invested today (time 0) yields a sure future return at time 1
Each individual shareholder has to trade off current and future consumption;
the marginal utility of additional consumption is positive, but decreasing
By investing/borrowing money, consumption can be shifted over time
Each individual shareholder wants to maximize his/her utility (satisfaction)
from consumption (indifference curve)
The company has access to a production technology (production opportunity
curve); the marginal revenue of investment is positive, but decreasing
→ How much to invest if all shareholders have different preferences and
indifference curves?
MAXIMIZE FIRM VALUE(and so on Shareholders value) BY INITIATE
ALL PROJECTS WITH + NPV
Afterwards, shareholders can adjust their income flows by
o lending/borrowing money at the market interest rate k
o buying/selling shares in the firm
o → Indifferent between smaller dividend today….
This indifference only results in the presence of perfect capital markets
o It is possible to make Pareto-optimal choices of current and future
consumption(because of existence of a capital market):
no individual has a lower utility
at least one person realizes a higher utility in the presence of the capital
market line (CML)
In equilibrium: return on marginal unit of investment =
k, i.e. opportunity cost of capital
Marginal substituion rate of current and future consumption for
each individual
o → When Marginal Return=k, it is optimal for every
shareholder, independent of preferences
exchanging consumption along the CML→no wealth creation!! Only project
scan)
Net Present value
o (Unleveraged)Free cash flows: all future cash resources after taxes generated by a
project, independent of the way the project is financed.
o The project cost of capital k accounts for project activity and financial risk.
Positive NPV only in the short run, when it enjoys a specific competitive
advantage.
In the long run, when this competitive advantage evaporates, the return on
each project tends to the normal market return for projects of comparable
If Correct price is paid, a firm cannot grow with M&A
Stockprice takes into account NPV once announced, NOT once
initiated
→In order to continue to create value for its shareholders, new projects with
a positive NPV have to be found or created.
Agency problems
2
1. The Investment Decision
1. Decision within corporate finance
There are three important (inter-related) decisions in corporate finance:
o The investment decision(allocate resources to projects)
Dixit and Pindyck (1994): “The act of incurring an immediate cost in the
expectation of future rewards”.
Invest only when expected return > minimum acceptable return (‘required
return’)
Returns come from free cash flows(leveraged=after all financing
charges are done)(after all net working capital etc has been
accounted and diminshed)
The required return (k) reflects the project’s 1) activity risk and 2)
financial risk
Hurdle rate(alternative)
Discounting unleveraged cashflow at the WACC
In most business, no opposite outcomes as value maximalization of
shareholders and the firm as a whole looks similar
o The financing decision(raise funds)
- What is the optimal mix of equity and debt in a firm?
- What is the optimal composition of the equity and the debt?
- What is the optimal maturity structure of the debt?
Choose a financial structure that contributes to firm value maximization, i.e.
a low WACC and leads to the proper selection of projects
o The dividend decision(distribution)
How much of the realized profits (‘earnings’) should be paid out to the firm’s
shareholders?
If dividends are retained, the share price will increase ↔ signaling
function of dividends
A large dividend now, means a smaller in the future
→→ Investment, financing and dividend decisions are highly inter-related:
o Investments + equity payments (dividends) + debt payments (interest + principal)
o =
o internally generated cash flows + externally raised funds (equity + debt)
2. Objectives of the investment decision
Maximization of the value of the firm
o The management of a firm serves best the interests of its shareholders when
maximizing firm value, at least when the firm is not in financial distress
o Consider the following one-period model:
The economy consists of one company, held by multiple (N) shareholders
1
, One euro invested today (time 0) yields a sure future return at time 1
Each individual shareholder has to trade off current and future consumption;
the marginal utility of additional consumption is positive, but decreasing
By investing/borrowing money, consumption can be shifted over time
Each individual shareholder wants to maximize his/her utility (satisfaction)
from consumption (indifference curve)
The company has access to a production technology (production opportunity
curve); the marginal revenue of investment is positive, but decreasing
→ How much to invest if all shareholders have different preferences and
indifference curves?
MAXIMIZE FIRM VALUE(and so on Shareholders value) BY INITIATE
ALL PROJECTS WITH + NPV
Afterwards, shareholders can adjust their income flows by
o lending/borrowing money at the market interest rate k
o buying/selling shares in the firm
o → Indifferent between smaller dividend today….
This indifference only results in the presence of perfect capital markets
o It is possible to make Pareto-optimal choices of current and future
consumption(because of existence of a capital market):
no individual has a lower utility
at least one person realizes a higher utility in the presence of the capital
market line (CML)
In equilibrium: return on marginal unit of investment =
k, i.e. opportunity cost of capital
Marginal substituion rate of current and future consumption for
each individual
o → When Marginal Return=k, it is optimal for every
shareholder, independent of preferences
exchanging consumption along the CML→no wealth creation!! Only project
scan)
Net Present value
o (Unleveraged)Free cash flows: all future cash resources after taxes generated by a
project, independent of the way the project is financed.
o The project cost of capital k accounts for project activity and financial risk.
Positive NPV only in the short run, when it enjoys a specific competitive
advantage.
In the long run, when this competitive advantage evaporates, the return on
each project tends to the normal market return for projects of comparable
If Correct price is paid, a firm cannot grow with M&A
Stockprice takes into account NPV once announced, NOT once
initiated
→In order to continue to create value for its shareholders, new projects with
a positive NPV have to be found or created.
Agency problems
2
