Summary Capital Investment Policy

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

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,  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

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