Capital investment policy
Lecture 1: Capital investment policy
Capital investment policy: what is it and why does it matter?
- Capital = assets generating cash flows over multiple periods
- Investments = allocation of scarce financial resources to assets today, in
exchange for expected future cashflow
- Policy = formal, repeatable set of rules that allow firms to prioritize among
mutually exclusive investment alternatives
Capital investment policies should enable us to develop decision frameworks that
align investment choices with the goals of the corporation
In corporate finance, companies face two broad questions:
1. What investments should they make?
2. How should they pay for these investments?
Investment policies focus on 1, but 1 & 2 are not independant
Why do Capital Investment Policies matter?
- Economic efficiency = financial resources contribute as much as possible to the
objective
- Strategic consistency = contributes to corporate strategy, provides quantitative
yardstick
- Risk management = embeds the price of risk in budgeting decisions, makes
alternative comparable
⇒ Without capital investment policies, firms may …
Waste resources on projects that do not serve their goals
Miss out on projects that could have contributed to these goals
What is the goal of a company? And why?
What is a company?
- Company = a group of projects → role of management: to choose the best
projects
- Project = a series of cash flows
- Cash flow = an amount of money paid at a specific time
Who determines a company’s goal?
- The owners (i.e. The shareholders)
- Management is hired to act on behalf of the owners
→ Two problems
1. Definition of goals. What if owners disagree amongst each other?
2. Implementation of shareholder’s goals. Seperation of ownership and control
may lead to agency conflicts
,⇒ Example of different kind of owners (see slides)
It is key that financial markets are well-functioning and competitive, and that all
shareholders have equal access
All shareholders – independant of their individual preferences – can agree to
assign one objective to the manager
“to maximize the current market value of shareholders’ investments in
the firm”
With functioning financial markets, wealth can then be used to serve each
shareholders’ individual objectives
!Careful: Maximize shareholder value ≠ maximize profits
- Increasing current profits by reducing long-term investments (training,
maintenance) may impair long-term value
- Reinvesting in a mature company - instead of paying dividends - might
increase pfoits without maximizing shareholder value
Implementing shareholder objectives:
- That shareholders agree on shareholder value maximization as the firm’s
sole objective facilitates the delegation of management
- But: manager’s private interest may not be aligned with the shareholder
objective (job security, bonuses, …) which can cause agency problems
- Agency costs arise when managers do not maximize firm value or when
shareholders incur costs to monitor and constrain managers
Maximizing shareholder value as the company’s only goal
- Elegant solution to the potential problem of hetereogeneous shareholder
preferences
- Convenient to delegate
- Quantifiability facilitates monitoring and helps to align manager incentives
(e.g. Stock price based executive compensation)
Positive and negative externalities may not be fully priced
- Firms that focus exclusively on shareholder value
o Might underinvest in training, communicty development, … or
o May overinvest in (irreversible) environmentally harmful activities
- Stock price-based monitoring and compensation can lead to short-terminsm
- Instrumental vs pluralistic “stakeholderism”
- Shareholders are pushing firms to consider externalities, even at the
expenses of shareholder values
Summary
- Under certain assumptions (frictionless financial markets, no information
asymmetries, …) shareholders with heteregeneous preferences can agree on
maximizing equity 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
Which investments contribute to the goal of the corporation
Investment decisions
- We are interested in investment decision because they determine the value
of the equity that shareholders own
- The goal should be to select the “most valuable” project
Next steps = we need to decide which projects add value for shareholders, we want
to know how much each project adds
Example (see slides)
Principle: a projects adds value if its return is higher than the return of comparable
investment alternatives
Rate of return rule:
o Invest if: return = profit/investment > r
Present value (PV) rule:
o Invest if: PV = C1/(1+r) > C0
Net present value (NPV) rule:
o Invest if: NPV = C0 + C1/(1+r) > 0
Investment decisions with multiple projects
PV with multiple cash flows
- The PV of a cash flow C1 one year from today is: PV = C1/(1+r)
- The PV of a cash flow Ct in year t is: PV = Ct/(1+r)^t
- The PV of a stream of cash flows C1, C2, … is: PV = C1/(1+r) + C2/(1+r)^2 +
…
Example (see slides)
- If the capital market is not frictionless or does not exist, one needs to know
the investor’s preferences to rank projects
- Instead, with frictionless markets all investors agree that the highest NPV
project is the best
- Managers can thus rank investment opportunities based on NPV
Capital rationing
- We established that firms should accept all projects with NPV > 0, and that
they should rank investment priorities according to NPV
See example resource constrained firm: buying 2 projects can yield higher
NPV than 1
How should the firm decide when it is resource constrained?
- Practioners often use a profitability index to identify the optimal combination
of feasible projects to undertake
o Profitability index = NPV/resource consumed
- The profitability index helps to prioritize among investment opportunities in a
straightforward fashion under two conditions
o The set of selected projects must exhaust all resources
o There is only one resource constraint
, Firms optimal investment decisions
- Managers use the NPV rule
o Pursue all positive NPV projects, reject all negative NPV projects
- This investment policy maximized the PV of the firm
o All shareholders can agree on this policy
Internal rate of return
- Most popular alternative to NPV rule
- Intuitive, usually correct (i.e. identical to NPV rule)
- IRR = interest rate that sets the NPV of cash flows
equal to zero
- Given C0, C1, …, the IRR is the r that solves:
C1 C2
0=C 0+ + +…
1+r ( 1+r )2
- The NPV is negative if and only if the cost of capital exceeds the IRR DO
NOT INVEST
- The NPV is positive if and only if the IRR exceeds the cost of capital
INVEST
Measuring sensitivity with IR
- The difference between the cost of capital and the IRR is the highest
estimation error in the cost of capital estimate that can excist without
altering the original decision
- IRR has complementary value, even if it is not used as the primary decision
rule
- IRR rule: accept projects if IRR > hurdle rate
Why use IRR?
- Lots of other people use it
- It works as long as
o One discount rate for all periods
o One negative cash flow in t = 0, follwed by positive cash flows
o We consider one investment
o No mutually exclusive projects
o No time varying interest rates
o Real solution (so no imaginary number, for example 5i)
- It provides an intuitive measure of a project’s rate of return and has
complementary value
- The NPV rule remains preferable
The payback rule
- The 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
- The payback rule 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
How do we identify project value? First step: efficient capital markets and
no arbitrage pricing
Lecture 1: Capital investment policy
Capital investment policy: what is it and why does it matter?
- Capital = assets generating cash flows over multiple periods
- Investments = allocation of scarce financial resources to assets today, in
exchange for expected future cashflow
- Policy = formal, repeatable set of rules that allow firms to prioritize among
mutually exclusive investment alternatives
Capital investment policies should enable us to develop decision frameworks that
align investment choices with the goals of the corporation
In corporate finance, companies face two broad questions:
1. What investments should they make?
2. How should they pay for these investments?
Investment policies focus on 1, but 1 & 2 are not independant
Why do Capital Investment Policies matter?
- Economic efficiency = financial resources contribute as much as possible to the
objective
- Strategic consistency = contributes to corporate strategy, provides quantitative
yardstick
- Risk management = embeds the price of risk in budgeting decisions, makes
alternative comparable
⇒ Without capital investment policies, firms may …
Waste resources on projects that do not serve their goals
Miss out on projects that could have contributed to these goals
What is the goal of a company? And why?
What is a company?
- Company = a group of projects → role of management: to choose the best
projects
- Project = a series of cash flows
- Cash flow = an amount of money paid at a specific time
Who determines a company’s goal?
- The owners (i.e. The shareholders)
- Management is hired to act on behalf of the owners
→ Two problems
1. Definition of goals. What if owners disagree amongst each other?
2. Implementation of shareholder’s goals. Seperation of ownership and control
may lead to agency conflicts
,⇒ Example of different kind of owners (see slides)
It is key that financial markets are well-functioning and competitive, and that all
shareholders have equal access
All shareholders – independant of their individual preferences – can agree to
assign one objective to the manager
“to maximize the current market value of shareholders’ investments in
the firm”
With functioning financial markets, wealth can then be used to serve each
shareholders’ individual objectives
!Careful: Maximize shareholder value ≠ maximize profits
- Increasing current profits by reducing long-term investments (training,
maintenance) may impair long-term value
- Reinvesting in a mature company - instead of paying dividends - might
increase pfoits without maximizing shareholder value
Implementing shareholder objectives:
- That shareholders agree on shareholder value maximization as the firm’s
sole objective facilitates the delegation of management
- But: manager’s private interest may not be aligned with the shareholder
objective (job security, bonuses, …) which can cause agency problems
- Agency costs arise when managers do not maximize firm value or when
shareholders incur costs to monitor and constrain managers
Maximizing shareholder value as the company’s only goal
- Elegant solution to the potential problem of hetereogeneous shareholder
preferences
- Convenient to delegate
- Quantifiability facilitates monitoring and helps to align manager incentives
(e.g. Stock price based executive compensation)
Positive and negative externalities may not be fully priced
- Firms that focus exclusively on shareholder value
o Might underinvest in training, communicty development, … or
o May overinvest in (irreversible) environmentally harmful activities
- Stock price-based monitoring and compensation can lead to short-terminsm
- Instrumental vs pluralistic “stakeholderism”
- Shareholders are pushing firms to consider externalities, even at the
expenses of shareholder values
Summary
- Under certain assumptions (frictionless financial markets, no information
asymmetries, …) shareholders with heteregeneous preferences can agree on
maximizing equity 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
Which investments contribute to the goal of the corporation
Investment decisions
- We are interested in investment decision because they determine the value
of the equity that shareholders own
- The goal should be to select the “most valuable” project
Next steps = we need to decide which projects add value for shareholders, we want
to know how much each project adds
Example (see slides)
Principle: a projects adds value if its return is higher than the return of comparable
investment alternatives
Rate of return rule:
o Invest if: return = profit/investment > r
Present value (PV) rule:
o Invest if: PV = C1/(1+r) > C0
Net present value (NPV) rule:
o Invest if: NPV = C0 + C1/(1+r) > 0
Investment decisions with multiple projects
PV with multiple cash flows
- The PV of a cash flow C1 one year from today is: PV = C1/(1+r)
- The PV of a cash flow Ct in year t is: PV = Ct/(1+r)^t
- The PV of a stream of cash flows C1, C2, … is: PV = C1/(1+r) + C2/(1+r)^2 +
…
Example (see slides)
- If the capital market is not frictionless or does not exist, one needs to know
the investor’s preferences to rank projects
- Instead, with frictionless markets all investors agree that the highest NPV
project is the best
- Managers can thus rank investment opportunities based on NPV
Capital rationing
- We established that firms should accept all projects with NPV > 0, and that
they should rank investment priorities according to NPV
See example resource constrained firm: buying 2 projects can yield higher
NPV than 1
How should the firm decide when it is resource constrained?
- Practioners often use a profitability index to identify the optimal combination
of feasible projects to undertake
o Profitability index = NPV/resource consumed
- The profitability index helps to prioritize among investment opportunities in a
straightforward fashion under two conditions
o The set of selected projects must exhaust all resources
o There is only one resource constraint
, Firms optimal investment decisions
- Managers use the NPV rule
o Pursue all positive NPV projects, reject all negative NPV projects
- This investment policy maximized the PV of the firm
o All shareholders can agree on this policy
Internal rate of return
- Most popular alternative to NPV rule
- Intuitive, usually correct (i.e. identical to NPV rule)
- IRR = interest rate that sets the NPV of cash flows
equal to zero
- Given C0, C1, …, the IRR is the r that solves:
C1 C2
0=C 0+ + +…
1+r ( 1+r )2
- The NPV is negative if and only if the cost of capital exceeds the IRR DO
NOT INVEST
- The NPV is positive if and only if the IRR exceeds the cost of capital
INVEST
Measuring sensitivity with IR
- The difference between the cost of capital and the IRR is the highest
estimation error in the cost of capital estimate that can excist without
altering the original decision
- IRR has complementary value, even if it is not used as the primary decision
rule
- IRR rule: accept projects if IRR > hurdle rate
Why use IRR?
- Lots of other people use it
- It works as long as
o One discount rate for all periods
o One negative cash flow in t = 0, follwed by positive cash flows
o We consider one investment
o No mutually exclusive projects
o No time varying interest rates
o Real solution (so no imaginary number, for example 5i)
- It provides an intuitive measure of a project’s rate of return and has
complementary value
- The NPV rule remains preferable
The payback rule
- The 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
- The payback rule 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
How do we identify project value? First step: efficient capital markets and
no arbitrage pricing
