CHAPTER 1

Long-Term Investing and Financial Decisions1

ObjectivesAfter completing this chapter you should be able to:

Describe why capital budgeting and appropriate financing is important to the firm Discuss the merits of wealth maximization as contrasted to other firm goals Identify the different parties that benefit from optimal capital budgeting and financing decisions2

ObjectivesAfter completing this chapter you should be able to:

Explain current business events in relation to the parties that benefit and the parties that may have lost in a particular event Recognize and discuss the sources of competitive advantage List & describe the importance of the steps in the capital budgeting process Describe the variables important in planning the long-term financing of the firm3

Long-term Financial Decisions

Why are capital budgeting decisions important to the firm, society, and to you personally in your career or private life? Three things that make capital budgeting decisions important: 1. Capital projects involve large amounts of money 2. Capital projects are typically hard (or costly) to reverse 3. Failed capital projects can break a firm Ford Edsel Lockheed L-1011 Tristar Northrop F-20 Tigershark

4. Capital projects and related financing are the source of all wealth to the firm and its stockholders4

Long-Term Investment Decisions

Corporate investments must typically meet three tests:1. Does it contribute to the corporate vision? 2. Will it provide enough benefits to satisfy the

investors who furnished the money? 3. Is the investment at an acceptable level of risk?

Watershed strategic investment decision?5

Stakeholders and Competing Desires

Stakeholder:

What their goals are (what they want):High Salary and perquisites Low risk, return of their money and interest Low prices and lots of features High salaries, job security High prices and long relationships Good citizenship and taxes Dividends or stock appreciation

Managers Creditors Customers Employees Suppliers Society Owners

6

Wealth Maximization

What is economic profit and how is it determined? How is wealth created? What is wealth maximization? What is Net Present Value and how is it determined? How is/should risk be incorporated into economic decisions?7

Economic Profit A Single Period Measure of Wealth

Determination of economic profit: Revenues - Expenses = Accounting Profit Required Return (Computed as RRR * Investment) Economic Profit (this is wealth created for a single period)8

Economic Profit

9

Wealth Creation versus Accounting Profit

A firm should maximize economic profit or wealth instead of profits because:

Wealth includes risk while profit does not Wealth is three dimensional (revenues, cost and risk) Profit is two dimensional ( revenues and cost)

10

Net Present Value: A Multi-period Measure of WealthNet Present Value: Take the present value of a series of future economic profits less the initial outlay This is wealth created for a multiple period In theory NPV of the firm divided by the number of shares gives you the intrinsic value of the stock11

Net Present Value

12

Who Benefits form Wealth Maximization?

Owners Managers Creditors Customers, Employees, & Suppliers Society

13

Competitive Advantage & Wealth Creation

How does advantages?

a

firm

create

competitive

Vision Strategy Product advantage Cost advantage Financing advantage14

The Capital Budgeting Process

Steps involved in the capital investment process: Establish Goals Develop Strategy Search for Investment Opportunities Evaluate Investment Opportunities Select Investments Implement and Monitor Post-Audit

15

Capital Investments

The term Investment, as it applies to Capital Budgeting, refers to commitments of resources that are made with the expectation of realizing financial benefits over an extended period of time in the future Capital Investments can be physical, financial, or intangible Capital Budgeting is the process of selecting capital investments 16

Establish Goals

Wealth maximization Increase market share Improve corporate ranking Rate of return

17

Develop Strategy

Sets the general direction of the firm Provides a framework within which capital investment opportunities are sought

18

Search for Investment Opportunities

Identification of potentially successful capital investments can be the key to survival in many industries Requires a commitment of resources such as Research & Development

19

Evaluate Investment Opportunities

Cost/Benefit Analysis Identify cash flows

Costs Operating Terminal

Quantify risk Apply appropriate rate of return20

Select Investments

Who makes the decision?

Director of Capital Budgeting Capital Budgeting Committee Executive Committee Board of Directors Economic & Financial factors Strategic , employee, environmental, governmental regulation and other factors21

What should be evaluated?

Implement and Monitor

Significant capital projects should be monitored during the acquisition, construction, and operating phases

Cost overruns Time deadlines Qualitative issues Performance issues

22

Post-Audit

Should include an assessment of actual performance and profitability Actual performance and returns should be compared to projections An honest and balanced review of actual performance is essential to detecting flaws in the evaluation process used for future projects23

What Makes a Capital Investment Attractive?

An attractive capital investment: Fits the strategy of the firm Within an appropriate risk level Has a positive net present value or economic profit across time

24

Long-Term Financing Decisions

The plan for long-term financing must address the magnitude of funds needed to enter into desirable investment opportunities the presently exist and those that are in the nearterm horizon

The amount needed, for what purpose, and the method of raising the capital are interrelated

25

Long-Term Financing Decisions

Wealth is very much affected by:

Rates of return paid to investors Risk How funds will be raised

Lower financing costs investment opportunities

lead

to

greater

26

Financing Choices

Debt? Equity? Important issues

Debt maturities Priority of claims Source of financing

Private versus public

27

Considerations in Financing

Cost

How do financing costs affect project NPVs? How are financing costs affected by income taxes? How does risk affect cost?

Availability and flexibility of financing Specialized sources of financing

28

The Capital Investment Crisis

How successful is the system of allocating investment capital within and across companies in the United States? The conflict between short-tem results and long-term wealth creation

29

SummaryA corporation has many stakeholders with conflicting desires Wealth creation for the shareholders is our goal Accounting income is not a sufficient measure of performance because it ignores risk and the cost of the invested funds Economic profit and net present value are two ways we measure wealth creation in a single period and multiple periods Capital projects create most of the wealth for the firm but not all projects are equal or should even be considered Strategy and competitive advantage should guide the capital budgeting process

30