Chapter 01 Long Term Investing and Financial Decisions

CHAPTER 1
Long-Term Investing
and
Financial Decisions
1
Objectives
After 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
decisions
2
Objectives
After 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 firm
3
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 stockholders
4
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):

 Managers High Salary and perquisites
 Creditors Low risk, return of their money and interest
 Customers Low prices and lots of features
 Employees High salaries, job security
 Suppliers High prices and long relationships
 Society Good citizenship and taxes
 Owners Dividends or stock appreciation
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 Wealth
 Net 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

stock
11
Net Present Value
12
Who Benefits form Wealth Maximization?
 Owners
 Managers
 Creditors
 Customers, Employees, & Suppliers
 Society
13
Competitive Advantage & Wealth Creation
 How does a firm create competitive

advantages?
 Vision
 Strategy
 Product advantage
 Cost advantage
 Financing advantage
14
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 return
20
Select Investments
 Who makes the decision?

 Director of Capital Budgeting
 Capital Budgeting Committee
 Executive Committee
 Board of Directors
 What should be evaluated?
 Economic & Financial factors
 Strategic , employee, environmental, governmental
regulation and other factors
21
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 projects
23
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 near-
term 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 lead to greater
investment opportunities
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 NPV’s?
 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
Summary
 A 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

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CHAPTER 1

 Describe why capital budgeting and appropriate

 Explain current business events in relation to the

 Why are capital budgeting decisions important to the firm,

 Corporate investments must typically meet

 Stakeholder: What their goals are (what they want):

 What is economic profit and how is it

Determination of economic profit:

 A firm should maximize economic profit or wealth

 (revenues, cost and risk)

 Profit is two dimensional

 ( revenues and cost)

 Net Present Value:

economic profits less the initial outlay

 In theory NPV of the firm divided by the number

of shares gives you the intrinsic value of the

 How does a firm create competitive

 Steps involved in the capital investment process:

 Search for Investment Opportunities

 Evaluate Investment Opportunities

 Implement and Monitor

 The term Investment, as it applies to Capital

 Sets the general direction of the firm

 Identification of potentially successful capital

 Who makes the decision?

 Significant capital projects should be monitored

 Should include an assessment of actual

 An attractive capital investment:

 Within an appropriate risk level

 Has a positive net present value or economic

profit across time

 The plan for long-term financing must address

 Wealth is very much affected by:

 How successful is the system of allocating

 A corporation has many stakeholders with conflicting desires

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