dr. ibrahem al-ezzee-fin421chapter1 1 chapter 1 long-term investing and financial decisions

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER11

Chapter 1Chapter 1

Long-Term Investing and Financial Decisions

2

Why are capital budgeting decisions important to the firm and society?

1. Capital projects involve large amounts of money.2. Capital projects are typically hard ( or costly) to reverse.3. Capital projects and related financing are the source of all wealth to the firm and its stockholders


3

Central Role of Wealth Maximization

Shareholder wealth maximization is generally considered the goal of investment and financing.

An action increases wealth if the benefits gained exceed the benefits expended.

Companies develop strategies and goals, and visions so they will be in a position to create wealth.


4

Wealth is created If cash inflow exceeds cash outflow by more than what would have been earned by investing the money somewhere else during that period (more than normal profit).

Economic Profit (EP)- A Single Period Measure of Wealth.

Net Present Value (NPV) is the economic profit or wealth created by a multi-period investment.


5

Competitive Advantage and Wealth Creation

Wealth creation (economic profit) is not possible in perfect competition. All wealth creation comes from competitive advantage.

Competitive advantage is achieved by a. product advantage (superior quality) or b. cost advantage (lower cost)



Competitive Advantage and Wealth Creation

The characteristics of perfect competition

1. No restrictions on entry and exit2. No producers so large that they have price

influence3. All producers manufacture identical products4. All producers have identical costs5. Complete information about competitor’s

actions.


Economic Profit:

Revenues- Expenses Accounting profit- Required return* Economic Profit**

(*Computed as RR on investment)(**This is wealth created for a single period)


Wealth Creation versus Accounting Profit

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

Wealth is three dimensional ( revenue, cost and risk) Profit is two dimensional (revenue and cost)


Other Definitions of Economic Profit

Economic profit = accounting income – opportunity cost of equity

Economic profit = Equity X (ROE – Ke)

Where Ke is the required return on equity

Economic profit = assets X (ROTA – Ka)

Where Ka is the required return on assets


Net Present Value (NPV)A Multi-Period Measurement of Wealth

Net Present Value (NPV) The present value of all cash inflows, minus

the present value of all cash outflows.

NPV is the economic profit or wealth created by a multi period investment.


Stakeholders and Competing Desires

Stakeholder: What their goals are? (What they want?):

Owners Dividends or stock appreciationManagers High salary and perquisitesCreditors Low risk, return of their moneyCustomers Low prices and lots of featuresEmployees High salaries, job securitySuppliers: Stable demandSociety Good citizenship


Capital budgeting for Nonprofit Organization

Capital budgeting process for nonprofit organization is not significantly different fromthat in a profit-seeking company:

If either of two capital investment will achievethe organization’s mission, the one with thesmallest present value of costs is desirable.


Steps in capital budgeting process:

a. Establish Goalsb. Develop Strategyc. Search for Investment Opportunitiesd. Evaluate Investment Opportunitiese. Select Investmentf. Implement and Monitorg. Post-Audit:


Long –Term Financing Decisions

Perfect market conditions The business value is unaffected by the way in which the firm finance its activities.

Imperfect market conditions: Finance choices matter.


Long-Term Financing DecisionsThe impact of the financing decision onstockholders’ wealth depends on:

How much money is needed What it is needed for How to raise the money financing cost (risk) The rate of return required by stockholders


Financing Choiceo Equity ( common , and preferred)o Debt ( size, payment, and maturity) o Priority of debto Collateral Sources of financing Public offering, Private placement, and/or Private borrowing• Range of financing choices Convertible debt, preferred, warrants


Considerations in Financing

Cost is the principal considerations in financing choice

The lower the rate of return required by investors, the greater the net present value and wealth contribution of each capital investmentCost is affected by a number of considerations *Cost of debt – interest is tax deductible *Large amounts of debt increase the risk of bankruptcy.


Agency costs which are related to agency problems

*Cost of Monitoring the agent Raises the cost of equity*Debt agency costs : managers might take more risks than creditors anticipated. The higher the level of debt the greater this risk. *Specific asset pledges and repayment schedule help to reduce this risk.


Minimizing agency cost

Financing mix: A mix of senior debt, with first priority inbankruptcy, and a junior debt that gets paid onlyafter the senior debt .

Asset type: A creditor will generally lend a company with a

high percentage of easily monitored assets more than the company with assets that are much more difficult to monitor.


Availability of funds The company does not want to be in a position where it has excellent investment opportunities but cannot raise moneyFlexibility of financing mix The company wants to be able to change its financing mix for the interest of the companya. Repaying the debt before maturityb. Keeping a lower debt to equity ratioc. Maintenance of numerous credit arrangementsd. International listing of the Firm’s stock


Strategy and financing choiceStrategy is designed toa. Create competitive advantage b. Guide Capital investment process and alsoc. Guides the financing plans

*Finance with equity or long-term debt if the company cannot commit itself to large cash payments to investors in the low-profitability Period.


*Secrecy may be an element of the strategy if the company does not want to announce the intended use of money ( private financing)

Concluding Remark:It is impossible to completely divorce investment and financing decisionsLow-cost financing always make investments

more attractiveStability of cash flows from investment allows

more fixed payments to creditors than would be possible with unstable cash flows.

dr. ibrahem al-ezzee-fin421chapter1 1 chapter 1 long-term investing and financial decisions

Documents