Chapter 1
 Long-Term
Investing and
Financial Decisions
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
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
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 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.
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
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.

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
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)

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
Competitive Advantage and Wealth Creation
The characteristics of perfect competition
No restrictions on entry and exit
2. No producers so large that they have price
influence
3. All producers manufacture identical products
4. All producers have identical costs
5. Complete information about competitor’s actions.
1.
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 Economic
Profit:
Revenues
- Expenses
Accounting profit
- Required return*
Economic Profit**
(*Computed as RR on investment)
(**This is wealth created for a single period)
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
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)
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
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
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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.
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Stakeholders and Competing Desires

Stakeholder: What their goals are?
Owners
Managers
Creditors
Customers
Employees
Suppliers:
Society
(What they want?):
Dividends or stock appreciation
High salary and perquisites
Low risk, return of their money
Low prices and lots of features
High salaries, job security
Stable demand
Good citizenship
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
Capital budgeting for Nonprofit Organization
Capital budgeting process for nonprofit
organization is not significantly different from
that in a profit-seeking company:
If either of two capital investment will achieve
the organization’s mission, the one with the
smallest present value of costs is desirable.
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
Steps in capital budgeting process:
a.
Establish Goals
Develop Strategy
Search for Investment Opportunities
Evaluate Investment Opportunities
Select Investment
Implement and Monitor
Post-Audit:
b.
c.
d.
e.
f.
g.
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
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.
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Long-Term Financing Decisions
The impact of the financing decision on
stockholders’ 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

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
Financing Choice
Equity ( common , and preferred)
o Debt ( size, payment, and maturity)
o Priority of debt
o Collateral
 Sources of financing
 Public offering, Private placement, and/or
Private borrowing
• Range of financing choices
Convertible debt, preferred, warrants
o
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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 investment
 Cost is affected by a number of considerations
*Cost of debt – interest is tax deductible
*Large amounts of debt increase the risk of
bankruptcy.

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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.

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Minimizing agency cost
Financing mix:
A mix of senior debt, with first priority in
bankruptcy, and a junior debt that gets paid only
after 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.
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Availability of funds
The company does not want to be in a position
where it has excellent investment opportunities
but cannot raise money
 Flexibility of financing mix
The company wants to be able to change its
financing mix for the interest of the company
a. Repaying the debt before maturity
b. Keeping a lower debt to equity ratio
c. Maintenance of numerous credit arrangements
d. International listing of the Firm’s stock

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Strategy and financing choice
Strategy is designed to
a. Create competitive advantage
b. Guide Capital investment process and also
c. 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.
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*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 decisions
 Low-cost financing always make investments
more attractive
 Stability of cash flows from investment allows
more fixed payments to creditors than would
be possible with unstable cash flows.
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