Firm's Capital Budgeting Decision PDF

Topic 4 The firm’s capital budgeting decision Lectures 7 to 10 1 Net Present Value Rule and Wealth Maximisation Lecture 7 2 Topic Outline 1. the firm’s objective 2. NPV rule 3. separation theorem and perfect capital markets 4. real investment options 5. alternative rules - payback, ARR, IRR, PI 6. i...

Topic 4 The firm’s capital budgeting decision Lectures 7 to 10 1 Net Present Value Rule and Wealth Maximisation Lecture 7 2 Topic Outline 1. the firm’s objective 2. NPV rule 3. separation theorem and perfect capital markets 4. real investment options 5. alternative rules - payback, ARR, IRR, PI 6. implementing the NPV rule 7. practical problems 8. planning and controlling capital expenditure 3 1. The goal of the firm 1. 2. 3. 4. 5. maximise maximise maximise maximise maximise the size of the firm? customer satisfaction? the firm’s sales? profits? dividend growth? maximise shareholder wealth = maximise the market price of the company’s shares Other stakeholders-customers, suppliers, employees, creditors, debtholders, government? If product and labour markets work efficiently, maximising shareholder wealth will benefit society most. Maximising wealth  firms allocate resources to their most productive use  they automatically respond to needs of other stakeholders 4 Wealth v. profit maximisation Microeconomics: firms choose from a menu of production plans, with no explicit time dimension  wealth  profit ? Finance: firms choose from a menu of investment projects, all with explicit time dimensions What does ‘profit’ mean?  Wealth? 5 2. The Net present value (NPV) rule What criterion should managers use when taking decisions? Under certain conditions, using the net present value rule (NPV) maximises share price and maximises shareholders’ wealth 6 Example: Using the NPV rule A property development firm is considering a proposal to build an out-of-town shopping centre. Required initial investment is £10m. Payoffs are cash flows of £2m in year 1, and £7m each for the next 3 years. year cash flow t=0 t=1 -10 2 t=2 7 t=3 7 t=4 7 Investors require a 20% return on this type of venture. Should the firm approve the proposal? 7 Discounted cash flow approach to calculating NPV: find the PV of the future cash flows at the return investors require and subtract the initial outlay. NPV = 2 7 7 7 −10 + + + + =£3.95m (1.2) (1.2)2 (1.2)3 (1.2)4 Decision rule: accept if NPV > 0, reject if NPV < 0 8 3. (Irving) Fisher’s separation theorem If capital markets for borrowing and lending are wellfunctioning, Companies can make their investment decisions independently of individual shareholders’ consumption decisions, by using the NPV rule Perfect capital market (PCM) 1. There are no transactions costs or other ‘frictions’ to accessing capital markets, either by firms or investors  the interest rate on borrowing equals the interest rate on investing. 2. Markets are competitive in the sense that access is free and equal, and no participants have the power to influence 9 prices. 3. All participants have the same information about prices and security/firm characteristics. 4. Other stakeholders in the firm face competitive prices. 5. There are no distorting taxes. PCM  maximising share price makes shareholders better off… … because shareholders can sell or buy shares and other securities, or borrow and lend to get their desired consumption – saving pattern 10 PCM  market interest rates and returns gives the opportunity costs of transferring wealth across different periods … … if firms use market interest rates and returns to calculate NPVs they make the same tradeoffs as investors Fisher’s separation theorem: With PCMs, the firm’s optimal investment decision depends only on estimated cash flows from the investment and market interest rates. It is independent of shareholders’ various preferences for current versus future consumption. Firms should accept positive NPV projects. 11 What happens when capital markets are imperfect? Eg. Borrowing rates >> saving rates 1. (impatient) investors who want to borrow and consume more than their income will want the firm to use a higher discount rate 2. (patient) investors who want to save for the future will want the firm to use a lower discount rate PCMs resolve this dilemma … both investor types want the firm to accept positive NPV projects because this increases their wealth 1. impatient investors can borrow money or sell shares to finance consumption 2. patient investors can lend money or buy shares to invest for future consumption 12 Example: Calculating NPV Assume project cash flows (CFs) are year 0 1 2 3 4 5 CF -13,000 3,000 4,000 4,000 4,000 6,000 required return = 15% 3000 4000 4000 4000 6000 − 13000 + + + + + NPV = (1.15) (1.15)2 (1.15)3 (1.15)4 (1.15)5 = £533.4 What happens to the market value of the firm? If the market had not previously anticipated the investment, once it does learn of the project the market value of the firm’s equity capital will immediately increase by £533.4 13 Is conventional DCF-NPV always appropriate? Conventional DCF-NPV assumes a once-for-all, now-ornever accept/reject decision but deferment option: there may be a choice of initiating the project now or delaying until a later date Why delay a project? ….delaying a project for a period  better informed decision interest rates might fall expected cash flows might increase One opportunity cost of deciding now is the lost opportunity of deciding later; conventional DCF-NPV ignores this. Other problems: where there are interdependencies through time in investment decisions----strategic investment decisions  real investment options Need to revise the conventional rule to include the costs of lost future opportunities or the benefits of opportunities gained. Only this revised NPV rule would be consistent with wealth maximisation. 14 Summary 1. under PCM, using the NPV rule maximises shareholder wealth 2. this is Fisher’s separation theorem 3. the traditional way to calculate NPV is to use DCF 4. with real investment options, DCF is not the appropriate way of calculating NPV 15