1 / 31

Module IV: Financial Strategy Real Investments and Strategy

Module IV: Financial Strategy Real Investments and Strategy. Week 8 – March 2, 2006. Objectives. Review investment criteria Introduce strategic investment concerns Real options First mover advantage Capital budgeting Reasons Relation to financing Leasing overview.

ketan
Download Presentation

Module IV: Financial Strategy Real Investments and Strategy

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Module IV: Financial StrategyReal Investments and Strategy Week 8 – March 2, 2006

  2. Objectives • Review investment criteria • Introduce strategic investment concerns • Real options • First mover advantage • Capital budgeting • Reasons • Relation to financing • Leasing overview

  3. Real and Financial Assets • A real asset is a long-lived tangible or intangible good that produces a stream of income over time • Examples: Patents, equipment, brand loyalty, etc. • A financial asset is a claim to a real asset or its income stream • Examples: Stocks, bonds, etc.

  4. Key Decisions • There are two fundamental functions of a financial manager • Capital Budgeting: Identify real assets to invest in and avoid those that do not create value • Raising Capital: Issue financial assets to finance real investments • A firm is the link between financial markets and goods markets

  5. The NPV and IRR Rules • Three step procedure: • Estimate future expected cash flows using accounting data and other sources • Compute a discount rate or target rate of return • Calculate NPV or internal rate of return • accept positive NPV projects (or projects with internal rates of return above the target rate of return) • reject negative NPV projects (or project with IRRs below the target rate of return)

  6. Evaluation of IRR • The internal rate of return is not the best criterion for ranking projects. Why? • It suffers from possible mathematical problems (non-uniqueness, non-existence) • There are problems in application (mutually exclusive projects, borrowing v. lending issues). • It also ignores the information contained in the yield curve.

  7. Example: • Consider two mutually exclusive projects: • Project A involves an initial outlay of $5 and repays $10 next year • Project B involves an initial outlay of $20 and repays $30 next year • What is the IRR of project A? Project B? At a 10% discount rate, what would you do?

  8. Target Rate of Return • Many corporations use a target rate of return or cutoff rate to value projects • In many cases, the target rate is the firm’s weighted-average cost of capital (WACC) • Firms entering new businesses or investing in new strategies may be changing the firm’s risk from levels assumed in a firm-wide WACC • Project risk or  is the relevant risk

  9. WACC Can Lead To Errors Discount Rate (%) Accept Bad Projects WACC Reject Good Projects Project b

  10. Capital Rationing • Capital rationing: Two types • Hard: The firm cannot obtain outside capital to fund all its positive NPV projects • This typically applies to small, growing firms with high insider ownership where there may be significant agency costs • Soft: To control managers or to have balanced divisional growth, a firm may limit the funds available for project investment even if it can raise funds from the capital markets

  11. Capital Rationing • Seemingly obvious rules like NPV, IRR, etc fail when there is capital rationing. • Some projects yield first-mover advantages and may free up capital for use in other projects later on, so just picking the highest NPV project is not correct. • Rather, we have to consider combinations of projects that maximize NPV.

  12. NPV versus Option Values • NPV estimates normally compute present value of expected future cash flows • Expected cash flows weight each possible outcome with the probability of that outcome • Management decisions through time can prevent some bad outcomes from occurring, e.g. by not making necessary future cash investments

  13. Example: NPV versus real option • Simple example of NPV: building a motel • Cost is $9.7 million, and WACC is 10% • Value of future cash flows estimated now at either $9 or $13 million with equal probability, thus expected value of project cash flows in one year now $11 million • NPV of motel project (in millions) is:

  14. Example: real option • If we wait one year we can take advantage of future information • If value turns out to be low, don’t build • If high, build motel • Value in one year is either 0 or $13 million • Revised value with option to postpone: • Option adds about $ .7 million to value

  15. Flexibility creates Real Options • Management options • Growth options • Timing options • Switching options • Option to expand or contract (scale) • Abandonment options • Real options exist with respect to investment in real resources • What are sources of value of real options?

  16. Management options Abandon Contract Switch Wait Expand Grow Currently Invested: React to Bad News Not Currently Invested Currently Invested: React to Good News

  17. Valuing Real Options • All options have value, since we are not obliged to use them • Seemingly unprofitable ventures may have positive NPV when real options are considered • Use of Black-Scholes and other option pricing techniques is used but option-pricing assumptions may not be met

  18. Strategic Concerns • Strategic issues may substantially alter our views of a project • These concerns cannot be easily quantified but are critical • Two types of factors • External • Internal

  19. Strategy: External Factors • The External Environment: • Political • Expropriation, war, trade policy, etc. • Economic • Currency devaluations, labor unrest, etc. • Regulatory • Rule changes, price controls, etc. • Industry • Growth, technology.

  20. Strategy: Internal Factors • Internal Factors: • Externalities with other divisions; synergies • Reaction of competitors • Followers or aggressive competitors? • Follow-up projects and options • Managerial constraints and incentives • Moral hazard, risk aversion, executive compensation.

  21. Example: Plant Capacity and Strategic Interactions • A firm faces a decreasing average cost curve; price is determined by world supply and demand. • Building a large plant is profitable at Q* but only if its competitors do not themselves expand their plants, reducing output to Q** • Project NPV depends on the reactions of competitors

  22. Quantity if competitors react Plant capacity Q** Q* Profits and Competitors’ Reactions Average Cost Curve Price Quantity

  23. Investment/Financing Strategy • If markets are efficient and there is no corporate taxation (Modigliani-Miller assumptions), firms should be able to finance all positive NPV projects • Many departures from those assumptions • Transactions costs • Bankruptcy risk • Tax differentials • These departures lead to a link between financing and investment strategies

  24. Leasing Overview • Two basic type of leases • Operating lease (use of asset over limited time) • Capital or financial lease (acquire asset over time from lessor) • Two basic considerations • Accounting treatment on financial statements • Tax treatment • Treatments differ between accounting standards and tax codes and lead to advantages to leasing

  25. Lessors • Owner of real property or equipment leases to users • Manufacturers of equipment lease equipment to users, often as a form of financing • Development of third-party leases began when investment tax credit (1964 to 1986) created opportunity for non-operating firms like banks to use tax credits by leasing equipment like airplanes

  26. Third-party Leases • Equity or leverage lease is determined by whether asset is owned outright by lessor or partially financed by debt • Synthetic lease creates a special purpose entity (SPE, a legal entity) to hold assets • Assets are financed by a combination of debt and equity • Asset ownership rights and cash flows distributions are determined by lease terms

  27. Division of Cash Flows • Cash flows from lessee to claimants on SPE are divided into tranches(a French word meaning cut) • The ordering of the claim on cash flows (lease payments) determines risk, with the “A” or higher tranche getting first claim, hence lowest risk • Other tranches have subordinated claims to cash flows • A residual trance (lowest claim) is equity claim

  28. Guarantees to Lease Investors • Principal and interest on debt issued by SPE can be guaranteed by lessee • Typically occurs with “A” tranche of synthetic lease • Use of corporate guarantee is “on-credit”, meaning affects lessee’s credit rating through claim on cash flows • Asset can be used as collateral for a tranche • “B” tranche has claim on asset value in synthetic lease

  29. Allocation of Risks • Risks to investors in lease are • Non-payment of interest and principal (Tranche A and B) • Loss of investment capital in case of default • Guarantee provides A-tranche investors recourse to corporate sponsor for claims, thus must be considered in credit rating • B-tranche investors have no recourse to corporation but have collateral in form of title to the underlying asset

  30. Summary • Project evaluation sounds scientific, but it often involves a considerable amount of artistry in its application • In the real-world, many factors contribute to complicate capital budgeting • While the tools and analytics are helpful, you also need to consider strategic interactions of projects and financing.

  31. Next Class – March 23, 2006 • Deliver take-home midterm exam and statement to me by March 2, 2006, 6pm • Review financial planning and RWJ, Chapters 2 & 3 on sustainable growth • Read and begin to prepare Clarkson Lumber as an individual case write-up • Work with group to arrange schedule for working on Avon Products case for week following

More Related