The PPT about the Financial Decision Making

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Lesson10MakingCapitalInvestmentDecisions.pptx

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MN7029 – Financial Decision Making

3.2 Making Capital Investment Decisions (2)/ Financing a business

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

Learning Outcomes

Explain the modifications needed to the simple NPV decision rules where investment funds are limited or where there are competing projects with unequal lives

Discuss the nature of risk and explain why it is important in the context of investment decisions

Describe the main approaches to the measurement of risk and discuss their limitations

Divisible projects

Earlier we considered projects that could not be divided up i.e. the decision was whether to go ahead with a project or not go ahead. We did not consider whether it was possible to do half a project.

The rules for NPV were:

If NPV is positive, accept the project

If you have competing projects accept the one with the higher NPV.

However, we might have a situation where we have one project that will cost £7m, another than will cost £5m but only £10m to spend. If we use the decision rule above we choose the project with the higher NPV and discard the other.

What if we could divide them up?

Example

I have £12m available to spend on a capital investment project. Three potential projects have been identified and the NPV calculated. Which should I choose if the product cannot be divided?

Ask students – hopefully they will identify that project Z gives the highest NPV and so if the project cannot be divided up, the £12m should be spend on the one with the highest NPV.

What about if we can do a “bit” of another project?

If we rank according to NPV we might decide to do all of Project Z with £11m (generating NPV of £3.6m) and then use the remaining £1m for Project Y (NPV would be 1/9 of the total NPV of £3.2m = £0.4m) so total NPV is £4m. Is this the best outcome?

Where projects are divisible, managers should seek to maximise the present value per £ of scarce resource

PI =

PV of future cash flows Initial outlay

Profitability index (PI)

A better way of calculating how much to do of divisible project is using the Profitability Index. This calculates how much PV of future cash flows is generated per £ of initial investment.

Example

I have £12m available to spend on a capital investment project. Three potential projects have been identified and the NPV calculated. Which should I choose if the product cannot be divided?

Ask students – hopefully they will identify that project Z gives the highest NPV and so if the project cannot be divided up, the £12m should be spend on the one with the highest NPV.

Example

Profitability Index = £10.8m/£8m =1.35

Profitability Index = £12.2m/£9m =1.36

Profitability Index = £14.6m/£11m =1.33

We calculate the Profitibiility Index (PI) by dividing the total future PV cash flows by the original outlay. As project Y has the highest PI we should use the funds here, then Project X and finally project Z.

Example

(2) Use remaining £3m on Project X = 3/8 x £2.8m = £1.05m

(1) Use £9m on Project Y = NPV of £3.2m

(3) Total NPV generated = £3.2m+£1.05m = £4.25m

By prioritising Project Y then project X as a result of calculating the profitability index the company can generate a better result of £4.25m

Comparing projects with unequal lives

Equivalent-annual-annuity approach

Shortest-common-period-of-time approach

Two possible approaches

Both methods should provide the same solution

A further complication might be where we need to compare projects with unequal lives. There are two methods we can use here that should give the same result.

Example

	Cash flow	Discount at 10%	Present Value
Machine A:
Initial outlay (Year 0)	(100)	1.00	(100)
Year 1	50	0.91	45.5
Year 2	70	0.83	58.1
NPV			3.6
Machine B:
Initial outlay (Year 0)	(140)	1.00	(140)
Year 1	60	0.91	54.6
Year 2	80	0.83	66.4
Year 3	32	0.75	24.0
NPV			5.0

The company has to make a decision between these two machines. Machine B produces a higher NPV, but over a longer period. Machine A will need to be replaced after Year 2. How do we decide which option to choose?

Figure 5.3 NPV for Machine a using a common period of time

Years	NPV	Discount factor	Adjusted NPV at Year 0
Cycle 1 at Year 0	£3.6m	1	£3.6m
Cycle 2 at Year 2	£3.6m	0.83	£3m
Cycle 3 at Year 4	£3.6m	0.68	£2.5m
Total			£9.1m

The first way to consider this is to calculate the NPV over a common period of time. Machine A runs from Year 0 to Year 2 and produced an NPV of £3.6m when we discount it back to Year 0. Assuming this pattern in repeated, the machine would be replaced for Year 2 to 4 and generate a further NPV of £3.6m when we discount it back to the start of the cycle in Year 2, then replaced again for years 4-6 to generate an NPV of £3.6m when we discount it back to the start of the machine cycle in year 4. We then need to discount these two cycles back to year 0 and that gives us a total NPV of £9.1 for 6 years use of the machines.

Figure 5.3 NPV for Machine a using a common period of time

Years	NPV	Discount factor	Adjusted NPV at Year 0
Cycle 1 at Year 0	£5m	1	£5m
Cycle 2 at Year 3	£5m	0.75	£3.8m
Total			£8.8m

£5m

£3.8m

£8.8m

Doing the same for Machine 2, this has a 3 year cycle so we go through this twice in order to get to the common period of 6 years. For years 0-3 the NPV discounted back to year 0 is £5m. For periods 3-6 the NPV discounted back to Year 3 is £5m, an therefore we discount it again back tot Year 0 to give us £3.8m. Overall this project has an NPV of £8.8m over a six year life. Given the choice between the projects we should therefore choose Machine A as the equivalent NPV over a six year period is £9.1m

Equivalent-annual-annuity approach

For machine A: £3.6m x = £2.07m

Equivalent Annual Annuity = NPV x

For machine B: £5m x = £2.01m

Therefore Machine A has the higher Equivalent Annual Annuity and should be chosen

An alternative way to approach this question is to calculate what the equivalent annual annuity would be relating to the project or what does it represent in terms of constant annual cash flows. To do this we use this formula shown on the slide. Using a discount rate of 10% (represented by i), again Machine A represents the higher EAA and should therefore be chosen.

Investment appraisal and risk

The size of the investment made

The long timescales involved

Risk is important because of:

Another aspect of investment appraisal is risk. We need to consider the risk of things not working out as they have in our prjections and we need to understand the risk profile because of the long timescales and the size of the investment.

Methods of dealing with risk in investment appraisal

Scenario analysis

Risk-adjusted discount rate

Simulations

Portfolio approach

Sensitivity analysis

Expected values

These are some of the methods we can use to assess risk in an investment

Sensitivity analysis involves changing one variable at a time (e.g. change in sales by 10%) to see the effect on NPV

Scenario analysis involves changing all variables and having usually three scenarios – best case, worst case and most likely (we did these two in our session on projections)

We may adjust the discount rate we use according to the risk profile e.g. an inherently more risky project might have a higher discount rate to reflect that risk

We can apply percentage likelihood of each outcome occurring to calculate an Expected Nep Present Value

We can use more complicated software simulations to determine outcome

We can consider diversification of our investment projects into a portfolio to reduce overall risk in the company.

Figure 5.11 Relationship between risk and return

Generally as the risk of a project increases the required return of that project also increases.

What types or sources of finance are available to companies to fund capital investment?

Capital Investment projects often need large sums of money to finance them, so alongside considering the viability of the investment project we also need to think about where the company can raise this finance and what form it might take. Ask the students to give ideas about what sources of finance are available to companies when considering capital investment projects. Hopefully they will be able to identify debt and equity, although they may also talk about the entity providing the finance (e.g. venture capital, crowdfunding etc)

This section moves onto types of finace – you may not be able to get through all of this section but that’s not a problem as we continue on the same topic in session 4.1.

Figure 6.1 The major external sources of finance

The main sources of finance can first be divided into external and internal sources. We are going to look at external first. This is finance that involves going outside of the company to a third party. It can be divided into long term (over 1 year) and short term (less than one year) and into two key types of finance - debt and equity and we will look at each one in turn.

The structure of a company

Company X

Management

Employees

Banks

Customers

Suppliers

General Public

Shareholders

A quick reminder – a company is a sperate legal entity. It is not the same as it’s management team – they have a contract to provide services to the company. It is also not the same as it’s shareholders – they own the shares of slices that the company is divided up into. It is also not the banks – this is a completely separate third party who has agreed to provide the company with money for a stated period of time under a contractual arrangement.

Ordinary shares

Looking first at share ownership, the most common type of shares are ordinary shares. There are a number of properties of ordinary shares, explained above.

No fixed right to a dividend

More volatile market price

“Residual”

High risk, therefore relatively high rate of return expected

High upside potential

Control/owners of the business

Preference shares

An alternative to ordinary shares in preference shares. These are much less common nowadays but the key difference is that they had a fixed right to a dividend but usually not voting rights and little upside (this residual goes to the ordinary shareholders who are bearing more risk).

Fixed right to a dividend & “first slice”

Less volatile market price

Rights documented in constitution documents

Lower risk than ord shares, therefore lower return

Little upside potential

Usually no voting rights.

Borrowing/Loan Capital

The other key long term finance option is a bank loan. This is completely different to shares as it is a contractual rather than an ownership relationship. It is low risk from the perspective of the bank as there is a right to interest and if the company is in trouble the bank loans take priority over the shareholders. There is little upside if the company does well and no voting rights.

Contractual right to interest

May be traded

Contractual obligation

Lower risk than shares, therefore lower return

No upside potential beyond more security

May use loan covenants or securities

Figure 6.2 The risk/return characteristics of sources of long-term finance

From the perspective of the person providing the finance this is the risk profile – loans have the lower risk going up to ordinary shares which carry the highest risk because they have no fixed or contractual right to a return and are the lowest priority if the company fails. They do however get the benefit of all of the upside if the company performs well.

Public v Private Companies

Company X

Management

Employees

Banks

Customers

Suppliers

General Public?

Shareholders

General Public

It is worth clarifying the difference between public and private companies. Both public and private companies are owned by shareholders, but in the case of public companies those shares can be traded freely among the general publiuc.

Public or Private Company

A private company (in the UK a Ltd) is held privately, usually by founders or other private individual investors.

The general public cannot buy or sell shares in Limited

May invite specific people to invest (e.g. a Private Equity Fund or Business Angel)

Does not appear on a Stock Exchange

A public company (in the UK a Plc) has sold some or all of its shares to the general public by way of an Initial Public Offering (IPO).

Listed on a stock exchange

Public can buy and sell shares on investment platforms

Has a higher level of scrutiny

Explanation of the terms

Public or Private Company

Public companies tend to be larger and have more access to funding, but there are some very large private companies

What is the function of a stock market?

The Stock Exchange

Secondary market

Primary market

Two important roles

A publicly traded company is listed on a stock market. The market has two functions – firstly for the company to raise new capital (the first time it does this on the stock market is known as an Initial public Offering or IPO). The second function is then to provide liquidity for the shares – shareholders can buy and sell their shares as they wish, without involvement of the company. It is worth clarifying that when individuals buy and sell shares among themselves this does not generate new finance for the company. It does however indicate the share price – if shares are in demand the price rises and therefore the value of the company increases.

What is an IPO (video)? https://www.youtube.com/watch?v =l4HMCr5roAM

What is an IPO (video)?

Stock Exchange listing

Advantages for a business

Enables other businesses to be acquired by shares rather than cash

Shares valued in an efficient manner

Broadens investor base/exit for founders

Raises profile

Funds acquired at lower cost

Easier to raise funds

Can help attract and retain employees (share incentives)

Self explanatory advantages – I like to use the example of Facebook which was listing at the same time as buying Instagram so the listing gave a valuation to Facebook and allowed it to use its shares as currency in the acquisition of Instagram

The PPT about the Financial Decision Making

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