Chapter 1: Longterm Financial Decisions

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Chapter 1 Long-term Financial Decisions

• A corporation has many stakeholders with
  conflicting desires.
• Wealth creation for the shareholders is our goal.
• Accounting income is not a sufficient measure of
  performance because it ignores risk and the cost
  of the invested funds.
• Economic profit and net present value are two
  ways we measure wealth creation in a single
  period and multiple periods.
• Capital projects create most of the wealth for
  the firm but not all projects are equal or should
  even be considered.
• Strategy and competive advantage should guide the
  capital budgeting process.

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Stakeholders and Competing Desires

• Stakeholder What their goals are (what
  they want)
• Managers High Salary and perquisites.
• Creditors Low risk, return of their money and
  interest
• Customers Low prices and lots of features
• Employees High salaries, job security
• Suppliers High prices and long relationships
• Society Good citizenship and taxes
• Owners Dividends or stock appreciation

3
Wealth Creation versus Accounting Profit

• A firm should maximize economic profit or wealth
  instead of profits because
• Wealth includes risk while profit does not.
• Wealth is three dimensional
• (revenues, cost and risk)
• Profit is two dimensional
• ( revenues 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 required return on assets

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Net Present Value A Multi-period Measure of
Wealth

• Net Present Value
• Take the present value of a series of future
  economic profits less the initial outlay.
• This is wealth created for a multiple period.
• In theory NPV of the firm divided by the number
  of shares gives you the intrinsic value of the
  stock.

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What Makes a Capital Investment Attractive?

• An attractive capital investment
• Fits the strategy of the firm
• Within an appropriate risk level
• Has a positive net present value or economic
  profit across time