MBA 540 Maximizing Shareholder Wealth

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MBA 540 Maximizing Shareholder Wealth

• Week 3
• Identification of Long-Term Financing
  Alternatives
• Peggy L. Determeyer

2
Week 3

• Explain the purposes of capital budgeting
• Differentiate among various investment and
  financing options
• Compare and contrast the roles of financial
  institutions in the global economy
• Describe factors that influence a capital
  budgeting analysis
• Explain how the time value of money influences
  financial decisions
• Describe the stages of raising capital

3
Time Value of Money

• Premise In the absence of other considerations,
  a dollar today is worth more than a dollar
  tomorrow
• Understand the workings many mathematical tools
  (calculators/spreadsheets) to help calculate
• Once get into extreme future, additional income
  has little value today
• Inflation affects the time value of money,
  reducing real costs or returns
• Practical applications interest costs, annuity
  values

4
The Basic Principle

• The basic financial principle of investment
  decision making is this
• An investment must be at least as desirable as
  the opportunities available in the financial
  markets.

5
Valuation

• Book Value accounting value of assets less
  accounting value of liabilities (biased on
  historical or original costs)
• Liquidation value quick sale of individual
  assets less liabilities owed
• Going concern value difference between minimum
  liquidation value and actual or market value
  considering- Future earning power of assets-
  Value of future investment opportunities
• Market value assigned by investors in
  reasonable market driven by expected level and
  variability of cash flows
• Market capitalization share price X no. of
  shares outstanding

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Techniques

• Accounting Rate of Return
• Payback period
• Net Present Value
• Internal Rate of Return

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Accounting Rate of Return

• ARR Accounting Income
• Accounting Assets
•  
• Rarely used for capital budgeting as it ignores
  time completely

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Payback

• Time until cash flows recover the initial
  investment of the project
• Rule investment should proceed if the payback
  exceeds a specified period
• Simple evaluation method for short-lived projects
• Timing and cash flows beyond payback are not
  considered
• Ignores risk of project cash flows
• Ignores investors opportunity rate of return

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Payback Example
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Net Present Value

• Measures each projects contribution to
  shareholder wealth
• Focuses on building shareholder value with few
  limiting assumptions
• Easy to use, but not always easy to understand
• NPV PV(Investment Outlay) PV(sum of all cash
  flows)- If positive, make investment- If
  negative, dont make investment
• Probably the most accurate measure

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Discounted Cash Flow

• Transaction recognition vs cash flow
• Relevant Cash flows
• Incremental after-tax cash in and out flows
• Net Initial Investment
• Net Operating Cash Flows
• Net Terminal Cash Flows

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NPV Example
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Internal Rate of Return

• IRR is difficult to calculate, but easy to
  understand for users
• What return will this project generate for us
• When discounting cash flows, will produce a
  present value equal to the cost of the project.
  If discount rate 12 and IRR 12, NPV 0.
• Rule Invest in any project offering a rate of
  return higher than opportunity cost of capital
• Iterate if doing manually
• If IRR gt cost of capital, go for it

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IRR Example
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Capital Rationing

• Theoretically, a company should invest in any
  project that will add value to the company.
• Realistically, there are constraints on capital
  and resources.
• Companies often rank opportunities by IRR, NPV,
  or Strategic Importance

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NPV vs. IRR

• Mutually exclusive projects, typically select
  project with highest expected NPV
• Mutually exclusive projects with different
  outlays may result in smaller project being
  selected
• IRR requires up-front investment, or cannot be
  calculated
• Change in sign in period cash flows produces
  different IRRs

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Step 4 Identify the Alternatives

• Possible solutions
• Assumptions
• Constraints

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Step 5 Evaluate Alternatives

• Alternatives vs. Goals
• Scoring System

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Step 6 Identify and Assess Risks

• Risks
• Positive and negative consequences
• Strategic implications

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Risk of Various Options

• Not all projects are of equal risk, companies
  have developed means of incorporating this into
  their analysis
• Sensitivity Analysis
• Certainty Equivalents (CES)

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Sensitivity Analysis

• Establish different scenarios / possible outcomes
• Pessimistic
• Most Likely
• Optimistic
• Run the NPV for each and determine the range of
  outcomes
• Standard Deviations are sometimes used to
  quantify the volatility of outcomes

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Certainty Equivalents

• Think of it as a subjective reduction of each
  cash flow
• Reflects that forecasts are usually less accurate
  the further into the future you look.

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CES Example
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International Implications

• Political
• Economic

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Shang-Wa Balance Sheet
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Shang-Wa Income Statement
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Shang-Wa Cash Flow Statement
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Lester Balance Sheet
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Lester Income Statement
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Lester Cash Flow Statement