Module%20IV:%20Financial%20Strategy%20Real%20Investments%20and%20Strategy

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Module IV Financial StrategyReal Investments
and Strategy

• Week 10 October 28 and 30, 2002

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Objectives

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

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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.

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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

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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)

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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.

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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?

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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 firms
  weighted-average cost of capital (WACC)
• Firms entering new businesses or investing in new
  strategies may be changing the firms risk from
  levels assumed in a firm-wide WACC
• Project risk or ? is the relevant risk

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

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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.

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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

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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

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Example real option

• If we wait one year we can take advantage of
  future information
• If value turns out to be low, dont 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

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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?

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Management options

• Abandon

Contract
Switch
Wait
Expand
Grow
Currently Invested React to Bad News
Not Currently Invested
Currently Invested React to Good News
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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

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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

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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.

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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

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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.

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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.

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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

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Profits and Competitors Reactions
Average Cost Curve
Price
Quantity
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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

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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

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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

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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

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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 tranche
  getting first claim, hence lowest risk
• Other tranches have subordinated claims to cash
  flows
• A residual trance (lowest claim) is equity claim

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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 lessees 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

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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

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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.

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Next Week Nov. 6 and 8, 2002

• Review financial planning and RWJ, Chapter 26 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