DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 1 Chapter 1 Long-Term Investing and Financial Decisions

2  Why are capital budgeting decisions important to the firm and society? 1. Capital projects involve large amounts of money. 2. Capital projects are typically hard ( or costly) to reverse. 3. Capital projects and related financing are the source of all wealth to the firm and its stockholders DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1

3  Central Role of Wealth Maximization  Shareholder wealth maximization is generally considered the goal of investment and financing.  An action increases wealth if the benefits gained exceed the benefits expended.  Companies develop strategies and goals, and visions so they will be in a position to create wealth. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1

4  Wealth is created If cash inflow exceeds cash outflow by more than what would have been earned by investing the money somewhere else during that period (more than normal profit).  Economic Profit (EP)- A Single Period Measure of Wealth.  Net Present Value (NPV) is the economic profit or wealth created by a multi-period investment. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1

5  Competitive Advantage and Wealth Creation  Wealth creation (economic profit) is not possible in perfect competition. All wealth creation comes from competitive advantage.  Competitive advantage is achieved by a. product advantage (superior quality) or b. cost advantage (lower cost) DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1

6  Competitive Advantage and Wealth Creation The characteristics of perfect competition 1. No restrictions on entry and exit 2. No producers so large that they have price influence 3. All producers manufacture identical products 4. All producers have identical costs 5. Complete information about competitor’s actions.

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 7  Economic Profit: Revenues - Expenses Accounting profit - Required return* Economic Profit** (*Computed as RR on investment) (**This is wealth created for a single period)

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 8  Wealth Creation versus Accounting Profit  A firm should maximize economic profit or wealth instead of profit because:  Wealth is three dimensional ( revenue, cost and risk)  Profit is two dimensional (revenue and cost)

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 9  Other Definitions of Economic Profit  Economic profit = accounting income – opportunity cost of equity  Economic profit = Equity X (ROE – K e ) Where K e is the required return on equity  Economic profit = assets X (ROTA – K a ) Where K a is the required return on assets

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 10 Net Present Value (NPV) A Multi-Period Measurement of Wealth Net Present Value (NPV)  The present value of all cash inflows, minus the present value of all cash outflows.  NPV is the economic profit or wealth created by a multi period investment.

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 11 Stakeholders and Competing Desires  Stakeholder: What their goals are? (What they want?): Owners Dividends or stock appreciation Managers High salary and perquisites Creditors Low risk, return of their money Customers Low prices and lots of features Employees High salaries, job security Suppliers: Stable demand Society Good citizenship

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 12 Capital budgeting for Nonprofit Organization Capital budgeting process for nonprofit organization is not significantly different from that in a profit-seeking company: If either of two capital investment will achieve the organization’s mission, the one with the smallest present value of costs is desirable.

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 13  Steps in capital budgeting process: a. Establish Goals b. Develop Strategy c. Search for Investment Opportunities d. Evaluate Investment Opportunities e. Select Investment f. Implement and Monitor g. Post-Audit:

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 14  Long –Term Financing Decisions Perfect market conditions The business value is unaffected by the way in which the firm finance its activities. Imperfect market conditions: Finance choices matter.

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 15  Long-Term Financing Decisions The impact of the financing decision on stockholders’ wealth depends on:  How much money is needed  What it is needed for  How to raise the money  financing cost (risk)  The rate of return required by stockholders

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 16  Financing Choice o Equity ( common, and preferred) o Debt ( size, payment, and maturity) o Priority of debt o Collateral  Sources of financing  Public offering, Private placement, and/or Private borrowing Range of financing choices Convertible debt, preferred, warrants

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 17 Considerations in Financing Cost is the principal considerations in financing choice The lower the rate of return required by investors, the greater the net present value and wealth contribution of each capital investment Cost is affected by a number of considerations *Cost of debt – interest is tax deductible *Large amounts of debt increase the risk of bankruptcy.

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 18  Agency costs which are related to agency problems *Cost of Monitoring the agent Raises the cost of equity *Debt agency costs : managers might take more risks than creditors anticipated. The higher the level of debt the greater this risk. *Specific asset pledges and repayment schedule help to reduce this risk.

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 19 Minimizing agency cost Financing mix: A mix of senior debt, with first priority in bankruptcy, and a junior debt that gets paid only after the senior debt. Asset type: A creditor will generally lend a company with a high percentage of easily monitored assets more than the company with assets that are much more difficult to monitor.

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 20 Availability of funds The company does not want to be in a position where it has excellent investment opportunities but cannot raise money Flexibility of financing mix The company wants to be able to change its financing mix for the interest of the company a. Repaying the debt before maturity b. Keeping a lower debt to equity ratio c. Maintenance of numerous credit arrangements d. International listing of the Firm’s stock

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 21 Strategy and financing choice Strategy is designed to a. Create competitive advantage b. Guide Capital investment process and also c. Guides the financing plans *Finance with equity or long-term debt if the company cannot commit itself to large cash payments to investors in the low-profitability Period.

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER1 22 *Secrecy may be an element of the strategy if the company does not want to announce the intended use of money ( private financing) Concluding Remark: It is impossible to completely divorce investment and financing decisions Low-cost financing always make investments more attractive Stability of cash flows from investment allows more fixed payments to creditors than would be possible with unstable cash flows.