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2022 | OriginalPaper | Buchkapitel

11. Investing in Assets: Theory of Investment Decision-Making

verfasst von : John B. Guerard Jr., Anureet Saxena, Mustafa N. Gültekin

Erschienen in: Quantitative Corporate Finance

Verlag: Springer International Publishing

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Abstract

Capital budgeting, or investment decision, depends heavily on forecasts of the cash and a correct calculation of the firm’s cost of capital. Given the cost of capital, that is, the appropriate discount rate and a reasonable forecast of the inflows, the determination of a worthwhile capital investment is straightforward. An investment is desirable when the present value of the estimated net inflow of benefits (or net cash inflow for pure financial investments) over time, discounted at the cost of capital, exceeds or equals the initial outlay on the project. If the project’s present value of expected cash flow meets these criteria, it is potentially “profitable” or economically desirable; its yield equals or exceeds the appropriate discount rate. On a formal level, it does not appear too difficult to carry out the theoretical criteria. The stream of the forecasted net future cash flows must be quantified; each year’s return must be discounted to obtain its present value. The sum of the present values is compared to the total investment outlay on the project; if the sum of the present values exceeds this outlay, the project should be accepted.

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Vorheriges Kapitel Debt, Equity, the Optimal Financial Structure, and the Cost of Funds

Nächstes Kapitel Regression Analysis and Estimating Regression Models

Nur mit Berechtigung zugänglich

One need consider the case of Joel Dean’s degree of necessity, in which projects must be undertaken regardless of their economic benefit (profit). Dean (1954) suggested that replacing a shop destroyed by fire could be an example of the degree of necessity, and he further suggested that you could not quantify the degree of necessity.

The discounted cash flow approach has been widely accepted since Dean (1954).

In a case of capital rationing, the profitability index is calculated and used. The profitability index is the project’s net present value divided by its initial cost [Brealey and Myers (2003).

The ACRS depreciation charges for a three-year asset are 0.3363, 0.4445, 0.1481, and 0.0741, respectively.

F. Modigliani and M. H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review, 48 (1958), pp. 261–297

“Tread Lightly Through These Accounting Minefields,” by H. David Sharman and S. David Young Harvard Business Review on Point, (2002) highlights most common tricks companies use to adjust financial statement to fit their purpose.

Gordon (1955) revealed that the payback period is proportional to the reciprocal of the project’s rate of profit.

I = Cost of the project

E = Earnings or savings before depreciation of the project

n = Number of years of the project

s = Scrap value at time t = n

k = Project’s expected rate of profit

$$ C=\frac{E_1}{1+k}+\frac{E_2}{{\left(1+k\right)}^2}+\dots +\frac{E_k}{a+k}+\frac{E_n+{S}_n}{{\left(1+k\right)}^n} $$

(11.9)

Gordon found if one ignored the scrap value, that:

$$ C=\sum \limits_{t=1}^n\kern0.5em \frac{S}{{\left(a+k\right)}^t}=\frac{S}{k}-\frac{S}{k}\ {\left(1+\frac{1}{\left(a+k\right)}\right)}^n $$

(11.10)

where (11.5) is the present value of an annuity

$$ k=\frac{E}{C}-\frac{E}{C}{\left(\frac{1}{1+k}\right)}^n $$

(11.11)

As the life of the project becomes very large, equation (11.6) becomes

$$ k=\frac{E}{C} $$

and the rate of profit is the reciprocal of the payback period. Furthermore, if the project life is infinite, then the rate of profit is the reciprocal of the payback period. The reader immediately recognizes the Gordon payback period analysis is consistent with the Gordon valuation of stock model shown in Chap. 8. If we buy a stock, we purchase a stream of expected future dividends. The stock price, P_CS, or P₀, is determined by the current dividends per share, D₀, and the growth rate of future dividends, g.

$$ {P}_0=\frac{D_0}{d-g} $$

(11.12)

where $ k=\frac{D_0}{P_0+g} $

The rate of profits earned by purchasing stock is its current dividend yield, $ \frac{D_0}{P_0} $, plus the rate at which dividends are expected to grow, as long as k > g [Gordon and Shapiro (1956)].

If a firm does not make the proper cost-of-investment determination, it could develop an unprogressive policy in regard to equipment replacement. The firm could repair its equipment long past an economic optimum because the fairly large total earnings on a repaired piece of equipment is credited just to the costs of repair. The economic investment in a reconstruction job, however, is the repair costs plus the salvage value of the unrepaired equipment. Furthermore, the forecasted cash flow should subtract the estimate of maintenance costs that may still have to be made in the future. When the problem is thus properly formulated, it may be that a replacement will show a higher rate of return than a repair job.

In a sense, the existence of the whole firm may be periodically measured against the same criterion: how does the withdrawal value of the firm’s assets compare to the discounted value of its projected cash flow.

The cost is not zero to the economy as a whole, but the individual firm is not concerned with aggregate economic costs at this point.

The amount made on the asset value of the equity—especially its growth or trend over time—may, however, be a fairly good index of the firm’s economic success.

“The Corporate Sector: A Net Exporter of Funds,” J.R. Aronson and E. Schwartz, Southern Economic Journal, October 1966.

It should also be recognized that the accounting results and the estimated rate of return may not necessarily coincide because accounting conventions on depreciation and calculation of profits may differ from the assumptions underlying the cash-flow rate of return analysis. This need not invalidate the usefulness of either the discounted cash flow techniques or of accounting procedures.

M. H. Miller and F. Modigliani, “Dividend Policy, Growth, and Valuation of Shares,” Journal of Business, 34 (1961), pp. 311−433.

After a long academic debate, consensus agreement is M&M’s assumption is correct.

Majority of academics agree that tax rules create distortions in the economy. In an ideal world to avoid distortions and opaque subsidies, corporate taxes should be 0%. Recipients of cash flows should be taxed.

See teaching note “Using APV: A Better Tool for Valuing Operations” by Timothy L. Luehrman, Harvard Business Review, (1997) for an extended discussion.

Bierman, H., & Smidt, S. (1993). The capital budgeting decision (8th ed.). Macmillan.

Brealey, R. A., & Myers, S. C. (2003). Principles of corporate finance (7th ed.). McGraw-Hill/Irwin.

Dean, J. (1951). Managerial economics. Prentice-Hall. Chapters 4, 10.

Dean, J. (1954). Measuring the productivity of capital. Harvard Business Review.

Gordon, M. J. (1955). The payback period and the rate of profit. Journal of Business.

Gordon, M. J., & Shapiro, E. (1956). Capital equipment analysis: The required rate of profit. Management Science.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Finance Economics, 187–243.

Hackbarth, D., & Johnson, T. C. (2015). Real options and risk dynamics. Review of Economic Studies, 82, 1449–1482.CrossRef

Lanzilotti. (1958). Pricing objectives in large companies. The American Economic Review, 921–940.

Lerner, E. M., & Carleton, W. (1964). The integration of capital budgeting and stock valuation. American Economic Review, 683–702.

Lerner, E. M., & Carleton, W. T. (1966). A theory of financial analysis. Harcourt, Brace, and World, Inc.

Levy, H., & Sarnat, M. (1982). Capital investment and financial decisions. Prentice-Hall International. 2nd edition, Chapter 4.

Lewellen, W. G. (1969). The cost of capital. Wadsworth Publishing Company.

Mauer, D. C., & Sarkar, S. (2005). Real options, agency conflicts, and optimal capital structure. Journal of Banking & Finance, 29, 1405–1428.CrossRef

Myers, S. C. (1974). Interactions of corporate financing and investment decisions: Implications for capital budgeting. Journal of Finance, 29, 1–25.CrossRef

Myers, S. C., & Reade, J. A. (2018). Real options, taxes, and financial leverage. Working Paper.

Robichek, A. A., & Myers, S. C. (1965). Optimal financial decisions. Prentice-Hall, Inc.

Rubinstein, M. E. (1973). A mean-variance synthesis of corporate financial theory. Journal of Finance, 167–181.

Schall, L. D. (1972). Asset valuation, firm investment, and firm diversification. Journal of Business, 45, 13–21.

Schwartz, E. (1959). Theory of the capital structure of the firm. Journal of Finance, 24.

Schwartz, E. (1962). Corporate finance. St. Martin’s Press. Chapters 10–11.

Schwartz, E. (1993). Theory and application of the interest rate. Westport, CT, Praeger.

Solomon, E. (Ed.). (1959). The management of corporate capital. University of Chicago Press.

Solomon, E. (1963). Leverage and the cost of capital. Journal of Finance, 28, 273–279.CrossRef

Spencer, M. H., & Siegelman, L. (1959). Managerial economics. Richard D. Irwin. Chapters 10, 11.

Titel: Investing in Assets: Theory of Investment Decision-Making
verfasst von: John B. Guerard Jr.
Anureet Saxena
Mustafa N. Gültekin
Verlag: Springer International Publishing
Buch: Quantitative Corporate Finance
Print ISBN: 978-3-030-87268-7

Electronic ISBN: 978-3-030-87269-4

Copyright-Jahr: 2022
DOI: https://doi.org/10.1007/978-3-030-87269-4_11

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