Investment Investment strategy and strategy and

processprocess

Chapter 5, 6, 7 & 8 Chapter 5, 6, 7 & 8Pike and NealePike and Neale

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Learning objectives The main DCF approaches, non-

discounting methods Assessing projects when capital is limited Evaluating investment proposals The investment process Strategic issues in investment Foreign Investment Complexities of FDI Evaluation of FDI

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Main appraisal methods

DCF Net present value (NPV) Internal rate of return (IRR) Profitability index (PI)

Traditional Payback Accounting rate of return

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Remember this??

Yr Invest W.C Revn Tax After-tax C/f

D.F @13 %

P.V

0 (20,500) (8,000) - - (28,500) 1 (28,500) 1 (20,500) - 27,200 (864) 5,836 0.885 5,164.86

2 - - 38,200 (2,184) 36,016 0.783 28,200.53

3 - - 42,500 (5,100) 37,400 0.693 25,918.20

4 1,000 4,000 47,000 (5,640) 46,360 0.613 28,418.68

N.P.V 59,202.27

Positive N.P.V, therefore accept proposal

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And this??? Cash Flow Discount

Factor 5% Present Value

Discount Factor 20%

Present Value

C0 -650 1.000 -650.0 1.000 -650.0 C1 200 .952 190.4 .833 166.6 C2 350 .907 317.5 .694 242.9 C3 400 .864 463.0 .579 231.6 NPV = +320.9 NPV = -8.9 IRR = R1 + (R2 – R1) x NPV1 (NPV1 – NPV2) IRR = 5 + (20 – 5) x 320.9 (320.9 – (-8.9)) IRR = 5 + 14.595

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The Other Methods

Profitability Index:= PV of cash inflows / PV of cash outflows – Basically the same as NPV, different rule

Payback: Period of time taken for inflows to match outflows– Criticisms: time value of money, future cash flows– Praise: Screening, uncertainty, liquidity

Accounting rate of return: Return on investment over the whole life of a project– Does not account for size, duration or time value of

money

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NPV is preferable when:

Mutually exclusive projects

Variable discount rates

Unconventional cash flows

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Investment appraisal where capital is rationed

Hard Rationing– External forces: Credit crunch, stock markets

Soft Rationing– Internal Forces: Borrowing limits, stable growth, risk aversion,

information asymmetry, economies of scale

Appraisal techniques Profitability index

– For single period rationing Mathematical programming

– For multi-period rationing

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Incremental cash flow analysis

Remember opportunity costs Ignore sunk costs Look for associated cash flows Include working capital changes Separate investment and financing

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Use of investment evaluation methods in large UK firms

1992

%Pike (1996)

1997

%Arnold &

Hatzopoulos (2000)

Payback 94 66

ARR 50 55

NPV 74 97

IRR 81 84

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Typical project classification

Replacement Cost reduction Expansion/improvement New product development/implementation Statutory and welfare

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Investment proposal checklist Purpose of project Project classification Finance requested Operating cash flows Attractiveness of proposal Project risk and sensitivities Review of alternatives Implications of not accepting project Non-financial considerations

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Post Auditing Final stage in Capital Budgeting process Compares actual performance to forecasts Aims:

– More thorough and realistic appraisals– Major overhauls of existing projects

Problems– Disentanglement– Projects may be unique– Prohibitive cost– Biased selection– Lack of cooperation– Encourages risk-aversion– Environmental changes

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When does post-auditing work best?

Focus on learning rather than a search for the guilty

Clear post-audit aims Begin with small projects At evaluation stage agree information

required at the post-audit

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Where do positive NPVs come from?

+ NPV project offers greater return than another project with similar risk

It is all about identifying and exploiting market imperfections

The best firms continually do this

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Figure 7.1 McKinsey–GE portfolio matrix

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Figure 7.2 Normal progression of product over time

Figure 7.3 Investment strategy

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Strategic Considerations Advanced Manufacturing Technology

(AMT) Investment– Offers less tangible, quantifiable benefits

• Greater flexibility• Reduced stock, work in progress• Lower manufacturing times

– How do you evaluate?1. Does it fit the corporate strategy2. What does DCF say3. Do intangible benefits make it worthwhile if (–)

NPV

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Strategic Considerations

Corporate Social Responsibility (CSR)– Firm has other stakeholders; local

community, business society, environment– Must account for cost/benefit to stakeholders– How do you evaluate

1. Value using DCF

2. Assess costs and benefits of CSR considerations

3. Assess impact of decision on shareholder wealth

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Foreign Investment Why firms invest abroad:

– Comparative costs - least cost location– Scale economies - spread fixed costs esp. R&D– Avoid transport costs– Restore/Maintain growth in mature products– Lack of domestic capacity– Overcome trade barriers– Use of retained profits difficult to repatriate– Local inducements;

• tax breaks, cheap loans, etc– To avoid FX risks

Foreign Direct Investment (FDI)

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Methods of Market Entry

FDI not the only means of serving foreign markets. Grant distinguishes between:

Transactions-based methods;– Exporting via agents, direct exporting, franchising,

licensing

Investment-based methods– Joint ventures, acquisitions, direct investment

Choice depends on:– Cost– Source of advantage: – ownership- or location-based– Ease of appropriation of technology

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The Switch Model

Figure 8.2 Exporting vs. FDI Source: Buckley and Casson (1981)

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Complexities of FDI

Tax system differs from that in parent’s location Movements in FX rate - exchange exposure Concessionary local financing Minority group local shareholders Relationship with present operations

– spillover effects, transfer pricing

Political risk Different local rates of inflation – does this

matter? – Not if Purchasing Power Parity (PPP) applies!

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The Focus of the Evaluating FDI Q. How to evaluate foreign projects?

– In terms of the inherent value of the project (local perspective)?

– Or from parent’s perspective i.e. in terms of the funds remittable to the parent?

A. Firm’s share price depends on cash flows usable by parent– Parent can only pay dividends out of repatriated

funds – Blocked funds irrelevant to project evaluation if

we aim to max. shareholder value

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What Discount Rate to Use?

Assuming all-equity finance Use the parent firm’s Beta?

– Foreign projects have higher risk, higher Betas?

Tailor-make a project-specific Beta?– Identify a suitable local company and use a discount

rate based on the Beta of the surrogate

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Two Opposing Forces

Diversification - – should lower risk and thus the discount rate?

Idiosyncratic risks of FDI - – argues for higher discount rate

Does the company want to diversify to lower risk?

Do shareholders want the company to diversify? – Can they achieve same effects by portfolio

diversification? But barriers to diversification –

– market segmentation

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A Solution

Use parent’s Beta coefficient Evaluate project as if equity-financed

Manage idiosyncratic risks in other ways:– FX hedging– Conservative forecasting– Insurance– Political risk management