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LECTURE 1
INTRODUCTION & CIP DEFINITION
What is capital investment policy?
Any investment policy [...] must embody two components:
(1) one or more criteria by which to measure the relative economic attributes of investment alternatives,
and
(2) decision rules [...] for selecting ‘acceptable’ investments.
A consistent and adequate investment policy has a double function:
à In the short run, it should indicate which investments should be chosen to achieve the financial
objectives of the corporation.
à In the long run, it should serve as a basis for identifying or developing investment alternatives that are
likely to match the policies selected.”
Any company had to answer 2 broad questions:
1) What investments should it make?
2) How should it pay for these investments?
à We primarily focus on 1 BUT Q1 & Q2 are generally not independent.
THE FINANCIAL GOAL OF THE CORPORATION
A company is a group of project
à the role of management is to choose the best projects
A project is a series of cashflows
à Cash inflows represent revenue
à Cash outflows represent initial investment and expenses
Cash flow is an amount of money paid at a specific time.
à Cash inflow = positive amount; or
à Cash outflow = negative amount.
Where do the company objectives come from?
à The goal of a firm is determined by the firm’s owners (for a corporation, by its shareholders)
2 problems:
1) Definition of goals: What if shareholders disagree among each other?
2) Implementation of shareholders’ goals: Separation of ownership and control may lead to
agency conflicts.
All shareholders – independent of their individual preferences – can agree to assign one objective to
the manager: to maximize the current market value of shareholders’ investments in the firm
à With functioning financial markets, the wealth can then be put to whatever purpose each
shareholder wants
Maximizing shareholder value =/= maximizing profits
• Increasing current profits by cutting back on long-term investments (staff training, maintenance,
...) may impair/damage/weaken long-term value.
• Not paying dividends (to the shareholders) and reinvesting additional cash in a mature company
might increase profits but not shareholder value.
Example: Paying dividends vs investing: Suppose Tesla considers launching a new electric car
and has set aside the necessary cash. The options: go ahead with the launch or pay cash to
shareholders.
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Suppose the launch is about as risky as the US stock market and that the stock market offers a
return of 10%.
à If the new car generates a return of 20% shareholders would be happy for Tesla to launch
à If it generates 5%, they prefer the cash.
à Minimum rate of return at which shareholders would be happy with the launch and not
demand their money back: 10% è = hurdle rate or cost of capital; it is an opportunity cost as
it depends on shareholders’ outside options. To remember: the appropriate opportunity cost
depends on the risk of the proposed investment
In perfect markets, maximizing shareholder value is a common objective for all shareholders.
This allows management to be delegated to hired managers. But: managers’ personal interests
(like job security and bonuses) may conflict with shareholder objectives, leading to agency
problems…
à Agency costs occur when managers do not maximize firm value, or when shareholders bear
costs to monitor and control management behavior.
Example: The return on A and G’s investment in F’s company would depend on F’s
commitment
à After funding, F might prioritize networking for a better job, potentially neglecting their
company. F might find it beneficial to focus on networking even if it harms their company’s
value.
à A and G’s investment would lose value, but holding F accountable could be costly
NPV RULE for investment decision
Goal: to choose “the most valuable” projects !!
! !
Present Value rule Invest if PV(benefits) = "#$ > PV(costs) = −C%
!!
Net Present Value: Invest if NPV = C% + "#$
>0
&$'()*
Rate of Return rule: invest if Rate of Return = )+,-.*/-+* > r
à projects add value if its return is higher than the return of comparable alternative investments (hurdle
rate, cost of capital)
Perpetuity = financial instrument that pays C dollars per period forever, starting one period from today: PV
!
=$
!
Growing perpetuity: PV = $01
Annuity = financial instrument that pays C dollars for T periods, starting one period from today: PV =
! "
$
(1 − ("#$)" )
! ("#1)"
Growing annuity: PV = ($01) (1 − ("#$)" )
à Regardless of our preferences for cash today versus cash in the future, we should always maximize NPV
first.
à all investors agree that the highest NPV project is the best when choosing among projects
So far, we have assumed riskless investment projects & discount rate r has been the riskless interest rate
à r represents the opportunity cost of capital : expected return on alternative but “equivalently
risky” investments
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ALTERNATIVE DECISION RULES
IRR: INTERNAL RATE OF RETURN (only use it complementary with the NPV rule)
!! Any method producing results that differ from NPV is WRONG. However IRR the most popular
alternative method.
A projects IRR is defined as the interest rate that sets the NPV of cashflows equal to zero. Given 𝐶, 𝐶1, …, 𝐶n
the IRR is the r solving the equation: 𝐶
Accept project if IRR > hurdle rate = r
In general, the difference between the cost of capital and the IRR is the maximum amount of estimation
error in the cost of capital estimate that can exist without altering the original decision
à If the difference is very small, a very precise estimate is needed (be sceptical)
Pitfalls of the IRR-method:
1) Lending or borrowing: IRR assumes a negative cashflow in t=0 and a positive
cashflow in t=1, however, if this is the other way around (negative NPV), IRR
still assumes it is a good project (still gives a positive %).
2) Multiple IRR values: not always an unique solution (due reinvesting) : ex.
graph
3) Mutually exclusive projects: ignores the scale of the project
4) Time varying interest rates: way too difficult
5) No real solutions exist ex. r = (-25)^2
It works (i.e., it exists, is unique, gives right decision) as long as:
à One discount rate for all periods
à One negative cash flow in period 0 followed by positive cash flows.
à We are only looking at one investment (so not comparing to make a selection)
THE PAYBACK RULE
The payback method is the amount of time it takes to recover or pay back the
initial investment
à If payback period is less than pre-specified length of time: accept the
project
!! Does not always give a reliable decision since it ignores the time value of money
EFFICIENT CAPITAL MARKETS & NO- ARBITRAGE PRICING
Efficient Capital Markets
o No taxes, no transaction costs, no differential information.
o Implication: 1) Investors can borrow and lend at the same (risk-adjusted) rate. 2) Unlimited short
selling is possible.
Efficient Market Hypothesis:
à Prices reflect all available information.
à In efficient markets, it's impossible to consistently "outsmart" or beat the market.
Arbitrage = Opportunity to make a profit without risk or investment.
à In efficient markets, arbitrage opportunities should not exist
Law of One Price = Equivalent assets must trade at the same price across different efficient markets
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Valuing a security:
The price of a security equals the present value of its future cash flows
à If the price deviates from the calculated present value, arbitrage opportunities arise.
à Arbitrage will continue until no risk-free profits are possible, setting the "no arbitrage price."
Ex. A bond's present value is $952.38, but it’s priced at $940, arbitrage forces will push the price to its
correct value ($952.38).
Ex. A bond's present value is $952.38, but it’s priced at $970, arbitrage forces will push the price to its
correct value ($952.38).
Financial investments: In efficient markets, financial investments have a Net Present Value (NPV) of 0.
Real investments: Unlike financial investments, real investments (e.g., projects, businesses) can have a
pos or neg NPV.
Making Money in Stock Markets
à Making money means earning more than the fair, risk-adjusted return (known as alpha).
à To consistently earn above-market returns, an investor must know more than those setting prices.
à Implication: Stock prices reflect public information, so only unique knowledge can help achieve excess
returns.
Ex. “An entrenched manager of “Dubious Operations” is known to invest in NPV negative projects such as
private jets, company retreats etc.. Thus, investing in that stock is clearly a bad investment.” : FALSE, het
feit (informatie) dat we weten dat ze vaak investeert in negatieve NAW is inbegrepen in de prijs (wordt dus
goedkoper) dus je betaald wat het waard is (niet veel).
Law of One Price in Portfolios: The price of a portfolio is the sum of the prices of its components:
Price(C) = Price(A + B) = Price(A) + Price(B)
à If two securities are equivalent (e.g., in cash flows), their prices must be the same.
Arbitrage with Transaction Costs:
Even with transaction costs, arbitrage keeps prices of similar securities close to each other.
Price deviations are limited to the cost of executing arbitrage trades.
INTEREST RATES
INTEREST QUOTES AND COMPOUNDING
Suppose we earn 3% interest every 6 months.
à Effective Annual Rate (EAR) = effectieve interest = 6,09%
à Annual Percentage Rate (APR) = schijnbare/nominale interest = 2 x 3% = 6%
Converting between k times per year and annual rates: 1 + 𝐸𝐴𝑅 = (1 + APR/K)K
As k gets very large, we converge to continuous compounding: 𝐸𝐴𝑅 = 𝑒APR − 1
INFLATION: NOMINAL VS REAL INTEREST RATES
A nominal cashflow is the number of dollars you pay out or receive (includes inflation) à will have
different purchasing power at different dates
A real cashflow is adjusted for inflation à always has the same purchasing power
To convert, we use: 𝑅𝑒𝑎𝑙 𝐶𝐹 = nominal CF / (1 + inflation rate)t
Or (a general rule): (1 + 𝑟real)(1 + 𝑖) = 1 + 𝑟
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