💳Principles of Finance Unit 16 – How Companies Think about Investing

Key Concepts and Terminology

• Investment involves allocating resources (money, time, effort) with the expectation of generating future benefits or returns
• Capital budgeting is the process of evaluating and selecting long-term investments that align with a company's strategic goals
• Net present value (NPV) is the difference between the present value of cash inflows and outflows, used to assess an investment's profitability
  • A positive NPV indicates a profitable investment, while a negative NPV suggests an unprofitable one
• Internal rate of return (IRR) is the discount rate that makes the NPV of an investment equal to zero, representing the expected rate of return
• Payback period measures the time it takes for an investment to recover its initial cost through cash inflows
• Weighted average cost of capital (WACC) represents the average cost of financing for a company, considering both debt and equity

Investment Decision-Making Process

• Identify investment opportunities that align with the company's strategic objectives and financial goals
• Gather relevant data and information about the potential investment, including cash flow projections, market trends, and risk factors
• Evaluate the investment using capital budgeting techniques such as NPV, IRR, and payback period to assess its financial viability
• Consider qualitative factors that may impact the investment's success, such as management expertise, competitive advantage, and regulatory environment
• Make a decision based on the analysis and the company's risk tolerance, capital constraints, and long-term objectives
• Implement the investment and monitor its performance, making adjustments as necessary to optimize returns and mitigate risks

Capital Budgeting Techniques

• Net present value (NPV) discounts future cash flows to their present value using the company's cost of capital and subtracts the initial investment
  • NPV provides a clear measure of an investment's expected profitability in today's dollars
• Internal rate of return (IRR) calculates the discount rate that makes the NPV equal to zero, indicating the investment's expected rate of return
  • IRR is useful for comparing investments with different cash flow patterns and durations
• Payback period calculates the time required for an investment to recover its initial cost through cash inflows
  • While simple to calculate, payback period ignores the time value of money and cash flows beyond the payback point
• Profitability index (PI) measures the ratio of the present value of future cash inflows to the initial investment
  • PI helps rank investments when capital is constrained, favoring projects with higher ratios

Risk and Return Analysis

• Risk refers to the uncertainty surrounding an investment's future cash flows and the potential for loss
• Return is the gain or loss generated by an investment over a specific period, usually expressed as a percentage
• Systematic risk (market risk) affects all investments in the market and cannot be diversified away (interest rates, inflation)
• Unsystematic risk (specific risk) is unique to a particular investment or company and can be reduced through diversification (management, competition)
• Sensitivity analysis assesses how changes in key variables (sales volume, prices, costs) impact an investment's profitability
• Scenario analysis evaluates an investment's performance under different economic or market conditions (best-case, base-case, worst-case)

Cost of Capital and Financing Decisions

• Cost of capital is the minimum rate of return required to justify an investment, reflecting the weighted average cost of debt and equity financing
• Cost of debt is the interest rate paid on borrowed funds, adjusted for tax deductibility
  • Cost of debt = Interest rate × (1 - Tax rate)
• Cost of equity is the return expected by shareholders, often estimated using the capital asset pricing model (CAPM)
  • Cost of equity = Risk-free rate + Beta × (Market risk premium)
• Optimal capital structure balances the benefits of debt (tax shield, lower cost) with the risks (financial distress, agency costs)
• Financing decisions should align with the investment's characteristics (duration, risk) and the company's overall financial strategy

Real-World Applications and Case Studies

• Amazon's decision to invest in electric delivery vans demonstrates the importance of considering long-term sustainability and regulatory risks
• Tesla's Gigafactory investment highlights the need to evaluate economies of scale, learning curve effects, and first-mover advantage
• Google's acquisition of YouTube illustrates the role of strategic fit, synergies, and growth potential in investment decisions
• Walmart's international expansion showcases the challenges of adapting to different market conditions, cultural preferences, and competitive landscapes
• Apple's decision to repatriate overseas cash and increase share buybacks reflects the impact of tax policy changes on financing strategies

Common Pitfalls and Misconceptions

• Overreliance on a single capital budgeting technique without considering the investment's unique characteristics and risks
• Ignoring non-financial factors (brand reputation, employee morale, environmental impact) that can affect an investment's long-term success
• Underestimating the importance of sensitivity and scenario analysis in assessing an investment's resilience to changing conditions
• Failing to consider the opportunity cost of capital and the potential returns from alternative investments
• Neglecting to re-evaluate and adjust investments as new information becomes available or market conditions change
• Overestimating the accuracy of long-term cash flow projections and underestimating the impact of uncertainty and risk

Key Takeaways and Review

• Investment decision-making involves evaluating long-term projects that align with a company's strategic and financial objectives
• Capital budgeting techniques (NPV, IRR, payback period) help assess an investment's profitability and risk-return trade-off
• Risk analysis (sensitivity, scenario) is crucial for understanding an investment's potential downside and resilience to changing conditions
• Cost of capital (debt, equity) represents the minimum required return and should guide financing decisions and capital structure
• Real-world applications demonstrate the complexity and multifaceted nature of investment decisions in practice
• Avoiding common pitfalls (overreliance on single techniques, ignoring non-financial factors) is essential for making sound investment choices
• Regularly reviewing and adjusting investments based on new information and changing circumstances is critical for long-term success