Class 2 - University of Southern California
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Transcript Class 2 - University of Southern California
Module IV: Financial Strategy
Real Investments and Strategy
Week 8 – March 2, 2006
J. K. Dietrich - FBE 532 – Spring, 2006
Objectives
Review
investment criteria
Introduce strategic investment concerns
– Real options
– First mover advantage
Capital
budgeting
– Reasons
– Relation to financing
Leasing
overview
J. K. Dietrich - FBE 532 – Spring, 2006
Real and Financial Assets
A real
asset is a long-lived tangible or
intangible good that produces a stream of
income over time
– Examples: Patents, equipment, brand loyalty,
etc.
A financial
asset is a claim to a real asset or
its income stream
– Examples: Stocks, bonds, etc.
J. K. Dietrich - FBE 532 – Spring, 2006
Key Decisions
There
are two fundamental functions of a
financial manager
– Capital Budgeting: Identify real assets to
invest in and avoid those that do not create
value
– Raising Capital: Issue financial assets to
finance real investments
A firm
is the link between financial markets
and goods markets
J. K. Dietrich - FBE 532 – Spring, 2006
The NPV and IRR Rules
Three
step procedure:
– Estimate future expected cash flows using
accounting data and other sources
– Compute a discount rate or target rate of return
– Calculate NPV or internal rate of return
» accept positive NPV projects (or projects with
internal rates of return above the target rate of
return)
» reject negative NPV projects (or project with IRRs
below the target rate of return)
J. K. Dietrich - FBE 532 – Spring, 2006
Evaluation of IRR
The
internal rate of return is not the best
criterion for ranking projects. Why?
– It suffers from possible mathematical problems
(non-uniqueness, non-existence)
– There are problems in application (mutually
exclusive projects, borrowing v. lending issues).
– It also ignores the information contained in the
yield curve.
J. K. Dietrich - FBE 532 – Spring, 2006
Example:
Consider
two mutually exclusive projects:
– Project A involves an initial outlay of $5 and
repays $10 next year
– Project B involves an initial outlay of $20 and
repays $30 next year
What
is the IRR of project A? Project B?
At a 10% discount rate, what would you do?
J. K. Dietrich - FBE 532 – Spring, 2006
Target Rate of Return
Many
corporations use a target rate of
return or cutoff rate to value projects
In many cases, the target rate is the firm’s
weighted-average cost of capital (WACC)
Firms entering new businesses or investing
in new strategies may be changing the
firm’s risk from levels assumed in a firmwide WACC
Project risk or is the relevant risk
J. K. Dietrich - FBE 532 – Spring, 2006
WACC Can Lead To Errors
Discount
Rate (%)
Accept Bad
Projects
WACC
Reject Good
Projects
Project
J. K. Dietrich - FBE 532 – Spring, 2006
Capital Rationing
Capital
rationing: Two types
– Hard: The firm cannot obtain outside capital
to fund all its positive NPV projects
» This typically applies to small, growing firms with
high insider ownership where there may be
significant agency costs
– Soft: To control managers or to have balanced
divisional growth, a firm may limit the funds
available for project investment even if it can
raise funds from the capital markets
J. K. Dietrich - FBE 532 – Spring, 2006
Capital Rationing
Seemingly
obvious rules like NPV, IRR, etc
fail when there is capital rationing.
Some projects yield first-mover advantages
and may free up capital for use in other
projects later on, so just picking the highest
NPV project is not correct.
Rather, we have to consider combinations of
projects that maximize NPV.
J. K. Dietrich - FBE 532 – Spring, 2006
NPV versus Option Values
NPV
estimates normally compute present
value of expected future cash flows
Expected cash flows weight each possible
outcome with the probability of that
outcome
Management decisions through time can
prevent some bad outcomes from occurring,
e.g. by not making necessary future cash
investments
J. K. Dietrich - FBE 532 – Spring, 2006
Example: NPV versus real option
Simple
example of NPV: building a motel
– Cost is $9.7 million, and WACC is 10%
– Value of future cash flows estimated now at
either $9 or $13 million with equal probability,
thus expected value of project cash flows in one
year now $11 million
NPV
of motel project (in millions) is:
$11
NPV Motel $9.7
$ .300
1.10
J. K. Dietrich - FBE 532 – Spring, 2006
Example: real option
If
we wait one year we can take advantage
of future information
– If value turns out to be low, don’t build
– If high, build motel
Value
in one year is either 0 or $13 million
Revised value with option to postpone:
1
1
1
$13
Value 0
$9.7
$ .963 $1
2
2 1.10
1.10
Option
adds about $ .7 million to value
J. K. Dietrich - FBE 532 – Spring, 2006
Flexibility creates Real Options
Management
–
–
–
–
–
options
Growth options
Timing options
Switching options
Option to expand or contract (scale)
Abandonment options
Real
options exist with respect to
investment in real resources
– What are sources of value of real options?
J. K. Dietrich - FBE 532 – Spring, 2006
Management options
Abandon
Contract
Switch
Wait
Expand
Grow
Currently Invested: React to Bad News
Not Currently Invested
Currently Invested: React to Good News
J. K. Dietrich - FBE 532 – Spring, 2006
Valuing Real Options
All
options have value, since we are not
obliged to use them
Seemingly unprofitable ventures may have
positive NPV when real options are
considered
Use of Black-Scholes and other option
pricing techniques is used but optionpricing assumptions may not be met
J. K. Dietrich - FBE 532 – Spring, 2006
Strategic Concerns
Strategic
issues may substantially alter our
views of a project
These concerns cannot be easily quantified
but are critical
Two types of factors
– External
– Internal
J. K. Dietrich - FBE 532 – Spring, 2006
Strategy: External Factors
The
External Environment:
– Political
» Expropriation, war, trade policy, etc.
– Economic
» Currency devaluations, labor unrest, etc.
– Regulatory
» Rule changes, price controls, etc.
– Industry
» Growth, technology.
J. K. Dietrich - FBE 532 – Spring, 2006
Strategy: Internal Factors
Internal
Factors:
– Externalities with other divisions; synergies
– Reaction of competitors
» Followers or aggressive competitors?
– Follow-up projects and options
– Managerial constraints and incentives
» Moral hazard, risk aversion, executive
compensation.
J. K. Dietrich - FBE 532 – Spring, 2006
Example: Plant Capacity and
Strategic Interactions
A firm
faces a decreasing average cost
curve; price is determined by world supply
and demand.
Building a large plant is profitable at Q* but
only if its competitors do not themselves
expand their plants, reducing output to Q**
Project NPV depends on the reactions of
competitors
J. K. Dietrich - FBE 532 – Spring, 2006
Profits and Competitors’ Reactions
Average Cost
Curve
Quantity if
competitors react
Price
Plant
capacity
Q**
J. K. Dietrich - FBE 532 – Spring, 2006
Q*
Quantity
Investment/Financing Strategy
If
markets are efficient and there is no
corporate taxation (Modigliani-Miller
assumptions), firms should be able to
finance all positive NPV projects
Many departures from those assumptions
– Transactions costs
– Bankruptcy risk
– Tax differentials
These
departures lead to a link between
financing and investment strategies
J. K. Dietrich - FBE 532 – Spring, 2006
Leasing Overview
Two
basic type of leases
– Operating lease (use of asset over limited time)
– Capital or financial lease (acquire asset over
time from lessor)
Two
basic considerations
– Accounting treatment on financial statements
– Tax treatment
Treatments
differ between accounting
standards and tax codes and lead to
advantages to leasing
J. K. Dietrich - FBE 532 – Spring, 2006
Lessors
Owner
of real property or equipment leases
to users
Manufacturers of equipment lease
equipment to users, often as a form of
financing
Development of third-party leases began
when investment tax credit (1964 to 1986)
created opportunity for non-operating firms
like banks to use tax credits by leasing
equipment like airplanes
J. K. Dietrich - FBE 532 – Spring, 2006
Third-party Leases
Equity
or leverage lease is determined by
whether asset is owned outright by lessor or
partially financed by debt
Synthetic lease creates a special purpose
entity (SPE, a legal entity) to hold assets
Assets are financed by a combination of
debt and equity
Asset ownership rights and cash flows
distributions are determined by lease terms
J. K. Dietrich - FBE 532 – Spring, 2006
Division of Cash Flows
Cash
flows from lessee to claimants on SPE are
divided into tranches (a French word meaning
cut)
The ordering of the claim on cash flows (lease
payments) determines risk, with the “A” or higher
tranche getting first claim, hence lowest risk
Other tranches have subordinated claims to cash
flows
A residual trance (lowest claim) is equity claim
J. K. Dietrich - FBE 532 – Spring, 2006
Guarantees to Lease Investors
Principal
and interest on debt issued by SPE
can be guaranteed by lessee
– Typically occurs with “A” tranche of synthetic
lease
– Use of corporate guarantee is “on-credit”,
meaning affects lessee’s credit rating through
claim on cash flows
Asset
can be used as collateral for a tranche
– “B” tranche has claim on asset value in
synthetic lease
J. K. Dietrich - FBE 532 – Spring, 2006
Allocation of Risks
Risks
to investors in lease are
– Non-payment of interest and principal (Tranche
A and B)
– Loss of investment capital in case of default
Guarantee
provides A-tranche investors
recourse to corporate sponsor for claims,
thus must be considered in credit rating
B-tranche investors have no recourse to
corporation but have collateral in form of
title to the underlying asset
J. K. Dietrich - FBE 532 – Spring, 2006
Summary
Project
evaluation sounds scientific, but it
often involves a considerable amount of
artistry in its application
In the real-world, many factors contribute to
complicate capital budgeting
While the tools and analytics are helpful,
you also need to consider strategic
interactions of projects and financing.
J. K. Dietrich - FBE 532 – Spring, 2006
Next Class – March 23, 2006
Deliver
take-home midterm exam and
statement to me by March 2, 2006, 6pm
Review financial planning and RWJ,
Chapters 2 & 3 on sustainable growth
Read and begin to prepare Clarkson Lumber
as an individual case write-up
Work with group to arrange schedule for
working on Avon Products case for week
following
J. K. Dietrich - FBE 532 – Spring, 2006