Module IV: Financial Strategy Real Investments and Strategy

Module IV: Financial StrategyReal Investments and Strategy Week 8 – March 2, 2006

Objectives • Review investment criteria • Introduce strategic investment concerns • Real options • First mover advantage • Capital budgeting • Reasons • Relation to financing • Leasing overview

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.

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

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)

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.

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?

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 firm-wide WACC • Project risk or  is the relevant risk

WACC Can Lead To Errors Discount Rate (%) Accept Bad Projects WACC Reject Good Projects Project b

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

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.

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

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:

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: • Option adds about $ .7 million to value

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?

Management options Abandon Contract Switch Wait Expand Grow Currently Invested: React to Bad News Not Currently Invested Currently Invested: React to Good News

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 option-pricing assumptions may not be met

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

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.

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.

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

Quantity if competitors react Plant capacity Q** Q* Profits and Competitors’ Reactions Average Cost Curve Price 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

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

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

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

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

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

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

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.

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

Module IV: Financial Strategy Real Investments and Strategy