Chapter 1: Long-term Financial
Decisions
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A corporation has many stakeholders with conflicting desires.
Wealth creation for the shareholders is our goal.
Accounting income is not a sufficient measure of performance
because it ignores risk and the cost of the invested funds.
Economic profit and net present value are two ways we measure
wealth creation in a single period and multiple periods.
Capital projects create most of the wealth for the firm but not all
projects are equal or should even be considered.
Strategy and competive advantage should guide the capital
budgeting process.
Stakeholders and Competing Desires
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Stakeholder:
What their goals are (what they want):
Managers
 Creditors
 Customers
 Employees
 Suppliers
 Society
 Owners
High Salary and perquisites.
Low risk, return of their money and interest
Low prices and lots of features
High salaries, job security
High prices and long relationships
Good citizenship and taxes
Dividends or stock appreciation
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Wealth Creation versus
Accounting Profit
 A firm
should maximize economic profit or
wealth instead of profits because:
 Wealth
includes risk while profit does not.
 Wealth is three dimensional
 (revenues, cost and risk)
 Profit is two dimensional
 ( revenues and cost)
Other Definitions of
Economic Profit
profit = accounting income –
opportunity cost of equity
 Economic profit = Equity X (ROE – Ke)
where Ke is the required return on
equity
 Economic profit = Assets X (ROTA - Ka)
where Ka is required return on assets
 Economic
Net Present Value – A Multi-period
Measure of Wealth
 Net
Present Value:
Take the present value of a series of future
economic profits less the initial outlay.
This is wealth created for a multiple period.
In theory NPV of the firm divided by the
number of shares gives you the intrinsic
value of the stock.
What Makes a Capital Investment
Attractive?
 An
attractive capital investment:
Fits the strategy of the firm
Within an appropriate risk level
Has a positive net present value or
economic profit across time