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
NPVMotel  $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