İŞLETME FİNANSI II

Investment consists all kinds of spendings made for acquiring, sustaining, and increasing production factors.

In many textbooks, capital budgeting activity is explained as a process, consisting of a number of stages. Megginson et al. (2010) briefly explain this process in three basic steps:

Projects A and B are mutually exclusive. If the company pursues A, it cannot also afford to pursue B and vice versa.

If the company pursues A, it cannot also afford to pursue B and vice versa. Project C, however, is independent. Regardless of which other project is pursued, the company can still afford to pursue C as well. The acceptance of either A or B does not impact the viability of C, and the acceptance of C does not impact the viability of either of the other projects.

Contingent projects are the type of projects in which approval or rejection of a project is contingent on approval or rejection of another project.

Competitive advantage refers to a firm’s attribute that may allow the firm to generate economic profits.

Incremental cash flow refers to a change in a firm’s net cash flow attributable to an investment project.

Net present value of a project is the sum of present value of all cash inflaws and cash outflows of a project over its life.

Internal rate of return is the rate of return that causes the net present value of a project to be zero.

Effect of the exercise (strike) price of the option in stock options is the effect of the present value of the delayed capital expenditure of future cost savings in real options.

Like every other financial decision area, capital budgeting decisions can be seen as financial managers’ strategic tool to use to contribute to the maximization of shareholder wealth, or creation of firm value. Capital budgeting includes long-term decisions about non-current assets of a company. Decisions about these assets need extra attention from managers because they are more expensive than the current assets, and unlike current assets, it is difficult to unwind once proceeded difficult to resell in the market quickly. The outcome of capital budgeting is either approval or rejection of the investment project. In order to come to that point, a financial manager needs analytical tools to make analysis and come to a conclusion according to the results of the analysis together with his/her intuition about the project. There are a number of simple and sophisticated analytical tools that managers use for project analysis. However, main consideration, of course, is “return and risk” and “benefit and cost” of each project proposal. In the end, if a financial manager approves an investment project, we can assume that he/she thinks that returns/benefits from the project will be greater than the associated risks/costs.

As also understood from the information given, the answer is E. All of the statements related to capital budgeting in the options are correct.

In order to position the capital budgeting in business finance, it is essential to identify the relationships between capital budgeting, cost of capital, and capital structure. A financial manager should consider a number of factors indicating whether a capital investment project has a positive effect on the firm value or not. One of the most important factors is the cost of capital because it determines how capital investment projects will be financed, and how capital structure will be changed. These two may change the value of the firm. At the same time, the cost of capital is used as a kind of measure or reference point to make an investment decision. Expected rate of return from a capital investment project should at least be equal to the cost of capital. If the cost of capital used in the evaluation is calculated wrong, then a financial manager may approve projects that should be rejected (overinvest), or may reject projects that should be approved (underinvest). Both overinvestment and underinvestment cost a company a lot of money because of the inefficient use of a company’s scarce resources and they both hamper managers’ efforts to create  shareholder value.

As also understood from the information given, the answer is E. All of the statements related to capital budgeting in the options are correct.

Investment of any kind is made with the intention of gaining returns over the money, time, and effort spent for making the investment. Investment consists all kinds of spendings made for acquiring, sustaining, and increasing production factors. If a financial manager approves any investment to be made, we can assume that he/she thinks that benefits/returns will be more than the costs/risks. Decisions about operating expenditures from which benefits are expected to be received within a year are easier to make than the decisions about capital expenditures from which benefits are expected to be received over a period of time, longer than one year.

As also understood from the information given, the answer is E. All of the statements in the options related to investment are correct.

Investment of any kind is made with the intention of gaining returns over the money, time, and effort spent for making the investment. Investment consists all kinds of spendings made for acquiring, sustaining, and increasing production factors. If a financial manager approves any investment to be made, we can assume that he/she thinks that benefits/returns will be more than the costs/risks. Decisions about operating expenditures from which benefits are expected to be received within a year are easier to make than the decisions about capital expenditures from which benefits are expected to be received over a period of time, longer than one year. Capital expenditure is the outlay of funds by the firm that is expected to produce benefits over a period of time longer than one year. Capital budgeting is the process of evaluating and selecting longterm investments which are consistent with the firm’s main objective of maximizing shareholders’ wealth.

“Companies make capital expenditures for many reasons. The basic motives for capital expenditures are to expand operations, to replace or renew fixed assets, or to obtain some other, less tangible benefit over a long period” (Gitman and Zutter, 2012:361).

In many textbooks, capital budgeting activity is explained as a process, consisting of a number of stages.

As also undertstood from the information given, the answer is E. All of the definitions in the options are correct.

In many textbooks, capital budgeting activity is explained as a process, consisting of a number of stages. Megginson et al. (2010) briefly explain this process in three basic steps:

All of these steps are critical in the process. If management does not spend enough effort to identify good investments, it will be pointless to analyze and prioritize projects because the outcome will not provide enough return regardless of the project evaluation techniques used. Likewise, if management does not work enough on controlling and monitoring the projects, all money, time and effort spent on project evaluation will be wasted because without good monitoring, a project cannot sustain generating cash flows as expected in the first place.

As also understood from the information given, the answer is E. All of the the statements related to capital budgeting activity in the options are correct.

We can classify capital investment projects based on motivations to make the investment, and based on relative state of the investments regarding dependence on each other. Motivations may vary in various types of ways. Generally, reasons to make a capital investment project fall in one of the following groups:

Relative state of the investments regarding dependence on each other may be one of the following:

As also understood from the information given, the answer is A. Think of a company that plans out an expansion of existing products to new geographic markets. If the company has two or more alternative projects associated with different markets to choose from, these projects are mutualy exclusive. If the company can expand to any possible alternative market that can create value, these projects are independent. Finally, if the company has to expand to a particular market before it can proceed expanding to another market, these projects are contingent.

The other two terms in the options i.e. externalities and opportunity cost are the terms related to estimating project cash flows.

Opportunity cost refers to the return on the best alternative use of an asset; the highest return that will not be earned if funds are invested in a particular project.

Externalities refer to the way in which accepting a project affects the cash flows in other areas of the firm.

Corporate Strategy and Capital Budgeting

Capital budgeting decisions are part of a company’s objectives, goals, and strategies, rather than being stand-alone ideas of managers. Engineering department, marketing department, or any other department proposes an investment project to senior managers. Then, managers allocate company’s funds to projects that they believe will create a positive value. These investment projects are ideas which stem from and which are in line with the company’s main objectives, goals and strategies. Let’s remember the concept of strategy. “A strategy is the formulation and implementation of a company’s key decisions” (Baker and English, 2011). Corporate strategy includes both strategies for company’s whole portfolio of resources and strategies for only business unit’s products (Baker and English, 2011). For capital budgeting matters, the aim of corporate strategy is to find investment projects which provide positive net present value for the company. In perfectly competitive markets it is assumed that it is not possible to find such a project. This assumption makes calculations of project valuation easy to make. At the same time, this assumption shows the importance of competition for capital budgeting decisions. The higher the competition levels in the market, the more difficult  the profitable investment projects to find. There are two main explanations to this. First, entry barriers are higher in more competitive markets. Second, arbitrage possibilities are less in more competitive markets. However, the market for capital investments is not perfectly competitive (market imperfection). It means that it is possible to find projects which add value to a company’s competitive advantage that is why they create shareholder value. Competitive advantage, “a firm’s attribute that may allow the firm to generate economic profits” is key here (Baker and English, 2011). Here, economic profit refers to the risk-adjusted present value of revenue minus all costs, including the opportunity cost of capital. Together with market imperfection, cost-saving projects that will create competitive advantage can be a source for positive economic profit. After valuations on the paper, investment projects are approved or rejected, but before starting to make any valuation, financial managers look at the structure of the market and see if the project contributes to the differentiation of the company from others and gaining competitive advantage. If the answer is yes, then they start choosing the technique, estimating the discount rate, estimating cash flows, and estimating initial cost.

As also understood from the information given, the answer is E. All of the statements above related to corporate strategy and capital budgeting are correct.

In perfectly competitive markets it is assumed that it is not possible to find investment projects which provide positive net present value.

Positive economic profits (or positive net present value projects) can stem from two sources: i) market imperfections, ii) creating competitive advantage.

Financial managers develop cash flow forecasts by using the input data coming from other departmets such as engineering, manufacturing, marketing, accounting, etc. At that point, managers have to realize and distinguish which variables are relevant to a particular project’s cash flow estimation, and which are not. Only information which is relevant to the project’s analysis is used in developing forecasts. This is called incremental cash flow, a change in a firm’s net cash flow attributable to an investment project (Besley and Brigham, 2012: 496). Incremental cash flows occur as a direct result of accepting the project, and should be included in the evaluation. Incremental cash flows may occur at the start of the project, may continue during the project, or may occur at the end of the project.

As also understood from the information given, the answer is E. All of the statements above related to incremental cash flow are correct.

Besley and Brigham (2012) list problematic areas related to incremental cash flows (which should be included in the evaluation). Some are simple to identify, but some are not. The ones that are not always very easy to identify are sunk costs, opportunity costs, externalities, shipping and installation costs, and inflation. As also understood from the information given, the answer is E. All of them are problematic areas related to incremental cash flows that are not always very easy to identify.

Sunk cost is defined as a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected. Therefore, it should not be included in the analysis as it is not an incremental cash flow. Opportunity cost is defined as the return on the best alternative use of an asset; the highest return that will not be earned if funds are invested in a particular project. Opportunity cost should be included in the analysis as it is an incremental cash flow. Externalities are defined as the way in which accepting a project affects the cash flows in other areas of the firm.  Externalities should not be included in the analysis as they are not an incremental cash flow. Shipping and installation costs should be included in the analysis as it is an incremental cash flow because they generally require cash payments. Lastly, effects of inflation on cash flows should be included in the analysis as it may be considered as an incremental cash flow because it changes the real value of a cash flow.

There are two very important items that are related to the estimation of investment projects’ cash flows: financing costs and depreciation.

Financing costs are incorporated in the capital budgeting analysis with the determination of discount rate, rather than with the estimation of cash flows.

A project’s cash flow = Net income of project + Depreciation

As also understood from the information given, the answer is E. All of the statements above related to the estimation of investment projects’ cash flows are correct.