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Investment triangle – three compromising objectives

Any investment decision will be influenced by three objectives – security, liquidity

and yield. A best investment decision will be one, which has the best possible
compromise between these three objectives.
Individually these objectives are very powerful in influencing the investors.
Collectively they work against each other forcefully, as can be seen below. Hence the
acclaim – A best investment decision will be one, which has the best possible
compromise between these three objectives.
When selecting where to invest our funds we have to analyse and manage these
three objectives.
Security: Central to any investment objective, we have to basically ensure the safety
of the principal. One can afford to lose the returns at any given point of time but
s/he can ill afford to lose the very principal itself. By identifying the importance of
security, we will be able to identify and select the instrument that meets this
criterion. For example, when compared with corporate bonds, we can vouch safe the
safety of return of investment in treasury bonds as we have more faith in
governments than in corporations. Hence, treasury bonds are highly secured
Liquidity: Because we may have to convert our investment back to cash or funds to
meet our unexpected demands and needs, our investment should be highly liquid.
They should be en cashable at short notice, without loss and without any difficulty. If
they cannot come to our rescue, we may have to borrow or raise funds externally at
high cost and at unfavorable terms and conditions. Such liquidity can be possible
only in the case of investment, which has always-ready market and willing buyers
and sellers. Such instruments of investment are called highly liquid investment.
Yield: Yield is best described as the net return out of any investment. Hence given
the level or kind of security and liquidity of the investment, the appropriate yield
should encourage the investor to go for the investment. If the yield is low compared
to the expectation of the investor, s/he may prefer to avoid such investment and
keep the funds in the bank account or in worst case, in cash form in lockers. Hence
yield is the attraction for any investment and normally deciding the right yield is the
key to any investment.
Relationship: There is a trade off between risk (security) and return (yield) on the
one hand and liquidity and return (yield) on the other.
Normally, higher the risk any investment carries, the greater will be the yield, to
compensate the possible loss. That is why, ‘fly by night’ operators, offer sky high
returns to their investors and naturally our gullible investors get carried away by
such returns and ultimately lose their investment. Highly secured investment does
not carry high coupon, as it is safe and secured.
When the investment is illiquid, (i.e. one cannot get out of such investment at will
and without any loss) the returns will be higher, as no normal investor would prefer
such investment.
These three points – security, liquidity and yield in any investment – make an
excellent triangle in our investment decision-making. Ideally, with given three points
of any triangle, one can say the center of the triangle is fixed. In our investment
decision too, this center – the best meeting point for S, L and Y – is important for
our consideration.
However, if any one or two of these three points are disturbed – security, liquidity
and yield in any investment – the center of the triangle would be disturbed and one
may have to revisit the investment decision – either to continue the investment or
exit the investment.
All these points – security, liquidity and yield – are highly dynamic in any market and
they are always subject to change and hence our investor has to periodically watch
his/her investment and make appropriate decisions at the right time.
If our investor fails to monitor her / his investment, in the worst circumstances, s/he
may lose the very investment.
Thus, we will return to our original statement - A best investment decision will be
one, which has the best possible compromise between these three objectives –
security, liquidity and yield.
Business and Financial Objectives of a Strategic
Investment Decision
By Victoria Duff, eHow Contributor
updated: January 25, 2011

Any strategic action taken by a company has the same basic

goals: to strengthen the financial condition of the company, increase the competitive edge,
improve operational efficiency and improve accountability and initiative. A strategic
investment is no different. Examples of strategic investments are upgrading the information
technology systems, acquiring new facilities, acquiring new machinery and even acquiring a
A good strategic investment creates opportunities and limits risk.

Size of Investment

1. The most important objective in evaluating a strategic investment is to

determine if the size of the investment is reasonable compared to its
expected benefit. Building a bridge to a deserted island from a small fishing
village may not be the best way to spend many millions of dollars. Likewise,
your investment should produce financial gain that exceeds the cost of the
investment. The opportunity cost of the money spent should also not exceed
the benefit value. If inventory growth and the resulting revenues suffered
because of the cost of a new office complex, the investment would be a poor

Goals of Investment

2. The goals of a strategic investment must be deep and broad. If a new

enterprise resource management system is to be purchased and installed, it
must do more than just produce snappy reports. The reports must make
decisions easier, quicker and more successful. The system must save money
over time and enhance the company's ability to produce more, faster and
better than it did before the system was installed.


3. Above all, the investment must be risk-controlled. There must be a

balance between the risk undertaken in the investment and the benefit, such
as borrowing large amounts of money to make the investment in new
machinery, delaying seasonal manufacturing while the old machinery is
replaced. A backup plan is needed to solve any scheduling problems that
may arise or the entire season's production will be lost. If an investment risks
the financial health or operational efficiency of the company, it may not be a
wise investment.


4. Similarly, a strategic investment must create opportunity and not limit

opportunity. It must add to the competitive edge of the company within its
industry and add new revenue sources. An investment in new machinery that
is not the newest technology is not a good investment.

ources of Information for Making Investment

By Eliah Sekirin, eHow Contributor
updated: July 20, 2010

There are different sources of information to help investors make investment


Investment decisions refer to decisions made to put money in different asset

classes, all with the objective of protecting and increasing wealth. There are
many factors to consider when an investment decision is made: What are the
risks involved? What financial instruments to use? Should you invest in
bonds, stocks ,real estate or other asset classes?

To answer these and other questions, investors employ different sources of


Financial and Economic Theory

2. Financial and economic theory provides a strong foundation on which to

base investment decisions. It serves as a guide in the wide array of choices
available to investors these days. For example, in periods of high inflation,
economic theory tells us that investors would be better off putting money in
stores of value that rise with inflation, such as gold, while fixed-income
securities like bonds should be avoided, as they yield a much lower return.

Financial Intelligence

3. There are many source of financial intelligence. The primary sources of

commentary and analysis are well-established publications, such as the Wall
Street Journal or the Economist, as well as more specialized business
intelligence products from business news agencies such as Thomson-
Reuters or Bloomberg Business & Financial News.

Historical Performance

4. Historical performance of assets (stocks, real estate, bonds and other

vehicles) can often provide information about which way the asset prices will
go in the future. While past is not always the best guide to what will happen,
the underlying trends often hold sway for prolonged periods of time. If gold
has been rising for the past five years, for example, the chances are that it
will also rise in the next six months.

Additional Information

5. There are additional, asset-specific sources of information that investors

can employ to help them make investment decisions. For example, if
investors invest in bonds, they can read bond prospectuses, documents that
accompany the issuance of bonds. If the assets in question are stocks, than
annual and quarterly reports to the regulators and shareholders (primarily the
annual financial report) can be accessed, with particular attention given to the
profit and loss statement and the balance sheet.

What is Corporate Finance?

It�s all corporate finance.

My unbiased view of the world

Every decision made in a business has financial implications, and any decision

that involves the use of money is a corporate financial decision. Defined broadly,

everything that a business does fits under the rubric of corporate finance. It is, in fact,

unfortunate that we even call the subject corporate finance, because it suggests to many

observers a focus on how large corporations make financial decisions and seems to

exclude small and private businesses from its purview. A more appropriate title for this
discipline would be Business Finance, because the basic principles remain the same,

whether one looks at large, publicly traded firms or small, privately run businesses. All

businesses have to invest their resources wisely, find the right kind and mix of financing

to fund these investments, and return cash to the owners if there are not enough good


In this introduction, we will lay the foundation for this discussion by listing the

three fundamental principles that underlie corporate finance—the investment, financing,

and dividend principles—and the objective of firm value maximization that is at the heart

of corporate financial theory.

The Firm: Structural Set-Up

In corporate finance, we will use firm generically to refer to any business, large

or small, manufacturing or service, private or public. Thus, a corner grocery store and

Microsoft are both firms. The firm�s investments are generically termed assets.

Although assets are often categorized by accountants into fixed assets, which are long-

lived, and current assets, which are short-term, we prefer a different categorization. The

assets that the firm has already invested in are called assets in place, whereas those assets

that the firm is expected to invest in the future are called growth assets. Though it may

seem strange that a firm can get value from investments it has not made yet, high-growth

firms get the bulk of their value from these yet-to-be-made investments. To finance these

assets, the firm can raise money from two sources. It can raise funds from investors or

financial institutions by promising investors a fixed claim (interest payments) on the cash

flows generated by the assets, with a limited or no role in the day-to-day running of the
business. We categorize this type of financing to be debt. Alternatively, it can offer a

residual claim on the cash flows (i.e., investors can get what is left over after the interest

payments have been made) and a much greater role in the operation of the business. We

call this equity. Note that these definitions are general enough to cover both private

firms, where debt may take the form of bank loans and equity is the owner�s own

money, as well as publicly traded companies, where the firm may issue bonds (to raise

debt) and common stock (to raise equity).

Thus, at this stage, we can lay out the financial balance sheet of a firm as follows:

Note the contrast between this balance sheet and a conventional accounting balance

An accounting balance sheet is primarily a listing of assets in place, though there are

some circumstances where growth assets may find their place in it; in an acquisition,

what gets recorded as goodwill is a conglomeration of growth assets in the target firm,

synergies and overpayment.

First Principles
Every discipline has first principles that govern and guide everything that gets done

within it. All of corporate finance is built on three principles, which we will call, rather

unimaginatively, the investment principle, the financing principle, and the dividend

principle. The investment principle determines where businesses invest their resources,

the financing principle governs the mix of funding used to fund these investments, and

the dividend principle answers the question of how much earnings should be reinvested

back into the business and how much returned to the owners of the business. These core

corporate finance principles can be stated as follows:

• � The Investment Principle: Invest in assets and projects that yield a return

greater than the minimum acceptable hurdle rate. The hurdle rate should be higher

for riskier projects and should reflect the financing mix used—owners� funds

(equity) or borrowed money (debt). Returns on projects should be measured based on

cash flows generated and the timing of these cash flows; they should also consider

both positive and negative side effects of these projects.

• � The Financing Principle: Choose a financing mix (debt and equity) that

maximizes the value of the investments made and match the financing to nature of

the assets being financed.

• � The Dividend Principle: If there are not enough investments that earn the hurdle

rate, return the cash to the owners of the business. In the case of a publicly traded

firm, the form of the return—dividends or stock buybacks—will depend on what

stockholders prefer.

When making investment, financing and dividend decisions, corporate finance is

single-minded about the ultimate objective, which is assumed to be maximizing the value

of the business. These first principles provide the basis from which we will extract the

numerous models and theories that comprise modern corporate finance, but they are also

commonsense principles. It is incredible conceit on our part to assume that until corporate

finance was developed as a coherent discipline starting just a few decades ago, people

who ran businesses made decisions randomly with no principles to govern their thinking.

Good businesspeople through the ages have always recognized the importance of these

first principles and adhered to them, albeit in intuitive ways. In fact, one of the ironies of

recent times is that many managers at large and presumably sophisticated firms with

access to the latest corporate finance technology have lost sight of these basic principles.

The Objective of the Firm

No discipline can develop cohesively over time without a unifying objective. The

growth of corporate financial theory can be traced to its choice of a single objective and
the development of models built around this objective. The objective in conventional

corporate financial theory when making decisions is to maximize the value of the

business or firm. Consequently, any decision (investment, financial, or dividend) that

increases the value of a business is considered a good one, whereas one that reduces firm

value is considered a poor one. Although the choice of a singular objective has provided

corporate finance with a unifying theme and internal consistency, it comes at a cost. To

the degree that one buys into this objective, much of what corporate financial theory

suggests makes sense. To the degree that this objective is flawed, however, it can be

argued that the theory built on it is flawed as well. Many of the disagreements between

corporate financial theorists and others (academics as well as practitioners) can be traced

to fundamentally different views about the correct objective for a business. For instance,

there are some critics of corporate finance who argue that firms should have multiple

objectives where a variety of interests (stockholders, labor, customers) are met, and there

are others who would have firms focus on what they view as simpler and more direct

objectives, such as market share or profitability.

Given the significance of this objective for both the development and the

applicability of corporate financial theory, it is important that we examine it much more

carefully and address some of the very real concerns and criticisms it has garnered: It

assumes that what stockholders do in their own self-interest is also in the best interests of

the firm, it is sometimes dependent on the existence of efficient markets, and it is often

blind to the social costs associated with value maximization.

The Investment Principle

Firms have scarce resources that must be allocated among competing needs. The

first and foremost function of corporate financial theory is to provide a framework for

firms to make this decision wisely. Accordingly, we define investment decisions to

include not only those that create revenues and profits (such as introducing a new product

line or expanding into a new market) but also those that save money (such as building a

new and more efficient distribution system). Furthermore, we argue that decisions about

how much and what inventory to maintain and whether and how much credit to grant to

customers that are traditionally categorized as working capital decisions, are ultimately

investment decisions as well. At the other end of the spectrum, broad strategic decisions

regarding which markets to enter and the acquisitions of other companies can also be

considered investment decisions. Corporate finance attempts to measure the return on

a proposed investment decision and compare it to a minimum acceptable hurdle rate to

decide whether the project is acceptable. The hurdle rate has to be set higher for riskier

projects and has to reflect the financing mix used, i.e., the owner�s funds (equity) or

borrowed money (debt). In the discussion of risk and return, we begin this process by

defining risk and developing a procedure for measuring risk. In risk and return models,

we go about converting this risk measure into a hurdle rate, i.e., a minimum acceptable

rate of return, both for entire businesses and for individual investments.

Having established the hurdle rate, we turn our attention to measuring the returns

on an investment. In analyzing projects, we evaluate three alternative ways of measuring

returns—conventional accounting earnings, cash flows, and time-weighted cash flows

(where we consider both how large the cash flows are and when they are anticipated to
come in). In extensions of this analysis, we consider some of the potential side costs that

might not be captured in any of these measures, including costs that may be created for

existing investments by taking a new investment, and side benefits, such as options to

enter new markets and to expand product lines that may be embedded in new

investments, and synergies, especially when the new investment is the acquisition of

another firm.

The Financing Principle

Every business, no matter how large and complex, is ultimately funded with a mix

of borrowed money (debt) and owner�s funds (equity). With a publicly trade firm, debt

may take the form of bonds and equity is usually common stock. In a private business,

debt is more likely to be bank loans and an owner�s savings represent equity. Though

we consider the existing mix of debt and equity and its implications for the minimum

acceptable hurdle rate as part of the investment principle, we throw open the question of

whether the existing mix is the right one in the financing principle section. There might

be regulatory and other real-world constraints on the financing mix that a business can

use, but there is ample room for flexibility within these constraints. We begin the

discussion of financing methods, by looking at the range of choices that exist for both

private businesses and publicly traded firms between debt and equity. We then turn to the

question of whether the existing mix of financing used by a business is optimal, given the

objective function of maximizing firm value. Although the trade-off between the benefits

and costs of borrowing are established in qualitative terms first, we also look at two

quantitative approaches to arriving at the optimal mix. In the first approach, we examine

the specific conditions under which the optimal financing mix is the one that minimizes
the minimum acceptable hurdle rate. In the second approach, we look at the effects on

firm value of changing the financing mix.

When the optimal financing mix is different from the existing one, we map out

the best ways of getting from where we are (the current mix) to where we would like to

be (the optimal), keeping in mind the investment opportunities that the firm has and the

need for timely responses, either because the firm is a takeover target or under threat of

bankruptcy. Having outlined the optimal financing mix, we turn our attention to the type

of financing a business should use, such as whether it should be long-term or short-term,

whether the payments on the financing should be fixed or variable, and if variable, what

it should be a function of. Using a basic proposition that a firm will minimize its risk

from financing and maximize its capacity to use borrowed funds if it can match up the

cash flows on the debt to the cash flows on the assets being financed, we design the

perfect financing instrument for a firm. We then add additional considerations relating to

taxes and external monitors (equity research analysts and ratings agencies) and arrive at

strong conclusions about the design of the financing.

The Dividend Principle

Most businesses would undoubtedly like to have unlimited investment

opportunities that yield returns exceeding their hurdle rates, but all businesses grow and

mature. As a consequence, every business that thrives reaches a stage in its life when the

cash flows generated by existing investments is greater than the funds needed to take on

good investments. At that point, this business has to figure out ways to return the excess

cash to owners. In private businesses, this may just involve the owner withdrawing a

portion of his or her funds from the business. In a publicly traded corporation, this will
involve either paying dividends or buying back stock. the discussion of dividend policy,

we introduce the basic trade-off that determines whether cash should be left in a business

or taken out of it. For stockholders in publicly traded firms, we note that this decision is

fundamentally one of whether they trust the managers of the firms with their cash, and

much of this trust is based on how well these managers have invested funds in the past.

Finally, we consider the options available to a firm to return assets to its owners—

dividends, stock buybacks and spin-offs—and investigate how to pick between these


Corporate Financial Decisions, Firm Value, and Equity


If the objective function in corporate finance is to maximize firm value, it follows

that firm value must be linked to the three corporate finance decisions outlined—

investment, financing, and dividend decisions. The link between these decisions and firm

value can be made by recognizing that the value of a firm is the present value of its

expected cash flows, discounted back at a rate that reflects both the riskiness of the

projects of the firm and the financing mix used to finance them. Investors form

expectations about future cash flows based on observed current cash flows and expected

future growth, which in turn depend on the quality of the firm�s projects (its investment

decisions) and the amount reinvested back into the business (its dividend decisions). The

financing decisions affect the value of a firm through both the discount rate and

potentially through the expected cash flows.

This neat formulation of value is put to the test by the interactions among the

investment, financing, and dividend decisions and the conflicts of interest that arise
between stockholders and lenders to the firm, on one hand, and stockholders and

managers, on the other. We introduce the basic models available to value a firm and its

equity, and relate them back to management decisions on investment, financial, and

dividend policy. In the process, we examine the determinants of value and how firms can

increase their value.

Some Fundamental Propositions about Corporate


There are several fundamental arguments we will make repeatedly in this


1. Corporate finance has an internal consistency that flows from its choice of

maximizing firm value as the only objective function and its dependence on a few

bedrock principles: Risk has to be rewarded, cash flows matter more than accounting

income, markets are not easily fooled, and every decision a firm makes has an effect on

its value.2. Corporate finance must be viewed as an integrated whole, rather than a

collection of decisions. Investment decisions generally affect financing decisions and

vice versa; financing decisions often influence dividend decisions and vice versa.

Although there are circumstances under which these decisions may be independent of

each other, this is seldom the case in practice. Accordingly, it is unlikely that firms that

deal with their problems on a piecemeal basis will ever resolve these problems. For

instance, a firm that takes poor investments may soon find itself with a dividend problem

(with insufficient funds to pay dividends) and a financing problem (because the drop in

earnings may make it difficult for them to meet interest expenses).

3. Corporate finance matters to everybody. There is a corporate financial aspect to almost

every decision made by a business; though not everyone will find a use for all the

components of corporate finance, everyone will find a use for at least some part of it.

Marketing managers, corporate strategists, human resource managers, and information

technology managers all make corporate finance decisions every day and often don�t

realize it. An understanding of corporate finance will help them make better decisions.

4. Corporate finance is fun. This may seem to be the tallest claim of all. After all, most

people associate corporate finance with numbers, accounting statements, and hardheaded

analyses. Although corporate finance is quantitative in its focus, there is a significant

component of creative thinking involved in coming up with solutions to the financial

problems businesses do encounter. It is no coincidence that financial markets remain

breeding grounds for innovation and change.

5. The best way to learn corporate finance is by applying its models and theories to real-

world problems. Although the theory that has been developed over the past few decades

is impressive, the ultimate test of any theory is application. As we will argue, much (if

not all) of the theory can be applied to real companies and not just to abstract examples,

though we have to compromise and make assumptions in the process.


This introduction establishes the first principles that govern corporate finance.

The investment principle specifies that businesses invest only in projects that yield a

return that exceeds the hurdle rate. The financing principle suggests that the right

financing mix for a firm is one that maximizes the value of the investments made. The
dividend principle requires that cash generated in excess of good project needs be

returned to the owners. These principles are the core for corporate finance.

The historically low interest rates in the current economic climate would
appear to provide an ideal scenario or companies to invest long term
in value-creating capital expenditures. However, the combination o
declining corporate proftability together with signifcant ongoing di-
fculties in raising external fnance continues to exert downward pres-
sure upon the unds available or investment. Almost daily, corporate
announcements include a statement regarding an intention to signif-
cantly reduce capital expenditure (hereater capex) during the upcoming
fnancial year. The ollowing sample o recent fnancial disclosures rom
the automobile, telecommunication, and mining sectors are indicative
o the current trend:
Toyota Motor Corp will slash capital and research spending or a
second year in a move that threatens to erode a signifcant advan-
tage it holds over ailing U.S. based rivals. Toyota said Friday its
budget or this fnancial year will cut capital spending by more
than a third, to $8 billion rom $13 billion. GM last year said
it would cut capital spending to $4.8 billion in 2009 and 2010,
down rom $9 billion.
AT&T, the largest U.S. telecoms group, yesterday said it would cut
capital spending by 10 to 15 per cent this year rom the $19.7bn
it spent in 2008.
Anglo American Plc has completed a wide ranging review o its
capital expenditure programme in recent weeks, at a time when
the mining industry has experienced an unprecedented period
o rapid declines in commodity prices due to global economic
uncertainty. Capital expenditure has been capped at $4.5 billion, a
reduction o more than 50%.2CorporateInvestmentDeCIsIons
The large capex cuts announced by aluminum giants are reduc-
ing the number and size o greenfeld smelters that were coming
on stream in the coming years. Rio Tinto Alcan is considering
slashing its capex or 2009 rom $9bn to $4bn. The company has
not given details on which projects will be axed, but revealed that
some projects will be delayed and others cancelled altogether.
A more general overview is provided by the ollowing excerpt rom Reuters:
A trade group or lenders that fnance hal the capital equipment
investment in the United States told Reuters on Monday that
businesses postponed new capex spending once again in June as
underwriting standards continued to tighten. The Equipment
Leasing and Finance Association, which measures the overall
volume o fnancings used to und equipment acquisitions, ell
36.9% year-over-year in June to $5.2 billion.
Despite the apparently oreboding economic outlook, at least in the
short term, it remains critical that companies appreciate the importance
o capex and continue to prioritize spending in spite o declining pro-
itability and competing demands rom, inter alia, dividends and pen-
sion contributions. Investments are important not only or companies
attempting to achieve an optimal asset structure but also or enabling the
introduction o new products or achieving structural cost reductions.
In addition to recognizing that investment is a prerequisite or both
growth and survival at the corporate level, it is also clear that national
economic growth is strongly correlated with investment intensity, espe-
cially or emerging economies. On average, about 20% o world gross
domestic product is spent on capital investment, with 8 o the 10 ast-
est growing economies exhibiting investment intensities signifcantly in
excess o the average.
However, while actively encouraging capital investment, we must
also recognize the complexities associated with identiying, evaluating,
and implementing appropriate investment strategies. Finance textbooks
generally propose a primary corporate objective o maximizing share-
holder wealth and then proceed to suggest that this is achieved simply
by investing in value-creating projects (i.e., those having positive netpresent value). An
overarching assumption commonly made is that
o a perect capital market, which, in turn, assumes a world o perect
inormation, devoid o uncertainty (along with various other associated
assumptions). Decision makers currently operate in a world radically di-
erent rom that o the fnance textbook, where high levels o volatility are
being experienced in consumer, commodity, and fnancial markets, and
even short-term predictions are not made with any degree o confdence.
Against this backdrop, the uncertainty inherent in real-world investment
decisions, which necessitate a medium- to long-term perspective to be
taken in normal circumstances, increases signifcantly, and the inorma-
tion required to evaluate potential investment projects becomes almost
impossible to orecast.
In addition to the uncertainties inherent in orecasting the prospec-
tive returns rom potential investments, a myriad o other difculties
ace those responsible or investment decisions. Investment patterns are
heavily inuenced by the industrial sector, within which the companies
operating in transport, telecommunications, oil and gas, and utilities are
among the most capital intensive. The rate o technological change is
also signifcant in particular industry sectors, with companies encounter-
ing timing issues when determining when to make the transition to a
new technology. While no company can aord to ignore technological
developments, there can also be signifcant risks rom moving too early
and encountering technological challenges that could prove insurmount-
able. When observing the bigger picture, it is also clear that cyclicality in
economic systems occurs in a regular, though not predictable, pattern.
Companies tend to react, though not immediately, to such imbalances
between demand and supply. Longer delays increase the susceptibility o
the economic cycle to cyclical patterns, so quicker responses can reduce
a company’s dependence on economic cycles and also allow it to gain an
advantage over its competitors.
Given the complexities o the real world in which companies oper-
ate, it becomes transparent that no textbook can provide a panacea to all
the problems aced by those responsible or making investment decisions.
However, despite this assertion, the existence o logical and consistent
procedures can prove benefcial when attempting to identiy and evalu-
ate long-term projects. While recognizing that practical investment deci-
sions could be deemed to be “as much art as science,” and sophisticatedvaluation
techniques cannot be viewed as a substitute or intuition and
experience, the primary objective o this book is to provide an appropri-
ate combination o theory and practice. In the pursuit o this objective, it
is intended that the content will be o relevance not only to those study-
ing investment appraisal as a component o an academic or proessional
course but also to those practitioners who may be encountering the vaga-
ries o assessing investment projects.
The opening chapter o the text provides both an overview o the
fnancial environment in which businesses operate and also an assessment
o the signifcance o the investment decision within the overall fnancial
management unction. Subsequently, in chapter 2 we develop a rame-
work with the intention o describing a logical sequence o stages through
which a typical investment proposal may pass, commencing with the
identifcation o the investment opportunity and concluding with an
assessment o the postimplementation perormance o the chosen proj-
ects. Investment decisions can be considerably enriched by the experience
and intuition o the managers involved. Given our assertion that the pro-
cess o making investment decisions is “as much art as science,” we can
beneft rom analyzing the outcome o decisions made previously.
Chapter 3 describes and evaluates the basic appraisal techniques that
are commonly applied to the estimated profts, or cash ows, predicted
or a potential investment. Some o the shortcomings o the basic tech-
niques are then addressed by considering modifed versions o these
techniques. Finally, survey evidence o the techniques used in practice is
discussed and critically compared with the recommendations emanating
rom academia.
Chapters 4 and 5 consider the adjustments necessary or cash ows to
reect the respective impacts o taxation, ination, and risk and uncer-
tainty. Initially in chapter 4, taxation is considered with reerence to tax
depreciation allowances and corporate taxation payable on the projected
profts generated by the proposal. Subsequently, the issues raised by the
presence o ination are considered together with the inuence on both
cash ows and discount rates.
Chapter 5 is devoted to the treatment o risk and uncertainty, a unda-
mental problem in investment decisions due to their implicitly unpredict-
able nature. Techniques available or allowing the inclusion o risk intoeither the cash
ow projections or the discount rate will be considered and
evaluated together with evidence gathered rom survey studies.
Capital rationing, a topic perhaps particularly relevant to the situ-
ation that many companies ace in the current economic downturn,
is addressed in chapter 6. In the perect capital market assumed in the
textbook, companies can invest unlimited amounts o capital and do not
ace restrictions in this regard. The implications o hard and sot capital
rationing are also discussed, and the appropriate techniques or dealing
with both single- and multiperiod capital rationing are illustrated.
In chapter 7, we consider another variant o the investment decision
in which companies are aced with the problem o replacing capital assets.
A range o varying time options are generally available, and the optimum
replacement cycle is identifed using techniques particular to this deci-
sion. Also in this chapter, we consider the lease versus buy decision that,
although technically a fnancing decision, is a dilemma oten aced par-
ticularly in smaller frms where capital available or projects is limited.
Some investments could be viewed as essential, such as the decision
to replace machinery that is nearing the end o its economic lie and is
unlikely to have a signifcant impact upon current activities. In contrast,
successul strategic investment decisions are likely to impinge heavily on
competitive advantage and will inuence what the company does, where
it does it, and how it does it. We consider strategic investment decisions
in chapter 8 and assess the emerging techniques to assist strategic deci-
sions prior to examining the extent to which such techniques fnd appli-
cation in practice.
In the modern global business environment, frms are oten com-
pelled to consider expansion into oreign markets in search o additional
revenue or when aced with stagnating domestic markets. Ultimately,
this may involve the establishment o a production acility in the or-
eign market requiring signifcant capital commitment and exposing the
frm to additional risks surrounding, inter alia, currency uctuations and
political uncertainty. In chapter 9, we attempt to provide a brie overview
o the motives underlying oreign expansion and an appreciation o the
additional risk actors requiring consideration when contemplating or-
eign expansion.
The current rontiers o investment decision theory are discussed and
evaluated in chapter 10. Although the concept o real options originated
in the 1980s, real options have not appeared to be widely applied, at
least in textbook orm, despite the potential benefts they oer by incor-
porating exibility into the investment decision. More recently, the con-
cept o value at risk has enjoyed both popularity and some notoriety in
the fnancial sector, and we consider the application o some o its deriva-
tives to capital budgeting. Other developments that have their origins
elsewhere but merit consideration include duration analysis (rom the
bond markets) and the intriguing concept o decision markets, in which
an internal betting market is established and used to predict the most
likely outcomes.
We conclude by attempting to provide a brie overview o the current
environment or capital budgeting, in which economies are beginning to
emerge rom recession and frms are encountering important investment
decisions involving where and when to invest. In addition, pressures are
mounting or the reduction o carbon emissions, which may well culmi-
nate in legislation obliging frms to incur signifcant capital expenditure
commitments when corporate proftability is still recovering, and the
purse strings o the capital markets have yet to be loosened.

he Financial Decisions

Every decision made in business has nancial implications, and any deci-
sion that involves the use of money is a nancial decision. When making
nancial decisions, conventional corporate nancial theory assumes that
the unifying objective is to maximize the value of the business or rm,
often referred to as maximizing shareholder wealth. Some critics would
argue against the choice of a single objective and argue that rms should
have multiple objectives that accommodate various associated stakehold-
ers. Others would recommend a focus on simpler and more direct objec-
tives, such as market share or protability, or, in the current economic
climate, simply surviving may assume priority.
If the main objective in corporate nance is to maximize company
value, any nancial decision that increases the value of a company is con-
sidered good, whereas one that reduces value is deemed poor. It follows
that company value must be determined by the three primary nancial
decisions—nancing, investment, and dividend—and recognizing that
the value of a company is determined primarily by the present value of its
expected cash ows. Investors form expectations concerning such future
cash ows based on observable current cash ows and expected future
growth and value the company accordingly. However, this seemingly
simple formulation of value is tested by both the interactions between
the nancial decisions and conicts of interest that emerge among the
stakeholders (managers, shareholders, and lenders).
The Financing Decision
All companies, irrespective of size or complexity, are ultimately nanced
by a mix of borrowed money (debt) and owners’ funds (equity). The
main issues to be considered are the availability and suitability of the vari-
ous sources of nance and whether the existing mix of debt and equity
is appropriate. Debt nance is generally regarded as cheaper than equity
due to lower issue costs and tax benets, but it raises considerations of
nancial risk. In contrast, equity nance is more expensive, but the nan-
cial markets tend, on average, to react negatively to equity issues. In both
the United States and the United Kingdom, companies tend to rely heav-
ily on retained earnings as a source of nance in accordance with pecking
order theory, which suggests that companies both avoid external nanc-
ing when internal nancing is available and avoid new equity nancing
when new debt nancing can be sourced at reasonable cost.
Once the optimal nancing mix has been determined, the duration
of the nancing can be addressed, with the recommendation being that
this should match the duration of the assets being nanced. However,
companies may elect to nance aggressively (using short-term nance to
nance longer term assets) or defensively (matching long-term nance
with shorter term assets), depending on cost and risk considerations.
The efcient capital markets hypothesis concludes that a stock market
is efcient if the market price of a company’s securities correctly reects
all relevant information. In particular, share prices can be relied on to
reect the true economic worth of the shares. This would imply that
attempting to time the issuance of new nancing is a futile exercise.
The Investment Decision
In its simplest form, an investment decision can be dened as involving
the company making a cash outlay with the aim of receiving future cash
inows. Capital investment decisions are generally long-term corporate
nance decisions relating to xed assets, and management must allocate
limited resources among competing opportunities in a process known as
capital budgeting. The magnitude of the investment can vary signicantly
from relatively small items of machinery and equipment to launching a
new product line or constructing a foreign production facility. We can
distinguish between the assets the company has already acquired, called
assets in place, and those in which the company is expected to invest in
the future, referred to as growth assets. The latter include internal and
external development projects, such as investing in new technologies or
entering into joint ventures, thereby potentially creating future invest-
ment opportunities in addition to generating benets from current use.
As we shall see, such investments present particular managerial and valua-
tion difculties, as traditional valuation and capital budgeting techniques
are both difcult to apply and may lead to incorrect conclusions.
Projects that pass through the preliminary screening phase become
candidates for rigorous nancial appraisal. To assist in making invest-
ment decisions and ensure consistency, methods of investment appraisal
are required that can be applied to the whole spectrum of investment
decisions, and that should help to decide whether any individual invest-
ment will enhance shareholder wealth. The results of the appraisal will
heavily inuence the project selection for investment decisions. However,
appraisal techniques should not be recognized as providing a decision
guide rather than providing a denitive answer.
The investment appraisal process and ultimate decision may also be
subject to agency problems arising between the owners and the man-
ager as a result of asymmetric information. It has been suggested
managers have an incentive to grow their companies beyond the optimal
size and predict that agency conicts give rise to overinvestment. A con-
trasting theory
predicts that asymmetric information between informed
managers and the public market causes underinvestment.