Firm Investment decisions

ECO562-Financial Economics
Semester: Summer 2021

Dr. Zulfiqar Hyder

Institute of Business Administration, Karachi

June 19, 2021

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Investment decisions

capital budgeting decisions

Capital budgeting decisions refer to financial decisions

regarding the use of a company’s scarce resources in making
capital investments.
Routine vs Strategic capital budgeting decisions
Projects with different degree of irreversibility.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Investment decisions

Classification of investment projects

Classification according to economic life: Short-term

Investment and Long-term Investment.
Classification according to Risk of Returns: New products and
markets, replacement projects, expansion projects, and
mandated projects.
Classification according to Dependence on other projects:
independent, mutually exclusive, contingent, and
complementary projects.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Investment decisions

NPV Rule

Objective: Increase Firms Current Market Value

Implication: take projects with positive NPV.
Project has cash flows of:

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Investment decisions

Example of NPV: An investment outlay of $10 million with

10% RRR

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Investment decisions

Example of NPV: Investment Decisions

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Investment decisions

The Investment Profile

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Investment decisions

Investment Criteria: Internal Rate of Return

For a single project, take it if and only if its NPV is positive

For many independent projects, take all those with positive
NPV
For mutually exclusive projects, take the one with positive and
highest NPV

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Investment decisions

Cash Flow Calculations: Main points

Use cash flows, not accounting earnings

Use after-tax cashflows
Use cash flows attributable to the project (compare firm value
with and without the project): Forget sunk costs: bygones are
bygones Include investment in working capital as capital
expenditure Include opportunity costs of using existing
equipment, facilities, etc. Correct for biases from fighting for
resources inside firm

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Firm Investment decisions

Discount rate

A project’s discount rate (i.e., required rate of return) is the

expected rate of return demanded by investors for the project
The discount rate(s) in general depend on the timing and risk
of the cashflow(s)
The discount rate is usually different for different projects
Therefore, it is in general incorrect to use a company-wide
cost of capitalto discount cash flows of all projects

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021