INVESTMENT DECISIONS

CHAPTER 5
TOPICS:

• COST OF CAPITAL
• COMPOUNDING AND DISCOUNTING
• HOW TO DETERMINE PROFITABLE INVESTMENTS
• BREAKEVEN ANALYSIS
• CHOOSING THE RIGHT MANUFACTURING TECHNOLOGY
• SHUTDOWN DECISIONS AND BREAKEVEN PRICES
• SUNK COST AND POST INVESTMENT HOLD-UP
• ANTICIPATE HOLD-UP
COST OF CAPITAL

THE WEIGHTED AVERAGE COST OF CAPITAL (WACC) IS THE RATE

THAT A COMPANY IS EXPECTED TO PAY ON AVERAGE TO ALL ITS
SECURITY HOLDERS TO FINANCE ITS ASSETS.

IT REPRESENTS THE MINIMUM RETURN THAT A COMPANY MUST EARN

ON AN EXISTING ASSET BASE TO SATISFY CREDITORS, OWNERS, AND
OTHER PROVIDERS OF CAPITAL.
COST OF CAPITAL

IN CASE A COMPANY IS FINANCED BY DEBT AND EQUITY, THE AVERAGE

COST OF CAPITAL IS COMPUTED:
𝐷 𝐸
WACC = CD + CE
𝐷+𝐸 𝐷+𝐸
WHERE:
D = TOTAL DEBT
E = TOTAL EQUITY
CD = COST OF DEBT
CE = COST OF EQUITY
COST OF CAPITAL

EX. A 20 DOOR APARTMENT BUILDING GENERATES AN ANNUAL PROFIT OF

P500,000. IT WAS TO BE BOUGHT BY THE COMPANY MANAGER THROUGH
FINANCING BY A BANK THAT OFFERED THE MANAGER 80% OF THE PURCHASE
PRICE AT A RATE OF 5.5% AND SOME INVESTORS THAT WERE EXPECTING A
15% RETURN ON THE REMAINING COST OF THE APARTMENT.
𝐷 𝐸 500,000
WACC = CD + CE =
𝐷+𝐸 𝐷+𝐸 7.4%

WACC = (0.055 x 0.8) + (0.15 x 0.2) = 6,756,756.756

WACC = 0.044 + 0.03
WACC = 0.074 or 7.4%
COMPOUNDING

THE PROCESS OF CONTINUOUSLY RE-INVESTING THE PRESENT VALUE AND

ITS INTEREST WITHOUT WITHDRAWING.

𝑗
F=P (1+i)n ;i= ; n = tm
𝑚
WHERE:
F = COMPOUND AMOUNT
P = PRESENT VALUE j = NOMINAL RATE
i = INTEREST RATE PER PERIOD t = TIME IN YEARS
n = NUMBER OF CONVERSIONS m = FREQUENCY OF CONVERSION
COMPOUNDING

A GOOD RULE OF THUMB TO KNOW WHEN THINKING ABOUT

COMPOUNDING IS THE “RULE OF 72”.

IF YOU INVEST AT A RATE OF RETURN j, DIVIDE 72 BY j TO GET THE

NUMBER OF YEARS IT TAKES TO DOUBLE YOUR MONEY.

AT 8%, AN INVESTMENT WILL DOUBLE IN 9 YEARS AND 6 YEARS AT A

RATE OF 12%.
COMPOUNDING

EX. FIND THE COMPOUND AMOUNT AFTER 4 YEARS IF P50,000 IS

INVESTED AT 8% COMPOUNDED QUARTERLY.
ANS.
P = P50,000 F = P (1+i)n
j = 8% F = 50,000 (1.02)16
m=4 F = P68,639.29
t=4
DISCOUNTING

THE PROCESS OF DETERMINING THE PRESENT VALUE OF A PAYMENT OR

STREAM OF PAYMENTS THAT IS TO BE RECEIVED IN THE FUTURE.

𝐹 𝑗
P= n; i = ; n = tm
(1+i) 𝑚
WHERE:
F = COMPOUND AMOUNT
P = PRESENT VALUE j = NOMINAL RATE
i = INTEREST RATE PER PERIOD t = TIME IN YEARS
n = NUMBER OF CONVERSIONS m = FREQUENCY OF CONVERSION
DISCOUNTING

EX. IF YOU WANT TO HAVE P85,000 IN YOUR ACCOUNT BY THE END

OF 3 YEARS, HOW MUCH SHOULD YOU INVEST TODAY IN A BANK THAT
PAYS 9% COMPOUNDED ANNUALLY?
ANS.
𝐹
F = 85,000 P=
(1+i)n
85,000
j = 9% P=
(1+0.09)3
t=3 P = 65,635.60
DETERMINING PROFITABLE INVESTMENTS

NET PRESENT VALUE – IS THE DIFFERENCE BETWEEN THE PRESENT

VALUE OF CASH INFLOWS AND THE PRESENT VALUE OF CASH
OUTFLOWS OVER A PERIOD OF TIME.

NPV RULE – A GENERAL DECISION RULE;

DISCOUNTING THE FUTURE BENEFITS OF AN INVESTMENT, AND
COMPARE THEM TO THE CURRENT COST OF THE INVESTMENT. IF THE
DIFFERENCE IS POSITIVE, THEN THE INVESTMENT EARNS MORE THAN
THE COST OF CAPITAL.
DETERMINING PROFITABLE INVESTMENTS

TABLE 5.1 NPV EXAMPLE

OUTFLOW INFLOW 1 INFLOW 2 NET
PROJECT 1 -$100 $115 N/A $15
PROJECT 2 -$100 $60 $60 $20
PRESENT VALUES
PROJECT 1 -$100 $100.88 N/A $0.88
PROJECT 2 -$100 $52.63 $46.17 -$1.20

THE COMPANY’S COST OF CAPITAL IS 14%

BREAKEVEN ANALYSIS

BREAKEVEN POINT: TR = TC

BREAKEVEN QUANTITY (Q) IS:

𝐹𝐶
BEQ = 𝑃 −𝑀𝐶
WHERE:
FC = FIXED COST
MC = MARGINAL COST
P = PRICE PER UNIT
BREAKEVEN ANALYSIS

A WIDGET PRODUCING COMPANY HAS FIXED COST CONSISTING OF ITS

LEASE, DEPRECIATION OF ASSETS, EXECUTIVE SALARIES AND TAXES
WHICH ADDS UP TO $60,000. VARIABLE COSTS CONSISTING OF RAW
MATERIALS, FACTORY LABOR AND SALES COMMISSIONS IN PRODUCING
THE WIDGET HAVE BEEN CALCULATED TO BE $0.80 PER UNIT. THE
WIDGET IS SOLD FOR $2.00 EACH.

𝐹𝐶 60,000
BEQ = =
𝑃 −𝑀𝐶 2.00 −0.80
BEQ = 50,000 UNITS
CHOOSING THE RIGHT MANUFACTURING
TECHNOLOGY

John Deere built a capital intensive factory to produce large 4wd

tractors. When the price of wheat dropped, he stopped the
construction because of reduced demand for tractors and
attempted to purchase VERSATILE, a Canadian company that
assembled tractors using off-the-shelf components. The abandoned
capital intensive factory had fixed cost of $100 and a marginal cost
of $10 while VERSATILE’s technology had fixed cost of $50 but
marginal costs of $20.
If the demand for tractors is low, did John Deere made the right
decision?
CHOOSING THE RIGHT MANUFACTURING
TECHNOLOGY

“IF YOU EXPECT TO SELL MORE THAN FIVE UNITS, CHOOSE THE LOW
MARGINAL COST TECHNOLOGY, OTHERWISE, CHOOSE THE LOW FIXED
COST TECHNOLOGY.”

PRICING AND PRODUCTION ARE EXTENT DECISIONS THAT REQUIRE

MARGINAL ANALYSIS, NOT BREAKEVEN ANALYSIS.
SHUTDOWN DECISIONS AND BREAKEVEN
PRICES
IF YOU SHUTDOWN, YOU LOSE YOUR REVENUE, BUT YOU GET BACK YOUR
AVOIDABLE COST.

AVOIDABLE COST – IS A COST THAT CAN BE ELIMINATED BY NOT ENGAGING

IN OR NO LONGER PERFORMING AN ACTIVITY. Eg. LABOR, PACKAGING,
MATERIALS.
UNAVOIDABLE COST – ARE COST TO BE INCURRED REGARDLESS OF THE
DECISION TO MAKE OR BUY A CERTAIN PART OR KEEP OR DROP A CERTAIN
PRODUCT LINE. EG. PROPERTY TAXES AND RENT.

IF REVENUE IS LESS THAN AVOIDABLE COSTS, OR EQUIVALENTLY, IF PRICE IS

LESS THAN AVERAGE AVOIDABLE COST, THEN SHUTDOWN.
SHUTDOWN DECISIONS AND BREAKEVEN
PRICES

COST TAXONOMY
FC = $100 / YEAR COST

MC = $5
AVOIDABLE UNAVOIDABLE OR
QTY = 100 COSTS “SUNK COSTS”
UNITS / YEAR

FIXED COSTS VARIABLE COSTS

(AVOIDABLE (AVOIDABLE IN
IN LONG RUN) SHORT RUN)
SUNK COSTS AND POST-INVESTMENT HOLD-UP

“IF YOU MAKE SUNK COST INVESTMENTS, YOU ARE VULNERABLE TO

POST-INVESTMENT HOLD UP.”

HOLD-UP IS A SITUATION WHERE TWO PARTIES MAY BE ABLE TO WORK

MOST EFFICIENTLY BY COOPERATING BUT REFRAIN FROM DOING SO
BECAUSE OF CONCERNS THAT THEY MAY GIVE THE OTHER PARTY
INCREASED BARGAINING POWER, AND THEREBY REDUCE THEIR OWN
PROFIT.
SUNK COSTS AND POST-INVESTMENT HOLD-UP

NATIONAL GEOGRAPHIC TRYING TO NEGOTIATE WITH A REGIONAL

COMMERCIAL PRINTER TO PRINT ITS MAGAZINE TO SAVE ON SHIPPING
COSTS. BUT TO PRINT A HIGH QUALITY MAGAZINE, THE PRINTER
MUST BUY A $12M ROTOGRAVURE PRINTING PRESS. IF THE MARGINAL
COST OF PRINTING A SINGLE COPY IS $1 AND THE PRINTER EXPECTS
TO PRINT 1M COPIES PER YEAR FOR A 2 YEAR PERIOD, THE AVERAGE
COST OF PRINTING OVER 2YEARS IS $7. THIS IS THE BREAKEVEN
PRICE FOR THE PRINTER AND REPRESENTS HER BOTTOM LINE IN
NEGOTIATIONS WITH THE MAGAZINE. BEFORE THEY ARE INCURRED,
SUNK COSTS ARE RELEVANT TO THE NEGOTIATION.
SUNK COSTS AND POST-INVESTMENT HOLD-UP

HOWEVER, ONCE THE PRINTER IS PURCHASED, THE PROFIT

CALCULUS CHANGES. IF THE PRINTER CANNOT RECOVER ANY OF THE
PRESS’ VALUE BY RESELLING IT, THEN IT IS SUNK COST. ONCE SUNK
COST HAVE BEEN INCURRED, THE MAGAZINE CAN HOLD UP THE
PRINTER BY RE-NEGOTIATING TERMS OF THE DEAL. SINCE THE COST
OF THE PRESS IS UNAVOIDABLE, THE PRINTER’S BREAKEVEN PRICE
FALLS TO THE MARGINAL COST OF PRINTING THE MAGAZINE ($1).