Download 6% Marginal Cost of Capital

100
80
Where?
How? When?
What?
Why?
2016-17
60
East
West
North
40
20
0
1st Qtr
2nd Qtr 3rd Qtr 4th Qtr
Who?
Managerial Economics
Stefan Markowski
Input sourcing and investment
The economics of competitive advantage
Detailed course schedule
Day no
Topic
Textbook ch.
1 (24 Nov;
3 hrs)
1. Introduction. Decision making process and its elements. The scope of
economic decision making. Application of marginal analysis
Chs. 1-2
2
3
3
3
2. Demand analysis and demand elasticities
Ch. 3
3. Buyer product valuation and choices. Consumer surplus. Buyer pricing
decisions
Ch. 4
4 (27 Nov;
2 hrs)
4. Production/transformation process. Production technologies and input-output
structure
Ch. 5
5 (28 Nov;
2 hrs)
5. Cost structure and cost drivers of producer pricing strategies. Production
scale and scope.
Chs. 5 and 7
6 (1 Dec; 3
hrs)
6. Structure-conduct-performance. Market structures: competition and
contestability. Pricing strategies of buyers and sellers
Ch. 8
7 (2 Dec; 3
hrs)
7. Market structures: monopoly/monopsony, monopolistic competition and
oligopoly. Pricing strategies and strategic behaviour
Chs. 9-10
8 (3 Dec; 3
hrs)
8. Input sourcing and investment
Chs. 6 and 11
9 (4 Dec; 2
hrs)
9. Decision making under conditions of uncertainty. Informational asymmetries
and risk management. Pricing and market power
Ch. 12
10 (5 Dec;
2 hrs)
10. Market research and market analysis. Auction and rings. Strategic
behaviour
Ch. 13
11 (8 Dec;
2 hrs )
12 (9 Dec;
2 hrs)
11. Public sector perspective
Ch. 14
13 (11
Dec; 2 hrs)
Examination
(25 Nov;
hrs)
(26 Nov;
hrs)
12. Revision
13. Examination
Input sourcing and investment
Contents
8.1 Managerial perspective
8.2 Input sourcing
8.3 Investment value calculations
8.4 The cost of capital
8.5 Life Cycle Costing (LCC)
8.6 Portfolio investment
8.7 Real options considerations
8.8 Further reading
8.1 Managerial perspective
• Input sourcing activities use resources and, thus, incur
costs. There are also alternative ways of achieving
particular outcomes: investment options
• Each of these options has an opportunity cost in that it
can be valued in terms of the best alternative option
forgone as well as the actual (historic) cost incurred
• Capital budgeting refers to the evaluation of investment
options associated with
– replacement of old equipment
– purchase of new capacity
– adoption of new production methods
– capacity expansion
– new product development
– compliance with government regulations
• This Topic is concerned with the viability of different
investments and the selection of the best option
8.2 Input sourcing
• When sourcing inputs firms face make or buy decisions
• They can buy materials in spot markets, hire labour, rent
equipment, borrow and raise capital through the market
• They can also integrate vertically upstream and produce
inputs in-house (e.g., components, power)
• Many inputs are highly specific to their subsequent
deployment, they have no substitute uses and, thus, high
sunk cost (e.g., asset specificity in manufacturing)
• Input suppliers and buyers also have market power and
once they enter into a contract they may engage in
opportunistic behaviour
• They may get away with it when the transaction cost of
switching to an alternative source of supply or demand
is high (hold-up problem)
• Contracts are also incomplete which leads to frustrated
expectations
8.3 Investment value calculations
• $1 today is worth more than $1 received in
future because the opportunity cost of the latter
is the foregone interest that would have been
earned were $1 received today
• This opportunity cost reflects the time value of
money
• To understand you must first understand the
concept of present value (PV) of a future value
(FV) to be received n years in the future
PV = FV/(1+i)n, where i the interest rate
• Example: FV=$100 to be received in 10 years with i = 0.07
PV = $100/(1+0.07)10 = $100/1.9672 = $50.83
8.3 Investment value calculations
• General PV formula
• PV = FV1/(1+i)1 + FV2/(1+i)2 + … + FVn/(1+i)n
• PV = S FVt/(1+i)t , where t = 1, 2, … n
• Net present value is the present value of the
income stream produced by an investment
option (opportunity) less the current (present)
cost of taking up that opportunity
• To choose between alternative investment
options we must first value their net worth (for
the investor), i.e., their expected (future)
benefits net of their expected costs, that is, the
net present value
8.3 Investment value calculations
• The net present value (NPV) of an investment option is
the present value of all future revenues, Rt, (where
benefits are revenues from sales) less costs, Ct,
discounted at the investor’s cost of capital minus the
initial (upfront) capital outlay, C*0, over the time period
t = 1, … n
NPV = S (Rt–Ct) /(1+r)t – C*0
• This is net cash flow or anticipated profit on equity
provided by the investor, providing she/he captures all of
it. If the NPV is positive the investor increases his/her
wealth by taking up (exercising) the investment option
•
t = 0 is the base date) and the end point, n (option end date) is
the terminal date; (Rt–Ct) - estimated net cash flow in time
period t and C*0 - the initial capital outlay; and r - rate of
discount and 1/(1+r)t is the discount factor applied to (Rt–Ct)
8.3 Investment value calculations
Example
The estimated revenues and costs of an investment option are :
Periods
0
Revenue (R)
-
Costs (C)
200,000
1
2
3
100,000 100,000 100,000
8,000
10,000
12,000
The firm's cost of capital (discount rate), r, is 10%
NPV at time t=0 is 83,636.36 + 74,380.17 + 66,115.70 - 200,000 =
224,132.23 - 200,000 = 24,132.23
This option yields a positive net present value and should
therefore be undertaken. Ditto all other options that yield
positive NPV if they can be financed
8.3 Investment value calculations
• Internal Rate of Return (IRR) is an alternative evaluation
method to rank investment options and select the best
investment. The internal rate of return of an investment
option is the discount rate that equates the present
value of the cash flow generated by the option to its
initial cost outlay
C*o = S (Rt–Ct) /(1+r*)t
where r* is the Internal Rate of Return
• The IRR measures the return on the investment (the
investor’s equity capital) with more profitable
investments generating higher returns
8.3 Investment value calculations
• Investment options can, thus, be ranked in
term of their IRR and the investor should
undertake those projects or take up those
options where the IRR is greater than or equal
to the discount rate he/she uses to evaluate the
cost of their capital (the marginal cost of
capital)
• This reflects the opportunity cost of employing equity
capital in the activity under consideration as opposed to
the best opportunity for its employment elsewhere (its
opportunity cost). If you could invest your own money
safely at 10% elsewhere you would expect to earn at
least 10% if you invest it in your own business
8.3 Investment value calculations
Example
• The estimated revenues and costs of an investment
option/project are as follows:
Period
0
Revenue (R)
Costs (C)
1
2
100,000 100,000
200,000
8,000
10,000
3
100,000
12,000
The investor's cost of capital is 10%
• Thus r*is approximately equal to 17%. This is greater
than 10% (the cost of capital) and if this is the only
investment option available (other than the opportunity
investment) it should proceed. But, if there are other
options they should be IRR-ranked first
8.3 Investment value calculations
Comparison of NPV and IRR
• Although the two techniques have been given as
alternatives, as long as a single option or independent
investment options (projects) are evaluated, the NPV and
IRR methods will lead to the same decision
• The NPV is only positive if the IRR is greater than the
firm’s discount rate (see below)
• This equivalence breaks down when investments are of
unequal size and/or capital (finance) rationing is required
NPV
0
r*
r
8.3 Investment value calculations
• The rule that the investor should invest if the
NPV is positive is equivalent to the rule that
he/she should invest if the IRR is greater than
the discount rate
• Another way of expressing the rule is to state
that the investor should invest up to the point
where the marginal return on investment equals
the marginal cost of investment
• Note that two small projects may each have
smaller NPVs than a larger project, but together
may increase the net worth of the firm more
than the large project. If there is no shortage of
capital all such project should be funded but
see capital rationing below
8.3 Investment value calculations
Capital Rationing
• Capital rationing may be needed when the investor
wishes to avoid the strains of rapid business
expansion or he/she does not want to become overexposed under unfavourable market conditions
• When investors cannot undertake all projects with
positive NPVs, they may rank projects according to
their profitability index (PI), which measures net cash
flow per dollar cost of investment outlay, and choose
the projects with the highest PI index values
8.3 Investment value calculations
Example: Ranking of Investment Projects A-E
Expected IRR % (Project Size in $m.)
A
10%($15m)
B
C
D
E
9%($5m)
8%($20m) 7%($10m)
6%
4%($50m)
Marginal Cost of Capital
A
B
C
D
E
Projects
8.3 Investment value calculations
Payback Period
• Another popularly used capital budgeting
procedure is the payback period criterion
• Under this rule, if the investment generates a
net flow of returns that covers the initial cost
before some arbitrarily set time period, the
option should be taken up
• For example, if an investment option cost
$300,000
and
returns
$50,000
in
each
succeeding year, it will be undertaken if the
investor sets a payback period of 6 years but
not if a payback period of 4 years is adopted
• This procedure ignores the time value of money
(cash flow is not discounted) but it is often used
as a rule of thumb in property development
8.3 Investment value calculations
Present value of perpetual returns
• Pperpetuity = FV1/(1+i)1 + FV2/(1+i)2 + …
• where t = 1, 2, … infinity and all FVt = FV
• Pperpetuity = FV/i
• Example: a consol (perpetual bond) offering
$100 a year in areas at nominal 5%
• Pbond = $100/0.05 = $2000
8.4 The Cost of capital
• The cost of raising capital to invest is an essential
element of the capital budgeting process, using either
the NPV or IRR method of evaluation
• Private investors raise capital from many sources
– externally from the issuing of debt and sale of stock
(common and preferred) The cost of using external
funding is the lowest rate of return that will ensure
that lenders or stakeholders keep their funds in the
business. This is debt funding
– internally from the use of retained earnings (own
money). The cost of using retained earnings is the
opportunity cost (the foregone return) on investing
these funds outside the business. This is equity
funding
8.4 The Cost of capital
The Cost of Debt
• The incremental cost of debt (as we consider new
investments we are concerned with the marginal cost of
debt, not the average cost) is the interest paid to lenders
of new debt, net of tax. Since the interest payments on
borrowed funds are allowed as a tax deduction from the
investor’s income, the after-tax rate of interest is the
true cost of debt
• For example, if the investor borrows at 15% but faces a
40% marginal tax rate on their taxable income, the aftertax cost of the funds is not 15% but [15% – (40% of 15%)]
= 15% – 6% = 9%
• More generally, the after-tax cost of debt = interest rate
(1 – tax rate)
8.4 The Cost of capital
The Cost of Equity
• The cost of equity capital is the rate of return the
investor must offer stockholders to induce them to
invest in the venture. There is no tax adjustment to the
cost of equity as dividends paid are not allowed as a
tax deduction. (However, a business firm may pre-pay
income tax due on the dividend and distribute dividend
payments to shareholders with the income tax prepaid)
• Purchasing stock in a business entails accepting some
risk of not getting a return
• Dividends vary with the company’s profits, so an
investor assumes the risk associated with its
performance
8.4 The Cost of capital
• Thus the return on equity, RE, can be considered as
having two components:
• a risk-free rate, RF, which is what could be earned if
investing in (riskless?) government bonds; and
• a risk premium, RP, that is the additional compensation
required for accepting the risk of a risky investment
RE = RF + RP
• For example, the risk free rate may be taken as the rate
available on Treasury bills. But, there are a variety of
methods for calculating the risk free rate. Two
examples below:
– Method A Risk Free Rate Plus Risk Premium; and
– Method B Capital Asset Pricing Model (CAPM).
• The overall cost of capital is the weighted average of
the cost of debt and the cost of equity
8.4 The Cost of capital
•
Method A Risk Free Rate plus Risk Premium
The risk premium can be considered as having two components.
First, there is the risk involved in investing in an option under
consideration rather than buying government bonds. This is
usually measured as the difference between the return on
government bonds and that on the investor’s borrowing (e.g.,
bonds). Second, when investors borrow from lenders they incur
an obligation to pay interest to them; dividend payments are
made only after interest payments are met. Therefore there is a
risk involved in purchasing the stock of the company rather
than lending to the company. This additional risk in purchasing
the company’s stock rather than bonds is measured by the
historic difference between yields on stocks and bonds issued
by private companies, say, at about 4%. For example, if the
return on government bonds is 10% and the return on the
investor’s bonds is 13%, the total risk premium is RP = (13% –
10%) + 4% = 7% and the cost of equity is RE =RF + RP = 10% +
7% = 17%
8.4 The Cost of capital
Method B
•
•
•
Capital Asset Pricing Model (CAPM)
This commonly used model takes into account the risk
differential between a particular investor’s (say, company)
stock and that of the stock of private investors/companies in
general, as well as the differential between the investor’s stock
and government securities.
The former differential is measured by an investor’s beta
coefficient, which is the ratio of the variability (e.g., as
measured by the coefficient of variation) of return on their stock
to the variability in the average return on the stock of all
investors/companies. A beta coefficient of 1.0 means that the
particular investor’s stock is as variable in its return as the
average; a coefficient of less than 1.0 indicates less variability
(less risk); greater than 1.0 indicates more variability (greater
risk).
Using this model, the cost of equity capital to the investor is
measured by RE = RF + beta (RM – RF), where RM is the
average return on the stock of all investors/companies.
8.4 The Cost of capital
•
The second term is the beta coefficient times the risk premium
on average stock, i.e., the risk premium on holding stock of a
particular investor/company. Therefore the cost of equity is
equal to the risk free rate plus the particular investor’s risk
premium.
•
For example, if the return on government bonds is 10%, the
average return on stocks is 17% and the beta coefficient for a
particular investor is 0.75, then the cost of equity to the
investor is RE = 10% + 0.75 (17% – 10%) = 10% + 5.25%
=15.25%
8.4 The Cost of capital
The Aggregate Cost of Capital
•
The overall cost of capital is the weighted average of the cost
of debt and the cost of equity, where the weights are the
proportions of the investor’s overall capital that comes from
the two financing methods
•
For example, if the cost of debt is 8% and the cost of equity is
15%, and 30% of the company’s capital comes from debt and
70% from equity, the cost of capital is
R = 8% x 0.30 + 15% x 0.70 = 12.9%
•
Since debt financing is cheaper than equity finance, investors
could lower their cost of capital by borrowing. However, they
should not opt for debt financing (high gearing) exclusively.
As the proportion of their debt increases, lenders see the
lending as being riskier and demand higher risk premium from
heavily-indebted companies: the marginal cost of capital
increases with gearing
8.5 Life Cycle Costing (LCC)
• LCC is normally defined as the sum of all funds
expended in the acquisition, ownership and disposal of
an asset or activity over its lifetime
• LCC aims to optimise the life-long cost of an
asset/activity by identifying all significant cost drivers
over its lifetime
• LCC is often confined to the cost side of the costbenefit evaluation; however, benefits are negative
costs
• In public investments, it is often assumed that benefits
of alternative investment options are the same but
cost streams are different. But, it is net worth that
matters
8.6 Portfolio investment
• Diversification of risky activities and assets by
acquiring portfolios of activities/assets to reduce the
average risk
• This could be used to tailor risk-return combinations to
the requirements of particular investors, e.g., pension
funds, logistic managers or venture capitalists
• This may also have applicability to logistic activities
where packages of different activities could be
adopted in maintenance or inventory management to
meet different appetites for risk and cost options
8.7 Real options considerations
• Traditional approach to investment appraisal
involves a projection of an investment
opportunity into the future on the assumption
that we can understand it and describe it in
sufficient detail upfront. But, can we?
• In this section, we look at areas where
traditional methods of capital budgeting do not
work well. These are:
– strategic/radical and costly investments with a lot of
uncertainty about how they might develop and operate;
– investment projects that evolve and must adapt to changing
environments; and
– complex investment projects that involve many
stakeholders such as prime contractors, original equipment
manufacturers, maintainers, government agencies
8.7 Real options considerations
• Through these notes the term “investment option” has
been used in contradistinction to “projects” or
“investment proposals”. This is to emphasise the
opportunity and associated right to engage in an
investment activity before they become an obligation or
a commitment
• In contrast to traditional investment appraisal, real
options approach involves decision making that is
contingent on the revealed rather than assumed or
projected reality. That is, a decision to proceed (to
exercise an option to act) is only taken AFTER it
becomes apparent what the reality is like. The payoff is
nonlinear – it changes depending on what the reality is: a
different decision is made if the outcome is good than if
it is bad (e.g., the option may or may not be exercised)
8.7 Real options considerations
• Under real options approach monolithic and complex
(hard to fathom) investment projects that must be
approved or rejected upfront are fragmented into staged
activities which can be assessed and accepted/rejected
as they are revealed and understood, i.e., firm decisions
to proceed are taken when CONTINGENT EVENTS
materialise and they are only taken as uncertainty is
reduced, i.e., new knowledge gained and the apparent
risk better understood
• There is a payoff in postponement of risky activity if it
results in fewer regrets
• In short, UNCERTAINTY CREATES OPPORTUNITIES
2.6 Further reading
Baye (2010): chs. 1 and 6
If you are interested in real options you may try to find and
look up
• Amram, M. And Kulatilaka, N. (1999) Real Options,
Managing Strategic Investment in an Uncertain World,
Harvard Business School Press, ch.2 “Uncertainty creates
opportunities”: 13-28
• Dixit, A. K. and Pindyck, R. S. (1994) Investment under
Uncertainty, Princeton University Press: ch. 2 “Developing the
concepts through simple examples”: 26-55