Return on Investment – Education Funding
Develop a three- to five-page analysis (excluding the title and reference pages) on the projected return on investment for your college education and projected future employment. This analysis will consist of two parts.
Part 1:
Describe how and why you made the decision to pursue an MBA. In the description, include calculations of expenses and opportunity costs related to that decision.
Part 2:
Analyze your desired occupation. Determine how much compensation (return) you expect to earn and how long will it take to pay back the return on this investment. Use the financial formulas, Net Present Value (NPV), Internal Rate of Return (IRR), and Payback, provided in Chapter 6 of your text.
If you do not have any educational costs due to employee reimbursements or scholarships, you should estimate the cost of your education for your calculations.
The analysis should be comprehensive and reference specific examples from a minimum of two scholarly sources, in addition to your text. The paper must be formatted according to APA.
Learning Objectives After studying this chapter, you should be able to: • Describe the significance of corporate investments in creating value. • Explain how identifying and classifying potential projects plays into project selection. • Estimate project cash flows. • Show how to select independent projects using NPV and IRR. • Describe how to select mutually exclusive projects that maximize value. • Identify the significance and different types of options and how to adjust for the option effect. Imaginechina/Associated Press6 Capital Budgeting: Investing to Create Value byr80601_06_c06_163-200.indd 163 1/24/13 3:58 PM CHAPTER 6Introduction Introduction Figure 6.0: Chapter 6 in focus Investments made by the company Funds from investors pay for corporate investment (costs) The Financial Balance Sheet Cash generated by corporate investments (value) In order to create value, firms must invest in projects whose value is greater than their cost. In Chapter 6, the techniques for determining whether value is greater than cost are explored. Throughout this text we have stressed the importance of creating value for corporate shareholders. We also indicated that the greatest opportunity for creating value lay in the investing activities of companies. In the context of the financial balance sheet, these are left-hand side activities. The potential payoffs on successful investments prompt ingenious efforts to develop new products, build existing products at lower cost, improve product quality, and devise new marketing strategies. For example, the advent of e-commerce allows small companies to sell products worldwide and large companies to supplement or possibly supplant traditional distribution channels. E-commerce has, in turn, spawned companies that design and manage websites, provide Internet services and make encryp- tion software. Some product developments create virtually new industries. Consider the spectacular growth in wireless communications that was made possible by the blending of satellite and digital technologies. In an effort to gain a competitive advantage, network providers have expanded their coverage areas, improved transmission quality, added services, and cut prices. Similarly, cell phone manufacturers embrace the latest in digital technology as they vie for market share. In this chapter, we address the fundamentals of corporate investing. First, we discuss product market opportunities created by imperfect competition. Next, we develop some guidelines for identifying and selecting investment opportunities. We then examine the investment decision itself, paying special attention to decision criteria and discounted cash flows. Finally, we discuss options that are intrinsic to many corporate investments. byr80601_06_c06_163-200.indd 164 1/24/13 3:58 PM CHAPTER 6Section 6.1 Corporate Investments and Value Creation Pre-Test 1. Net present value measures the dollar amount that shareholder wealth will increase if a project is accepted. a. True b. False 2. The least common strategies for exploiting market opportunities are cost leader- ship and differentiation. a. True b. False 3. The cash flows used in NPV analysis are incremental after-tax cash flows. a. True b. False 4. A project can have just one NPV but could have more than one IRR. a. True b. False 5. The payback period is a good alternative to either NPV or IRR. a. True b. False 6. In capital budgeting, the ability to abandon a project early can add value to the project. a. True b. False Answers 1. a. True. The answer can be found in Section 6.1. 2. b. False. The answer can be found in Section 6.2. 3. a. True. The answer can be found in Section6.3. 4. a. True. The answer can be found in Section 6.4. 5. b. False. The answer can be found in Section 6.5. 6. a. True. The answer can be found in Section 6.6. 6.1 Corporate Investments and Value Creation We will draw upon several important ideas covered thus far in the text in our dis-cussion of corporate investing: • It is cash flows, not income or earnings, that measure the success of a business or investment. • The value of cash flows depends on when they are paid or received. • The effect of timing on the value of future cash flow is incorporated into the dis- count rate. byr80601_06_c06_163-200.indd 165 1/24/13 3:58 PM CHAPTER 6Section 6.1 Corporate Investments and Value Creation • The appropriate discount rate is the investors’ required rate of return. • This required rate of return is a function of risk. Investors buy bonds and stocks that represent claims against future corporate cash flows. Corporate investments must, therefore, generate at least enough cash flow to provide all investors with their required returns. If investments generate less than the required return, the value of the company’s securities—and, therefore, the value of the company—will decline. Of course, investments are made in the hope that they will produce enough cash to pay off creditors with enough left over to increase returns to shareholders. Investing in Fixed Assets Depending on the industry, much corporate investment is in long-term, or fixed, assets. These assets can be classified as tangible (machinery, real estate) or intangible (copyrights, patents, contracts). Traditional capital-intensive industries invest in factories that manu- facture durable goods, such as metals, chemicals, transportation equipment, and machin- ery. However, virtually all companies, not just manufacturers, have fixed assets. Retailers either own or lease stores. R&D firms have laboratories and patents. Book and music publishers have copyrights and, perhaps, long-term contracts with writers and musicians. One of the best-known assets is the secret formula for Coca-Cola. Whether tangible or intangible, fixed assets are essential to the long-run viability of a firm. Identifying Asset Value: NPV and IRR The ability to identify which assets are expected to add value to the firm is central to the financial management role. In this chapter, we explore this selection process (called capi- tal budgeting) in some detail. Essentially, to identify value-creating projects, businesses use either the net present value (NPV) or internal rate of return (IRR) criteria. Net present value measures the dollar value added to the firm by the investment. The NPV of an investment is the present value of the future cash flows minus the initial investment. Net present value 5 Present value of future cash flows – Initial investment NPV directly measures the present value of the cash flows a project is expected to gen- erate. It then compares this value to the project’s cost. If the project value is expected to exceed the cost, the project should be pursued. The IRR criteria compares the IRR (expected return) for a project to the required return for investors, given the project’s risk. If the expected return exceeds that requirement, then the project should be pursued. We will look at the equations for finding NPV and IRR later in this chapter. For now, it is important to know that companies can add value to the business and increase owners’ wealth by pursuing positive NPV projects, or project’s whose IRR exceeds its required return. With this objective in mind, we will begin our discussion of corporate investments. byr80601_06_c06_163-200.indd 166 1/24/13 3:58 PM CHAPTER 6Section 6.1 Corporate Investments and Value Creation Product Market Opportunities The financial model of the corporation is based on the premise that product markets provide valuable investment opportunities for firms. Firms that identify and exploit these opportunities create value because they do what their shareholders individually cannot do. The search for investment opportunities occurs within the overall mission and strategic plan of the corporation. Investment opportunities are often short-lived because suc- cessful products attract compet- itors. For example, the success of Starbuck’s coffee spawned many purveyors of specialty coffees and espresso, and Black- Berry was supplanted by the iPhone after a few years of mar- ket dominance. Competition, or the threat of competition, means that firms must not only remain alert for new opportunities but also try to protect their existing mar- kets. For example, major air- lines on occasion have used sometimes illegal predatory pricing to discourage low-cost “no-frills” airlines from serv- ing their hub cities. Even seem- ingly entrenched firms may be vulnerable to competition. Before Japanese autos entered the market, the United States was the nearly exclusive turf of the big three American automakers. Firms have a number of weapons with which to fend off competitors. Patents and copy- rights protect, for a time, valuable intellectual property, such as inventions, publications, and computer software. Sometimes protecting a competitive position requires invest- ment. For example, McDonald’s attempted to forestall competition by being the first to buy choice restaurant locations. Investing in a modern plant may lower production costs or increase product quality. Some industries invest heavily in promotion. Athletic apparel manufacturers engage in a frenzied competition to sign hot sports stars to expensive long- term contracts. Seeking out and successfully pursuing valuable investments places great demands on management. There are many potential hazards. Managers may fail to recognize oppor- tunities, or they may chase opportunities that do not exist. For example, a market may appear to be attractive because it produces extraordinarily high profits. Yet a closer exami- nation reveals that existing producers hold patents on key technologies or may control supply sources or distribution channels. Shareholders must pay attention to the product market when deciding on investment opportunities because competitors can quickly overshadow a leading product as demonstrated by iPhone’s dominance over BlackBerry. Associated Press byr80601_06_c06_163-200.indd 167 1/24/13 3:59 PM CHAPTER 6Section 6.2 Project Selection High-end retailers like Neiman Marcus focus on a differentiation strategy that emphasizes style, quality, and service. Associated Press When an apparent investment opportunity reveals itself, managers should ask the follow- ing questions: • If this is a genuine opportunity, why is there not greater competition in this market? • Are competing products on the horizon that may reduce market demand? • Are there costly barriers to entry? • Is the current competitive posture likely to remain over the long haul? • Are market forces already at work to increase competition? • Will the corporation be able to protect its investment by keeping competitors at bay? Taking reasonable precautions should actually encourage investing by making poor investments less likely. Companies that have a record of successful investing may be more aggressive in searching for new opportunities than those that have experienced