Real Options and Decision Trees

When you use discounted cash flow (DCF) to value a project, you implicitly assume that the firm will hold the assets passively. But managers are not paid to be dummies. After they have invested in a new project, they do not simply sit back and watch the future unfold. If things go well, the

1 Comments

How Firms Organize the Investment Process

1. The Capital Budget Senior management needs some forewarning of future investment outlays. So for most large firms, the investment process starts with the preparation of an annual capital budget, which is a list of investment projects planned for the coming year. Smaller investments are not item­ized separately in the budget. For example, they

1 Comments

Look First to Market Values

Let us suppose that you have persuaded all your project sponsors to give honest forecasts. Although those forecasts are unbiased, they are still likely to contain errors, some positive and others negative. The average error will be zero, but that is little consolation because you want to accept only projects with truly superior profitability.

Economic Rents and Competitive Advantage

Profits that more than cover the cost of capital are known as economic rents. Economics 101 teaches us that in the long run, competition eliminates economic rents. That is, in a long-run competitive equilibrium, no company can expand and earn more than the cost of capital on that investment. Economic rents are earned when

3 Comments

Marvin Enterprises Decides to Exploit a New Technology – an Example

To illustrate some of the problems involved in predicting economic rents, let us leap forward several years and look at the decision by Marvin Enterprises to exploit a new technology.[1] One of the most unexpected developments of these years was the remarkable growth of a completely new industry. By 2041, annual sales of gargle

2 Comments

What Agency Problems Should You Watch Out For?

The CEO, CFO, and other managers cannot be perfect agents of their shareholders. The man­agers are human beings who cannot completely set aside their own interests and concerns. It’s naive to think that they will find and invest in all and only positive-NPV investments. Agency costs are incurred when they don’t. Agency costs of

Monitoring the Investment

Agency costs can be reduced by monitoring a manager’s efforts and actions and by interven­ing when the manager veers off course. Monitoring can prevent the more obvious agency costs, such as blatant perks. It can con­firm that the manager is putting in sufficient time on the job. But monitoring requires time and money. Some

1 Comments

Management Compensation

Monitoring can’t be perfect. Therefore, compensation plans must be designed to attract com­petent managers and to give them the right incentives. For U.S. public companies, compensation is the responsibility of the compensation com­mittee of the board of directors. The Securities and Exchange Commission (SEC) and New York Stock Exchange (NYSE) require that all directors

2 Comments

Measuring and Rewarding Performance: Residual Income and Economic Value Added

Almost all top executives of firms with publicly traded shares have compensation pack­ages that depend in part on their firms’ stock price performance. But their compensation also includes a bonus that depends on increases in earnings or on other accounting measures of performance. For lower-level managers, compensation packages usually depend more on accounting measures

1 Comments

Biases in Accounting Measures of Performance

Anyone using accounting measures of performance had better hope that the accounting num­bers are accurate. Unfortunately, they are often not accurate, but biased. Applying EVA or any other accounting measure of performance therefore requires adjustments to the income statements and balance sheets. For example, think of the difficulties in measuring the profitability of a

Differences between Investment and Financing Decisions

In some ways, financing decisions are more complex than investment decisions. The number of different securities and financing strategies is well into the hundreds (we have stopped counting). You will have to learn the major families, genera, and species. You will also need to become familiar with the vocabulary of financing. You will learn

2 Comments

The Efficient Market Hypothesis

Economists define three levels of market efficiency, depending on the kinds of information incorporated in security prices. In the first level, prices incorporate all information contained in the record of past prices. This is called weak efficiency. If weak-form efficiency holds, prices follow random walks. We will explain “random walk” in a moment. The

Bubbles and Market Efficiency

So far, we have asked whether individual stocks are “priced right,” given the information that investors can see or acquire. But what about the market as a whole? Are there cases where the overall level of prices cannot be justified by fundamentals? We will look at the evidence in a moment, but first we

1 Comments

Behavioral Finance

Why might prices depart from fundamental values? Some believe that the answer lies in behavioral psychology. People are not 100% rational 100% of the time. This shows up in investors’ attitudes to risk and the way they assess probabilities. Attitudes toward risk. Psychologists have observed that, when making risky decisions, people are particularly loath

2 Comments

The Five Lessons of Market Efficiency

The efficient-market hypothesis emphasizes that arbitrage will rapidly eliminate any profit opportunities and drive market prices back to fair value. Behavioral-finance specialists may concede that there are no easy profits, but argue that arbitrage is costly and sometimes slow-working, so that deviations from fair value may persist. Sorting out the puzzles will take time,

1 Comments

Patterns of Corporate Financing

Corporations invest in long-term assets, such as property, plant, and equipment, and in current assets, such as inventory and accounts receivable. Figure 14.1 shows where U.S. corporations get the cash to pay for these investments. Most of the cash is generated internally. That is, it comes from cash flow allocated to depreciation and from

2 Comments

Common Stock

1. Ownership of the Corporation A corporation is owned by its common stockholders. You can see from Figure 14.4 that in the United States, 39% of this common stock is held directly by individual investors, and a similar proportion belongs to financial intermediaries such as mutual funds, pension funds, and insurance companies. Mutual funds

1 Comments

Debt and Types of Debt

When companies borrow money, they promise to make regular interest payments and to repay the principal. However, this liability is limited. Stockholders have the right to default on the debt if they are willing to hand over the corporation’s assets to the lenders. Clearly, they will choose to do this only if the value

2 Comments

Financial Markets and Intermediaries

The flow of savings to large public corporations is shown in Figure 14.7. Notice that the savings travel from investors worldwide through financial markets, financial intermediaries, or both. Suppose, for example, that Bank of America raises $300 million by a new issue of shares. An Italian investor buys 6,000 of the new shares for

1 Comments

The Role of Financial Markets and Intermediaries

Financial markets and intermediaries provide financing for business. They channel savings to real investment. That much should be loud and clear. But other functions may not be quite so obvious. Financial intermediaries contribute in many ways to our individual well-being and the smooth functioning of the economy. Here are some examples. 1. The Payment

1 Comments