Investment Principle

Firms have scarce resources that must be allocated among

competing uses.
Investment decisions are often referred to as capital budgeting
decisions or capital expenditure(CAPEX) which are long term
decisions.
Investments are designed to generate profits for the firm.
Investments may not generate profits but reduce costs.
For eg. Inventory management may save cost .
Replacing existing lighting system with power saving lights will
save cost.
Decisions regarding which markets to enter, which acquisitions to
be made etc.
Investment Principle continued……..
• Today’s capital investment generates future returns-
returns are spread into distant future.
• For.eg an airline invests $10 b to design,test and
manufacture its dreamliner.
• Plan would generate returns for 30 yrs or more when it
enters commercial service.
• Returns should cover huge initial investment and provide
atleast an adequate profit on that investment.
• The larger the airline waits for cash to flow back the
greater the profit it requires.
• Timing of the project return is crucial.
• Returns are uncertain.
 Investment principle-Measuring Returns
Investment principle states that firms should invest in assets only when they are
expected to earn a greater return than a minimum acceptable return.
The minimum return is called the hurdle rate or the expected rate of return.
All earnings, future additional investments have to be consolidated into one
measure of return for the purpose of comparison to the hurdle rate.
Hurdle rate is the minimum rate of return an investor or a manager is looking for
ie above which an investment proposal can be pursued.
Hurdle rate is decided keeping in mind the riskiness of a project.
Hurdle rate has to be set higher for riskier proposals, and has to reflect the
financing mix used ie. the proportion of owner’s funds (equity) or borrowed
money(debt) .
A hurdle rate, which is also known as minimum acceptable rate of return (MARR),
is the minimum required rate of return or target rate that investors are expecting to
receive on an investment. The rate is determined by assessing the cost of capital,
risks involved, current opportunities in business expansion, rates of return for
similar investments, and other factors that could directly affect an investment.
Investment principle continued
 Investments to be taken up that generate revenue/profits
 After establishing hurdle rates, expected returns to project have to be
compared with the minimum.
 If the expected returns from the project is higher than the minimum, then
the investment should be made.
 hence financial manager must be concerned not only with how much cash
they expect to receive ,but also with when they expect to receive it and how
likely they are to receive it.
 When evaluating a business decision, the size, timing, and risk of cash flows
are most important criterion.
 If hurdle rate is 10% and the project earns 12% then the project has to be
accepted.
 If project earns 10% and the hurdle rate is 12% then the project should not
be taken up.
 Investment Principle
20% Make this investment
Hurdle Rate
18%
Return on Investment
16%
14% Do not make this
12% investment

10%
8%
6%
4%
2%
0%

Return/Hurdle
Tradeoff for Corporate Investment decisions
Company has an investment opportunity-A project
Company has cash to invest in the project.
If Finance Manager decides not to invest then it has to be distributed to the
shareholders as dividend.
If FM decides to invest- there is a tradeoff between the rate of return of
the project and rate of return of shareholders if they can invest on their
own .
If return offered by the project is more than the rate of return that
shareholders can earn by investing in other instruments then shareholders
would vote for the project.
If vice versa shareholders will not give their consent.
Eg. Pantaloon wants to open up 10 new stores.
If pantaloon business as risky as other financial instrument and if other
financial instrument offers a 12% expected rate of return and if stores
offer a 20% then shareholders would invest in stores.
If stores offer only 5% then shareholders are better off with the cash.
 Opportunity Cost of Capital
• So minimum return is 12%.
• 12% is also called opportunity cost of capital.
• Whenever a firm invests in a new project its shareholders lose the
opportunity to invest in cash on their own.
• Firms increase their value by going ahead with projects that earn
more than the opportunity cost of capital.
• Shareholders are not just risk-averse .
• They have to trade off risk against return when they invest on their
own.
• Opportunity cost of capital is not just the interest cost of the company
on its borrowings.
• The expected return on risky securities is normally well above the
interest rate of Corporate borrowing.
• Managers look at financial markets to measure OCC for the firm’s
investment projects.
 The Financing Principle
Decides the capital structure(financial structure) of the business.
Two broad choices to be made regarding financing.
Select a mix of debt(borrowed money) and equity (owner’s funds).
Debt includes bank loan, debentures, bonds ,G-secs.
Equity- it includes both equity shares and preference shares.
Optimal mix of debt and equity has to be sought.
Firm’s have a great deal of flexibility in choosing a financial structure.
Financing decisions are less imp than investment decisions.
Most successful corporations have the simplest of financing strategies.
Financing Principle continued……

• Financing decisions are less important

than investment principle .
• Profitability does not come from
financing decisions but taking the right
investment decisions.
• For eg. In 2020 Aug 19th Infosys share
traded at rs.963 at BSE at 2:03pm
 Financing Principle continued……….
• Infosys where does its market value come? Product development,
brand name, worldwide customer base, its R&D and ability to make
profitable future investments. Value does not come from sophisticated
financing.
• Infosys strategy simple: it carries no debt to speak of and finances
almost all investment by retaining and reinvesting cash flows.
• The question of whether one structure is better than the other for a
particular firm is the heart of the capital structure issue.
• The expense associated with raising long term financing can be
considerable so different possibilities should be carefully evaluated.
• In the absence of debt the shareholders return is equal to the firm’s
return.
• Infosys has almost zero debt ,it has retained earnings and reinvests its
cash flows.
Raising capital

• Primary markets- Newly formed (issued) securities are bought

or sold in primary markets, such as during Initial Public
Offerings(IPO). The transactions in primary markets exist
between issuers and investors

• Secondary markets. Secondary markets allow investors to buy

and sell existing securities. in secondary market transactions
exist among investors.
 Equity Funds

• Firms can raise –capital by issuing equity/preference shares.

• Equity holders are the owners of the company. They expect return in the form of
divideneds and capital gains.
• Capital gains /losses are made by selling their shares.
• Shareholders are of two types-preference and equity/ordinary holders.
• Preference shareholders receive dividend at a fixed rate and have a priority over
ordinary shareholders.
• Dividend rate for ordinary shareholders is not fixed and can vary from year to
year depending on the decisions of the board of directors. And they receive
dividend(or repayment of invested capital, in case the company is wound up)after
meeting the obligations of others, they are generally called owners of the residue.
• Divideneds paid by the company are not deductible expenses for calculating
corporate income tax and are paid out of the profits after the corporate taxes.
• A company can also obtain funds by retaining earnings available to shareholders.
• Retained earnings are undistributed profits of equity capital.
 Borrowed Funds

• Another source of securing capital is creditors/lenders.

• Lenders are not the owners of the company.
• They make money available to the firm as loan or debt and retain
title to the funds lent
• Loans are furnished for a specified period at a fixed rate of interest.
• Lenders get returns in the form of interest. Interest is the cost of
debt to the firm. Payment of interest is a legal obligation.
• Interest paid is a deductible expense for computing corporate
income tax . Thus interest provides tax shield to a firm.
• Debt instruments have the amount, rate of interest and the maturity
mentioned on it.
 The Financing Principle

The Financing Mix Question:

Borrowed
What proportions of debt
Money
and
Debt Equity should the firm use?

The Financing Type Question:

Owner’s
What type of debt and Equity
Funds
financing should the firm
use?
Equity