Bài 2:INVESTMENT DECISIONS:

THE CERTAINTY CASE

INVESTMENT DECISIONS
• Investment decisions under economic certainty.
• Investment decisions under economic
uncertainty
Investment decision in the condition of knowing
the parameters in advance
• Decision Criteria: Optimizing the present value of
consumptions in ALL periods
• Pre-Known Parameters: Know for sure interest rates at
different times.
• Interest rates may change but investors know those changes
in advance (non-stochastic)
• Know the cash flow of investment decision projects
• Perfect capital markets (no imperfections), no transaction
fees; loan interest = borrowing interest
Investment decision in the condition of knowing
the parameters in advance
• Research question: How can investors optimize
consumption and investment activities in the case that
the above parameters are known in advance?
• Research results:
Maximizing consumption =Maximizing stock prices
Relevant issues
• Methods of selecting investment projects
NPV, IRR, Payback period, Accounting average return

• The consistency (theoretically) of the (Net present

value) NPV method with the criterion of
maximizing consumption activities in all periods of
investors.
Fisher separation theorem:
Separation between investment choice and optimal utility
choice
• Problem: Each investor has a different utility
curve, so how can the enterprise maximize the
benefits of all its shareholders?
• I don't know which student is happier (more
benefits) when they both celebrate their 100th
birthday (even if both are equally "rich").
• Answer: Fisher effect
Separation between investment choice and
optimal utility choice
• According to the Fisher effect, individuals
can assign investment decisions to Firms
and firms choose to invest in production up
to the point 𝑃0 𝑃1 where: 𝑀𝑅𝑇=−(1+𝑟) is
the interest rate determined by the market
• Implicit assumption: The firm's production
decision depends on the market interest
rate
• The slope of W0W1=−(1+𝑟)
• After enterprises decide the point of
production investment, individuals will
choose to borrow or lend by sliding on the
capital market line to optimize benefits.
Fisher Effect
• Implication of Fisher Effect:
• Choosing the optimal level of production is up to the business. Individuals have the
same productive investment choices even though each individual has a different
utility function.

=>Shareholders do not contradict each other while deciding on the production of the
enterprise because they jointly decide on the optimal production.

• Individual Utility Maximization=Consumption

Maximization=Maximization of present values of future
consumption.
𝐶1
• Utility Maximization = 𝑀𝑎𝑥𝑖𝑚𝑖𝑧𝑎𝑡𝑖𝑜𝑛(𝑊0 = 𝐶0 + )
1+𝑟
Agency Problem
• In a perfect market, shareholders want business managers to follow the general
investment decision-making principle: Choose projects where marginal return = market
discount rate. Therefore, shareholder value is considered as the value of the discounted
cash flow at the opportunity cost of capital (the interest rate is determined by the
market).
• But shareholders also need to monitor the decisions of business managers to ensure that
their decisions really maximize their benefits.
• There is clearly a difference between ownership and control, and there is no reason to
fully trust a manager, who represents the shareholders, in doing his best for the interests
of the shareholders.
• Monitoring costs are usually not small. Therefore, it is necessary to consider the trade-off
between monitoring costs and rewards
• If the manager is rewarded with shares of the enterprise, the monitoring cost is =0.
However, this form of bonus often has no practical meaning, because the manager has
always been rewarded in the manner of benefiting from comfortable rooms, expensive
restaurant meals, flying vip cabins, ...

• Alternatively, shareholders bear the cost of monitoring to ensure managers will make
decisions for them.

• Between these two forms there is an optimal solution (will consider in chapter 12).

• Anyway, we also assume that managers always make decisions that maximize the
interests of shareholders. To do this, they must find and select the best investment
projects to pursue their goals
Shareholder wealth maximization
• Shareholder’s benefit
• Dividend: After-tax profit distributed to shareholders

• Shareholder value = present value of the firm's dividend

stream
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑡𝑡
• 𝑆0 = σ∞
𝑡=1 (1+𝑘𝑠 )𝑡
Where ks is the market-determined cost of equity n (𝑟)
This view is consistent with the assumption that cash flows from investing
activities and interest rates on capital markets are known in advance.
• There is often confusion about the meaning of profit.
• Economists use the word profit to refer to the rate of return that exceeds the opportunity cost for funds
using n projects of equal risk.
• To estimate economic returns, the exact time pattern of the cash flows provided by a project and the
opportunity cost of capital must be known.
• For managers the appropriate return when making decisions is discounted cash flow to shareholders - in
other words, dividends.
• Dividends should be understood in a broad sense.

• Dividends include
• any cash that may be paid to shareholders,

• including capital gains,

• payments to shareholders,

• payments in liquidation or bankruptcy, stock repurchases,

• awards in shareholder lawsuits and

• refunds due to mergers or acquisitions.

• Stock dividends, unrelated to cash flow, are not included in the definition of dividends.
Shareholder wealth maximization
• If after a while, investors sell shares on the market, the shareholder benefit function does not change

• For example: After 5 years, the stock price in the market is S5 and the annual dividend growth rate is , then the
shareholder value is as follows:

Because cash flow S5 is equal to present value of cash flows from year 5 onwards
𝐷𝑖𝑣6 𝐷𝑖𝑣7 𝐷𝑖𝑣𝑛
• 𝑆5 = + + ⋯ + ,n → ∞
(1+𝑘𝑠 )6 (1+𝑘𝑠 )7 1+𝑘𝑠 𝑛
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑡𝑡
→ 𝑆0 = σ∞𝑡=1 (1+𝑘 )𝑡 (unchanged, given the different prices)
𝑠
Shareholder wealth maximization
• Economic Definition of Profit
• Assuming no borrowing, no tax for the company
• Starting point: Source of money = used funds in the business
• Source of money: Revenue, Issuance and sale of new shares in the market (m shares, $
S/share→ $ 𝑚𝑆 issuance).
• Used funds: wages of workers, materials, services (𝑊&𝑆); investment , and dividends
• At time t:

• If no new shares are issued, the profit of the business is:

Shareholder wealth maximization
• Shareholder’s wealth in economics::

• The accounting definition of profit is net income:

Shareholder wealth maximization
• ∆𝐴𝑡 : 𝑛𝑒𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑎 𝑦𝑒𝑎𝑟
∆𝐴𝑡 = 𝐼𝑡 − 𝐷𝑒𝑝𝑡 → Share price

Difference between the accouting definition and economic definition of

profit:
Accouting : not focus on CFs when then occur
Economic: focus on CFs when they occur.
 Difference between the accouting definition and
economic definition of profit:
- Accouting : not focus on CFs when then occur
Economic: focus on CFs when they occur.

The economic definition of profit deducts the entire expenditure for

investment in plant and equipment at the time the cash outflow
occurs.
• Financial managers are often confused when they focus on
the accounting definition of profit, or earnings per share.
• The company's goal is not to maximize earnings per share.
• The exact objective is to maximize shareholder wealth, i.e.
price per share equals discounted cash flow of the company
•
example of difference between EPS maximization and
discounted cash flow maximization
• For example the difference between FIFO (first in, first out) and LIFO
(last in, first out) inventory accounting.
• The cost of producing the oldest items in stock is less than the cost of
producing the newest items.
• Therefore, if the cost of the oldest manufactured good (the cost
entered for the first time) is recorded as an expense relative to the
revenue, EPS will be higher than would be the case if the price of the
newest item (inventory) last) is written to .
Mistake in using accounting profit

• Điều gì xảy ra:

• What happens:
• If investors use accounting profit?
• What if an investor maximizes earnings per share
(EPS) ?
• Consider an example
Mistake in using accounting profit
• Which inventory accounting method to choose for your business? Last
in first out (LIFO) hay First in First out (FIFO)?
Capital Budgeting Techniques
• Rules
• Firm value = σ 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑣𝑎𝑙𝑢𝑒𝑠
• Maximize shareholder value = Maximize present value of cash flows generated from projects.

• Assumptions

• Know in advance the cash flow generated from the project

• Know the cost of financing the project in advance
• The market is perfect, so it is possible to separate the production
decision and the investor's profit optimization decision (Fishser effect)
• Zero manager monitoring cost (Agecy cost = 0)
Capital Budgeting Techniques
• 3 problems businesses face when choosing investment projects

• Look for investment and technology opportunities (foundation of

value)
• Not the job of financial economics

• Forecast cash flow generated from the project

• Select projects based on sound principles
Capital Budgeting Techniques
• 4 characteristics of the principle of investment project selection

• Consider all project cash flows

• Cash flow must be discounted by the opportunity cost of capital
• Capital cost of the equivalent project
• In case only one project can be selected Select the project that maximizes
shareholder value (Mutually exclusive projects)
• Each project can be considered independently, the value of the business equals the total value of the projects. (Value-additivity
principle)

• It is not necessary to consider the project in its myriad correlations with other projects.
4 capital budgeting techniques
4.1.Thời kỳ hoàn vốn (Payback period)
4.2.Lợi nhuận kế toán trung bình (Accounting average return)
4.3. Giá trị hiện tại ròng (Net present value, a.k.a. NPV)
4.4. Suất hoàn vốn nội bộ (Internal rate of return, a.k.a IRR)
• NPV vs. IRR (xét trong môi trường mọi thay đổi đều có thể dự đoán
được chính xác)
4.1.Thời kỳ hoàn vốn (The Payback Period)
• Number of years it takes to recover the initial cash outlay on a project
• Example

Which
projec
t to
choos
e??
Thời kỳ hoàn vốn (The Payback Period)
• At least 2 of the rules are not met:
• Not consider all cash fows
• No discounting factors are accounted →
• Can not differentiate a project A and A’ that has the first CF
of $900 and 2nd CF of $100.
• Violate the value-additivity (self reading)
4.2.Lợi nhuận kế toán trung bình
(Accounting average return - AAR)
Average after tax profit
• 𝐴𝐴𝑅 =
Initial outlay
• Project A
−1000+100+900+100−100−400
• Average after-tax profit = = −80
5
−80
• 𝐴𝐴𝑅 = = 8%
1000

Project B ARR = 26%

Project C ARR = 25%
Project D ARR = 22%
4.2.Lợi nhuận kế toán trung bình
(Accounting average return - AAR)
• No time value of money
• Not able to accurately calculate CFs
• Not differentiate B and B’ with similar CFs but different orders of occurance
4.3. Giá trị hiện tại ròng NPV
• NPV calculation
• Discounted at opportunity cost of capital
Giá trị hiện tại ròng NPV

Select the project with

NPV > 0
The higher NPV the
better → Select C
4.4. Suất hoàn vốn nội bộ
(Internal rate of return - IRR)
• IRR is the rate that makes the computed NPV equal to
zero

• IRR is the rate of return on invested capital that the

project is returning to the firm
Suất hoàn vốn nội bộ
(Internal rate of return - IRR)
• IRR of 4 projects

• Select the one with IRR >

opportunity cost of
capital(10%)
• Based on IRR, select D
 Comparison of NPV and IRR of project C

• Discount rate =0 → No time value of

money → No need to discount CFs
• Higher discount rate=> lower NPV
• Discount rate > IRR → NPV<0
NPV vs. IRR
• NPV selects C vs. IRR selects D
• Which one to follow?
• Prove that NPV is consistent with the investment
theoretical framework in the condition that the change
of parameters is known in advance and is consistent
with the criterion of "maximizing shareholder value"
NPV vs. IRR
• According to the theoretical framework: The opportunity cost of capital (10%) is the market
interest rate and is the only reasonable discount rate.

• The implicit discount rate is the reinvestment rate

• Implied NPV of the reinvestment rate is the market interest rate

• A, B, C, D have the same risk must have the same reinvestment rate

• The implicit IRR method assumes that the reinvestment rate is IRR .

• C is reinvested at 22.8% interest, D's reinvested return is 25.4%?!

•
NPV vs. IRR
• Vấn đề đa nghiệm trong phương pháp IRR
• IRR có thể đưa ra nhiều hơn 1 kết quả nếu dòng tiền của dự án đổi dấu nhiều
hơn 1 lần.
• Ví dụ: Một công ty dầu mỏ cân nhắc quyết định lắp một máy bơm dầu công
suất lớn. Chi phí của máy bơm là $1600. Trong năm đầu, sản lượng tăng $10K
so với hiện tại nhưng năm sau sản lượng giảm $10K vì giếng dầu cạn kiệt. Có
nên lắp đặt máy bơm mới hay không?
NPV vs. IRR
• This equation has 2 solutions.
• Descarte's Rule: Each time the cash flow changes sign adds a solution

• IRR = 25% or IRR = 400%

NPV vs. IRR
• Y axis: NPV
• X axis: Discount rate

500

1 2 3 4 5 6 7

500

1000

1500
Nguyên tắc gia tăng giá trị (Value-additivity
Principle)
• Requires managers to be able to review a project
independently of all other projects.
• it implies that the value of the company is equal to the sum of
the value of each of its projects,
• To demonstrate that the IRR rule may violate the value-added
principle, Consider the three cash flow projects given in Table
2.4.
Nguyên tắc gia tăng giá trị (Value-additivity
Principle)
• Project 1 and 2 are mutually
exclusive and project 3 is
independent of them.
• If the value-added principle
is upheld, we can choose
the better project out of two
mutually exclusive projects
without having to consider a
third independent project.
Nguyên tắc gia tăng giá trị (Value-additivity
Principle)
• The NPVs of the three projects as well as their IRRs are
also given

• If we used the IRR rule to choose between projects 1

and 2, we would not choose project 1.

• But if we consider combinations of projects, then the

IRR rule will favor projects 2 and 3 over projects 1 and
3.

• The IRR rule favors project 1 alone, but project 2 in

conjunction with an independent project.

• In this example, the IRR rule does not follow the value-
added principle.

• The implication for management is that it will have to

consider all possible combinations of projects and
choose the one with the largest internal rate of return.

•
Nguyên tắc gia tăng giá trị (Value-additivity
Principle)
• NPV rule always follows the principle of added value.

• Assuming that the opportunity cost of capital is 10%, we will choose project 1 as best on its own or
in combination with project 3.

• Note that the combination of 1 and 3 or 2 and 3 is simply the sum of the NPVs of the projects
considered separately.

• Therefore, if we apply the NPV rule, the value of the firm is the sum of the values ​of the separate
projects.

• In Chapter 6 we will see that this result persists even in an uncertain world where the firm can be
viewed as a portfolio of risky projects.
 Example: Firm CFs
• Giả định dòng tiền không thay đổi
theo thời gian (công ty không tăng
trưởng)
• Doanh nghiệp tái đầu tư $200 hàng
năm để bù đắp khấu hao tài sản cố
định
• Khoản đầu tư ban đầu cho công ty
$1000 trong đó $500 đi vay (mãi mãi)
với lãi suất 10%, $500 vốn tự có với
chi phí vốn 30%
• Lưu ý: Net income không phải
là dòng tiền (NI ≠ cashflow)
WACC
• Chi phí vốn bình quân (Weighted average cost of capital - WACC)
• Giá trị hiện tại của dòng lợi nhuận ròng (Net income)

• Giá trị hiện tại của khoản vay

• Chi phí vốn bình quân

• Thuế TNDN 50%
CFs of company in the next 5 years
Thuế suất Dòng tiền từ
Tiền từ hoạt Khấu hao tài Lợi nhuận Tái đầu tư tài Dòng tiền
Năm trước thuế thuế thu khấu hao tài
động SXKD sản cố định và lãi sản cố định tự do
nhập 50% sản cố định
Firm CFs

250
• PV 𝑜𝑓 𝑓𝑟𝑒𝑒 𝐶𝐹𝑠 𝑓𝑟𝑜𝑚 𝑦𝑒𝑎𝑟 6 𝑜𝑛𝑤𝑎𝑟𝑑𝑠 = = 1250
0.2
Exercises
• Company X has project A's cash inflows of $140,000 and cash outflows of
$100,000 per year. The initial investment of the project is $100,000 with a term of
10 years. The tax rate is 40% and the opportunity cost of capital raised for the
project is 12%. Calculate the net present value (NPV) of project A, assuming
depreciation is evenly divided over 10 years (straight-line depreciation).
• Garment company VC is considering replacing old punching machines with new
ones that are likely to increase pre-depreciation profit from $20,000 to $51,000 a
year. New machines cost $100,000 and fully depreciate over eight years. Taxes are
at 40% and the opportunity cost of capital raised to buy new punching machines
is 12%. The old punching machine has been fully depreciated and almost no
money is collected when reselling. So should VC buy a new machine or not?