Table 7 - Chapter 5
Investment Decisions
Investment Decision - the process of
choosing where to allocate money in order to
achieve certain financial goals. It involves
evaluating different opportunities, considering
risks and returns, and deciding on the best way
to use available funds.
Investment - involves allocating resources,
typically money, with the expectation of
generating future income or profit. It could
include purchasing stocks, bonds, real estate, or
funding projects with the goal of achieving
returns over time.
Net Present Value Rule (NPV Rule) - The
concept of focusing on projects with a positive
Net Present Value (NPV) suggests a financially
prudent approach, as it considers future cash
flows discounted to their present value. It helps
ensure that investments generate more returns
than the initial cost, promoting sound financial
decision-making.
Avoidable Costs - Are expenses that can be
eliminated or reduced by making specific
business decisions. These costs are tied to
certain activities or projects and can be avoided
if those activities or projects are discontinued or
altered.
Sunk Costs - expenses that have already been
incurred and cannot be recovered. Once
you've spent money on something, it's a sunk
cost, and decision-makers should focus on
future costs and benefits rather than trying to
recover what's already spent.
Rule 72 - a simple formula used to estimate the
number of years it takes for an investment to
double in value, given a fixed annual rate of
return. You divide 72 by the annual rate of return
to get an approximate doubling time.
Present Value - the current worth of a sum of
money to be received or paid in the future,
discounted at a specific interest rate. It
represents the value of future cash flows in
today's terms, considering the time value of
money.
Future Value - the projected worth of a current
sum of money at a specific date in the future,
assuming a certain interest rate or rate of return.
It accounts for the growth or accumulation of the
initial amount over time.
Cost Capital - the overall rate of return that a
company expects to earn on its investments to
maintain or enhance its value. It includes the
cost of debt and the cost of equity, reflecting
the expenses associated with obtaining funds for
business operations and projects.
Weighted Average Cost of Capital (WACC) -
is a calculation that considers the proportion of
debt and equity in a company's capital
structure. It represents the average rate of return
a company must pay to its investors (both debt
and equity) to finance its assets. WACC is used
to evaluate the attractiveness of investment
opportunities.
Cash Flow - the movement of money into or
out of a business over a specific period.
Positive cash flow occurs when a company
receives more money than it spends, while
negative cash flow occurs when expenses
exceed incoming funds. It's a crucial measure of
a company's financial health and ability to meet
its obligations.
Economic Profit - is the total revenue from
sales that is received by a business minus the
opportunity costs (explicit and implicit) from all
inputs.
Accounting Profit - is also referred to as
financial profit. It is the total profit of a company
minus explicit costs. This is used to assess the
performance of the company and to compare its
financial performance with other competitors.
Break-Even Quantity - amount you need to sell
to cover costs. Formula to get a break-even
quantity is Q = FC/(P-MC).
Contribution Margin (P-MC) - what is left after
marginal cost to contribute to covering fixed
costs.
Market Share - represents a percentage of the
industry that is owned by a company over a
particular period of time. Calculated by dividing
the sales of a company in the period and the
total sales of the industry.
Sales - is any transaction of exchanging
ownership of a good over money or value. It can
be of amount or quantity.
Break-Even Advice - Do not invoke break-even
analysis to justify higher prices or greater output.
Note: Managers sometimes believe they
must raise prices to cover fixed costs or they
must sell as much as possible to make average
costs lower. These are extent decisions which
require marginal analysis, not break-even.
Shut-Down Decisions - made using break-
evenprices rather than quantities,
The break-even price is the average
avoidable cost per unit.
- Profit = (Rev-Cost)= (P-AC)(Q).
- If you shut down, you lose your revenue,
but you get back your avoidable cost
- If the average avoidable cost is less
than price, shut down.
Cost Taxonomy - Determining avoidable costs
can be difficult. Cost Taxonomy is then used to
identify avoidable costs firms use.
Example of Cost Taxonomy
FC=$100, MC=$5, and you produce 100
units/year
● How low of a price before you shut
down? IT DEPENDS.
● It depends on which costs are
avoidable.
Long-run - fixed costs become avoidable so
they are included in the shutdown price.
Short-run - they are unavoidable and should not
be included in the shutdown price.
Sunk-Cost and Post-Investment Hold Up -
Always remember the business maxim “look
ahead and reason back.” This can help you
avoid potential hold up.
- Before making a sunk cost investment,
ask what you will do if you are held up.
- What would you do to address hold up?
Example of Sunk-Cost and Post-Investment
Hold Up
National Geographic can reduce shipping costs
by printing with regional printers.
• To print a high quality magazine, the printer
must buy a $12 million printing press.
• Each magazine has a MC of $1 and the printer
would print 12 million copies over two years.
• The break-even cost/average cost is $7 =
($12M / 2M copies) + $1/copy
• BUT once the press is purchased, the cost is
sunk and the break-even price changes.
• Because of this the magazine can hold up the
printer by renegotiating the terms of the deal –
because the price of the press is unavoidable,
and sunk, the break-even pricefalls to $1, the
marginal cost.
Vertical Integration - One possible solution to
post-investment hold-up. It refers to the common
ownership of two firms in separate stages of the
vertical supply chain that connects raw materials
to finished goods.
Example: Bauxite mine and alumina
refinery
• Refineries are tailored to specific
qualities of ore
• The transaction options are:• Spot-
market transactions
• Long-term contracts
Contractual View of Marriage - Long-term
contracts induce higher levels of relationship-
specific investment.