Making capital investment decisions – further issues

Profitability index (PI)

Frequency of use of profitability index by large businesses

Comparing projects with unequal lives

NPV for Machine A using a common period of time

Inflation and investment appraisal

Investment appraisal and risk

Methods of dealing with risk in investment appraisal

      Sensitivity analysis

      Scenario analysis

      Simulations

      Risk-adjusted discount rate

      Expected values

      Portfolio approach

Factors affecting the sensitivity of NPV calculations for a new machine

Sensitivity analysis

      Helps managers see the margin of safety of each key factor.

      Can provide a basis for planning.

However,

      Does not give clear decision rules concerning acceptance or rejection of the project.

      Is a static form of analysis - Only one factor is considered at a time while the rest are held constant.

Scenario analysis

      Unlike Sensitivity analysis, Scenario analysis overcomes the problem of dealing with a single variable at a time.

      Scenario analysis changes a number of variables simultaneously so as to provide a particular ‘state of the world’, or ‘scenario’, for managers to consider.

      A popular form of scenario analysis is to provide 3 different states of the world or scenarios as follows:

                - Optimistic view of likely future events

                - Pessimistic view of likely future events

                - ‘Most likely’ view of future events

      This popular approach, however, does not indicate the likelihood of each scenario occurring and because it does not identify other possible scenarios that might occur.

      Nevertheless, optimistic and pessimistic scenarios may be useful in providing managers with some feel for the ‘downside’ risk and ‘upside’ potential associated with a project.

Simulations

      The Simulation approach is really a development of Sensitivity analysis.

      This approach involves a likelihood/probability distribution of occurrence.

      The main steps in simulation:

                Step 1 -  Identify the key variables and their interrelations

                Step 2 -  Specify the possible values for each variable

                Step 3 -  Carry out repeated trials using a selected value for each key variable and obtain a probability distribution of the cash flows of the project.

      Benefits of simulations approach include:

                - can help managers understand the nature of an investment project and the key issues to be resolved.

                -  provides a distribution of outcomes that can help assess the riskiness of a project.

      However, simulations can be costly and time-consuming.

Risk preferences

Relationship between risk and return

Expected value – standard deviation rule

Two projects whose returns have a perfect positive correlation

Two projects whose returns have a perfect negative correlation

 Diversifiable and Non-diversifiable risk

Diversifiable risk (Unsystematic risk):

      Specific to a particular project so a business can avoid/reduce the diversifiable risk associated with its projects by holding a diversified portfolio of investment projects.

      Ideally, a business should hold a spread of projects, such that when certain projects generate low returns, others generate high returns.

                Non-diversifiable risk (Systematic risk):

      Common to all projects so cannot be diversified away and

      Is based on general economic conditions (such as inflation rate, general level of interest rates, and economic growth rate) so all businesses are affected by systematic risk.

Reducing risk through diversification

Making distributions to shareholders

Dividend policy

According to the traditional view:

      Dividend policy is important for shareholders.

      Shareholders prefer current dividends to future dividends as the latter are more uncertain.

      Shareholders are likely to discount the future dividends at a higher rate to account for greater uncertainty of future dividends.

      A generous dividend policy represents optimal dividend policy

      The level of dividend payout affects shareholder wealth.

According to the modernist view:

      The pattern of dividend payments adopted by a business has no effect on shareholder wealth.

      It is possible for individual shareholders to adjust the dividend policy of a business to meet his or her particular requirements.

      If a business does not pay a dividend, the shareholder can create home-made dividends by selling shares.

      If a business provides a dividend that the shareholder would not like to receive, the dividend received can be reinvested in additional shares.

      There is no optimal dividend policy and the dividend decision is irrelevant to shareholder wealth. 

 The importance of dividends

      Clientele effect: particular dividend policies adopted by businesses tend to attract different types of shareholders.

      Information signalling: managers may use dividend policy to signal new information relating to future prospects.

      Reduction of agency costs: shareholders may try to reduce the cash available for managers to spend by insisting that the surplus cash be distributed to them in the form of dividend. Also, shareholders may try to reduce their stake in the business through withdrawals in the form of dividends

Lintner ’s findings on managers include:

      Commitment to long-term dividend payout ratios

      Emphasis on variations in dividends rather than the absolute dividend

      Investors’ preferrence for a smooth increase in dividends

      Reluctance to increase dividends as a result of a short-term increase in profits

Alternatives to cash dividends

Scrip dividends:

      Issue of shares rather than the payment of cash to shareholders

      Number of shares issued to each shareholder in proportion to the number of shares held

Share repurchase:

      When a business buys its own shares and then cancels them

      Public companies are normally required to buy back shares from funds generated either from distributable profits or from the proceeds of a new shares issue