GROWING A FIRM Chapter 5

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GROWING A FIRMChapter 5
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Perspective .

• 25,000 Publicly Owned Firms
• Several Million Privately Owned
• Our Focus the Privately Owned!

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Why Grow??

• Economic
• Personal
• Some dont want to grow!

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Key Questions

• Are you willing to make the effort?
• Are your key people capable?
• Money is only a challenge should not be a
  limiting factor.

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GROWING A FIRM

• What do you mean by Growth?
• Growth is Growth in Earnings.
• For example
• 
  Desired
• Earnings
• Earnings Gap

Projected
Yr 1
Yr 3
Yr 4
Yr 5
Yr 2
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GROWING A FIRM

• How do you fill the Earnings Gap?
• Two ways to fill the Earnings Gap
• Internal
• More of the Same
• (Share repurchase)
• Capital Budgeting
• External
• Mergers and Acquisitions

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GROWING A FIRM

• In this part of the course we will be discussing
  Capital Budgeting (Internal means) At the end of
  the course we will discuss External means of
  growing.
• Now we will discuss how much money you have for
  Capital Budgeting?

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HOW MUCH MONEY DO YOU HAVE FOR CAPITAL BUDGETING?
Profit Producing
0
S
NOCF
Necessary
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DISTRIBUTION OF NOCF

• Necessary Expenditures
• Health and Safety
• Other
• Hanky Panky
• Profit producing - What we are talking about in
  this course

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CAPITAL BUDGETING

• What is capital budgeting?
• Capital budgeting is the process of selecting
  attractive capital proposals.
• Later this will be described as the process as
  selecting sets of proposals.

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FOUR NAIVE WAYS TO SELECT PROPOSALS

• 1. PAYBACK PERIOD - - The length of time it
  takes to recover your investment.
• 2. AVERAGE RATE OF RETURN - Defined as Average
  Yearly Net Income / Average Investment.

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AVERAGE RATE OF RETURN
A
B
S
Net Income
TIME
Proposals A and B have the same average Net
Income, but are they the same?
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FOUR NAIVE WAYS TO SELECT PROPOSALS

• 3. NET PRESENT VALUE - Present value of the cash
  flows, discounted at the so-called cost of
  capital.
• This method has two assumptions
• same size
• same time length

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FOUR NAIVE WAYS TO SELECT PROPOSALS

• 4. INTERNAL RATE OF RETURN - Defined as that rate
  of discount that makes the present value of the
  cash flows equal zero.
• Makes the assumption that the reinvestment rate
  is equal to the ex ante (calculated) rate of
  return.
• See also MIRR

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INTERNAL RATE OF RETURN

• Reinvestment assumption for corporate finance

Proposals
s
IRRs
IRRs
Year 2
Year 1
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CAPITAL BUDGETING

• CRITERIA FOR A DISCRIMINATE
• Does it measure profitability?
• Does it take account of the time value of money?
• Does it take account of the Time shape of the
  Cash Flow?

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CRITERIA FOR DISCRIMINATES

• DEFINITION OF TIME SHAPE OF THE CASH FLOW
  Three shapes
• t t

t
-
Quickie
Mañana
Smoothie
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EVALUATING DISCRIMINATES

• 
  PROFITABILITY TIME VALUE
  TIME SHAPE
• Payback No
  No No
• Ave. R of R Sort of
  No No
• Net Present Value Yes
  Yes No
• Internal R of R Yes
  Yes No

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WHY THESE METHODS ARE CALLED NAIVE?

• THESE METHODS ARE ONLY SINGLE DISCRIMINATE
  METHODS
• SUPPOSE, FOR EXAMPLE, THAT YOU TAKE A HIGH RATE
  OF RETURN PROPOSAL AND THIS PROPOSAL CAUSES THE
  COMPANY TO GO BANKRUPT? WOULD YOU STILL THINK
  THAT IT WAS A GREAT PROPOSAL?

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METHOD USED

• In the following multiple discriminate model, the
  Internal Rate of Return is used, but it is only
  one discriminate and not the sole source of
  discrimination. It is used because it is a method
  that can handle mutually inclusive proposals.

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GROWING A FIRM

• END