Which investments should a firm make?

To recap, Corporate finance as a discipline tries to maximise the value of the firm by (a) investing in assets that earn a return above its hurdle rate, (b) optimising the mix of debt and equity to fund the firm, and (c) returning money to shareholders in the form of dividends or share buy-backs if the firm can’t succeed at (a). These principles are universally applicable to all firms, of any size or location.

In the last quarter of 2011, we covered the core principles of what drives valuation and the cost of capital, effectively giving you the tools to determine the optimal mix of debt and equity to fund the firm and to quantify its Cost of Capital. In the framework above, this gives you the tools to tackle (b). In the next few articles we’ll turn our attention to answering the other core questions in corporate finance (a) what projects should be invest in that increase the value of the firm? and (b) when should we declare dividends or buy back shares? Both of these are common areas of misconception and value-destruction in the world of smaller businesses.

Lets start with the decision around which projects a firm should invest in if it is to increase its value:

The high-level answer is simple: firms should invest in projects that offer risk-adjusted returns higher than the minimum acceptable hurdle rate.

Unpacking this, there are two things we need to understand: 1. What are the risk adjusted returns, and 2. What is the minimum acceptable hurdle rate?

Understanding Risk-adjusted returns requires understanding the magnitude and timing of cash-flows from the investment project as well as all side effects. In most projects we expect cash outflows before inflows. Over the life of the project we hope to be in a situation where the total inflows are higher than the outflows plus their financing cost. The key thing to realise is that any project/investment takes up time and money, both of which are scarce. As such, taking one project now can prevent us from taking on a better one later (opportunity cost). So aside from a good fundamental understanding of the projects inflows and outflows, you also need to make a judgement call around what future opportunities you’ll be excluding. We’ll go into some detail around how to do this in the next weeks.

Determining the best hurdle rate to use depends on the size of the firm and the project. In the world of large investments (typically those made by large corporations), the individual project will have its own mix of debt and equity funding and its own risk profile. In which case the hurdle rate will be set based on the risk profile and financing mix of the specific project. For most entrepreneurs the typical situation is that all funding to the business gets spread across all investments without any change in the mix of funding used, so stick simply with your Weighted Average Cost of Capital calculation (see previous articles); for those with specific assets (such as vehicles, property, or machinery & equipment) where different types of commercial loans are available it makes sense to take them – there is no point using your bond to finance a car: you’ll be paying for the car 20 years after you last used it.

Why do we use the firms’ cost of capital as the hurdle rate? If the firm invests in a project where the returns are lower than the cost of capital, then the earnings of the firm will be diluted by the relatively poor investment and the return to equity holders will drop (as more of the return on equity is used to pay debt-holders first). Conversely, if a firm invests in projects that offer returns higher than the cost of capital, then returns to equity holders are being increased.

In the next weeks we’ll unpack the investment decision further, before moving on to understanding when to return cash to shareholders via dividends or share re-purchases.

Remember to ask for help if anything here has confused you: @valuationup