Page 476 - Introduction to Business

450 PART 5 Finance

Firm Financial Decision Making

Financial managers manage the assets of the firm by using capital budgeting and
manage the liabilities of the firm by making financing decisions. To make capital
budgeting decisions, they must take into account the time value of money by find-
ing the net present value of future profits. To make financing decisions, they must
consider alternative sources of funds, including retained earnings, debt, and com-
mon stock. They must also manage the cash held by the firm.
Net Present Value and Capital Budgeting Decisions 1

LEARNING OBJECTIVE 3
Apply net present value analyses to the basic capital budgeting decisions facing
financial managers.

Let’s expand on our bank loan example to demonstrate how financial managers
make capital budgeting decisions. Suppose that Sony borrows $100 million for one
year from a bank at a 10 percent interest rate. Sony uses the money to purchase
materials and labor to build a new product to be sold in the marketplace. Let’s
assume that the new product is a high-tech television with a clearer screen than
current televisions have, which consumers would like. The new television is esti-
mated to generate net profits (after material, labor, marketing, and other costs) of
$120 million by the end of the year. This investment project has some amount of
risk. That is, it is possible that Sony will have a lower or higher net profit than $120
million. A very bad scenario is a net profit of $80 million, while a very good scenario
is a net profit of $160 million. However, the expected or average net profit is $120
risk The variability of profits over time, million. Risk is defined here as variability of profit. Higher variability means more
with higher risk implying more variability risk, say, a range of net profits from $40 million to $160 million, and less variability
implies less risk, say, a range of net profits from $90 million to $110 million.
Since the investment’s average net profit is $120 million, and the investment’s
cost is $100 million, we might quickly conclude that the investment’s economic
profit is $20 million. Jumping to this simple answer would be a mistake! The $100
million cost is incurred at time 0 (now), whereas the $120 million net profit is real-
ized at time 1 (one year from now). There is a difference in the timing of project
EXHIBIT 13.4
costs and project profits. To figure out the economic profit of the new product, we
The Future Value of $100 must compare cash flows in present value terms at time 0 (now). Using our present
Using a 10 Percent Interest value formula and the notation r for the interest rate, we have
Rate
800 How $100 grows Present value of net profit $120 million/(1 r)
Future value of money ($) 700 over time at 10 the interest rate of 10 percent on the bank loan of $100 mil-
But what do we use for r in this equation? We might use
600
lion. Jumping to this simple solution would be another mis-
percent interest.
500
take! The bank priced the loan at 10 percent based on the
400
risk of Sony going bankrupt. Sony needs to do the same
300
thing as the bank. It should consider the risk of the invest-
200
account the real rate of interest, the inflation rate, and the
100 Linear rate ment project and demand a rate of return that takes into
project risk. But how does Sony know what this rate of
return should be?
2 4 6 8 10 12 14 16 18 20
Time (years) The best way to get the rate of return, or r, is to think
about alternative investments that the $100 million could
Compound interest (or the force of interest)
makes money grow faster. buy. Sony’s shareholders might be able to earn, say, 15 per-

Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.