Investment Decisions: Look Ahead and Reason Back

Investment Decisions: Look Ahead and Reason Back

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CHAPTER

Investments imply willingness to trade dollars in the present for dollars in the future. Wealth-creating transactions occur when individuals with low discount rates (rate at which they value future vs. current dollars) lend to those with high discount rates.

Companies, like individuals, have different discount rates, determined by their cost of capital. They invest only in projects that earn a return higher than the cost of capital.

The NPV rule states that if the present value of the net cash flow of a project is larger than zero, the project earns economic profit (i.e., the investment earns more than the cost of capital).

Although NPV is the correct way to analyze investments, not all companies use it. Instead, they use break-even analysis because it is easier and more intuitive.

Break-even quantity is equal to fixed cost divided by the contribution margin. If you expect to sell more than the break-even quantity, then your investment is profitable.

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Avoidable costs can be recovered by shutting down. If the benefits of shutting down (you recover your avoidable costs) are larger than the costs (you forgo revenue), then shut down. The break-even price is average avoidable cost.

If you incur sunk costs, you are vulnerable to post-investment hold-up. Anticipate hold-up and choose contracts or organizational forms that minimize the costs of hold-up.

Once relationship-specific investments are made, parties are locked into a trading relationship with each other, and can be held up by their trading partners. Anticipate hold-up and choose organizational or contractual forms to give each party both the incentive to make relationship-specific investments and to trade after these are made.

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Title?

In summer 2007, Bert Matthews was contemplating purchasing a 48-unit apartment building.

The building was 95% occupied and generated $550,000 in annual profit.

Investors expected a 15% return on their capital

The bank offered to loan Mr. Matthews 80% of the purchase price at a rate of 5.5%

Mr. Matthews computed the cost of capital as a weighted average of equity and debt.

.2*(15%) + .8*(5.5%) = 7.4%

Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still break even.

Mr. Matthews decided not to buy the building. A good decision – one year later, the cost of capital was 10.125% and Mr. Matthews could offer only $5.4 million for the building.

This story illustrates both the effect of the bursting credit bubble on real estate valuations and, more importantly, the relevant costs and benefits of investment decisions.

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Background: Investment Profitability

All investments represent a trade-off between possible future gain and current sacrifice.

Willingness to invest in projects with a low rate of return, indicates a willingness to trade current dollars for future dollars at a relatively low rate.

This is also known as having a low discount rate (r).

Individuals with low discount rates would willingly lend to those with higher discount rates.

Discounting helps you figure out if future gains are larger than current sacrifice.

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Compounding

To understand discounting, let’s first look at compounding:

(future value, k periods in the future) = (present value) x (1 + r)K

Example: If you invest $1 (present value) today at a 10% (r), then you would expect to have $1.10 in one year.

In two years, $1 becomes $1.21 = $1.10 x (1+.1)

A good compounding rule of thumb: “Rule of 72”: If you invest at a rate of return r, divide 72 by r to get the number of years it takes to double your money

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Discounting

Discounting (the inverse of compounding):

Present value = (future value, k periods in the future)

(1 + r)k

Example: At a 10% r, $1 is worth:

Next year: ($1)/1.1 = $0.91

Two years: ($0.91)/1.1 =$0.83

Discussion: If my discount rate is 10%, would I lend to or borrow from someone with a discount rate of 15%?

What does this say about behavior?

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Example: Nashville Pension Obligations

The city of Nashville uses discounting to decide how much to save for future pension obligations.

For a pension that pays out $100,000 in 20 years, with a discount rate of 8.25% Nashville must save:

$100,000/(1.0825)20 =$20,485

If the city invests the $20,485 and earns 8.25%, then the savings will compound in 20 years – unrealistic!

Somewhat of high savings rate that may not be returned; however, a high savings rate means less current spending, which is politically popular

A more realistic (but less popular) discount rate would be 6.5%, which would lead to saving $28,380 now.