AN INTRODUCTORY COURSECORPORATE FINANCE:AN INTRODUCTORY COURSEDISCUSSION NOTESMODULE #71THE JOURNEY CONTINUESI. A PAUSE TO REVIEW, REFLECT, QUESTION, AND INDICATE EXTENSIONS At this point, about midway through the term, let us pause to reflect on some of the implications and extensions of topics we’ve already covered.Recall from our discussion at the start of the semester that financial managers are preoccupied with two major types of decisions: - The Investment Decision, or decisions involving the size and composition of assets for the left-hand side of the firm’s balance sheet, and- The Financing Decision, or the composition of financing sources on the right-hand size of the balance sheet.The financial manager is also involved with two important second-order decisions: - Decisions involving net working capital management, or how the firm should manageits day-to-day cash account, other current assets, and current liabilities. In this sense, working capital management decisions involve elements of both the investmentand financing decisions. - Decisions involving dividend policy, which is a subset of the financing decision. Also recall that in making these decisions financial managers should adopt decision rules that haveone primary objective -- how will the decisions affect the wealth of the owners of the firm, or the stockholders? - Financial managers’ objective should be to maximize the wealth of the shareholders.In the context of making the investment and financing decisions with the objective of maximizing shareholder wealth, you were introduced to the concepts of asset valuation -- both real assets (left-hand side assets, both tangible and intangible) and financial assets (right-hand side assets). Recall that asset valuation, both real and financial, is tied to the following conceptual equation: Asset Value = f (Size, Timing, and Risk of the Cash Flows Generated by the Asset).1 This lecture module has been designed to complement Chapters6 and 7 in B&D.1Accordingly, you learned how to discount an asset’s after-tax future cash inflows, and compared the present value of the inflows to the asset’s cost, to establish whether or not to acquire the asset. If the PVs of the inflows exceed the PVs of the outflows, or the asset has a positive NPV, the asset should be acquired. Shareholder wealth will increase by the amount of the NPV.II. BUT, WHERE DO POSITIVE NPV PROJECTS COME FROM?In Chapter 7 of RWJ and Module #7, you learned about NPV and Capital Budgeting. However, you may not have spent much time thinking about how positive NPV projects can exist.In a perfectly competitive market for productive goods, would you expect to find positive NPV projects lying about in neat little piles just waiting to be “plucked” by the casual manager? Think about this question! Why haven’t a firm’s competitors already taken similar projects, or why haven’t these same competitors bid up the prices associated with the inputs for the project, e.g., materials and labor, such that the project earns a zero NPV? After all, this is the equilibrium process in a perfectly competitive market. Prices adjust until no “surplus rents” exist, in the language of economics or finance, until the rate of return actually earned is the minimum required rate of return which, or course, gives rise to a zero NPV project.One explanation for why positive NPV opportunities exist in real asset markets relates to the relative efficiency of the markets in which these real assets trade. I contend that real asset markets are much less efficient than the capital markets, where financial assets trade. Barriers to entry, high transaction costs, patent protection, regulatory restrictions, imperfect information, oligopolistic industries, asset illiquidity, etc., are common to real asset markets. As we will soon see, these market imperfections are much less severe or nonexistent in the capital markets.However, upon reviewing a project that apparently has a positive NPV, managers should ask themselves what it is about this project that produces a positive NPV. In general, if the firm participates in a competitive market, managers should be suspicious of calculations that indicate a project has a positive NPV. The managers should ask, “what are the possible sources of value in the project?” Skepticism should rule the day!We will conclude that manager’s can and do find positive NPV investment projects. Uncovering these investment opportunities in real assets is the financial manager’s main contribution to creating value (wealth) for their shareholders. Conceptually, the idea is that managers should take actions to shift the investment opportunity curve upward and to the right, creating incremental wealth for the shareholders.Here are some specific ways that positive NPV projects can exist or be created:- Hire innovative employees and provide then with incentives to be creative in developing ideas for revenue enhancement, cost reduction, product innovation, research and development, etc. (e.g., General Electric),- Introduce a new product (e.g., Henry Ford’s introduction of the internal combustion engine for automobiles, Apple Computer’s introduction of the personal computer, or 2Jake Burton’s introduction of snowboards,- Develop a core technology (e.g., Honda’s mastery of small-motor technology, or 3 M’s mastery of sandpaper technology, which later developed into products which range from abrasive wheels to the ubiquitous “post-it” notes), - Create barriers to entry (e.g., Alcoa, AT&T, Polaroid, and Merck monopoly positions often resulting from patient protection), - Introduce “tweaks” to an existing product that increase demand (e.g., Royal Crown Cola, the first diet cola, or Chrysler’s introduction of the minivan!), - Create product differentiation by aggressive advertising and marketing (e.g., Coke’s “It’s the real thing,” and Chevrolet’s “Like a Rock”),- Utilize organizational innovation (e.g., Motorola’s use of “just-in-time” inventory management, Amway International, Tupperware, and Mary Kay Cosmetics innovative “multi-level marketing systems),- Other?Keep in mind, however, that we don’t expect positive NPV projects to come easily for a firm in a competitive industry. As mentioned above, managers should be skeptical when presented with an attractive (+NPV) project. Is the source of the positive NPV forecaster optimism, computational