This is a part of upcoming series of posts on Real Estate Finance and Valuation.
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The primary goal of a company/firm is to maximize shareholders' wealth. As shown in figure 1, a firm makes two basic financial decisions:
- Investment decision
- Financing decision
Figure 1: Basic decisions of the firm
The outcome of these decisions impact the stock price, and thereby impacts shareholders' wealth. Lets consider the firm's Investment Decision. The investment decision is the answer to the question: what investment opportunities should the firm invest in? The firm needs to identify valuable investment opportunities.
Well, what is a valuable investment opportunity? How will the firm recognize one? What are its salient characteristics?
Suppose you were offered an opportunity to purchase a real estate property for $5,000,000 and you know that you can immediately sell it to another party for $5,500,000. You instantly recognize this as a valuable investment opportunity, because it worth more than its cost. The difference between the investment cost and its worth is the investment's impact on wealth. By purchasing a property in $5,000,000 that's worth $5,500,000 you have increased your wealth by $500,000 (profit). So we can identify a valuable investment opportunity by its monetary impact on wealth. Alternatively, we can also identify a valuable investment opportunity by the rate of return it offers on our investment.
So, how do we know if the rate of return offered by an investment is enough to make it a valuable investment opportunity.
To answer that question, let's introduce one of the most important concept in Finance, the Opportunity Cost of Capital.
Opportunity cost of capital:
The concept of the opportunity cost of capital is often misunderstood. The cost of capital is not the cost of the funds used to finance an investment. It is an opportunity cost of capital. It is the opportunity cost of investing the capital in an investment opportunity, and forgoing the return on an alternative investment in the financial market. Figure 2 explains this concept.
The outcome of these decisions impact the stock price, and thereby impacts shareholders' wealth. Lets consider the firm's Investment Decision. The investment decision is the answer to the question: what investment opportunities should the firm invest in? The firm needs to identify valuable investment opportunities.
Well, what is a valuable investment opportunity? How will the firm recognize one? What are its salient characteristics?
Suppose you were offered an opportunity to purchase a real estate property for $5,000,000 and you know that you can immediately sell it to another party for $5,500,000. You instantly recognize this as a valuable investment opportunity, because it worth more than its cost. The difference between the investment cost and its worth is the investment's impact on wealth. By purchasing a property in $5,000,000 that's worth $5,500,000 you have increased your wealth by $500,000 (profit). So we can identify a valuable investment opportunity by its monetary impact on wealth. Alternatively, we can also identify a valuable investment opportunity by the rate of return it offers on our investment.
So, how do we know if the rate of return offered by an investment is enough to make it a valuable investment opportunity.
To answer that question, let's introduce one of the most important concept in Finance, the Opportunity Cost of Capital.
Opportunity cost of capital:
The concept of the opportunity cost of capital is often misunderstood. The cost of capital is not the cost of the funds used to finance an investment. It is an opportunity cost of capital. It is the opportunity cost of investing the capital in an investment opportunity, and forgoing the return on an alternative investment in the financial market. Figure 2 explains this concept.
Figure 2: Residual cash flow of the firm (non-financial asset management)
The firm generates residual cash flow, which is the equity cash flow that belongs to the shareholders. The firm can pay it out to the shareholders as cash dividends or it can retain it in the firm. Suppose it paid out to shareholders as cash dividends. Shareholders can have investment horizons that extend over a number of years. So, when they receive cash as dividend from their investment they will re-invest the cash in order to earn a return on these funds over their investment horizon. Shareholders have access to financial markets and to the rates of return offered by the financial markets. So they can re-invest the cash in the financial assets and earn a return on financial assets.
Alternatively, the residual cash flow can be retained in the firm and managers can invest it for shareholders. But managers shouldn't invest that cash in financial assets (expect in case of financial asset management company). They are not paid to do what shareholders can do on their own. Shareholders don't need managers to invest in financial assets for them. They have access to the financial markets and can do that on their own. Besides, managers does not have any particular expertise in investing in financial assets. But managers have knowledge of their firms and industries and experience of development projects, and managing operations that produces good and services at a profit. So their particular expertise is in identifying investment opportunities in real productive assets. So if managers invest cash on behalf of shareholders they should invest in real assets and earn a return for shareholders from these real assets.
Now, which of the two will shareholders prefer. Should shareholders prefer cash and invest on their own in financial markets, or should they prefer managers to invest for them on real assets? Well it depends. It depends on the return managers can earn from the investment in real assets. Shareholders will prefer managers to invest for them only if managers can do better than they can do it on their own. That is if managers can earn a rate of return better than that is available on comparable (comparable in risks on future cash flow) investments in the financial market.
It means that the decision to invest or not invest in the investment opportunity depends on the rate of return from the comparable investment in the financial assets. Return on comparable financial assets form the financial standard against which the alternative investment is evaluated. Only if the return from the alternative investment beats the financial standard, you make the investment.
The return on financial assets is the opportunity cost in making the investment because return on financial asset is forgone if we make alternative investment. This is what is meant by the Opportunity Cost of Capital.
All investment are judged against their financial standards, i.e. all investments are judged against their opportunity cost of capital.
The important points to understand are:
So, what is a valuable investment property?
These two statements are identical. An investment worth more than its cost has a return greater than the opportunity cost of capital. An investment with returns greater than its opportunity cost of capital is worth more than its costs.
These are two definitions by which we can identify valuable investment opportunities.
In the next post we will discuss about some capital budgeting tools to quantify these two definitions.
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The firm generates residual cash flow, which is the equity cash flow that belongs to the shareholders. The firm can pay it out to the shareholders as cash dividends or it can retain it in the firm. Suppose it paid out to shareholders as cash dividends. Shareholders can have investment horizons that extend over a number of years. So, when they receive cash as dividend from their investment they will re-invest the cash in order to earn a return on these funds over their investment horizon. Shareholders have access to financial markets and to the rates of return offered by the financial markets. So they can re-invest the cash in the financial assets and earn a return on financial assets.
Alternatively, the residual cash flow can be retained in the firm and managers can invest it for shareholders. But managers shouldn't invest that cash in financial assets (expect in case of financial asset management company). They are not paid to do what shareholders can do on their own. Shareholders don't need managers to invest in financial assets for them. They have access to the financial markets and can do that on their own. Besides, managers does not have any particular expertise in investing in financial assets. But managers have knowledge of their firms and industries and experience of development projects, and managing operations that produces good and services at a profit. So their particular expertise is in identifying investment opportunities in real productive assets. So if managers invest cash on behalf of shareholders they should invest in real assets and earn a return for shareholders from these real assets.
Now, which of the two will shareholders prefer. Should shareholders prefer cash and invest on their own in financial markets, or should they prefer managers to invest for them on real assets? Well it depends. It depends on the return managers can earn from the investment in real assets. Shareholders will prefer managers to invest for them only if managers can do better than they can do it on their own. That is if managers can earn a rate of return better than that is available on comparable (comparable in risks on future cash flow) investments in the financial market.
It means that the decision to invest or not invest in the investment opportunity depends on the rate of return from the comparable investment in the financial assets. Return on comparable financial assets form the financial standard against which the alternative investment is evaluated. Only if the return from the alternative investment beats the financial standard, you make the investment.
Return on Real Assets > Return on Financial Assets
The return on financial assets is the opportunity cost in making the investment because return on financial asset is forgone if we make alternative investment. This is what is meant by the Opportunity Cost of Capital.
All investment are judged against their financial standards, i.e. all investments are judged against their opportunity cost of capital.
The important points to understand are:
- Managers are hired to earn return on investment better than the return shareholders can earn on their own in the financial markets.
- The returns in the financial markets provide a financial standard against which all investment opportunities are judged.
- The return forgone on a comparable investment in the financial market represents an opportunity cost of making an alternative investment.
- All investments are evaluated against their Opportunity Cost of Capital.
So, what is a valuable investment property?
- An investment worth more than its costs
- An investment with a rate of return greater than its opportunity cost of capital
These two statements are identical. An investment worth more than its cost has a return greater than the opportunity cost of capital. An investment with returns greater than its opportunity cost of capital is worth more than its costs.
These are two definitions by which we can identify valuable investment opportunities.
In the next post we will discuss about some capital budgeting tools to quantify these two definitions.
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All credits goes to Prof. Samuel Szewczyk, Drexel LeBrow College of Business.
