Assume a two-period world, perfect certainty, and perfect capital market. A firm has an initial endowment of $70 million. The firm has identified the following available investment opportunities:
| Proposal | Period-0 Outlay | Period-1 Return |
| P | $19.85 million | $20.86 million |
| Q | $12.33 million | $13.55 million |
| R | $13.84 million | $15.88 million |
| S | $10.18 million | $13.45 million |
| T | $9.68 million | $11.88 million |
These are not divisible projects, which cannot be invested in a fraction (the firm must invest 100 percent of each proposal or none of it). Assume that the average market rate of return is 11.7 percent.
(i) Which projects will the firm undertake to maximise the value of the firm? using IRR
(ii) If the firm undertakes projects that will maximise the value of the firm, how much money will it invest in period-0 (now)?
(iii) Does the firm need borrowing in period-0? If yes, how much? Why?
(iv) What period-0 dividend will be paid to shareholders (owners)?
(v) What will the period-1 (next) dividend be?
(vi) What is the Present Value (PV) of period-1 returns from optimum investment in (ii)?
(vii) What is the Net Present Value (NPV) from optimum investment in (ii)?
(viii) How will the value of the firm change due to the decision of optimum investment in (ii)?
(ix) How would your answers from (i) to (viii) above change if the firm had an initial endowment of $6 million only? Show your work.
In a two-period world with perfect certainty and capital markets, firms strive to maximize their value through strategic investment decisions. This essay explores the investment opportunities available to a firm with an initial endowment of $70 million. The firm’s objective is to identify the projects that will yield the highest Internal Rate of Return (IRR), leading to value maximization.
Project Selection Based on IRR
The firm evaluates five investment proposals, namely P, Q, R, S, and T. To determine the projects that maximize the firm’s value, the IRR of each project is calculated. Projects with IRR greater than the market rate of return (11.7 percent) are considered. After evaluating the IRR of each project, the firm will undertake those projects for which the IRR exceeds the market rate.
Initial Investment Amount in Period-0
Once the projects with IRR exceeding 11.7 percent are identified, the firm will invest the entire required amount in period-0. The sum of the initial outlays of the selected projects represents the amount the firm needs to invest in the present period to initiate these projects.
Need for Borrowing in Period-0
In some scenarios, the total initial outlay of the selected projects might exceed the firm’s initial endowment. In such cases, the firm would need to secure additional capital through borrowing to cover the investment costs. The borrowed amount would ensure that the firm can pursue all chosen projects and maximize value.
Period-0 Dividend to Shareholders
Before making investments, the firm might choose to distribute a dividend to its shareholders. This dividend payment can be determined based on the available funds after accounting for the required investment outlays and any potential borrowing. It’s important to strike a balance between retaining funds for investments and providing returns to shareholders.
Period-1 Dividend Projection
The period-1 dividend for the firm can be estimated by considering the returns from the selected projects. These returns will depend on the success and profitability of the undertaken projects. The firm would allocate the returns among shareholders based on its dividend policy and financial considerations.
Present Value of Period-1 Returns
To calculate the Present Value (PV) of period-1 returns from the optimum investment, the future returns from the selected projects are discounted back to the present period using the market rate of return (11.7 percent). This calculation provides insight into the potential value generated by the investments.
Net Present Value (NPV) from Optimum Investment
The Net Present Value (NPV) is calculated by subtracting the total investment outlay from the PV of future returns. A positive NPV indicates that the selected projects generate value above and beyond the initial investment costs, while a negative NPV suggests that the projects might not be worthwhile.
Impact on Firm Value
The decision to undertake the optimum investment projects in period-0 will likely lead to an increase in the overall value of the firm. The potential positive NPV signifies that the projects’ returns are expected to exceed the investment costs, contributing to enhanced shareholder wealth and firm value.
Alternate Scenario: Initial Endowment of $6 Million
If the firm’s initial endowment were reduced to $6 million, the analysis would need to be revisited. The projects’ initial outlays might need to be scaled down or selected more carefully to align with the available funds. This could potentially affect the project selection, investment amounts, borrowing requirements, dividend payments, and overall firm value.
In conclusion, the optimal investment decision-making process in a two-period world with perfect certainty and capital markets involves evaluating investment proposals based on their IRRs and aligning them with the firm’s initial endowment. This strategic approach aims to maximize the firm’s value by selecting projects that generate returns exceeding the market rate of return. The analysis takes into account various factors such as investment outlays, borrowing needs, dividend payments, and the impact on firm value, ultimately guiding the firm towards its value-maximizing investment strategy.
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