Tag Investment

What investors are looking for in a business plan?

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Focus on why venture may fail. When investors consider a business venture they focus on why this particular new business venture may fail. This is in comparison to the perspective of the entrepreneur who focuses mainly on why this particular venture will succeed.

Main concerns of investors: It is important to clearly address areas that investors are looking for first and foremost. This includes whether the product or service will be accepted by the market as well as potential demand for the product or service. The calibre of the management team and critical risks are also of vital importance to prospective investors. Investors also look for honesty and transparency in the way information is presented to them.

Short, simple and to the point: Investors receive a lot of business plans. Therefore, generally, investors will spend only five minutes briefly looking through the business plan to determine whether this particular plan deserves more time investment for exploration.

Investors usually briefly consider new business opportunity by the reading executive summary or by listening to in-person presentations by entrepreneurs. If within five minutes the opportunity does not seem to be promising, investors will likely to move on to another opportunity.

Therefore, it is vital to be well prepared. An executive summary must highlight all important details why this opportunity is promising. Presentations by the entrepreneur should be concise, to the point and first focus on what investor is most interested.

Value credibility: When an opportunity is presented to an investor in person or via a business plan, the fact whether the investor feels he or she can believe entrepreneur or not will play an important role.

Perceived credibility of an entrepreneur influences the interest of the investor. If the investor will not believe an entrepreneur’s claims and will see entrepreneur as not being trustworthy, the investor most likely will not do business with such an entrepreneur even if the opportunity is promising. Therefore, it is imperative to provide factual support for any claims made in the presentation to the investor, verbally or in writing. The plan should include realistic sales projections and profit margins which are aligned with average figures for the industry, with the exception where the opposite can be factually supported.

High level of preparation: Investors want to see the entrepreneur thoroughly researched the opportunity and considered all important areas.

Value passion: Investors look for passionate entrepreneurs. Investors often invest in entrepreneurs and the management team rather than the business opportunity itself.

After investing: After an investor provides funds to help establish a new business venture, it is imperative to act with integrity and follow through the business plan as agreed at the commencement of the relationship between an entrepreneur and investor. Furthermore, an entrepreneur should monitor actual performance against performance standards and milestones to ensure that he or she stays on track. In building relationship with the investor, it is advisable to follow the simple rule of under promising and over delivering instead of the opposite, which is more customary. Also, the entrepreneur can only control what he or she can control. However, as long as the entrepreneur remains true to his or her word and acts with integrity – natural setbacks and troubles should not be a problem with investors as they usually understand that in the turbulent start-up enviornment setbacks and troubles are inevitable.

 

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External sources for financing Pearlparadise.com

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Let’s use Portia as an ongoing example. Portia can consider using external financing, which refers to funds invested by outside investors and lenders. External financing is divided into equity and debt financing. Portia can either borrow money with the agreement to repay the borrowed sum plus interest or can obtain funds in exchange for equity, or use a combination of equity and debt financing.

Portia can consider debt as a source of external financing. Debt financing increases her financial risk because debt must be repaid regardless of whether or not the firm makes a profit. If debt is not repaid according to an agreed upon schedule, creditors may even force the enterprise into bankruptcy. Alternatively, equity investors are not entitled to more than what is earned by the enterprise.

When borrowing from the bank, an entrepreneur has number of options. The following types of loans are generally available:

Lines of credit – this is when bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed, but only in place if the bank has sufficient funds available. Such agreement is generally made for a period of 1 year.

Revolving credit agreement – this is similar to the lines of credit but the amount is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such arrangement is generally more expensive for the borrower.

Term loans – such loans are generally used for the financing of equipment. The loan is generally corresponds to the useful life of the equipment.

Mortgages – such loans are long-term loans and are available for purchase of the property which is used as collateral for the loan.

Portia can also consider equity financing. Private equity investors include venture capital firms and business angels. Venture capital firms raise a fund and then select portfolio of businesses in which to invest. Portfolios generally include start ups and existing businesses.

In exchange for investment, venture capital firms obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred. This is because the venture capital firm would like to have the senior claim on assets in case of liquidation but still wants to have an option to convert it to common stock if the business becomes successful.

Business angels, which are also referred to as informal venture capital, are wealthy private individuals who invest in the firms in their individual capacity. A very small percentage of start ups manage to get such funding. Therefore, entrepreneurs should have other options available as well.

There are also government supported financing options available to Portia which are specific to Portia’s location.

Further, Portia can use personal sources of funds. The “personal” sources could be personal savings, credit cards, borrowing from friends and relatives or any other way of obtaining money such as selling an asset, such as a car or a summer house, to free up funds for investment in the enterprise.

Personal savings are usually the leading source of “personal” funds. Credit cards are often used but needed to be used with extreme caution as interest rates on outstanding amounts can be incredibly high.

Borrowing from friends and family is also very tricky and should be done with extreme care. If Portia’s business fails or does not perform as expected and money is not repaid when agreed than it can destroy or severely damage relationships. When borrowing from friends and family, it is a good guideline to ensure that it is seen as an investment rather than a gift by the lending side of the transaction. An agreed upon deal should be put in writing since memory is not always reliable. Moreover, the amount borrowed should be repaid as soon as possible.

Overall, Portia has a number of the sources of external financing to choose from. Portia needs to evaluate upsides and downsides of each option and consider all options in light of the unique situation of the business to choose the best option or combination of options.

 

Types of Risks

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Below we describe types of risks:

Inflation risk – refers to risk that money today will not worth as much tomorrow, or in a year. Many safe investments, such as fixed deposits offered by banks do not keep pace with inflation.

Opportunity risk – risk that a safe investment that is undertaken will lead to the loss of additional return that could have been earned if money were placed into a better investment.

Concentration risk – risk of putting entire funds into one investment such as an investment in one’s own business or investment in shares of a specific company. If such an investment will not yield the return that was expected than there is no other investment that could make up for such loss.

Interest rate risk – risk that interest rates will fluctuate with adverse effects on the company. For example, an adverse effect those changes in interest rates can have on servicing debt.

Marketability risk – refers to risk that marketability of the investment may turn out to be low. It refers to the chance that if the need arose to sell the investment in a timely manner, there will be no ready market to sell it to.

Credit risk – refers to possibility that the borrower will not be able to meet its obligations as it comes due.

 

The Hurdle Rate

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The hurdle rate is also called minimum acceptable rate of return (abbreviated MARR) or break-even yield. It refers to the minimum rate of return that is required before any project can be undertaken. The hurdle rate is used in the capital budgeting and is the same as the required rate of return in the discounted cash flow analysis of long-term investment opportunities. It is a discount rate used when different investment alternatives are considered.

If the expected return on the proposed investment is below the hurdle rate, than the investment is not acceptable and vice versa. Sometimes the hurdle rate also refers to the minimum internal rate of return (IRR) for the project to be undertaken.

The hurdle rate should be equal to the marginal cost of capital, which is also referred to as the incremental cost of capital. The hurdle rate is also a rate of return which is necessary to maintain market value of the firm. The market value of the firm refers to the firm’s current market price of shares.

Organizations use hurdle rates to evaluate long-term investment projects using discounted cash flow techniques (capital budgeting). This allows assessing potential projects more systematically. Such evaluation allows having better confidence that selected long-term investments will at least have returns equal to the marginal cost of capital.

Hurdle rates should be set for each project or at least for each business unit or division to account for differences in risk profiles across the enterprise.

 

Residual theory of dividends

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Residual theory of dividends purports that dividends must only be distributed after firm undertakes all acceptable investments. To determine whether any retained earnings are left to be distributed to shareholders, the three steps described below are undertaken.

Step 1 – The optimal level of capital expenditures is determined by finding the intersection between the investment opportunities schedule and the weighted marginal cost of capital schedule.

Step 2 – Taking into account the optimal capital structure proportions, the amount of financing that must come from equity is determined.

Step 3 – Retained earnings are used to cover necessary expenditures in proportion to a company’s capital structure equity percentage. If retained earnings do not cover the portion that must come from equity then new stock is issued.

The dividends are only distributed if retained earnings were enough to cover the equity portion of the investment (the second portion of investment is covered by debt) and only if there are any funds left in the retained earnings after investment expenditure is covered.

The residual theory of dividends also implies that if companies do not have investments with internal rate of returns (IRR) higher than weighted marginal cost of capital (WMCC) or Net present value (NPV) higher than zero than all retained earnings should be distributed as dividends.

Test yourself:

ABC Company has a capital structure of 35% of debt and 65% of equity. ABC’s retained earnings in this financial period are $2,000,000. The new investment required, which were determined by the intersection of IOS and WMCC, is $2,400,000. Determine if ABC will be able to distribute any dividends.

Solution:

The funds required to cover new investment is $2,400,000. The amount that must come from equity is $2,400,000*.65=$1,560,000. The rest of the amount, which is $840,000 (2,400,000-1,560,000) will come from debt. The ABC Company has $2,000,000 of retained earnings. Since only $1,560,000 is required to cover portion of funds that must come from equity, $440,000 (=$2,000,000-$1,560,000) is left in the retained earnings and can be distributed to shareholders as dividends.

Test yourself:

BCD Company has a capital structure of 35% of debt and 65% of equity. BCD’s retained earnings in this financial period are $1,000,000. The new investment required, which were determined by the intersection of IOS and WMCC, is $2,400,000. Determine if BCD Company will be able to distribute any dividends in this financial period.

Solution:

The funds required to cover new investment is $2,400,000. The amount that must come from equity is $2,400,000*.65=$1,560,000. The rest of the amount, which is $840,000 (2,400,000-1,560,000), will come from debt. The firm has $1,000,000 in retained earnings. The additional common stock needs to be issued to the amount of $560,000 to obtain enough funds that must come from equity. Since retained earnings were completely used to cover the expenditures associated with investment, there can be no dividends that BCD Company can distribute to shareholders during this financial period.

From the above two examples it is evident how under the residual theory of dividends, dividends are only distributed if there is any money left in the retained earnings after all acceptable investments are undertaken.

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Weighted Marginal Cost of Capital (WMCC) and Investment Opportunities Schedule

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By finding all break points, we can construct the weighted marginal cost of capital – WMCC – schedule. (WMCC) schedules show the relationship between the level of total new financing and a company’s weighted average cost of capital.

Thereafter, we can construct the investment opportunities schedule (IOS), which is a graph where the business’s investment opportunities are ranked based on their returns and financing required, arranged from the highest returns and all the way to the lowest returns. It is the decreasing function of the level of total financing.

If we combine the weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS), we can use it to make investment decisions. The rule is to invest in projects up to the point on the graph where marginal return from investment equals its WMCC (where IOS=WMCC).

All projects on the left of the point where IOS=WMCC will maximize shareholders wealth and all points on the right of the point where IOS=WMCC will decrease shareholders’ wealth.

It is important to note that the majority of firms stop investing before the marginal return from investment equals its weighted marginal cost of capital (WMCC). Therefore, the majority of businesses prefer a capital rationing position (the position below the optimal investment budget, which is also called the optimal capital budget).

Test yourself

ABC Company has to make an investment of $1,000,000. The long-term debt weight in the capital structure is 35%. ABC has $700,000 of retained earnings but 50% of it must be paid to common stock shareholders in the form of dividends. Preferred stock is currently not used as a source of finance by ABC.

What are the weights that ABC will have for each source of capital?

SOLUTION:

Firstly, we need to find out how much of retained earnings ABC has left after payment of dividends to shareholders: $700,000*0.5=$350,000.

Therefore, the weight of retained earnings is 35% ($350,000 out of $1,000,000).

$1,000,000-$350,000 (35%, funds available from long-term debt source) – $350,000 (35%, funds available from retained earnings) = $300,000 (30%)

Therefore, the weights are as follows:

Long-term debt – 40%

Retained earnings – 35%

Common stock – 30%

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Capital Rationing

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Many firms operate under capital rationing. Firms ration capital because more often than not firms do not have unlimited funds to invest. Therefore, not all acceptable projects can be actually accepted. This is, of course, contradictory with goal of maximizing shareholders value.

We can formally define the rationing of capital as follows: It is a situation when firms do not accept all acceptable projects due to a limited amount of funds or due to limits imposed on investments. The goal is to select portfolio of projects with the highest net present value.

Under situations involving scarce capital, businesses will select a portfolio of projects with the highest NPV and which does not exceed the allocated budget. There are two commonly used techniques to select projects in these situations, the net present value NPV approach and the internal rate of return (IRR) approach.

The IRR approach graphs return against the total investment on the investment opportunities schedule (IOS) and by drawing the budget constraint shows the group of projects that are acceptable to be invested in. The NPV approach ranks projects by IRR and than generates a portfolio of projects with the highest overall present value.

When selecting projects, the net present value (NPV) approach is preferred because it maximizes shareholders’ returns whereas an internal rate of return (IRR) approach just generates a portfolio of acceptable projects.

 

Risk Adjusted Discount Rate: Dealing with Risk in Capital Budgeting

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Breakeven cash inflow analyses, risk adjusted discount rate (RADR) and scenario analyses are tools that facilitate better insight into managing risk in capital budgeting.

Risk in capital budgeting especially refers to variability of the returns (variability of cash inflows), because the initial investment is more or less known with some level of confidence. Therefore, we need to ensure that present value (PV) of cash inflows will be large enough to ensure that project is acceptable.

To adjust the present value of future cash inflows for risk embodied in particular project, we can either adjust cash inflow directly or we can adjust the discount rate. Because adjusting cash inflow is highly subjective, we will rather adjust discount rate. This is when risk adjusted discount rate technique comes into play.

RADR is a discount rate that must be earned to compensate an investor for the risk undertaken. Under RADR the value of the firm must be at least maintained or must increase. Risk adjusted discount rate is the most popular risk adjustment technique that utilize NPV.

The higher is the risk of specific project, the higher RADR will be.

The deployment of RADR is best illustrated by the use of an example:

EXAMPLE

Amanda can invest in two shares, A and B. Both shares presently cost $50 and Amanda wants to hold shares for 4 years. Annual dividends from share A expected to be $7. Annual dividends from share B are expected to be $12. However, shares B are more risky. In 4 years time Amanda expects to be able to sale shares A for $55 each and shares B for $70 each. Amanda’s required return is 8%. However, for shares B she adjusts her return so that her risk adjusted discount rate becomes 12%. Calculate risk adjusted net present values (NPVs) of shares A and B and recommend which shares should Amanda purchase.

Solution:

We will use financial calculator to find risk adjusted net present values (NPVs) of shares A and B.

Risk adjusted NPV of shares A:

Clear calculator: second function, C ALL

CFo: -50

CF1: 7

CF2: 7

CF3: 7

CF4: 62 (7+55)

I: 8

Second function, NPV: $15.38

Risk adjusted NPV of shares B:

Clear calculator: second function, C ALL

CFo: -50

CF1: 12

CF2: 12

CF3: 12

CF4: 82 (12+70)

I: 12

Second function, NPV: $30.94

Since investment in shares B offers higher risk adjusted NPV, Amanda should choose to invest in shares B.

The main difficulty in using risk adjusted discount rate (RADR) technique is in determining level of risk and approximating an appropriate risk adjusted discount rate (RADR). There is currently no systematic way to adjust required return to risk adjusted discount rate (RADR). Management usually determines risk adjusted discount rate (RADR) subjectively.

Sometimes risk index is determined which reflects risk adjusted discount rate (RADR) for every subsequent level of risk. For example, risk can be categorized into below average, average, above average and very high. Past experience and CAPM can be used to subjectively determine the risk adjusted discount rate (RADR) appropriate for each subsequent level (category) of risk.

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Initial investment in capital budgeting decisions

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Within context of capital budgeting decisions, initial investment refers to the cash outflow at the beginning of the project and is calculated by taking the total cost of the new asset (cost plus all expenses required to make asset operational), less after-tax proceeds from sale of the old assets and further adding or subtracting change in the net working capital, as shown below.

Initial investment (Initial cash outflow) determined as follows:

Total cost of the new asset (cost plus installation)

Less: After-tax proceeds from sale of the old asset (proceeds from sale of the old asset less cost of removing asset less tax on sale of the old assets.

Less or Add: Change in net working capital

Tax on the sale of the old asset is only paid if the asset sold for more than asset’s book value. Book value of an asset refers to the total cost of the asset (cost of the asset at the time it was purchased + installation cost) less accumulated depreciation.

Accumulated depreciation refers to the collective depreciation of an asset up to a point under consideration. For example, if asset were bought exactly 5 years ago, than accumulated depreciation will include sum of individual depreciation amounts for each of the five years.

If the asset sold for more than its book value than any value above original total cost of asset referred to as capital gain and any value above book value and up to original total cost of asset referred to as recaptured depreciation.

If asset is sold for less than book value than tax credit is generated, provided the country specific legal requirements for such tax credit to be effective are met.

As stated above, an initial investment is affected by the change in net working capital. This occurs because organization’s working capital requirements will change if project will be undertaken and it should be incorporated into calculations. A change in net working capital is calculated as change in current assets (e.g. accounts receivable and inventories) less change in current liabilities (e.g. accounts payable and accruals).

If net working capital increased (increase in current assets larger than increase in current liabilities) than we treat it as cash outflow and add it to the initial investment amount in calculation of the initial cash out flow. This is because the company’s investment in current assets increased due to the new project being undertaken. Therefore, it is an additional cash outflow.

If, however, an increase in current liabilities was higher than increase in current assets (if net working capital decreased) than we subtract this change in net working capital from the initial investment amount in calculating initial investment (outflow at time zero).

Commonly, there is an increase in net working capital (cash outflow) at the beginning of the project life. Such cash outflow is recovered at the end of the project when the terminal cash flow is calculated.

When determining cash flows we also need to consider opportunity and sunk costs.

Opportunity costs

Opportunity costs refer to the cash inflows that could have been earned in case of alternative employment of the asset. Therefore, it should be taken into consideration when determining cash flows.

For example, if success of the proposed project requires use of the equipment which organization already owns, the usage of equipment should be considered as a cost as if it would have to be bought or rented. Moreover, if such equipment could generate higher cash inflows in alternative use than this also should be incorporated.

Sunk costs

Sunk costs refer to the costs associated with the asset which is already was incurred in the past and cannot be recovered in spite of whether the particular project is undertaken or not.

An example of sunk costs is the feasibility study cost or marketing expenses which were already incurred for the project. In other words, any past costs that were incurred are not pertinent. Since sunk cost cannot be recovered – it should not affect decision regarding whether proposed project should be undertaken. In other words, sunk costs are not taken into account when cash flows for the potential project are calculated.

***

An understanding of how the initial investment is calculated is an important first step in understanding how to properly make capital budgeting decisions. Make sure you gained a good understanding of concepts discussed above before moving on to further sub-sections on capital budgeting decisions.

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