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This chapter begins the discussion of cost of equity estimation. Various economic theories postulate how the cost of equity is determined in capital markets. Tests of those theories have not yet resolved the matter. As a result, there are a number of methods that in practice are used to estimate the cost of capital. This chapter sets the stage by framing the problem and by addressing some implementation issues common to all models, for example, sample selection.

Mining companies are dependent on the successful execution and operation of capital projects. The choice of which projects to pursue and which to put on hold is therefore a critical strategic decision. This chapter provides an overview of the assessment and financing of capital projects. The first step in this assessment is to prepare the project financials, that is, the projection of the free cash flow over the lifetime of the project. The next step is the calculation of the decision criteria, such as payback period, return on investment, net present value, and internal rate of return. The final step is to recommend a decision based on these criteria, as well as on other factors such as strategic fit and risk. Funding for the project can come from the company's own ability to raise capital through equity and debt means or to raise substantial debt through legal structures such as project finance and nonrecourse finance.

In this paper we provide a model which describes how voluntary disclosure impacts on the timing of a firm’s investment decisions. A manager chooses a time to invest in a project and a time to disclose the investment return in order to maximise his monetary payoff. We assume that this payoff is linked to the level of the firm’s stock price. Prior to investing, the profitability of the project and the market reaction to the disclosure of the investment return are uncertain, but the manager receives signals at random points in time which assist in resolving some of this uncertainty. We find that a manager whose objective can only be achieved through voluntarily disclosing the return is motivated to invest at a time that would be sub-optimal for an identical manager with a profit maximising objective.

This chapter provides a survey of payout policy—the return of capital by firms to their equity investors through dividends and share repurchases. The modern study of payout policy is rooted in the irrelevance propositions developed by Nobel Laureates Merton Miller and Franco Modigliani. Payout policy is irrelevant when capital markets are perfect, when there is no asymmetric information, and when the firm’s investment policy is fixed. Relaxing these assumptions leads to a role for payout policy to control agency problems and convey information to investors. Although changes in dividend policy are associated with changes in firm value, there is mixed evidence regarding tax effects and little evidence that payout decisions are driven by motives to signal true firm value to investors. The evidence does support a link between payout decisions and conflicts of interest between the firm’s various claimholders. This chapter also surveys the evidence relating to share repurchases as an alternative form of payout and describes recent behavioral theories of payout policy.

Although accounting-based numbers will tend to generate misleading noise, for the purpose of investment that noise is certainly not the sole reason for the lack of alpha in traditional active fund management. Investing by numbers is not the favorite technique of investors. The framework of an economic model reduces the possibilities of speculation to a minimum and frames investment analysis within a narrow field. An economic model will characterize a company, any company except financial groups, with three endogenous and two exogenous variables: an amount of invested capital, a real growth rate, and a real cash return associated with this capital, complemented by an ambient expected return (cost of capital) and a market price. This chapter deals primarily with the three endogenous variables whose study is called “fundamental analyses.” The price of an asset is the result of an immensely complex process, which includes a good dose of randomness and behavioral patterns impossible to model.

Publisher Summary This chapter discusses the sources of return, how they are determined, and the assumptions required to use the process, and the results one might expect from using the process. The concept of total return is defined and developed. The interest rate (nominal annual rate compounded semiannually) that equates the present value of the final amount with the amount originally invested is called the rate of total return. The final, or total, amount in the fund includes the interest earned on the original investments, the interest earned on the reinvested interest, and the capital gain or loss when the investments mature or are sold at the end of the horizon. An investment fund has earnings from three sources: the interest earned, the interest on interest, and the capital gain or loss when the bonds mature or are sold, or the fund is dissolved. As the investment horizon increases, reinvestment rate generally becomes increasingly more important, and capital gain or loss becomes increasingly less important.

This chapter focuses on the financial analysis factors for a pollution prevention (P2) project. There are four financial analysis factors—payback period, internal rate of return, benefit-to-cost (B/C) ratio, and present value of net benefit. The payback period of an investment is essentially a measure of how long it takes to break even on the cost of that investment. In essence, the importance of lifecycle costing is lost in using the minimum payback-time standard, because it only considers costs and benefits to the point where they balance, instead of considering them over the entire life of the project. The term return on investment (ROI) is defined as the interest rate that would result in a return on the invested capital equivalent to the project's return. The B/C ratio is a benchmark that is determined by taking the total present value of all of the financial benefits of a pollution prevention or P2 project and dividing it by the total present value of all the costs of the project. Finally, the present value of net benefits (PVNB) shows the worth of a P2 project in terms of a present-value sum.

This chapter discusses the methods for interpreting financial information. The financial performance of any business is measured by a series of comparisons with other businesses, with trends over a time or with some accepted norm. The return on net assets (or capital) ratio is the key ratio. It should be as high as possible. One can improve it by managing assets efficiently—keeping them as low as possible—and managing profit effectively keeping prices as high as possible and costs as low as possible. Gearing measures the amount of borrowing a business has as a part of its total capital. If it gets too high it can prove fatal. The return to the shareholder measures how well the shareholders do from a business. If one can borrow at a rate of interest lower than the return on net assets it will be higher than the return on net assets and vice versa. The liquidity ratio measures how much cash and other liquid assets—debtors and stock—a business has compared to its current liabilities.

Publisher Summary The concept of human capital refers to the fact that human beings invest in themselves, by the means of education, training, or other activities, which raises their future income by increasing their lifetime earnings. The term investment refers to expenditure on assets that will produce income in the future and contrast investment expenditure with consumption, which produces immediate satisfaction or benefits but does not create future income. It is possible to measure the profitability of investment in human capital using the same techniques of cost benefit analysis and investment appraisal that have been traditionally applied to physical capital. The profitability, or rate of return on investment, is a measure of the expected yield of the investment, in terms of the future benefits or income stream generated by the capital compared with the cost of acquiring the capital asset. Explanations of the concept of human capital suggest that education or training raised the productivity of workers. Migration, as well as health care, can all increase earning capacity, and can therefore be regarded as investment in human capital.

The rate of return on invested capital is a widely used concept in both regulated and unregulated sectors of the economy. It provides a measure of actual performance as well as required or expected performance (the latter is often termed the "cost of capital"). In the utility field, regulatory agencies often focus on the rate of return as a major instrument for assessing and controlling the performance of firms under their jurisdictions. Unfortunately, two altogether distinct units are employed for measuring rate of return: (1) book rate units and (2) discounted cash flow units. Rarely will the two produce the same result, and the use of one measure as a surrogate for the other may prove highly misleading. This paper indicates the relationship between the two measures and shows the impact of some variations in depreciation and expensing procedures, growth rate, etc. The object is to point out the potential hazards associated with the use of measures of different things in a context that requires the use of measures of the same thing.

This chapter highlights the long-run distributional consequences of overseas investment. The key factor in the foreign investment process was the package of technical and entrepreneurial skills that accompanied the international movement of capital. Indeed, foreign investment has been regarded as one of the main vehicles for international transfer of technology in this broad sense. Accordingly, for purposes of aggregate analysis, it will be convenient to regard DFI as a combination of capital flow and technology transfer. In a more dynamic view, real foreign investment takes place as new capital goods are purchased by foreign subsidiaries from the output streams of both the host and home economies. The resulting changes in real capital stock in both locations will affect incomes, savings, capital formation, and local rates of return in subsequent periods—implying that additional rounds of capital movements and related adjustments must take place before the global economy is fully stabilized. In the long run, the current account, that is, net exports plus net earnings on overseas investment, must be in balance with new capital outflow from additional DFI. An important feature of foreign investment is that it generates higher corporate profits which are, in turn, a significant source of funds for investment that would not otherwise be available. This hypothesis raises at least the possibility that if the corporate savings propensity were high enough, the distributional effects on income from encouraging DFI would induce extra aggregate saving that would offset the adverse effects.

This chapter discusses the basic principles of investment appraisal. It presents an investigation of the different long- and short-term sources of funds available to a company so that an appropriate financing mix can be chosen. Funds can be used for either short- or long-term purposes. The short-term use of funds to build up stocks, provide customers with more credit, etc., is the subject of working capital management. The long-term allocation of funds to major capital investment projects is known as capital budgeting. An accountant distinguishes between revenue and capital expenditures. The former are charged against profits as soon as they are incurred; the latter are capitalized, shown on the balance sheet as fixed assets, and often depreciated over a period of time. Any long-term major allocation of funds is considered to be a capital investment.

Publisher Summary This chapter explains the cost-benefit model. Cost-benefit analysis is also known as rate of return analysis and is similar in principle to the procedure followed in ordinary investment project evaluation. The most important distinction is between a private and social rate of return. A private rate is estimated when the benefits and costs refer to the individual undertaking the investment. However, it is possible to relate the social costs and benefits of an educational activity, thus arriving at the social rate of return. If one accepts infinitely elastic demand functions for all types of labor, it follows that the elasticity of substitution between all pairs of skills and between labor and other factors of production is infinite as well. In other words, different amounts of labor skill mixes are consistent with the same relative wages and therefore the elasticity of substitution between the two kinds of labor is infinite. Rate of return analysis is based on observed market earnings. Therefore, for a social rate of return calculation one has either to assume that wages are equal to the value of the marginal product of labor, or apply shadow pricing.

This chapter reviews some techniques of financial analysis, which are applied to capital investment appraisal. Some of the financial information which are required in practice for capital investment appraisal include (1) the initial outlay on net operating assets; (2) future cash flow from operations; (3) the life of the project; (4) impact on taxation; including capital allowances, grants, and subsidies, and (5) an assessment of the riskiness of the project. The three methods used in investment appraisal are (1) payback method, (2) return on net assets (RONA), and (3) discounted cash flow (DCF). Payback method is the simplest of the three and it is the most widely used method in practice. Each of these methods suffers certain weaknesses and each method has certain unique advantages. The wise firm would use all three methods within its capital investment appraisal routines. After all, it represents relatively little cost and effort in the context of the whole project evaluation and might just prevent an expensive management mistake.

Publisher Summary This chapter emphasizes on return on capital employed. It is essential to remember that the real return on capital invested, as far as the ordinary shareholder is concerned, is the total profit of the particular year available for distribution, and not the amount actually distributed. Undistributed profits are the shareholder's savings; albeit involuntary due to a State policy of dividend restraint. It is the ratio of total profit to capital employed that indicates the comparative adequacy of the return the company is making on the capital that appertains to the shareholders. It is, of course, true that the main concern of the investor who buys in the market is the ratio that the annual dividend bears to the amount that he originally invested. If the company is continually accumulating reserves then this fact means that part of the investor's profit is being reinvested without his express authority, and he should expect a dividend which represents a reasonable return on this also. This applies to ordinary shares though occasionally preference shares do have a right to participate in the reserves. It is obvious that in considering the return on capital, present conditions make inter-company comparisons misleading.

Publisher Summary This chapter discusses the capital investment decision for accounting of business decisions. Capital investment is concerned with the allocation of resources to long-term assets in such a way as to optimize the return on the capital. The capital investment decision is important not only because it involves very large sums of money but also because the decision can influence the fortunes of the business for years to come. A company's funds come from a number of different sources—ordinary and preference shares, reserves, debentures, bank loans; each source has a cost, and the cost of the sources jointly is referred to as the company's cost of capital. Taxation affects the investment decision by reducing the cash flow left in the company's hands. A sophisticated method of investment appraisal that does not make use of probability is that of sensitivity analysis, which is a critical analysis of all of the factors associated with a particular project to establish how sensitive the net present value is to changes in any one of the variables.

This chapter focuses on the rate of return on capital employed, having defined this as the ratio that profits before tax bear to total share capital and reserves. The investor when he purchases shares in the market is interested solely in the return he will make on the money he pays for these shares. However, as at any particular time the cost of the shares is principally determined by the dividend paid or expected to be paid, there would be little advantage at this point in prowling through the records of the past in order to include in the table the rate which the dividend paid bears to the current market price. This would give the return which the public demands on that particular investment — taking into account various factors such as the risk element. There seems little point in discussing the position of each company separately at this point in as much as the information we have accumulated has not, except for the dividend position. It is best, then, to go on to the next problem, that being the incidence and proper treatment of depreciation reserves. It is a matter of some delicacy and the ideas used have no general acceptance at the present.

This chapter discusses the prospects for profits and stability in the fixed-base business. The attractiveness of a long-term investment in the fixed-base business should be judged on the assumption that virtually all the permanent capital in the business is provided by the proprietary investment rather than through the expedient of borrowed funds. From the point of view of long-term investment in this business, the characteristic 7% rate of return during the relatively easy 1946 and 1947 period does not appear especially attractive. Those few exceptional companies, which could earn close to 25% on their invested capital at least temporarily, offered the new investor a rate of return perhaps sufficiently attractive to offset the inevitable risks inherent in such a new and unproven type of business. For the great majority of fixed-base companies, however, earnings of from 5% to 10% on the invested capital are about as good as can be expected under even 1946 conditions. An analysis of the sources of recent profits for the fixed-base business has shown that the industry has been highly dependent on revenues from the subsidized GI flight training program. Except for a few unusually advantageous operations, the immediately foreseeable profit from the fixed-base business does not appear sufficient in itself to justify investment of the amount of capital needed to conduct the present size and number of fixed-base operations satisfactorily.

Publisher Summary This chapter discusses the theory of exploitative trade and investment policies. It is recognized in the classical doctrine that achievement of an international optimum would require not only a consensus as to the optimal distribution of output but also a willingness to implement that consensus by undertaking lump-sum redistributions of income. If the home country is a borrower and the foreign country specializes, it will be the home country's advantage to encourage the foreign country to withdraw some of its capital, as the resulting excess of capital in the lending country will lower its rate of return there, thus lowering the opportunity cost of borrowing capital. The rationale for taxing income from home capital invested abroad, or from foreign capital invested at home, is quite a different one when the foreign country diversifies. The cases in which the tariff rate and tax rate on income from foreign investment have opposite sign are termed as paradoxical.

Publisher Summary This chapter discusses investment. Speed of economic growth in non-totalitarian democratic states can only be realized by supplementing, with outside aid, the modest capital formation based on savings. Import of capital was the chief source for financing new investment. Public investment was an important stimulant and catalyst of private investment. Even the negative phenomenon of inflation, causing a flight from money to material assets, for a given period of time promoted the expansion of investment. A very large part of private savings went exclusively on financing the construction of houses. The substantial part of invested capital was derived from public sources such as reparations, the independence and development loans, gift funds, and foreign loans. Investment in industry and transport reflects the process of industrialization, and the somewhat low investment in commerce and services is an index of the structure of a segment of the economy, which is labor intensive and requires little capital. In Israel, the capital imported and available was ready to seize any opportunity for investment if only a market could be found.