Managerial Economics/Investment and innovation

Capital Expenditure Decisions

Capital expenditure is a cash purchase of assets expected to generate future cash flows that extend beyond a one-year period. It is different from a normal operating expenditure, which is expected to result in cash flow within a one-year period. Examples of capital expenditures include land, buildings, machinery, business vehicles or intangible assets (such as a licence or patent). Capital expenditure is important as it has a long-term impact on the future of a firm; determining what products will be produced, markets that will be entered, the location of plants and facilities, and the type of technology that the firm will use. Therefore, capital expenditures need to be carefully thought through and analysed as they are costly decisions and are usually more costly to change. (James R. McGuigan, R. Charles Moyer, Frederick H. deB. Harris 2013)

Capital Budgeting Process

Capital budgeting is the process a firm uses to plan and evaluate capital expenditures. Capital budgeting techniques can be used, in addition to firm expansion and asset replacement decisions, to also analyse research and development expenses, investing in education and training for employees, lease-vs-buy decisions, and potential mergers and acquisitions. (James R. McGuigan, R. Charles Moyer, Frederick H. deB. Harris 2013)

The process of selecting capital investment projects consists of the following important steps:

1. Generate alternative capital investment project proposals.

New capital investment ideas can originate from multiple revenues, inside and outside the company. Proposals can be initiated at different levels in the firm, from contract workers to the board of directors. Often, medium and large-sized firms consist of departments whose job involves studying and finding capital expenditure projects. These departments include cost accounting, industrial engineering, marketing research, research and development, and corporate planning. (James R. McGuigan, R. Charles Moyer, Frederick H. deB. Harris 2013)

2. Estimate cash flows for the project proposals.

Research has shown that a relationship exists between the presentation of financial information and user decisions. Whilst earnings are very important, investors perceptions of cash flow information has increased significantly and is useful in the assessment of financial decisions. When estimating the cash flows, it is useful to follow certain basic guidelines. Firstly, cash flows should be measured on an incremental premise. This means that the difference between the cash flows streams to the firm with and without acceptance of the investment project, should be represented in the cash-flow stream for that project. Secondly, use the firm’s marginal tax rate to measure cash flows on an after-tax basis. Thirdly, all indirect effects of the firm throughout the firm should be incorporated in the calculations for cash-flow. If a department is considering a capital investment that will change other department’s revenues or costs, these external effects should then be included in the cash-flow estimates. Fourth, when evaluating the project, sunk costs should not be considered. Sunk costs are expenditures that have been made and cannot be avoided; hence, they should not be considered when deciding whether to accept or reject a project. Lastly, opportunity costs should be used to measure the value of the resources used in the project. Opportunity cost is the value of a resource’s next best alternative use. (James R. McGuigan, R. Charles Moyer, Frederick H. deB. Harris 2013)

3. Evaluate and choose investment projects to implement.

After identifying the capital expenditure project and the cash flows have been estimated, a decision needs to be made whether to accept or reject the project. Accepting the project would mean a cash-flow stream to the firm – series of either cash inflows or outflows in future years. A project will typically see an initial outflow (first-year investment), followed by a series of cash inflows (returns) over a number of succeeding years.(James R. McGuigan, R. Charles Moyer, Frederick H. deB. Harris 2013)

4. Review

Finally, after the investment project has been implemented a review must be completed to ensure the accuracy of assumptions. Any inaccurate assumptions should be modified and noted for similar future investment projects. (James R. McGuigan, R. Charles Moyer, Frederick H. deB. Harris 2013)

Estimating Cash Flows

When estimating Cash Flows some basic guidelines are helpful:

1. Cash flows should be measured on an incremental basis (It should represent the difference between the cash-flow streams to the firm with and without acceptance of the investment project)

2. Cash flows should be measured on an after-tax basis, using the firm’s marginal tax rate.

3. All indirect effects of the project throughout the firm should be included in the cash-flow calculations.

4. Sunk costs should not be considered when evaluating the project (Sunk costs = Costs that has already been incurred and cannot be recovered)

5. The value of resources used in the project should be measured in terms of their opportunity costs.

In a typical investment project, an initial investment is made in year 0, generating a series of yearly net cash flows over the life of the project (n). The net investment (NINV) of a project is defined as the initial net cash outlay in year 0, including the acquisition cost of any new assets plus the installation and shipping costs and tax effects.

The incremental, after-tax net cash flows (NCFs) of a particular investment project is equal to cash inflows minus cash outflows. These could be defined as the difference in net income after tax (ΔNIAT) with and without the project plus the difference in depreciation (ΔD):

                        NCF = Δ NIAT + ΔD

ΔNIAT is equal to the difference in net income before tax (ΔNIBT) times (1 – T), where T is the corporate marginal income tax rate:

                       ΔNIAT = ΔNIBT (1 – T)

ΔNIBT is defined as the difference in revenues (ΔR) minus the difference in operating costs (ΔC) and depreciation (ΔD):

                       ΔNIBT = ΔR – ΔC – ΔD

Substituting some equations, the net cash flow could be yield as follows:

                       NCF = (ΔR – ΔC – ΔD) (1 – T) + ΔD

Investment Projects Evaluation

In capital budgeting, there are various approaches that can be used to evaluate a project. In order to determine whether or not to invest in a project, qualitative methods namely Internal Rate of Return (IRR) and Net Present Value (NPV), can be used. Other relevant investment criteria include the payback period and the average accounting return. The payback period determines the point in time when the firm will have generated enough cash to cover the cost of investment, and the average accounting return measures return using book values as opposed to market values. As long as the the cash inflows and outflows are known or accurately estimated over a number of years, the value or return of the project can be determined. An investment project is usually incurs a negative cash flow in the first year, known as the cost of investment. Then, during the following years, the investment typically generates positive incomes known as returns.

Net Present Value (NPV)

Net present value (NPV) can be defined as a tool to calculate the the present value of the cash inflows (returns) and outflows (costs) of a project over it's working life, with a required rate of return. A positive NPV of a project denotes that the stream of revenues generated from the project exceeds the cost of the project while also being discounted at the required rate of return. This then infers that a project with a positive NPV is profitable and should be accepted. If a project has a predicted negative NPV then the project will not be profitable and should not be accepted by the firm. The NPV is the main deciding factor when a firm is considering whether or not to accept a project and is a more important consideration than the IRR. The calculation for NPV is seen below.

$NPV=\displaystyle \sum _{t=1}^{n}{\frac {NCF_{t}}{(1+k)^{t}}}-NINV$

where;

NCF, is the net cash flow at time t,

NINV, is the net investment,

k, is the required rate of return,

n, is the expected working life of the project,

Time inconsistent preferences

When given a choice between getting $10 right now or $12 in a week, many people chose to take $10, even though the amount they could get if they waited would be higher. This can be explained because, for most people, the $2 difference is not worth waiting a week for. However, when given the choice between $10 in a week and $12 in 2 weeks, people tend to change their mind and go for the second option. In both cases, individuals chose between $10 or $12 a week later. The choice should, therefore, be the same. Conversely, is that the first scenario lets individuals chose between a reward in the present or one in the future. The second one only allows for future rewards. The shift in people's choice shows that preferences can be inconsistent through time. One way to explain this is through the concept of present bias. Present bias is the assumption that people are more impatient if benefits or costs are immediate. Procrastination and self-control problems can be explained using time-inconsistent preferences. For example, when you decide on a Monday that you will go to the gym on Friday, you have made this decision because you know that the benefits outweigh the costs. However, once you get to the end of the week, your decision may change because you actually have to face the costs of going to the gym. This time-inconsistent behaviour cannot be explained using an exponential model, because exponential discounting does not account for present bias. However, the use of hyperbolic discounting functions can help shine a light on this phenomenon. This bias can be accounted for via the use of a discount factor which makes it possible to explain why an individual can change their opinion between time periods.

Benefits

1. Quantified cash flow

- NPV will only consider the visible money value flow of the project. It can help the decision-makers to understand how much actual money they can earn.

2. Considering time value of money

- The advantage of using the NPV method over IRR is that NPV can handle multiple discount rates as a year's cash flow can be discounted separately from the others. NPV will be adjusted by the discount rate to affect the future cash flow to the value of today. It can help the decision-makers know about the whole project’s income as of today's value.

The NPV is primarily used to determine whether an investment such as a project, merger or acquisition will add value to a company. Positive net values will ensure shareholder satisfaction, whereas negative values are not feasible.

Weakness

1. Difficult to determine the discount rate(cost of capital)

- The cost of capital is a vital component in the NPV. Wrongly estimate the discount rate to lead the NPV error and not reliable.

2. Does not available to make the decision without comparison to another project.

Internal Rate of Return (IRR)

IRR is a method of project evaluation which calculates the interest rate where the NPV of all project’s cash flows is equal to zero. In other-words, given the initial investment, the IRR is the discount rate/interest rate needed for the project to breakeven. It is an annualised rate that ranks prospective projects. A project is more attractive when its IRR is higher than the other comparable options. When the market’s opportunity cost (the project’s cost of capital) is lower than the estimated average return (IRR) on a project, at a similar maturity period and risk, the project should be undertaken. In contrast, when the cost of capital is higher than the IRR, the project should be turned down. However, IRR may provide misleading investment decisions as the IRR rule may disagree with the NPV rule due to certain situations such as delayed investments (positive cash flows precede negative cash flows), non-existent IRR, multiple IRR and comparing projects with different scale, timing and risk. in this case (when the rules conflict), the NPV decision rule should be followed.

The calculate the IRR the following equation is used:

$NPV=\displaystyle \sum _{t=1}^{n}{\frac {NCF_{t}}{(1+r)^{t}}}-NINV$

Where;

NCF, is the net cash flow at time t,
NINV, is the net investment

n, is the life of the investment

r, is the IRR

Benefits

1. Easy to understand

IRR is defined as an easy method to calculate and provides a simple way to compare the value of the various projects under consideration. IRR provides for the small business owner which capital projects will provide the greatest potential cash flow. It can also be used for budgetary purposes, such as providing the potential value of buying new equipment or cost savings, rather than repairing old equipment.

（There is no need of the pre-determination of cost of capital or cut off rate.）

2. Considering the time value of money

Time value of money is the basic concept of finance. Money has a time value, which is based on people's desire to obtain money now rather than in the future. Therefore, when money is used for saving or investing, it should earn interest. In this way, the future value of money should be greater than the present value

3. IRR provides for maximizing profitability.

IRR is able to correlate the lifetime return of a project with the total amount of investment, indicating the maximum return that can be made on the project. To compare IRR with the industry benchmark return on investment then can determine whether the project is worth the investment.

Weakness

1. As discount rates change substantially over time, IRR does not account for this, therefore this is not an adequate method for long term projects where discount rates are volatile.

Example: A one year T-bill returned between 1% and 15% in the last 20 years, evidently the discount rate is varying.

2. IRR only can show one constant Cost of borrowing of the whole project

IRR can not present the changing of the cost of borrowing during the cash inflow and outflow and it also does not represent the rate of return.

Therfore, IRR calculations are ineffective when a project has a mixture of both positive and negative cash flows. This could be the case if a firm has to redesign the brand every few years in order to remain competitive and trendy in the evolving market.

3. For the IRR to be a valid method to evaluate a project it must be compared to a discount rate, therefore if this is not known, then the IRR bears no value. Hence, if the IRR is above the discount rate, the project is deemed practical and if it is below the discount rate, then the project is not feasible.

4. Ignoring the risk of the investment project.

IRR assumes the NPV is equal to 0 to calculate the cost of borrowing. But NPV set the cost of capital which considered the risk of the investment project. In contrast, IRR has ignored the risk to reflect the projects.

5. IRR focuses on profitability, not on the early recovery of capital expenditure. Also, IRR sometimes prefers projects that take longer to recoup capital expenditure. With uncertainty in the future, following IRR may not recoup all capital expenditure.

Problems with discounting

1. The first problem is the determining of the discount rate, to be sued either to calculate the NPV or to be compared to the IRR. Defining this as the opportunity cost of capital gives some insight but is of limited value since the opportunity cost is essentially subjective, depending both on the circumstance of the investor and the investors view of these circumstances.
2. The opportunity cost of capital used for investment is dependent on both the method of financing that investment and the degree of risk associated with that investment.
3. The treatment of uncertainty is another concern; if the alternative to investing in risky productive assets is investing in risk-free financial assets, the discount rate for productive assets will exceed the interest rate on financial assets by a margin determined by the attitude towards the risk of the investor.

Conclusion: NPV vs IRR

The above discussion provides a detailed analysis on NPV and IRR. The table presented below provides a brief analysis defining the key differences between the two.

	Net Present Value Method (NPV)	Internal Rate of Return Method (IRR)
Decision Rule	It the projects NPV is zero or positive accept the project i.e. if the NPV of cash flows is greater than the required net investment	If the IRR is greater than or equal to the cost of capital of the firm accept the project
Benefits	Takes into account the timing of the cash flows An objective is specified Criteria regarding whether to accept or reject a project	The meaning of IRR is simple to interpret Takes into account the timing of the cash flows An objective is specified Criteria regarding whether to accept or reject a project
Weaknesses	The meaning of NPV is somewhat difficult to interpret	The decision outcome can sometimes disagree with the NPV Problems with multiple rates of return

Estimating the Cost of debt

The cost of debt faced by a firm is the rate of interest that it pays on loans and bonds. Riskier firms tend to have a higher cost of debt due to a higher premium to compensate for the additional risk by the debtholder.

The following formula is used to calculate the cost of debt

ki=kd(1-T)

With;

ki, is the after tax cost of debt

kd, is the pre tax cost of debt

T, is the firms marginal tax rate

An example of how a firm raises debt capital is shown below. Assume Disney sells $100 million worth of 7% corporate bonds at par value. If the corporate tax rate is equal to 30%, then the after-tax cost of debt is equivalent to:

= 7*(1-0.3) = 4.9%

The cost of debt is usually influenced by a firm’s credit rating. Credit ratings range between AAA and D. For instance, again using Disney from the example above, Standard and Poor’s currently assigns it a credit rating of A. Any rating above BBB- is classed as an “investment grade”. 

Estimating the Cost of capital

The cost of funds supplied to a firm are known as the cost of capital. The cost of capital can be comprised of both debt and equity components, and forms the minimum rate of return that must be earned on new investments. The debt component (or the cost of debt capital) is the rate of return required by investors, whereas the equity component (or the cost of internal equity capital), is the rate required by the firm's stock investors. Firms raise equity capital through retained profits or the sale of shares, while debt capital is raised through loans or the issue of debt instruments such as bonds. The proportion of debt and equity form the company's target capital structure, and are used to calculate the weighted cost of capital figure. This figure is used to determine a discount rate to use when evaluating proposed capital expenditure projects.

Both the net-present-value and the internal-rate-of-return methods result in identical decisions to either accept or reject individual projects. NPV is greater than 0 if and only if the IRR is greater than the required rate of return k.

For example:

Two projects: X and Y are mutually exclusive, requiring both same net investment but different cash flows over the years. If:

IRR: Project X > Project Y --> Project X is preferred

NPV: Project Y > Project X --> Project Y is preferred

In this case, it is necessary to determine which of the two criteria is the correct one to use. The outcome depends on what assumptions the decision maker chooses to make about the implied reinvestment rate for the net cash flows generated from each project.

The NPV method assumes that cash flows are reinvested at the firm’s cost of capital, while the IRR method assumes that the cash flows are reinvested at the computed IRR. In general, the cost of capital is considered to be a more realistic reinvestment rate than the computed IRR because it is the rate the next marginal investment project can be assumed to earn.

Cost of Equity Capital

The cost of equity capital, to the firm, is the equilibrium rate of return required by the firm's common stock investors. Firms can raise equity capital in two ways:

1. Internally: through retained earnings

2. Externally: through the sale of new common stock.

The cost of internal equity to the firm is less than the cost of new common stock because the sale of new stock requires the payment of flotation costs. Flotation cost is the total cost incurred by a firm offering its securities to the general public. The concept of the cost of equity can be developed using several different methodologies, including the dividend valuation model.

The cost of external equity is greater than the cost of internal equity because of two reasons. First, associated flotation costs with new shares are generally so high that realistically, it cannot be ignored. Secondly, the selling price of new shares to the public need to be lower than the market price of the stock before the new issue is announced, if not the shares may not sell. Before being announced, the current market price of a stock usually represents the supply and demand equilibrium. If supply increase, ceteris paribus, the new equilibrium price will be lower. (James R. McGuigan, R. Charles Moyer, Frederick H. deB. Harris 2013)

Cost of Equity Capital and Capital Asset Pricing Model

The cost of equity capital for a particular firm is often estimated by reference to the Capital Asset Pricing Model (CAPM). The CAPM is a useful framework for substantiating cost of equity assumptions used in valuations that may otherwise be arbitrary (e.g. 10% or 15%). The model is expressed as follows:

Cost of equity capital = risk-free rate + equity beta * (market risk premium)

The risk-free rate is the return on an investment that presents (virtually) no risk of default. Government bonds are typically used as a proxy for a risk-free asset.

The equity beta measures the risk of a firm relative to the market. For example, a beta above 1 indicates that the firm faces greater risk than that of the market and are more exposed to economic conditions (e.g. technology stocks, tourism-related companies). Meanwhile, a beta below 1 indicates that the firm is less risky than the market as a whole (e.g. water and energy utilities, telecommunication companies etc.). Beta can be estimated by looking at other similar companies that are listed on the stock market.

The market risk premium (MRP) is the return (in excess of the risk-free rate) required by investors in the market as a whole. The cost of equity capital reflects the forward-looking rate of return required by investors, so past performance is not necessarily an indicator of future performance. However, extensive research has been undertaken into estimating historical returns. Jorda et al. (2019) estimate real rates of return for equity for a broad sample of countries, including Australia. For the post-1950 sample, the real rate of return on equity was 7.53%; for the post-1980 sample the real rate of return on equity was 8.70%. This compared to real rates of return on equity for the United States of 8.89% and 9.31% for the post-1950 and post-1980 periods, respectively.

Dividend Valuation is a measurement of estimating the cost of equity capital of a firm. A firm's value, such as the wealth of the shareholders, is equivalent to the firm's future dividend payment's present value, discounted at the required rate of return of the shareholders.

Weighted Cost of Capital

Firms calculate their cost of capital to determine a discount rate to use when evaluating proposed capital expenditure projects. As the purpose of a capital expenditure analysis is to determine which proposed project a firm should actually undertake, it is logical that the capital whose cost is measured and compared with the expected benefits from these projects should be the next capital the firm raises. Typically, companies estimate the cost of each capital component as the cost they expect to have to pay on these funds during the coming year. Additionally, a firm normally does not specify the proportions of debt and equity financing for each individual project. Instead, each project is presumed to be financed with the same proportion of debt and equity contained in the company's target capital structure. Therefore, the appropriate cost of capital figure to be used in capital budgeting is not only based on the next capital to be raised but also weighted by the proportions of the capital component in the firm's long range target capital structure. This figure is called the weighted cost of capital. A formula for the weighted cost of capital is shown by:

WACC=(E/V)*Ke+(D/V)*Kd

Where E: Equity fraction of capital structure

     D: Debt fraction of capital structure

     V: Firm value where E + D = V

     Ke: Cost of equity capital

     Kd: Cost of debt capital

Eg. Telstra has a target capital structure of 40% equity and 60% debt. A new project is planned to be financed with $50 million of retained earnings and $80 million of long-term debt. The cost of equity is 10% and the cost of debt is 8%. The corporate tax rate is 30%. Applying the WACC formula gives:

WACC = 0.4 * 10% + 0.6 * 8% * (1-0.3) = 7.36%

Cost-Benefit Analysis (CBA)

Cost-Benefit Analysis (CBA) is a tool used to identify, measure and compare the implications of a project from a social benefit and cost perspective. CBA can also be used to assess on-going and existing projects, and whether suggested improvements or alternatives are economically justifiable. Finally, CBA is useful as a policy intervention to guide firms and decision-makers in making more informed decisions by accounting for externalities . Shadow-pricing is often used within CBA to account for externalities which are traditionally not awarded a monetary value. By accounting for shadow pricing CBA is able to provide a greater level of detail to decision-makers which may not be accounted for in a financial analysis. Equivalent annual cost (EAC), net present value (NPV) and internal rate of return (IRR) are critical tools used in conjunction with a CBA for decision-makers to determine whether an investment is viable.

Steps in Cost-Benefit Analysis

The general principles of cost-benefit analysis may be summarised by answering the following set of questions:

1. What is the objective function to be maximised?

2. What are the constraints placed on the analysis?

3. What costs and benefits are to be included, and how may the be valued?

4. What investment evaluation criterion should be used?

5. What is the appropriate discount rate?

Constraints in Cost-Benefit Analysis

Although a project may seem attractive if its benefits exceed the costs, it does not necessarily mean it will be implemented. This is because of the following constraints as defined by James McGuigan in 2014 (McGuigan et al, 2013):

1. Physical Constraints

Physical constraints refer to the limitations imposed by the current state of technology and production inefficiencies. An example of this could be skin cancer treatment. As there is currently no cure for skin cancer, an emphasis must instead be placed on early detection and treatment.

2. Legal Constraints

Legal constraints refer to laws pertaining to the project under consideration. Examples of legal constraints could be the necessity of a government permit to build a hospital, or the illegality of marijuana preventing someone from farming it.

3. Administrative Constraints

Although a program may be conceived as extremely attractive, effective implementation of such a program requires individuals with a mix of the required knowledge and administrative skills to carry it out. Due to administrative constraints, even some of the best conceived projects may fail if the individuals involved lack the proper skills to implement it effectively.

4. Distributional Constraints

Distributional constraints refers to the discrepancies of gains and losses distributed to all parties involved with a project. When the distributional impacts of a project are a concern, the constraint imposed on the project will be making sure the benefits-less-costs for a particular group (usually the group who benefits the least from the project) reaches a desirable level.

5. Political Constraints

Political constraints are imposed when the feasibility of a project may be at risk due to the inefficiency of the political process. This can be caused by a ruling government being unfriendly to a given business or by the processes themselves within a given government.

6. Financial or Budget Constraints

Although a project may seem desirable if its benefits exceed costs, it may not be feasible if it is not actually affordable. Therefore the budget/financial constraint imposed requires maximising benefits of a project with a fixed budget.

7. Social or Religious Constraints

Different societal and religious beliefs may impose constraints which will restrict the potential feasibility of a project. An example of this would be attempting to build a residential development on land reserved for wildlife protection.

Cost-Effectiveness Analysis

Cost-effectiveness analysis is a tool used by public decision makers to assist in the allocation of resources when benefits, in monetary terms, are not simply quantified but the costs, in monetary terms, can be quantified. When governments are determining the feasibility of a potential investment such as programs that result in health, safety and well-being benefits, it is difficult to measure the benefits of a project if they are not monetarily based. In this situation, it is much more useful to use cost-effectiveness analysis to determine the expected payoff of the project. There are two main approaches to determining the feasibility of a project with non-monetary benefits:

1. Least-Cost Approach - This method focuses on achieving a certain level of output/result using the least amount of money. For example, a government may want to reduce crime by 10% and wants to figure out the best policy to achieve this. While it is difficult to determine the monetary benefit from the reduction in crime, the government can evaluate the best option by comparing the expected costs of different policies;
2. Objective-Level Approach - The other way to conduct a cost-effective analysis is to use an objective-level approach. This method compares the cost of achieving different levels of the same objective. For example, if the government wants to reduce emissions given a certain budget, it can estimate the cost of reducing different levels of emissions. This technique can illustrate the relationships (linear/exponential) between emission reduction and the cost of the endeavour.

From: McGuigan, J, Moyer, C, & Harris, F 2013, Managerial Economics : Applications, Strategies and Tactics, Cengage Learning, Andover. Available from: ProQuest Ebook Central. [16 October 2019].

Categorisation of Costs and Benefits within a CBA

In the private sector, firms are traditionally governed by the notion that revenue must be equal to or greater than expense in the long-term for the firm to be profitable and survive, this is known as profit-and-loss accounting. Cost-benefit analysis is based on the same principle with two key differences, firstly, the analysis is implemented from the point of view of society, not a firms bottom line. Cost-benefit analysis’s ask the question whether society as a whole will benefit or not benefit, from the adoption of a specified project. Secondly, the benefits and costs measured are not as static as revenues and expenses, benefits and costs do not have to be directly quantifiable and can also be based on assumptions rather then pure facts. Because of this it is possible to evaluate benefits and costs into three forms, direct, indirect and intangible. It is also important to note that because the recommendations of cost-benefit analysis’s can be based off assumptions, sensitivity analyses of key assumptions must always accompany CBA’s.

Direct Costs

Direct or primary costs are generally quite easy to measure and report. They are costs that are necessary for the project to be undertaken and are directly tied to the production of goods or services. They may include capital costs, such as land, buildings and materials incurred throughout a project, ongoing operating and maintenance costs or employee wages. For example, direct costs involved in the construction of a dam would include: materials, equipment, labourers and operators’ wages and machinery.

Direct Benefits

Direct or primary benefits can be more difficult to recognise then direct costs as they are not as easy to quantify. Direct benefits are the value of goods and services produced by a project compared to the benefits before the project was built. Using the example from above, if a dam was constructed and the water used for crop irrigation, the direct benefit of the project would be the value produced by the irrigated crops minus the expenses incurred producing the crops (e.g. equipment, labour, seeds).

Indirect Costs and Benefits (Real and Pecuniary)

Any project invariably creates indirect or secondary costs and benefits, and indirect effects may be categorized further into real or pecuniary effects. Indirect costs and benefits are effects caused by the project, which are not the express purpose of the project. Real, indirect costs and benefits are effects which, despite being indirect cause actual, quantifiable impacts that were not present before the project. For example, a real indirect benefit is the reduced amount spent in the healthcare system on supporting smoking relating to illnesses due to a campaign aimed at reducing smoking. Similarly, a real indirect cost would be damaging to an endangered species as a result of a new housing development.

Pecuniary costs and benefits should not be included in a cost-benefit analysis. They are costs or benefits which arrive due to a project; however, rather than being created due to a new project they have merely been distributed from another project or location. For example, upgrading an existing highway may increase the traffic and business for shops along that highway as motorists opt to take the upgraded route. However, the increased business is only at the expense of businesses along the alternative highways. Therefore, the benefits have not been created but only distributed from another location.

Intangible Costs and Benefits

The last type of costs and benefits are intangibles, these are categorised as impacts resulting from a project which are close to impossible to quantify. Therefore, the cost/benefit is not represented by a single dollar value, instead intangibles are quantified by the extra increase or decrease in known quantities which is caused by incrementally changing a related tangible cost/benefit. An example of an intangible cost would be a if a company’s product caused a consumer to get sick and the consumer sued the company. Expenses the company pays, such as settling the lawsuit represent tangible costs, however the damage to the company’s reputation represents an intangible cost.

The Appropriate Rate of Discount

For comparison purposes, the costs as well as the benefits are to be discounted to a mutual time for any given program (AKA the time value of money). As many individuals desire current consumption as the measurement, rather than future consumption, discount rates are usually configured to fit that preference. The percentage rate of return that the goods being used in the project would otherwise give in the market is the correct discount rate for the evaluation of a project.

The appropriate choice of discount rate for the evaluation of public investments is crucial to conclude to any type of cost-benefit analysis. A particular chosen discount rate influences whether or not the project will be accepted or rejected. For example, if a justified 5% discount rate is selected, then a higher rate of 15% may indicate a gross misallocation of resources. High discount rates favour projects who received benefits shortly after the initial investment, however, a low rate favours an investment opportunity that has a high project lifespan such as a “brick and mortar” type of business.

In addition, differentiating between the public and private sector can be determined by the chosen discount rate. The appropriate discount rate will indicate which resources belong in which sector. If resources can earn 10% in the public sector, then they should not be transferred into the private sector to invest their resources. In the case of a government project, the right discount rate will reflect directly as the percentage rate of return where the resources utilized would otherwise provide in the private sector. (McGuigan, 2013)

While the discount rate is a useful tool, it should not be considered the be all and end all of project viability.

Present Value of Perpetuity

Financially speaking, a perpetuity is an annuity, aka, a monetary instrument which supplies a never-ending stream of cash flows. It is calculated to find a company’s future cash flow’s present value, when discounted back to a certain rate. Although set payments are used, the value of the perpetuity can differ over time as the discount used may change. The formula used to determine the present value of a perpetuity includes dividing cash flows by some specific discount rate. An example of a perpetuity flow being used in finance is within British issued bonds (consols). When an individual purchases a bond through the British Government, they are then entitled to receive continuous (never-ending) interest payments. Though slightly illogical, there is a finite present value in countless cash flows. As the value of money changes overtime, the infinite payments made will decrease in value.

PV of Perpetuity = Σδ^t x d_t = d/r for a constant dividend rate.

where

PV = Present value

d = Dividend per period

r = Discount rate

δ = 1/(1+r) = Discount factor

Discounting functions

The ‘Discount function’ is a function used in economic models to understand the different weighted values given to rewards set at different periods of time. Usually in finance, this process is most commonly modelled using exponential discounting. However, studies have shown that individuals can deviate from their initial preferences from the continuous discount rate given in exponential discounting, and therefore hyperbolic discounting can be a more appropriate model.

Exponential discounting , which is a specific system of the discounting function, decreases value by a fixed given percentage over any period of time. This means that the preference of any two rewards does not change, regardless of the time leading up to obtaining these rewards. Therefore, the rate of discounting is not affected and does not change with time such as hypobolic discounting is.

Hyperbolic discounting on the other hand, shows the change in preference over the period of time. Originally, a larger reward with a later obtainment may be preferred over a more immediate smaller reward, however, as the smaller reward lures closer, the individual may then decide to choose the closer/smaller reward as the rate of discounting changes with time to reward.

Time inconsistent preferences refers to how the different decision-making preferences of an individual become inconsistent over time as the different ‘selves’ of an individual make different decisions. For example, one day a person may be given the option to receive a $50 gift card at the end of the week, or a $100 at the end of the month. Initially, the person may pick the $100 gift card at the end of the month as they value the higher payment at that time, however, as time gets closer to the end of the week, the individual may change their mind and take the more immediate reward. Therefore, time-inconsistent preferences cannot be explained by exponential discounting, rather hyperbolic discounting can be used to understand this occurrence.

Save More Tomorrow

Recently, individuals have been placed in control of savings decisions affecting their retirement. These type of savings decisions are in reality highly complex as they involve distinct levels of self-control and forward planning. Hence, these types of decisions can be assisted through guided plans and consistency of saving.

For example: In the US multiple companies have gone from a defined-benefit system to a defined-contribution system. This allows individual employees to make decisions about their retirement funds, however many people are short-sighted and do not make these contributions.

SMarT (Thaler & Benartzi, 2004)

Thaler and Benartzi (2004) created a program known as Save More Tomorrow (SMarT) utilising behavioural economics in order to assist people in saving for the future. The initiative was formed to address and overcome many of the following behavioural biases that individuals have a tendency to pertain:

1. Loss Aversion

Loss Aversion (associated with Prospect Theory) refers to an individual's irrational preferences, emphasising the high amount of psychological pain associated with losing something compared to the proportionally smaller amount of happiness received by gaining an equivalent amount - losses hurt roughly twice as much as gains yield pleasure. For example, if an individual receives a £300 bottle of wine, they will gain a small amount of happiness (utility). However, if that individual bought a £300 bottle of wine and then dropped it, they would place a heavier weight on the loss compared to the gain. Empirically speaking, it has been proven in studies that people weight losses almost twice as heavily as they do equivalent gains. Loss aversion tends to affect savings as households get used to a certain level of disposable income, and any reductions in this value are seen as a loss.

2. Hyperbolic Discounting

Hyperbolic Discounting is defined as people's myopic preferences to place a higher value on short term gains compared to larger rewards received at a later date. This is a widely accepted irrational preference that is taken into account in all forms of future Cost-Benefit Analysis. Discount Factors (or Discount Rates) are applied to future gains in order to estimate their reduced present value, with a 7% per annum rate being the standard normally applied . For example, consumers may have a preference of receiving 40 dollars today compared to 50 dollars next week.

3. Procrastination

Defined as the tendency to put off and delay something that needs to be completed, usually unpleasant tasks. From a behavioural economics standpoint, it can be viewed as a result of irrational consumers time-inconsistent preferences, a notion closely associated with both loss aversion and hyperbolic discounting. Procrastination can be considered a direct result of an individuals tendency to place greater weight on current satisfaction than on future satisfaction. The most common examples experienced include quitting smoking, eating healthier, beginning an exercise regime or saving more money for the future. As all of these examples display higher future gains than what present satisfaction can account for. Individuals procrastinate because they (falsely) think that whatever they will be doing later will not be as important as what they are doing now. The more naive the individual, the more pronounced the tendency to procrastinate. There is considerable evidence showing that people display time inconsistent behaviour specifically weighing current and near term consumption especially heavily.

4. Inertia

Procrastination produces a strong tendency toward inertia. Inertia is defined as ones tendency to remain unchanged or to do nothing, and is closely associated with maintaining the status-quo bias. For example, when a decision cannot be made and you are left within inaction.

5. Status-quo Bias

The tendency to favour decisions that maintain the status quo (i.e., the existing state of affairs). Those affected by this bias choose not to divert from established behaviours unless there is compelling incentive to change. For example, people often leave their money in low-yield savings accounts. This status quo bias leads people to maintain their financial situation as it currently is, rather than taking a the initiative to improve their financial outlook. Some firms may promote free for trial is another example taking advantage of this bias.

Four Main Processes of the SMarT Program

1. Approaching Employees - A considerable time prior to scheduled pay increases, employees were approached about increasing their savings contribution rates. Separation of dates between schedules pay increases and approaching employees was used to account for hyperbolic discounting. Where the gap between should be as long as feasible.

2. Increase in Contribution - For employees who decided to join, their contribution according to the plan was increased at the beginning of their fist pay check after a pay rise was done. This mitigates the perceived loss aversion of a cut in take home pay.

3. Continued increase in Contribution - The contribution rates then would continue to be raised according to a scheduled raise put in place. This would occur until the contribution reached a pre-set maximum. Here, status quo bias and inertia work toward keeping people in the SMarT plan

4. Opt Out - During the implementation of the initiative employees were told that they were allowed to opt out of the contribution schedules at any time. This was also to help insecurities about joining the program.

SMarT Findings

Overall, the study found that individuals who implemented the SMarT program were able to increase savings the most, over time. This was opposed to other individuals who followed financial consultants advice or followed their own intuitive saving methods. Individuals who did not acknowledge the complex behavioural biases in making such savings decisions ultimately recorded lower contributions as time progressed.

It is distinct that a prescriptive savings program aids individual in making savings to their retirement fund. Helping individuals to consistently save and decrease the behavioural biases that cloud peoples thinking.

Type of Research

Comparison	Basic Research	Applied Research
Meaning	Refers to the study that is aimed at expending the existing base of knowledge	Designed to solve the specific and practical problems or answer certain questions
Nature	Theoretical	Practical
Application	General	Limited
Concerns	Developing existing knowledge and predictions	Developing technique skills
Goal	To add some knowledge to the existing study	To find out solutions for the current problems

Basic Research

Basic research is designed to drive curiosity and public interest via a scientific question. Conventionally conducted within universities the basic research aims to expand knowledge and understanding. An example might be examining how coffee/caffeine consumption impacts students' study efforts. Discoveries founded from pure basic research were not intended to hold commercial value. Researchers believe all branches of research depend on some level of basic research to drive knowledge and understanding. In principle, basic research is essential in assisting the development of applied research.

To summarise, basic research is not applicable in the real world. The philosophy used within basic research is predominately theoretical in nature. It uses advanced scientific knowledge of a natural phenomenon. The benefit provided by using a basic research approach is increased flexibility to control over variables. However, results may be subject to biases and human error.

Applied Research

Applied research is used to solve practical problems via developing new products and processes. Applications of applied research vary greatly and include business optimisations and improving the human condition. A motivation for firms to conduct applied research is the possibility to profit from product developments and patents.

It is used to answer any particular and specific questions so as to solve any problems that firms/ society/ business organisations may have. This is possible as it has real world application and is present in most industries, for example, the medical industry. There are a few advantages of applied research; these include resolving issues that arise in our everyday lives, developing innovative technology that can possibly reduce business costs, and even curing illnesses when used in the medical industry. Some disadvantages of applied research also include results being only limited to the problem that was researched on. It can also be rather inflexible with tight deadlines to get results causing inefficiencies and a decrease in quality of work produced.

Reasons to Invest in Research

Investing in research and development (R&D) is one of the many strategic decisions made by firms that consume current resources to generate future returns. An obvious posited difference in risk-taking is evident from who’s perspective is considered. Shareholders, i.e. Owners, implore participation in projects with a positive NPV. Whereas CEO’s and managers ration projects from their current appetite for risk. Hence management decisions might conform to the majority and sacrifice profitable projects (Rashad, 2014).

From a holistic standpoint, firms seek to ensure their survival in a continuously changing market. Research is required to retain or increase their current market share and profit margins. In the long run, it is imperative for firms to invest in research to maintain a competitive edge. Research can allow for innovations to occur, which can give firms an advantage should they choose not to share their findings through patents, copyright protection, trade secrets, etc. The patentability of an innovation is not guaranteed, however, as it depends on its subject matter, utility, novelty and non-obviousness.

It is worth highlighting, that another crucial reason for investing in research, is to for companies to be more aware of their competitive landscape. In this way, organizations will be able to optimize their decision making. As a result, they can be more efficient on their internal operations and also be one step ahead from its competitors.

Why Invest in Research

For Firms

1. Increase future revenue

R&D efforts may result in patents, trademarks and copyrights which can be used to create new or improved products and help the business achieve long-term profitability. To ensure profitability, the firm must first undertake a cost-benefit analysis to find the net present value of any research endeavour, if the net present value is positive, firms can expect increased future profits. Many long-term investors will seek out companies with aggressive R&D efforts, as this can be an indicator of increased revenue in the future.

2. Ensure future survival

Through R&D, firms are able to gain a competitive advantage by developing competencies that its competitors are unable to easily replicate. These competitive advantages help ensure the firm can fight off attackers and maintain market share in their industry. Examples of R&D based competitive advantages are innovations which provide increased productivity or the development of a new product.

3. Increase market Share

New and innovative products created through R&D and protected by patents or copyrights can create a competitive edge which firms are able to exploit in order to increase their market share. This is beneficial for firms as increased market share can build their market power, build a strong consumer base and help create barriers to entry for new competitors.

4. Buyouts

Investing in research and development can allow a firm to come across a good innovation or idea which then either be monetized, or in the case of many smaller companies which don't have the capital to actually proceed with monetizing their research findings. The good idea can be sold to companies with this ability for large sums of money. This is especially common with companies finding new software features or easily licenseable products.

General reasons When their is incentive to innovate, and usually this incentive is monetary related, firms will always be participating in research and development. Potentially designing and creating new products in any market or optimizing and enhancing previous technology or processes used within a firm all have extreme monetary value and always have a positive effect on a firm's future.

For Universities

There is no exact answer for this question. However, the following are common factors considered by most universities:

1. Reputation of the university (market share)

2. Future student admission (survival)

3. Having adequate academics for innovation as well as understanding innovations done by other scholars from other universities. (Ability for future development)

4. Increase in knowledge and ideas that lift innovation and productivity in the firms

5. Increase the knowledge and idea generation of university graduates

6. Create proximal benefits with ideas and knowledge that spill over due to a mix of formal and informal interactions between firms and universities

7. Ensure growth of direct commercial activity, increasing income generated directly by universities

8. Generate partnership interest from companies that partake in similar research and development directions. (Gain internship or long-term reputation surplus)

9. Attracting more research grants. For instance, UQ ranks at the top in the research of the mining industry. A high reputation helps UQ to attract more research funds for the mining industry from public or private companies.

Innovation

Innovation describes firms producing novel products or services that give them an edge on competitors. For example, Apple, a highly innovative firm, developing the iPhone, which completely revolutionized what a phone could be. Information goods are non-rival and, in-principal, nonexcludable. An innovative company or innovative entrepreneur may generate higher profits and return.

Reasons to Encourage Innovation

Innovation gives firms an edge on competitors and ensures products and services remain unique. Consistent innovation is an efficient way to prevent competitors from copying designs and ideas and draws the consumers attention to market leaders. Reasons for innovation include:

1. Patents: Awards monopoly rights for 17-20 years(ie:medicine)

• Allows publication of research findings that lead to further innovations.
• Patent rights(for certain applications) can be transferred.

2. Copyright protection: Pertains to books, brand names, and the media.

3. Companies also have their own trade secrets that give them an edge for future innovation. This information needs to be kept secret to prevent other companies negating the advantage, this could be recipes or formulas. An example of such would be:

• plant breeders'right: it is the right granted to breeders who are developing new plants. It allows exclusive sales of varieties and allows farmers to reuse seeds.

4. Prizes: may be awarded to innovators who find a technical solution to a problem.

Advantages of innovation

First-mover advantage: it is the profit gain by first opening a market niche or to explore new technology.It can gain sustainable competitive advantage by establishing themselves before other competitors of the industry enter to the market.

1. learning curve: firm may gain advantage in selling more in early periods than its competitors and achieve lower costs than its competitors.

2.reputation: firms with innovation may gain advantage in raising reputation and competitiveness, which can further strengthen market position. It has potential to leave a lasting impression on the customer, which lead to brand recognition and brand loyalty.

Patentability

A patent is a form of intellectual property granted by a government authority or licence conferring a right or title for a set period of time that gives its owner the legal right to exclude others from selling, making, importing or using an invention

An innovation is patentable if it meets the relevant legal conditions to be granted a patent. However, not all innovations are patentable:

The threshold requirement for patents

1. Patentable subject matter

It is important to know if your invention is patentable or not. For example:

Patentable

• New products like toys, tools, medical devices, pharmaceutical drugs
• New process, like a manufacturing process or an industrial method
• Composition of matter, a compound created through two or more elements
• Improvement, requires novel or improved element in a known invention

None-patentable

• Non-functioning products
• Mathematical algorithms or models
• Informative presentations, such as plans or schemes for performing mental task
• Immoral inventions and software/business methods that are not technical thus non patentable
• Principles or theories

2. Utility, usefullness

In this case, not only is it necessary to demonstrate that the subject matter of the invention is patentable, but it is also required to demonstrate that the claimed invention is “useful” for some purpose.

3. Novelty, New

You cannot patent something that is already publicly known, as it would be unfair to confer the economic benefits of a patent for the discovery of something that is already publicly known.

4. Non-obviousness

If the invention is 'obvious' to a skilled person, it is not patentable.

EU patent law: The following shall not be regarded as inventions:

1. discoveries, scientific theories and mathematical methods;(ie.mrth solutions)
2. aesthetic creations;(ie.beauty, taste or preferences that involve subjective judgement)
3. schemes, rules and methods for performing mental acts, playing
4. games or doing business, and programs for computers;
5. presentations of information.

R&D Spillovers

• Since not all innovations are patentable, or worth patenting,

industries that are agglomerated have high R&D Spillovers mainly via personnel movements between firms.

• Firms often use non-disclosure agreements or non-compete

clauses in employment contracts to reduce such spillovers. - Leads to monopsony power in labour markets

Shortcomings

Enforceability: Even if a confidentiality agreement is signed, the company cannot ensure that the information will not be disclosed.

Importance of market power

Innovation can drive market power and increase competitive intensity. competitive intensity - refers to a company's potential profitability. A higher competitive intensity indicates that the company is more competitive and able to transfer more values. It is presented as an inverted U shape with the amount of innovation.

As Sharp and Currie (2008) state that, more and more researches indicate that open and competitive as drivers of innovation and productivity is overwhelming. Innovation is used to increase with growth in competition up to a point and then decline.

Innovation in Entrepreneurship

In William's research has given some insight of innovation in entrepreneurship(innovative entrepreneur). It represents truly new ideas and explore a new market niche. William has stated that innovative company can be regarded as "entering the white space", which means creating new products to new customers. It is the most risky investment as company need to adjust supply accordingly to sustain(transformation). If the company invest in innovation and succeed, a high return and profit can be secured.

When the entrepreneurs are creative in their business ideas and making innovation, their business are succeed. Under the global environment, innovation and creativity acts as a platform for the organisations to compete and sustain in the marketplace. （Rangarajan & Lakshmi, 2013)

Enterprise innovations include:

Thinking innovation

Some companies are constantly recruiting new talents. One of the important reasons is to expect them to bring new ideas, new ideas and continuous innovation. Its purpose is to carry out innovative training in thinking.

2. Product (service) innovation

For industrial enterprises, it is product innovation. For finance, the main service innovation. This can better attract customers.

3. Technological innovation

As far as a company is concerned, technological innovation refers not only to the commercial application of independent innovation technology, but also to the innovative application of legally acquired new technologies developed by others or technologies that have entered the public domain to create market advantages. Focusing on tasks and technologies, tasks are re-allocated, updating equipment and technological innovations to achieve organizational innovation.

4. Organization and institutional innovation

Typical organizational change and innovation is to enable employees to recognize and realize organizational change and innovation through employee attitudes, values ​​and information exchange. Through corporate organizational change and innovation, people's behavioral style, values, and proficiency can be changed. And at the same time, managers can be changed.

Should policymakers encourage entrepreneurship?

Whether policymakers encourage entrepreneurship is a difficult and complex topic to discuss. There have been numerous life-changing inventions from entrepreneurs, such as Bill Gates and Mark Zuckerberg that have a daily impact on many around the world. In practice, calculating the benefit gained from such entrepreneurs cannot be well-defined and makes it difficult to quantify how much extra effort policymakers should put towards encouraging entrepreneurship. The issue is a contentious area, as many believe enough incentive already exists. Firstly, the pros for incentivising is that entrepreneurship is important for the countries competitiveness, where the benefits could spill over to other industries. In the Australian retail industry, increased competition has lowered net profit margins causing firms to become more efficient by reducing operating cost and ultimately offer consumers lower prices to retain sales. An example of the positive spillover effect can be seen by the recent growth in online networking tools such as LinkedIn that create a positive feedback loop where users share knowledge and create a large exchange of ideas from various individuals. This also has the potential to cause a chain reaction with the creation of more industries such as software wanted for the platform or the utilisation of user data. Additionally, if governments were to encourage it, it would allow lower barriers to entry as companies are paid to enter the market, which also increases the competition.

However, the main challenge that surrounds entrepreneurship is the riskiness of the practice. The likelihood of a successful invention is less than 1%. This has allowed a dissolution of transparency where we don’t have a sufficient understanding of the true costs as they are all privately born. The public is only exposed to success stories, so any failures are generally unaccounted for. This has created a strong selection bias that highlights only those successful. R&D type industries have far greater transparency in terms of what’s being recorded and tax revenues etc.

To answer whether policymakers should encourage entrepreneurship is not straightforward. The trade-off for policymakers is the risk and benefit of generating a successful start-up, the cost of which is not easily identifiable. Other factors that remain influential involve the current competitive environment and whether more competition will enhance or degrade its current economic situation.

Acquisition as a Form of Investment

What is an acquisition?

In its most simplistic form, the Oxford dictionary defines an acquisition as “an asset or object bought or obtained” (Oxford Dictionary, 2013). Expanding upon this in an economic context, an acquisition is an agreement in which one company gains control over another, usually through the purchase of shares or assets. There are several types of acquisitions, not all of which are of mutual agreement. The purpose of an acquisition, or better put, the incentive to acquire, differs depending on the type of acquisition.

Types of Acquisitions

• Horizontal Acquisition: A scenario where one company acquires another with similar products or services. The acquiring firm does so to expand their range of products or services without taking on the costs of expanding themselves. The incentive to acquire lies in the synergies between the two companies operations, industry and production stage. The newly combined firm would expect to have gained considerable competitive position due to an increase in market share or scalability, which were only achieved due to the acquisition.
• Vertical Acquisition: A scenario where one company acquires another acquires another whom operates in the same industry, but occupies a different position in the supply chain. The incentive to acquire lies in synergies derived from efficiency of production and supply, as well as low cost volatility. The newly combined firm would expect to gain competitive advantage through increased control of the distribution channels (Buzzell, 1993).
• Conglomerate Acquisition: A scenario where a company acquires another despite both being involved in unrelated industries. The incentive to acquire lies in the opportunity to reduce capital and overhead costs whilst achieving new efficiencies. Typically, the acquiring firm is seeking to expand into new industries, eliminate redundant activities and/or attain production or distribution synergies (Herger & McCorriston, 2016).
• Concentric Acquisition: A scenario where a company acquires another whom they share the same industry but do not directly compete. Typically, concentric acquisitions involve firms who share similar distribution channels or have overlapping systems of production or technology. The incentive to acquire lies in the opportunity to expand product range or boost efficiencies through production or distribution synthesis (Kenton, 2018).

EVALUATING ACQUISITION SUCCESS

There are a number methods used to measure the success of an acquisition. Some of the more basic methods include a measure of market share increase versus cost, as well as the gross increase in profit, whilst the more complex methods involve calculating cumulative abnormal returns (CAR). Each method is used for a different purpose, and involves a degree of subjectivity. In an economic context, however, it is most appropriate to measure acquisition success by the total economic impact of the transaction. That is, to measure the impact of the acquisition on both the acquirer and acquiree, rather than the more traditional method of measuring the impact on shareholders of the former.

Consider the following formula:

[XA – X0] + [YA + Y0] Where, XA = Shareholders value of acquirer after the acquisition YA = Shareholders value of acquiree after the acquisition X0 = Shareholders value of acquirer before the acquisition Y0 = Shareholders value of acquirer before the acquisition

In its most basic form, this methodology measures the total economic impact of the acquisition. It is, though, not without assumption. Kaplan (2006) theorises that this formula holds three assumptions.

1. Firstly, the market must be well informed about the value of the companies before the acquisition;
2. Secondly, there is suitable information available at the announcement of the acquisition; and
3. Thirdly, the acquisition is unanticipated. He goes on to consider how this formula could be better arranged to consider the synergies of the acquisition, though acknowledges that, as a foundational economic principle, the formula in its current state is useful.

Practical Example Consider two companies, X and Y, which are worth $10 million each. If X acquires Y, X will gain $1 million in synergies. Based on this, X acquires Y for $15 million. Upon announcement of the acquisition, Y’s value increased by $5 million (from $10 million to $ 15 million) based on X’s decision. Note simplistic models for measuring acquisition success end here. However, X is paying $15 million for $11 million value ($10 million company Y + $1 million synergies), and therefore loses $4 million of its own value. Depending on which perspective you take, you might consider this to be either a good or bad deal. From a combined perspective, though, the formula above dictates:

[XA – X0] + [YA + Y0] = [$6mil - $10mil] + [$15mil - $10mil] = -$4mil + $5mil = $1mil

Thus, the deals overall economic impact is positive.

Summary

This section briefly summarises each section above:

Capital budgeting: Used as a process to assess capital expenditure decisions. The process typically involves evaluating the cash flow of several projects before one is chosen based upon a decision rule. Finally, the assumptions of the project are re-evaluated after the project begins to find any potential improvements for future projects.

Investment Project Evaluation: Analysis of the profitability of a project typically using net present value or internal rate of return.

Net Present Value (NPV): Defined as the present value of cash inflows minus the present value of cash outflows over a certain period of time.

Internal Rate of Return (IRR): Used in calculating the profitability of an investment and is a discount rate that sets the net present value of an investment equal to zero.

Cost-Benefit Analysis (CBA): Process used to examine all the associated costs and benefits with a project before undertaking it and takes in account various perspectives of the project.

Present Value of Perpetuity: A never-ending sequence of cash flows that is discounted back to a present value.

Investing into Research and Development: Firms usually invest in to gain a competitive advantage that can be used for additional revenue and market share over competitors. Universities typically use research to create a better reputation and more attractive for students and academics.