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1.6. The Principles of Investment

The previous section illustrates that modern financial management (strategic or otherwise) raises more questions than it can possibly answer. In fairness, theories of finance have developed at an increasing rate over the past fifty years. Unfortunately, unforeseen events always seem to overtake them (for example, the October 1987 crash, the fiasco of 2000, the aftermath of 7/11, the 2007 sub-prime mortgage crisis and now the consequences of the 2008 financial meltdown).

To many analysts, current financial models also appear more abstract than ever. They attract legitimate criticism concerning their real world applicability in today's uncertain, global capital market, characterized by geo-political instability, rising oil and commodity prices and the threat of economic recession. Moreover, post-modernists, who take a non-linear view of society and dispense with the assumption that we can maximise anything (long or short) with their talk of speculative bubbles, catastrophe theory and market incoherence, have failed to develop comprehensive alternative models of investment behaviour.

Much work remains to be done. So, in the meantime, let us see what the "old finance" still has to offer today's investment community and the "new theorists" by adopting a historical perspective and returning to the fundamental principles of investment and shareholder wealth maximisation, a number of which you may be familiar with.

We have observed broad academic agreement that if resources are to be allocated efficiently, the objective of strategic financial management should be:

- To maximise the wealth of the shareholders' stake in the enterprise.

Companies are assumed to raise funds from their shareholders, or borrow more cheaply from third parties (creditors) to invest in capital projects that generate maximum financial benefit for all.

A capital project is defined as an asset investment that generates a stream of receipts and payments that define the total cash flows of the project. Any immediate payment by a firm for assets is called an initial cash outflow, and future receipts and payments are termed future cash inflows and future cash outflows, respectively.

As we shall discover, wealth maximisation criteria based on expected net present value (ENPV) using a discount rate rather than an internal rate of return (IRR), can then reveal that when fixed and current assets are used efficiently by management:

If ENPV is positive, a project's anticipated future net cash inflows should enable a firm to repay cheap contractual loans with accumulated interest and provide a higher return to shareholders. This return can take the form of either current dividends, or future capital gains, based on managerial decisions to distribute or retain earnings for reinvestment.

However, this raises a number of questions, even if initial issues of cheap debt capital increase shareholder earnings per share (EPS).

- Do the contractual obligations of larger interest payments associated with more borrowing (and the possibility of higher interest rates to compensate new investors) threaten shareholders returns?

- In the presence of this financial risk associated with increased borrowing (termed gearing or leverage) do rational, risk-averse shareholders prefer current dividend income to future capital gains financed by the retention of their profit?

- Or, irrespective of leverage, are dividends and earnings regarded as perfect economic substitutes in the minds of shareholders?

Explained simply, shareholders are being denied the opportunity to enjoy current dividends if new capital projects are accepted. Of course, they might reap a future capital gain. And in the interim, individual shareholders can also sell part or all of their holdings, or borrow at an appropriate (market) rate of interest to finance their preferences for consumption, or investment in other firms.

But what if a reduction in today's dividend is not matched by the profitability of management's future investment opportunities?

To be consistent with our overall objective of shareholder wealth maximisation, another fundamental principle of investment is that:

Management's minimum rate of return on incremental projects financed by retained earnings should represent the rate of return that shareholders can expect to earn on comparable investments elsewhere.

Otherwise, corporate wealth will diminish and once this information is signaled to the outside world via an efficient capital market, share price may follow suit.

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