Financial Strategy, Second Edition

Section 2

Adding Value Through Investment

SECTION OVERVIEW

Janette Rutterford

In this section, we look at corporate investment – both in projects and in companies. In a sense, the company can be thought of as a collection of projects, and the Capital Asset Pricing Model teaches us that managers should evaluate each project as a standalone investment, using the hurdle rate appropriate to the project activity and financing rather than using, as many companies in practice do, a company-wide discount rate.

As far as investment in projects or companies is concerned, the use of discounted cash flow techniques and the theoretical dominance of the Net Present Value rule as a decision tool for investment appraisal have long been part of finance textbooks. In this section of the book, we look at the investment decision from different perspectives from that of the methodology of decision-making. First, we explore what happens in the real world when investment decisions are being made and why managers do not in practice always follow the theoretically optimal model. Second, we explore how option valuation, in particular the valuation of “real” options, can be used to improve project appraisal. Third, we look at mergers and acquisitions and why managers keep on buying companies, when the evidence as to their success is fairly thin on the ground.

Isabelle Royer, in “Why Bad Projects Are So Hard to Kill”, shows that, despite a better understanding of the financial tools available for project ...