Lessons in Corporate Finance

CHAPTER 14 Valuation and Cash Flows (Sungreen A)

At the start of this book, we stated the three key tasks of a CFO are:

1. Make good financing decisions
2. Make good investment decisions
3. Don’t run out of cash while doing the first two

Chapters 2 through 4 focused on working capital management, which involves not running out of cash. Those chapters featured a number of tools (sources and uses, ratios, and pro formas). Chapters 5 through 12 then focused on how to make good financing decisions. We discussed M&M (1958, 1961, and 1963), the advantages of tax shields, the costs of financial distress, signaling, asymmetric information, the pecking order theory, and dividend policy.

The current chapter begins our section on how to make good investment decisions. We concentrate primarily on how to do valuation. The idea is to see if expected investment returns are high enough to justify the initial investment and expected risk. As with the prior sections, it may be a little frustrating at first since we are climbing up the knowledge curve, but we believe it will all come together at the end. So here we go.

Investment Decisions

All investment decisions have three major elements:

1. The strategic element. Does the project under consideration make economic sense? Does it fit with the firm’s business and objectives?
2. The valuation analysis. What is the project worth? Is it a good investment or not from a valuation point of view?
3. Execution. How do we bring the investment to fruition? What are ...