In order to maximize shareholder’s wealth, there are three factors, identified by Watson and Head (2007), that directly affect shareholder’s wealth, have to be considered.
1. The magnitude of cash flow accumulating to the company.
2. The timing if cash flow accumulating to the company.
3. The risk associated with the cash flow accumulating to the company.
Scenario
BMW wants to invest £ 50,000,000 to build up a factory in Northeast in UK. The investment details and expected returns are given below. The factory will be disposed at the end of 10 year time with the salvage value of 0. LIBOR interest rate 6.7% is assumed to be discount factor.
Table 1 Detail of the investment project
year Income (£) Discounted cash flow Expected unites sold (cars) Variable cost (£) Price (£) Discount factor
0 - 80,000,000 - 80,000,000
1 8,000,000 7,497,657 2,000 6,000 10,000 0.937
2 12,000,000 10,540,286 3,000 6,000 10,000 0.878
3 16,000,000 13,171,242 4,000 6,000 10,000 0.823
4 16,000,000 12,344,182 4,000 6,000 10,000 0.772
5 16,000,000 11,569,055 4,000 6,000 10,000 0.723
6 16,000,000 10,842,601 4,000 6,000 10,000 0.678
7 16,000,000 10,161,763 4,000 6,000 10,000 0.635
8 16,000,000 9,523,676 4,000 6,000 10,000 0.595
9 16,000,000 8,925,657 4,000 6,000 10,000 0.558
10 16,000,000 8,365,190 4,000 6,000 10,000 0.523
Payback period
The payback period is, according to Watson and Head (2007), the number of years that it is expected to take to recover the initial investment for the cash inflow resulting from an investment project. The payback period of this project is shown below.
Table 2 Payback period calculation
year Cash flow (£) Cumulative cash flow Discounted cash flow cumulative discoun ...