The Role of Probability in Capital Budgeting Decisions - Essay Example

Corporate Finance Discuss the importance of equity capital to business. Your discussion may include the Modigliani and Miller's Theorem on capital structure and the factors that influence the capital structure of a company The capital for a company form of organisation is normally raised by issuing equity/ordinary shares and / or debt securities to the public at large. Another king of security which also form part of the capital structure is preference shares. When equity shares are purchased, the investors will become the shareholders/owners of the company. This source denotes the permanent capital for which the investors do not ask for any fixed rate of return. This capital need not be paid back to the investors as long as the company is in existence. Thus, equity source is the least risky source of fund from the view point of borrower. At the same time, when the company makes huge profit, the profit left after meeting all obligations might be distributed among the equity shareholders, and this is the most appealing factor of equity capital. That does not mean that company has to distribute capital whenever it makes residual profit (profit left after making all other payments). The decision to distribute or not to distribute divisible profit is ultimately taken by the Board of Directors. The return to ordinary shareholders (dividend/cost to the company) is paid after meeting all payments like dividend to preference share holders and interest payments to debenture holders and other long term suppliers of funds. Financial needs are continuous for any growing firm. As the needs for expansion and diversification enhances these days. This capital can come from debt or equity. When companies can finance themselves with either debt or equity, certain questions arise. Is one better than the other' If so, should firms be financed with all debt or all equity' If the best solution is some mix of debt and equity, what is the optimal mix' It is generally understood that the optimal capital structure of a firm is the composition of debt and equity which results in the minimum cost of capital. But the determination of an optimal capital structure is not an exact science. Firms have to first analyze a number of factors such as the firm's business risk, its need for financial flexibility, shareholder wealth maximization, survival against competition, assurance of a steady source of funds, acquisition and maintenance of a good rating in the market, profitability, and growth rate before deciding upon an appropriate capital structure. All these factors are a pointer to one important fact, that, companies will have to search for the right capital structure which enhances firm value while minimizing costs. The capital required for investment, while often scarce, can be generated from a variety of sources. How firms choose among these various sources and why, have been the source of much debate in financial literature. Many theories have been developed to show the relationship between capital structure and firm value. There are different views on how capital structure influences firm value. Some authors argue that there is no relationship between capital structure and the value of the firm, whereas others hold that financial leverage has a positive effect on firm value. There are also some who take the intermediate approach that financial leverage has a positive effect on the value of the firm that is only up to a certain point and thereafter there will be negative effect, another contention that, other things being equal, the greater the leverage, the greater the firm value. According to the net income approach when leverage varies, the cost of debt and the cost of equity remain unchanged. Therefore, the weighted average cost of capital declines as leverage increases and the value of the firm will increase. Under the net operating income approach, the overall capitalization rate remains constant for all degrees of leverage and therefore, the value of the firm will remain unchanged. The market capitalizes the firm as a whole at a rate, which is independent of the firm's debt-equity choice. As a consequence, the division between debt and equity becomes irrelevant. The benefit derived with increase in the leverage with higher debt, is exactly offset by an increase in equity capital rate. This happens because equity investors seek higher compensation as they are exposed to greater risk. The market value of a firm depends on its net operating income and business risk. According to traditional theory, the cost of capital is dependent on the capital structure and there is an optimal capital structure, which minimizes the cost of capital. The theory assumes that the cost of debt remains more or less constant up to a certain degree of leverage, but rises thereafter at an increasing rate. The modern theory of capital structure may be said to have begun with Modigliani and Miller's (M & M) theorem presented in 1958, namely, "the value of a firm is independent of its capital structure" and "the average cost of capital to any firm is completely independent of its capital structure". Miller (1977) introduced personal income taxes into the analysis and stated that for a wide range of value of dividend, interest and corporate tax rates, "the gain from leverage vanishes entirely or even turns negative". The subsequent researchers on capital structure relaxed assumptions made by M & M like bankruptcy costs associated with debt and agency costs, and have developed the theoretical models of capital structure. The debate on capital structure gained momentum following the seminal work of Modigliani and Miller (1958). In this theoretical work Modigliani and Miller argue that capital structure does not affect the basic wealth creating capacity of the company and, therefore, under perfect capital markets, the firm's cost of capital is not affected by capital structure decisions. Thus, Modigliani and Miller have supported the NOI approach. However, this view has been contested by Ezra Solomon (1963), who argues that there exists an optimum capital structure and, therefore, the capital structure decisions affect the cost of capital and the value of the firm. Since the publication of Modigliani and Miller, there has been a raging controversy in the financial literature as to whether the proportion of debt and equity in a firm's capital structure affects its value. Following the work of Modigliani and Miller, authors such as Kraus and Litzenberger (1973), Scott (1977) and Kim (1978), developed relevant studies, whose line of study is commonly referred to as the trade-off theory. This theory recognizes the existence of an optimal debt to equity ratio that maximizes the company's market value. The greater the debt level is, the greater the tax shields. Therefore, the advantage of corporate taxes is that interest payments of debt are deductible as an expense. On the other hand, a greater amount of debt increases the company's financial risk; consequently they are more likely to go bankrupt (Van Horne, 1992). According to trade-off theory, the capital structure choice is a trade-off between the tax advantages of borrowing and the cost of financial distress (Van Horne, 1992). Agency theory approaches the conflicts, on the one hand, between managers and shareholders, and on the other, between the shareholders and the debt holders, and that influences the capital structure decisions (Harris and Raviv, 1991). Myers (1977) makes the point that managers can reject profitable investment projects with the aim of reducing the need for debt. Harris and Raviv (1990) and Stulz (1990) state that managers can also choose investment projects with the aim of improving company's image and its market value. Compare and contrast probability, scenario and sensitivity analysis in the management of risk in investments Investment is always uncertain. The expected return from and the risk involved in an investment opportunity cannot be determined in advance with perfection. Many theories and models have been developed by experts using statistical and mathematical models. All the theories must use the past data with modifications for change in future to predict the likely return of or risk from an investment. Probability as a measure of uncertainty quantifies the future events by predicting the likelihood of the happening of an event in future. It expresses the chance of occurring a future event by converting the chance into numbers. The measure of probability has a tremendous role to play in investment management as the latter is always concerned with the prediction of future risk and return. The chance of incurring loss from an investment is coined as risk in investment. The risk arises when the expected return from the investment is less than the actual return. The study of risk or risk analysis is a pre-requisite in any investment, especially those that involves huge funds such as capital budgeting. The following paragraphs will discuss the role of probability (decision tree analysis), scenario and sensitivity analysis in capital budgeting decisions. The Decision tree Approach; Sensitivity analysis; and Scenario Analysis The decision tree approach involves the use of probability measures with different alternative investment options. Each investment option is evaluated in terms of the assigned probability values representing the possibility of each investment outcome. It provides the investor with the knowledge of different investment outcomes and their probability so that he can select the most rewarding investment opportunity. A decision tree as the very name suggests looks like a tree with many branches. The branches in the tree represent the investment options with assigned probability. Every branch (investment option) has two delineating points, namely decision point and chance point. A decision point is an investment option available for experimentation and the chance point represents the probability of likely outcome with its monetary values. This technique can be used only in situations where the project is made and expressed in well defined stages, the outcomes in each stage fall into few broad categories, and the probabilities and cash flows associated with various outcomes can be specified at the beginning of the project and that required past data. Therefore, it may be difficult to apply this technique to a project where the product is a new one for which no prior data is available. Also, they cannot be applied when investments are gradually made over a period of time rather than in a few well defined stages. Sensitivity analysis is another important tool used by investors to predict the future investment prospects. To analyze an investment opportunity with sensitivity analysis, it is necessary to have past data on the investment behaviour. This tool takes a number of variables, each of which is expressed under two conditions, namely pessimistic and optimistic conditions. This tool shows how vulnerable a project is to changes in the underlying variables. However, it suffers from serious limitations. It does not depict how likely a change will occur rather than merely giving what happens to a variable as a result of a change. In sensitivity analysis, typically one variable is varied at a time. But, in scenario analysis, several variables are varied at the same time. Most frequently three scenarios are considered: expected scenario, pessimistic scenario, and optimistic scenario. In the normal scenario, all variables assume their expected or normal values; in the pessimistic scenario, all variables assume their pessimistic values; and in the optimistic scenario all variables assume their optimistic values. Therefore, scenario analysis is considered superior to sensitivity analysis as it considers variations in several variables together. The shareholder and stakeholder theory have been fundamental in the management of companies. Discuss the two opposing views giving examples where appropriate (600) The issue as to whether the interests of shareholders should take precedence other those of other stakeholders is an old debate, and will continue to be disputed for some time to come. Due to the changing nature of current organisations and the economy there have been various efforts towards implementing both beliefs towards creating efficiency, competitive advantage and synergy amongst companies. The difficulty lying in being able to create value for the shareholders in conjunction with the company's main objective but at the same time taking into consideration upon the stakeholders of the companies. One of the main advocates in this issue is Milton Friedman, who in his 1970's Article (The social responsibility of business is to increase its profits) argued that "Boards should focus on maximising profits for shareholders and that managers were ill-equipped to do anything else, as they had neither the mandate nor the skills nor the resources to decide the correct trade-offs between stakeholders." In justifying this statement Friedman's main argument was that the shareholders are the owners of the corporation therefore the corporate profits belong to them. However, Friedman does acknowledge that there are constraints on how corporate value can be maximised, as the company must provide its customers with goods and services they wanted at a fair price, and that this must be achieved without breaking the law and without offending existing social values. Taking the opposite position, Edward Freeman in his 1984 paper gave a definitive counter argument to stakeholder theory when he stated that "Management should make decisions that take account of the interests of all the stakeholders in a firm." In providing a more broad definition to the term 'stakeholder', Freeman defined a stakeholder as any individual or group who can substantially affect, or be affected by, the welfare of the firm, a category that includes not only the shareholders, but also employees, customers, and even the local community. In addition to Freeman, another author Sumantra Ghoshal recently produced a paper which also argued that shareholders do not have priority over other stakeholders. In his paper, Sumantra Ghoshal (Ghoshal, S. 2005) highlighted the danger of applying theoretical management techniques upon real world situations. Furthermore Ghoshal gives a particularly relevant example by investigating whether the argument of Friedman, "that few managers today can publicly question, that their job is to maximise shareholder value", is in fact justified. Ghoshal begins by commenting upon whether it is reasonable to classify shareholder as the owners or 'principle' of the company, as most, he argues, would agree that shareholders do not own the company, at least not in the sense that they own their homes or their cars. He goes on further to point out that shareholders simply own a right to the residual cash flows of the company, and in fact have no actual ownership of the assets or businesses of the company, which under law, are owned by the company itself. Another point of his argument is that as all companies create value through combining the resources of employees, management and shareholders, for example employees contribute their human capital, while shareholders contribute financial capital. Therefore, why do managers only deem it necessary to maximise the returns of just one of these groups, the shareholders. Ghoshal also points out that, managers whose sole objective is to maximize shareholder returns rely upon a wholly unjustifiable assumption, that labour markets are perfectly efficient. The definition of which would be that the wages of every employee accurately represents the total value of their contributions and, if they didn't, the employee could easily move to another job. Taking this assumption, (Jensen & Meckling, 1976) argued that because the shareholders are carrying the greater risk, their contribution of capital could be argued as being more important than the contribution of human capital provided by employees and therefore, it is for this reason that shareholder returns must be maximised However, as the majority of shareholders are able to sell their stocks far more easily than most employees could find another job, Ghoshal disagrees with (Jensen & Meckling, 1976) assumption stating that "In every substantive sense, employees of a company carry more risks than do the shareholders" In summing up the counter arguments, Ghoshal takes an argument from Milton Friedman in which he states that it is not important if the assumptions of our theories do not reflect reality; what matters is that these theories can accurately predict the outcomes. The theories are valid because of their explanatory and predictive power, irrespective of how absurd the assumptions may look from the perspective of common sense. In 2001, a paper titled "Value Maximization, Stakeholder Theory, and the Corporate Objective Function", Michael Jensen looked to test the validility of whether stakeholder theory could be viewed as a legitimate contender to value maximization. To summarise Jensen's findings he concluded that "shareholder theory should not be viewed as a legitimate contender to value maximization because it fails to provide a complete specification of the corporate purpose or objective function." What Jensen is saying is that while value maximization theory looks to provide corporate managers with a single objective, stakeholder theory directs managers to fulfil numerous objectives. So therefore, without the clarity provided by a single objective, companies who embrace stakeholder theory will likely experience managerial confusion and conflict, of which lead to inefficiency, and perhaps even failure. Mills and Weinstein (Mills & Weinstein, 2000) pointed out that shareholder and stakeholder interests did not have to conflict if the issues of the measurement of value and the distribution of value were to be looked at separately. They acknowledged that the creation of value is critical in all organizations, and that the efficient use of resources should involve ensuring that an economic return in excess of the cost of capital is achieved. However, their argument was that the wealth created did not have to be distributed with the shareholder taking the majority share'as they believed that there is no reason why other stakeholders with legitimate claims should not be a key part of the distribution process. Critically evaluate the importance of securitisation, options and futures in the management of companies The Financial Service of Securitisation One of the recent phenomena that underscore the steady sophistication of the financial services sector across the world is the increased volume of securitization transactions and the varied nature of such transactions. Securitization is a process wherein homogenous illiquid financial assets are grouped and repackaged into smaller, marketable financial instruments for subsequent sale to investors. Simply put, securitization is the process of converting illiquid or non marketable assets into smaller, marketable assets by selling the expected cash flow generated from these assets. Securitization Deal Consider the following hypothetical securitization case. A bank pools a part of its home loan portfolio (of similar tenor and risk profile) and breaks down the portfolio into smaller marketable securities which are sold to investors. The investors are promised a certain rate of return, which the bank pays depending on the loan EMIs it receives from customers. The parties to the deal include the following: The process starts with the Originator (The entity on whose books the assets being securitized initially exist ) identifying a pool of homogenous assets (same asset type, similar tenor and risk profile) and transferring the same, in lieu of upfront payment, to an SPV, a separate legal entity formed exclusively to facilitate the securitization process. The transferred assets (the Originator's debtors) now reside in the books of the SPV and are off the balance sheet of the Originator. The SPV repackages the purchased assets into marketable securities, which are called Pass Through Certificates (PTCs) for sale to investors (individuals and entities which purchase the securities from the SPV), as they pass through the rights to the investors. Where the Originating bank securitizes a pool of loans, the PTCs are called Collateralized Loan Obligations or CLOs, while if the bank transfers a portfolio of bonds, the emergent PTCs are called Collateralized Bond Obligations or CBOs. The SPV may provide additional credit enhancements to the cash flows via either external means (insurance, third party guarantees or third party Letter of Credit etc.) or internal means (Credit Tranching wherein SPV issues two or more tranches of security which establishes a predetermined servicing priority for investors), over collateralization wherein Originator allots excess assets as collateral, cash flows from which service overdue payments, if any, before accruing to the Originator or Cash Collaterals etc). An external rating agency (an external independent agency which assesses the strength of the cash flows on the basis of the quality of the asset, the securitization structure, extent of credit enhancements etc., and not on the basis of the credit risk of the Originator) evaluates the quality of the cash flows and other factors mentioned above and assigns a rating for the proposed PTCs which encourage investors to subscribe to the same. Interest rate offered on the PTCs is inversely proportional to the quality of the credit rating. As per the periodic repayment obligations of the Obligors, the SPV pays the investors on agreed terms after deducting its service fees (difference in rate of interest on the loan and rate offered to investors). Usually, an administrator is assigned to collect payments from delinquent Obligors/initiate legal proceedings against defaulters etc. The Derivative Family- Options and Futures A derivative is commonly understood as a contract that does not have a value of its own, instead derives its value from an underlying asset. Derivates are risk hedging instruments that are extensively used in business of the modern era where risk exists in all spheres of activities. Basically, a derivative is a contract between parties who are known or unknown to each other who want to mitigate the likely loss from the operational and financial activities of their business. The derivative family four members to be used in varied contexts of business and financial operations. They are forward, options, futures and swaps. Forward is the simplest and oldest of the derivative in its genus. The following paragraphs take a brief discussion of the most commonly used derivative instruments, i.e., options and futures: Option is a derivative financial instrument by which a contract between a buyer and a seller is formed for buying and selling an underlying asset at an agreed price on a future date. An option contract gives the buyer the right (but not the obligation) to buy or sell the contract, whereas the seller is given an obligation to perform the contract. Like any other instrument, option trading is subject to uncertainty and hence high risk. The buyer may incur loss in terms of the already paid premium, if he does not perform his part. However, seller has the chance of incurring huge loss potential if the other party exercises his right. Therefore, it is necessary for both parties to apply certain strategies so as to ensure minimum profits and minimize risks. The most commonly affecting determinants of option contract are price, volatility, time value of the options contract, the market movement, risk bearing capacity of the investor etc. An option trader uses a number of strategies that are formulated on the basis of the presence or absence of the above parameters. Mainly, options are of two types, namely American options and European options, the difference lies in period during which the parties can exercise his part. When the American option allows the trader to exercise his right at any day during the life span of the option, the other one can be traded only on the day of expiration. Similar to options contract, a futures contract refers to an agreement (legally binding) to purchase or sell an underlying asset (commodity or financial instrument) at a point of time in future for an agree price decided at the time of the agreement. The actual delivery of the underlying asset takes place seldom in a future contract. They specify certain standards in respect of delivery, quality, quantity, and time and location. The standardization feature of futures contracts allows some flexibility to both parties. Both sellers and buyers can go for extending the future contract in such a manner that can exchange one contract for another and thereby mitigate the obligation to take delivery on a commodity or instrument underlying the futures contract. Here, the term 'offset' implies that the parties can take another futures position opposite or equal to one's initial futures transaction. References Friedman, M. (1970) 'The social responsibility of business is to increase its profits', New York Times Magazine, September 13. Freeman, R. E., (1984). Strategic Management: A stakeholder approach, Boston: Pitman. Ghosals, S., (2005). 'Bad Management Theories Are Destroying Good Management Practices', Academy of Management Learning and Education, Vol 4, No 1, pp. 75-91. 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