Corporate Finance and Governance - Essay Example

Corporate Finance & Governance “Critics of American business claim that U.S. managers rely too heavily on a few financial techniques to weigh major investment decisions. Calculation of discounted cash flows, internal rates of return, and net present values, say critics, is inherently biased against long-term investments. But according to the authors, DCF procedures can work if the management sets realistic hurdle rates, and carefully examines its assumptions. Decision makers need to consider three critical issues: the effects of inflation, the different levels of uncertainty in different phases of a programme, and management's own ability to mitigate risk.” (Hodder and Riggs, 1985) “It has long been recognised that the recognition of risk is an important component in capital budgeting decisions. The future is uncertain and investment appraisal techniques that fail to recognise this fact will almost certainly lead to incorrect conclusions and erroneous recommendations.” (Brookfield, 1995) “In a longitudinal survey of capital budgeting practices of large UK companies between 1975 and 1992, substantial increase in the usage of discounted cash flow (DCF) and risk appraisal techniques were reported. Despite the increased usage of the more theoretically sound discounting techniques, several writers in both the UK and US have claimed that companies are underinvesting because they misapply or misinterpret DCF techniques. It has been asserted by several writers that firms are guilty of rejecting worthwhile investments because of the improper treatment of inflation in the financial appraisal. Many firms are understating NPVs and IRRs because of the incorrect treatment of inflation and the use of excessively high discount rates. Concern has also been expressed by various commentators that many companies are failing to invest in advanced manufacturing technologies (AMT) as fully as they should. Financial appraisal techniques have been cited as a major reason for the under-investment in new manufacturing technology. DCF procedures should not be ignored or relegated in importance merely because they might be used incorrectly. Instead, decision-makers should recognize potential problems and be careful to ensure that the financial appraisal is performed correctly.” (Colin and Mike, 1986) “In a world in which information is not costlessly and symmetrically available to all economic agents, corporate project choices do not abide by the golden rule that all positive NPV projects should be accepted. In a sense, this is somewhat unsettling because it is difficult to prescribe simple rules for managers, and there has been little normative research into optimal capital allocation policies in different types of informationally constrained environments. However, the contemporary research highlights the pitfalls of policy-oriented discussions about corporate investment behaviour and managerial compensation packages that rely on the prescriptions of the traditional, symmetric-information paradigm of capital budgeting and financing. The research done to date indicates that many interesting things can happen under asymmetric information, none of which may be irrational, but some of which could be deleterious to the shareholders' welfare.” (Thakur, 1993) Given these observations about investment appraisal techniques and DCF techniques in particular, this report aims to assess the feasibility of using traditional investment appraisal techniques, while incorporating real-time variables such as risk and uncertainties. In particular, the report focuses on NPV as a basis for capital budgeting and evaluates how the concepts of risk-adjusted discount rates and sensitivity analysis can bolster traditional NPV estimation and thus provide business managers with realistic and flexible options when it comes to assessing the suitability and profitability of a particular investment or project. Accordingly, management approach should not be limited to using a fixed number of investment appraisal techniques; rather they should be more flexible while appraising the gains from a particular investment. There are certain factors which must be incorporated in any method of investment appraisal – inflation and its effects, mitigation of risk and varying levels of uncertainty at different points of time when considering long-term investments. CONTENTS Page 1. Introduction 5 1.1 Common Investment Appraisal Techniques 5 1.2 Objective and Purpose of Report 6 2. DCF Analysis – Components & Application 7 2.1 Expected Net Present Value 7 2.2 Risk-Adjusted Discount Rate 8 2.3 Sensitivity Analysis 9 3. Conclusion 11 3.1 Recommendations 11 4. References 12 1. Introduction Investment appraisal decisions are typically made using a few tried-and-tested techniques, which often fail to take into account future uncertainties. Hence, more often than not, companies tend to overlook long-term investment projects, because of the inability to successfully predict long-term trends and behaviour. In the sections which follow, we will take a look at the various appraisal techniques used by a majority of business managers, their benefits and limitations and the methods by which long-range forecasting can be improved, thus providing a more realistic and beneficial analysis of investments undertaken by the business. 1.1 Common Investment Appraisal Techniques Generally, most companies and businesses use a limited number of investment appraisal techniques such as Discounted Cash Flows (DCF), Internal Rate of Return (IRR) and Net Present Values (NPV). While these are sound techniques to use in capital budgeting, they fail to consider risk and future uncertainties, with the result that managers tend to overlook profitable long-term investments (Hodder and Riggs, 1985). According to Brookfield (1995), appraisal techniques which do not incorporate risk as an integral part of capital budgeting will result in conclusions and recommendations which are erroneous. When using investment appraisal techniques as those mentioned above, managements need to consider the following three important factors: (a) inflation and its effects; (b) changing levels of uncertainty; and (c) mitigation of risk (Hodder and Riggs, 1985). 1.2 Objective and Purpose of Report Given the fact that the end goal of any business is to maximise profitability and shareholder benefits, the decision to invest in projects must be carefully considered using appraisal techniques which are flexible and able to account for future risks and uncertainties. Accordingly, the objective of this report is to analyse and discuss the following appraisal methods: Evaluating the concept of Expected NPV (E-NPV) as a basic tool for investment appraisal Using risk-adjusted discount rates in the evaluation of investment proposals The advantages of using Sensitivity Analysis (SA) in risk assessment while undertaking new investment projects The information and knowledge available to business managers at any given point in time is limited and there is a danger of misinterpreting discounted cash flow (DCF) techniques or else the results obtained are wrongly applied (Drury and Tayles, 1997). Furthermore, the failure to factor the effects of inflation while using DCF techniques means that NPV and IRR are often understated or excessive discount rates are used and the wrong investment projects may be selected by business (Drury and Tayles, 1997). With the proper application of E-NPV, risk-adjusted discount rates and sensitivity analysis, business managers can make the right investment decisions and ensure the maximisation of profitability and shareholder returns. 2. DCF Analysis – Components and application Most business managers use the DCF method for appraising investment proposals. Within DCF there are two approaches which are used by a company, namely, Expected Net Present Value (E-NPV) and Internal Rate of Return (IRR). Of these two methods, it is generally accepted that E-NPV is a better method for investment analysis, but more businesses end up using the IRR method because the concept ‘rate of return’ is more understandable than with actual values (Dayananda et al, p. 91, 2002). 2.1 Expected Net Present Value (E-NPV) NPV is the difference between cash outflows and cash inflows. Alternatively, NPV can also be calculated by discounting net cash flows at specified rates (Dayananda, et al, p. 92, 2002). This specified rate is also called ‘discount rate’ or ‘opportunity cost’ or ‘cost of capital’. The NPV technique of investment appraisal essentially works on the surmise that future cash flows can be discounted to the current period of time, in order to calculate net profit or loss if the investment in question was approved. In simple terms, if the NPV is positive the investment is feasible and profitability is increased. “Traditional NPV makes implicit assumptions concerning an “expected scenario” of cash flows and presumes management's passive commitment to a certain “operating strategy” (e.g., to initiate the project immediately and operate it continuously at base scale until the end of a pre-specified expected useful life)” (Trigeorgis, 1995). In real time, uncertainties and market forces such as competition mean that an “expected scenario” may not actually come to pass, unless the management has the flexibility to modify its strategies in managing the project. Therefore, one of the suggested approaches of capital budgeting is to wed traditional NPV with options which allow for flexibility in making investment decisions. The options on offer are numerous – deferment, expansion, contraction, abandonment, alteration, etc – leading to an option-based expected/expanded NPV or E-NPV. In order to derive the maximum benefits from DCF techniques such as NPV for investment appraisal, it is important that the business/project manager does not misinterpret or wrongly apply these techniques. One way to overcome this problem is to consider a variety of permutations and combinations of NPV and the value of options as stated above. 2.2 Risk-adjusted Discount Rate NPV is a technique which usually operates under some level of certainty. However, in real-time uncertainties are a fact of life and in nearly all instances of investment appraisal, managers are required to factor future ‘risk’ as a parameter in investment analysis. Before making any prudent investment decision, a manager is required to measure the risk(s) associated with expected cash flows, and incorporate the same while calculating NPV (Dayananda et al, p. 114, 2002). Four methods of incorporating risk in NPV calculation have been accepted by most economists and business managers: (i) Risk-adjusted discount rate; (ii) certainty equivalent; (iii) sensitivity analysis; and (iv) break-even analysis and simulation. Of these, the risk-adjusted discount rate method (RADR) is discussed in this section and sensitivity analysis (SA) in the next section. The RADR method is more or less the same as the traditional NPV method, with the appreciable difference being that the discount rate which is applied is higher than the risk-free rate assumed under NPV. Under RADR, risk-free discount rate (r) is supplanted by the required rate of return (RROR), which is a combination of the time value of money and the quantum of risk associated with expected cash flows. Therefore, in using the RADR method to calculate NPV, three basic components are required: (i) a risk-free discount rate, (ii) an average risk premium which accounts for the risks associated with existing business or investment, and (iii) additional risk factor which is a nil, positive or negative value which differentiates between existing risk and the risk attached to the proposed investment or project (Dayananda, et al, 2002). Each of these three components can be calculated or derived in order to calculate the final RROR, but in estimating the average risk premium, the cost of capital must first be calculated. Cost of capital can be calculated using weighted average cost of capital (WACC) or the capital asset pricing model (CAPM). To calculate the additional risk factor, most businesses assign a specific range of values, but the rationale for adopting these risk values is quite subjective. For example, average risk projects can be assigned a value of 0, above-average risk projects are assigned a risk value between 2% to 4%, high risk projects have risk values in the 4%-7% range low risk objectives could be assigned risk values in the negative range (-2% to -4%) (Dayananda et al, p. 119, 2002). Once the RADR is ascertained, one can derive the NPV and usually such NPV is always marginally lower than the NPV derived in a risk-free scenario. Hence, it can be concluded that the NPV calculated by using a RADR presents a much more realistic picture and allows management the flexibility to incorporate different risk scenarios to arrive at a real-value NPV to appraise particular investments. 2.3 Sensitivity Analysis Generally, two methods have been adopted to evaluate investment risk. The objective of both these methods is to identify and understand the variables or parameters which have the most effect on the investment outcome (Dayananda, et al, p. 133, 2005). The two methods are Sensitivity Analysis (SA) and Break-even Analysis (BA). We will consider only Sensitive Analysis as a means of evaluating investment risk in this report. Under SA, variables which can have an impact on the project outcome are identified and each of these variables are run through various scenarios, namely, the most-pessimistic, the most-optimistic and the most-likely scenarios. In each scenario, the variables which have the greatest impact on the NPV are evaluated. Therefore, SA can be defined as the “process of analysing risky projects by estimating a NPV for each variable under consideration, under the most-pessimistic, most-likely and most-optimistic scenarios” (Dayananda, et al p. 134, 2002). In carrying out a sensitivity analysis, the business manager must ensure that each variable is examined under different situations, while keeping the remaining variables at a fixed level. To summarise, sensitivity analysis can be carried out in the following manner and allows the manager to determine which variables have the most effects on the NPV of a project. (1) Calculate regular NPV by assigning the most likely value to each variable or parameter (2) List all key variables or parameters which are likely to impact NPV (3) Tweak the value of one variable – making it higher or lower – other variables remaining the same, and rework the NPV (4) Repeat step 3 with other key variables and derive different values of NPV with the changed values (5) Lastly, plot the new NPV derived from changing one variable at a time and compare with the standard NPV calculated in step 1. This will help in identifying sensitive variables or parameters which have the higher impact on NPV and refine decisions on new investments or projects. 3. Conclusion It is evident that among DCF and non-DCF techniques for investment appraisal and capital budgeting, the Net Present Value (NPV) method is more superior when compared with IRR, Payback Period, ARR, etc. However, the traditional NPV model has a drawback in that it is based on a certainty factor and assumes zero risk. Business managers are aware that real-life is filled with uncertainties and risks which are known as well as unknown. Therefore, capital budgeting techniques need to be resilient and flexible to factor risks and to arrive at realistic NPVs. This is where risk-adjusted discount rate (RADR) and sensitivity analysis (SA) come in. 3.1 Recommendations Accordingly the recommendations made by this report on the importance of NPV, RADR and SA are as below: 1. NPV method of investment appraisal is preferred over DCF and non-DCF techniques 2. NPV calculation should take into account real-time factors such as market risk, uncertainties, etc. 3. NPV can be made more flexible and resilient with the use of additional appraisal methods such as RADR and sensitivity analysis 4. With the flexibility offered by undertaking a sensitivity analysis, business managers can arrive at multiple NPVs and scenarios and choose those which have the best impact on profitability and shareholder wealth. 4. References Brookfield, D., (1995) ‘Risk and capital budgeting: avoiding pitfalls’ Management Decision, Vol. 33, p.56 Dayananda, D., Harrison, S., Herbohn, J., Irons, R. and Rowland, P., Capital Budgeting: Financial appraisal of investment projects, Cambridge University Press, 2002 Drury, C. and Tayles, M., ‘The misapplication of capital investment appraisal techniques’ Management Decision, Vol. 35, p. 86 Hodder, J.E. and Riggs, H.E ‘Pitfalls in Evaluating Risky Projects’ Harvard Business Review, Vol. 63, Issue 1; p. 128, 1985 Trigeorgis, L., Real Options in Capital Investment: Models, Strategies and Applications, Praeger Publishers, 1995 Read More