The Strengths of the NPV in Business - Research Proposal Example

Section First, the strengths of the NPV are discussed. Next, the weaknesses of the IRR are discussed. NPV uses cash flows. Cash flows from a project can be used for other corporate purposes (e.g., dividend payments, other capital-budgeting projects, or payments of corporate interest). By contrast, earnings are an artificial construct. While earnings are useful to accountants, they should not be used in capital budgeting because they do not represent cash1. NPV uses all the cash flows of the project. Other approaches ignore cash flows beyond a particular date1. NPV discounts the cash flows properly. Other approaches may ignore the time value of money when handling cash flows1. For both independent and mutually projects, the IRR does not have a clear decision rule for project acceptance, unlike NPV that has a clear rule, that is, accept the project if its NPV is positive. If the project is an investing project, the decision rule for accepting the project is to accept the project if the IRR is greater than the discount rate. If the project is a financing project, the decision rule for accepting the project is to accept the project when the IRR is less than the discount rate1. For both independent and mutually projects, when the project’s cash flows exhibit two or more changes of sign, the project has more than one IRR. In theory, a cash flow stream with M changes in sign can have up to M positive internal rates of return. In a case like this, the IRR does not make any sense. Because there is no good reason to use one IRR over the other, IRR simply cannot be used here. On the contrary, there is only one NPV for a project regardless of changes of sign in the project’s cash flows1. For mutually exclusive projects, the problem with IRR is that it ignores issues of scale, resulting in the acceptance of the wrong project if the IRR is used as a decision criterion. Project 1 may have a higher IRR but the investment is smaller. Another project, project 2, may have a lower IRR but the investment is bigger. The high percentage on project 1 is more than offset by the ability to earn at least a decent return on a much bigger investment under project 2. Therefore, project 2 should be accepted. However, if IRR is used as the decision criterion, project 1 with a higher IRR will be accepted and project 2 will be rejected. The NPV does not have the scale problem. Using NPV as the decision criterion will result in the right decision to accept project 2 with a higher NPV1. For mutually exclusive project, another problem with IRR is that it ignores issues of timing, resulting in the acceptance of the wrong project if the IRR is used as a decision criterion. The cash flows of project 1 occur early, whereas the cash flows of 2 occur later. If we assume a high discount rate, we favour investment 1 because we are implicitly assuming that the early cash flow can be reinvested at that rate. Because most of investment 2’s cash flows occur in later years, investment 2’s value is relatively high with low discount rates. Using the IRR as the decision criterion may result in the wrong investment being selected. The investment with the higher IRR will be selected regardless of the discount rate used. Using NPV as the decision criterion will result in the right decision to accept the project with the higher NPV1. In conclusion, NPV is theoretically superior to IRR. The strengths of NPV are that NPV uses cash flows instead of earnings, NPV uses all the cash flows of the project, and NPV discounts the cash flows properly. IRR has flaws that are not applicable to NPV. For both independent and mutually exclusive projects, the problem is that some projects have cash inflows followed by one or more outflows. The IRR rule is inverted here, that is, one should accept when the IRR is below the discount rate. Another problem is some projects have a number of changes of sign in their cash flows. Here, there are likely to be multiple internal rates of return. The practitioner must use NPV here. For mutually exclusive projects, either due to differences in size or in timing, the project with the highest IRR need not have the highest NPV. Hence, the IRR rule should not be applied. Of course, NPV can still be applied1. SECTION 2 (i) The expected net present value of the proposal is the present value of the expected savings (in cash) minus the investment outlay. The present value of the expected savings (in cash) is the sum of the discounted expected estimated savings (in cash) in each year. The expected estimated savings (in cash) in each year is estimated savings (in cash) multiplied by the probability of occurrence each year. The discount rate is the cost of capital of 10% of the new bank loan. The investment outlay is the purchase price of the system of ₤540,000. Expected savings (in cash) in year 1 = 80,000 X 0.3 + 160,000 X 0.5 + 200,000 X 0.2 = 144,000 Expected savings (in cash) in year 2 = 140,000 X 0.4 + 220,000 X 0.4 + 250,000 X 0.2 = 194,000 Expected savings (in cash) in year 3 = 140,000 X 0.4 + 200,000 X 0.3 + 230,000 X 0.3 = 185,000 Expected savings (in cash) in year 4 = 100,000 X 0.3 + 170,000 X 0.6 + 200,000 X 0.1 = 152,000 Expected net present value of the proposal = - 540,000 + 144,000/1.1 + 194,000/1.12 + 185,000/1.13 + 152,000/1.14 = - 5408.22 The expected net present value of the proposal is negative and the project should be rejected. (ii) The net present value of the worst possible outcome is the present value of the lowest expected savings (in cash) minus the investment outlay. The present value of the lowest expected savings (in cash) is the sum of the discounted lowest estimated savings (in cash) in each year. The discount rate is the cost of capital of 10% of the new bank loan. The investment outlay is the purchase price of the system of ₤540,000. Net present value of the worst possible outcome = - 540,000 + 80,000/1.1 + 140,000/1.12 + 140,000/1.13 + 100,000/1.14 = - 161,895.30 The expected net present value of the proposal is negative and the project should be rejected. The probability of occurrence of the worst possible outcome is a joint probability. The probability of occurrence of the worst possible outcome is the probability that the estimated savings (in cash) in year 1 is ₤80,000, the estimated savings (in cash) in year 2 is ₤140,000, the estimated savings (in cash) in year 3 is ₤140,000, and the estimated savings (in cash) in year 4 is ₤100,000. Probability of occurrence of the worst possible outcome = 0.3 X 0.4 X 0.4 X 0.3 = 0.0144 Section 3 In a world of no taxes, the famous Proposition 1 of Modigliani and Miller proves that the value of the firm is unaffected by the debt-to-equity ratio. In other words, capital structure is of no consequence to a company. Either a high or a low corporate ratio of debt to equity can be offset by homemade leverage. The result hinges on the assumption that individuals can borrow at the same rate as corporations, an assumption that is quite plausible1. MM’s Proposition II in a world without taxes states This implies that the expected rate of return on equity (also called the cost of equity or the required return on equity) is positively related to the firm’s leverage. This makes intuitive sense, because the risk of equity rises with leverage1. While the above work of MM is quite elegant, it does not explain the empirical findings on capital structure very well. MM imply that capital structure is of no consequence to a company, while capital structure appears to be of consequence in the real world1. This may be due to taxes, bankruptcy costs, agency costs of debt and equity, and signaling. In a world with corporate taxes but no bankruptcy costs, firm value is an increasing function of leverage. The formula for the value of the firm is VL = VU + TCB Expected return on levered equity can be expressed as rS = r0 + (1 – TC) X (r0 – rB) X B/S Here, value is positively related to leverage. This result implies that firms should have a capital structure almost entirely composed of debt1. Kim identified a major defect in the past models that academics have proposed. According to Kim, these models have failed to recognise that in the presence of bankruptcy costs, debt capacity, defined as the maximum of borrowing allowed in the capital market, occurs well before the point of 100% debt financing is allowed. Therefore, accordingly, there should be an optimal capital structure for firms, well before 100% debt financing is allowed2. According to Kim, the cost of bankruptcy can be thought of as comprising three major components. The first is the various administrative expenses to be paid to third parties, such as legal fees. The second is shortfall arising from liquidation, such as the difference between market value and depressed value of assets, or indirect cost of reorganisation, such as jeopardy of future business transactions. The last component is tax credits loss. The firm would have received tax credits had they not gone bankrupt. An example is tax credits accumulated in the previous fiscal years for which the firm was in red2. Kim shows that in the absence of taxes and bankruptcy costs, but with positive probability of bankruptcy, the market value of the firm is independent of its capital structure. However, with a positive income tax rate and positive bankruptcy costs, the market value of the levered firm is equal to the market value of the unlevered firm plus the present value of tax deductibility of interest payments, minus the present value of the loss of tax credits in the event of bankruptcy, and the fraction of the present value of bankruptcy costs2. Jensen and Meckling3 used agency cost to argue that the probability of cash flow of a company is dependent on its capital structure and this could help find optimal structure of firms. Agency costs arises from agency relationship, which consists of agency cost of equity and agency cost of debt. An owner-manager in a wholly owned firm fully bears the costs of perks such as taking an afternoon break and travelling in first class planes. When the owner-manager sells off a portion of his shares of the firm to outside shareholders, conflicts of interest arise. He may maximise his welfare at the expense of the new shareholders. The manager does not fully conduct activities that the new shareholders desire him to do so as to increase their welfare and wealth. Thus co-ownership of equity implies agency problems. The new shareholders will have to incur monitoring costs to ensure that the original owner-manager acts in their interest. It is assumed that the agency costs of equity increases as a percentage of financing supplied by external equity. Agency costs of equity can be decreased if the manager and the shareholders agree to hire an independent auditor or if the manager volunteers to provide accounts and financial information to report to the external shareholders. In the former, monitoring costs will be incurred and in the latter, bonding costs will be incurred. Even if these are done, there will still exist divergence of ideal maximisation of shareholders wealth, resulting in residual costs. Hence, bondholders need to have protective covenants and monitoring devices to protect their interests3. There are contractual methods for reducing agency costs. Jensen and Meckling3 focused on secured debt as a way of reducing agency costs. However, the cost of writing these covenants may be non-trivial. Bondholders must charge higher yields to compensate them for the possible wealth expropriation. Jensen and Meckling3 suggest that, given increasing agency costs with higher proportion of equity one hand and higher proportion of debt on the other, there is an optimum combination of outside debt and equity that will be chosen because it minimises total agency costs. In this case, it is possible to argue for existence of optimum capital structure even in a world without taxes or bankruptcy costs. In signaling hypotheses, the assumption of corporate insiders and outsiders having the same set of information, made in the Modigliani–Miller propositions, is relaxed. Managers may therefore use capital structure decision to convey information to the market. There are two competing theories of capital structure: tradeoff theory4 and pecking order theory5. In tradeoff theory, the search is for an optimum capital structure. The tradeoff is between the interest tax shield, bankruptcy costs and agency costs. The firm would seek the optimum debt ratio that maximises the value of the firm. It therefore balances the marginal present values of interest tax shields against bankruptcy costs and agency costs. The theory therefore predicts the mean reversion of the actual debt ratio towards a target or optimum and also predicts a cross-sectional relation between average debt-ratios and asset risk, profitability, tax status and asset type4. Ross4 shows that greater financial leverage can be used by managers to signal an optimistic future for the firm. Signals cannot be mimicked by unsuccessful firms because such firms do not have sufficient cash flows to back them up and managers have incentives to tell the truth. There would be no signaling equilibrium if there were no incentives to signal truthfully. In pecking order theory, there is no optimal debt ratio. Due to asymmetric information and signaling problems associated with issuing equity, financing policies follow a hierarchy, with preference for internal over external financing and for debt over equity. The debt ratio is therefore a cumulative result of hierarchical financing over time5. Myers and Majluf5 demonstrate that there exists a pecking order in financing, with preference for internal over external financing and for debt over equity. References: Jensen, MC & Meckling, WH 1976, ‘Theory of the firm: managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, vol. 3, no. 4, pp. 305-360. Kim, EH 1973, ‘A mean-variance theory of optimal capital structure & corporate debt capacity’, The Journal of Finance, vol. 33, no. 1, pp. 45-63. Myers, SC & Majluf, NS 1984, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, no. 2, pp. 187-221. Ross, SA 1977, ‘The determination of financial structure: the incentive-signaling approach’, Bell Journal of Economics, vol. 8, pp. 23-40. Ross, SA, Westerfield, RW & Jaffe, J 1996, Corporate finance, McGraw Hill, International Edition. Read More