Invoice Discounting: the Profitability of the Firm - Essay Example

The CAPM refers to a set of predictions concerning equilibrium expected returns on risky assets. The CAPM was developed twelve years following the foundations of modern portfolio theory laid down by Harry Markowitz. (Bodie et al., 2005). The CAPM was developed by William Sharpe, John Lintner and Jan Mossin. (Bodie et al., 2005). The CAPM is based on a number of assumptions, which have been attacked by a number of researchers. For example, the CAPM assumes that all investors invest only for a single holding period, which is not the case in practice. In addition, the CAPM assumes that all investors borrow and lend at the risk-free interest rate which is also not feasible in real life. The CAPM can be stated Mathematically as: (1) Where is defined as (Bodie et al., 2005). Where represents the return on security I, is the return on a risk-free investment such as the Treasury bill or government bond is the sensitivity of the return on security I, to movements in the market portfolio, and is the expected return on the market portfolio. (Bodie et al., 2005). The CAPM predicts that the expected excess return from holding an asset is proportional to the covariance of its return with the market portfolio (i.e., its beta) as shown in equation (1) above. (Merton, 1973). This implication of the CAPM has been contested by a number of researchers. For example, Black et al. (1972) provide evidence contrary to the above. They find that low beta stocks earn a higher return on average and high beta stocks earn a lower return on average than those predicted by the CAPM. This indicates that, there should be other variables that account for the return on an asset. Despite this criticism, Merton (1972) suggest that the CAPM is still useful because it is an equilibrium model which provide a strong specification of the relationship among asset yields that is easily interpreted although it fails to explain a significant fraction of the variation in asset returns. Based on the criticisms of the CAPM a number of other models have been developed to account for the variability of asset returns. These include models such as the Arbitrage Pricing Theory (APT) and the Fama and French three factor model. The APT was formulated by Ross (1976) and it offers and it offers a testable alternative to the CAPM (Roll and Ross, 1980). The APT is an asset pricing model that explains the cross-sectional variation in asset returns. (Chen, 1987). The APT assumes that markets are perfectly competitive and frictionless and that individuals believe that returns are generated by a number of factors. For k-number of factors, the return on an asset i, can be written as follows (Chen, 1987): (2) Where is the expected return; , j = 1, ..., k, are the mean zero factors common to all assets; is the sensitivity of the sensitivity of the return on asset i to he flucatuations in factors j; and is the “firm specific risk” or “non-systematic” risk component idiosyncratic to asset i, which has a zero expected valued, that is, E{ / } = 0 for all j. In a well diversified economy with no arbitrage opportunity, the equilibrium expected return on asset i is given by (Chen, 1987): (3) If there exists a riskless (or “zero-beta”) asset, its return will be . The other parameters, , ..., , can be interpreted as risk premiums corresponding to risk factors to . In other words, is the expected return per unit of long investment of a portfolio with zero net investment and and (Chen, 1987). The APT is particularly appropriate because it agrees perfectly with what appears to be the intuition behind the CAPM. (Roll and Ross, 1980). Unlike the CAPM, the APT is not restricted to a single period; it holds in both single and multi-periods and the market portfolio need not be mean-variant efficient. (Roll and Ross, 1980). In a study of the joint roles of the market, size earnings-to-price ratio, leverage and book-to-market equity in he cross-section of average stock returns, Fama and French (1992a) find that used alone or in combination of other variables, the slope in the regression of a stock’s return on a market return has little information about average returns. On the contrary, holding other things equal, Fama and French (1992a) find that size, earnings-to-price ratio, leverage and book-to-markt equity have explanatory power. In combinations, size and book-to-market equity, seem to absorb the apparent roles of leverage and Earnings to price in average returns. As a result one can conclude that two empirically determined variables, size and book-to-market equity, do a good job explaining the cross-section of average returns on the NYSE, Amex, and NASDAQ stocks from 1963 to 1990. (Fama and French, 1992b). Based on the above, in addition to the CAPM and the APT, Fama and French (1993) developed a three-factor model, which states that expected returns can be explained by the excess return on the market, a size factor (SMB) and a book-to-market factor (HML). The three factor model implies that the returns on a security can be expressed as a function of three variables including the market return, the size of the company and the market-to-book equity. 2. Behavioural Finance Theory and its Relationship to the EMH Fama (1991) describes an efficient market as: “A market in which firms can make production-investment decisions, and investors can choose among the securities that represents ownership of firms’ activities under the assumption that security prices at any time “fully reflect” all available information” (Fama, 1991: p. 383) Fama (1991) divides efficiency in 3 levels: -The weak form hypothesis asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interest. -The semi strong form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. -The strong form hypothesis states that stock prices reflect all information relevant to the firm, even including information available only to company insiders. The efficient market hypothesis therefore assumes that investors are always rational when making investment decisions given that it is not possible for them to make abnormal returns by trading on extra information since this information is already available to all investors. On the contrary, behavioural finance theory indicates that investors do not have enough time to analyse and process all the information at their disposal and as such tend to make investment decisions using heuristics. Consequently, behavioural finance theory contends that it is possible to make abnormal profits by hedging bets on superior information. According to (Rutterford and Davison, 2007: p. 462) a common starting point for the study of behavioural finance is the observation that as human beings are famously less than perfectly rational in every other major area of decision making, it actually seems almost perverse to assume that in one field alone- that of investment – they should uniquely act with perfect rationality. Behavioural finance is basically an area of research developed by kenhaman and Tversky (1974) which posits that psychology plays a major part in financial decision making. Hong and Stern (1999) posit that “behavioral” can be broadly construed as involving some departure from the classical assumptions of strict rationality and unlimited computational capacity on the part of investors. Behavioural finance theory implies that, even if investors were both intellectually equipped and temperamentally disposed to act in a perfectly rational way, they could not in practice give full expression to that rationality, as there is not sufficient time to process all the information that might be relevant to the valuation of any particular security. (Rutterford and Davison, 2007). Like many other areas of decision making, investment decisions require enough time to process information, as well as intellectual ability to ensure that a rational decision is arrived at. However, like with other decision making areas, investment decisions need to be made very fast and it may be practically difficult to go through all the complex processes of processing and analyzing information so as to arrive a rational decision. In this light therefore investors use psychological judgments which may be subjective to arrive at a decision. When investors are confronted with the impossibility of making a perfectly rational decision, they learn by experience “to get by in order to get on”. (Rutterford and Davison, 2007: p. 462). People often use heuristics – that is, a set of rules-of-thumb which experience has shown to produce an acceptable prepondence of good decisions, and a bearable or containable minority of bad decisions. The theory of behaviroural finance is negatively related to the efficient market hypothesis (EMH). 3. Major findings of Behavioural Finance and implications to EMH Major findings of behavioural finance suggest two families of pervasive regularities: underreaction and overreaction. (Barberies et al., 1998; Fama, 1998; Hong and Stern, 1999). On the one hand, according to the underreaction evidence, over long horizons, say 1 to 12 months security prices underreact to news. This indicates that news is incorporated only slowly into prices, which tend to exhibit positive autocorrelations over these horizons. (Barberies et al., 1998). Current good news therefore has power in predicting positive returns in future. On the other hand, the overreaction hypothesis suggests that over longer horizons, say 3 to 5 years, security prices overreact to consistent patterns of news pointing in the same direction indicating that securities that have had a long record of good news tend to become overpriced and have low average returns after-wards. In other words, stocks with strings of good performance, however measured, receive extremely high valuations, and these valuations on average return to the mean in the long run. (Barberies et al., 1998). The above findings from behavioural finance theory present a challenge to the efficient market hypothesis. The efficient market hypothesis suggests that stock prices exhibit random walks in stock prices (Fama, 1991; Rotterford and Davison, 2007) implying that investors cannot make superior profits by hedging bets on sophisticated information. On the contrary behavioural finance suggests positive autocorrelations in security prices (Barberies et al., 1998). The evidence from behavioural finance therefore suggests that in a variety of markets, sophisticated investors can earn superior returns by taking advantage of underreactions and overreactions without bearing extra risk. (Barberies et al., 1998). 3. Weighted Average Cost of Capital Companies are often financed from two main sources. These include equity and debt. Each of these funding sources has a cost to the firm and the firm adjusts its mix of the two sources to minimise the overall cost to the firm. The weigted average cost of capital can be written as follows: WACC = D/(D+E) x rd(1-Tc) + E/(D+E) x re (4) Where D is the market value of debt; E is the market value of equity; rd is the cost of debt; re is the cost of equity capital and Tc is the corporate tax rate. (Ross et al., 1999; Myers and Brealey, 2002). It is often believed that when a firm employs more debt it reduces the overall cost to the firm. However, there is a trade-off between financial risk and minimising the cost of capital. (Ross et al., 1999; Myers and Brealey, 2002). Equation 4 above shows that when as we increase the proportion of debt and as the tax rate increases, the overall cost of capital to the firm increases. However, there is an optimal level of debt that the firm can contain. As the firm exceeds this level of debt, its overall cost of capital starts rising. 4. Factoring and Invoice Discounting. Factoring involves a process where a specialised firm assumes the responsibility for the administration and collection of the account receivable for its clients. It can be considered a form of short-term commercial financing based on the selling of trade credit at a discount, or for a prescribed fee plus interest (Forman and Gilbert, 1976). The factoring process involves the interaction of three types of firms or economic agents including the client firm which provides trade credit to its customers, the customer firm that receives goods on credit from the client firm and is charged with the responsibility of making timely payments, the factoring firm which provides the client firm with specific functions, including the substitution of accounts receivable with cash. The factoring firm assumes the credit risk for the accepted accounts and thus takes full responsibility for the solvency of such customers to the extent of the accepted or approved amounts. (Soufani, 2000). The factoring firm also checks the credit and collects the accounts from the customer firm. The factoring fee is calculated as a proportion of sales, and ranges from between 0.25 percent an 2.5 percent for the full factoring service, and where credit is extended, the interest ranges bet between 2 and 3 percent above the base rate. (Soufani, 2000). The factoring process is shown in figure 1 below. Factoring has a lot of advantages to a firm. For example factoring helps to reduce transaction cost to the firm. It reduces that cost of acquiring information between buyer and seller. The factor is better placed to evaluate the debtor and thus provide the seller with this information, which will determine whether credit will be extended in future. (Summers and Wilson, 2005). Buyers can also benefit in that the factoring firm can provide them with more information about the price and quality of the products of the seller. Factoring also provides a firm with economies of scale. When a firm has a number of uncollectible accounts to a number of different customers, factoring reduces the fixed costs associated with such customers become spread over a number of customers. (Summers and Wilson, 2005). Despite these advantages, factoring comes at a cost as it reduces the amount of money ultimately collected from the customer and may have an impact on the profitability of a firm. Figure 1: The Factoring Process. Pike and Cheng (2001) Invoice Discounting is a process whereby a firm offers a discount to customers if they pay their debt in time. Invoice discounting is advantages in that it enables the company to collect cash in time and thus reduces the liquidity and credit risk to the company, that is, the risks that customers may not pay. This is because customers are motivated to pay their debt so as to take advantage of the discount. However, invoice discounting is disadvantageous in that it reduces the amount of cash collected by the amount of the discount provided thereby reducing the profitability of the firm. Bibliography Ross. S A. (1976). "The Arbitrage Theory of Capital Asset Pricing." Journal of Economic Theory, vol. 13, pp. 341-60. Fama E., French K. R. (1992). The Cross Section of Expected Stock Returns. Journal of Finance, vol. XLVII, No. 2, pp. 427-465. Bodie Z., Kane A., Marcus A. J. (2005). Investments. Sixth Edition. McGraw-Hill. Roll R., Ross S. A. (1980). An empirical Investigation of the Arbitrage Pricing Theory, Journal of Finance, vol. XXXV, No. 5, pp. 1073-1103. Soufani K. (2000). The role of factoring in financing UK SMEs: A supply side analysis. Journal of Small Business and Enterprise Development, Volume 8, Number 1 Summers, B., Wilson, N. (2000). Trade Credit Management and the Decision to Use Factoring: An Empirical Study. 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