Capital Budgeting - Statistics Project Example

Capital Budgeting - An Introduction Business firms need finance mainly for two purposes - to find the long-term decisions and for meeting the working capital requirements. The long-term decisions of a firm involve setting up of the firm, expansion, diversification, modernization and other similar capital expenditure decisions ((ICMR), 2003). All these decisions involve huge investment, the benefits of which will be seen only in the long-term and these decisions are also irreversible in nature. By nature of these projects, long-term sources of funds become the best suited means of financing. One of the most important considerations for an investment and financing decision will be proper asset-liability management. Companies will have to face a severe asset-liability mismatch if the long-term requirements are funded by the short-term sources of funds. Such a mismatch will lead to an interest risk thereby enhancing the interest burden of the firm and a liquidity risk with the short-term funds being help up in long-term projects. Whenever a business firm plans to invest in a long-term project, it needs to assess the benefits that can be reaped out from that particular long-term investment and come to a conclusion whether that particular investment is profitable for the business or not. The entire process of assessing a proposed long-term investment and coming to a conclusion whether it is worth investing or not is termed as "Capital Budgeting." The ultimate goal of any individual or a firm's maximization of profits or rate of returns - in other words market value of one's investments. Thus, investment management is an ongoing process which needs to be constantly monitored by way of information as this may affect the value of securities or rate of returns of such securities. Therefore, a finance manager needs to have basic knowledge and understanding of the framework of security valuation which is essentially based on conceptual understanding of time of value of money and risk -return relationship. Hence, while making valuation judgements about securities or long-term investments, the analyst constantly applies a process which may achieve the following. a. A true picture of a company over a representative time span. b. An estimation of current normal earning power and dividend pay-out c. Estimate of future profitability and growth and the reliability of such expectations. d. Translation of all these estimates into valuation of the company and the securities. The global financial markets now-a-days are getting more integrated, and people and firms are entering into more and more cross - border financial deals. In order to make these transactions feasible, a system for determination of the amount and method of payment of the underlying financial flows is needed. Since the domestic currencies of the parties involved will be different, the flows will take place in some mutually acceptable currency. All the relevant transaction taking place would hence be on account of international trade in goods or services, or due to acquisition or liquidation of financial assets, or because of creation or repayment of international credit. Measurement of Total risk Undoubtedly, all the modern forms of risk quantification find their origins in Risk is associated with the dispersion in the likely outcomes. Dispersion refers to variability. If an asset's return has no variability, it has no risk. An investor analyzing a series of returns on an investment over a period of years needs to know something about the variability of its returns or in other words the assets' total risk1. There are different ways to measure variability of returns. The range of the returns, i.e. the difference between the highest possible rate of return and the lowest possible rate of return is one measure, but the range is based on only two extreme values. The variance of an asset's rate of return can be found as the sum of the squared deviation of each possible rate of return from the expected rate of return multiplied by the probability that the rate of return occurs. Where VAR (k) = Variance of returns = Probability associated with the ith possible outcome = Rate of return from the ith possible outcome K = Expected rate of return n = Number of years. A third and most popular way of measuring variability of returns is standard deviation. The standard deviation denoted by ' is simply the square root of the variance of the rates of return explained above. ' = The standard deviation and variance are conceptually equivalent quantitative measures of total risk2. Standard deviation is preferred to range because of the following advantages: Unlike the range, standard deviation considers every possible event and assigns each event a weight equal to its probability. Standard deviation is a very familiar concept and many calculators and computers are programmed to calculate it. Standard deviation is a measure of dispersion around the expected or average value. This is an absolute consensus with the definition of risk as "variability of returns." Standard deviation is obtained as the square root of the sum of squared differences multiplied by their probabilities. This facilitates comparison of risk as measured by standard deviation and expected returns as both are measured in the same costs. This is why standard deviation is preferred to variance as a measure of risk. A model for stock return was proposed by Heston and Rouwenhorst in the year 1994. It is capable of disencumbering country and industry effects. The return for any stock i that belongs to industry j and country k can be calculated by using the following formula: (1) In the above cited formula, ' represents a common component of all stocks, 'j captures the industry effect and 'k the country effect. 'i is the error term and is considered to be return specific. It is also assumed to have a mean of zero and also a finite variance. Any interaction between the country and industry effect would be ruled out by this specification. In the sample considered for our study, we have 12 countries (k=1 to 12), with each belonging to one of ten industries (j=1 to 10). Iij is used for defining industry dummies. This is in order to have a value of a single stock i that belong to either industry j or zero. In the same way Cik, is used to define country dummies. Even here we consider a value of one single stock i that belong to country k and zero otherwise. Thus, equation (1) can be re-written in the following manner: (2) In the case of the equation (2) it is not possible for it to be estimated in its current form as both the country and industry dummies equate to a same value, which results in a perfect multi co-linearity between the regressions. It is possible to proceed anyway by dropping an arbitrary industry and country and by measuring everything else relative to this. It can be done by constraining the weighted industry and country effects to zero. This equals to the measurement of each industry relative to the average firm or a weighted portfolio in case of our study. If the weights are simply apportioned to the number of stocks in each country and industry, we get the equally weighted index as follows: (3) In the above representation, nj and mk represent the number of firms in industry j and country k respectively. Alternatively, a relative value-weighted portfolio of stocks can be measured by weighing the industries and countries by the proportion of the total Euro zone market to which they account for. (4) In the above equation no.4, 'j and 'k are the value weights of industry j and country k respectively. In order to form a pooled regression as proposed, the following equation is estimated: (5) It is to be taken into account that the error term considered above may have a variance that is non-constant in the pooled dataset of the study. There is a chance of it varying from time to time and from industry to industry. A solution to this problem is the estimation of a 'random effects' model, given the time invariance of the regression. The error term, 'i, may be decomposed into a purely random component, a firm-specific effect and a time effect. The finding is that allowing for both the specific and time effects, results in the elimination of variance differences in the error term 'i and then the model is estimated by the Generalized Least Squares (GLS). The Capital Asset Pricing Model (CAPM) The CAPM is one of the major developments in the financial theory. The CAPM established a linear relationship between the required rate of return of a security and its systematic or un-diversifiable risk or beta, The CAPM is represented mathematically by Kj = Rf+Bj (km - Rf) Where Kj = expected or required rate of return on security j Rf = risk-free rate of return Bj = beta coefficient of security j km = return on market portfolio Assumptions The CAPM is based on a list of critical assumptions, some of which are as follows. Investors are risk-averse and use the expected rate of return and standard deviation of return as appropriate measures of risk and return for their portfolio. In other words, the greater the perceived risk of a portfolio, the higher return a risk-averse investor expects to compensate the risk. Investors make their investment decisions based on a single-period horizon i.e., the next immediate time period. Transactions costs in financial markets are low enough to ignore and assets can be bought and sold in any unit desired. The investor is limited only by his wealth and the price of the asset. Taxes do not affect the choice of buying assets. All individuals assume that they can buy assets at the going market price and they all agree on the nature of the return and risk associated with each investment. The assumptions listed above are somewhat limiting but the CAPM enables to be more precise about how trade-offs between risk and return are determined in financial markets. In the CAPM, the expected rate of return can also be thought of as a required rate of return because the market is assumed to be in equilibrium. The expected return is the return from an asset that investors anticipate or expect to earn over some future period. The required rate of return for a security is defined as the minimum expected rate of return needed to induce an investor to purchase it. In general, all the investors earn a riskless rate of return by investing in riskless assets like treasury bills. This risk - free rate of return is designated Rf and the minimum return expected by the investors. In addition to this, because investors are risk - averse, they will expect a risk premium to compensate them for the additional risk assumed in investing in a risky asset. Required Rate of Return = Risk-free rate + Risk premium The CAPM provides an explicit measure of the risk premium. It is the product of the Beta for a particular security j and the market risk premium km-Rf. Risk premium= 'j (km-Rf) This beta coefficient ''j' is the non-diversifiable risk of the asset relative to the risk of the market. If the risk of the asset is greater than the market risk, i.e. ' exceeds 1.0; the investor assigns a higher risk premium to asset j than to the market. For example, suppose a fertilizer company had a 'j of 1.5, that its required rate of return on the market (km) was 15 percent per year and that its risk-free interest rate (Rf) was 6 percent per annum. Using the CAPM the required rate of return can be calculated as below: Kj = Rf+Bj (km - Rf) = 0.06+1.5(0.15-0.06) = 0.195 or 19.5% The above calculations show that the required rate of return on this stock would be 19.5% - the sum of 6 percent risk-free return and a 13.5 percent risk premium. This 19.5 percent is larger than the 15 percent required rate on the market because the fertilizer stock is riskier than the market. Net Present Value Discounting is an alternative approach for reckoning the time value of money. Using this approach, it is possible to determine the present value of a cash flow or a stream of cash flows. Net Present Value can be defined as the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project (Investopedia, 2008). The NPV'analysis is sensitive to the'reliability of future cash inflows that an investment or project will yield.'The formula for the same is as follows: 3 NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative (Investopedia, 2008). Payback Period The Payback Period is believed to be one of the simplest methods of looking at one or more investment projects. This method focuses on the recovery of the cost of investment (Value Based Management.com). The Payback Period is defined as the amount of time taken by a capital budgeting project to recover the initial investment or cost. The following is the formula used to calculate the Payback Period of an investment: Cost of project / annual net revenue = payback period Hurdle rate Hurdle rate is defined as the minimum amount of return that a person requires before they will make an investment in something (Investopedia.com, 2008). Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that generates a zero net present value for a series of future cash flows. To be more specific, IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project or an investment equal to its current market value (Visitask.com, 2004). In simple words, IRR is the'discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project'equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first (Investopedia.com, 2008). IRR can be mathematically calculated using the following formula: In the above formula, CF is the Cash Flow generated in the specific period (the last period being 'n'). IRR, denoted by 'r' is to be calculated by employing trial and error method (Visitask.com, 2004). Accounting Rate of Return (ARR) ARR is most often used internally when selecting projects. It can also be used to measure the performance of projects and subsidiaries within an organisation (moneyterms.co.uk, 2006). It is calculated by using the following formula: ARR = average profit ' average investment4 Real Options Method Companies create shareholder value by identifying, managing and exercising real options associated with their investment portfolio. The real options method applies financial options theory to quantify the value of management flexibility in a world of uncertainty. If used as a conceptual tool, it allows management to characterize and communicate the strategic value of an investment project (Appalachian State Universtiy, 2005). When at times traditional methods like net present value etc. fail to accurately capture the economic value of investments in an environment of widespread uncertainty and rapid change the real options method represents the new state-of-the-art technique for the valuation and management of strategic investments. There are five types of real options: Waiting-to-Invest option, Growth option, Flexibility option, Exit option and Learning option. Capital Budgeting and Capital Markets with reference to Poland In the late 1980s, capital markets world-wide experienced an unprecedented increase in the number of stocks traded by institutional investors which increased the interest of researchers into the impact of institutional trading on stock prices. The special feature arises from the pension reform in Poland in 1999 when privately managed pension funds were established and started to invest on the domestic capital market (Bartosz Gebka, 2003). Trading on the Polish stock market exclusively takes place on the Warsaw Stock Exchange (WSE). A major change in the investor structure took place after the Polish pension reform. In 1999, the public pension system was enriched by a private component. In 1989 Poland, and thereupon other Eastern European countries, started the transition process from a centrally planned economy to a market economy. There was no pre-existing economic theory of such a process to rely on. The early 1990s were extremely difficult for these countries. Stock quotations on the Warsaw Stock Exchange (WSE) were launched on April 16, 1991. But from various researches that have been done on the capital markets of Poland and the stocks of the Polish companies, it has been evident that in the Polish stock market the volatility-volume relationship is independent of the direction of the observed price change. Apart from this fact, it has also been observed that stocks with a higher degree of institutional trading become more liquid, which causes spreads to narrow and autocorrelation to increase. Also, a higher degree of institutional trading is believed to cause adverse selection components of spreads to increase since the probability of informed trading is higher, and autocorrelation decreases with the degree of institutional trading. Cost of Capital As discussed in the earlier part of the paper, if a company decides on investing on a long-term investment, it needs to know if the investment is worthwhile for the company and this is termed as Capital Budgeting. Now, once the company assesses that particular long-term investment and say it comes to a conclusion that it is worth investing in the project, then the next step would be to think about ways to raise capital. The following part of the paper now looks at aspects like what it costs the company to raise these various types finance. The cost of capital to a company is the minimum rate of return that it must earn on its investments in order to satisfy the various categories of investors who have made investments in the form of shares, debentures or term loans. Unless the company earn this minimum rate, the investors will be tempted to pull out of the company, leave alone participate in any further capital investment in that company. For example, equity investors expect a minimum return as dividend on their perception of the risk undertaken based on the company's past performance, or on the returns they are getting from shares they have of other companies. The weighted arithmetic average of the cost of different financial resources that a company uses is termed as its cost of capital. Yet, there are certain assumptions on which the cost of a capital of a company measure depends upon. The following are the assumptions on which the measure of the cost of capital depends upon: a) The risk characterizing the new project under consideration is not significantly different from the risk characterizing the existing investments of the firm, and b) The firm will continue to pursue the same financing policies. Put differently, there will be no deviation from the debt-equity mix presently adopted by the firm. Before actually starting to calculate the cost of capital of the firm, let us first look at the various sources of finance that are typically tapped by a firm. They are i. debentures ii. term loans iii. preference capital iv. equity capital, and v. retained earnings As a measure of collective investor mood, the risk aversion factor is a composite, fundamental-technical indicator, since it reflects corporate earnings expectations, bond market activity, and stock market pricing and volatility. As already defined, the cost of capital is the expected return that is required on investments to compensate you for the required risk. It represents the discount rate that should be used for capital budgeting calculations. The cost of capital is generally calculated on a weighted average basis (WACC). ' It is alternatively referred to as the opportunity cost of capital or the required rate of return. It is calculated based on the expected average rate of return of investors in a firm. The following example shows the calculation of the cost of capital more clearly: The following is the Balance Sheet of an investment company: Bonds $ 200,000 Common shares $ 200,000 Retained Earnings $ 100,000 ------------- $ 500,000 ========= Bonds: - Annual interest rate 6% - Years to maturity is 9 years Common shares: - Shares held 100,000 - Current share price $5 - Market return over next year 12% - Beta (somewhat risky) 1.15 - Treasury bills currently yield 4% - Tax rate 25% Calculation: Initially, it is required to determine market values Bonds: FV = $200,000 Interest per year = $200,000 x 0.06 = $12,000 N (number of years) = 9 i (interest rate) = 6% PV (present value of the bonds) '''''''''' S P = ---------- ''''''' (1+rt) '''' $ 200,000 P = ------------- '' [1 + (0.06)9] ''''' $ 200,000 P = -------------- '''''''''' 1.54' P = $129,870.12 Interest per year = $129,870.12 x 0.06 = $7,792.21 Interest for nine years = $ 7,792.21 x 9 = $ 70,129.88 Amount to be paid at maturity = $ 129,870.12 + $ 70,129.88 = $ 200,000 (this is the face value). Common Shares: 100,000 shares x $ 5 = $ 500,000 The next step is the calculation of weightings based on market values: Bonds $ 129,870 0.2062 Common shares $ 500,000 0.7938 ' --------------- --------- ' $ 629,870 ' 1.0000 (should always be 1) After the above calculation, the actual costs are calculated: Common shares: Rate of return = Risk-free rate (treasury bills rate) + [market return over next'year - risk free rate] Beta = 0.04 + (0.12 -0.04)1.15 = 0.04 + 0.092 = 0.132 Bonds: PV = $ 129,870 FV = $ 200,000 i (after tax) = $ 12,000 (1 - 0.25) = $ 12,000 x 0.75 = $ 9,000 Effective rate = $ 9,000/$ 200,000 = 0.045 or 4.5% Finally, cost of capital is calculated: ' Weightings Costs Weightings x Costs Bonds 0.2062 0.045 0.0093 Common Shares 0.7938 0.132 0.1048 ' ' ' --------- ' ' ' 0.1141 ' ' ' ====== Cost of Capital = 11.41% At the time of developing the concept of cost of capital, it has been assumed that the risk profile and financing policy of the firm do not change. Normally, the Weighted Average Cost of Capital (WACC) increases with the level of financing required. The suppliers of capital generally require a higher return as they supply more capital. The following are the steps that are to be followed for determining the weighted marginal cost of capital: 1. The cost of each individual source of finance for various levels of usage has to be estimated. 2. Given the ratio of different sources of finance in the new capital structure, it is necessary to find out the levels of total new financing at which the cost of various sources would change. These levels, called breaking points, can be found out as: Breaking Point on Account of a Source Total new financing from that source at the breaking point Proportion of that financing source in the capital structure 3. The weighted average cost of capital is to be calculated for various ranges of total financing between the breaking points. 4. Finally, the weighted average costs of capital for each level of total new financing are to be listed. This is the weighted marginal cost of capital schedule. Capital Structure Theories Equity and debt capital are the two important sources of long - term finance for a firm. Finding out the proportion of equity and debt in the capital structure of a firm is indeed a difficult aspect. If the above aspect is to be answered, it is necessary to know the relationship between the financial leverage and firm valuation or financial leverage and cost of capital. And prior to that, it is also necessary to know if there is any relationship between the above said issues. Many approaches have been propounded to get and understanding of the same which are discussed in detail in the following paragraphs. Various methods of estimating the cost of capital 1. Net Income Approach According to this approach, the cost of equity capital and the cost of debt capital remain unchanged when B/S, the degree of leverage varies. This means that the average cost of capital Ko is measured as Ko = Kd B/ (B+S) + keS/ (B+S) 2. Net Operating Income Approach According to the net operating income approach, the overall capitalization rate and the cost of debt remain constant for all degrees of leverages. Therefore, in the following equation Ko and Kd are constant for all degrees of leverage. Ko = Kd B/ (B+S) + keS/ (B+S) Therefore, the cost of equity can be expressed as: Ke = Ko + (Ko - Kd )*(B/S) Traditional Approach The traditional approach has the following propositions: i. the cost of debt capital, Kd remains more or less constant up to a certain degree of leverage but rises thereafter at an increasing rate. ii. The cost of equity capital, Ke , remains more or less constant or rises only gradually up to a certain degree of leverage and rises sharply thereafter. iii. The average cost of capital, Ko , as a consequence of the above behaviour of the cost of equity and debt capital decreases up to a certain point and remains more or less unchanged for moderate increases in leverage thereafter and also rises beyond a certain point. The capital structure of a company refers to the mix of the long - term finances used by the firm. It is financing plan of the company. The Capital Structure decisions taken by any firm are very important. The objective of any company is to mix the permanent sources of funds used by it in a manner that will maximize the company's market price. In other words companies seek to minimize their cost of capital. This proper mix of funds i referred to as the Optimal Capital Structure. 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