Mathematics of Finance - Essay Example

Traditional approaches to financial appraisals emphasis given to the application of DCF methods to future cash flows. Evaluate the techniques. Is one superior? The potential of real option analysis is like Discounted Cash Flows (DCF), and other investment analysis techniques is simply another tool. The two techniques are complementary. Management should employ both methods in the analysis of potential investments and gather information from both (Amram, 2000). Further, we must consider a real option analysis is not ordinarily a simple technique. With it comes an amount of technical comfort required on the part of the analyst in order to implement the technique correctly. Like most techniques derived from financial theory, it is easily abused. Those who will utilize the information provided by real option analysis need training in the proper interpretation of its results (Eiteman, 2007). DCF analysis, defined as the process of valuing capital budgeting projects by discounting their future expected cash flows. DCF framework, defined as the valuing of an asset by discounting its expected future cash flows at some discount rate. Real option analysis is gaining in use and popularity. Senior management prefers this option because it has two sequences of a project. It describes the cash inflows and out flows at different times. Usually this is the way that management sees projects unfold. Real option analysis values management by its very nature. It gives credit to management to gain new information and make good business decisions at the points in time when the decisions made (Keck, 1998). Multinational Enterprises (MNE), have surveyed over the past 35 years, have shown about half of them adjust the discount rate, and half adjust the cash flows. One recent survey indicated a rising use adjusted discount rate over adjusting cash flows. This same survey showed an upswing of increasing use of multifactor methods discount rate adjustment, cash flow adjustment, real options analysis and qualitative criteria in evaluating foreign investments. Important to remember when an MNE evaluates competitive projects traditional discounted cash flow analysis is typically unable to capture the strategic options that an individual investment options may offer. This lack has led to the development of real option analysis. Real Option Analysis is the application of option theory to capital budgeting decision (Brealey, 1996). Real option valuation also allows us to analyze a number of managerial decisions that in practice characterize many major capital investment projects. Management will have (the option to defer, the option to abandon the option to alter capacity and the option to start up or shut down or switch). ROA treats cash flows in terms of future value in a positive sense, whereas DCF treats future cash flows negatively on a discounted basis. ROA is a particularly powerful device when addressing potential investment projects with extremely long life spans, or investment that do not commence until future dates (Godfrey, 1996). NPV or net present value is the present value of the expected future cash flows minus the cost. NPV is a capitol budgeting approach in which the present value of the expected future cash inflows then subtracted from the present value of expected future cash inflows and then subtracted from the present value of outflow to determine the net present value. NPV and IRR are two methods for making capital budget decisions, or choosing between alternate projects and investments when the goal is to increase the value of the enterprise and maximize shareholder wealth. Defining the NPV is simply: the present value of cash inflows minus the present value of cash outflows, which arrives at a dollar amount that is the net benefit to the organization (Eiteman, 2007). Companies often use the weighted average cost of capital, or WACC, as the appropriate discount rate for capital projects. The WACC is a function of a firms capital structure (common and preferred stock and long-term debt) and the required rates of return for these securities (Brealey, 1996). In capitol, budgeting decision criteria will apply to NPV and IRR to determine the acceptability of priority ranking of potential projects. It is possible to make a decision on a project by using the NPV rule. Say yes to a project if the NPV is positive; say no if NPV is negative. As a tool for choosing among alternates, the NPV rule would prefer the investment with the higher positive NPV (Brounen, 2004). The most important aspect of risk is the overall risk of the firm as viewed by investors in the marketplace. Over risk significantly affects investment opportunities and even more importation the owners wealth. The basic theory that links risk and return for all assets is capital asset pricing model or CAPM. We use CAPM to understand the basic risk return tradeoffs involved in all types of financial decisions. Risk averse defined as the attitude toward risk in which an increased return would be required for an increase in risk. Risk rate of return is the required return on a risk-free asset. Risk indifferent is the attitude toward risk in which no change in return would be required for an increase in risk. Risk seeking is the attitude toward risk in which a decreased return accepted for an increase in risk (Keck, 2001). What CAPM model does is link non-diversifiable risk and return for all assets? The CAPM model relies on historical data. The betas may or may not actually reflect the future variability of returns. The required returns specified by the model can be view only as rough approximations. Users of betas commonly make subjective adjustments to the historically determined betas to reflect their expectations of the future (Godfrey, 1996). CAPM was developed to explain the behavior of security prices and provide a mechanism where an investors could assess the impact of proposed security investment on their portfolios overall risk and return (Fama, 1992). Project viewpoint measurement uses assumptions to forecast rate of return. The same probabilistic techniques are available to test the sensitivity of results to political and foreign exchange risks to test sensitivity to business and financial risks. Managers or decision makers feel more comfortable about the necessity to guess probabilities for unfamiliar political and foreign exchange events than they do about guessing their own familiar business or financial risks. Therefore, a series of what if scenarios are used (Gitman, 2007). Foreign complication, including foreign exchange and political risk mentioned in this report. The following are important concepts. Parent cash flows (Must Be) distinguished from project cash flows. Each of these two types of flows contributes to a different view of value (Brealey, 1996). Parent cash flows also depend on the form of financing available. Cash flows cannot be clearly separated from financing decision as is done in domestic capital budgeting (Brounen, 2004). Additional cash flows generated by a new investment in one foreign subsidiary (may be in part or wholly taken) away from another subsidiary with the net result that the project is favorable from a single subsidiary point of view but contributes nothing to worldwide cash flows. Remittance of funds to the parent must be explicitly recognized because of differing tax systems, legal and political constraints on the movement of funds, local business norms and differences in how financial markets and institutions function. The best example of a risk free hedge is an airline. Many times an airline will use future hedges to relieve their exposure to the price of jet fuel. They know that they must purchase jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile. Hedging strategies include but are not limited to forward exchange contract for currencies, currency future contracts, money market operations for currencies, forward exchange contract for interest, money market operations for interest, future contracts for interest (Gilster, 1997). DCF methods to future cash flow techniques examined internationally, evaluated and supported. Appraisals to allow for risk uses a variety of techniques and risk and return examined and the approaches explained. References: Amram, M. & Kulatilaka, K. (2000). Strategy and Shareholder Value Creations. The Real Options Frontier. Journal of Applied Corporate Finance. Vol. 13, No.2. pp.15-28. Brealey, A., Cooper, I.A. & Habib, M.A. (1996). Using Project Finance to Fund Infrastructure Investments. Journal of Applied Corporate Finance, Vol.9, No.5, pp.25-38. Brounen, D., Jong, A.D., & Koedjik, K. (2004). Corporate Finance in Europe: Confronting Theory with Practice. Financial Management. Vol. 33, No. 4, pp. 71-101. Eiteman, D. K., Stonehill, A.J. & Moffett, M.H. (2007). Multinational Business Finance. (11th, ed.). Pearson/Prentice Hall. Pearson Education Inc. Fama, E.F. & French, K.R. (1992). The Cross Section of Expected Stock Returns. Journal of Finance 47. Gitman, L. (2007). Principals of Managerial Finance. (12th. ed.). Pearson/Prentice Hall. Godfrey, S. & Espinosa, R. (1996). A Practical Approach to Calculating the Cost of Equity for Investment in Emerging Markets. Journal of Applied Corporate Finance. Vol.9, No.3, pp.80-89. Gilster, J.E. (1997). Financial Management. Retrieved May 6, 2011. From website http://ideas.repec.org/a/fma/fmanag/gilster97.html Keck, T., Levengood, E., & Longfield, A. (2001). Using Discounted Cash flow Analysis in an International Setting. A Survey of Issues in Modeling the Cost of Capital. Journal of Applied Corporate Finance. Vol. 11, No.3. pp. 82-99. Read More