Financial Strategy and Evaluation of Investment Opportunities - Essay Example

FINANCIAL STRATEGY Table of Contents Introduction 3 Evaluation of Investment Opportunities 3 Assumptions & Theoretical Approaches 5 Capital Structure& Cost of Capital 7 Consideration of Appropriate Discount Rate 9 Problems with Implementing Theoretical Approaches 12 Conclusion 13 References 14 Bibliography 17 Introduction The functions of financial management of a firm deal with the management of the sources from which funds are received and the effective utilization of such funds. Debt holders and equity holders are the suppliers of finance, and they supply finance for raising capital for assets of the company. So they have the right to participate in cash flows generated from the investment of the raised capital. As cost is also an important component of financing, so on a way to examine the net benefit from an investment, the cost incurred on such investment is also to be accounted. But, with trillions of dollars of cash available to the corporate for investment, the basic question that emerges is how the management decides to invest capital. The theoretical approaches to appraise capital investment reveals that investment opportunities varies across industries and companies. Previous studies suggest that standard approaches to capital budgeting markedly ignores non-diversifiable risks and focus on special cases where diversifiable risks do not affect the value of firm based on contribution of capital project. Hence, such approach ignores the impact of capital investment on firm’s cost of capital and total risk. Inappropriate assessment of capital investment decisions profoundly influence how efficiently the capital is utilised (Stulz, 1999, pp.1-4). Evaluation of Investment Opportunities The survival of business and its growth depends on correct decision making on the basis on available financial information. Appropriate capital investment appraisal techniques help to identify key areas which are more profitable and areas which require attention and improvement. The financial risk of a firm is associated with the financing decision of the firm which is essentially the decision regarding the extent to which debt capital is used in capital structure of the firm. Debt capital is cheaper source of raising fund for projects than equity capital (Brounen and Eitchholtz, 2001, pp.1-19). The use of debt capital in capital structure of the firm increases the rate of return on equity to the shareholders as long as the rate of return exceeds the cost of debt capital. Using debt capital a firm can magnify the effect of earnings per share of shareholders. Inclusion of debt capital implies payment of fixed interest charges on the outstanding debt (DeAngelo, 2008, pp.1-5). When the firm’s earnings are good, the burden of regular interest payment is not worrisome but when earnings are uncertain, debt funding decision should be taken after analysing all scenarios and probable outcomes (Sheeba, 2011, p.249). Decision regarding accepting or rejecting a project should be based on cost and benefit analysis of the project which depends on the expected future cash flow from investment. The cost-benefit analysis should be made on the basis of cash flows since non-cash elements such as depreciation are not considered in decision making as they do not actually result in movement of cash flow. The relevant cash flows are incremental to project of the project especially when the project is in nature of expansion or diversification. The most common investment appraisal techniques in contemporary era entails the use of the concept of ‘time value of money’. The most commonly used investment appraisal technique in almost all industry employ Net Present Value (NPV) that gives the present value of all expected future cash flow of the project is discounted at the cost of capital. According to the theory, NPV follows a simple thumb rule which states a project maximises shareholders’ wealth if it NPV is greater than zero. Thus, according to the theory of NPV, projects with positive NPV should be selected and projects with NPV should be rejected. So, from the above discussion it can be said that two important aspects of this technique are the stream of cash flows which should be used for making decisions are incremental cash flows such as initial investment, operational cash flows, terminal flows and the discount rate. A survey conducted by Harvard Business Review reveals that almost 80 percent finance professionals use the discounted cash flow techniques to evaluate capital investment. These techniques rely on determinations and appropriate forecasting of free-cash flows over particular time period to estimate the fair value of investment (Akhtar et.al, No Date, pp.3-10). The free-cash flows have to be discounted by the cost of capital (which is generally the weighted average cost of capital in case of levered firm). Capital resources are not abundant and therefore they have to be allocated optimally in best investment alternatives that will maximise shareholders’ wealth or the value of firm. When there are multiple opportunities available to firm and the projects are not mutually exclusive then the firm might choose to rationalise investment in more than one projects. Consider another case where two projects having same expected cash flows, the project less volatile cash flows will be more valuable than the project with more volatile cash flows. Theoretical approaches also state that since the total risk of the firm do not affect its value, it is irrelevant how the cash flows of the firm are correlated with cash flows of the project. The above discussion suggests that the choice of discount rate of the project will depend on only the risk of the capital project as determined by the capital markets. Thus, unless there exists distinct synergies between the existing investments of the firm and the new project, the value of the project remains same irrespective of firm’s acceptance or rejection decision. Assumptions & Theoretical Approaches The theory to appraise capital investments has originated from the research of Miller and Modigliani (1958), where it was examined that in certain situations the choice of debt or equity does not affect the value of the firm, thus capital structure is not affected; but with tax-deductible interest payment capital structure and firm value are positively related. Thus this theory pointed on the direction which the capital structure must take in relevance to situation (Glickman,1996, pp.1-12). The agency cost theory is premised on the idea that the concern of the company’s manager and its shareholders is not perfectly associated. Meckling and Jensen (1976) emphasized the significance of agency cost of equity in corporate finance arising as a result of separation of control and ownership of firms, whereby managers aim to maximize their own benefit rather than the value of the firm. Agency costs can also result from the conflicts between debt and equity investors which arise due to risk of default. The default risk may also arise due to debt overhang or underinvestment issues, which might adversely affect on the value of the firm. This effect on the firm’s performance due to change in its value affects the choice of capital structure (Kisgen, 2006, pp.1035-1067). An organization’s choice of an appropriate capital structure is affected by several factors, such as, some companies are not eligible to receive bank loans, some companies have enough amount of retained earnings balance so as to finance any new or required venture, or some may not want to undertake any debt by the principle amount. There are more suitable and significant measures to use while analyzing the capital structure of a firm than those specified by Miller and Modigliani (1958). The following factors have been found to influence choice of capital structure- The size of debt depends on the size of the company Capital structure is affected by the age of the company, as a company becomes old the proportion of debt in the overall capital structure decreases Older companies have an option to build up capital with the previous revenues earned, but young companies have no option to avail this facility, so they need to take the help of bank loans. A company having an availability of solid liquid cash faces fewer problems than a company with a volatile cash flow. Investors and potential investors will wish and be obliged to invest their hard earned savings in an organization that promises to give a return that will increase their wealth position after a particular point of time. This objective shall become hard to achieve, if the hard earned savings of the investors are not utilized optimally into a financial structure that shall have an appropriate combination. Thus the essence of capital structure decisions is to guarantee a right combination of financing resources that will yield maximum return with minimum risk available without inevitably hampering the interest of the stakeholders (Titman and Wessels, 1988). Capital Structure & Cost of Capital The discounted cash flow analysis require projection of expected future cash flows discounted at appropriate cost of capital over the investment time horizon or forecast period. The selection of investment time horizon should be based on the project rather than any particular standard valuation. This is the reason that the projected cash flows vary from one industry to another. For, instance, a pharmaceutical company might evaluate investment opportunity over the life of patent compared to a software company which generally uses shorter time horizons. Further, the selection of time frame is not limited to industry of operation but it also depends on individual life of project. However, contrary to the above discussion it was found that practically companies around the world tend to use standard time-frame (say, 5 years, 10 years, etc.) rather than project-specific horizons. The time horizon helps to forecast or project expected future cash flows and the terminal value of investment (Jacobs and Shivdasani, 2012, pp.5-6). After estimation of expected cash flows of an investment the financial managers are required to estimate the discount rate that depends on the cost of debt. It is based on the firm’s cost of capital which is usually the weighted average of cost of equity and debt. Studies have determined that the most acceptable method for determining the cost of equity is the capital asset pricing model (CAPM). The total risk of portfolio can be divided into systematic (non-diversifiable) and unsystematic (diversifiable) risk. An investor can reduce the unsystematic risk of investment through proper diversification of securities in the portfolio. Since systematic risk cannot be eliminated, the capital asset pricing model (CAPM) can be used as a tool to determine expected return of asset that is chosen to be added in a well diversified portfolio. When the expected return of a security is determined using the model then it can be compared to the estimated return of security over a given time period. Such comparison will help the investor to analyse whether it is worthwhile investing into the security (Halov, Heider, and John, 2009, pp.1-5). The technique theoretically requires estimation of equity risk premium, risk-free rate, and the volatility of firm’s stocks relative to market which is given by ‘Beta’(β). The accuracy of investment appraisal technique depends on the financial model on which decision is based. The fair valuation of an investment varies because cost of equity varies. The standards reference for determining the risk-free rate include proxies such as US treasury bill rates. The rate varies with maturity that ranges from 90-days to 3 years. To illustrate this point it was found that while the rate of 90-day T-bill is close to 0.5 percent, the 10 year treasury note yields about 2.25 percent. In other words, two companies may be identical in all aspects could still use different cost of capital depending on their choice of risk-free rate. The next step is determination of equity risk premium which the firm expect to earn over the risk-free rate ((Jacobs and Shivdasani, 2012, p.6). Theoretically, the equity risk premium remains same at all time irrespective of individual investor expectations. The general relationship states that higher the risk the higher would be the premium attached with investment and vice-versa. Beta indicates the stock volatility relative to a benchmark or market. The benchmark can be international index like S&P 500, FTSE 100, etc. The beta of market or benchmark is always one. The value of stock is stated relative to benchmark beta. Consider an example where the chosen benchmark is S&P 500 whose beta is 1 and the beta of particular company’s stock is 1.5 (say). It implies that stock is 50% more volatile compared to benchmark and hence more risky. For risky stocks, the market premium is also higher. Alternatively, the stock would return 15% when the market returns 10%. Similarly, beta less than one implies less volatility, more safety, lower return compared to benchmark. A desirable value of beta would depend upon individual risk tolerance. So, in case the beta is high it will mean higher return but at the same time when the market falls, the stock of companies with higher beta is expected drop much more. Consideration of Appropriate Discount Rate Computation of NPV or any other discounted cash flow analysis involves selection of an appropriate rate known as the discount rate. The discount rate reflects the opportunity cost of capital invested in the project. The discount rate represents the true commercial value of investment involving future cash flows on present date thereby analysing whether the returns are sufficient to cover obligations represented by stream of cash outflows. The discount rate aims to capture the true value of receiving or making investment in future. The various literature on corporate finance suggests that the appropriate discount rate of the firm should be its weighted average cost of capital. The determination of discount rate based on market observed yield curve requires proper identification and measurement of risk-free rate of interest. The discount rate is primarily used convert stream of costs and benefits over time to their net present value. The most common reference to cost of debt includes average historical rate, current rate on existing debt, forecasted rate on issue of fresh debt. Studies have also found that when firm’s adjust cost of borrowed capital with tax rate there occurs major implications in determination of cost of capital. Irrespective of whether the firm uses effective or marginal tax rates while determining the cost of capital, the outcome of investment decision would vary significantly (Ross, 2005, pp.409-430). For instance, consider a project that requires initial investment of $20 million from which the investors could expect steady annual positive cash flows between $3.25 million for period of 10 years. If it is assumed that the cost of capital of the project is 10 percent then the NPV of the project will break-even. In such case it is up to the management to decide whether to accept/reject investment decision which will further depend on current economic factors, market competition, and availability of alternative investment opportunities. If the firm expects that the actual cost of capital will vary +/- 100 basis points (1%= 100 basis points) then also the investment decision could vary. In this case, +1 percent increase in cost of capital will show that the project will incur losses or negative NPV of approximately $1 million and hence should be rejected. Considering the reverse situation, if the cost of capital is underestimated and changes by -1 percent then the same project will reflect positive NPV of $1 million. The above discussion highlights how important it is to select an appropriate selection of discount rate on which accept/reject decision of project is dependent. Problems with Implementing Theoretical Approaches The theoretical approaches on capital investment appraisal techniques has certain implementation issues in practical world as these theories are based on certain assumptions that varies according to circumstances and economic conditions. Some of the issues that arise while implementing capital investment appraisal techniques are: 1. It is difficult to determine the alternative returns that could be earned on internal funds. The interest payments for future opportunities on investment do not always correspond present cost of financing. 2. The forecasting of time horizon should be less standardised and more customised based on individual project. 3. Selection of cost of debt is very important because the cost of capital or the discount rate depends on both cost of debt and cost of equity. The common implementation issues include whether to refer current rate on outstanding rate or forecasted rate on new debt issue. 4. The selection of risk-free rate in the CAPM approach requires selection of proper time period of maturity which depends on management outlook. 5. The selection of period of beta (which could be 1year, 2year, 3years, etc.) varies from one firm to another and consequently the decision could also vary. 6. Choice of debt-to-equity ratio is another important criteria for determining the true value of an investment using discounted cash flow technique. Many financial professional consider their firm’s current book debt-to-equity ratio while others prefer targeted book-to-equity ratio (Graham and Harvey, 2002, pp.8-19). 7. Calculation of terminal value is to be considered when cash flows of the project cannot be forecasted perpetually over the life of project. The terminal value of cash flows represents the discounted present value of all cash flows beyond the period for which predictions would be practical. Conclusion This study analyses and discusses how a company is supposed to appraise capital investments considering appropriate discount rates. The study has found that it is possible that no two companies, irrespective of industry of operation, could determine different weighted average cost of capital depending on company specific risk-profile for a given investment or opportunity for acquisition. Studies also show that many companies still do not consider any reasonable variations from calculated cost of capital. Instead most companies simply subtract/add certain percentage point over target rate as shown in the theoretical approach. But any such arbitrary adjustment exposes the firm to under/over-estimation in risky projects. This could result in passing up good projects (when adjustment is too high) or acceptance of bad project (when adjustment is underestimated). Further the companies are recommended to use project specific cost of capital to quantify project returns and not the risk profile of their business as these are different and could result in different outcomes (Stulz, 1999, pp.2-10). Conclusively it can be said that the disparities in assumptions influences how capital is allocated or deployed in the economy and that the financial advisors and business leaders should determine appropriate cost of capital, time-horizon, and project’s risk adjusted return before taking investment decision. References Modigliani, F. and Miller, M. H., 1958. 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