Fishers Effect Analysis - Essay Example

What, if any, are the mistakes in proposal Correcting for any mistakes produce revised estimates of the company's current cost of capital and currentvalue. Brief explanation of the reasons for any revisions should be included. Hussey (1999) defined capital gearing as the relationship between the funds provided by the ordinary shareholders and the long-term funds with fixed interest charge. Companies are highly geared when the fixed charges are substantially higher than the competition. Gearing is speculative and expected to provide benefits for shareholders when the firms are performing well. The concept of gearing has always been linked with uncertainties. The results of the strategy are dependent of the performance of the companies. Basically, the concept of capital gearing is designed to provide competitive advantage and to provide long-term benefits to the consumers. Actually, the proposal of the board of directors appears to be right. Capital gearing is an instrument that tends to decrease the cost of capital. Simple computations will suggest that gearing is increased in three ways: increase in net assets, decrease net borrowings, and decrease shareholder funds. Cost of capital is reduced by minimising issuance of stocks and issuance of borrowings. In addition, not venturing to internal financing also maintains the level of capital cost. Theoretically, the proposal is sound because capital gearing will definitely decrease the value of capital. Basically, it will depend on the strategy of the firm on which item to concentrate. The notion provides an interesting subject that has to be analysed before the gearing is finally approved. The weighted average cost of capital is computed as: c= (E/K)*y + (D/K)*b *(1-Tc) The symbols are defined as follows: c = weighted average cost of capital y = required or expected rate of return on equity b = required or expected rate of return on borrowings Tc = corporate tax rate D = total debt and leases E = total equity and equity equivalents K = total capital invested in the going concern Actually, the board of directors failed to notice an important component of the equation. The corporate tax was secluded for the computation. Thus, the calculation has to be corrected by inserting the missing part of the equation. Weighted Average Cost of Capital: 11.8% * (350m / 519m) + (169m / 519m)* 8% (1-30%) = (.118 * .674) + (.326*.08*.7) = .079 + .018 = 9.7 % Weighted Average Cost of Capital (estimated): 11.8% (259.5m / 519m) + (259.5m /519m) * 8% * (1-30%) = (.118 * .5) + (.5 * .08 * .7) = .059 + .028 = 8.7 % The increase in gearing has resulted to a decrease total capital by 1%. Ignoring the importance of the corporate tax was crucial in the actual results. Despite of the minimal change in the results, the managers was still right in doubting the computations. The small change in the decrease in cost of capital was favourable for the company. The impact of the decrease will be observed in the benefits provided to all stakeholders, in particular the investors. Assuming that the cost of equity and cost of debt do not alter, estimate the effect of the share repurchase on the company's cost of capital and value. Basically, this method of gearing will have more substantial effects to the cost of capital. As mentioned, gearing is possible when the assets of the company are greater than the debts and equity. Share repurchase will definitely affect the cost of equity. Perhaps this notion contradicts to the earlier statement that the equity cost retains its value. Even with the repurchase shares, the cost of capital will not affected. In the previous discussion, it was mentioned that internal financing also promotes gearing. By doing such, the company can use its earnings to repurchase the share. Basically, the company will not resort into borrowings and will not use the available equity as means to do the repurchase. The internal investment will have similar effects to the company in terms of the reduction of capital cost and benefits gained. Although, it is forecasted that the decrease in capital cost will be less significant, the gains will definitely compensate for the discrepancy. Aside from boosting the equity and increasing debt, the company can use its earnings as instrument to decrease the capital cost and increase the gains from such investment. Acting as an external consultant to Jay, discuss the validity of the proposed strategy to increase gearing, and explain whether or not the estimates produced above are likely to be accurate. The initial proposal of gearing capital to reduce the cost of capital is accurate. In contrast, the approach in the proposal has several flaws. This leads to the reassessment of the gearing strategies and the method in which the cost is reduced. Other than the suggested method, it is possible for the company to seek for better alternatives. The alternative involves the use of the earnings of the company in venturing to internal financing. The second option provided is predicted as more beneficial. Definitely, the idea of financing through the earnings pertains to the use of the company's resources. Capital cost will be reduced as the earnings of the company are boosted. Also, it has to be noted that acquiring debt means that the company will increase its long-term liabilities. This means that the company has to pay for the interest rate agreed as well as the interest. Because of the unpredictability of the future, such method is risky. Also, the company will be financially burdened as the resources supposedly allocated for other purposes will be channelled to debt services. It is also important to note that the acquisition of equity also provides several risks. Market prices of securities are uncertain and are difficult to predict. Definitely, other forms of gearing such as asset purchase will provide better outcomes. Undeniably, the impact of internal financing to the cost capital is similar to the effect of increased debt. The strategy of internal financing, however, limits the possible risks and eliminates the doubt among investors. Most important, the overall benefits of promoting such strategy are unparalleled. The method of internal financing is an effective tool and more efficient than the suggested method in the first proposal. Critically discuss, using current empirical evidence the various parity theories. Are any of these theories more applicable in the global economy Purchasing Power Parity Among the theories of parity, purchasing power parity is one of the most used. Basically, the theory is designed to equalise the difference of two currencies in term of the real. Also, the purchasing power parity is used as basis for the determination of the standard of living in an economy. Since equilibrium is difficult to maintain in the global market, it is best that purchasing power parity be used. The concept of purchase power parity has two natures: the absolute purchasing power parity and relative purchasing power parity. The former promotes the law of one price that indicates the exchange adjusted pricing level has to be constant when applied in the world market. The later, explains the need to adjust the currencies of two countries to determine the price levels. The theory assumes that the actions of importers and exporters, motivated by cross country price differences; induce changes in the spot exchange rate. In another vein, PPP suggests that transactions on a country's current account, affect the value of the exchange rate on the foreign exchange market. (Suranovic, 2000) Bilson (1984) suggests that tests of purchasing power parity using the traditional econometric tests are unacceptable. The assessment of a forecasting equation has been manifested by assessing the forecasts from a system of equations. The evaluation of the accuracy of forecasted spot rates in traditional econometrics, although it remains a concern as it does not imitate the behaviour of a rational trader. Generally, the forecasted values of spot rates are evaluated according to some norm, such as mean squared error. Nevertheless, econometric testing only provides marginal support for the PPP condition. It was observed that there are finds substantial profits to a trading strategy based on PPP. Instead of the traditional econometric tests, it was proposed that trading strategy test be used evaluating the value of PPP for predicting exchange rates from a currency trader's perspective. It was revealed that significant profits exist in trading strategy, supporting PPP. Critics argue that the inability of the theory to provide accurate interpretations in the short term is a detriment. It is ascertained through observations that purchasing power parity is fallible. In truth, the effects of short term detriments such as costs of delivery and barriers to trade are vital. In addition, the change in currency affects the price level in minimal values. This means that purchasing power parity is sometimes useless in determining economic situations. Fisher's Effect Fisher's effect assumes two basic components: a real international required rate of return ands; an amount equal to expected inflation. According to this parity theory, the interest rate differential and inflation rate differential are equal given that government intervention is inexistent. This situation occurs in the state of equilibrium. In simple terms, Irving Fisher attests that the real interest rate is the nominal rate less inflation. (Wikipedia, 2006) Mishkin and Simon (1995) indicated that while long-term Fisher effect appears to exist in Australia, there is no proof of a short-run Fisher effect. The notion suggests that, while short-run changes in interest rates reflect changes in monetary policy, longer run levels indicate inflationary expectations. Hence, the longer run level of interest rates is insufficient to characterise the position of Australia's monetary policy. Recognition that the level of inflation and interest rates control stochastic trends implies that the correlation between expected inflation and short-term nominal interest rates in Australia is the result of a long-run Fisher effect. The situation shows inflation and interest rates trend along with the long run than a short-run Fisher effect and the changes in short-term interest rates reflect modifications in expected inflation. These outcomes have important implications for policy makers. It is imperative to for policy makers to indicate the level of short-term interest rates can be an improper guide for monetary policy because a high interest rate that has persisted for some time is an indication that expected inflation is high. Thus, the high level of the interest rate does not indicate that monetary policy is tight; definitely, it indicates the reverse. The notion maintains that looking solely at the level of short-term interest rates can provide misleading situation of the position of monetary policy. Interest Rate Parity Keynes has the first idea on the effects of interest rates in the level spot exchange rate and forward exchange rate. It is stated that the interest rates is equal to the difference between the forward exchange rate and the spot exchange rate. The assumption in this theory is that arbitrage opportunity is inexistent. Interest rate parity can be classified as covered and uncovered. Covered interest parity indicates that the interest rate difference between two countries' currencies is equal to the percentage difference between the forward exchange rate and the spot exchange rate. The parity condition assumes that financial assets are mobile and similarly risky. Uncovered interest parity holds that in the presence of risk-neutral investors, risk premium is zero. In addition, the forward rate and spot rate varies from time to time. As long as the market is uncertain and currencies are unpredicted, it is advisable to exclude the use of uncovered interest rate parity. Louis, et al. (1999) formulated and tested a model of interest rate parity (IRP) with bid-ask spreads using information on the Belgian franc, the Deutschmark, and the Swiss franc. The group analysed the bid and ask rates at one- and three-month maturities. It was observed that the model specification suits the data. The forward market is efficient because the IRP holds well in the Euro market. The results, however, propose the bounds provided by IRP are unbinding. The result shows that despite the overall goodness of fit of the model, covered interest arbitrage opportunities are available. Such opportunities are marked by violations of the arbitrage margins for the Deutschmark at one- and three-month maturities. The researchers also studied the behaviour of the bid-ask spread. The data strongly suggest the bid-ask spread is positively related to the maturity date and currency volatility and perhaps to the lag between buying and selling. The outcome reveals that no evidence of calendar-day patterns in spreads, contrary to the findings of previous studies. Evidences suggest that interest parity is will never hold in the floating rate regime. Arbitrage opportunity is common in the area of predicting spot and forward exchange. Since this situation is prevalent in nature, the interest rates are harder to predict. Moreover, the uncertainties in the market create confusion as to the determination of interest rates. Finally, interest rate parity is difficult to accomplish and making it affect interest accurately is a tough order. International Fisher Effect This theory emphasises the equality of interest rate to the expected change in spot rate when in the state of equilibrium. Actually, the theory was designed to expand the concept of Uncovered Interest Arbitrage. Accordingly, the assumption is based on the investors' nature to predict spot rates and hedging in the forward market. The International Fisher's Effect is the internationalised version of the parity theory developed by Irving Fisher. Also, it is related to the Purchasing Power Theory discussed above. Actually both assumptions used in the Fisher's Effect and PPP are equated to form the International Fisher's Effect. The use of the International Fisher's Effect is seen in the activities performed by investors. Usually, investors forecasting future spot rate for the purpose of making profits tend to move the currency from countries with low interest rates from countries with high interest rates. In effect, the nominal exchange rate differential will be offset by the movement of exchange rates. Once an investor decides to purchase foreign assets the gain is realised in the payment of interest and the changes in the currency value. Currently, the foreign exchange market uses the International Fisher Effect to justify foreign investments. The theory reveals that the change in foreign currency offsets gains form investments. Likely, domestic investment provides better rewards. Empirically, International Fisher's Effect is flawed. For one, the theory is only effective in long run situations. Since predictions are used, the short term situations are sometimes forgotten. Also, investors have to pay close attention to the cause of the depreciation or appreciation of currencies. In truth, currency changes are sometimes caused by inflation, nominal interest rate, and real interest rates. When those mentioned factors are present, other theories of parity overlap. Such situation creates confusion as to validity and accuracy of the currency valuation. Economists have found out that contradictory evidences are observed in the theory. It has been revealed that International Fisher's Effect is less substantial than the Fisher's Effect and the Purchasing Power Parity. (Sundqvist, 2002) Unbiased Forward Rate This theory implies that the forward rate has to reflect the future spot rate during the period of settlement of the forward contract. The theory suggests two important scenarios that are relevant to the foreign exchange market. When the forward rate and the future spot rate are in equilibrium, it is expected that the home currency value of foreign currency is the same as the foreign discount on foreign currency. In the state of disequilibrium, speculators will take the advantage of the discount and sell foreign currency forward to home currency. Primarily, the theory is used for the benefit of investors participating in the trade of currencies. The foreign currency market is a viable avenue for exchange and beneficial transacting. To gain from the foreign exchange markets, investors have to secure the value of future spot exchange as regards to forward exchange. Also, this serves well in the process on trading between nations. The determination of future spot rates provides advantages when import and export activities are performed. Myers and Hanson (1996) have derived an optimal dynamic hedging rule when futures positions can be updated at regular intervals over a cash-holding period. The rule is taken under general assumptions on utility functions and the joint distribution of cash and futures prices. Specifically, the derivation does not need exponential utility or joint normally distributed prices or both. The cost of this overview is that assumptions are made that the size of the cash position is non-stochastic and that the current futures price is an unbiased predictor of upcoming futures prices. Hence, the rule will be useful in situations where there is no uncertainty in the size of the cash position and when the unbiased futures market assumption appears to be a good approximation. Analysis Interestingly, the five mentioned theories of parity are seemingly interrelated. The relationship is seen with the existence of all the theories of parity in the foreign exchange market. Basically, all of the theories have their advantages. Primarily, the theories are designed to make decisions flexible and beneficial. It has to be noted that these theories were developed out of the eagerness of economists to neutralise the aspects that revolve in the market. Although all the theories have their own reasons to be chosen as the best, only one will stand out as the most efficient. In doing this, it is only proper to discuss the valid reasons behind the choice. In reality, criteria are never given to make such decision. Since the theories have something to do with foreign exchange market, it is best to use the perspective of an investor in foreign exchange. Thus, the Unbiased Forward Rate Theory is the most effective. Illustration 1.1 This diagram above justifies the soundness of the unbiased forward rate compared with the other four parity theories. As the theory earlier stated, the forward rate has something to do with the forecasting of future spot rate. In the diagram, it is clear that the emphasis on equality is established. This diagram represents the idea of unbiased forward rate. All the four assumptions are being considered. In truth, unbiased forward rate reconciles the other four theories into one. It has to be noted that empirical evidences point the loopholes in the theories presented. For investors, these shortcomings have to be resolved to promote better investments. The forward exchange rate is affected by the interest rate, inflation rate, difference with the spot rate, and the predicted value of spot rate. It can be observed that all the aspects mentioned were discussed in the four theories prior to the chosen theory. Unbiased forward theory is considered as the best because it makes use of the advantages of other theories and compensates for the weaknesses. Basically, forward rates are more accurate as it already included the mentioned aspects in the diagram. Another important thing about the Unbiased Forward is that it is widely used by most investors. For foreign currency investors, gain is imperative. Indeed, the use of the four parity theories will help in determining income from investments. First, PPP measures the expected change in spot rate. Second, Fisher's effect considers the effects of inflation. Third, Interest Rate Parity account interest rates as vital. Fourth, International Fisher's Effect computes for the difference in the forward rates and the spot rates. Still, none of the theories are deemed as accurate in short run situations. Empirical evidence suggests that the mentioned theories of parity have shown success only in long run situations. Instead of computing for the four, investors are provided with one alternative in Unbiased Forward Rate. After all, the aim of the other four theories is the determination of the future spot exchange rate. The theory if Unbiased Forward Rate assumes all the concepts presented in the other four theories. This can be done through the use of forward rates. The theory suggests that forward rates are already computed with interest, inflation, and other aspects. Hence, the use of Unbiased Forward Theory presents more accurate and precise value of the currency. References Bilson, J. F. (1984). Journal of Finance. Purchasing Power Parity as a Trading Strategy. Pages 715-724. Crowder, William. (2004). Southern Economic Journal. Why areInterest Rates not Equalised Internationall High Beam Research. Hussey, R. (1999). A Dictionary of Accounting. "Capital Gearing." London: Oxford University Press. Mishkin and Simon. (1995). Economic Record. An Empirical Examination of the Fisher Effect in Australia. Economic Society of Australia. Page 217. Myers and Hanson. (1996). American Journal for Agricultural Economics. Open Dynamic Hedging in Unbiased Future Markets. Sarno, Lucio and Taylor Mark. (2002). IMF Staff Papers. Purchasing Power Parity and the Real Exchange Rate. International Monetary Fund. Page 65+. Spagnolo, Fabio, et. al. (2001). Testing the Unbiased Forward Exchange Rate Hypothesis Using a Markov Switching Model and Instrumental Variable. London: Birkbeck College. Sundqvist, Emil. (2002). An Empirical Investigation on the International Fisher's Effect. Lulea University of Technology. Suranovic, Steven. (2000). Introduction to Purchasing Power Parity. Retrieved from: Investopedia.com. Interest Rate Parity. Date Retrieved: 9 March 2006. Retrieved from: Wikipedia Online Encyclopaedia. Fisher's Effect. Date Retrieved: 9 March 2006. Retrieved from: Read More