The Net Present Value Rule - Essay Example

1. Compare and contrast the Net Present Value rule with other available criteria for evaluating investment decisions. Discuss the issues which are relevant to the appropriate application of the Net Present Value rule. An investor ought to make an investment only when it has a positive Net Present Value (NPV). Those investments or projects whose returns are negative must be disregarded. The following formula is generally used to depict the NPV of an investment or a project. The hypothetical example that follows the formula shows a positive NPV equal to £123,928.60 at the end of the five year period. Here the opportunity cost of capital is assumed to be 12%. Year Cash flow Discounted cash flow 0 = £-(10,000.00) 1 10,000.00 = £ 8,928.57 2 20,000 .00 = £ 17,857.14 3 40,000 .00 = £ 35,714.28 4 50,000.00 = £44,642.85 5 30,000 .00 = £ 26,785.71 ----------------- NPV = £123,928.60 Thus by adopting it as the discount rate for all future cash flows one can effectively obtain the NPV for them. This gives a few advantages. In the first place proper financial management requires a realistic opportunity cost to be set against capital. Though over a period of 5 years there can be considerable pressure on interest rates, a steady return of earnings would be ensured through proper cash flow management. After all the above cash flow forecasts are assumed to be constant though, in reality they might vary. The decision to make the investment is based on the apparent returns by way of future cash flows and it does not take into account the risk factor involved. For instance the investor has totally disregarded DCF method because he probably considers those future returns to be final and conclusive with respect to their values. The DCF calculations and the NPV figure of the total investment show that the decision is fairly justifiable because the NPV is equal to £ 123,928.60 which is a considerable value against probable future inflationary pressure, i.e. the opportunity cost of capital. The importance of discounting future cash flows by using these formulas also depends on other factors as well. Discounted cash flows give a real picture of the future possibilities. Since DCF is what an individual is willing to pay at present in order to have what he expects to have in the future, it’s a process of expressing future revenue flows in terms of today’s value. Probably the most important reason behind DCF is the fact that inflation erodes the value of money in times to come, i.e. future. Therefore it’s essential to make up for the loss. That is why in each subsequent DCF multiplied by the number of years, a lower value comes up. The Internal Rate of Return (IRR) sets the present value of all future cash flows of an investment equal to zero. IRR usually holds the assumption that all future cash inflows would be reinvested at the internal rate as calculated at present. Assuming that there are investment projects with returns that exceed the cost of capital or interest, such projects would be seriously considered for investment. In other words when the IRR is greater the investment is more attractive. However it’s the NPV that every investor seeks to adopt because it has a less number of disadvantages or flaws. 2. Discuss, in detail the different assumptions and implications of the “trade-off” and “pecking order” theories. A. Trade-off theory Since this theory focuses on agency costs and financial distress of firms, there is some theoretically valid argument attached to its outcomes though. Agency costs apart financial distress arises due to the firm’s failure to meet demands from debtors. If debt holders find out that the firm is unable to meet its obligations, then they would force the firm to declare bankruptcy and go for liquidation. In the first instance there is the direct cost entailed by insolvency. Thus subsequent liquidation process would compel the management to sell assets at distress prices. All this is associated with a particular outcome, viz. value of the firm. Thus the inverse relationship between distress costs and value of the firm could be used as a measure of capital structure but nevertheless capital structure is not determined by the value of the firm. Trade-off theory is not against the existence of bankruptcy costs. The theory supports debt-financing of assets rather than equity-financing because of the associated tax benefits (Brealey and Myers, 2002). The theory goes onto add the disadvantages also. Its original assumption of the existence of bankruptcy costs entails more of a burden in times of failure because bankruptcy would further encumber the firm with debt. Further there are non-bankruptcy costs also such as trained staff leaving the company and demanding favorable settlement packages. Above all such costs would compel the firm to increase its debt. Thus the marginal benefit associated with original debt-financing would diminish and turn into a marginal cost. Thus the theory essentially focuses on the trade-off between equity and debt. 3. Pecking order theory Pecking order theory was developed in response to the relatively weaker arguments of Trade-off theory by Myers and Majluf (1984) and simply states that managers choose their financing sources according to the inherent rule of least effort in which equity-financing is carried out only as a last resort, i.e. after exhausting every possibility of raising debt. Thus according to Myers and Majluf the firm goes by priorities – first, it uses internal reserves, then debt and finally equity capital. In contrast to Trade-off theory, Pecking order theory has a clear advantage in that it adequately captures the negative relationship between the firm’s profitability and debt. According to Pecking order theory this proposition has a number of other advantages. In the first instance, firms attempt to match their ratios of target dividend payment with their investment plans. Secondly such sticky dividend pay-out policies would ensure a constant positive cash flow despite unpredictable profit margins and erratic changes in investment opportunities. However there is no guarantee that the net cash flow would be always greater than the sum total of capital expenditures. Assuming that the firm generates net positive cash flow it would be able to invest it in securities or just use to pay off debt. Either way a constant return on the individual share holder’s investment is ensured. Naturally debt issue gives out a positive message to the financial markets while an equity issue gives out a negative message. Further the cost involved in an equity issue is much higher in comparison to a debt issue. Pecking order theory does not necessarily comment on the value determination of the firm; neither does it discuss irrelevance of the capital structure to value determination. 3. Show and explain the implications of the Modigliani-Miller proposition in relation to a company’s capital structure. Critically discuss the assumptions required for this proposition to hold. The capital market structure of the firm can be examined with reference to a number of theories. The Modigliani-Miller proposition is the earliest of such theories to consider the relevance of capital structure to determine the value of a firm. Modigliani-Miller proposition (M&M) occupies a very important place in the determination of relevance or irrelevance of capital structure for the value of the firm (Modigliani and Miller, 1963). Therefore it’s equally important in examining the efficiency of capital markets. According to M&M the value of a firm depends on its capacity to earn and distribute profits among its shareholders along with the associated risk of assets. In other words the value of the firm has nothing to do with the way in which it makes its investments and distributes dividends. The firm might adopt one or more of the following methods to finance its assets. After all M&M says that it is irrelevant how the firm finances its assets whether by issuing equity or raising debt. Even the dividend policy does not matter. If there were no dividend policy at all still it would be irrelevant (See Q. 5). In short M&M is also known as “capital structure irrelevance theorem”. Therefore it’s essential to consider the very basis of M&M in the backdrop of an evolving theoretical framework on the subject and delineate the connected arguments on the relative efficiency of the capital market. The firm might borrow and invest, it can issue shares or/and it can reinvest money from its reserves. Whatever it does, its freedom to choose between choices is limited by the very structure of capital. In other words the leverage decisions might interfere with its freedom to have more of one and less of the other even if it were desirable. Despite this limitation according to M&M there is no need for the firm to have a dividend policy. Above all M&M seeks to prove its validity through an example of two firms, one adopting a leverage policy in which the firm borrows money partially (debt) and finances its assets and another adopting an unlevered approach in which it finances its assets only through equity. M&M comes to the conclusion that the value of both the firms would remain the same. Jensen and Meckling (1976) however question the credibility of M&M’s assumption that individual firms make their investment decisions with no regard to capital structure. They cite the asset substitution effect as the basis on which such conclusions cannot be warranted. In other words equity-holders of levered firms can benefit at the expense of debt-holders through manipulating risk when investments have been made. The levered firm stands to gain by way of tax deductions, i.e. it is entitled to compensation of interest related expenses. This means leveraging would help the firm to pay less taxes than those unlevered firms. Thus it brings the argument to the very beginning again. M&M proves that as long as the capital market is efficient in preventing additional costs of borrowing, i.e. other variables remain constant, then leveraging helps the firm to achieve a degree of efficiency but capital structure itself does not determine the value of the firm (Chisholm, 2002). Thus in the absence of this last mentioned proposition about the efficiency of capital and financial markets and all other variables remaining constant, the M&M doesn’t have a validity. It holds as long as these two conditions are fulfilled. But nevertheless in reality such certainties might not exist all the time and even if they at times there would be corresponding costs being imposed on the firm. Therefore it’s obvious that M&M has some limitations and difficult-to-satisfy assumptions for it to hold. 4. Explain the theoretical debate on how the weighted average cost of capital is affected by capital structure. What is the empirical evidence on this issue? Capital market is the market for investment funds in the long-term where equity, bonds and other securities are traded. There are a long term primary market for the primary equity issues and a secondary market for those existing shares (www.thefreedictionary.com). Thus it’s clear that capital markets don’t include short term money markets where money is lent and borrowed in the short run through the interaction of the institutional and non-institutional players such as banks, financial houses and individual money lenders. Functional efficiency of the capital market is determined by a number of factors including the government’s regulatory mechanisms. On the other hand capital structure of the firm is defined as the manner in which a company would seek to finance its assets by using a combination of equity and debt or/and some hybrid securities. It’s a long term effort to keep the company going (www.investorwords.com). A company’s capital structure is determined by the manner in which it combines its assets such as between equity capital and debt capital. If the company issues 90% debt and 10% equity by way of ordinary shares then its capital structure is 90% financed by debt and 10% financed by equity (Friedrich, 2007). Weighted average cost of capital (WACC) is a measure used to calculate the amount of debt that a firm holds against the amount of equity. However it’s much better to put it this way it’s a measure of the amount of debt that a firm should hold against the amount of equity. Thus capital structure of the firm is basically determined by the WACC and the formula given below explains how it’s calculated. [Rd x D/V x (1-5)] + [Re x E/V] Rd = Bonds yield up to maturity; D = Market Value of Bonds; (1 - t) = 1 - tax rate = Deductible tax shield of interest expenditure; Re = Shareholders return requirement; and V = Total value of (Debt + Equity). WACC is an overall amount that the firm should make on its current operations so that it might be able to increase or keep constant the current value of its capital stock. For instance let’s assume that the British Airways’ WACC is 12% and its share price is estimated to be £20, then it’s necessary to earn 125 on its investments in order to keep its share price at £20. In other words it’s the hope of the management of British Airways at least to maintain its current market price per share without falling. It’s common knowledge that higher levels of leverage or debt drive up share prices while the converse is true when more equity is issued. Theoretical underpinnings of the debate go further than this. High-leveraged firms tend to have a higher WACC and therefore must able to earn a very high return in order to maintain their current market share price from falling. However, with every equity issue the share price tends to come down because more shares means less demand. Thus theoretically the management desires to drive the market value of the firm’s assets by leveraging rather than raising equity capital through stock issues, i.e. the agency problem. Empirical evidence in the EU suggests that high-leveraged firms especially those in the IT sector prefer to remain so with attention focused on the market prices of their shares. In other words they prefer debt to equity and therefore their WACC is very high. Demand-driven strategically important industries like the IT have been able to take greater risks despite the long term doubts about their ability to repay. 5. Critically discuss the concept of dividend policy irrelevance. Assuming that the capital market functions efficiently, there won’t be the need to manipulate this capital structure as advocated under various theories. For example the Modigliani-Miller Theorem suggests that when there are perfectly competitive market conditions, there is no relevance in considering the manner in which the firm’s assets are financed in order to determine its value. Thus even in the absence of a theoretically determined value for the firm, there can be an optimum capital structure. However the most important question is whether perfectly competitive financial markets do exist or not and if they do, under what circumstances and wherefore (Pettit, 2007). If they do exist, the dividend policy of the firm is surely irrelevant and serves no purpose at all by being an adjunct in evenly balanced demand-against-supply scenarios. In addition to the Modigliani-Miller Theorem of the optimal capital structure, there are some highly influential theories. With the help of them it’s possible to discuss how best an efficient capital market can be brought into existence (or not) thus rendering both capital structure and dividend policy of the firm irrelevant. However the extent to which those capital market imperfections can be overcome would determine the degree of perfection of the capital market in a given situation. Dividend policy is adopted by the management to distribute profits to those equity holders of the company and naturally such distribution is sanctioned after debt holders have been paid. As such the dividend policy becomes irrelevant when the company’s assets are mostly financed through debt, i.e. debt has to be settled irrespective of whether surplus profits would remain or not for distribution among equity holders. The capital structure of the firm is the basis on which it carries this policy. It’s obvious that the capital structure of the firm is decisive in levering or not levering the firm. However it must be noted here that in case there are no taxes or/and tax-related benefits to be gained through leverage, the whole set of assumptions and the subsequent theoretical postulate break down because the levered firm loses when there are not tax-related benefits to be gained by leveraging. It’s the tax-related benefits that enable the firm to make financial gains. As the above diagram illustrates the actual value of the firm declines as the optimal amount of debt is surpassed at D1. The value of the firm without leverage (Vu) is shown by the flat horizontal arrow. Value of the firm with leverage (VL) is shown by the extended blue arrow and its total value is depicted by taxes, debt and a residual value. The diagram has been modified by this writer to place emphasis on the leveraging decisions of the firm to achieve optimum capital structure. 6. What are the different types of mergers? Critically discuss the possible motives behind merger activity. There are different types of mergers. A merger can be either horizontal, vertical or lateral. For example in a horizontal merger two firms in the same industry at the same stage of production can merge together, such as brewer joining hands with another brewer. Or it can be a vertical merger where two firms at two different stages of production in two different industries merge together, such as a brewer with a pub owner (Vertical forward) or a brewer with a malt grower (Vertical backward). Lateral or conglomerate mergers occur across diverse industries such as a car manufacturer merging with a brewer. The motives behind a merger can vary from the desire to have more synergies to higher price-to-earnings ratios. Stranger mathematical synergies have been worked out in respect of mergers and acquisitions (M&A). For instance the formula 1 + 1 = 3 is a reference to technical synergies or economies of scale that multiply with each merger. Such strange algorithmic values have been put forward by analysts who argue that mergers bring about fundamental changes within the combined company to drive a range of values across a broader spectrum of activity. This happens at both the departmental level and the organizational level. This rationale is perhaps the most appealing to a majority of managers because it enables economies of scale - technical, managerial, labor, financial, marketing and so on – to be achieved by the combined entity. Even if it were an acquisition these synergies would be possible though the latter is slightly different from the former. An acquisition can take place even without the consent of the majority of shareholders of the acquired company, i.e. a hostile acquisition or a merger. Even though there can be a majority of shareholders numerically the total number of shares held by them might be insignificant. Thus the majority shareholder(s) will dictate terms to them. Where market concentration ratios are high with a smaller number of rivals operating in the market, mergers through horizontal integration would help them to acquire market power. This market power is defined as the power to dictate prices and control output. In other words in extreme situations it could mean the creation of monopoly power. Irrespective of the relative power afforded by either vertical or horizontal merger, the regulators seek to limit such freedom to merge by adopting far impacting legislation. Different companies adopt different growth strategies. Whatever the strategy adopted, mergers allow managers to achieve growth without much trouble in raising funds at premium rates in the financial markets. This is a blessing in disguise because it’s desirable to increase output at the lowest possible average cost or to operate on a flatter marginal cost curve. Production and marketing managers are under constant pressure to achieve these output and sales related goals despite the fact that there is nowhere to grow. Bootstrapping earnings are those extra earnings that occur as a result of the acquiring firm’s higher price-to-earnings ratio than the target firm. Thus these benefits are not related directly to the merger. Even if there is going to be an evenly-balanced marriage, one firm would definitely have a higher P/E ratio. These extra benefits enable the dominant firm to have control over the smaller firm to such an extent that the latter’s identity would almost vanish after the merger. At times this is known as asset-stripping because all the assets of the smaller firm would be sold by the dominant firm thus capturing its market share. Finally diversification is considered to be a motive behind merger. Diversification enables the newer combined management to identify different market segments and place products with a strategic shift in policy. REFERENCES 1. Brealey, R.A. and Myers, S.C. 2002, Brealey & Myers on Corporate Finance: Financing and Risk Management, McGraw-Hill, New York. 2. Capital Structure Definition, 2009, from, www.investorwords.com. 3. Chisholm, A. 2002, An Introduction to Capital Markets: Products, Strategies, Participants, John Wiley & Sons Ltd, West Sussex 4. Friedrich, B. 2007, The Theory of Capital Structure: How theory meets practice in the German market, BookSurge Publishing, South Carolina. 5. Jensen, M.C. and Meckling, W.H. 1976, Theory of the firm: Managerial behavior,agency costs, and ownership structure, Journal of Financial, Economics, Vol.3, No.4, pp305-360. 6. Modigliani F. and Miller, M.H. 1963, Corporate income taxes and the cost of capital: a correction, American Economic Review, Vol. 53, pp. 433-443. 7. Myers, S., and N. Majluf, 1984, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, Vol.13, pp187-222. 8. Pettit, J. 2007, Strategic Corporate Finance: Applications in Valuation and Capital Structure, John Wiley & Sons, Inc, New Jersey. 9. 3100 Bankruptcy and Capital Structure Theory, 2009, from, www.scribd.com Read More