(147)---SHAREHOLDERS' OPPORTUNITIES AND VALUE

Shareholders’ Opportunities and Values

In the case of companies, there is a divorce between management and ownership. In an all-equity financed company, management makes investment decisions, but shareholders supply the capital. Therefore, a question may be raised: whose opportunity cost or the required rate of return should be considered in evaluating the investment projects?

Since the firm’s objective is to maximize the shareholder’s wealth, the investment projects should be analyzed in terms of their values to shareholders. To appreciate this point, suppose you are the owner-manager of a firm. You make the investment decisions and you supply funds to finance the investment projects. You will use your required rate of return to evaluate the investment projects. Your required rate of return will depend on investment opportunities of equivalent risk available to you in the financial markets. Thus, the required rate of return or the opportunity cost of capital is market-determined rate.

Suppose you appoint a manager to manage your business. She has the responsibility for the investment decisions. Whose opportunity cost should the manager use? Since you are the supplier of funds and you own the firm and the manager is acting on your behalf, you will required her to use your required rate of return in making investment decisions. If she is unable to earn return equal to your required rate of return, you can ask her to return the money to you, which you can invest in securities in the financial markets and earn the required rate of return.

Assume that you convert your firm into a joint stock company where you invite other shareholders to contribute the capital and share ownership with them. Now many shareholders own the firm. The manager should consider all owners’ required rate of return in evaluating the investment decisions. Hence, in an all-equity financed firm, the equity capital of ordinary shareholders is the only source to finance investment projects, the firm’s cost of capital equal to opportunity cost of equity capital, which will depend only an the business risk of the firm.

(146)---THE CONCEPT OF THE OPPORTUNITY COST OF CAPITAL

The Concept of the Opportunity Cost of Capital

Decision making is a process of choosing among alternatives. In the investment decisions, an individual or a manager encounter innumerable competing investment opportunities to choose from.

For example, you may invest your savings of 1000$ either in 7% 3 year postal certificates or in 6.5% 3 year fixed deposit in a nationalized bank. In both the cases, government assures the payment; so the investment opportunities reflect equivalent risk. You decide to deposit your savings in the bank. By this action, you have foregone the opportunity of investing in the postal certificates. You have, thus, incurred an opportunity cost equal to the return on the foregone investment opportunity. It is 7% in case of your investment.

The opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk. Thus, the required rate of return on an investment project is an opportunity cost.

In our next posts we will discuss,

• Shareholders opportunities and values
• Creditors claims and opportunities

(145)---SIGNIFICANT OF THE COST OF CAPITAL

Significant of the Cost of Capital

Financial experts express conflicting options as to the correct way in which the cost of capital can be measured. Irrespective of the measurement problems, it is a concept of vital important in the financial decision making. It is useful as a standard for:

• Evaluating investment decisions.
• Designing a firm’s debt policy.
• Appraising the financial performance of top management.

Investment evaluation

The primary purpose of measuring the cost of capital is its use as a financial standard for evaluating the investment projects. In the net present value (NPV) method, an investment project is accepted if it has a positive NPV. The project’s NPV is calculated by discounting its cash flows by the cost of capital.

Designing debt policy

The debt policy of a firm is significantly influence by the cost consideration. In designing the financing policy, that is, the proportion of debt and equity in the capital structure, the firm aims at maximizing the overall cost of capital.

The cost of capital can also be useful in deciding about the methods of financing at a point of time.

Performance appraisal

The cost of capital framework can be used to evaluate the financial performance of top management. Such an evaluation will involve a comparison of actual profitability of the investment projects undertaken by the firm with the projected overall cost of capital, and the appraisal of the actual costs incurred by management in raising the required funds.
The cost of capital also plays a useful role in dividend decision and investment in current assets.

(144)---THE COST OF CAPITAL

The Cost of Capital

The opportunity cost of capital or simply, the cost of capital for a project is the discount rate for discounting its cash flows. The project’s cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. Since the investment projects undertaken by a firm may differ in risk, each one of them will have its own one unique cost of capital. It should be clear at the outset that the cost of capital for a project is defined by its risk, rather than the characteristics of the firm undertaking the project.

The firm represents the aggregate of investment projects undertaken by it. Therefore, the firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects. Thus the firms cost of capital is not the same thing as the project’s cost of capital.

Can we use the firm’s cost of capital for discounting the cash flows of an investment projects?

The firm’s cost of capital can be used for discounting the cash flows of those investment projects, which have risk equivalent to the average risk of the firm. As a first step, however, the firm’s cost of capital can be used as a standard for establishing the required rates of return of the individual investment projects. In the absence of a reliable formal procedure of calculating the cost of capital for projects, the firms cost of capital can be adjusted upward or downward to account for risk differentials of investment projects. That is, an investment project’s required rate of return may be equal to the firm’s cost of capital plus or minus a risk adjustment factor depending on whether project’s risk is higher or lower than the firm’s risk. There are does exit a methodology to calculate the cost of capital for projects. The objective method of calculating the risk-adjusted cost of capital for projects is to use the capital asset pricing model (CAPM).

(143)---VARYING OPPERTUNITY COST OF CAPITAL

Varying Opportunity Cost of Capital

Evaluation investments we have made a simple assumption that the opportunity cost of capital remains consistent over times. This may not be true in reality. If the opportunity cost of capital varies over time, the use of the internal rate of return (IRR) rule creates problems, as there is not a unique benchmark opportunity cost of capital to compare with internal rate of return (IRR).

There is no problem in using net present value (NPV) method when the opportunity cost of capital various over time. Each cash flow can be discounted by the relevant opportunity cost of capital.

It is clear that for each period there is a different opportunity cost of capital. With which of the several opportunity costs do we compare the IRR to accept or reject an investment project? We cannot compare internal rate of return (IRR) with any of these costs. To get a comparable opportunity cost of capital, we will have to, in fact, compute a weighted average of these opportunity costs, which is a tedious job. It is, however, much easier to calculate the net present value (NPV) with several opportunity costs.

(142)---NPV VERSUS PROFITABILITY INDEX

NPV versus Profitability Index

The net present value (NPV) and profitability (PI) yield same accept or reject rules, because profitability index (PI) can be grater than one only when the project’s net present value is positive. In case of marginal projects, net present value (NPV) will be zero and profitability index (PI) will be equal to one. But a conflict may arise between the methods if a choice between mutually exclusive projects has to be made.

Consider the following illustration where the two methods give different ranking to the projects.

Project X

Present value of cash inflows 200000 $
Initial cash out flow 100000 $
NPV 100000 $
Profitability index 2

Project Y

Present value of cash inflows 100000 $
Initial cash out flow 40000 $
NPV 60000 $
Profitability index 2.5

Project X should be accepted if we use the NPV method, but project Y is preferable according to the profitability index (PI).

Which method is better?

The net present value (NPV) method should be preferred, except under capital rationing, because the NPV reflects the net increase in the firm’s wealth. In our illustration, project X contributes all that project Y contributes plus additional NPV of 40000$ (100000$ - 60000$) at an incremental cost of 100000$ (200000$ - 100000$). As the NPV of project X’s incremental outlay is positive, it should be accepted. Project X will also be acceptable if we calculate the incremental profitability index. This is shown as follows:

Because the incremental investment has a positive NPV, 40000$ and a profitability index (PI) grater than one, project X should be accepted.

If we consider a different situation where two mutually exclusive projects return 200000$ each in terms of NPV and one project costs twice as much as another, the profitability index (PI) will obviously give a logical answer. The net present value method will indicate that both are equally desirable in absolute terms. However, the profitability index (PI) will evaluate these two projects relatively and will give correct answer. Between two mutually exclusive projects will same NPV, the one with lower initial cost or higher PI will be selected.

(141)---REINVESTMENT ASSUMPTION AND MODIFIED IRR

Reinvestment Assumption and Modified IRR

The net present value (NPV) and internal rate of return (IRR) rules are sometimes assumed to rest on an underlying implicit assumption about reinvestment of the cash flows generated during the lifetime of the project. It is contented that the source of conflict between the two techniques lies in their different reinvestment rates.

The internal rate of return (IRR) method is assumed to imply that the cash flows generated by the project can be reinvestment at its internal rate of return (IRR), whereas the net present value (NPV) method is thought to assume that the cash flows are reinvested at the opportunity cost of capital. Advocates of the reinvestment assumption calculate terminal values of project to prove their point.

(140)---RANKING OF MUTUALLY EXCLUSIVE PROJECTS

Ranking Mutually Exclusive Projects

The net present value (NPV) and internal rate of return (IRR) methods yield the same accept or reject rule in case of independent conventional investments. However, in real business situations there are alternative ways of achieving an objective and, thus, accepting one alternative will mean excluding the other. Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded.

For example, in order to distribute its products a company may decide either to establish its own sales organization or engage outside distributors. The more profitable out of the two alternatives shall be selected. This type of exclusiveness may be referred to as technical exclusiveness. On the other hand, two independent projects may also be mutually exclusive if a financial constraint is imposed. If limited funds are available to accept either project X or project Y, this would be an example of financial exclusiveness or capital rationing. The NPV and IRR methods can give conflicting ranking to mutually exclusive projects. In the case of independent projects ranking is not important since all profitable projects will be accepted. Ranking of projects, however, becomes crucial in the case of mutually exclusive projects. Since the NPV and IRR rules can give conflicting ranking to projects, one cannot remain indifferent as to the choice of the rule.

The net present value (NPV) and internal rate of return (IRR) rules will give conflicting ranking to the projects under the following conditions:

• The cash flow pattern of the projects may differ. That is, the cash flows of one project may increase over time, while those of others may decrease of vice versa.
• The cash outlays of the projects may differ.
• The projects may have different expected lives.

(139)---NPV VERSUS IRR

Net Present Value versus Internal Rate of Return

The net present value (NPV) and the internal rate of return (IRR) methods are two closely related investment criteria. Both are time adjusted methods of measuring investment worth. In case of independent projects, two methods lead to same decisions. However, under certain situations, a conflict arises between them. It is under these cases that a choice between the two criteria has to be made.

Evaluation of NPV and IRR

It is important to distinguish between conventional and non-conventional investments in discussing the comparison between NPV and IRR methods. A conventional investment can be defined as one whose cash flows take the pattern of an initial cash outlay followed by cash inflows. Conventional projects have only one change in the sign of cash flows.

In the case of conventional investments, which are economically independent of each other, NPV and IRR methods result in same accept or reject decision if the firm is not constructed for funds in accepting all profitable projects. Same projects would be indicated profitable by both methods. The logic is simple to understand. All projects with positive NPV’s would be accepted if the NPV method is used, or projects with IRR higher than the required rate of return would be accepted if the IRR method were followed. The last or marginal project acceptable under the NPV method is the one, which has zero NPV; while using the IRR method, this project will have an IRR equal to the required rate of return. Projects with positive NPV would also have IRR higher than the required rate of return and the marginal project will have zero present value only when its IRR is equal to the required rate of return.

(138)---CAPITAL BUDGETING METHODS IN PRACTICE

Capital Budgeting Methods in Practice

In the study of the capital budgeting practices of fourteen medium to large size companies, it was found that all companies, except one, used a payback. With payback and/or other techniques, about two-thirds of companies used internal rate of return (IRR) and about two-fifths net present value (NPV). Internal rate of return (IRR) was found to be second most popular method.

The reasons for the popularity of payback in order of significance were stated to be its simplicity to use and understand its emphasis on the early recovery of investment and focus on risk.

It was also found that one-third of companies always insisted on the computation of payback for all projects, one-third for majority of projects and remaining for some of the projects. For about two-thirds of companies’ standard payback ranged between three and five years.

(137)---EVALUATION OF ACCOUNTING RATE OF RETURN (ARR)

Evaluation of Accounting Rate of Return

The accounting rate of return (ARR) method may have some merits:

• Simplicity. The accounting rate of return (ARR) method is simple to understand and use.
• Accounting date. The accounting rate of return (ARR) can be readily calculated from the accounting data; unlike in the net present value (NPV) and internal rate of return (IRR) methods, no adjustments are required to arrive at cash flows of the project.
• Accounting profitability. The accounting rate of return (ARR) rule incorporates the entire stream of income in calculating the project’s profitability.

The accounting rate of return (ARR) is a method commonly understood by accountants, and frequently used as a performance measure. As a decision criterion, however, it has serious shortcomings.

• Cash flows ignored. The accounting rate of return (ARR) uses accounting profits, not cash flows, in appraising the projects. Accounting profits based on arbitrary assumptions and choices and also include non-cash items.
• Time value ignored. The averaging of income ignores the time value of money. In fact, this procedure gives more weight age to the distant receipts.
• Arbitrary cut off. The firm employing the accounting rate of return (ARR) rule uses an arbitrary cut-off yardstick. Generally, the yardstick is the firm’s current return on its assets (book-value). Because of this, the growth companies earnings very high rates on their existing assets may reject profitable projects with positive net present values and the less profitable companies may accept bad projects with negative net present values.

(136)---ACCOUNTING RATE OF RETURN

Accounting Rate of Return

The accounting rate of return (ARR), also known as the return on investment (ROI), uses accounting information, as revealed by financial statements, to measure the profitability of an investment. The accounting rate of return (ARR) is the ration of the average after tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly. Alternatively, it can be found out by dividing the total of the investments book values after depreciation by the life of the project. The accounting rate of return (ARR), thus, is an average rate and can be determined by the following equation,

• ARR = Average income / Average investment

Acceptance rule

As an accept or reject criterion, this method will accept all those projects whose accounting rate of return (ARR) is higher than the minimum rate established by the management and reject those projects which have accounting rate of return (ARR) less than the minimum rate. This method would rank a project as number one if it has highest accounting rate of return (ARR) and lowest rank would be assigned to the project with lowest accounting rate of return (ARR)

(135)---DISCOUNTED PAYBACK PERIOD

Discounted Payback Period

One of the serious objections to the payback method is that it does not discount the cash flows for calculating the payback period. We can discount cash flows and then calculate the payback. The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis. The discounted payback period still fails to consider the cash flows occurring after the payback period.

Let us consider an example. Projects X and Y involve the same outlay of 8000$ each. The opportunity cost of capital may be assumed as 10%. Project X and Y have 2 years payback but Project X discounted payback 2.6 years and project Y payback 2.9 years.

The projects are indicated of same desirability by the simple payback period. When cash flows are discounted to calculate the discounted payback period, project X recovers the investment outlay faster than project Y, and therefore, it would be preferred over project Y. Discounted payback period for a project will be always higher than simple payback period because its calculation is based on the discounted cash flows. Discounted payback rule is better as it discounts the cash flows until the outlay is recovered. But it does not help much. It does not take into consideration the entries series of cash flows.

(134)---DISADVANTAGES OF PAYBACK

Disadvantages of Payback

In spirit of its simplicity and the so-called virtues, the payback may not be a desirable investment criterion since it suffers from a number of serious limitations:

• Cash flows after payback. Payback fails to take account of the cash inflows earned after the payback period.
• Cash flows ignored. Payback is not an appropriate method of measuring the profitability of an investment projects as it does not consider all cash inflows yielded by the project.
• Cash flow patterns. Payback fails to consider the pattern of cash inflows. I.e. magnitude and timing of cash inflows. In other words, it gives equal weights to return of equal amounts even though they occur in different time periods.
• Administrative difficulties. A firm may face difficulties in determining the maximum acceptable payback period. There is no rational basis for setting a maximum payback period. It is generally subjective decision.
• Inconsistent with shareholder value. Payback is not consistent with the objective of maximizing the market value of firm’s shares. Share values do not depend on payback periods of investment projects.

Let us re-emphasize that the payback is not a valid method for evaluating the acceptability of the investment projects. It can, however, be used along with net present value (NPV) rules as a first step in roughly screening the projects. In practice, the use of discounted cash flow (DCF) techniques has been increasing but payback continues to remain a popular and primary method of investment evaluation.

Payback is considered theoretically useful in few situations. One significant argument in favor of payback is that its reciprocal is a good approximation of the rate of return under certain conditions.