Capital budgeting and the cost of capital are the most important decisions the financial manager of an institution or an enterprise has to make. The procedure of making the specific decision is important and the financial manager is obliged to follow a line that would lead to the maximization of the shareholders equity. The capital budgeting analysis is a procedure of evaluation of how the capital assets should be invested when there are a variety of choices for investment. In other words, the capital budgeting answers the question "the future income of assets of investment A are going to be enough, to justify investment A, amongst other choices, given the risk every investment may hide". Amongst the most famous methods used are, the net present value method (NPV), the internal rate of return (IRR), the modified internal rate of return, the discount cash flow, the profitability index, the payback period technique, the return of capital employed, and the discounted payback period technique.
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Academics prefer, propose and teach the net present value technique for a number of reasons (i) the NPV technique represents the expected change in the shareholders equity given the expected cash flows and a discount rate. Although, there is a conflict for the case of the mutually excluded investing plans. (ii) When the expected cash flows go far in time, the NPV method supposes that the mid-term cash flows are re-invested in the cost of capital. On the other hand, the IRR method supposes that the mid-term cash flows are re-invested in the internal rate of return, which, for every investment with a positive NPV is higher than the cost of capital. On the other hand, there is the opinion expressed by Brealy and Myers (1995) that the cost of re-investment does not play a significant part in the judgment of an investing proposal. (iii) the NPV method represents in absolute numbers the amount of money that the shareholders equity may rise or fall if he/she accepts to fund a specific investment proposal. For the specific reason, it is not very vulnerable in the sign changes of the expected cash flows. However, the NPV method is not the only one used and a number of studies have ended up in mixed conclusions with respect to what method financial managers are going to select in different time periods from 1960 to nowadays, reflecting the different complication of every period as well as the technological advance
Net Present Value (NPV)
The logic behind the rule of the Net Present Value is that the present value of the future cash flows of an investing program is today's financial worth of the investment. Therefore, if a correct selection of the investing rate r, the present value shows how much we should be able to sell the investing program in the market. In other words the present value shows the revenue growth the investing program is producing. It should be highlighted that the right choice of the interest rate plays the most important part, since it reflects the risk of the expected cash flows that are going to be received by the investment. (Gitman, Mercurio, 1982) The net present value rule states that an investing plan should be funded if it's NPV is greater than zero
Where r is the interest rate CF0 is the initial investment and is negative CF1, CF2,â€¦,CFn are the cash flow at year 1 year 2 etc up to year n. For r>0 the denominator becomes greater by the year and consequently the incoming cash flow every year is worth less than it would the previous year. Now if someone is to choose between two investing programs, they should compare the NPV of each investment and choose the one with the greatest NPV.
Internal rate of return (IRR)
The internal rate of return is an alternative criterion for the evaluation of financial projects, just like the NPV. The IRR is defined as the interest rate for which the NPV equals to zero. Let us assume that an investment is to be funded. As mentioned above, the IRR can be calculated by setting the NPV equal to zero.
The IRR rule states that an investment is either going to be accepted or rejected if the interest rate is smaller or greater than the IRR respectively
NPV vs IRR
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Both the NPV and the IRR rule have logical existance and interpretation. There are many cases where the application of the NPV and the IRR rule lead to the same result. There are, although, cases where the NPV rule and the IRR lead to opposite conclusions. In these cases, the NPV rule is considered more trustworthy. This is because the NPV rule measures the absolute increase or decrease in the shareholder's equity.
The CAPM and the project acceptance
For the calculation of the return of an investment, usually three methods are used
The Capital Asset Pricing Model (CAPM)
The Discounted Cash Flow (DCF)
The bond yield plus risk approach
The CAPM gives an answer to the question 'How much rate is needed to confront the given risk level'. This model puts into numbers the relationship between risk and rate of every investment. The CAPM owes its existence in W.F. Sharpe (1964) who was given the Nobel Prize in 1989
The assumptions of the CAPM are:
Investors intend to maximise their usefulness and are going to select amongst portfolios in terms of risk and performance
All investors can borrow and lend whatever amount of capital at the interest rate without any market risk
All investors have similar expectations about the expected performance, variances, covariances between the performance rates of all the assets
All investor assets are infinitively divisible and fully liquidable and there is no transaction cost
There is no taxation
Prices are given externally to all investors and no one can influence them
The amount of capital assets are identified beforehand
There is no inflation and the changes at the interest rates and markets are in balance
The Security Market Line (SML)
With two assets, many portfolios can be designed and the indifference curves are in use for the choice of the optimum portfolio from the feasible portfolio set. The optimum portfolio is selected by the contact point of an indifference curve and the curve of the efficient set of portfolios. This is the point where the investor is going to maximise performance for a given risk level and vice versa, the minimum risk for a given performance level. Given the assumptions above, anyone could think that all investors build the same portfolios. This is not true because every investor has a different indifference curve. Because the expected performance and the performance risks are linear combinations, a graph can be plotted representing the set of all possible combinations of risk and performance as a straight line. Point M from which the straight line passes through, has coordinates M= (ÏƒÎœ,rM), where M represents the market portfolio, ÏƒÎœ is the portfolio risk and rM is the market return. The line does not pass through point 0,0 but it crosses the performance axis at the point where the investment is risk free. All efficient portfolios lay on this line which begins from the risk free point, passes through point M and represent alternative choices of risk-performance. This linear effective set of the CAPM is called Capital Market Line (CML) (Brigham, 1975)
CML expresses the balance relationship between expected performance and risk of efficient portfolios, but not for sole assets such as for example stocks. Under the CAPM assumptions the risk of a stock is measured by the Î² coefficient and, the relationship between the stock risk and the expected performances is given by the Security Market Line. Figure 3 is a representation of the security market line. The vertical axis represents the expected performance rates, while the horizontal axis represents the covariance of the performance rates of the market to the performance of the securities. The expression of the SML is derived by the equation
SML is used for the calculation of the risk adjusted cost of capital. The total risk equals the addition of the systematic risk and the unsystematic risk of the market. The systematic risk cannot be reduced via diversification. On the other hand, the unsystematic risk can be reduced via diversification. Under the assumptions of the CAPM, the SML states clearly that the systematic risk is the dangerous risk and thus, the expected performance of a security is related linearly with the level of the systematic risk. Therefore, the greater the value of Î², the greater the systematic risk and the greater the performance expected by the investors.
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If a security or an asset has a combination of performance-risk above the SML, then it is considered underestimated. This is because it offers a better performance rate with respect to the market rate, given a specific systematic risk. Consequently the demand is going to be high, until the performance is reduced and the combination of performance-risk spot falls on the SML. The exactly opposite thing happens when a spot is below the SML.
Project acceptance and the use of CAPM
The CAPM has received a lot of criticism, but it is considered a very useful tool and it is being used a lot by financial managers. Indeed, if all the assumptions of the CAPM are fulfilled, it can be used for the acceptance or the rejection of investments. The investment plans can be evaluated with respect to their relationship with the systematic risk.
Where rk is the appropriate discount rate and Î²k is the slope that determines the relationship between the expected exceeding performance against the market performance for the investing plan and the expected exceeding market performance. All investing plans above the SML lead to a boost in the market value of an enterprise. (Jagannathan, Wang, 1996) Such an investment promises better performance, adjusted to the systematic risk compared to the performance the market has to offer. In other words, investments with a combination of performance- risk above the SML are accepted and the ones that are below the SML are rejected.
One of the important results-under the CAPM-is that the expected performance of an investment is not related to the enterprise which is undertaking it. Given the systematic risk of the investment, market is expecting one and only performance. Therefore, any of the enterprises undertaking the specific investment, the expected performance is going to remain the same. On the other hand, every similar investment is not priced the same way depending on the enterprise undertaking it. This is because some enterprises may receive higher cash flow(Trigeorgis, 1993)
s. This is because there may be different experience by the management, differentiation on the time that every enterprise is taking action in the market, its size, its functional effectiveness, it's marketing capabilities, synergies etc so that the expected performance of various enterprises is differentiated.
Therefore, the CAPM clarifies that investing projects should be evaluated with respect to the systematic risk and not with respect to the total risk or the role the enterprise plays on moving the total risk. The appropriate discount rate is a function of Î² which is a function of the systematic risk. The coefficient Î² is calculated considering a similar enterprise with similar financial characteristics. The Î² coefficient embodies another two types of risk. The financial risk and the business risk (Brennan, 2001)
. The variability of a stock price against the market changes is a function of its systematic risk and of the financial risk. Increased leverage of an enterprise leads to a high Î². As far as the enterprise continues borrowing money, the Î² coefficient of the investment, and consequently the expected performance is increased linearly. Therefore, if an enterprise uses the Î² coefficient of a similar enterprise with higher leverage, the Î² coefficient should be adjusted according to the needs of the enterprise.
This essay dealt with capital budgeting and the use of CAPM. Initially, the two most famous capital budgeting techniques were introduced. The NPV and the IRR are based on the selection of an interest rate, upon which a financial manager can make a decision whether or not to invest on a project or not. The NPV technique is based on the net present value of a project. If the discounted cash flows offset the initial investment in a way that the NPV turns out to be positive, then the project is accepted, of not then it is rejected. The IRR technique accepts projects that have a performance rate greater than the Internal Rate of Return. The IRR is the rate of an investment that has an NPV equal to zero. Finally the CAPM relates the expected performance of a project to the risk it may entail. With the aid of the CAPM a linear equation is constructed that connects the expected market performance to the market risk. If a project has a combination of performance, with a given risk, above this SML (Security Market Line) then projects are accepted, if not then projects are rejected.