Corporate Finance - Fishers Theory of Optimal Investment Decision - Essay Example

Corporate Finance - Fisher’s Theory of Optimal Investment Decision 1. Discuss Fisher’s theory of “optimal investment decision”. Fisher’s theory of optimal investment decision assumes a perfect market meaning that the rate a firm can lend or borrow at is not affected by the total amount of the firm’s lending or borrowing. Fisher also assumed that all capital was circulating capital thus all capital is investment. Fisher assumed two time periods as investment in one period would lead to output only in the next period. Thus there is a tradeoff between consumption now and consumption later. The optimal investment theory assumes two time periods t=1,2. The output in year 2 is dependent on investment in year 1, the greater the investment in year 1, the greater the output in year 2. Fisher’s theory states that when the marginal rate of return on investment is equal to the rate of interest, which is the optimal amount of investment. Y2 Y2* Y* I1* (1+r) Y1* E1 Y1 The optimal investment is when the investment frontier is tangent to the interest rate line. Below that or above that marginal diminishing returns on investment will set in. I1* is the amount of investment in year 1 as Y1* is being consumed out of the total expenditure which is E1. If consumption increases then investment would decrease causing less output in year 2. The cost of investment would also increase. If Y1* was to be decreased, the I* and Y2* would increase but there would be less to consume this year and the diminishing marginal return would set in causing the cost of investment to be higher. At Y*, the marginal rate of return and the cost of investment are equal thus I1* is the optimal amount of investment. The investment theory states that investment decisions are independent of the owner’s preferences and the financing elements; rather they are dependent on the maximization of the present value. The optimal investment plan is where the net present value of the projects is maximized without regards to individual preferences and all shareholders would be better off with such a plan. The firm focuses on the maximizing the internal rate of return and that is where the investment is optimal. Thus investment appraisal techniques that focus on rate of return are the techniques that should be used. Fisher’s theory focuses on internal rate of return and thus that method should be used according to this theory. Fisher’s theory is the basis of NPV and IRR as it focuses on the present value of investment and the trade off between investment and consumption. 2. Discuss the following capital budgeting techniques: a. Net Present Value Rule b. Payback Rule c. Internal rate of return Rule What are their MERITS and DEMERITS? Which is the better decision making tool and why? The net present value rule follows the technique of discounted cash flows. The project’s cash inflows and out flows are discounted at the cost of capital of the project. The sum of these discounted cash flows is called the net present value. If the net present value is positive, then the project is feasible and if it is negative the project should not be chosen. When comparing two projects, the project with the higher NPV is the better option. NPV is a direct and straight forward method of making investment decisions and it gives the dollar benefit of the project. It also uses cash flows discounted at the cost of capital which gives a more accurate value of cash flows. It is simple to understand and includes the total value added to the firm due to the project. However, it has certain drawbacks as it does not provide information about the safety margin in the cash flows or the amount of capital at risk; for example if project A has an investment of $100,000 and discounted return of $ 95000 after a year and Project B has an investment of $20,000 with a discounted return of $15000 after a year. They both have positive NPVs of $5000 and thus are equally profitable investments from an NPV perspective. However, it is riskier to invest $100000 than to invest $20000. Also, if project A’s cash flows fell by just 10% the NPV would become a negative $ 4,500 whereas if Project B’s cash flows fell by the same 10% the NPV would still be positive at $3500. Thus NPV does not take into account the magnitude of the project or cash flows. Payback rule is one of the basic techniques involved in investment decision making. Payback period is the number of years needed to recover the initial investment in a project. The decision rule is that the shorter the payback period the more feasible the project, thus the project with the shorter period is chosen. The payback rule is criticized for not considering the cost of capital and thus discounted payback rule is a method which discounts cash flows at the cost of capital before calculating the payback period. The advantages of this method are that it is simple and identifies the time to recover the investment which is always an important consideration. This method has many disadvantages as it does not take into account the cash flows after the initial investment is recovered. Many projects may have a longer payback period but cash flows may increase or keep coming for a number of years whereas a shorter payback period does not necessarily signify profitability. However, payback is an effective measure of liquidity and how long funds will be fixed in a project. Also, future cash flows are riskier and uncertain thus it may be better to focus on the immediate cash flows. The payback rule however does not consider the increase in value to the company or the shareholders of a project. The internal rate of return is the discount rate at which the present value of the cash inflows of the project is equal to the present value of the costs. The IRR is the rate at which NPV is zero, thus if the NPV is positive the IRR is greater than the cost of capital and if NPV is negative the IRR is lower than the cost of capital. The IRR is also derived from Fisher’s theory of optimal investment, it is the rate at which marginal rate of return and marginal cost is equal. IRR has many merits as it predicts the rate of return on investment and can be compared to the cost of capital to make a decision. However, IRR does not measure the sensitivity of the project’s cash flows into account nor does it measure how soon investment will be recovered. IRR is not feasible if the project has cash outflows in the future apart from the initial investment as it may result in multiple IRRs. As a decision making tool payback is not feasible as it does not measure profitability or take into account future cash flows after the payback period. The normal payback rule does not discount cash flows either. NPV and IRR are both discounting techniques that provide same results in individual projects. NPV is a better decision making tool in mutually exclusive projects as it assumes that cash flows can be reinvested at the cost of capital which a more realistic assumption than IRR’s assumption that the cash inflows are reinvested at the IRR. Thus IRR overstates the return from a project as it is not the market reinvestment rate. Following Fisher’s theory, the IRR would produce optimal results if the reinvestment rate is greater than Fisher’s rate of return over cost, and NPV would be a better measure if the reinvestment rate is lower. Mutually exclusive projects that differ in time period or the scale of the project should be chosen on the basis of NPV. NPV provides a realistic estimate of reinvestment which is the cost of capital. NPV also takes into account cash flows and their sensitivity to the changes in cost of capital. NPV also takes into account cash outflows that might occur in the following years. However, there are many other qualitative factors that should be analyzed before taking as investment decision; rather than solely focusing on quantitative measures. The IRR method focuses on the optimal investment decision and so does the NPV. The NPV considers the rate of interest whereas the IRR the marginal rate of return. In an optimal investment decision both rates should be equal. As NPV is zero at the IRR this means that IRR is the measure for optimal decision making. Explain the practical application of the Capital Asset Pricing Model (CAPM) and critically evaluate its use in investment decision. Hint i. You need to establish the model, discuss its assumptions and to what use was it intended. ii. See if its intensions hold in practice, if not, why not? iii. With examples, show its use in practice iv. What are your conclusions (evaluation)? The Capital Asset Pricing Model (CAPM) focuses on the relationship between the required rate of return and risk of an asset when it is held in diversified portfolio. The CAPM measures the risk of a stock as beta; which stands for a stock’s contribution to the risk of a portfolio. Thus, it is the relevant measure of risk. As risk increases so does the required rate of return and market risk premium is the difference between the required rate of return on a portfolio minus the risk free rate multiplied by the beta of that stock. RPs = (km –krf) bs The basic assumptions of CAPM are that investors choose among portfolios to maximize their return and wealth. The CAPM focuses on a single holding period and assumes the investors can borrow or lend at the risk free rate. There are no limits on short sales and all investors have homogenous estimates of return, risk, and variances. There are no taxes and transaction costs and all assets are highly liquid and marketable. The quantities of the assets are fixed and there is perfect market meaning investors cannot influence price and are price takers. The CAPM is based on the Capital Market line and the Security Market Line. The CML implies that all investors under the CAPM assumption must hold a combination of risk free securities and a market portfolio. If the market is in equilibrium the market portfolio will consist of every security in the same proportion as it is in the market. The CML specifies the relationship between an efficient market portfolio’s risk and return. CAPM focuses on individual securities as well and the SML defines the relationship between the risk and return of individual securities which can be figured out by using the risk premium formula RPm = (km –krf) bm The required return on a specific stock according to CAPM would be the sum of the risk free rate and the product of the risk premium into beta. ki = krf + (RPi)bi Expected rate of return required rate of return CML SML kep σ efficient portfolio Risk σ risk(beta) The SML signifies that the only relevant risk of an individual security is beta, the addition to the risk of the portfolio, because other risk is diversified. SML is an important part of the CAPM as it is used to calculate the cost of capital of separate projects and investments. Beta is the relevant risk of an asset and is calculated as the gradient of the characteristic line which is the plotting of historical returns of an individual stock. Beta measures the volatility of returns compared to the volatility in the market. It is the measure of risk used in the SML whereas standard deviation is used as the market risk measure in CML. Although, CAPM has been used in security valuations its assumptions do not reflect a real market setting. CAPM does not hold up in practice and is not applicable in the real world. The theory cannot be tested empirically. As most investors in the real world do not hold fully diversified efficient portfolios, the beta would not be a sufficient measure of risk and SML would not be applicable for the required rates of return. As there are taxes and transaction costs in reality and assets have different degrees of liquidity this assumption does not hold true either. All investors do not have same forecasts of expected risk and return and they usually borrow according to their credit standing which is higher than the risk free rate. There is a disparity in borrowing and lending rates which will distort the CML and thus the SML line. In many markets, large investors can influence price through buying and selling securities. The CAPM can be used in practice to calculate the values of equity and portfolios. For example, to calculate the cost of common stock through the insertion of the risk free rate, expected market risk premium and the beta coefficient into the SML equation. For example: Krf= 8% Km=12% Beta for Kellogs foods is 1.2 Then the cost of equity would be = 8 + ( 12-8 ) 1.2 = 8 + 4.8 = 12.8 % The required return on Kellog’s stock would be 12.8%, 0.8% greater than the market return as its beta is greater than 1. However, due to CAPM’s limitations beta might be higher than 1.2 and thus 12.8% might not be a valid return for Kellog’s stock. Another factor is Kellog’s stock holders which might be individuals without market portfolios and thus may bear stand alone risk as well and require a greater return. In the same case, the market premium which is calculated to be 4% in this case, may be much more due to transaction costs, borrowing costs and taxes which are not involved in the CAPM model. When it comes to efficient portfolios and CAPM, the CML line may not be valid due to borrowing and lending at greater than the risk free rates and it s highly unlikely that investors will have efficient portfolios with the exact proportion of a security as there is in the market. The CAPM is used in calculations of NPV and investors also use it to compare book values of securities with their market values. The CAPM model may not be produce accurate results but does produce relevant trends and close numbers. It is widely used practically and is generally a good basis for calculation of risk and return. It does not take into account other assets, opportunity costs and the absence of efficient markets but it does provide a general ballpark measure for the valuation of securities and their risk and return relationships. The CAPM is a forward looking model and calculated expected return and risk in the future holding period. The CAPM does not take into account company specific risk and is based on historical data to calculate beta and risk premium. It also does not apply to all financial assets such as bonds and thus in not a realistic measure. It is a theory based on simplified assumptions with conceptual importance. However, it application in a real market scenario is flawed. When used in practice, it provides answers that may not represent the true picture as it uses historical data to predict future risk and returns. CAPM’s factors are difficult to estimate and the model cannot be proven. The results from CAPM may predict correct relationships but are not accurate in their results. As a theoretical tool, it is useful in explaining risk and return and behavior of investors and market but it has many limitations when applied to practice. It is still commonly used in the valuation of securities and investment decisions. DOES CAPITAL STRUCTURE REALLY MATTER? I. What is the effect if debt on the value of firms? II. What is the cost of debt? III. What is the traditional view of debt on firm value? IV. What has MM’s view on this? V. What would you attribute their views to? VI. What is the effect of tax on MM’s propositions? VII. What is your view/conclusion/assessment of debt on equity/shareholder wealth/firm value? The capital structure of a firm consists of the combination of debt and equity that it uses to raise funds. If a firm has low debt ratio it may use debt to finance its new ventures whereas if it is highly leveraged it may opt to issue new stock. The firm needs to strike a balance between debt and equity in order to minimize risk and maximize the return on equity. The effect debt may have on the value of the firm is debatable. Debt affects the value of the firm and risk and expected return. When a firm finances through debt, the financial risk increases which adds to the business risk shared by the shareholders. However, the expected return also increases for the shareholders. When a firm opts for the debt option, it gets a tax shield as tax is applied on earnings after interest payments. Also, earnings per share which is EBIT (1-t)/ number of shares increases as earnings would increase due to new investments, tax would decrease and the number of shareholders would remain the same, however the interest payment expense would increase and the business risk for the shareholders would increase. As an increase in debt increases the risk for shareholders and increases the expected earnings per share the effect on the value of the firm is only determined by how highly leveraged the firm is. The increase in risk puts a downward pressure on the stock price whereas the increase in expected return puts an upward pressure on stock price. Thus, a firm’s value increases due to debt till the increase in earnings per share is greater than the increase in risk. The cost of debt is kd which is the interest rate at which the firm has borrowed. This rate keeps increasing as the debt ratio increases as lenders will take into account the financial risk that increases as the debt ratio increases. The cost of debt to the firm can be calculated as Debt/Assets(kd)(1-T) which is the after tax cost of debt to the firm. The non financial costs of debt to the firm are an increase in financial risk borne by the shareholders. In the traditional view of debt’s effect on the firm’s value; a firm entirely based on equity will experience a favorable shift in stock prices and weighted average cost of capital with the advent of debt. WACC is calculated on the basis on the cost of equity and the cost of debt. When the firm in not leveraged with 100% equity, the WACC would the cost of equity. When it first starts to finance through debt, it will get a lower interest rate due to low financial risk for investors, this would be lower than the cost of equity causing WACC to fall and EPS and share price to rise. However, further usage of debt would lead to higher cost of debt and higher cost of equity as well due to the increased risk. According to traditional theory share price will be maximized and WACC will be minimized at 40% debt. After this ratio, using lower cost debt would be offset by the increases in rebounding costs of debt and equity. However, MM’s theory of capital structure states that capital structure does not affect the value of a firm. According to this theory, how a firm finances its operations makes no difference to its value. This theory is based on stringent assumptions such as the absence of brokerage costs, bankruptcy costs and taxes. It also assumes that investors and corporations borrow at the same rates and have the same amount of information as the management about prospective investments. Lastly, it assumes that EBIT is not affected by debt. This view may not be applicable to the real market but it establishes the reasons behind the importance of capital structure. Bankruptcy costs are a cost of debt if it cannot be repaid and thus it stops companies from having high debt/equity ratios, however if they did not exist then firms only the cost of capital would matter and not whether its debt or equity. No taxes would mean no tax shield for debt and thus no preference towards debt. Perfect information with no transaction costs would mean that investors and management know the exact same details and thus can make informed decisions thus decreasing risk due to information asymmetry. The MM theory thus proposes that the cost of equity for a leveraged firm would be the same as an unleveraged firm except for an added financial risk premium thus; having no effect on firm’s value. MM relaxed the assumption of tax, which affected corporations as they could deduct interest as expense payments, however dividends were not exempted. This approach called for a 100% debt structure due to the inclusion of corporate tax and if all other assumptions hold as the cost of capital would keep decreasing due to the tax shield as debt keeps increasing. However, this was later modified to include personal taxes. Thus, interest on bonds is taxed higher than the dividends and capital gains from bonds which led to the conclusion that investors were more willing to accept low returns on stocks than on bonds. Whereas the traditional theory does not focus on the role of information asymmetry, agency costs and bankruptcy costs; the MM theory focuses on these factors only. In conclusion, these factors play an important part in increasing the riskiness of debt and increasing the cost of equity, thus affecting capital structure and in turn the value of the firm. Thus MM’s theory has become the basis of modern capital structure theory. As a high debt ratio increases the threat of bankruptcy but is also useful for tax purposes, firms are involved in this trade off in their capital structure rather than the effect it has on the firm’s value. However, the increase in debt financing leads to greater business risk shouldered by the shareholders even if there are no transaction costs or bankruptcy costs, and shareholders stand to gain from new projects with a positive NPV thus debt does affect the value of the firm through an pressures on stock prices depending on the firm’s leverage and business risk. Books Hedge Me: The Insider's Guide -- U.S. Hedge Fund Careers, by Claude Schwab. Lynx Media, Inc., 2004. Options, Futures, and Other Derivatives, by John Hull. Prentice Hall, 2005. Econometric Analysis, by William H. Greene. Prentice Hall, 2007. Dynamic Asset Pricing Theory, by Darrell Duffie. Princeton University Press, 2001. Energy and Power Risk Management: New Developments in Modeling, Pricing and Hedging by Alexander Eydeland and Krzysztof Wolyniec. Wiley, 2002. Careers in Finance, by Trudy Ring. McGraw-Hill, 2004. Corporate Financial Management, by Douglas R. Emery and John D. Finnerty. Prentice Hall, 1997. Read More