Prof. Thomas Chemmanur

MF807

Fall 2008

Topic Note-6

1. Corporate Finance

In the first half of this course, our focus was on Valuation: We discussed the issue: How does the capital market value different securities? We now know that the answer to this question is that investors compute the expectation of the cashflows that holders of the security are entitled to in each period, and find the present value of these cashflows at the risk-adjusted discount rate. We also learned about a model which helps us calculate this risk-adjusted discount rate: the Capital Asset Pricing Model.

Thus, we now have some idea about how the equilibrium prices of securities issued by corporations are determined in an efficient capital market.

In the second half of this course, we will focus on how corporations should make various decisions, given the valuation rules we have studied above. The first decision that corporate managers face is the investment decision: what is the set of projects (out of several the firm may have access to) the firm should undertake? (In this context, by project we mean any investment proposal which involve cash outlays that are expected to result in benefits to the firm). Of course, the firm needs funds to invest in these projects. It can either use funds generated from its past operations (called retained earnings) or raise new financing from the capital market by issuing new stock, or bonds, or preferred stock, or a combination of these or other securities. This decision about how to finance the investment in various projects undertaken by the firm is known as its financing decision. While in reality, the investment and financing decisions may be interrelated, we will, to begin with, pretend that the investment decision is completely independent, and later study the interactions between the two.

The third corporate decision we will discuss is the dividend decision: Out of the earnings of the company, how much should be paid out to shareholders as dividends, and how much retained (hence the name 'retained earnings') for future investment? Clearly, the dividend decision is also intimately related to the financing decision and thus to the investment decision, but we will again study this separately at first before integrating it with the other two important corporate decisions.

Throughout our analysis, we will assume that firm managers' objective in making these decisions is the maximization of the total value of the firm's equity (stock). We know that this may not be strictly true in many cases in the real world, where managers sometimes put their own perks and careers ahead of stockholders' interests. However, we study the decisions managers should make if they had stockholders' welfare at heart so as to serve as a bench mark against which we can compare the behavior of real-world corporate managers. After all, the stockholders of a firm, acting through the company's Board of Directors (elected by them), can always fire the firm's managers if they are seen to act very much against stockholder interests.

2. The Investment Decision: Capital Budgeting

It is sometimes useful to classify projects into two categories: Expenditures which are expected to generate future cash benefits which are expected to last longer than one year, called 'capital expenditures'. On the other hand, cash outlays which are expected to result in benefits for a short horizon only (less than one year) are classified as 'operating expenditures'. Capital expenditures are usually incurred to obtain capital assets, which are used by the company in the actual production of goods and services. The plans for capital expenditures are summarized in a capital budget and the process of determining exactly which projects to invest in and how much to invest in each project is called capital budgeting. While the techniques we will study can be used equally effectively in evaluating operating expenditures, we will focus here on capital budgeting, since the dollar volume involved in capital expenditures is much larger, and hence it pays to subject these decisions very careful analysis. Examples of capital expenditures which lend themselves to capital budgeting analysis are the purchase of new machinery, real estate, construction of new factories, expansion of product lines, purchasing a patent for a new technology, replacing existing machinery, or even acquiring another company.

The capital budgeting decision is a complex process that involves several activities: searching for new projects, marketing and production analysis to determine economic attractiveness and leading to careful cash flow estimates, preparation of cash budgets, evaluation of the project proposals, and the control and monitoring of past projects. We will, however, focus only on those steps which are important from the point of view of financial analysis.

3. Steps involved in evaluating project proposals

Consider a firm which has monopoly access to several projects. What are the steps involved in deciding which ones to invest in, and which to ignore?

The steps involved in project evaluation are:

1. Estimate the cashflows involved in the project at various points in time:

These cashflows should include not only the benefits from the project, but also the investment required for the project.

2. Estimate the riskiness of the project cashflows and thus the appropriate discounting rate to use in evaluating the project cashflows.

3. Select the projects to be undertaken and amount to be invested in these projects (if the projects are of the type where you can invest in them to varying degrees) by using appropriate evaluation criteria. In making this final step, one clearly has to take into account limits, if any, on the total funds available for investment. (If there are limits on the total amount of funds available for investment in various projects, then the firm has an investment constraint and faces a situation of capital rationing ).

We will study each of these steps in turn. First, we will study the various evaluation criteria (step 3) used for project evaluation, assuming for the moment that we already know the results of steps (1) and (2).

4. Project Evaluation Criteria (Read Brealey and Myers, Chapter 5)

We will study three project evaluation criteria in some detail:

i. Net Present Value Rule.

ii. Internal Rate of Return.

iii. Benefit to Cost Ratio or Profitability Index

We will also briefly look at three ad-hoc evaluation rules, which do not make much sense from an economic point of view, but are still somewhat widely used in industry in some situations. These are:

iv. Payback period rule.

v. Discounted payback period rule.

vi. Average return on book value.

i. The Net Present Value (NPV) Rule

Consider a project with an investment requirement I0 at the beginning (ie., at t=0) and subsequent expected cashflows C1, C2, ....Cn at the respective dates 1, 2, 3, ..n, where 'n' is the date at which the project ends. (Since we are usually uncertain about the cashflows in the various future periods these cashflows are really random variables; C1, C2, ..etc are the expectations of these uncertain cashflows). The NPV of this project is now given by,

(1)

where r1, r2, r3,..rn are respectively, are the risk-adjusted discount rates to be used in discounting cashflows obtained one period from now, two periods from now, ....etc 'n' periods from now. We know from our study of the term-structure that if the yield curve is not flat, these discounting rates need not be the same. However, in many cases, it is a good enough approximation if we set r1 = r2 = ...= rn = r, a single discount rate for the entire stream of cashflows arising from a project (in these cases, we are implicitly assuming a flat term-structure).

Decision Rule: If there is no capital rationing, accept all projects with a positive NPV. If, however, we can accept only a certain number of projects, accept the projects having the highest NPV. Under capital rationing, accept that project or combination of projects which gives the highest NPV, given the constraint on investment. (For example, assume that we have four projects with investment requirements of respectively, $5000, $5000, $3000 and $2000. The NPV of project one is $800, that of two is $400, that of three is $350 and that of four is $300. Assume that we have only $10,000 to invest. Then we should pick projects one, three and four since combined NPV is $1450, instead of one and two, which have combined NPV of only $1200. Thus project two is not picked even though it has the second highest NPV).

The NPV of a project can be interpreted as the increase in the total value of the firm that will take place if the project is accepted (Remember our discussion of stock valuation). An important property of NPV is that the NPV s are additive: If we consider two independent projects A and B,

NPV of the two projects together = NPVA + NPVB

ii. Internal Rate of Return (IRR)

The IRR of a project is that rate of return at which the initial investment requirement I0 equals the present value of all future cashflows from the project. i.e.,

(2)

Taking I0 to the other side,

(3)

Comparing the right hand side of (3) with the definition of NPV given by (1), we see that the IRR of a project is that value of the discounting rate at which the NPV of the project becomes 0. In many cases, we have to use trial-and-error in computing the IRR.

Decision Rule: If there is no capital rationing, accept all projects with an IRR above a cut-off rate of return, which depends on the riskiness of the project. Under capital rationing, accept that combination of available projects which satisfies the investment constraint and gives the highest IRR.

Comparison of IRR and NPV

The IRR can lead to wrong decisions or no decisions in the following cases: (1) IRR cannot distinguish between 'lending' and 'borrowing': When a project's initial cashflows are positive, for instance, the IRR may lead to an acceptance for a negative NPV project (2) When there is more than one change in the sign of the cashflows for the project, there may be multiple IRRs (An investment is a negative cashflow and a benefit is a positive cashflow. Most projects have only one change in sign of the cashflow: from a negative cashflow at t=0 to positive cashflows ever after. However, if there is an additional investment to be made later on in the life of the project there may be a negative cashflows later on in the life of the project, leading to more than one change in sign). (3) When judging mutually exclusive projects, IRR may give wrong rankings for the projects when the timing of the cashflows of the two projects are significantly different (4) When the term-structure of interest rates is not flat, IRR rule is difficult to apply. (See Brealey and Myers, pages 79 to 85 for details of each situation).

The IRR of a project is a measure of its profitability: we do not need to factor in the risk of the cashflows when computing IRR. This is done later, when comparing the IRR with the cut-off rate of return. On the other hand, NPV computations require the correct discounting rate which depends on the riskiness of the project. It is possibly this freedom from using any discounting rate at the initial stages of project evaluation which makes the IRR popular with managers despite all the above drawbacks relative to the NPV.

iii. Profitability Index or Benefit to Cost Ratio

The profitability index (PI) or benefit-to-cost ratio is given by:

Present Value of benefits from the project

PI = ------

Present Value of amounts invested in the project

Decision Rule: Accept all projects with PI > 1, if there is no capital rationing. If there is capital rationing, accept that combination of projects which satisfies the investment constraint and gives the highest PI. The PI can give wrong answers, different from NPV when ranking mutually exclusive projects. This is because, the PI rule tries to maximize present value of benefits per dollar spent rather than maximize firm value. However, because of this, in situations of capital rationing, this can be a convenient rule to use to identify that combination of projects which gives the highest NPV.

iv. The payback period rule

This is an ad-hoc project evaluation rule. We discuss it only because it is popular in industry for evaluating small projects, perhaps because of its ease of use. The payback period is defined as the number of periods required for the project cashflows to add-up to the initial investment. i.e., how much time does the project take to pay back the initial investment?

In other words, it is the smallest value of n at which C1 + C2 + .....Cn > I0, the initial investment.

Decision Rule: Accept all projects with payback periods less than a certain cut-off number of periods. A project with a smaller payback period is preferable to one with a larger payback period.

Problems with payback period:

1. Does not take into account time-value of money (since there is no discounting). Thus it treats all cashflows before the cut-off period the same irrespective of when they are received.

2. The choice of cut-off period is quite arbitrary, and has no economic content. All cashflows after this cut-off period are ignored in making the accept/reject decision. Thus, this criterion leads to accepting many short lived projects (sometimes with negative NPV s), and rejecting positive NPV projects with a large portion of their benefits in the later periods.