FINM 1001 foundation of finance
TABLE OF CONTENT
Introduction
This paper will discuss four main techniques that can be used in investment appraisal at example of Company XYZ, and perform a discussion on whether some other factors will influence investment decision-making. However, according to concept of Capital Asset Pricing Model (CAPM), there are a lot of controversy on how to choosing appropriate discount rate that can truly reflect the project’s value and risk related to the project. The second part of paper contains some discussion on this matter.
Project’s Free Cash Flow
To evaluate investment proposals, we must first identify all the relevant cash flow related to each project, which refer to all the incremental cash inflow and incremental cash outflow diverted from project, such as change in taxes, change in depreciation or change in working capital. Usually, free cash flow is used to evaluate the value of project, which is come from the operating cash flow of project, and then adjusted by any future possible capital-expending related to project. So it correctly reflect the benefits and costs related to project. (Jensen, Michael C. 1986). In this case, an assumption should be taken in estimate of cash flow, which are that: 1. the cash flow provided in the question is a project’s free cash flow after adjustment; and 2. all the free cash flow will be received uniformly throughout the life of project; and 3. at end of period, the residual value will be certainly received by company; and 4. the assets are going to work immediately after purchased; and 5. all the cash inflow and outflow over the life of project have the same risk; In this papers, all calculation will be based on these assumptions, and show in Appendix.
Investment appraisal
In the case of Company XYZ, there are a budget of £80 million for four new projects. In this step, some budgeting techniques will be employed in making decision of which project should be undertaken by company. 1. NPV
Based on the concept of time value, the net present value (NPV) has been widely used in investment appraisal activates. It can be expressed as the difference between the total initial investment outlay and the present value of all expected future cash inflow which discounted at cost of capital that is 10% in here. A positive NPV indicates that the return of the project is more than the required return of investors, and increase the value of firm. And a negative NPV implies the return form the project is not sufficient to compensate the return the investors required. And if the present value of project’s free cash flow is equal to the initial investment, it means that shareholders’ wealth will not be changed. Therefore, it is clearly that the project with a positive NPV should be accepted, and the project with a negative NPV should be rejected. The other indicator that similar to NPV is profitability index (Benefit-Cost Ratio), it just expressed as a percentage of present value of future cash flow to the initial cash outlays. The Table 1 in Appendix shows that all the four project have positive NPV, if the these proposal are independent investments, all the proposal should be accepted, but in this case, these project are mutually exclusive, so the project C is preferred since it has the greater NPV. Although the using of operating cash flow resulting from the project rather than the accounting profit is greatly improve quality of capital budgeting, but in NPV method, it is difficult to determine which discount rate should be appropriate for discounting the future cash flow back to present. And the NPV method cannot reflect profitability of project.
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2. IRR
The method of internal rate of return (IRR) is similar with the NPV that is the discount rate at which the NPV of the project’s free cash flow will equal to zero. In other word, the IRR is the return the company can earned on average per year. If the NPV is positive, and then the IRR must be higher than the cost of capital that is required of rate of return of investors. Therefore, when the project is independent and there is no capital rationing, we can accept all projects that with the IRR greater than its NPV. However, when the project are mutually exclusive, it is possible that the project that with the highest IRR is not the project that have best NPV, it means that the decision made based on the method of IRR may not maximize the owner’s wealth. The reason for this might because of different of the payback period, cash flow amounts or useful lives of project. And also, when use IRR and NPV to evaluate project, we need to consider the assumption on these methods. The assumption on NPV is to say that reinvest cash flows from the project at the cost of capital, while the assumption on IRR is that reinvest cash flows at IRR. Obviously, reinvest the cash flow at IRR will overstate the return received from project. Therefore, if the projects are mutually exclusive, the indicators of NPV and PI should be used as main indicator to determine which project would be accepted, which can maximizes owner’s wealth. (P.P.Drake et al, 2010) In this case, all the project is not completely mutually exclusive, under the budget of $80 million, we can select any two from four projects. Therefore, based on the decision criteria of NPV, PI and IRR, the Project B and C should be accepted.
3. Payback period
The payback period of project is to measure that how long it needed to recover the initial investment related to an investment. It also called as payoff period or the capital recovery period. The payback period measurement cannot reflect the profitability of project and also cannot tell us which project will maximize shareholder’s wealth. But it also considered the time value of money, because the cash flow received in the early years will be more valuable than cash flow received later. And also can reflect the risk of investment, long payback period imply that more uncertainty on future cash flow. Therefore, a simple decision criteria is that the project with shorter payback period is more worth than the project with long payback period. (P.P.Drake et al, 2010) In this case, an assumption should be made in using of payback period that is assumed that the cash flow from all project will be received uniformly throughout the year. Therefore, we can see from Table 1 that the Project C have shortest payback period, and then Project B.
4. Accounting Rate of Return
Accounting rate of return (ARR) is the indicator of measure of profitability of investment, and widely used in investment appraisal. The formula used to calculate the ARR is:
The average accounting profit is measured as arithmetic mean of expected accounting income over the life of project. Obviously, the simple decision rule is that accept the project if its ARR is equal to or greater than its cost of capital. And when the projects are mutually exclusive, the project with highest ARR should be accepted. Therefore, in this case, also Project C should be accepted. However, in the measuring of ARR, the time value of money is ignored, and using of accounting profit does not truly reflect the cash flow from operating of project.
In addition to these analysis tools, decision maker should also consider any uncertainty related to the future project’s cash flow, such as sales risk, operating risk and financial risk and so on, so the decision maker should measure the losses if these risk materialising and the its benefits---cost-benefits consideration. Overall, In this case, we have assumed that all the cash flow from each project will be under the same risk. Therefore, under allowance of budget of $80 million, Project B and C should be accepted. If the project is divisible, the $26 million left should be invested into Project C. Capital Asset Pricing Model
Capital Asset Pricing Model (CAPM) has been developed on the basis of Markowitz’s portfolio theory by American economists Sharpe, Linter and Mossin. CAPM is used to provide a theoretically required rate of return of an asset through measure the relationship between the risks and returns. The risk of investment portfolio is divided into systematic risk and unsystematic risk. And based on the theory of CAPM, the unsystematic risk can be eliminated through investment diversification, and excess expected rate of return can be treated as a compensation for systematic risk, which include political risk, interest risk and fluctuation risk and so on. Therefore, systematic risk or market risk become an important component of investment portfolio risk. The beta (β) is used to represent the degree of the market risk, and describe the relationship between the expected return on portfolio and expected return of market, and CAMP believe that there is a positive correlation between the expected rate of return of asset and market risk (β). Therefore, the CAPM provided a simple conclusion which is that only one way to get high return is to invest in high-risk asset. In other word, investors should be paid higher return to compensate for the more risk they bore. Expected rate of return
In theory, CAPM give investor a simple method to help the investor for forecasting expected rate of return according to their risk appetite. And it give us two simple ideas: first, majority of investors should receive extra return for taking more risk; and second is that investor focus their attention on the market risk that cannot eliminate by diversification. When the shareholders invest their money in the company rather than into capital market, they should be paid a return that at least be equal to the return from investing in capital market, which called opportunity cost of capital. However, the expected rate of return of different securities will depend on its own risk. So the opportunity cost of capital should be adjusted to the expected return on a security that has a same risk with that of the project. Accordingly, in evaluating investment proposals, the determining of cost capital should depend on the risk of the particular project (β of project). It means that a high risk project, we need to discount the cash flow from the project at higher cost of capital to truly reflect the value and risk of the project. Based on this, the security market line (SML) that is the graphical representation of the CAPM can be used as a standard to suggest which project should be undertaken. For instance, if the expected rate of return of project are greater than the expected rate of return indicated by the SML, it means investor can gain a higher return by investing their funds in company compare to investing in security. In this case, the project with positive NPV will be more attractive. (Brealey et al, 2012) From my own perspective, therefore, the CAPM not only provide us with a right direction to understand the relationship between the expected rate of return and the risk in investment, but also provide a theoretical basis for determining the discount rate in cash flow analysis, greatly improve the quality of investment appraisal. Application of CAPM
Over the past decades, the CAPM has been widely used in the evolution of investment proposal, and to estimate the riskiness of firm’s investment opportunities for investors. But there are some controversy on the using of CAPM in practice. The main debate mainly concentrate on two part---market risk premium and beta value. According to the CAPM, the investor’s expected rate of return form invest in a security is calculated by risk free rate plus market risk premium, and beta is a multiple of market risk premium, which represent the riskiness of project. It means that if we know the beta (β) of project and market risk premium, then we can forecast the expected rate of return of investor. However, in practice, there is not a clear explanation on how to determine the market risk premium, the history average return usually be used to measure the market risk premium, but average return have been always substantially higher than the risk premium. Secondly, other important factor in CAPM is beta value, due to lack of historical data, the beta value is difficult to be determined in real world. Besides, the beta will changes over the time as a result of developing of economic environment. Thus, estimate of beta value rely on the historical data cannot truly reflect the degree of risk in future, and then mislead the value of investment proposals. (Ravi Jagannathan, Iwan Meier, 2002) Furthermore, the CAPM is supported by some assumptions, like the capital market is completely competitive; and investors are rational and risk averse and so on. However, the fact is that almost of these assumptions is difficult to achieve in real world. Therefore, it also reduced its effectiveness in practice. Conclusion
In summary, CAPM play an important role in capital budgeting, it provide a reasonable method for evaluating of cost of capital that is key input for measuring the net present value of project. Although there are some challenges against CAPM due to itself limitation. But, there is still no one theory can compare with CAMP.
Reference
P.P.Drake and F. Fabozzi, (2010) “The Basics of Finance: An Introduction to Financial Markets, Business Finance, and Portfolio Management”, John Wiley & Sons, Inc
Arthur J. Keown, John D. Martin, J. William Petty, (2011). “Foundations of Finance” (7th ed), Prentice Hall. Jensen, Michael C. (1986). "Agency costs of free cash flow, corporate finance and takeovers". American Economic Review 76 (2): 323–329. doi: 10.2139/ssrn.99580. Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, (2012). “Fundamentals of Corporate Finance” (7th Edition). The McGraw-Hill Companies, Inc. Ravi Jagannathan, Iwan Meier. (2002). “DO WE NEED CAPM FOR CAPITAL DUBGETING?” NATIONAL BUREAU OF ECONOMIC RESEARCH, NBER Working Paper No. 8719. Richard A. Brealey, Stewart C. Myers, Franklin Allen. (2011). “Principles of Corporate Finance” (10th Edition). The McGraw-Hill Companies, Inc.
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