QUESTION ONE
a.)
According to finance theory, the risk associated with securities can be divided into two categories: systematic (market) risk and unsystematic (non-market or specific) risk. Unsystematic risk is unique to a security and will often relate to unexpected pieces of good news and bad news relating either to the company concerned or to the industry in which it is operating. (, and , 1999) The idea is that you can diversify away unsystematic risk by investing in several companies operating in many different industries, leaving only the systematic risk relating to the market as a whole. Finance theory suggests that, when assessing an individual company for your portfolio, you need only concern yourself with the effect that the market as a whole will have on that business, the behavior of the firms’ systematic risks is examined as the re-rating point is approached. (, and , 1999)
According to the capital asset pricing model (CAPM), the required return on equity capital for a firm is an increasing function of its systematic risk only; nonsystematic risk is not relevant. If financially distressed firms do experience a reduction in systematic risk and the market accords them an improvement in the terms on which equity capital is supplied and in effect, the market is supplying such firms with a boost in overcoming financial difficulty. (, and , 1999) Second, the notion that the risk associated with financial distress is nonsystematic and implicitly underlies an investment strategy that has become popular: consciously investing in troubled companies. (, and , 1999) Third, the behavior of the systematic risk of financially distressed companies has evidential bearing upon the question of the role of systematic risk considerations in the utility rate-making process. No fully developed theory relates systematic risk of equity securities in the presence of default risk to dimensions of the underlying business enterprise. (, and , 1999) Therefore, it is possible that changes in the product of the valuation and equity participation ratio may rise only by a small amount with the onset of financial distress. As noted, systematic risk in the equity marketplace is a positive function of both leverage and systematic earnings risk. Prior commentators on the systematic risk of financially distressed firms have concentrated on the leverage dimensions of the relationship.
It is possible that declines in the systematic component of earnings risk may compensate for the increase in leverage that accompanies the onset of financial distress, the systematic risk component drops substantially despite the increase in total earnings risk, a result that is consistent with the concurrent decline in estimated betas, paralleling the increase in estimated betas from the earlier period to the later; these periods precede the onset of financial distress for the sample firms and are less likely to be contaminated by changing leverage effects. (, 1993) Therefore, systematic risk does consider managerial interventions and show that systematic risk is not necessarily confined to movements in relation to a market portfolio whether the fictitious market portfolio used for theory development as the market proxy. In this context, unsystematic risk is idiosyncratic risk that is wholly unpredictable. Thus, the argument that CAPM makes is quite specific. (, 1993)
b.)
Some companies will be more sensitive to market forces than others and will have a higher systematic risk. The measure of risk for a particular company against the market as a whole is called its beta, where a beta of 1.0 indicates that the firm will react exactly as the market does. A more sensitive company has a beta of more than 1.0 and a less sensitive company will have a beta of less than 1.0 (, 1993). An assumption used in computing the CAPM is that investors are risk-averse and assess securities on the basis of expected return and standard deviation or variance of return. A higher return for a given standard deviation is preferred. Other assumptions include the belief that investors can borrow and lend freely at the risk-free rate, the market is perfect and there no taxes or transaction costs. If follow portfolio theory and eliminate unsystematic risk, it must be recognized that this creates an opportunity cost. (, 1993) The finance in-charge can use discounted cash flow techniques to tell whether or not the intangible assets on the balance sheet are generating sufficient earnings to justify the investment, including intangible assets as the measure of the investment.
In addition, to assess whether or not the total intangible valuation in the share price can be justified as treat the investment as being the part of the market valuation that’s not backed up by tangible assets. (, 1993) This is particularly important, because many companies have negative assets as their intangibles are eliminated. The first step is to ascertain a cost of capital for every firm using the gearing approach rather than sophisticated methods such as the CAPM and must recognize that the calculated cost of capital percentage for a company on this basis will be conservative, which must be remembered when interpreting the results. (, and , 1999) The second step is to treat the actual intangible and market intangible as the investment in year zero and the earnings before amortisation and depreciation as the positive cash flow to justify the investment, the net cash flow must be at least zero. A negative figure indicates that the investment is not justified. In these cases it’s a simple matter of calculating the growth required in earnings to get the discounted cash flow back to zero where the investment is justified, it is possible to calculate the negative growth in earnings to get the discounted cash flow back to zero. (, and , 1999)
The initial betas are substantially greater than 1.0, a result found by other researchers. This result suggests that firms that ultimately experience financial distress are likely to have above average levels of debt and systematic earnings risk simply put, firms characterized by high financial and/or high operating risk are more apt to experience financial distress. The betas uniformly decline from period -2 to period -1 to period +1, (, and , 1999) representing a convergence on unity. Betas estimated with the equally weighted index are not as large initially as those estimated with the value-weighted index, nor do they decline as drastically. The mean values for the adjusted are of the order of explanatory power one customarily encounters with beta estimation of this type in the early periods, but the explanatory power declines substantially in period -1 and period +1. (, and , 1999) The period -2 betas appear to be a bit higher for these securities than for the entire sample the rate of regression of their betas is more rapid than for the sample. In order to explore this inconsistency further, the 12 firms for which the relevant data are available in both the period preceding and the period following the rating change are partitioned according to the sign of the change in their estimated beta. For example, firms experience an increase in beta and the mean change in the earnings correlation measure increases. ( and 1992)
For other firms with a beta decrease, the mean change in the earnings correlation measure also increases. The pattern of behavior for the systematic earnings risk component is similar. In consideration of the debate on the usefulness of CAPM, beta may or may not be an unreliable proxy of firm risk. One caveat we would like to point out is that CAPM only captures or measures systematic risk when it captures the efficient market portfolio. ( and 1992) The proxy used for the market portfolio, and the estimated beta derived from it, may not be perfectly efficient and may not truly measure a firm’s sensitivity to market-wide factors and that betas are not stable over time as any reference that suggests that beta always captures and perfectly parses systematic and unsystematic risk is incorrect. ( and 1992)
c.)
Thus, managers ought to be able to protect and navigate their firms in ways that are valuable to investors. , , and (1999) claim the CAPM implores managers to focus on lowering their firm’s systematic risk, and not be concerned with unsystematic or firm-specific risk. Specifically they identify two dilemmas between the CAPM’s implications and strategic management theory: (, 1983) First, reducing beta requires that managers do something which they cannot reduce investors’ exposure to macroeconomic uncertainties at a lower cost than what investors could transact on their own by modifying their investment portfolio; second, asking managers to downplay the importance of firm specific risk is not only contrary to the field (, 1983). Thus, CAPM is clearly at odds with strategic theory since it implies that managers should focus on that which they cannot influence, and should not be concerned with that which they can and, per strategic theory, should influence (, and , 1999 ).
In its theoretical state, CAPM defines an equilibrium model to determine the price of securities. In utilizing a single market portfolio, CAPM prices the exposure that an individual asset’s returns have relative to the returns on that market portfolio. (, 1983) Thus, if total risk comprised the complete variation of a firm’s returns, the systematic component would be represented by the portion of the firm’s returns that co-vary with the market portfolio. As stated in , “Conundrum #1: modern financial theory suggests that the equity markets will not reward unsystematic risk management, but unsystematic risk management lies at the heart of strategic management” (1983 ). Like, finance and management disciplines accept that firms, through their managers’ actions, increase in value by making strategic decisions that ultimately result in positive net present value projects. From a financial management perspective, the value enhancing effect of these projects depends on the cost of capital that is derived from a pricing model. If managers follow CAPM’s argument of systematic risk, are managers doing nothing to add value to the firm? Should managers focus only on unsystematic or firm-specific risk? (, 1983)
For example, supposedly a firm hires a manager with skill, taking actions that affect EBIT like business risk, the manager decides to invest in an advertising campaign, the net effect of which is to increase revenues by more than what was spent, yielding a positive impact on the firm’s cash flow. (, 1983) Similarly, an investment in research and development could be made to enhance production efficiency, or the manager may uncover a tax credit accruable to the firm in each period, which enhances free cash flows. However, if management is aware of a potential uprising, does nothing to prevent it and investors are also aware, then it is no longer an unpredictable, idiosyncratic event. Similarly, the manager that wins a surprise or government contract will see the value of the company’s stock rise independent of any market-wide movements at the time. The manager that continues to win contracts has now taken the surprise out of the equation and contracts become expected. (, 1983) Aside, theoretical models such as CAPM are useful for corporate managers as they can provide a practical way for managers to ascertain how investors judge the risk of potential projects, investment opportunities, and strategic decisions. ( and , 1996) Thus, models such as CAPM ought to help managers allocate and use their firm’s resources more efficiently. Managers ought to make decisions that are in the best interests of their shareholders and stakeholders, but managers do not necessarily know what their firm’s owners would like them to do and a way for managers to get a sense of what investors like or approve. ( and , 1996)
QUESTION TWO
a.)
‘’The time value of money – the concept, used as the basis for discounted cash flow calculations that cash received earlier is worth more than a similar sum received later, because the sum received earlier can be invested to earn interest in the intervening period. For the same reasons, cash paid out later is worth less than a similar sum paid at an earlier date’’. (cited in, 2002, 2002) Discounted cash flow (DCF) A method of capital budgeting or capital expenditure appraisal that predicts the stream of cash flows, both inflows and outflows, over the estimated life of a project and discounts them, using a cost of capital or hurdle rate, to present values or discounted values in order to determine whether the project is likely to be financially feasible. A number of appraisal approaches use the DCF principle, namely the net present value, the internal rate of return, and the profitability index. Most computer spreadsheet programs now include a DCF appraisal routine. (cited in, 2002, 2002)
For instance, when property has supported an on-going business, there may be even greater variation in estimates of market value resulting from differences of opinion concerning relevant cash flows, timing and longevity of cash flows and appropriate discount rates used to value those cash flows. When one would expect that differences of opinion concerning value would be much less variable than in those circumstances where cash flows have to be estimated. ( and , 1996) In such circumstances, when there are differences of opinion concerning market value, the differences in the estimates lie primarily in the choice of an `appropriate’ discount rate. The use of a discount rate to determine the present value of an income stream captures all of the expected future cash flows generated from an investment while the use of a capitalization rate assumes that an income stream is nominally constant in perpetuity and only takes into account the initial periodic cash flow in determining a present value for the investment. ( and , 1996) Furthermore, the use of a discount rate to determine present value offers the user the flexibility of considering cash flows of finite time periods as well as a variation in the growth rate of those cash flows as there continues to have some perplexity regarding their application by professional appraisers. Thus, the choice of an appropriate discount rate used for valuing a particular asset or security involves an estimation of the risks involved. The greater the chance that the actual return from an asset differs from the expected return, the greater the risk, and therefore the greater the discount rate used to determine the present value of the asset (, and , 1999).
b.)
The rate at which to discount expected future cash flows is a fundamental issue in the valuation of income-producing real estate. Until quite recently, professional appraisers have been primarily concerned with the appropriate derivation or construction of the “cap rate”; the denominator in the simple income capitalization formula for estimating market value. ( and , 1996) Multi period discounted cash flow analysis is not subject to these constraints; on the contrary, it is appropriate for any pattern of future income. As appraisers of income property increase their reliance on DCF techniques, the issue of the appropriate discount rate to use in these multiperiod valuation models has received more attention. ( and , 1996) The equity valuation technique explicitly incorporates the cash flows associated with the debt financing; the amount disbursed by the lender at loan origination; the periodic payments of interest and principal and the repayment of the remaining loan balance at the end of the investment holding period because discounting cash flows allows analysts to take into account the timing and the magnitude of each yearly cash flow, investors end up with a sensitive tool for measuring investment return. (, and , 1995) The underlying assumption is that the consideration of all likely factors results in the most likely scenario. If an appraiser can be certain of one thing, it is that the expected cash flows will not precisely occur and that the calculated value will differ from the market-determined value. (, and , 1995)
c.)
Net present value (NPV) In discounted cash flows, the difference between the present values of the cash outflows and the present values of the cash inflows. The NPV is the application of discount factors, based on a required rate of return to each year’s projected cash flow, both in and out, so that the cash flows are discounted to present values. If the NPV is positive, the required rate of return is likely to be earned and the project should be considered; if it is negative, the project should be rejected. (cited in, 2002, 2002) Internal rate of return (IRR) An interest rate that gives a net present value of zero when applied to a projected cash flow. This interest rate, where the present values of the cash inflows and outflows are equal, is the internal rate of return for a project under consideration, and the decision to adopt the project would depend on its size compared with the cost of capital. The approximate IRR can be computed manually by interpolation but most computer spreadsheet programs now include a routine enabling the IRR to be computed quickly and accurately. The IRR technique suffers from the possibility of multiple solution rates in some circumstances. (cited in, 2002, 2002)
d.)
A key input to the capital budgeting process is the cost of capital. Financial managers most often use the CAPM to estimate the cost of capital for which they need to know the market risk premium. The classic rule for making capital budgeting decisions is to take projects with positive Net Present Value (NPV). To decide whether to Invest in this project or not, we discount all future cash flows and subtract the initial investment to get the NPV. (, and , 1995) The decision rule is then simple: if the NPV is positive, take it; if the NPV is negative, leave it. The CAPM asserts that the only relevant risk measure for a project is its beta. The beta factor times the excess return of the market over the risk free rate determines the risk premium of the investment. The common practice has been to use the historical average return over a long period as a measure of what investors expect to earn as a proxy for the market portfolio, a broad equity market index is applied. (, and , 1995) For example, consider a firm that has several attractive positive NPV projects, but can undertake only one of them due to organizational capital being in limited supply in the short run. In that case, it would be sufficient to identify the project that has the highest NPV for making the right decision. (, and , 1995)
A manager who uses too high a value for cost of capital would still undertake the right project as long as the NPV computed using the wrong cost of capital is positive and ranks the projects in the right order. In a well functioning capital market, the cost of capital will adjust to equate supply and demand for financial capital. (, and , 1995) Henceforth, financial capital is always available at the right price. In view, the firm may compute NPV using a hurdle rate that is sufficiently higher than the cost of capital and take only those projects that have a positive NPV computed using the hurdle rate. As long as a reasonable hurdle rate that is sufficiently higher than the cost of capital is used the firm would make nearly optimal decisions. (, and , 1995) and (2002, ) mention that “for our consulting, we typically use a risk premium of 5 percent, but we would have a hard time arguing with someone who used a risk premium in the range of 4.5 to 5.5 percent. The bottom line is that there is no way to prove that a particular risk premium is either right or wrong, although doubtful that the market premium is less than 4 percent or greater than 6 percent.” ( and , 2002)
This explains why a manager may continue to use the same hurdle rate although the cost of capital has changed by a substantial amount. The growth rate of the cash flows cannot be above the cost of capital forever, otherwise the value of the project would be infinite, the net cash flows are always positive. ( and , 2002) In the situation, the net present value rule is equivalent to equivalent to the following hurdle rate rule: Invest in the project if the internal rate of return of the project that becomes available at date t exceeds the hurdle rate. The internal rate of return is the discount rate at which the discounted present value of project cash flows minus the investment required to undertake the project equals zero. ( and , 2002) The present value of the project taken up at some future point in time decreases over time at the rate whereas the present value of the initial investment decreases at a higher rate with volatile cash flows, the optimal strategy is to invest when the NPV of the project clears the target level (, , and , 1998). The internal rate of return was the dominant choice, and payback was commonly used as a secondary capital budgeting technique. The capital budgeting process plays an important role in most corporations. Managers cannot take every positive NPV project that comes along. It would sometimes be optimal to wait for a better investment opportunity to show up and by using a hurdle rate that is higher than the cost of capital along with traditional NPV calculations, a manager can take into account the value of the option to wait. (, , and , 1998)
REFERENCES
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