INTRODUCTION
Finance, as related to growth strategies have been increasingly given attention to by businesses in the past decades as an added attempt to become market leaders in this progressively more boundless globalized market. Risks, as part of daily business activities, are now given more attention to. In fact, the field of risk management has been pretty much in the spotlight of business handling in response to the growing need of businesses to stay ahead of the countless competitors arising at an incredible fast rate. A sound risk management process fits into a sound general management framework, whether it be at a bank, a pharmaceutical company, or a pension plan. Risk management as a process is rationalized, investigated, and demystified in terms of the new business strategies and tactics it engenders as well as the old strategies and tactics it impacts. A picture of risk management is painted that strives to eliminate thinking of risk management as a separate field. More than anything, a good understanding of risk management requires not an understanding of calculus or value at risk, but rather a solid grasp of the basic tenets of corporate finance and strategy. In finance, many contend that the world has become more dangerous, both for individuals whose wealth is exposed to seemingly larger and larger swings in global equity markets and for corporations whose cash flows seem to depend more and more on unpredictable cross-border variables. True, change often creates new risks. The interest rate, currency, and commodity price risks that derivatives help firms eliminate also pose a greater threat when derivatives are abused or misused.
PART A
COMPARISON BETWEEN SYSTEMATIC AND UNSYSTEMATIC RISKS
According to the CAPM, the total risk of a security or portfolio of securities can be split into two specific types, systematic risk and unsystematic risk. (1999) stated that this is sometimes referred to as risk partitioning, as follows: Total risk = Systematic risk + Unsystematic risk. A systematic risk, according to (2001), ‘refers to changes in the values of assets that are driven by movements in some risk factors that affect all bundles of cash flows’. (1999) puts the definition in a more understandable context: that ‘it cannot be diversified away: it is the risk which arises from market factors and is also frequently referred to as undiversifiable risk. It is due to factors which systematically impact on most firms, such as general or macroeconomic conditions (e.g. balance of payments, inflation and interest rates)’. (2001) defines that a systematic risk factor is any economic factor (e.g., aggregate consumption growth) whose changes drive all asset prices. The impact of a change in a risk factor on any particular asset price may be different depending on the asset, but if the risk factor is truly systematic, it affects all asset prices in some way.
Unsystematic risk, on the other hand, can be diversified away by creating a large enough portfolio of securities: it is also often called diversifiable risk or company-unique risk (1999). It is the risk which relates, or is unique, to a particular firm. Factors such as winning a new contract, an industrial dispute, or the discovery of a new technology or product would contribute to unsystematic risk. In consequence, there is no reward for bearing such risk i.e., for failing to diversify. Thus consumer detriment arises unless the consumers’ pension fund is invested in a well-diversified portfolio whose return is correlated with that of the investment market as a whole. (1995) noted that they can, in principle, be minimized by holding a diversified portfolio of bonds or loans. As observed by (1999), for any rational, risk-averse investor, it is only systematic risk which is relevant, because if the investor creates a sufficiently large portfolio of securities, unsystematic or company-specific risk can be virtually eliminated through diversification. It is therefore the measurement of systematic risk which is of primary importance for rational investors in identifying those securities which possess the most desired risk—return characteristics. It is the measurement of systematic risk which becomes critical in the CAPM because the model relies on the assumption that investors will only hold well diversified portfolios, so only systematic risk matters.
BETA IN THE CONTEXT OF CAPM
Beta is a measure of the sensitivity or volatility of an individual security’s or portfolio’s return (capital gains plus dividends) in relation to changes in the overall capital or stock market return. In the capital asset pricing model, market return is the return (capital gains plus dividends) from the market portfolio (1999). The beta coefficient, β, is therefore used to measure only part of a share or portfolio’s risk, namely the part that cannot be reduced by diversification that is the systematic or market risk of an individual share or portfolio of shares. In the CAPM, all systematic risk thus is reflected in the relation between expected asset returns and expected market returns, and the price of this systematic risk—the degree to which it affects returns on a particular asset—is reflected fully in beta ( 2001).
A share’s beta, according to (1999) is determined from the historical values of the share’s returns relative to market returns. It is important to appreciate therefore that beta is a relative, not an absolute, measure of risk. As each individual beta is derived from a common base, that is, the return on the market portfolio or a suitable stock index substitute, then beta is a standardized risk measure, i.e. this makes the beta of one share directly comparable with the beta of another. One way of determining the beta for a share is to plot on a graph the historic (ex post) relationship between the movement in the share’s returns and the market (or stock index) returns over a defined period of time ( 1997). On the other hand, to determine the portfolio beta, or the systematic risk for a portfolio, a simple calculation of the weighted average of the betas of the individual securities making up the portfolio is all that is needed (1999). However, it must be noted that altering the portfolio weightings or the proportions invested in each security would alter the portfolio’s risk. Clearly the systematic risk (beta) of the portfolio will depend on the betas of the individual securities making up the portfolio. If all the individual securities in the portfolio have high betas then the portfolio beta will be high and vice versa. The portfolio beta should be interpreted in the same way as the beta for an individual security (Brealey & Myers, 1996). Being aware of this allows investors to create portfolios that match their risk-return preferences.
Betas can be obtained from published sources e.g. the Business School (LBS) and through brokerage firms. The LBS publishes β values and other data for UK and Irish companies listed on the London Stock Exchange every quarter in its Risk Measurement Service publication ( 1994). Individual betas are produced for all companies listed in the Financial Times (FT) All-Share Index. According to (1995), the individual betas are calculated from the monthly returns over the most recent five-year period related to the monthly returns from the FT All-Share Index using a standard least squares regression computer programme. Most investment firms and analysts utilise β books which give beta values for all the major companies listed on the stock market although different investment firms may give varying beta estimates for the same company due to the different methods and timings used in their calculations. In the United States beta values are commonly obtained from Value Line Investment Survey and from brokerage and investment firms such as Merrill Lynch (1999).
However useful are betas, they also have limitations, because deriving them is not an exact science. According to
(1999), essentially, betas rely extensively on historic data; can and do change over time; have been seriously challenged as a useful risk measure; are essentially average measures; and are available from different sources. Fama and French, as examples, have challenged the usefulness of beta as a measure. Based on their research in 1992, these two authors have essentially concluded that beta is an inappropriate measure of risk. Their research failed to find any significant relationship between historic betas and historic returns on over 2,000 shares over the period 1963 to 1990. However, the jury is still out on this and their research findings are still being rigorously debated in the academic community.
The beta coefficient is like a share’s market sensitivity indicator. For example, if the average rate of return on the stock market rises or falls by 10 per cent, how does the rate of return on an individual share respond? If the share’s rate of return similarly rises or falls by 10 per cent in exact harmony with the market, then we say that the share has a beta coefficient of 1.0; it is just as risky as the ‘average’ share in the market. Financial managers, as well as investors can use this information provided by the beta to make decisions, a very insightful methodology for recognising and making explicit the relationship between risk and return inherent in financial decisions. In making investment decisions, which are the key wealth-creating decisions, it is clearly important that the financial manager considers both elements, risk as well as return, in evaluating the decision. (1999) asserted that by recognising that a vital risk-return trade-off is inherent in every investment decision, and by endeavouring to take account of and evaluate risk together with return in such decisions, the financial manager will be guided towards realizing the goal of shareholder wealth maximization. Recognising that shareholder wealth is reflected in the market price of a company’s shares, the financial manager will now realise that the company’s share price in the market will fluctuate until investors perceive that it offers a ‘fair’ return relative to its risk.
PART B
What is the time value of money? Why is it important to “discount” future cash flows?
The concept of the time value of money is as old as money itself. Money is an asset, the same as plant and equipment and other owned resources. The time value of money is reflected in the existence of positive interest rates and is one of the key concepts in financial management, together with cash flows and opportunity costs (1999). Time value concepts are important in ordinary business dealings, especially those involving contracts because business contracts and agreements generally specify payments that are due at future times. If such payments are more than a few months into the future, the correct analysis of the value of the agreement depends on a recognition of the time value of money. Also, the time value concepts are crucial in determining what a bond or a share of stock should be worth because all securities derive their value solely from the future cash flows that come from owning them. The only way to value a future cash flow today is through the present value concept. Therefore, the value of a security depends entirely on time value ideas. Finally, the time value of money is the concept used to compare and predict the value of something you own or the cost of borrowing money now or in the future (2004).
There are two ways of looking at investment in terms of the time value of money, namely the future value and the present value ( 2004). Future value is the sum to which an initial amount of principal, or present value, is expected to grow over a period of n years, when interest is earned at the rate of r% per year is the future value, while present value (PV) is the reverse of this (1997). With present value we are trying to determine today’s value of a sum of money to be received at some time in the future. The process of finding present value is also called discounting cash flows. More formally, present value can be defined as: the cash equivalent today of a sum of money due to be received or paid at a specified future date, discounted at a known rate of return (1997). Further, in finding future values, compounding or growth in value and the technique of compound interest (where the interest earned on a principal sum invested becomes part of the principal after a specified period) is concerned, underlies the concept of future value (1997). Additionally, future value increases as the frequency of compounding increases. The more frequent the compounding, the higher the effective rate of interest or annual percentage rate being earned. Present value or discounting cash flows is a financial technique that is used extensively in the appraisal of investment decisions, so it is a concept which is of fundamental importance in financial management.
In finance, the discounted cash flow (or DCF) approach describes a method to value a project or an entire company using the concepts of the time value of money (1997). According to (1998), the DCF methods determine the present value of future cash flows by discounting them using the appropriate cost of capital and is necessary because cash flows in different time periods cannot be directly compared since most people prefer money sooner rather than later (put simply: a dollar in your hand today is worth more than a dollar you may receive at some point in the future). Further according to them, the same logic applies to the difference between certain cash flows and uncertain ones, or ‘a bird in the hand is worth two in the bush’, due to opportunity cost and risk over time.
What factors need to be taken into account when choosing 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 and 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. (1996) pointed out what has long been realized by investors when they state, ‘the discount rate is a market-driven rate It represents the expected yield rate–or rate of return–necessary to induce investors to commit funds to the subject investment, given its level of risk’ ().
Determining the level of risk associated with an investment is one of the most critical components necessary to construct an appropriate discount rate for use in determining value. A well-developed measure of the risk associated with holding an asset, or portfolio of assets, is the standard deviation. This measure of risk takes into account all the risk associated with holding an asset regardless of the source of the risk (1999). 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. The first step for valuation professionals must be a thorough understanding of the historical long-term risk-return relationship that exists in publicly traded securities. (1999) states, ‘There is no reason to assume that (these) relative relationships (based on the historical record) will differ significantly in the future’ (). It is only with this understanding that valuation professionals can make the appropriate adjustments necessary to the discount rate, which depend on the specific risk characteristics of the asset involved, to properly estimate the value of privately traded assets. For corporate financial decision making, the selection of an appropriate discount rate follows a conceptually similar process. The firm’s opportunity cost is related to the cost of funds to the firm. The cost of funds to the firm is referred to as the firms cost of capital, a cost treated as a ‘given’ for present purposes (1997).
Specifically, there are three factors that must be taken into account when choosing an appropriate discount rate. The three are: investment opportunities, risk and inflation. The first consideration should ask what alternative opportunities are available for investment, the second should consider if the proposed project more or less risky than the other options and the third if how much will inflation reduce the future purchasing power of the money. Alternative opportunities, as gleaned from the phrase, means other available investment-making activities available to the person. Performance of an investment analysis may help analyze and evaluate investment opportunities. According to (1999), risk means the chance that the actual returns may differ from the expected returns, and in finance a risky investment is one whose potential returns are expected to have a high degree of variation or volatility. Inflation, according to (1982) has often been defined as ‘too much money chasing too few goods’. This, however, is more an explanation of inflation than a definition, attributing the cause of inflation to monetary growth relative to the output of goods and services. It is best defined as a sustained rise in the general level of prices (1999)
What do you understand by the terms ‘net present value’ (NPV) and internal rate of return (IRR)?
Net present value, according to my own understanding, refers to the discounted sum of the expected net cash flows. Some of the cash flows, such as capital outlays, are cash outflows, while some, such as cash proceeds from sales, are cash inflows. Net cash flows are obtained by subtracting a given period’s cash outflows from that period’s cash inflows. The discount rate takes into account the timing and risk of the future cash flows that are available from an investment. The longer it takes to receive a cash flow, the lower the value investors place on that cash flow now. The greater the risk associated with receiving a future cash flow, the lower the value investors place on that cash flow. NPV is a method of selecting capital budgeting projects also commonly referred to as ‘discounted cash flow’, ‘DCF analysis’, ‘discounted present value’, and ‘present-value analysis’. Whatever name is used, the nature of the technique is the same and is actually quite simple in concept. The net-present-value method compares the present value of the expected future benefits of a project to the present value of the expected cost of the project. The net present value of the project is simply the difference between the present value of the benefits and the present value of the costs. If the net present value is positive — that is, if the present value of the benefits exceeds the present value of the cost — then the project would be accepted. If the reverse is true and the net present value is negative, the project would be rejected. If a choice must be made between two mutually exclusive projects, the project with the highest net present value should be selected.
Internal rate of return is an alternative measure for evaluating projects, a method other than NPV, which is discussed above. Many have defined it as the highest rate at which the future cash flows can be discounted making the project’s NPV equal to zero, calculated rate of return (or discount rate) r at which the NPV will be equal to zero. In project evaluation this rate has to be equal to or greater than the required rate of return for the project to be acceptable. It is calculated manually by trial and error, or by a special routine in computerized spreadsheets. The IRR remains in use because decision-makers are used to dealing in ‘rates of return’ rather than the more esoteric NPV. The IRR measure is useful for easily comparing the rate of return from the project being considered with various alternative returns.
Compare and contrast the NPV and IRR.
According to (2002), theoretically, the NPV approach to project evaluation is superior to that of IRR. The NPV technique discounts all future project cash flows to the present day to see whether there is a net benefit or loss to the firm from investing in the project. If the NPV is positive, then the project will increase the wealth of the firm. If it is zero, then the project will return only the required rate of return, and will not increase the firm’s wealth. If the NPV is negative, then the project will decrease the value of the firm and should be avoided. In spite of the theoretical superiority of the NPV technique, project analysts and decision makers sometimes prefer to use the IRR criterion. The preference for IRR is attributable to the general familiarity of managers and other business people with rates of return rather than with actual dollar returns (values). Since interest rates, profitability, investment income and so on are normally expressed as annual rates of return, the use of IRR makes sense to financial decision-makers. They find it easy to understand, and useful for comparing the profitability of alternative investments. Decision-makers and other business people tend to find NPV more difficult to use because it does not really measure benefits relative to the amount invested in terms of a rate of return that they are familiar with. The computational method for IRR can be modified so that particular algebraic pitfalls within the IRR analysis can be avoided. In these cases the IRR technique is safe to use, so the widespread use of IRR should not be viewed as reflecting a lack of sophistication on the part of project analysts and financial decision-makers.
CONCLUSION
Like in any discipline, the field of financial management has developed and changed over time. At the turn of the century, it emerged as a field separate from economics when large industrial corporations were created by early industrialists, has focused on risk return relationships and the maximization of return for a given level of risk, and continues to become more analytical and mathematical. This is where the previous discussions come in. The concepts of risk and time value of money involve a number of computations and analysis which have become an integral part of the financial management process. It is therefore imperative that financial managers get a good grasp of the above-mentioned concepts in order to use that knowledge to contribute to the finance and growth strategies of the organization as a whole. Their integral functions of allocating funds to current and fixed assets, obtaining the best mix of financing alternatives, and developing an appropriate dividend policy within the context of the firm’s objective is now compounded with the responsibility of having the knowledge of the above-discussed concepts. These functions are performed on a day-to-day basis as well as through infrequent use of the capital markets to acquire new funds. As time progresses, the nature of the work of the financial manager is increasingly becoming more challenging and more contributory to the development of the organization, and it is up to the people involved in that field to make the best of what is currently known in the quest to find better ways of managing the financial and growth strategies of the business.
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