Research Articles Base: Present Value Of Money

Finance

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.   Credit:ivythesis.typepad.com

Finance

INTRODUCTION Finance, as related to growth strategies have been increasingly given attention to by businesses in the past...

Discount Rates

REVIEW OF LITERATURE          One of the complications in comparing the various reports is that they use different discount rates for calculating net present values. Sofregaz originally used 7.5 per cent, though in its later calculations it uses 7 per cent, BG/KeySpan use 8 per cent, while the Shannon-McManus report uses 7 per cent. The test rate recommended by the Department of Finance for non-commercial public sector capital projects is 5 per cent, though in the case of commercial projects which may involve higher than average risk, a somewhat higher rate may be appropriate. Evaluations carried out on the first interconnector have used 7 per cent.      That said, the discount rate is meant to represent the cost of capital or the required rate of return for a project. In the low inflation and interest rate environment that exists at the moment, both the cost of capital and the required rate of return on investments in the general economy have been falling. This would suggest that the discount rate used to evaluate this project should also be lower than that used in the past. The real rate of return on Irish State index-linked bonds has recently been around 2.7%.        UK regulators have recently been indicating that permitted real rates of return for the various industries subject to tariff controls may be in the range 5 to 6 per cent. There has as yet been no determination in Ireland of the rate which will be permitted, although it is clear from the Electricity Regulation Bill currently before the Oireachtas that there will certainly be a ceiling. At this stage, our judgement is that it could well be lower than the 7 and 8 per cent real rates used in the various studies listed.  Where the timing of expenditure differs between investment options, the discount rate chosen can have an impact on the determination of the least cost option. Therefore it is important to investigate the sensitivity of the various options to changes in the discount rates used. We have done this, for the three reports in question, for discount rates of 5, 6, 7, and 8 per cent.         We consider here the revised data produced by Sofregaz, as opposed to that produced for the Gas 2025 report. Table 9.1: Sensitivity Analysis to Discount Rates, Sofregaz/BGE Figures   UK1 UK1 S-N UK2   1998 US$ 1998 US$ 1998 US$ Gas World B:       Capex 827 868 933 Capex + Opex discounted at: 5% 754 786 853 6% 700 730 791 7% 652 679 736 8% 609 634 686 Conventional Wisdom:     Capex 658 733 733 Capex + Opex discounted at:       5% 551 608 649 6% 507 560 597 7% 468 517 550 8% 433 479 509 Note: The rate used by Sofregaz/BGE is 7 per cent.               As can be seen, UK1 is the least cost option, followed by UK1 S-N, and UK2. Discounting, and the choice of discount rate within the range considered here, make no difference to this ordering, but affect the size of the gap.       This is an interesting case, because for the central demand case and a discount rate of 8 per cent, while the Scotland-Dublin route is cheaper in Capex terms, it is more expensive in NPV terms. It follows, that at some discount rate, the Scotland-Dublin route is cheaper.          This rate cannot be determined with accuracy, because the report only gives 5-yearly capex and Opex figures, and these only for the central demand case. BGE would not provide us with yearly figures, citing confidentiality reasons. Without yearly figures it is impossible to carry out a proper sensitivity analysis. However, we did carry out an exercise based on the 5-yearly costings in the report, for the central demand scenario.    Subjecting this imputed expenditure schedule to a range of discount rates indicates that the BG/KeySpan and Scotland-Ireland options have an equal NPV at a discount rate just below 6 per cent. Any rate lower than this will favour the latter route. A different expenditure schedule, for example where expenditure happened in the middle of each five-year period, or was spread evenly throughout each period, would further favour the Scotland-Ireland route.           Table 9.2: Sensitivity Analysis to Discount Rates, BG/KeySpan Report   BG/KeySpan Option Sc-Dublin Option Difference   US$ US$ US$ Central Demand Case 586 439 147 Capex       Capex + Opex discounted at:     5% 389 380 10 6% 350 355 - 5 7% 317 333 - 17 8% 290 317 - 26 High Demand Case       Capex 754 591 163 Capex + Opex discounted at:     5% Insufficient info. Insufficient info. Insufficient info. 6% Insufficient info. Insufficient info. Insufficient info. 7% Insufficient info. Insufficient info. Insufficient info. 8% 457 393 64 Low Demand Case       Capex 472 419 53 Capex + Opex discounted at:     5% Insufficient info. Insufficient info. Insufficient info. 6% Insufficient info. Insufficient info. Insufficient info. 7% Insufficient info. Insufficient info. Insufficient info. 8% 254 294 - 40 Notes: 1. The BG/KeySpan report uses a discount rate of 8 per cent. 2. The BG/KeySpan report is expressed in stg£; the exchange rate used is US.65/stg£.       This reflects two features in the BG/Keyspan report – the differences in NPVs are modest, so small changes in the make-up of the figures can have an impact. The Scotland-Ireland route is cheaper in Capex terms under all demand scenarios, despite being more expensive in NPV terms in all but the high demand case. The lower the discount rate used, the more closely the NPV figures will reflect the Capex figures. As a result, it is not surprising that as the discount rate was reduced the option with the cheapest Capex was favoured.       In the Shannon-McManus report, BG and Sofregaz revisit their calculations, using an agreed databook of assumptions. Both come up with the same ordering of capex for three infrastructure options, equivalent to UK1, UK1 S-N and UK2 in the Gas 2025 report. When a discount rate of 7 per cent is applied, the NPVs are in the same order.  Recalculating the NPVs using discount rates ranging from 5 to 8 per cent does not change the order of the projects.       Table 9.3: Sensitivity Analysis to Discount Rates, Shannon-McManus Report   BG Calculations Sofregaz Calculations   Option 1 Option 2 Option 3 Option 1a Option 2 Option 3   1998 US$ 1998 US$ 1998 US$ 1998 US$ 1998 US$ 1998 US$ Capex 787 625 571 780 681 623 Capex + Opex discounted at: 5% 652 539 491 688 589 531 6% 603 502 458 637 547 492 7% 560 473 428 590 509 459 8% 521 439 402 551 475 427 Note: 1. The discount rate used in the report is 7 per cent.           Within the range considered above, only the BG/KeySpan ordering was sensitive to the discount rate used. Lack of detail in this report prevents a proper analysis. However, for their central demand case, and using the timing assumptions we have made, it appears that a discount rate above 5.7 per cent favours the North-South pipeline option, whereas below that rate twinning the Scotland-Ireland interconnector is favoured. Altering the timing assumptions would tend to favour the Scotland-Ireland interconnector.     In all other cases, the ordering of the NPV calculations were robust with respect to the choice of discount rates.      We would note that the gas pipeline industry and the powergen industry are capital intensive, and both will be regulated under Irish legislation. The determination of the allowable real rates of return for these industries will no doubt be an early priority for the regulatory system, and such a determination would help to clarify the uncertainties deriving from this source. Finally, there is a potential complication, which we merely note here, in that import interconnectors would fall under regulatory review in both Ireland and the UK.  () tackled the importance of the discount rate. If saving a life is worth spending million today, how much should we spend to save a life in twenty years? The answer, according to the federal Office of Management and Budget (OMB), is 0,000. The OMB uses a ten percent annual “discount rate” to convert future regulatory costs and benefits into their “present value.”  Because government regulation of carcinogens cannot be expected to affect the cancer rate for twenty or thirty years. OMB’s choice of discount rates has dramatic implications for regulatory policy. Its choice of discount rates has even greater impact on long-term global environmental issues such as ozone depletion and the greenhouse effect. The basic principle underlying discounting is simple: A dollar today is worth more than a dollar at some time in the future. This is the same “time value” principle that underlies the concept of interest. Suppose lender L loans borrower B 0 in year one, to be repaid in year two. L will forego current use of the 0 only if B pays her a premium for that forgone use when B repays the loan in year two. That premium is interest. If B and L agree that B will pay 0 in year two for the use of L’s 0 in year one, the simple interest rate is ten percent. If we asked L how much 0 in year two is worth to her today, she would presumably answer “0.” L “discounts” the money she will receive in the future by ten percent. This reflects the time value of money principle: X dollars one year from now is worth less than X dollars today. The term “present value” describes the current value to the recipient of a benefit that will be conferred in the future. In the above example, the present value to L of 0 in year 2 is 0. The ten percent rate L uses to discount the money she will receive in year two is called the “discount rate.” Note that this analysis also applies to costs to be incurred in the future. Everything else being equal, L would be indifferent between paying a cost (for example, a tax) of 0 in year two or 0 today, because L discounts future costs at a simple rate of ten percent per year. The arithmetic becomes more complicated when more than one period is involved. As money or monetary costs are conferred further in the future, compound interest decreases their present value geometrically. The formula for determining the present value of a sum to be conferred in some future year is: where Bt represents the amount that the beneficiary will receive in future year t, r stands for the discount rate, and t represents the number of years from the present when the beneficiary receives the money. By substituting the monetary value of the benefit for Bt, one can use the above formula to determine the present value of any future benefit that can be expressed in monetary terms. Analysts similarly can discount future costs expressed in monetary terms to present value. The costs and benefits of a given government policy often extend over more than one year. A policy generally distributes those costs and benefits unequally over time, so simple comparison of gross costs and gross benefits would ignore the time value of money. Consequently, cost-benefit analysts generally discount all costs and benefits to present value before comparing them. The difference between the present value of all benefits and the present value of all costs of a project or regulation is often called its “Net Present Value” (NPV). A positive NPV (benefits exceed costs) suggests that the government should adopt a regulation and a negative NPV suggests that it should not. Thus, to determine the NPV, the policymaker must derive a social discount rate that reflects the time value of the stream of costs and benefits for the entire population affected by the regulation. Determination of the appropriate discount rate presents a tremendous practical problem that federal agencies have not resolved uniformly, despite prodding from OMB. Though justification of the discount rate and estimates of its numerical value vary substantially, economists generally agree that cost-benefit analysis requires discounting future benefits and costs to present value. Given this consensus regarding the need for discounting, an understanding of the impact of the choice of discount rate on the results of cost-benefit analysis becomes important.                 Discounting can dramatically affect the value of a proposed regulation’s costs or benefits depending on the size of the discount rate and the length of time before society realizes the costs or benefits. Because society often incurs the costs of environmental regulation long before the benefits compound discounting generally has a greater impact in the calculation of the present value of benefits than of costs.        (2001) did a paper which focuses on the construction of, and relationship between, discount rates and capitalization rates and then illustrates their proper application and construction in the context of a recent valuation assignment in a property condemnation.         Valuation of assets is inherently subjective. In addition, the particular approach used to determine value, whether it is the income, cost or market data approach, or combinations thereof, is subject to professional judgment. In this particular case, where we have unchallenged and irrefutable evidence on the magnitude of the lease income loss due to the “take,” the income approach must be superior to the market data approach if for no other reason than the arbitrariness inherent in selecting comparable properties. Competent appraisers can and do have differences of opinion concerning the estimation of cash flows (both amount and length) for income producing property when leases are short term in nature. In addition, differences of opinion do exist concerning appropriate discount rates utilized in valuing cash flows. However, when faced with factual data concerning the magnitude and duration of the lease income loss due to a property condemnation, the only real issue to be debated concerns the discount rate. We have provided evidence here, based on our opinion of the actual character of the income stream, the characteristics of the subject property and the holding period profile of the property owner, that suggests that the “net” discount rate utilized by the APPRAISER was inordinately high.       studied the impact of the discount rate on US treasury bills. For some time market analysts have been aware that market interest rates respond to announcements of changes in the Federal Reserve’s discount rate that are made for reasons other than simply to keep the discount rate “in line” with market interest rates. What is far less clear is the reason for the response.  Thornton investigated the hypothesis that T-bill rates respond to discount rate changes because the market interprets a nontechnical change in the discount rate as a signal of a change in the Federal Reserve’s target for the federal funds rate. The evidence indicates that the federal funds and three-, six-, and twelve-month T-bill rates respond immediately and simultaneously to announcements of nontechnical discount rate changes. Consequently, there is no way to differentiate this hypothesis from several other hypotheses of why T-bill rates respond to announcements of discount rate changes.     The hypothesis was further investigated by Thornton when he tested whether there was a lag in the response of the T-bill rate to changes in the discount rate during periods when the Fed was using a fuzzy federal funds rate target. The results, that there were no delayed responses, reject Cook and Hahn’s hypothesis that the markets respond to discount rate changes because they signal a change in the Fed’s target for the federal funds rate.       The evidence also rejects Cook and Hahn’s suggestion that their evidence supports the standard view that the Fed controls the structure of interest rates through its influence over the federal funds rate. The degree to which the Fed can influence the structure of interest rates through its ability to influence the federal funds rate cannot be determined by investigating the daily reaction of market interest rates to changes in the discount rate because, at this frequency, the responses are simultaneous.         The results are consistent with the efficient-markets hypothesis in that the information   Credit:ivythesis.typepad.com

Discount Rates

REVIEW OF LITERATURE One of the complications in comparing the various reports is that they use different ...

Investment Appraisal Techniques

Background on Bahrain Duty Free Issues about the investment landscape of BDF are numerous.  To this need, there are a number of investment appraisal techniques that can be used to increase the profitability and generation of cash flows from their investment.  Assets must be allocated efficiently while liabilities and equity must be coordinated to come-up with the right mixture of financing.  This cannot be done without relevant appraisal techniques.  The role of Board of Directors in BDF investment proposals is superior to any of individual managers and employees of the corporation.  As a result, their very decision will be the carry-over to the future engagement of the firm.  However, there are several projects that are studied.  And one cannot be measured on profitability criteria without imploring investment appraisal techniques.                         Different techniques have their strengths and weaknesses.  Some are able to forecast the future performance of the firm while others are able to set comparable figures against other projects.  With value judgment, the BOD must incorporate quantitative data into their decision-making.  Financial information is far more important to settle investment decisions rather than simply hunch, experience or even academic learning.  The former presents an unbiased glance on where the firm will go after making a decision and what impacts are to be expected if the project fails or succeeds.  Investment appraisal techniques are good source of information because it incorporates economics, financial management, accounting methods and even subjective view on proposals.             Different Investment Appraisal Techniques Time value of money or TVM is an investment principle in which investors prefers to receive the money as early as possible and that the value attached to present money holdings is greater than future or expected money holdings even they have the same nominal values (Mcmenamin 1999; Investopedia 2006).  This is because market effects such as inflation, change in interest rates and regulations can increase or decrease the future value of assets, thus, making them more exposed to risks (Mcmenamin 1999).  Deferral in consumption has also some forms of sacrifices which happens when an investor dedicatees present income and wealth to investments.  In effect, the investor would demand interest to compensate such investment due to these reasons.  For example, a loan requires interest payments, collateral and other forms of guarantees which indicate that TVM principle holds in the transaction.  Further, equity investments in the form of stocks also provide dividends in both money and other assets as well as capital gains in the price of the stock.  These are mere resolution of investors to compensate their sacrifices through the guide of TVM principle.    TVM is the foundation of discounting future cash flows although applied in most big business that plans to undergo huge financing for a project or several projects.  The table below shows an investment project with cash flows that can contribute to firm’s value up to three years.  As observed, forecasted sales needed to be converted in to their present values to be able to adhere to TVM principle.  There is a standard table of future/ present values in which a particular discounts rate and specific year can be cross referenced to determine the discount rate for the particular year (e.g. .901).    As observed, as the value of future sales increase and/ or their timing go further from the present, the discount rate tends to be lower which means future inflows are deducted with relatively more discounts.  Thus, discounting is a practical application on how investors assess associated risks for a particular return.  That is, as returns tend to go further into the future, their value depreciates because moving further to the future suggests more ambiguity than the current time.  And so, the higher the returns of these futuristic returns, the higher will be the deductions of the discount.  This situation is consistent to the positive relationship of risk and return.           Project 1: DIY Renovations  Year  Sales  Initial Outlay  Discount rate (at 11%)  PV         -                    -      75,000.00           1.000     75,000.00      1.00       10,000.00               -   .901       9,010.00      2.00       30,000.00               -   .812     24,360.00      3.00     100,000.00               -   .731     73,100.00          NPV =     31,470.00     The terminal year cash flow is relevant in financial analysis particularly in investment and budgeting because of its ability to estimate annual cash flows that a firm can have at specific number of years in the future (Mcmenamin 1999).  The method allows the inclusion of the value of future cash flows to mitigate valuing problems.  Computation is less complex since the use of constant rate for a going concern firm is suggested.  When computed in present value terms, it can readily be added to the present value of free cash flows to determine the value of the business.  On the other hand, when the firm is planning for dissolution, the approach can easily show the bearing to defer or expedite dissolution stages as getting the returns for a certain number of years in the future is possible.    Thus, the approach is flexible and a tool for forecasting.  However, this strength have back clash making it necessary to consider some important factors.  The discount rate and growth rate undergo perpetuity which means that there value remain constant from year 1 to year N (the final year).  In the contrary, market conditions as well as internal performance of the firm are always vague especially on hi-tech and internet-based industries.  In effect, environmental scanning and internal audit should be used to be able to have a more accurate representation of future PESTEL, industry, competitor and corporate strategy implications to discount and growth rate.   The weighted average cost of capital (WACC) determines the cost of main individual sources of capital which can be in the form of debt capital, equity capital and retained earnings (Mcmenamin 1999 p. 436).  Thus, discount rate should also represent not only WACC but also other costs occurring in the phase of investing such money in stock or money markets.  With this, the firm can have NPVs which can be readily used to evaluate investment decision without the anxiety of missing out some “costs” of funding.  WACC is also often referred as discount rate expected by investors.  Thus, WACC harmonize the stance of investors and ease of attaining an acceptable level of discount rate for a particular security.    On the contrary, WACC cannot by itself classify whether an individual source of capital is being used to finance a new investment or not (Mcmenamin 1999 p. 437).  There is a need to install monitoring system to account the financing performance of each project which can result to additional monitoring cost otherwise WACC would be inconsistent across time horizons.  Also, as WACC offers a scientific basis for a firm to have minimum financing rate and available discount rate (which is used in NPV calculation), it is a common approach for firms to have its own preferred cost of capital (p. 440).  Due to this, WACC does not reflect the practical problems and evaluation criteria that most managerial decision-making uses.            Payback period method is advantageous when a firm tightly adheres to the time value of money concept, that is, the money to be received in the future has higher risks and lower value than the same amount of money on-hand today.  This becomes crucial when a firm is bound to be acquired in which its objective is not to maximize profits rather minimize the time required to recoup investments (say) for a period of two years in which it is also bound to be formally acquired.  Alternatively, its computation (see appendix 2) ignores time value of money due to the absence of discounting cash inflows to find their present values (Mcmenamin 1999 p. 359) unlike NPV or IRR.  Nonetheless, it is used frequently because it is the most popular and easily understood investment appraisal techniques (p. 357).  Easy it is because it is internally-driven from the view and subjectivity of the firm preventing technical calculations and market research in favor of the “fastest way to recover investment” rule.  .        The key in determining NPV is the discount rate.  Used in capital budgeting, NPV is the most dynamic and widely used method in evaluating long-term projects.  Its major criteria state that “projects that have positive NPVs are worthwhile while those with negative are not”.  But NPVs are not perfect.  Although analytical tools like net present value (NPV) are helpful, the greatest obstacle to minimize the need for working/ physical capital to be able to enhance free cash flows is not guaranteed.  There is some work to do even after computing for NPVs.  By locating inefficiencies and value-adding activities, deferral or elimination of projects that can be a deceptive action (due to savings) can be re-analyzed to locate possible opportunities that are kept untapped (Copeland & Ostrowski, 1993).  NPVs are simply the summation of discounted annual cash flows of a project.  It is derived after the net income of the project is illustrated (e.g. expenses like marketing costs are deducted or non-cash transactions like depreciation expense are brought back to the net income).   Capital budgeting directly affects the long-term investment decisions of the firm (see appendix 1) to remain consistent to its goals (Dayananda et al 2002 p. 2).  It embodies the intention of the firm and sustains the relationship its culture affords to offer to its stakeholders.  Thus, when capital budgeting has erred to protect its intentions and fails to derive its culture planted to (say) debtors, it may not receive the previous support from their financing.  This can be in the case when the firm fails to accurately forecast its cash inflows that tell the profitability of an engagement.  As it is strategic in nature, the capital budgets should be flawless when prepared and translated to a project.    As an example, Airbus and Boeing had committed substantial resources to build A380 and Sonic Cruiser respectively (Hitt et al 2003 p. 160).  If their capital budgeting has flaws, it is difficult to reverse the strategy due to the substantial costs of initial outlay or some outstanding contracts with suppliers as well as customer expectations for improved technology.  And when Airbus or Boeing continued overturn their budget loopholes, they would suffer from stakeholder doubts that can result to reduce share attractiveness, broken supplier relationship, cancelled orders and lost opportunity in the airline industry.  These case studies only reflect that the ability to know quantitative side of investment will create competitive advantage to companies.   Bibliography Mcmenamin, J 1999, Financial Management: An Introduction, Routledge, London.   Stickney, C & Weil, R 1997, Financial Accounting: An Introduction to Concepts, Methods and Uses, 8th Edition, Harcourt Brace and Company, Fl.     Credit:ivythesis.typepad.com

Investment Appraisal Techniques

Background on Bahrain Duty Free Issues about the investment landscape of BDF are numerous. To this need, there are a number of investmen...