Investment Decisions. A Critical Evaluation of the impact on shareholder wealth of the techniques used for the appraisal of capital budgeting projects.
Investment appraisal is a strategic decision-making process for determining how a firm’s management should allocate limited capital resources to long-term investment opportunities. Investment decisions will not be made in isolation from other business decisions and plans; the question of strategic fit arises. Accordingly, investment decisions should be made in the context of the firm’s strategic business plan, with the goal of maximizing the long-term market value of the firm and the realization of its strategic objectives. The investment decision-making process involves identifying, evaluating and implementing long-term investment opportunities which will enhance shareholder wealth and achieve the firm’s objective (Mcmenamin 1999).
The costs and benefits of these investment opportunities will be spread out over time. Because the outcome of long-term investment decisions, more so than any other type of business decision, will directly affect the firm’s future and its value, it is vitally important that investment proposals are properly evaluated before they are implemented. The essence of investment is to forego present consumption of resources in order to increase the total amount of resources which can be consumed in the future. The objective of an investment decision is to acquire an asset for less than its value, this way corporate or personal wealth can be increased. Acquiring an asset for at least its value will maintain wealth or value. It would not make good financial sense to acquire an asset for more than its value as wealth would be eroded (Mcmenamin 1999).
From the corporate firm’s point of view the financial manager’s objective should be to invest in projects which add to corporate and shareholder value. The problem is that at the outset it is often difficult to determine which assets or projects will be wealth enhancing and which will be wealth reducing. All the more reason people should employ good appraisal techniques and procedures to help us make the right choice. For a wealth-maximizing business enterprise, the most common form of investment is in real corporate assets. Such assets are clearly very important since, for most firms, they represent the largest financial investment and are the key earning assets of the firm. In business, investment decisions are made for many reasons, but although the motives may differ, the techniques used to evaluate them are essentially the same (Mcmenamin 1999).
The fundamental benefits of investment decisions are derived in its ability to present numerical evidence as a basis of decision-making. However, even though there are many types of computing for the appraisal of capital budgeting projects, the firm should consider the method that best define its business and factors affecting the wealth of the shareholder. There are numerous types of computing for the appraisal of capital budgeting projects and these are payback, net present value (NPV), internal rate of return (IRR) and accounting rate of return (ARR).
Basically, 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 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. .
On the other hand, 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).
Apparently, the calculated IRR shown should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in. With this, we may say that in cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders’ wealth) and should thus be accepted over the second project (assuming no capital constraints).
IRR presumes reinvestment of optimistic cash flows during the project at the same calculated IRR. When optimistic cash flows cannot be put into the project, IRR overstates returns. IRR is most excellent for projects with singular optimistic cash flows at the end of the project stage. If the computed IRR is larger than the exact reinvestment rate for provisional cash flows, the appraisal will overrate — at times very extensively — the annual equal return from the task.
Then again, accounting rate of return (ARR) is the rate used by an organization as a standard expected return on their investment calculation. Basically, ARR gives a quick estimate of a project’s worth over its useful life. ARR is derived by finding profits before taxes and interest and its purpose is for comparison. The major drawbacks of ARR are that it uses profit rather than cashflows, and it does not account for the time value of money.
Financing Decisions
Impact of Debt Introduction to Capital Structure
Using the financial reports, the level of a firm’s financial risk is assessable which means that the firm can identify if financial resources are able to pay planned or on-going financial commitments or not (Mcmenamin 1999). In this way, the firm can make decisions and implement strategies according to its financing ability. This upper hand is worthy not only because it places the firm in a safer stance but more importantly it is able to control one side of the general risk confronting a business (financial side) which relaxes problems emerging from the uncontrollable business/ environmental risks.
With this, the survival of the firm is protected by capital structure (CS) as internal consequences of a firm’s strategy are detected. Questions such as “Do we have enough money for the project?”, “Is there a need to borrow or issue shares?” and “What is the gearing ratio to be adopted to maximize the potential of the project?” This facility has also its implications on corporate ability to forecast, exploit and mitigate environmental changes and even apply influence over its gradual evolution. This can achieve merit by using the resource-based model of above average returns wherein core competencies are matched against the changing environment (Hitt, Hoskisson & Ireland 2003 p. 22).
Using CS as the basis for project planning and implementation, the firm can enjoy the computed future earnings without interference from pending obligations to creditors or shareholders. This is important for project cash flows to be obtained all throughout its life span because creditors can sue a company when debt contract or shareholders’ expectation are not met. As an example, in the early years of US operations of News Corporation (the owner of Twentieth Century Fox), its CEO and financial officers faced difficulty to calm its creditors and defer lawsuit that can substantially disrupt its corporate life in the US (Hill, Jones & Galvin 2004 C101).
The company’s debt came from its huge acquisition costs on most American-owned media companies where some are unsuccessful to meet their expected earnings. This case shows how lack of financial planning can provide a big headache for (expanding) firms. However, through CS, this highly-owned family company may have give-up some of its control in favor of equity financing. Thus, it may have prevented the last minute plead and risky confrontations to its creditors.
In general, debt financing is cheaper than equity financing because it is a tax allowable expense (Mcmenamin 1999 p. 16). However, it is also more committed (thus, risky) because repaying includes the principal and interest and it is mandatory even if the company results to a loss. In addition, too much debt can discourage shareholder and their funds from entering the firm’s coffers because ordinary shareholder is only awarded with the profit residual after the creditors are paid (p. 16). In the contrary, focus on equity financing can be unacceptable (in the case of News Corporation) or not strategic because the firm can loose its identity as it also looses control to major corporate decisions. When company’s shares are concentrated to one entity on the market, it may also face hostile takeover. This literally is one way to say that the original company has already perished.
The fundamental benefits of CS are derived in its ability to present numerical evidence as a basis of decision-making. However, even though there are many types of computing for the cost of capital, the firm should consider the method that best define its business and factors affecting its operations. One is the capital asset pricing model which is criticized by the weighted average cost of capital. Risk from a venture can also be attached to a single-asset or a portfolio of assets in which the method of getting the associated risk is different.
In addition, there are many ways for common stock valuation (e.g. freezing the complex content of preferred shares and the dynamic interest-bearing in debts). This various valuation techniques are related to the regularity of the firm to issue dividends. What if the company does not issue dividends for the current year? Well, it should use a more challenging platform for arriving at an accurate measure of pricing the stock. These overlapping techniques can create decision bottlenecks to the management which ultimately suggest the very important role of the underlying CS knowledge.
Impact on Business Organization
One would argue that a firm can certainly avoid debt/ equity dilemma by using its lone profits or retained earnings, thus, serving as a reduction for the need for CS consideration. However, in most cases, such idea does not hold. For example, Excite@Home is a daring internet service provider and an internet portal that decided to compete head-to-head with Yahoo! since its existence on 1999 (Hitt, Hoskisson & Ireland 2003). Two years later, it declared bankruptcy as customers are dissatisfied with the service.
The cause of its downfall is the lack of coherent and clear business plan on how to operate and implement strategies. Hence, an indication that shareholder and creditor emphasis is disregarded evidenced by lender’s demand for M payment on the verge of the corporate failure. This is a situation where CS is undermined in favor of exploiting the attractiveness of then booming internet/ hi-tech industry. In effect, the firm did not even get closer to Yahoo! or its profit target which ultimately explain how leveraging ratio should be used to protect the survival of the firm especially when profits is not flowing and financing entities are rigid or hostile.
With regards to specific types of debt and equity financing (as applied in US setting), CS consideration is also useful for the firm to achieve profitability. Seller financing is a debt facility in which the firm can readily use a certain resource like plant through acquisition under a seller contract (UAEP 2006). In effect, it can reduce the cost of construction and planning including shortening the time for cash inflows to pursue. However, the contract can be customized to seller needs in which periodic payments and litigation clauses can impede contingent actions from the buying firm that may arise due to resources problem or lack of synergy. The withdrawing aspect and ending the contract is tight which brings the acquirer in a risky position. To avoid this scenario, the acquirer can evaluate other debt financing options such as government programs, commercial banks, mezzanine financing and asset-based lenders.
On other hand, equity financing options can also provide more attractive profitability schemes than debt options. Initial public offering (IPO) is a financing option in which stocks are sold to investors giving them the right to receive dividends or payback after every profitable period (UAEP 2006). As observed, IPO does not limit the actions of the firm unlike seller financing but there are cautions in the stability of investor support as especially when they are just “playing” the stock market. Stocks are easily tradable and gains from the practice are fast. Similar to debt financing, equity option takes other strategies to prevent sudden loss of internal funding capability due to over-speculation. As a bottom-line, there are varieties of ways that the firm can manipulate its CS. It can choose between equity and / or debt financing and also choose between the combinations of different types and strategies involve in the broader genre.
Dividend Decisions
Factors to consider in Dividend Decisions
Theoretically, a corporation takes a look at its position and decides what they are going to need for operations, investments, expansions, new equipment, etc. Thus it is a kind of decision whether a company should issue a dividend or reinvest the cash into new or continuing projects. What’s left over is potentially available for dividend payments. Sometimes there is nothing left for dividends, but the company wants to reward shareholders anyway so they will issue stock dividends and splits. Occasionally, a company might need an influx of cash and will sell and issue common or preferred stock. Despite the names, preferred stock usually doesn’t have any voting capacity and doesn’t participate in common stock dividends. What makes it preferred are that they are usually guaranteed a dividend of x amount of dollars per year. They also have priority if the company liquidates. They are treated as creditors instead of owners.
A company’s responsibility is to increase shareholder value. Dividends can play an important roll in this regard. A company has to decide what to do with excess cash on its books but there are several options. They could reinvest that money into the company. This could be purchasing new equipment, hiring on new employees, expanding into new regions, etc. They could use the money to acquire another company. They could pay off debt. They could buyback their own shares. Last but not least they could pay out a dividend or increase existing dividends. It all comes down to what is the best way to return value to shareholders. Most new companies do not pay dividends because their best use for cash is to grow their business. On the other hand, many utility companies pay nice dividends due to the fact that it would be difficult to use that money to expand in that type of business. Therefore giving it back to the shareholders so that they may invest it however they may choose to makes more sense. When increasing a dividend a corporation may look at trying to set it at a sustainable level. Decreasing a dividend is usually considered a bad sign and shares tend to decrease in value. One last thing to consider is the tax environment. The lower the capital gains taxes are the more important a dividend becomes to the individual shareholders.
In business, dividend decisions are made for many reasons, but although the motives may differ, the techniques used to evaluate them are essentially the same. Growth of global financial markets was further accelerated by improvements in the fundamentals, particularly by more rapid economic growth in the emerging market and matured industrial economies. It was also assisted by economic and structural reforms in the emerging market and transition economies. The portfolio framework has described that when opportunities come, decisions should not be hastily made. Different considerations have to be analyzed.
Effect of Global Financial Crisis to Dividend Decisions
In the case of the current financial crisis, businesses should have careful assessment of their dividend decisions to avoid downfall. Shareholders and the company itself should have risks management. The cost of indemnity had restricted management’s alternatives in dealing with the hazards faced by the organisation. With regards to the current financial crisis, HSBC of Hong Kong as example identified that one of their foremost problems was that insurers rated them according to business in such a way that a fine run firm that had few losses were required to pay for the claims of poorly run firms within the same industry. With this, the role of risk management appeared. Management began to make out that abridged losses intended reduced cost of risk. If managers reduced losses they could hold them themselves without resorting to indemnity. However, it took some time for industries to settle in management.
The delicate inquisitiveness in management is the result of a number of instantaneous drifts. With the current economy, the trade and production has augmented financial and direct investment in unstable up-and-coming markets. With this we may say that risk management has also ensnared consideration as a result of the recurring and well-publicised breakdowns linked with its execution. Regardless of the amplified academic and specialised concentration paid to risk management, common instances still occur when classy investors or firms experience abrupt, unexpected, and devastating losses.
Lantos (2001) stated that corporations should have economic and legal responsibilities to the public at large due to the influence that they bestow upon the public. Novak (1996) enumerated seven economic responsibilities of firms, which are: satisfy customers with goods and services of real value; earn a fair return on the funds entrusted to the corporation by its investors; create new wealth, which helps lift the poor out of poverty as their wages rise; create (and the writer would add, maintain) new jobs; defeat envy through generating upward mobility and giving people the sense that their economic conditions can improve; promote innovation; and diversify the economic interests of citizens so as to prevent the tyranny of the majority. Legal responsibilities, on the other hand, should be to follow the law or the rules that govern firms.
Today, business like HSBC operates in a more complicated, and more regulated, environment. The strategic task, then, is to create a distinctive way ahead, using whatever core competencies and resources at its disposal, against the background and influence of the environment. Through these distinctive capabilities the organisation seeks sustainable competitive advantage.
With regards to financial issue, financial evaluation and implementation of dividend decisions can be a demanding exercise. With this, we may conclude that is difficult to foresee what the future holds (e.g. the actual future outcome may be entirely unexpected), i.e. to foresee what the scenarios are, and to assign probabilities to them; and this is true of the general forecasts never mind the implied financial market returns. However, this is an important procedure because it enables the organisation to make decisions that will be advantageous and beneficial to the shareholder of the company. In addition, organisations that are open to change and willing to counter the current financial crisis are generally more successful compare to companies that resist it. On the other hand, corporate leadership in accordance to their of power focuses on the techniques and expertise of efficient organisation, planning, direction, financial planning, credit assessment and control of the operations of a business is really vital. In this ever changing global business environment a company must be competitive and do everything it can to counter any threat from its competitors. Having a good shareholders gives the company some edge in facing competition in the business environment. In examining issues of companies’ initiatives to counter financial crisis, we may argue that it is integral to any business’ success. We may also wonder how the economy would affect businesses if there is action towards the current crisis we are facing.
References:
Case 10 “News Corporation: entering the US pay TV industry.” (C101) in the textbook: Hill, CWL, Jones, GR & Galvin, P 2004, Strategic management an integrated approach, John Wiley & Sons, Milton, Qld.
Hitt, M, Hoskisson, R & Ireland 2003, Strategic Management: Competitiveness and Globalization, 5th Edition, South Western; Thomson Learning, Singapore.
Lantos, GP 2001, The boundaries of strategic corporate social responsibility. Journal of Consumer Marketing, Vol .18, No. 7; pp. 595 – 630.
Mcmenamin, J 1999, Financial management: an introduction, Routledge, London.
Novak, M 1996, Business as a Calling: Work and the Examined Life, New York: The Free Press.
UAEP 2006; Fitzgerald Institute for Entrepreneurial Studies; viewed on 20 February 2009, <www.uakron.edu>
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