- Length: 15 pages
- Subject: Economics
- Type: Term Paper
- Paper: #3964936

On the difficulties side, first of all, the opportunity cost of capital is the hardest assumption to be drawn. Opportunity cost of capital is the expected rated of return which could be achieved from investing in a business endeavor with the same risk. It can be looked upon as the 'depreciation rate' of the future earnings for the investor. The opportunity cost of capital thus reflects the inflation rate and the risk of the project. For example, one can invest $1,000 today in project a and generate $1,100 in a year. This will give the expected rate of return of 10%. Also, another business idea with the same risk level exists, which will yield $1,200. As the risk for the project B. is the same, we can find the present value of this income gain, using 10% as the opportunity return that could be achieved from investing in project a. Discounting the future $1,200 at 10% discount rate, the present value of this cash flow is $1,090, which means that with the same risk for both opportunities, opportunity B. is worth more today.

This simple example exploits calculation of Net Present Value of the business opportunity in order to see how much it is worth today. Net Present Value refers to the present value of all the earnings generating from accepting the project deducted for the initial outlays necessary for starting this project. This investment assessment tool estimates by how much in today's dollars the wealth of investor will increase if he pursues this initiative. As the perceptions of benefits from the projects are different for different investors, as well as valuation needs vary, other techniques are used to estimate whether the deal is worthy. The Internal Rate of Return rule states that the affair is worthy if the rate of return that it provides is higher than the opportunity cost of capital, or the return that could have been achieved from investing in the project with the same risk. The Internal Rate of Return is simply the discount rate at which the Net Present Value of the activity equals zero. The Payback Period Rule uses estimation of the time period which it will take for the initial spending on the investment activity to recover. Different investors require different payback periods, and if the estimated payback period meets this requirement (is shorter), then the affair is worthy. Having stressed the importance of considering the time value of money, it is clear that the Payback Period Rule is faulty as it does not account for this fundamental, and also this rule does not add to the overall project value the benefits generated by the project after the cutoff date. Managers as well employ the Book Rate of Return or Average Accounting Return (accounting income divided by book value) to set the benchmark for estimating the worthiness of the opportunity. Remembering the fact that accountants are rewarded to reflect the accounting profits in ways favorable for the taxation of the company, and that in the majority of cases the market value of a company or a project differs from the accounting numbers, this method cannot lead to proper conclusions. The Profitability Index Tool, can favor projects with high rates of return but low value added to the company value, as it measures the ratio of present value to initial investment. Recapitulating, NPV rule is the superior in making investment pursuing decisions and leads to most accurate calculations, thus I chose considering it in more details as the core for my work.

The NPV canon declares that the financial managers increase the wealth of the stockholders and the value of the company by singling out and accepting the projects that are worth more today than they cost, therefore, they have positive Net Present Values. The equation for estimating the activity's NPV is as follows:

NPV = -C0 + C1 / (1 + r) + C2 / (1 + r) 2 +...+ Cn / (1 + r) n,

Where -C0 is the initial outlay necessary for taking on the project, and thus it is negative, and C1, C2, Cn are the earnings from the project and r is the discount rate to bring the future incomes to one date and it is the opportunity cost of capital.

The opportunity cost of capital will not only depend on the risk of the project, but all will be impacted by the financial structure of the company and the financing of the project. Finding the correct discount rate is the crucial task for the manager. The work by Colin Drury and Mike Tayles reveals that the most frequently used investment assessment technique is unadjusted payback period rule which is exploited by 63% of managers, followed by the IRR method used by 57% of managers, and then 43% use NPV technique. Another empirical finding by the authors is that bigger companies that can afford to higher managers with better education employ the NPV and IRR rules more often to estimate the attractiveness of the business ideas. The research work by Graham and Campbell suggest that 74,9% of the surveyed CFOs always or almost always work with Net Present Value method as the capital budgeting decision benchmark, while 75,7%n of the CFOs always or almost always work with the Internal Rate of Return tool.

Even though these techniques are most currently used, C. Drury and M. Tayles proved that several mistakes are commonly made when employing these methods. These mistakes lead to underinvestment, or lower level of accepting investment proposals that rationality based on careful financial analysis will advise. The first common mistake is the incorrect treatment of inflation. Often, managers do not fully understand the time value of money conception and the nominal and real interest rates. Thus, they discounted the future cash flows in nominal prices by real discount rates, or the cash flows in real terms (current prices) by nominal interest rates. The second will lead to underestimating the net present value of the project and means that many good business opportunities were missed because of this misperception. Another mistake was traced when managers used cash flows in real terms to calculate the internal rat of return of the project, but then compared this rate of return with the nominal discount rate on the project with the same risk. As the authors pointed out, if the rate of inflation is 3% annually, discounting the real cash flows at nominal discount rate but not adjusting them for this level of inflation, will underestimate the NPV y 14% if the project lives 5 years. This can be a great deal of money for a company lost due to such managerial imperfections.

Furthermore, the companies tend to be more risk-averse, thus using higher discount rates to find the value that the activity will add to their company, than the real cost of capital for this company is. A good benchmark estimated by the authors, that can be used by financial managers, is the fact that a project with average risk, all equity-financed, which lives from five to fifteen years, should be given the discount rate of 11% in real terms and 15% in nominal terms. For the project with the same life and financing, but high risk, the discount rates should be 20% nominal and 23% real terms. If the company is partially debt financed and the cost of the debt (the percent paid on the loan) is 9% (assuming 2% premium for risk of default over return on government bonds), taking corporation tax of 35%, the project with the same risk as the whole stock market risk, should be assigned the nominal discount rate of 13% and 9-10% real discount rate. For the same debt-holding company, but a project with high risk, the discount rates must be set at a level of 19% in nominal terms and 15-16% in real terms.

The empirical evidence shows that more than half of the firms use larger numbers as discount rates which leads to lower NPVs of the projects and thus less projects are desirable as investment opportunities. The explanation to this phenomenon can be the fact that sometimes financial middle managers tend to overestimate the earnings generated by the project due to their irrational positive expectations. By setting higher discount rates, top management tries to eliminate this effect. Higher rates of return are also required from separate projects which do not diversify the activities of the company (cannot thus reduce the risk of the portfolio of company activities).

Liquidity constraints experienced by some companies lead to acceptance of short-lived projects with short payback periods. Employing this technique means that…