Corporate Finance
Corporate finance focuses on how to manage a firm’s assets and liabilities so as to create value for investors. We generally believe that firms that are most efficient in creating value will survive, and those that are not will become extinct during takeover or bankruptcy, so it is up to managers to create value for their organizations.
A major field in corporate finance is capital budgeting, which examines how firms should make decisions to invest capital. All investment decisions have a common feature: In exchange for a certain cost, the investment is expected to generate a stream of uncertain earnings. The dominant tool used in capital budgeting decisions is the net present value rule, or the NPV rule.
The concept of present value recognizes that a dollar tomorrow is worth less than a dollar today. There are three reasons for this.
First, there is a time value of money. For example, if today I loaned you $100 for a year, I would effectively give up the use of that $100 for a year. So I would charge you interest to compensate me for deferring my use of that $100 for a year. This is referred to as the time value of money. It is generally accepted that the time value of money is worth about 3 percent.
Second, a dollar tomorrow is worth less than a dollar today because most of the time the overall price level is expected to be higher tomorrow than it is today. So the purchasing power of a dollar tomorrow is less than the purchasing power of a dollar today if the overall price level increases. When inflation is expected, the rate at which future dollars are discounted includes a premium for inflation expectations. In countries with hyperinflation, such as Brazil 20 years ago, interest rates are enormous because of this inflation expectation. In rare cases where the price level is expected to decline – that I, in deflation, the “inflation” premium in the discount rate is actually negative.
Third, a dollar tomorrow is worth less than a dollar today because a dollar tomorrow is uncertain, while a dollar today is certain. If I told you that a firm is expected to generate $100 million in cash flow in five years, but that there is some risk associated with this, you would prefer $100 million today over a promise to receive the firm’s expected cash flows of $100 million in five years. This is just another way of saying, “A bird in the hand is worth more than a bird in the bush.” Consequently, the more uncertain a future dollar is, the higher the rate at which we discount it. This is why the discount rate used to value high risk firms and projects is so high. For example, venture capital firms typically apply discount rates of at least 40 percent to the future cash flows of startup companies, largely to compensate them for the high risk associated with these ventures.
So there are three reasons for discounting expected future dollars: the time value of money, inflation expectations, and risk. A major part of any capital budgeting project is selecting an appropriate discount rate, that is, a rate at which to discount the expected future dollars from a project. Discount rates vary widely across projects and firms. For example, a low risk project in the food industry might have a discount rate of less than 10 percent, while a high-risk project in the biotech industry might have a discount rate of over 20 percent.
To compute the present value of a project, one projects the cash flows that are most likely, and then discounts them by a factor related to the discount rate. Obviously, the quality of this calculation depends on the quality of the assumptions made about expected cash flows and discount rates. Anyone working with the present value model quickly appreciates how sensitive value is to assumptions about future cash flows and discount rates. That’s why we should be very skeptical of any one particular present value calculation. A golden rule in doing this type of analysis is to conduct lots of sensitivity analyses.
After calculating the project’s present value, its net present value is calculated. The net present value is simply the present value minus the cost of the project. Under the NPV rule, if the net present value is positive, the project should be accepted. If the NPV is negative, the project should be rejected. Although there are many technical complications associated with the use of the NPV rule, this in essence is how it works. It remains the dominant capital budgeting rule.
The major limitation of the NPV rule is that it ignores the value of managerial flexibility. In projecting cash flows, the NPV approach does not allow managers to ramp up production if cash flows turn out to be better than expected, or to cut back production if cash flows turn out to be worse than expected. In recent years, financial economists have developed a new tool, referred to as “real options,” which is designed to value the value of these so-called flexibility options. The real options approach attempts to apply variants of option pricing models, such as the Black-Scholes model, to capital budgeting decisions. While it is theoretically appealing, as a practical matter, the real options approach is very difficult to apply in most settings, since some of the key variables in the model are usually unobservable. In my opinion, despite its shortcomings, the NPV model, with sensitivity analysis, is still the most reliable approach to capital budgeting.
Tags: Corporate finance, Finance