1. Introduction
a. China’s economy → undergone fundamental change:
i. From complete reliance on state-owned and collective enterprise → mixed economy where private enterprises play strong role
b. The discrepancy between the dynamism of the private sector and its limited use of intermediated financing → private sector may not be able to sustain its current rate of growth unless it can increase its access to financing
2. Financing Patterns
a. Survey of private firms in Beijing, Chengdu, Shunde, and Wenzhou → the private sector arm of the World Bank Group → 80% considered the lack of access to finance to be a serious constraint
i. More than 90% of their initial capital came from the principal owners, the start-up teams, and their families
b. The relative importance of different sources of financing among surveyed firms → depend on firms size
i. Smallest firms → external sources are mainly informal channels
ii. Larger Firms → internal sources become less important
c. Commercial banks → the second most important source of funds for the largest firms after retained earnings
d. Banks provide more support for larger and relatively successful private firms
e. Chinese firms rely more on internal sources of financing than do firms in transition and developed economies
3. Factors Affecting Access to Financing
a. Difficulty private Chinese firms face in obtaining financing is due partly to factors within the financial system and partly to the nature of Chinese private enterprise
i. Bank incentives
§ China has made significant progress in reducing government interference in bank lending
§ Bank still do not consider a bad loan to a state-owned enterprise to be as serious as bad loan to a private enterprise
§ Expectation → State-owned enterprise is helped by government → private enterprise does not
§ Banks will discriminate against private sector firms
§ Banks need added incentives to lend to private enterprises
§ Banks concentrate to avoiding losses and show little interest in sharing the rewards of projects that might be riskier but have higher expected return
§ There are controls on interest rates and transaction fee
§ Banks are taking advantage of this more flexible interest rate regime, but interest rates need to be liberalized further to encourage more lending to private firms
§ State banks charge effective interest rates that are comparable to those in the informal market
ii. Bank procedures
§ The procedures rely on collateral and personal relationship rather than on project appraisal
§ Collateral requirements, the cost of the application process, and relationship banking tend to make it harder for smaller firms to gain access to financing
iii. Collateral requirement
§ Inability to meet collateral requirements → the most frequent reason for not being able to obtain a bank loan
§ In practice → real estate assets appear to the most common kind of collateral accepted
iv. Information problems
§ Information problem → especially severe for state firms in China
§ The resulting of clear ownership management in structures imposes obvious constraint of borrowing
4. Policy Agenda for Financial Sector
a. Improving private firms’ access to external financing requires:
i. Strengthen banks’ incentives to lend to private enterprises
§ An important step → strengthen profit incentives through private ownership and competition
§ Private financial institutions are less likely to be swayed by political considerations and more likely to be profit oriented
§ The big state owned banks → likely to dominate the domestic financial landscape for the foreseeable future
§ Strengthening the profit incentives of these banks → have a major impact on improving private firm’s access to bank loans
ii. Further liberalize interest rates
§ Further liberalization of interest rates → needed to improve private firm’s access to bank loans
§ Access to financing is more important than the cost of funds
iii. Allow banks to charge transaction fees
§ Bank finds → lending to private companies → carries higher unit transaction cost
§ Transaction fees → encourage banks to consider:
o More proposals from small firms
o Develop a more service-oriented culture
o Promote greater transparency and better accounting standards
iv. Develop alternatives to bank lending (Leasing and Factoring)
§ Leasing and factoring are underdeveloped in China
§ In China, leasing faces obstacles:
o Rent arrears have long been a problem
o Accounting standards are unclear
o The regulatory environment does not provide equal treatment with other sources of capital investment financing
o Funding is a perpetual concern
§ Factoring → the sales of firm’s account receivables to a financial institution
§ Factoring → is a way to improve a company’s liquidity by substituting a cash balance for book debt
v. Create the framework for the development of private equity markets
§ Private equity markets in China are at an embryonic stage of development
§ Industrial investment funds → No regulations cover the organizational structures that can be used to establish private equity funds
§ Structure equity funds → can be developed is:
o Legal instruments are in place
o High ability of investors to use a variety of financial instruments to structure investment
§ Private enterprises → have lack of flexibility in their financial arrangements
vi. Improve access to public equity
§ The availability of exit mechanisms is a key condition for the development of private equity markets
§ Quota system on listing → private firms would have greater opportunity to acquire long-term funding through the equity market
§ Two ways to further improve private firm’s access to public equity:
o Broaden the range of exit mechanism available to investors
o Relax listing requirements
Monday, March 31, 2008
Sunday, March 30, 2008
Pecking Order or Trade-Off hypothesis? Evidence on the Capital Structure of Chinese Companies
I. Introduction
a. Determine capital structure of a firm
i. Trade-off theory
§ A value-maximizing firm will pursue an optimal capital structure by considering → the marginal cost and benefits of each additional unit of financing → then choosing the form of financing that equates these marginal cost and benefits
o Benefits of debts → include its tax advantage and the reduced agency costs of FCF
o Cost → include the increase of risk of financial distress and increased monitoring and contracting costs associated with higher debt levels
ii. Pecking order theory
§ Based on the argument → asymmetric information creates a hierarchy of cost in the use of external financing which is broadly common to all firm
b. Distinguish the two theory in practice is not easy
i. Fama and French can only identify two predictions on which either theory performed better than another
§ Trade-off theory → better in “large equity issues of low leverage firms”
§ Pecking order theory → better in “the negative impact of profitability on leverage”
c. It is difficult to distinguish between trade-off and pecking order models because many determining variables are relevant in both models
d. Several reasons why one might expect firms in developing and transition economies (DTEs) to have different financing objectives from their counterparts in the industrial countries
i. Many private firms in DTEs were originally state enterprises and carry different goals and corporate strategies from this heritage
ii. Capital markets are less developed in DTEs → narrower range of financial instruments → wider range of constraints on financing decision
iii. Accounting and auditing standard in DTEs tend to be relatively lax → implementing asymmetric information is more problematic
e. Singh and Hamid (1992) and Singh (1995) → concluded that firms in developing economies rely more heavily on equity than on debt to finance growth than do their counterparts in the industrial economies
f. None of the researchers explicitly set out to discriminate between trade-off and pecking order theories in a manner designed to discriminate between them
g. This paper studies the determinants of capital structure decisions in a sample of listed Chinese companies
i. China is of interest for several reasons → but particularly because it is in the almost unique position of being both a developing economy and a transition economy
II. Hypotheses
Three related aspects of corporate financing where trade-off and pecking order theories give different predictions:
a. Determinants of Leverage: profitability, size, and growth
i. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relationship between leverages and profitability
o Unprofitable firms facing a positive NPV investment opportunity will avoid external finance in general and leverage in particular
§ Pecking orders theory → there will be negative relationships between leverage and profitability
o Firms will use retentions first then debt and equity issues as a last resort
o Less profitable firms facing a positive NPV investment opportunity will be more willing to use external funds if cash flow are weak
ii. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relation between leverage and firm size
o There are economic scale of bankruptcy → agency cost will be lower for larger company
§ Pecking order theory → a negative relation between leverage and size
o Larger the firm → more complex the organization →higher the cost of information asymmetries → more difficult to raise external finance
b. Leverage and Dividends
i. Trade-off theory → negative relationship between dividends and leverage
§ Dividend are high (retention low) → because external financing low
ii. Pecking order theory → Positive relationship between dividends and leverage
§ Firms with higher past dividends will have less financial slack → higher leverage → because they require more external funds
c. Corporate investment and financing
i. Trade-off theory → Leverage should be negatively related to investment → because of funding limitations arising from high leverage
ii. Pecking order theory → larger firms are less transparent than smaller firms
III. Data and Methodology
a. Use base in China
i. China → in transition from a planned economy to a market economy → continues to be characterized by a fragmented capital market, fragile banking system, poorly specified property rights and institutional uncertainty
ii. Chinese firms → have a relatively short operating history → have not accumulated much reputation
iii. Most listed companies→ originally state-owned enterprises → privatization has been incomplete with the state often retaining a controlling share
iv. Banks → often process commercial loans and collect debts in a preferential way → the market is subject to irregular government intervention
v. A well-functioning and fully-enforced accounting and auditing system has developed only gradually in China
vi. Firms could partially disclose, distort, and even forge information for transaction or taxation purposes with low risk of being caught
b. Study attention and methodology
i. China top 50 companies for the period 2001-2003 → data were extracted from the published accounts of non-financial companies listed on the Shanghai and Shenzhen stock exchange
ii. The listing is based on total assets, income from main businesses, net profit and market value
iii. For holding companies → the consolidated data were used
iv. Two datasets:
§ For 2002 and 2001 → using 2002 annual report
§ For 2003 and 2002 → using 2003 annual report
v. Two measure of leverage
§ Wide measure → ratio of total liabilities to total assets
§ Standard ways → two comments:
o In measuring ROA → one should ideally use the ratio of operating income to operating assets rather than total assets
o Dividend → scaled by book equity rather than the market value
IV. Results
a. More than 50% of the cross sectional variation in leverage
b. Profitability → mostly has a negative and generally significant coefficient irrespective of whether it is lagged in the regression →provide quite robust support for pecking order theory
c. Assets growth → highly significant and has a positive sign contrary to the predictions of trade-off theory
d. Size → signed positive, a finding that is more consistent with trade-off theory
e. Dividend → positively signed as predicted by pecking order theory
f. Dividend and size → signed negative but not significant → consistent with pecking order theory
g. Profitability:
i. Negative but significant in 2002 → consistent with trade-off theory
ii. Positive but significant in 2003 → consistent with pecking order theory
h. There is some degree of stability in the parameters across time periods
a. Determine capital structure of a firm
i. Trade-off theory
§ A value-maximizing firm will pursue an optimal capital structure by considering → the marginal cost and benefits of each additional unit of financing → then choosing the form of financing that equates these marginal cost and benefits
o Benefits of debts → include its tax advantage and the reduced agency costs of FCF
o Cost → include the increase of risk of financial distress and increased monitoring and contracting costs associated with higher debt levels
ii. Pecking order theory
§ Based on the argument → asymmetric information creates a hierarchy of cost in the use of external financing which is broadly common to all firm
b. Distinguish the two theory in practice is not easy
i. Fama and French can only identify two predictions on which either theory performed better than another
§ Trade-off theory → better in “large equity issues of low leverage firms”
§ Pecking order theory → better in “the negative impact of profitability on leverage”
c. It is difficult to distinguish between trade-off and pecking order models because many determining variables are relevant in both models
d. Several reasons why one might expect firms in developing and transition economies (DTEs) to have different financing objectives from their counterparts in the industrial countries
i. Many private firms in DTEs were originally state enterprises and carry different goals and corporate strategies from this heritage
ii. Capital markets are less developed in DTEs → narrower range of financial instruments → wider range of constraints on financing decision
iii. Accounting and auditing standard in DTEs tend to be relatively lax → implementing asymmetric information is more problematic
e. Singh and Hamid (1992) and Singh (1995) → concluded that firms in developing economies rely more heavily on equity than on debt to finance growth than do their counterparts in the industrial economies
f. None of the researchers explicitly set out to discriminate between trade-off and pecking order theories in a manner designed to discriminate between them
g. This paper studies the determinants of capital structure decisions in a sample of listed Chinese companies
i. China is of interest for several reasons → but particularly because it is in the almost unique position of being both a developing economy and a transition economy
II. Hypotheses
Three related aspects of corporate financing where trade-off and pecking order theories give different predictions:
a. Determinants of Leverage: profitability, size, and growth
i. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relationship between leverages and profitability
o Unprofitable firms facing a positive NPV investment opportunity will avoid external finance in general and leverage in particular
§ Pecking orders theory → there will be negative relationships between leverage and profitability
o Firms will use retentions first then debt and equity issues as a last resort
o Less profitable firms facing a positive NPV investment opportunity will be more willing to use external funds if cash flow are weak
ii. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relation between leverage and firm size
o There are economic scale of bankruptcy → agency cost will be lower for larger company
§ Pecking order theory → a negative relation between leverage and size
o Larger the firm → more complex the organization →higher the cost of information asymmetries → more difficult to raise external finance
b. Leverage and Dividends
i. Trade-off theory → negative relationship between dividends and leverage
§ Dividend are high (retention low) → because external financing low
ii. Pecking order theory → Positive relationship between dividends and leverage
§ Firms with higher past dividends will have less financial slack → higher leverage → because they require more external funds
c. Corporate investment and financing
i. Trade-off theory → Leverage should be negatively related to investment → because of funding limitations arising from high leverage
ii. Pecking order theory → larger firms are less transparent than smaller firms
III. Data and Methodology
a. Use base in China
i. China → in transition from a planned economy to a market economy → continues to be characterized by a fragmented capital market, fragile banking system, poorly specified property rights and institutional uncertainty
ii. Chinese firms → have a relatively short operating history → have not accumulated much reputation
iii. Most listed companies→ originally state-owned enterprises → privatization has been incomplete with the state often retaining a controlling share
iv. Banks → often process commercial loans and collect debts in a preferential way → the market is subject to irregular government intervention
v. A well-functioning and fully-enforced accounting and auditing system has developed only gradually in China
vi. Firms could partially disclose, distort, and even forge information for transaction or taxation purposes with low risk of being caught
b. Study attention and methodology
i. China top 50 companies for the period 2001-2003 → data were extracted from the published accounts of non-financial companies listed on the Shanghai and Shenzhen stock exchange
ii. The listing is based on total assets, income from main businesses, net profit and market value
iii. For holding companies → the consolidated data were used
iv. Two datasets:
§ For 2002 and 2001 → using 2002 annual report
§ For 2003 and 2002 → using 2003 annual report
v. Two measure of leverage
§ Wide measure → ratio of total liabilities to total assets
§ Standard ways → two comments:
o In measuring ROA → one should ideally use the ratio of operating income to operating assets rather than total assets
o Dividend → scaled by book equity rather than the market value
IV. Results
a. More than 50% of the cross sectional variation in leverage
b. Profitability → mostly has a negative and generally significant coefficient irrespective of whether it is lagged in the regression →provide quite robust support for pecking order theory
c. Assets growth → highly significant and has a positive sign contrary to the predictions of trade-off theory
d. Size → signed positive, a finding that is more consistent with trade-off theory
e. Dividend → positively signed as predicted by pecking order theory
f. Dividend and size → signed negative but not significant → consistent with pecking order theory
g. Profitability:
i. Negative but significant in 2002 → consistent with trade-off theory
ii. Positive but significant in 2003 → consistent with pecking order theory
h. There is some degree of stability in the parameters across time periods
Tuesday, March 25, 2008
ST. LOUIS CHEMICAL: THE INVESTMENT DECISION
A. Abstract
§ St. Louis Chemical is a regional chemical distributor
§ The company reported small losses during it first two years → reported increasing sales and profits
§ The growth has required:
i. acquisition of equipment
ii. expansion of storage capacity
iii. increasing the size of the work force
B. Case Overview
§ headquartered in St. Louis → considering the opportunity to increase its packaged goods sales, sales of material in 55 gallon drums
§ to take advantage of this opportunity → additional equipment must be obtained → requiring a major capital investment
§ Williams is considering two alternatives
i. The acquisition and installation of used equipment that will provide the capacity to fill an additional 200,000 fifty-five gallon drums annually → economic life 3 years
ii. The acquisition and installation of new equipment with the capacity to fill 400,000 drums annually → economic life 7 years
a. New equipment is more efficient thus the cost to fill a drum is less than the per drum filling cost of the used equipment
§ Bush feels that Williams may be willing to consider using debt if she can convince him of the advantages of using debt in the firm's capital structure
C. Content
1. Prepare a presentation for Williams regarding the concept of WACC
§ the weighted average cost of capital (WACC) is the cost the company is paying to finance its assets and reflects the riskiness of the firm or the firm's assets
§ it is a weighted average of the costs of the various sources of capital (debt and equity) used in the firm's capital structure
§ WACC is an after-tax cost → calculated using the after-tax cost of each source of capital
§ determine WACC:
i. calculate the cost it must pay for each source of capital
ii. determine the target mix of debt and equity to be used by the firm
2. Calculate St. Louis Chemical's WACC (round to the nearest whole number). arguments should be made to convince Williams of the advantage of using long-term debt in the firm's capital structure
§ WACC = W^sub d^(k^sub d^)(l-t) + W^sub 8^(k^sub 8^)
§ The best argument that can be made to convince Williams to use debt capital in its capital structure is to calculate the firm's WACC with and without debt
§ Without debt, the firm's cost of capital is 16% → with 30% debt, its cost of capital is 13%
§ The use of debt lowers St. Louis Chemical's cost of capital because low cost debt capital is substituted for high cost equity capital
§ Debt has a lower cost than equity because to the holder of debt there is less risk
§ Debt has less risk → the certainty of payments associated with debt (interest and principal) is greater than the payments associated with equity (dividends and stock appreciation)
3. Since the used equipment will be financed with internal capital and the new equipment with a bank loan, the same discount rate should be used to evaluate each alternative
§ The discount rate used to evaluate the project reflects the risk level of the project, not the cost of the financing
§ The cost of capital represents the risk level of the firm's assets
4. An accurate WACC is important to a firm's long-term success.
§ A firm's WACC is used to assess investment decisions
§ An asset's return is less than the WACC → shareholders will not receive their required return
§ If the WACC is underestimated → the firm risks losing equity capital as unsatisfied investors take their funds elsewhere or will have difficulty raising capital in the future
§ If the WACC is overestimated → the firm risks missing profitable growth opportunities
§ Making investment decisions based on informal analysis is an unacceptable process and will not result in an effective allocation of the firm's scarce resources
5. Evaluate the strengths and weaknesses of the NPV, IRR and Cash Payback Period capital expenditure budgeting methods. Prepare a recommendation for Williams regarding the capital budgeting method or methods to use in evaluating the expansion alternatives
§ Cash Payback Period is the number of years it takes a firm to recover the original investment
i. The advantages of the Payback Period
a. easy to calculate and explain
b. focuses on future cash flows
c. places a premium on liquidity
ii. The disadvantages of the payback period
a. ignores time value of money
b. ignores cash flows beyond the payback period
c. does not include an accept/reject feature
§ Net Present Value (NPV) method is determined by:
i. calculating the present value of the future cash flows
ii. deducting the project's cost from the present value of the future cash flows
© If the project's value (the present value of its future cash flows) exceeds its cost → the project is a good investment and should be accepted
i. Advantages of this method
a. focuses on future cash flows
b. takes into account time value of money
c. considers all cash flows associated with the project
d. includes an accept/reject feature
ii. Disadvantages of this method
a. relatively difficult to explain and calculate
b. requires knowledge of a firm's WACC
§ Internal Rate of Return (IRR) method is calculated by determining the discount rate that will cause the present value of the future cash flows to equal the project's cost
© If the IRR exceeds the firm's WACC, the project should be accepted
i. Advantages of this method
a. focuses on future cash flows
b. takes into account time value of money
c. considers all cash flows associated with the project
d. does not require knowledge of a firm's WACC
ii. Disadvantages of this method
a. relatively difficult to explain and calculate
b. if the project's future cash flows include some years with cash outflows rather than cash inflows, multiple IRRs may result
§ Recommendation should include the use of all evaluation methods because each provides valuable information regarding a potential project
§ Priority should be given to the results of the NPV method because it compares the projects value to the projects cost
6. The projected cash flow benefits of both projects did not include the effects of inflation. Future cash flows were determined using a constant selling price and operating costs (real cash flows). The cash flows were then discounted using a WACC that included the impact of inflation (nominal WACC). Discuss the problem with using real cash flows and a nominal WACC when calculating a project's NPV or IRR.
§ If inflation is neutral, impacting revenues and costs equally, the NPV and IRR will be underestimated → Because revenues are usually greater than costs, revenues will increase by a greater dollar amount than costs
§ St. Louis Chemical is a regional chemical distributor
§ The company reported small losses during it first two years → reported increasing sales and profits
§ The growth has required:
i. acquisition of equipment
ii. expansion of storage capacity
iii. increasing the size of the work force
B. Case Overview
§ headquartered in St. Louis → considering the opportunity to increase its packaged goods sales, sales of material in 55 gallon drums
§ to take advantage of this opportunity → additional equipment must be obtained → requiring a major capital investment
§ Williams is considering two alternatives
i. The acquisition and installation of used equipment that will provide the capacity to fill an additional 200,000 fifty-five gallon drums annually → economic life 3 years
ii. The acquisition and installation of new equipment with the capacity to fill 400,000 drums annually → economic life 7 years
a. New equipment is more efficient thus the cost to fill a drum is less than the per drum filling cost of the used equipment
§ Bush feels that Williams may be willing to consider using debt if she can convince him of the advantages of using debt in the firm's capital structure
C. Content
1. Prepare a presentation for Williams regarding the concept of WACC
§ the weighted average cost of capital (WACC) is the cost the company is paying to finance its assets and reflects the riskiness of the firm or the firm's assets
§ it is a weighted average of the costs of the various sources of capital (debt and equity) used in the firm's capital structure
§ WACC is an after-tax cost → calculated using the after-tax cost of each source of capital
§ determine WACC:
i. calculate the cost it must pay for each source of capital
ii. determine the target mix of debt and equity to be used by the firm
2. Calculate St. Louis Chemical's WACC (round to the nearest whole number). arguments should be made to convince Williams of the advantage of using long-term debt in the firm's capital structure
§ WACC = W^sub d^(k^sub d^)(l-t) + W^sub 8^(k^sub 8^)
§ The best argument that can be made to convince Williams to use debt capital in its capital structure is to calculate the firm's WACC with and without debt
§ Without debt, the firm's cost of capital is 16% → with 30% debt, its cost of capital is 13%
§ The use of debt lowers St. Louis Chemical's cost of capital because low cost debt capital is substituted for high cost equity capital
§ Debt has a lower cost than equity because to the holder of debt there is less risk
§ Debt has less risk → the certainty of payments associated with debt (interest and principal) is greater than the payments associated with equity (dividends and stock appreciation)
3. Since the used equipment will be financed with internal capital and the new equipment with a bank loan, the same discount rate should be used to evaluate each alternative
§ The discount rate used to evaluate the project reflects the risk level of the project, not the cost of the financing
§ The cost of capital represents the risk level of the firm's assets
4. An accurate WACC is important to a firm's long-term success.
§ A firm's WACC is used to assess investment decisions
§ An asset's return is less than the WACC → shareholders will not receive their required return
§ If the WACC is underestimated → the firm risks losing equity capital as unsatisfied investors take their funds elsewhere or will have difficulty raising capital in the future
§ If the WACC is overestimated → the firm risks missing profitable growth opportunities
§ Making investment decisions based on informal analysis is an unacceptable process and will not result in an effective allocation of the firm's scarce resources
5. Evaluate the strengths and weaknesses of the NPV, IRR and Cash Payback Period capital expenditure budgeting methods. Prepare a recommendation for Williams regarding the capital budgeting method or methods to use in evaluating the expansion alternatives
§ Cash Payback Period is the number of years it takes a firm to recover the original investment
i. The advantages of the Payback Period
a. easy to calculate and explain
b. focuses on future cash flows
c. places a premium on liquidity
ii. The disadvantages of the payback period
a. ignores time value of money
b. ignores cash flows beyond the payback period
c. does not include an accept/reject feature
§ Net Present Value (NPV) method is determined by:
i. calculating the present value of the future cash flows
ii. deducting the project's cost from the present value of the future cash flows
© If the project's value (the present value of its future cash flows) exceeds its cost → the project is a good investment and should be accepted
i. Advantages of this method
a. focuses on future cash flows
b. takes into account time value of money
c. considers all cash flows associated with the project
d. includes an accept/reject feature
ii. Disadvantages of this method
a. relatively difficult to explain and calculate
b. requires knowledge of a firm's WACC
§ Internal Rate of Return (IRR) method is calculated by determining the discount rate that will cause the present value of the future cash flows to equal the project's cost
© If the IRR exceeds the firm's WACC, the project should be accepted
i. Advantages of this method
a. focuses on future cash flows
b. takes into account time value of money
c. considers all cash flows associated with the project
d. does not require knowledge of a firm's WACC
ii. Disadvantages of this method
a. relatively difficult to explain and calculate
b. if the project's future cash flows include some years with cash outflows rather than cash inflows, multiple IRRs may result
§ Recommendation should include the use of all evaluation methods because each provides valuable information regarding a potential project
§ Priority should be given to the results of the NPV method because it compares the projects value to the projects cost
6. The projected cash flow benefits of both projects did not include the effects of inflation. Future cash flows were determined using a constant selling price and operating costs (real cash flows). The cash flows were then discounted using a WACC that included the impact of inflation (nominal WACC). Discuss the problem with using real cash flows and a nominal WACC when calculating a project's NPV or IRR.
§ If inflation is neutral, impacting revenues and costs equally, the NPV and IRR will be underestimated → Because revenues are usually greater than costs, revenues will increase by a greater dollar amount than costs
Tie Your Capital Budget to Your Strategic Plan
A. Introduction
§ Upgrade the equipment to support a product that was in the mature stage → possibly approaching a point where it would be phased out
§ Capital assets decisions → the most irrevocable long-range activities because:
i. Involve significant corporate funding
ii. The least flexible in terms of changing the strategic direction of the business
iii. The least flexible for conversion into more liquid assets
iv. May geographically impact the long-term raw material supply capabilities of the business
v. May geographically impact the business’s long-term customer access
vi. Involve decisions about assets that are unique to the company
§ Unique features of capital assets → represent the source of a company’s product individuality and position in the market place
B. Defining the Strategic Plan
§ Strategic plan must be a living document that:
i. Managers keep it
ii. Easily updated → depend on events
iii. Requires management explanation when the projection aren’t met → can be adjusted
iv. Represent management’s philosophy of managing with a planning process →the product is the plan; the process is the interaction → employees and management → that takes to develop the plan
v. Reflect the corporate leadership’s visions of the company’s future
vi. Supported with individual functional plans
vii. Contains objectives → specific measurable results that outline exactly what should be accomplished in a given time frame
viii. Identifies the strategies → How, where, and when of resource commitment to achieve objectives
§ Strategic plan → focus on customers needs then business capabilities to meet those needs with its products and services
C. Building the Plan
The strategic plans contains
§ Corporate mission → company purpose
§ Where the business wants to be in the future
§ How it plans to get there
§ It identifies guidelines for targeting the corporate market
§ It identifies the corporate organizational features
D. Managing the Assets
§ Develop the strategic plans → need to look at the fixed assets
§ Stages of asset management:
i. Companies acquire new physical assets → operating management determines the plant facilities are inadequate → for growth or corporate citizenship → acquisition include:
a. Equipment replacement expenditures
b. Expansion investment
c. Investment to support strategic improvements → existing or new product
ii. Maintenance → management should be concerned about the potential for piecemeal maintenance programs for older facilities
iii. Disposition of assets → get rid of assets when it still has value → both company (acquired or sell) can get benefit
a. The goal → to ensure the assets will fully utilized and support management’s strategic vision
E. Some Common Evaluation Techniques
§ Payback period
i. Its strengths
a. Simplicity
b. Identifying the time required to return the money
ii. Its weakness
a. It ignores the time value of money
b. The cash outflows after the payback period
§ Average Annual Rate on Investment
i. Its advantages
a. The consideration of the full income of the project
b. The ease of locating comparable data later in the accounting records
ii. Its Disadvantages
a. Failure to consider time value of money
b. Influence of inflation
§ Present Value method
i. Its Disadvantages
a. Difficult to compute
b. Management must select the discount rate
c. Result may be misleading when comparing projects
§ Discounted Cash Flow method
i. Its advantages
a. Consideration of time value of money
b. Consideration of all project’s cash flow
c. Results are easily understood
d. Compensates of unequal lives and cash flow
ii. Its Disadvantages
a. Difficult to compute
b. Implication that the cash can be reinvested at the internal rate of interest
§ Purchase vs. Lease
F. Is the Program Effective?
Key measurements that will keep the program viable and effective
§ Periodically review all capital asset acquisition project to make sure you still need them
§ Review the project to see if the initial planning projections were on target
§ Continuously review all capital acquisition expenditures to make sure that all assets are being acquired according to the strategic plan
G. The Capital Budget
§ Capital budget → portion of strategic plan; select which assets you should acquire; allocates available resources; based on quantitative and qualitative evaluation; determine the best investment
§ Corporate decision-making process:
i. Defining and communicating a firm’s long-range and strategic plans and goals
ii. Developing a system → permits gathering and ranking of company proposals
iii. Determining the accuracy of the estimates that will be used in the estimation of rate of return calculation
iv. Determine and assign levels of risk probabilities to each investment proposals
H. Effective Implementation is Key
§ Driving force of any strategic plan is its effective implementation
§ Develop the corporate strategic plan assumption → next step is to merge this information to the various functional plans and link all short-term and long-term plans
§ The prime decision-making factors of the capital program should be
i. The time value of money
ii. The cost of capital
iii. The inherent risk of each project/proposal
§ Fixed assets → long-term present-dollar commitments that will be used over a long period of time in the normal course of business
§ Upgrade the equipment to support a product that was in the mature stage → possibly approaching a point where it would be phased out
§ Capital assets decisions → the most irrevocable long-range activities because:
i. Involve significant corporate funding
ii. The least flexible in terms of changing the strategic direction of the business
iii. The least flexible for conversion into more liquid assets
iv. May geographically impact the long-term raw material supply capabilities of the business
v. May geographically impact the business’s long-term customer access
vi. Involve decisions about assets that are unique to the company
§ Unique features of capital assets → represent the source of a company’s product individuality and position in the market place
B. Defining the Strategic Plan
§ Strategic plan must be a living document that:
i. Managers keep it
ii. Easily updated → depend on events
iii. Requires management explanation when the projection aren’t met → can be adjusted
iv. Represent management’s philosophy of managing with a planning process →the product is the plan; the process is the interaction → employees and management → that takes to develop the plan
v. Reflect the corporate leadership’s visions of the company’s future
vi. Supported with individual functional plans
vii. Contains objectives → specific measurable results that outline exactly what should be accomplished in a given time frame
viii. Identifies the strategies → How, where, and when of resource commitment to achieve objectives
§ Strategic plan → focus on customers needs then business capabilities to meet those needs with its products and services
C. Building the Plan
The strategic plans contains
§ Corporate mission → company purpose
§ Where the business wants to be in the future
§ How it plans to get there
§ It identifies guidelines for targeting the corporate market
§ It identifies the corporate organizational features
D. Managing the Assets
§ Develop the strategic plans → need to look at the fixed assets
§ Stages of asset management:
i. Companies acquire new physical assets → operating management determines the plant facilities are inadequate → for growth or corporate citizenship → acquisition include:
a. Equipment replacement expenditures
b. Expansion investment
c. Investment to support strategic improvements → existing or new product
ii. Maintenance → management should be concerned about the potential for piecemeal maintenance programs for older facilities
iii. Disposition of assets → get rid of assets when it still has value → both company (acquired or sell) can get benefit
a. The goal → to ensure the assets will fully utilized and support management’s strategic vision
E. Some Common Evaluation Techniques
§ Payback period
i. Its strengths
a. Simplicity
b. Identifying the time required to return the money
ii. Its weakness
a. It ignores the time value of money
b. The cash outflows after the payback period
§ Average Annual Rate on Investment
i. Its advantages
a. The consideration of the full income of the project
b. The ease of locating comparable data later in the accounting records
ii. Its Disadvantages
a. Failure to consider time value of money
b. Influence of inflation
§ Present Value method
i. Its Disadvantages
a. Difficult to compute
b. Management must select the discount rate
c. Result may be misleading when comparing projects
§ Discounted Cash Flow method
i. Its advantages
a. Consideration of time value of money
b. Consideration of all project’s cash flow
c. Results are easily understood
d. Compensates of unequal lives and cash flow
ii. Its Disadvantages
a. Difficult to compute
b. Implication that the cash can be reinvested at the internal rate of interest
§ Purchase vs. Lease
F. Is the Program Effective?
Key measurements that will keep the program viable and effective
§ Periodically review all capital asset acquisition project to make sure you still need them
§ Review the project to see if the initial planning projections were on target
§ Continuously review all capital acquisition expenditures to make sure that all assets are being acquired according to the strategic plan
G. The Capital Budget
§ Capital budget → portion of strategic plan; select which assets you should acquire; allocates available resources; based on quantitative and qualitative evaluation; determine the best investment
§ Corporate decision-making process:
i. Defining and communicating a firm’s long-range and strategic plans and goals
ii. Developing a system → permits gathering and ranking of company proposals
iii. Determining the accuracy of the estimates that will be used in the estimation of rate of return calculation
iv. Determine and assign levels of risk probabilities to each investment proposals
H. Effective Implementation is Key
§ Driving force of any strategic plan is its effective implementation
§ Develop the corporate strategic plan assumption → next step is to merge this information to the various functional plans and link all short-term and long-term plans
§ The prime decision-making factors of the capital program should be
i. The time value of money
ii. The cost of capital
iii. The inherent risk of each project/proposal
§ Fixed assets → long-term present-dollar commitments that will be used over a long period of time in the normal course of business
Monday, March 24, 2008
The Capital Budgeting Decisions of Small Business
1. Introduction
§ Capital investments in the small business sector → important to both the individual firms and the overall economy
§ Small and large firms → use different criteria to evaluate the project
o Small business owners → balance wealth maximization against other objectives (e.g. independency of business)
o Small firms lack of personal resources → have no time or expertise as deep as the large firm
o Some small firms are capital constraints
§ Result of research:
o Types of investment the firm makes
o Tools to evaluate the project
o Firm’s use of other planning tools
o Owner’s willingness to finance project with debts
o Relation between capital budgeting practice and firm’s characteristics
2. Capital Budgeting Theory and Small Firms
§ Simple rule managers can use to make capital budgeting decisions
o Invest in all positive net present value projects and rejects those which have negative net present value
© Firms will make set of investment decision that will maximize the shareholder’s value
© No need to consider alternative capital budgeting tools → payback period or ARR
§ Problem → small firms often operated in environment that do not satisfy the basic capital budgeting model
A. Capital Budgeting Assumptions and the Small Firm
§ Capital budgeting theory → The primary goals of a firm’s shareholders is to maximize firm value
o Firm is assumed to have access to perfect financial markets
o Allowing it to finance all value enhancing projects
§ Reasons why it cannot be implemented to small firm
o Shareholder wealth maximization may not be the objectives of all small firms
o Many small firm have limited management resources → lack expertise in finance and accounting
o Capital market imperfections → constraint the financing options for small firm (wrong information)
B. Cash Flow Estimation Issues
§ Estimation issues managers must confront when implementing discounted cash flow analysis
§ Discounted cash flow is less valuable when the level of future cash flows is more uncertain
o Discounted cash flow analysis can be applied most directly to projects with cash flow profiles similar to the firm’s current operations
§ Small firms is considering investment in new product lines → future cash flow cannot be estimated directly from the past performance of the firm’s current operations
§ Small firms may not rely exclusively on discounted cash flow analysis when evaluating investments in new product lines
§ Small firms may not use discounted cash flow analysis to evaluate replacement decisions
o Small firm may have limited replacement options and differences in future maintenance costs of the various option can be difficult to forecast
3. Description of Data
§ Survey provide information that cannot be readily gleaned from financial statements
§ Survey can shed light on how firms make investment and financing decisions and why they use these approach
§ 72% of samples → construction, manufacturing, retail, all industries requiring substantial capital investment
o 20% is services industries
4. Survey Results
§ Three questions concerning the capital budgeting activities of small firms
o We consider whether the investment and financing activities of small firms conform to the assumptions underlying capital budgeting theory
o We look at the overall planning → identify firm’s characteristics
o We provide evidence about the specific project evaluation techniques small firms use
A. Investment Activity
§ The most important type of investment is replacement for 46% of the sample firms
o Firms in service industry are more likely select this response → firms in manufacturing industry were less likely
o Firms with highest growth rates and those who in business less than six years were less likely than the firm which report replacement activities as the primary investment type
o The importance of replacement activity increases with the age of the business owner
§ Project to extend existing product lines are shown as the primary investment activity for 21 % of the sample firms
o Construction and manufacturing firms, firms with highest growth, young firms → more likely to expand the existing project
o Low growth rates firms, oldest firms → less likely to expand the existing project
§ Many small firms face real capital constraints → wait for cash
o Youngest firms, the smallest firms, firms with older owners, and those whose owners does not have a college degree → wait for cash
§ Reasons why small firms might not follow the prescriptions of capital budgeting theory
o Replacement is not the most important type of activities
i. Maintaining the viability of the firm is going concern might be the owner’s objectives
o Many small firms place internal limits on the amount they will borrow
o Personal financial planning considerations of business owners may effect the investment and financing decisions of small firms
B. Planning Activity
§ 31 % of the sample firms have written business plan
§ Over 30 % of the sample firm do not estimate future cash flows
§ 26 % of the firms do not consider the tax implications of investment decisions
o Firms with highest growth rates, firms that extend business project, newer firms and younger owners, firms which the owners have college degree → more likely to have formal and complete business plan
C. Project Evaluation Methods
§ Primary tools firm use to assess a project’s financial viability → payback period, accounting rate of return, discounted cash flow analysis, “gut feel”, or combination
§ Use of Gut Feel → related to owner’s background → inverse with firm’s planning tools
o It is widely used by firms that make primarily replacement investments
o Small business owners use relatively unsophisticated methods of analysis to evaluate replacement options
o Gut Feel → Service industry
i. Firm’s primary considerations when evaluating the purchasing decision → cost, reliability, product features → structuring discounted cash flow is difficult
§ Payback period → used by firms that will use wait for cash
o Use of payback period → increase → related to educational level of owners
o Payback period can be a rational project evaluation tool for small firms facing capital constraints
§ Accounting Rate of Return → the use increase → with firm’s growth rates
o ARR → important → if firm must provide with periodic financial statements or is required to comply with loan covenants based on financial statement ratios
§ Discounted cash flow → primary evaluation method of only 12 % of the firms
o Firms with written business plan, those who consider taxes of investment, less than six years firms, and also firms extending existing product lines → more likely use this method
D. Multivariate Analysis
§ Using multinomial logit → jointly identify factors influencing the choice of a project evaluation tools
§ This technique → appropriate → when unordered response has more than two outcomes
§ Result
o Firms using any formal investment evaluation tools → more likely to make cash flow projection
o Firms using ARR, DCF, or a combination → more likely consider tax implications
o Capital constraints and the type of investment can influence how firms evaluate projects
o Wait for cash coefficient → positive and significant to both payback period and DCF
o Firms committed to funding projects internally are not necessarily irrational or unsophisticated
o ARR → the choice of firms pursuing either growth strategy, expand product lines or new product line
o The importance of DCF analysis → depend on the type of growth the firm is pursuing
§ Capital investments in the small business sector → important to both the individual firms and the overall economy
§ Small and large firms → use different criteria to evaluate the project
o Small business owners → balance wealth maximization against other objectives (e.g. independency of business)
o Small firms lack of personal resources → have no time or expertise as deep as the large firm
o Some small firms are capital constraints
§ Result of research:
o Types of investment the firm makes
o Tools to evaluate the project
o Firm’s use of other planning tools
o Owner’s willingness to finance project with debts
o Relation between capital budgeting practice and firm’s characteristics
2. Capital Budgeting Theory and Small Firms
§ Simple rule managers can use to make capital budgeting decisions
o Invest in all positive net present value projects and rejects those which have negative net present value
© Firms will make set of investment decision that will maximize the shareholder’s value
© No need to consider alternative capital budgeting tools → payback period or ARR
§ Problem → small firms often operated in environment that do not satisfy the basic capital budgeting model
A. Capital Budgeting Assumptions and the Small Firm
§ Capital budgeting theory → The primary goals of a firm’s shareholders is to maximize firm value
o Firm is assumed to have access to perfect financial markets
o Allowing it to finance all value enhancing projects
§ Reasons why it cannot be implemented to small firm
o Shareholder wealth maximization may not be the objectives of all small firms
o Many small firm have limited management resources → lack expertise in finance and accounting
o Capital market imperfections → constraint the financing options for small firm (wrong information)
B. Cash Flow Estimation Issues
§ Estimation issues managers must confront when implementing discounted cash flow analysis
§ Discounted cash flow is less valuable when the level of future cash flows is more uncertain
o Discounted cash flow analysis can be applied most directly to projects with cash flow profiles similar to the firm’s current operations
§ Small firms is considering investment in new product lines → future cash flow cannot be estimated directly from the past performance of the firm’s current operations
§ Small firms may not rely exclusively on discounted cash flow analysis when evaluating investments in new product lines
§ Small firms may not use discounted cash flow analysis to evaluate replacement decisions
o Small firm may have limited replacement options and differences in future maintenance costs of the various option can be difficult to forecast
3. Description of Data
§ Survey provide information that cannot be readily gleaned from financial statements
§ Survey can shed light on how firms make investment and financing decisions and why they use these approach
§ 72% of samples → construction, manufacturing, retail, all industries requiring substantial capital investment
o 20% is services industries
4. Survey Results
§ Three questions concerning the capital budgeting activities of small firms
o We consider whether the investment and financing activities of small firms conform to the assumptions underlying capital budgeting theory
o We look at the overall planning → identify firm’s characteristics
o We provide evidence about the specific project evaluation techniques small firms use
A. Investment Activity
§ The most important type of investment is replacement for 46% of the sample firms
o Firms in service industry are more likely select this response → firms in manufacturing industry were less likely
o Firms with highest growth rates and those who in business less than six years were less likely than the firm which report replacement activities as the primary investment type
o The importance of replacement activity increases with the age of the business owner
§ Project to extend existing product lines are shown as the primary investment activity for 21 % of the sample firms
o Construction and manufacturing firms, firms with highest growth, young firms → more likely to expand the existing project
o Low growth rates firms, oldest firms → less likely to expand the existing project
§ Many small firms face real capital constraints → wait for cash
o Youngest firms, the smallest firms, firms with older owners, and those whose owners does not have a college degree → wait for cash
§ Reasons why small firms might not follow the prescriptions of capital budgeting theory
o Replacement is not the most important type of activities
i. Maintaining the viability of the firm is going concern might be the owner’s objectives
o Many small firms place internal limits on the amount they will borrow
o Personal financial planning considerations of business owners may effect the investment and financing decisions of small firms
B. Planning Activity
§ 31 % of the sample firms have written business plan
§ Over 30 % of the sample firm do not estimate future cash flows
§ 26 % of the firms do not consider the tax implications of investment decisions
o Firms with highest growth rates, firms that extend business project, newer firms and younger owners, firms which the owners have college degree → more likely to have formal and complete business plan
C. Project Evaluation Methods
§ Primary tools firm use to assess a project’s financial viability → payback period, accounting rate of return, discounted cash flow analysis, “gut feel”, or combination
§ Use of Gut Feel → related to owner’s background → inverse with firm’s planning tools
o It is widely used by firms that make primarily replacement investments
o Small business owners use relatively unsophisticated methods of analysis to evaluate replacement options
o Gut Feel → Service industry
i. Firm’s primary considerations when evaluating the purchasing decision → cost, reliability, product features → structuring discounted cash flow is difficult
§ Payback period → used by firms that will use wait for cash
o Use of payback period → increase → related to educational level of owners
o Payback period can be a rational project evaluation tool for small firms facing capital constraints
§ Accounting Rate of Return → the use increase → with firm’s growth rates
o ARR → important → if firm must provide with periodic financial statements or is required to comply with loan covenants based on financial statement ratios
§ Discounted cash flow → primary evaluation method of only 12 % of the firms
o Firms with written business plan, those who consider taxes of investment, less than six years firms, and also firms extending existing product lines → more likely use this method
D. Multivariate Analysis
§ Using multinomial logit → jointly identify factors influencing the choice of a project evaluation tools
§ This technique → appropriate → when unordered response has more than two outcomes
§ Result
o Firms using any formal investment evaluation tools → more likely to make cash flow projection
o Firms using ARR, DCF, or a combination → more likely consider tax implications
o Capital constraints and the type of investment can influence how firms evaluate projects
o Wait for cash coefficient → positive and significant to both payback period and DCF
o Firms committed to funding projects internally are not necessarily irrational or unsophisticated
o ARR → the choice of firms pursuing either growth strategy, expand product lines or new product line
o The importance of DCF analysis → depend on the type of growth the firm is pursuing
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