MTA – II (09): FINANCIAL MANAGEMENT AND ACCOUNTING.-module 2

Module 2:

Long Term Investment Decision: Capital Budgeting- meaning and importance of Capital Budgeting Rationale for Capital Expenditure, Techniques of selecting capital Budgeting proposals-NPU Vs. IRR. 

Dividend Policy Decisions: The irrelevance of Dividend, Relevance of Dividend, Determinants of dividend policy.

Long Term Investment Decision:

Capital budgeting, or investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures.^[1] One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.

Many formal methods are used in capital budgeting, including the techniques such as

·         Accounting rate of return

·         Average accounting return

·         Payback period

·         Net present value

·         Profitability index

·         Internal rate of return

·         Modified internal rate of return

·         Equivalent annual cost

·         Real options valuation

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

# Capital Budgeting- meaning and importance of Capital Budgeting Rationale for Capital Expenditure

Definition and Meaning:

Economics is concerned with the allocation of scarce resources between alternative uses in order to obtain best objectives.

Capital expenditure/budgeting, on the other hand, concentrates on these allocations over time; on decisions which involve current outlays in return for expectations of future benefits, i.e., a return for an anticipated flow of future benefits.

In other words, it is applied in order to evaluate expenditure decisions which involve current outlays but the benefits are likely to be produced in future, i.e., over a longer period of time. The said benefits may be earned either in the form of reduction in cost or in the form of increased revenues. And that is why it includes addition, alternation, modification, disposition and replacement of fixed assets.

Therefore, the salient features of capital budgeting are:

(i) Potentially large anticipated benefits;

(ii) A relatively high degree of risk; and

(iii) A relatively long time period between the initial outlay and the anticipated ‘return’.

However, capital budgeting decision seeks to provide a body of analyses giving answers to the following three questions:

(i) What specific investment projects should the firm accept?

(ii) How much of capital expenditure should the firm undertake?

(iii) How should this portfolio of projects be financed?

Obviously, the above three decisions are closely related to each other. The problem is not simply to decide which investments should be financed with a given amount of funds for the amount of borrowings and the volume of shares issued are variables with the firm’s control. As such, the two problems must be tackled simultaneously. So, capital budgeting covers all the three questions.

It may be noted that a capital budgeting decision is a two-sided process. The first one is that the analyst must evaluate a proposed projects to forecast the likely or expected return from the project.

The said return may be calculated with the help of two methods:

(i) Internal Rate of Return, and

 (ii) Net Present Value.

The other side of a capital budgeting decision is to determine the required return from a project.

From the discussion made so far, it may be summarised that capital budgeting decision is the firm’s decision to invest its funds most efficiently in long-term activities against an anticipated flow of future benefits over a number of years.

Importance of Capital Budgeting:

Capital Budgeting decisions have given the primary importance to financial decision-making since they are the most crucial and critical business decisions as they have significant impact on the profitability aspect of the firm. As the capital budgeting/expenditure decision affects the fixed assets only which are the sources of earning revenue, i.e., the profitability of the firm, special attention must be given to their treatment.

Capital budgeting decisions have placed greater emphasis due to:

(a) Capital budgeting has long-term implications:

The most significant reason for which capital budgeting decisions are taken is that it has long-term implications, i.e. its effects will extend into the future, and will have to be endured for a longer period than the consequences of current operating expenditure. Because, a proper investment decision can yield spectacular returns, whereas a wrong investment decision can endanger the very survival of the firm.

That is why, it may be stated that the capital budgeting decisions determine the future destiny of the firm. Moreover, it also changes the risk complexion of the enterprise. When the average benefits of the firm increase as a result of an investment proposal which may cause frequent fluctuations in its earnings that will become a risky situation.

(b) Capital budgeting requires large amount of funds:

Capital investment decisions require large amount of funds which the majority of the firms cannot provide since they have scarce capital resources. As a result, the investment decisions must be thoughtful, wise and correct. Because, a wrong/incorrect decision would result in losses and the same prevents the firm from earning profits from other investments as well due to scarcity of resources.

(c) Capital budgeting is not reversible:

Once the capital budgeting decisions are taken, they are not easily reversible. The reason is that there may neither be any market for such second-hand capital goods nor there is any possibility of conversion of such capital assets into other usable assets, i.e., the only remedy is to dispose-off the same sustaining a heavy loss to the firm.

(d) They are actually the most difficult decisions:

Capital investment decisions are, no doubt, the most significant since they are very difficult to make. It is because of the fact that their assessment depends on the future uncertain events and activities of the firm. Similarly, it is practically a difficult task to estimate the accurate future benefits and costs in terms of money as there are economical, political and technological forces which affect the said benefits and costs.

The rationale behind the capital budgeting decisions is efficiency. A firm has to continuously invest in new plant or machinery for expansion of its operations or replace worn out machinery for maintaining and improving efficiency. The main objective of the firm is to maximize profit either by way of increased revenue or by cost reduction. Broadly, there are two types of capital budgeting decisions which expand revenue or reduce cost

1. Investment decisions affecting revenue: It includes all those investment decisions which are expected to bring additional revenue by raising the size of firm’s total revenue. It is possible either by expansion of present operations or the development of new product in line. In both the cases fixed assets are required.

2. Investment decisions reducing costs; It includes all those decisions of the firms which reduces the total cost and leads to increase in its total earnings i.e. when an asset is worn out or becomes outdated, the firm has to decide whether to continue with it or replace it by new machine. For this, the firm evaluates the benefit in the form of reduction in operating costs and outlays that would be needed to replace old machine by new one. A firm will replace an asset only when it finds it beneficial to do so. The above decision could be followed decisions following alternative courses: i.e., Tactical investment decisions to strategic investment decisions, as briefly defined below

3. Tactical investment decisions; It includes those investment decisions which generally involves a small amount of funds and does not constitute a major departure from what the firm has been doing in the past.

4. Strategic investment decisions: Such decisions involve large sum of money and envisage major departure from what the company has been doing in the past. Acceptance of strategic investment will involve significant change in the company’s expected profits and the risk to which these profits will be subject. These changes are likely to lead stock-holders and creditors to revise their evaluation of the company.

# Techniques of selecting capital Budgeting proposals-NPU Vs. IRP. 

Net Present Value
NPV and IRR are two methods for making capital-budget decisions, or choosing between alternate projects and investments when the goal is to increase the value of the enterprise and maximize shareholder wealth. Defining the NPV method is simple: the present value of cash inflows minus the present value of cash outflows, which arrives at a dollar amount that is the net benefit to the organization.

To compute NPV and apply the NPV rule, the authors of the reference textbook define a five-step process to be used in solving problems:

1.Identify all cash inflows and cash outflows.
2.Determine an appropriate discount rate (r).
3.Use the discount rate to find the present value of all cash inflows and outflows.
4.Add together all present values. (From the section on cash flow additivity, we know that this action is appropriate since the cash flows have been indexed to t = 0.)
5.Make a decision on the project or investment using the NPV rule: Say yes to a project if the NPV is positive; say no if NPV is negative. As a tool for choosing among alternates, the NPV rule would prefer the investment with the higher positive NPV.

Companies often use the weighted average cost of capital, or WACC, as the appropriate discount rate for capital projects. The WACC is a function of a firm's capital structure (common and preferred stock and long-term debt) and the required rates of return for these securities.

The Internal Rate of Return
The IRR, or internal rate of return, is defined as the discount rate that makes NPV = 0. Like the NPV process, it starts by identifying all cash inflows and outflows. However, instead of relying on external data (i.e. a discount rate), the IRR is purely a function of the inflows and outflows of that project. The IRR rule states that projects or investments are accepted when the project's IRR exceeds a hurdle rate. Depending on the application, the hurdle rate may be defined as the weighted average cost of capital.

NPV vs. IRR
Each of the two rules used for making capital-budgeting decisions has its strengths and weaknesses. The NPV rule chooses a project in terms of net dollars or net financial impact on the company, so it can be easier to use when allocating capital.

However, it requires an assumed discount rate, and also assumes that this percentage rate will be stable over the life of the project, and that cash inflows can be reinvested at the same discount rate. In the real world, those assumptions can break down, particularly in periods when interest rates are fluctuating. The appeal of the IRR rule is that a discount rate need not be assumed, as the worthiness of the investment is purely a function of the internal inflows and outflows of that particular investment. However, IRR does not assess the financial impact on a firm; it only requires meeting a minimum return rate.

The NPV and IRR methods can rank two projects differently, depending on thesize of the investment. Consequences of the IRR Method
In the previous section we demonstrated how smaller projects can have higher IRRs but will have less of a financial impact. Timing of cash flows also affects the IRR method.

# Dividend Policy Decisions: The irrelevance of Dividend, Relevance of Dividend, Determinants of dividend policy.

Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.

If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then – finance theory suggests – management should return some or all of the excess cash to shareholders as dividends. This is the general case, however there are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition, retain most of the excess earnings so as to fund future growth internally. By with holding current dividend payments to shareholders, managers of growth companies are hoping that dividend payments will be increased proportionality higher in the future, to offset the retainment of current earnings and the internal financing of present investment projects.

Management must also choose the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see corporate action. Financial theory suggests that the dividend policy should be set based upon the type of company and what management determines is the best use of those dividend resources for the firm to its shareholders. As a general rule, shareholders of growth companies would prefer managers to have a share buyback program, whereas shareholders of value or secondary stocks would prefer the management of these companies to payout surplus earnings in the form of cash dividends.

Concept

Coming up with the dividend policy is challenging for the directors and financial manager of a company, because different investors have different views on present cash dividends and future capital gains. Another confusion that pops up is regarding the extent of effect of dividends on the share price. Due to this controversial nature of a dividend policy it is often called the dividend puzzle.

Various models have been developed to help firms analyse and evaluate the perfect dividend policy. There is no agreement between these schools of thought over the relationship between dividends and the value of the share or the wealth of the shareholders in other words.

One school consists of people like James E. Walter and Myron J. Gordon (see Gordon model), who believe that current cash dividends are less risky than future capital gains. Thus, they say that investors prefer those firms which pay regular dividends and such dividends affect the market price of the share. Another school linked to Modigliani and Miller holds that investors don't really choose between future gains and cash dividends.^[1]

Relevance of dividend policy

Dividends paid by the firms are viewed positively both by the investors and the firms. The firms which do not pay dividends are rated in oppositely by investors thus affecting the share price. The people who support relevance of dividends clearly state that regular dividends reduce uncertainty of the shareholders i.e. the earnings of the firm is discounted at a lower rate, k_e thereby increasing the market value. However, its exactly opposite in the case of increased uncertainty due to non-payment of dividends.

Two important models supporting dividend relevance are given by Walter and Gordon.

Walter's model

Walter's model shows the relevance of dividend policy and its bearing on the value of the share.

Assumptions of the Walter modelRetained earnings are the only source of financing investments in the firm, there is no external finance involved.

1.   The cost of capital, k _e and the rate of return on investment, r are constant i.e. even if new investments decisions are taken, the risks of the business remains same.

2.   The firm's life is endless i.e. there is no closing down.

Basically, the firm's decision to give or not give out dividends depends on whether it has enough opportunities to invest the retained earnings i.e. a strong relationship between investment and dividend decisions is considered.

 

Model description

Dividends paid to the shareholders are reinvested by the shareholder further, to get higher returns. This is referred to as the opportunity cost of the firm or the cost of capital, k_efor the firm. Another situation where the firms do not pay out dividends, is when they invest the profits or retained earnings in profitable opportunities to earn returns on such investments. This rate of return r, for the firm must at least be equal to k_e. If this happens then the returns of the firm is equal to the earnings of the shareholders if the dividends were paid. Thus, it's clear that if r, is more than the cost of capital k_e, then the returns from investments is more than returns shareholders receive from further investments.

Walter's model says that if r<k_e then the firm should distribute the profits in the form of dividends to give the shareholders higher returns. However, if r>k_e then the investment opportunities reap better returns for the firm and thus, the firm should invest the retained earnings. The relationship between r and k are extremely important to determine the dividend policy. It decides whether the firm should have zero payout or 100% payout.

In a nutshell :

·         If r>k_e, the firm should have zero payout and make investments.

·         If r<k_e, the firm should have 100% payouts and no investment of retained earnings.

·         If r=k_e, the firm is indifferent between dividends and investments.

Mathematical representation

MandarMathkar has given a mathematical model for the above made statements: where,

·         P = Market price of the share

·         D = Dividend per share

·         r = Rate of return on the firm's investments

·         k_e = Cost of equity

·         E = Earnings per share'

The market price of the share consists of the sum total of:

·         the present value of an infinite stream of dividends

·         the present value of an infinite stream of returns on investments made from retained earnings.

Therefore, the market value of a share is the result of expected dividends and capital gains according to Walter.

Criticism

Although the model provides a simple framework to explain the relationship between the market value of the share and the dividend policy, it has some unrealistic assumptions.

1.   The assumption of no external financing apart from retained earnings, for the firm make further investments is not really followed in the real world.

2.   The constant r and k_e are seldom found in real life, because as and when a firm invests more the business risks change.

Gordon's Model

Myron J. Gordon has also supported dividend relevance and believes in regular dividends affecting the share price of the firm.^[2]

The Assumptions of the Gordon model

Gordon's assumptions are similar to the ones given by Walter. However, there are two additional assumptions proposed by him:

1.   The product of retention ratio b and the rate of return r gives us the growth rate of the firm g.

2.   The cost of capital k_e, is not only constant but greater than the growth rate i.e. k_e>g.

Model description

Investors are risk averse and believe that incomes from dividends are certain rather than incomes from future capital gains, therefore they predict future capital gains to be risky propositions. They discount the future capital gains at a higher rate than the firm's earnings, thereby evaluating a higher value of the share. In short, when retention rate increases, they require a higher discounting rate. Gordon has given a model similar to Waltematical formula to determine price of the share.

Mathematical representation

The market prices of the share is calculated as follows:

Where,

·         P = Market price of the share

·         E = Earnings per share

·         b = Retention ratio (1 - payout ratio)

·         r = Rate of return on the firm's investments

·         k_e = Cost of equity

·         br = Growth rate of the firm (g)

Therefore, the model shows a relationship between the payout ratio, rate of return, cost of capital and the market price of the share.

Conclusions on the Walter and Gordon Model

Gordon's ideas were similar to Walter's and therefore, the criticisms are also similar. Both of them clearly state the relationship between dividend policies and market value of the firm.

As a consequence the theory can be tested in an unambiguous way.

Irrelevance of dividend policy

The Modigliani and Miller school of thought believes that investors do not state any preference between current dividends and capital gains. They say that dividend policy is irrelevant and is not deterministic of the market value. Therefore, the shareholders are indifferent between the two types of dividends. All they want are high returns either in the form of dividends or in the form of re-investment of retained earnings by the firm. There are two conditions discussed in relation to this approach :

·         decisions regarding financing and investments are made and do not change with respect to the amounts of dividends received.

·         when an investor buys and sells shares without facing any transaction costs and firms issue shares without facing any floatation cost, it is termed as a perfect capital market.^[5]

Two important theories discussed relating to the irrelevance approach, the residuals theory and the Modigliani and Miller approach.

Residuals theory of dividends

One of the assumptions of this theory is that external financing to re-invest is either not available, or that it is too costly to invest in any profitable opportunity. If the firm has good investment opportunity available then, they'll invest the retained earnings and reduce the dividends or give no dividends at all. If no such opportunity exists, the firm will pay out dividends.

If a firm has to issue securities to finance an investment, the existence of floatation costs needs a larger amount of securities to be issued. Therefore, the pay out of dividends depend on whether any profits are left after the financing of proposed investments as floatation costs increases the amount of profits used. Deciding how much dividends to be paid is not the concern here, in fact the firm has to decide how much profits to be retained and the rest can then be distributed as dividends. This is the theory of Residuals, where dividends are residuals from the profits after serving proposed investments.^[6]

This residual decision is distributed in three steps:

·         evaluating the available investment opportunities to determine capital expenditures.

·         evaluating the amount of equity finance that would be needed for the investment, basically having an optimum finance mix.

·         cost of retained earnings<cost of new equity capital, thus the retained profits are used to finance investments. If there is a surplus after the financing then there is distribution of dividends.

Extension of the theory

The dividend policy strongly depends on two things:

·         investment opportunities available to the company

·         Amount of internally retained and generated funds which lead to dividend distribution if all possible investments have been financed.

The dividend policy of such a kind is a passive one, and doesn't influence market price. the dividends also fluctuate every year because of different investment opportunities every year. However, it doesn't really affect the shareholders as they get compensated in the form of future capital gains.

Conclusion

The firm paying out dividends is obviously generating incomes for an investor, however even if the firm takes some investment opportunity then the incomes of the investors rise at a later stage due to this profitable investment.