1FINANCIAL MANAGEMENT Table of Contents Part A...............................................................................................................................................3 1. Summary of Recent Trend of Literature and Direction in Capital Budgeting........................3 1.1 Use of Net Present value and Internal Rate of Return.......................................................3 1.2 Discounted Cash Flow Techniques...................................................................................4 1.3 Dependence of Payback Method.......................................................................................4 2. Techniques of Capital Bu dgeting...........................................................................................5 2.1 Accounting Rate of Return (ARR) and Payback Period (PBP).........................................5 2.2 Internal Rate of Return (IRR) and Profitability Index (PI)................................................6 2.3 Net Present Value (NPV)...................................................................................................6 3. Usefulness of Capital Budgeting Techniques in Wealth Creation..........................................7 4. Conclusion...............................................................................................................................8 References..................................................................................................................................10 Part B.............................................................................................................................................12 1. Summary of Recent Trend of Literature and Direction in Capital Budgeting......................12 2. Is EMH Testable?..................................................................................................................13 3. Is it possible for an investor to make excess return consistently?.........................................14 4. Conclusion.............................................................................................................................15 References..................................................................................................................................17
2FINANCIAL MANAGEMENT Part A 1. Summary of Recent Trend of Literature and Direction in Capital Budgeting Capital Budgeting refers to the planning procedures used for the determination of the fact that whether the long-term investments of the companies like buying of new machinery, replacement of machinery or others are worth cash funding with the help of capitalization structure. Capital Budgeting is an important aspect for the business organizations and thus, much research has been conducted on this particular topic. Some of them have similar findings and some of them have different. 1.1 Use of Net Present value and Internal Rate of Return According toBennouna, Meredith and Marchant (2010), most of the business organizations prefer the use of Internal Rate of Return model as the most important as well as efficient model for making investment decisions. According to him, majority portion of the companies consider that the determination of the cash flow projections is the toughest stage in the process of capital budgeting. As perLundholm and O'keefe(2001),the model of internal rate of return is the most preferred techniques for decision-making to the business organizations. He has stated that most of the companies stay concerned for the selection of capital budgeting techniques for investment decision-making process. Moreover, to the companies, the technique of present value is useful for the evaluation of the new product lines. However, in the opinion ofFroot and Stein (1998), the model of discounted cash flow is the most popular technique of capital budgeting for the firms around the globe. In this context, he mentioned about the internal rate of return model for
3FINANCIAL MANAGEMENT effective decision-making process. However, many firms are still using the model of payback period as a secondary approach for investment decision making. 1.2 Discounted Cash Flow Techniques According to the findings ofCarr, Kolehmainen and Mitchell (2010), for the evaluation of capital budgeting projects, most of the companies use either Net Present Value or Internal Rate of Return model as their primary methods; and they also use payback period as secondary approach. As opined byDenison (2009), most of the large business corporations put emphasis on discounted cash flow models for their capital budgeting decision-making model and they heavily depend on payback period techniques for taking decisions in the smaller projects. As per the findings ofKester and Chang (1999), most of the large organizations in Hong Kong, Malaysia and Singapore prefer to use the model of Payback Period for the evaluation and rank the capital projects. He concluded that the discounted cash flow techniques are more popular among the companies as a primary technique for the evaluation of projects. 1.3 Dependence of Payback Method According to the findings ofOkoruwa, Cox and Thompson, many small business organizations struggle while measuring and evaluating the capital projects. For this reason, they largely rely on the technique of payback method as a primary method to measure and evaluate their business projects. As the small companies take the business risks very seriously, their required rate of return for risky project tends to be very high. As opined byDrake (2006),more than 75% companies in Canada employ discounted cash flow model for the assessment of their capital investments. He also mentioned that the companies use internal rate of return techniques more frequently than Net present value in the assessment of capital decisions. According toAdkins and Paxson (2014), most of the hundred-fortune companies use discounted cash flow model and
Paraphrase This Document
Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
4FINANCIAL MANAGEMENT for this reason, they use internal rate of return techniques more than net present value for the assessment of capital projects. As perLilian Chan (2004), majority portion of the companies prefer to use net present value method for capital budget decision-making model. 2. Techniques of Capital Budgeting In the process of capital budgeting, many techniques assist the organizational managers in the process of making decisions. The following discussion shows the description of some of these capital budgeting processes. 2.1 Accounting Rate of Return (ARR) and Payback Period (PBP) One of such technique isAccounting Rate of Return (ARR). ARR refers to the proportion of annual net profit average to either the net investment or the average investment in the particular project.ARR is expressed as Average Annual net profit / Initial investment or Average Investment. In most of the cases, ARR is calculated based on average investment rather than original investment. After the determination of ARR, it is compared with the desired rate of return. According to the rules, the project will be acceptable in case the calculated ARR is bigger than or equal to the desired rate of return. The next capital budgeting technique is called Payback Period (PBP). It refers to the required number of years for the recovery of initial investment by using net cash flow after tax. After the calculation of the PBP, a comparison is done between the PBP and minimum acceptable payback period that is selected arbitrarily (Hall 2012). According to the decision rule, the particular project will be accepted in case the PBP calculated is equal to or less than the selected desired period as it is better to recover the amount of initial investment in shorter time. Payback Period is expressed as Cash Outlay (Investment) / Annual Cash Inflow.
5FINANCIAL MANAGEMENT 2.2 Internal Rate of Return (IRR) and Profitability Index (PI) The next important technique for capital budgeting is calledInternal Rate of Return (IRR). IRR can be expressed as the discount rate for equaling the present value of the expected net cash inflows with an initial investment having net present value equal to zero. For selection, it is good to have higher IRR as projects having higher IRR become more profitable (Bhuller, Mogstad and Salvanes 2017). This method also considers as time value of money. It needs to be mentioned that it is tedious task to calculate the value of IRR. The next capital budgeting technique is called Profitability Index (PI) or Benefit-Cost Ratio. In the process of PI, the discounting method for future cash flows is done; after that, the process of adding up the present value is done. Then, all the present value sums are divided by the initial investment (Pasqual, Padilla and Jadotte 2013). According to the decision rule, managers should accept the project having PI of one or greater than one. PI is expressed as present value of cash inflows / initial cost outlay or net present value (benefits) / net present value (costs). 2.3 Net Present Value (NPV) The last important techniques for capita budgeting isNet Present Value (NPV). NPV is considered as most preferred as well as most popular method for capital budgeting. The calculation of NPV is done by discounting the after tax future cash flows with the use of risk- adjusted cost of capital. After that, process of adding up the present values of future cash flows is done. According to the decision rule, capital projects having zero NPV or greater than zero will be accepted (Pasqual, Padilla and Jadotte 2013). Example: YearsAmount ($) 0(300,000)
6FINANCIAL MANAGEMENT 175,000 2140,000 3125,000 4265,000 5220,000 NPV295399.90 IRR37% Table 1: Calculation of NPV and IRR In the above hypothetical situation, $ 300,000 is invested in the initial year for a particular project. From this investment, the company received certain amount of cash inflows throughout the five years. It is assumed that the discount rate is 10%. After applying the formula of NPV and IRR, it can be observed that NPV is positive and IRR is greater than 10%. As per the rules of NPV, a project will be accepted when its NPV is positive. On the other hand, the rules of IRR states that a project will be accepted when the IRR will be more than the discount rate. Thus, it can be concluded that the project will be accepted from both the perspectives of NPV and IRR. 3. Usefulness of Capital Budgeting Techniques in Wealth Creation The above discussion shows various techniques of capital budgeting. It needs to be mentioned that these techniques have their usefulness for the organizational managers in the context of wealth creation. Capital budgeting techniques help the organizational managers to set up long-term goals for the growth and prosperity of their businesses (Carr, Kolehmainen and Mitchell 2010). The ability of these techniques to appraise the investment projects helps in
Secure Best Marks with AI Grader
Need help grading? Try our AI Grader for instant feedback on your assignments.
7FINANCIAL MANAGEMENT creating framework for firms to plan their long-term directions. In addition, with the assistance of the capital budgeting techniques, organizational manages can find new investment for their business organizations that is very mush helpful in the wealth creation of the companies. Most importantly, organizational managers can make the forecast and estimation of their future cash flows with the assistance of different techniques of capital budgeting. These aspects help the managers in taking decisions regarding the acceptance of certain capital projects (Adkins and Paxson 2014). At the time of the selection of the capital projects, organizational managers are requiredtotakemanydecisionsthatrequirethetimelyflowofprojectinformation. Organizational managers can get all the necessary information about different capital projects from different capital budgeting techniques. One of the major aspects of wealth creation is to monitor and control expenditures. Capital budgeting techniques help to define the necessary expenditure for an investment project. Thus, the managers become able to identify the necessary expenses so that they can control them (Brunzell, Liljeblom and Vaihekoski 2013). Most importantly, the capital budgeting techniques assist the organizational managers in taking valuable decisions for their companies. Thus, the above discussion shows that the capital budgeting techniques have many important in the business organizations (Brief 2013). All these aspects help managers identify the aspects that are helpful for the companies in wealth creation. As a result of this, the managers are able to take decisions for wealth creation in the companies. 4. Conclusion From the above discussion, it can be seen that there are many tetchiness for capital budgeting in the companies; they are IRR, NPV, PBP, PI and ARR. However, according to the trend of last ten years literature review on capital budgeting, it can be seen that most of the companies all over the world prefer to use two techniques as their primary capital investment
8FINANCIAL MANAGEMENT decision-making technique; they are IRR and NPV. However, companies prefer to use the technique of PBP as their secondary techniques to appraise investment projects. Thus, it implies that IRR, NPV and PBP are the most popular techniques of capital budgeting. The above discussion also shows that these techniques of capital budgeting have major importance in increasing wealth in the companies. The capital budgeting techniques help the organizational managers in providing important information regarding various capital projects so that they can be helpful in wealth creation. In addition, these techniques assist the managers in setting long- term goals of their companies. Apart from this, the estimation and projection of future cash flows are two of the major contributions of capital budgeting techniques that lead to wealth creation.
9FINANCIAL MANAGEMENT References Adkins, R. and Paxson, D., 2014. Stochastic equipment capital budgeting with technological progress.European Financial Management,20(5), pp.1031-1049. Bennouna, K., Meredith, G.G. and Marchant, T., 2010. Improved capital budgeting decision making: evidence from Canada.Management decision,48(2), pp.225-247. Bhuller, M., Mogstad, M. and Salvanes, K.G., 2017. Life-cycle earnings, education premiums, and internal rates of return.Journal of Labor Economics,35(4), pp.993-1030. Brunzell, T., Liljeblom, E. and Vaihekoski, M., 2013. Determinants of capital budgeting methods and hurdle rates in Nordic firms.Accounting & Finance,53(1), pp.85-110. Carr, C., Kolehmainen, K. and Mitchell, F., 2010. Strategic investment decision making practices: A contextual approach.Management Accounting Research,21(3), pp.167-184. Denison, C.A., 2009. Real options and escalation of commitment: A behavioral analysis of capital investment decisions.The accounting review,84(1), pp.133-155. Drake, P.P., Capital budgeting techniques.Online (datum poslednĂ revize: 29.6. 2006): www. fau. edu/~ ppeter/fin3403/module6/capbudtech. pdf. Froot, K.A. and Stein, J.C., 1998. Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach.Journal of financial economics,47(1), pp.55-82. Hall, J.H., 2012. An analysis of capital budgeting methods, the cost of capital and decision- makers in listed South African firms.Corporate Ownership & Control,9(4), pp.381-390.
Paraphrase This Document
Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
10FINANCIAL MANAGEMENT Kester, G.W. and Chang, R.P., 1999. CAPITAL BUDGETING PRACTICES IN THE ASIA- PACIFIC REGION: AUSTRALIA, HONG KONG, INDONESIA,...Financial Practice and Education,9(1), pp.25-33. Lilian Chan, Y.C., 2004. Use of capital budgeting techniques and an analytic approach to capital investment decisions in Canadian municipal governments.Public Budgeting & Finance,24(2), pp.40-58. Lundholm, R. and O'keefe, T., 2001. Reconciling value estimates from the discounted cash flow model and the residual income model.Contemporary Accounting Research,18(2), pp.311-335. Okoruwa, A., Cox, A.T. and Thompson, A.F., Three Treatments of Debt Financing for Capital Budgeting Decisions.Appraisal J,62, pp.189-96. Pasqual, J., Padilla, E. and Jadotte, E., 2013. Equivalence of different profitability criteria with the net present value.International Journal of Production Economics,142(1), pp.205-210. Pasqual, J., Padilla, E. and Jadotte, E., 2013. Equivalence of different profitability criteria with the net present value.International Journal of Production Economics,142(1), pp.205-210.
11FINANCIAL MANAGEMENT Part B 1. Summary of Recent Trend of Literature and Direction in Capital Budgeting Efficient Market Hypothesis (EMH) is a financial market theory developed in the year of 1960. According to the theory of EMH, in the liquid market at any point of time, the prices of securities fully reflect all available information about them. Considering the importance of the theory of EMH, many researchers have been done on them. Some of them have different findings and some of them have similar findings. According toJordan (1983), based on the thesis paper he concluded that the prices of stock is highly unpredictable and they followed a random walk. This is considered as one of the major findings in EMH. The same writer also states that the financial market is called efficient when the prices of the shares and securities fully reflect the available information. The findings ofFama and French (1997)support the above findings. According to this finding, a large number of shares have random walk and they do not show any sign of predictability. In this context, it needs to be mentioned that the results of many early researches on the subject of EMH shows the signs of weak predictability. Thus, it can be seen that it is highly impossible to predict the prices of shares in the market. As opined byFama (1991), the prices of shares in the share market fluctuate on a highly random basis. This particular aspect indicates a random walk in the share prices in the share market and they are inconsistent in the rational market. According to the findings ofRao (2017), this un-predictive nature of the share prices lead to weak form of market efficiency. According to this finding, to some extent, one can predict the share prices of next period from the share prices of current period. For this reason, in case a market was efficient in the past period, it will not able to provide any help to predict the share prices of the future period. According to the findings ofLo
12FINANCIAL MANAGEMENT (2007), the weak form ofEMH states that all the past prices or the past history about the share prices fully reflect all the information about prices of securities. In this context, an immediate implication is the version of EMH with the help of charting and technical analysis does not have any impact on the companies for making abnormal profit. According to the findings ofLim (2006), business organizations play an integral part to affect the efficiency of information of the share prices. After the examination of the NYSE listed stocks, it was found that the stocks having greater institutional ownership were priced on more efficient basis and they followed the random walkmoreclosely.AsopinedbyShiller(2003),inthepresenceofpoorinformation environment, it is difficult for the investors to predict the share prices. According to the findings ofStassen (2009), efficient market has the capacity to paralyze the investors. As the stock market is highly competitive, the investors will be able to earn more money in the presence of superior information or insight. 2. Is EMH Testable? In the discussion of EMH, one important factor is whether it is possible to test EMH or not. For this reason, there have been many studies on the testing of EMH. According toStassen (2009), there is a particular way for the testing ofEMH without having the problem of low power. For the testing of EMH, two approaches have been considered for the testing of EMH in the shorter horizon. A simple variance analysis shows that it is possible to predict the future dividends in the presence of moving average of earnings. This particular aspect also shows the fact that this particular model is an effective model for the testing of EMH. It needs to be mentioned that sometimes it become difficult to observe the financial data and it is required to provide more importance on the robustness of financial data (Hamidet al.2017). However, there is a small loophole in this model of EMH testing and that is the lack of long and stable moving
Secure Best Marks with AI Grader
Need help grading? Try our AI Grader for instant feedback on your assignments.
13FINANCIAL MANAGEMENT average. Apart from this model, there is another model available for the testing of EMH. It is the NPV valuation model for the testing of EMH. In this context, in case the NPV valuation model of true and correct, the model’s share prices and dividends of the shares should co-integrate. However, there is a possibility of failing this method of EMH testing in the absence of longer and stable time series. From the findings of this research, it can be seen that it becomes possible to test EMH more effectively in the presence of relative share indices. For the testing of EMH, it is required to mention the example of the merger between Royal Dutch and Shell in the year of 2005 (Kristoufek and Vosvrda 2013). After the merger of these two companies, they issued new shares based on 60/40 ratio in the favor of Royal Dutch shareholders and they kept two shares apart from trading. In this process, the large and persisting derivates from the relationship can take place even though the ratios of the share prices should stay in the ratio of 3:2. From these types of cases, it can be seen that there is clear proof of market inefficiencies, but there is not any explanation of their existence. There are many other researches done for the testing of EMH. According toStassen (2009), for the smaller cap organization, it is required to use the technique of autocorrelation for the testing ofEMH. According to these findings, it can be seen that it is easy to predict the variance in return than other returns. The time varying equilibrium is the main reason for the predictability of the share prices. Thus, from the above discussion, it can be seen that there are many ways for the testing of EMH. Findings of different researches show various techniques of the testing of EMH. 3. Is it possible for an investor to make excess return consistently? The above discussion shows that it is not possible to predict the future prices of stocks in the share market due to the volatility in the stock prices. However, in the presence of some techniques, it is possible for the investors to make excess return on a constant basis. The first
14FINANCIAL MANAGEMENT technique is dump luck. In this process, the investors invest in the stocks of the companies based on the advices of some barkers or article of the companies in the newspaper or others. In this particular process, the investors are able to fetch high return on a constant basis. After that, the investors are able to make constant excess return by combing market index with the cash investments or borrowings (Degutis and Novickyte 2014). The main basis of this technique is a theory that states that market portfolio in the most efficient portfolio depends on the risk and expected returns. For this reason, this technique have strong theoretical base and has many empirical support. The major advantage of this technique is that it helps the investors in gaining higher return on a long-term basis. Another technique for gaining excess return for long-term basis is to add more risks (eml.berkeley.edu 2017). There is a misconception among the investors that more amount of risks lead to higher amount of return. Out of this concept, the investors start investing in the firms having higher risks. It has been seen that many times the investors end up by getting higher return for a long time. The next process is charting and momentum techniques. This process is based on the prediction of the movements of the market and the individual stocks in the short as well as long-term basis. The main advantage of this technique is that this method is extremely useful in fetching high amount of return on long-term basis (Lee, Tsong and Lee 2014). 4. Conclusion From the above discussion, it can be observed that EMH is considered as an important aspect for the business organizations as well as investors. Many researchers have found different important aspects about EMH. The above discussion shows that in the theory of EMH, it is not possible for the investors and companies to predict the future price of the stocks due to its high un-predictive nature. In addition, it can also be seen that the result of many researchers found the
15FINANCIAL MANAGEMENT weak form of market predictability. It can also be seen that the perfect market reflects all the information about the stock prices. The above study also shows that there are many ways to test EMH. One of such technique is called the variance analysis. With the help of variance analysis, the investors are able to analyze various aspects of EMH. From the above analysis, it can also be observed that certain techniques help the investors to gain higher returns for long time. Some of these techniques are dump luck, investing in high-risk securities and others.
Paraphrase This Document
Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
16FINANCIAL MANAGEMENT References Degutis, A. and Novickyte, L., 2014. The efficient market hypothesis: a critical review of literature and methodology.Ekonomika,93(2), p.7. Degutis, A. and Novickyte, L., 2014. The efficient market hypothesis: a critical review of literature and methodology.Ekonomika,93(2), p.7.. Fama,E.F.andFrench,K.R.,1997.Industrycostsofequity.Journaloffinancial economics,43(2), pp.153-193. Fama, E.F., 1991. Efficient capital markets: II.The journal of finance,46(5), pp.1575-1617. Hamid, K., Suleman, M.T., Ali Shah, S.Z., Akash, I. and Shahid, R., 2017. Testing the weak form of efficient market hypothesis: Empirical evidence from Asia-Pacific markets. Hamid, K., Suleman, M.T., Ali Shah, S.Z., Akash, I. and Shahid, R., 2017. Testing the weak form of efficient market hypothesis: Empirical evidence from Asia-Pacific markets. Jordan,J.S.,1983.Ontheefficientmarketshypothesis.Econometrica:Journalofthe Econometric Society, pp.1325-1343. Journal Of Economic Perspectives—Volume 17, Number 1—Winter 2003—Pages 5 (2017).The EfficientMarketHypothesisandItsCriticsŽ.[online]eml.berkeley.edu.Availableat: https://eml.berkeley.edu/~craine/EconH195/Fall_14/webpage/Malkiel_Efficient%20Mkts.pdf [Accessed 28 Dec. 2017]. Kristoufek, L. and Vosvrda, M., 2013. Measuring capital market efficiency: Global and local correlations structure.Physica A: Statistical Mechanics and its Applications,392(1), pp.184-193.
17FINANCIAL MANAGEMENT Lee, C.C., Tsong, C.C. and Lee, C.F., 2014. Testing for the efficient market hypothesis in stock prices:Internationalevidencefromnonlinearheterogeneouspanels.Macroeconomic Dynamics,18(4), pp.943-958. Lim, K.G., 2006. EFFICIENT MARKETS HYPOTHESIS. Lo, A.W., 2007. Efficient markets hypothesis. Poshakwale, S., 1996. Evidence on weak form efficiency and day of the week effect in the Indian stock market.Finance India,10(3), pp.605-616. Rao, A., 2017. A Theory of Market Efficiency.arXiv preprint arXiv:1702.03290. Shiller,R.J.,2003.Fromefficientmarketstheorytobehavioralfinance.TheJournalof Economic Perspectives,17(1), pp.83-104. Stassen, C.E., 2009.Testing the Efficient Market Hypothesis(Doctoral dissertation, Master Thesis at the Department of Economics, University of Copenhagen).