Strategic Financial Management

Chapter III

Valuing Real Assets in the Presence of Risk

After reading this chapter, you will be conversant with: Tracking Portfolios and Real Asset Valuation Different Approaches of Valuing Real Assets Capital Budgeting and Strategic Policy

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Strategic Financial Management

TRACKING PORTFOLIOS AND REAL ASSET VALUATION

The discounted cash flow method in valuation process is actually based on the platform of tracking portfolio approach1. This particular approach applies well to the risk less cash flows but in case of risky projects it encounters certain problems. The portfolio that is capable in perfectly tracking the cash flows of risky projects exists only in certain cases. As in most of the cases, there exists some tracking error which is basically the difference between the cash flows of the tracking portfolios and the cash flows of the projects. So valuing the projects in these cases calls for a theory that best describes how to generate the tracking portfolios for which the present value of the tracking error is zero. The tracking portfolio approach is one such way by which this can be accomplished.

Asset Pricing Models and the Tracking Portfolio Approach

The use of this approach is relevant for valuation when the present value of the tracking error is zero. This is possible only when the tracking error consists entirely of unsystematic or firm specific risks. It is to be always remembered that when a tracking error with zero systematic risk and zero expected value is generated by a tracking portfolio for the future cash flows of a project, the market value for the tracking portfolio is the present value of the projects future cash flows.

Implementing the Approach

Identifying the tracking portfolio that is mean variant efficient makes the valuation task much simpler. It does not call for the expected return of the market, the riskfree return or even the expected cash flows for the computation of the present cash flows. But it becomes very difficult to estimate the correct investment without estimating the expected future cash flows and the expected return of the market portfolios. Estimating a tracking portfolio without the knowledge of expected returns or the expected cash flows can be done in several ways. One such way is when there is perfect or almost perfect tracking. In these cases the tracking error is zero or very close to zero, which makes the approach superior to the CAPM and the APT methods. Another way of estimating the tracking portfolio is by using the market portfolio or factor portfolios. Actually the use of the market portfolios combined with risk-free assets is needed due to the presence of the tracking error. Table 3.1: Examples of Companies that Issued Tracking Stock to Separate an Existing Division Year 1991 1995 1996 Company USX Genzyme Corporation Tele-Communications Inc (TCI) Division Marathon Group (oil) Stock Steel Group Stock Tissue Repair Group Stock Liberty Media Group Stock separated media business from other business CarMax stock separated new and used car business from electronics business Timber stock separated timber business from manufacturing business

1997

Circuit City

1997

Georgia-Pacific

A stock issued by a parent company to create a financial vehicle to track the performance of a particular division or subsidiary.

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Valuing Real Assets in the Presence of Risk

Year 1998

Company Applera Corporation

Division Biosystems stock separated its genomics division from life sciences division Rainbow Media Group stock separated film and music business from content business MCI group stock - separated the long distance telecom and dial-up internet businesses from voice, data and international services

2001

Cablevision

2001

WorldCom

Source: ICFAI Reader, June 2002. Table 3.2: Examples of Companies that Issued Tracking Stock While Acquiring Other Businesses Year 1984 1985 1996 Issuing Company General Motors General Motors TCI/Viacom Acquired Company Electronic Data Systems Hughes Aircraft Company A cable subsidiary

1999 AT&T TCI Source: Outline Tracking Stock by Dickson G Brown and Jonathan Cantor, 2001, www.stblaw.com

Risk Adjusted Discount Rate Method (RADR)

One of the popular ways of estimating the present value of the future cash flows is by the use of the discount rate method. The rate at which the future cash flows are discounted is actually the projects cost of capital. The method is generally used in case where there is a comparison firm or set of firms in the same line of business as the project. Calculation of the net present value of the future periods cash flows using the risk adjusted discount rate can be done using the following formula: PV = E (cf)/{1 + rf + beta (RT rf )} Where, E (cf) denotes expected future cash flows in the next period Beta denotes the beta of the return of the project rf denotes the risk-free return RT denotes the expected return of the tangency portfolio.

Using the Cost of Capital to Value a Non-Traded Subsidiary

Company A, a wholly owned subsidiary of company B, has a beta of 1.3 when computed against the tangency portfolio. The tangency portfolio has an expected return of 20% per year. The risk-free rate is 8%. The expected value per share of A one year hence is Rs.12. As per the above formula the companys present value of the share assuming no dividend payment is: 12 / [1 + 0.08 + 1.3 (0.20 0.08)] = 9.70 In case of the traded securities, the comparison approach is used in identifying the betas of the stocks. This is done by estimating the betas of the traded stocks of the similar firms in the industry using some average of their betas as a representative of the subsidiary companys beta. In fact this comparison approach assumes that the present value is not negative or zero. 26

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The Effect of Leverage on Comparison

It is important to note that the beta risk of the equity of the comparison firms is truly comparable. Further it has been seen that the debt financing in firms has an impact on the equity betas, so it is also important to make a proper adjustment regarding these beta risk comparisons. This beta can be very well used to compute the risk adjusted discount rates (RADR) for the individual projects. This is most suitable in cases where firms stocks are widely traded and the chances of bankruptcy are minimum.

Using Beta to Estimate the Cost of Capital in all Equity Firms

While estimating the cost of capital in an all equity firm the capital asset pricing model (CAPM) can be used. The firms cost of capital is the minimum rate of return that the firms investors require. So for an all equity firm the firms cost of capital is its minimum rate of return that the stockholders require. Using the CAPM framework the minimum expected rate of return required from stock a, will be Ra = r + (Rm r) ba Where, Ra denotes the minimum expected rate of return required from stock a r denotes risk less interest rate Rm denotes market portfolios expected rate of return ba denotes the beta of stock a Now as Ra is the minimum expected rate of return required from stock a, and the firm is an all equity firm, it can be used as the firms cost of equity. Now if one denotes the cost of capital by k, and the beta of the firm by b, the above equation looks like: k = r + (Rm r) b Example Stock Holders Corporation, an all equity firm, is considering a new project with a perpetual cash flow. The initial outlay of the project is Rs.1,00,000, and the beta of the project is 4. The market portfolios expected rate of return is 14%, and the risk less interest rate is 3%. The projects minimum rate of return is: k = 3% + (14% 3%)4 = 47%

Debt and Equity Financing

Debt financing, also termed as financial leverage, tries to distinguish between the cost of equity ke, and the financial cost of capital denoted by k. First we will take into account of a situation where no corporate taxes are present. It can be found out that the firms cost of capital is actually the weighted average of the specific costs of the debt and the equity, where the weights are the proportions of the debt and equity of the firms total financing. The Weighted Average Cost of Capital (WACC) can be represented as: WACC = weke + wdkd Where, WACC denotes the weighted average cost of capital of the firm we denotes the proportion of equity financing wd denotes the proportion of debt financing ke denotes the cost of equity kd denotes the cost of debt. 27

Valuing Real Assets in the Presence of Risk

Here it is assumed that all the projects have the same level of risk. Thus it can also be said that the WACC is equal to the projects cost of capital (pcc) as well as the firms cost of capital (fcc). The cost of debt is usually lower than the cost of equity. So it is logical for a firm to increase on the level of debt financing and thereby reducing its WACC. But as a practice it is not so. With the increase in debt financing, the stockholders risk increases as the firms have to commit to larger future repayments of debt. This results in the cost of equity to increase which in turn may increase the WACC in spite of using the cheaper debt financing. So the firm always seeks for that debt equity mix that minimizes the WACC. Since the issue of equity every year may prove expensive to the firm it may think of spacing its issues. Say when the interest rate is relatively high the firm may decide to issue stock and wait for the interest rate to decline before it goes on for issuing bonds. At the same time even for a firm that is fully financed by debt, it is advisable for the firm to use the WACC as its discount rate. So, discounting all the projects by the WACC avoids the arbitrary decisions based solely on how the firm finances its projects. Now let us take into account of the situation where there is existence of taxes. This is a more realistic aspect as taxes do exist, and only the after tax cost of capital is relevant. The firms after tax cost of capital can be calculated using the following formula: k = fcc = WACC = weke + wd (1 T) r Where, (1T) r denotes the after tax cost of debt k d. So the above equation can be written as: k = fcc = WACC = weke + wdkd Further the after tax cost of equity can be calculated as: ke= [(1 T) (X rB)]/EL Where, ke denotes the cost of equity T denotes the tax rate X denotes the expected annual pre-tax cash flows r denotes the interest rate B denotes the amount of debt financing used And the after tax cost of debt can be calculated as: kd= (1 T) r The notations remain unchanged. Distinguishing the Risk-free Debt from the Default-free Debt There can be two sources of risks that can be associated with debt. One form is the interest rate risk which is associated with the general changes in the long-term interest rates, and the other is the credit risk that is associated with the possibility of default. The risk-free debts are necessarily short termed; this is true because it cannot have its value changed by the long-term interest rates. The short-term default-free debts tend to have a beta near to zero. Here it is important to mention that the risk-free debt is always a default-free debt but the converse may not always be true.

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Cost of Equity, Cost of Debt and the Cost of Capital as a Function of Leverage As long as the firms debt is default-free, the cost of equity capital increases linearly in the firms leverage ratio. But when the firm is burdened with extreme debt, the expected return on the risky debt rises as the debt-equity ratio increases. Now as the debtholders share a part of this risk, the cost of equity rises slower than the debt-equity ratio as compared with default-free debt. The following figure best describes the situation. Figure 3.1: Functions of Leverage
Expect ed Return

Figure a.

rE

rA rD

No default Leverage ratios

Defaul t possib

Computation of the Cost of Capital Using the Dividend Discount Models

Though the capital asset pricing model and the arbitrage price theory model are the most widely used theories in determining the risk adjusted discount rates (RADR), there are certain problems that arise out of these two methods. In case of the application of the CAPM, it is essential to know the value of the covariance of the return of the investment with the return of the market portfolio along with the estimation of the expected return of the market portfolio. On the other hand, the APT requires multiple factors and their corresponding expected returns on multiple factor portfolios. So in order to overcome these shortcomings, the dividend discount model provides a better approach.

The Dividend Discount Model

The dividend discount model takes into account the expected future earnings in order to determine the required rate of return. This brings into the application of the Gordon Growth Model that considers the equity of a firm with a dividend stream growing at a constant rate. The following equation explains the way it can be done: So= dividend1/(rE g) Where, So denotes the current price of the stock dividend1 denotes the expected dividend of the share in one years time rE denotes the market rate of return of the firms stock g denotes the expected growth rate in the dividends of the share.

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Valuing Real Assets in the Presence of Risk

Using the Plowback Ratio Formula to Estimate the Expected Dividend Growth Rate From the above formula the expected growth in the dividend can be easily estimated. This is actually using the analyst forecast in the growth rate estimation. This approach assumes that the firm pays out a fixed percentage of earnings as dividends. The expected growth rate in the dividends equals the forecasted growth rate in the earnings. This growth rate can then be added to the existing dividend in order to get the expected return on the firms stock. Well, there is an alternative way of computing this growth rate g, by the use of the plowback ratio formula. This can be done by the use of the following formula: g = (b) x (ROE) Where, b denotes the plowback ratio ROE denotes the book return on equity and g denotes the growth rate of the dividends In this case it is assumed that the book return on the equity represents the growth of the capital invested in the firm. Here it is to be mentioned that the constant paying of dividends out of the companys earnings may result in slowing down the companys growth rate. But at the same time, as the earnings and dividends are a constant proportion of the amount that has been reinvested, the growth rate will remain to be the same as the growth rates of the funds available for the investment in the firm. Drawbacks of the Dividend Discount Model The DCM calls for the use of the book return on equity in place of the return on new investments, but in practice this is much more difficult to calculate. Now if there is a difference in the returns of the new assets and the old assets, the ROE should be the return on the new asset investments. In this case if the project has a positive value of NPV, then the more suitable book return on the equity may exceed the firms cost of capital. Further the DCM is based on certain assumptions. Keeping in mind that these assumptions hold good, this approach may provide with a better understanding and estimate of the expected rate of return of the firms stock price than that can be estimated with the CAPM or the APT. Some of these assumptions are: The expected earnings growth is unbiased. The growth forecast takes into account of the available information that the investors possess. The rates at which the firms earnings and the dividends grow are the same. Box 3.1: What If No Pure Comparison Firm Exists? Many firms are large diversified entities that have many lines of business. In this instance, the equity returns of potential comparison firms are distorted by other lines of business and cannot easily be used as comparison firms for projects that represent only a single line of business. Unfortunately, in many situations, there is no appropriate comparison firm with a single line of business. A financial manager in this situation still may be able to obtain an appropriate comparison by forming portfolios of firms that generate a "pure" line of business. Example Finding a Comparison Firm from a Portfolio of Firms Assume that AOL-Time Warner is interested in acquiring the ABC television network from Disney. It has estimated the expected incremental future cash flows from acquiring ABC and desires an appropriate beta in order to compute a 30

Strategic Financial Management

discount rate to value those cash flows. However, the two major networks that are most comparable, NBC and CBS, are owned by General Electric and Viacom - respectively - which have substantial cash flows from other sources. For these comparison firms, the table below presents hypothetical equity betas, debt to asset ratios, and the ratios of the market values of the network assets to all assets: E General Electric 1.1 D D+E 0.1 Network Assets N = All Assets A 0.25

Viacom 1.3 0.4 0.50 Estimate the appropriate beta for the ABC acquisition. Assume that the debt of each of the two comparison firms is risk-free. Also assume that the non-network assets of General Electric and Viacom are substantially similar and thus have the same beta. Answer: Using equation = [E/(D + E)]first find the asset betas of the two comparison firms. For the two firms, these are, respectively, A General Electric 0.99 = (0.9)(1.1) Viacom 0.78 = (0.6) (1.3) Viewing the comparison firms as portfolios of network and non-network assets, and recognizing that the beta of a portfolio is a portfolio-weighted average of the betas of the portfolio components, implies the following equation. A = N AN x (network assets beta) + x (non-network assets beta) A A

For the two comparison firms this equation is represented as General Electric: 0.99 = (0.25) NETWORK+ (0.75) NON-NETWORK Viacom : 0.78 = (0.5) NETWORK + (0.5) NON-NETWORK Multiplying both sides of the second equation (Viacom) by 1.5, subtracting it from the first equation (General Electric), and solving for NETWORK yields NETWORK = 0.36, which is used for the ABC acquisition. The procedure used in the above example is based on the idea that portfolio betas are portfolio-weighted averages of the betas of individual securities. If we view firms with multiple lines of business as portfolios of lines of business, it may be possible to infer the betas of the individual lines of business by solving systems of linear equations. When valuing a potential acquisition, it may be possible to identify an appropriate comparison portfolio using accounting numbers. For example, regression coefficients from a regression of the historical sales numbers of the acquisition target on the comparable sales figures of a group of tracking firms generate a portfolio of these tracking firms that best track the historical sales figure of the acquisition target. If one thought that the critical accounting value to target was an equal weighting of sales, earnings, assets, and book/market ratio, then regressing this equal weighting of the historical accounting numbers from the target firm on the historical values from an equal weighting of the accounting numbers from a group of tracking firms would also generate an appropriate weighting of these tracking firms. Such a portfolio is the one that, in a statistical sense, has best tracked the acquisition in the relevant accounting dimensions.

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Valuing Real Assets in the Presence of Risk

Pitfalls Using the Comparison Method There are several pitfalls in using the comparison approach for portfolio valuation. Some of them are cited below. Difference in Project Beta and Firm Beta Generally firms use their own cost of capital as a discount rate for evaluating specific investment projects. But in most cases such an approach may be inappropriate. New projects may have a higher project risk than the firms more mature projects. This may be the case when the project is in its early years and incurs a lot of R&D expenditure. On the other hand, a project may be less risky than the firms existing projects which may be due to a lower cost of capital for the project than that experienced by the firm. But as a matter of fact, a firms market value is determined by both its existing projects and on the expectations of how a firm can develop new profitable projects. Growth Opportunities are Usually the Source of High Betas As stated earlier a firms value is seen from the angle of how it can go on in developing newer projects. This is more commonly referred to as growth opportunities or growth options. Growth options have an implicit leverage that leads to an increase in the beta, thus they contain a fair amount of systematic risk in them. So it can be said that the individual projects can differ in their risks from the firm as a whole because they lack the growth options that are inherent in the firms stock prices. Multiperiod Risk Adjusted Discount Rates In this approach the equity beta from the comparison firm is calculated using the historical data. Then the expected return is computed with the help of risk expected return formula using either the CAPM or the APT. The post-tax cost of capital is then calculated. Finally, the cost of capital is used as a single discount rate for each period. Drawbacks in Using the Approach Though it may apparently appear that the use of a single discount rate for the multiple future cash flows is easier, but actually there may be several drawbacks in using the approach. The use of a single discount rate may not result in the proper valuation of the cash flows. This is even more predominant in case of risky cash flows. Say there is a particular bond that matures in five years time has a rate of 5% attached to it, then the bond cash flow at the end of year five is to be discounted at this particular rate. Say, on the other hand, another bond that matures in ten years time has a coupon attached as 10%. So the cash flow of the bond at the end of ten years has to be discounted at this rate only. Now assume a single rate of discount of 8% is used in both the cases. This would result in the undervaluation of the near term cash flows and overvaluation of the future term cash flows. There is an interesting argument that often comes up while deciding upon whether to take the long-term risk-free rate or the short-term, while using the capital asset pricing model or the arbitrage price theory risk expected return relation. Now as a matter of fact there is no practical basis to select a short-term risk-free rate over a long-term risk-free rate or vice versa. In practice, the beta of certain cash flows, which is measured over long-term horizons, is zero and the risk-free rate is the long-term risk less rate. At the same time, if the authenticity of the CAPM is taken into account, then it is proper to consider certain long-term cash flows with shortterm risk less bonds and the market portfolio. It is also important to note that while considering short-term intervals of time, the value of certain cash flows as well as the market portfolio tends to decrease with the increase in the expected inflation. This may result in the cash flows to have a positive beta while measured against the short-term beta of the market portfolio. Though theoretically correct, the short-term CAPM method of valuing a risk-free long-term cash flow has a 32

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certain amount of tracking error. So in order to completely avoid the tracking error that might exist in the process it is always preferable to use the long-term risk-free bond as the only instrument in tracking portfolio for any long-term risk less cash flow and not use the CAPM based approach under any circumstance. Now let us focus on the dependence of the beta on the chosen time-frame of the cash flows. As a general practice, while implementing the risk adjusted discount rate method, the same value of beta is used irrespective of the different cash flows in the cash flow streams. But following this approach may lead to serious valuation errors. The price of the comparison stocks acts as a representative of the cash flow streams. But what happens if the cash flow pattern of the comparison firms does not match with the streams of the cash flows that are being valued. This may result in the beta risk of the comparison firms not providing an appropriate discount rate for the project though there is no rule of thumb as to how the betas may vary with the cash flow horizons. In some cases it might happen that the initial cash flows are comparatively safe, but the future cash flows depend on the market returns. In such cases it is better to use the lower discount rates for the short-term horizon cash flows. On the other hand, it may also happen that the longterm cash flows have less of undiversifiable risk than the similar cash flows of short-term horizons due to many cash flows having a high correlation with the returns of the traded securities.

The Scenario Analysis

This is another technique that can be used to assess the risk of an investment project. This approach involves the simultaneous changes in the key variables, and their impact on the project. While using the approach, the various estimates of the projects net present value is called for. This might involve both the optimistic as well as the most pessimistic estimates of the projects value. The former may be defined in terms of the most optimistic values of each of the input variables whereas the pessimistic scenario can be explained as the pessimistic values of the inputs used in the project. Further there will also be the existence of the probabilities of these different situations of the project. Outcome Pessimistic Most likely Net Present Value (NPV) (15,00,000) 10,00,000 Probability (p) 0.20 0.60 0.20

Optimistic 12,00,000 The net present value of the project can be calculated as follows:

NPV = 0.20(15,00,000) + 0.60(10,00,000) + 0.20(12,00,000) = 5,40,000 Now the standard deviation of the variable, that is, the net present value is: Sigma = [(15 5.4)20.20 + (10 5.4)20.60 + (12 5.4)20.20]0.5 = 6,31,189 Now the expected NPV of the project is 5,40,000. The probability of the project having a negative present value can be calculated as z = (0 NPV)/sigma = (0 5.4 lakh)/6.31189 = 0.8555 Now, from the table, it can be found that the probability of the value less than 0.08 standard deviation from the mean is around 46%. This implies that there is a 46% chance that the project will have a negative probability. Advantages of the Risk-Free Scenario Method In the risk-free scenario, the investors expect the stocks to appreciate at the given risk-free rate. In a moderately pessimistic scenario, the manager finds it easier in estimating the future cash flows of the project than in estimating the expected value over all scenarios.

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Valuing Real Assets in the Presence of Risk

The Certainty Equivalent Approach In contrast to the RADR approach that involves the adjustments made in the denominator of the NPV equation, this approach deals with adjusting the numerator of the equation. In other words, the CE cash flows are discounted at the risk-free interest rates rather than at risk adjusted discount rates that are done in the case of RADR approach. The certainty equivalent factor (CE) is actually the amount of cash that someone would require with certainty at a point of time which will make him indifferent between that certain amount and an amount expected to be received with risk at that same point of time. Here the risk-free rate and not the firms cost of capital are used as a discount rate for the estimation of the net present value. This is mainly done because the companys cost of capital is a risky rate, that reflects the firms average risk and using this rate may result in double counting of the risk. It is to be kept in mind that the certainty equivalents range from 0 to 1.0 and the higher the factor the more certain is the expected cash flow. The CE can be computed in the following way: t= (certain returns/risky returns) Further the net present value can be calculated as: NPV = NIV(o) + (NCFtt)/(1 + rf)t Where, o denotes the CE factor associated with the net initial investment t denotes the economic life of the project t denotes the CE factor associated with the net cash flows at each period of time t rf denotes the risk-free rate Now let us take an example. Year 0 1 2 3 4 5 Expected NCF (Rs.) (8,000) 6,000 5,000 10,000 7,000 3,000 CE factor () 1.0 0.9 0.8 0.7 0.6 0.5 CE cash flows (8,000) 5,400 4,000 7,000 4,200 1,500 PVIF0.08t 1.00 0.926 0.857 0.794 0.735 0.681 Present value cash flows (8,000) 5000.4 3428 5558 3087 1021.5 CE = 10094.9 Discussion of the Problem Let us consider the certainty equivalent cash flow for the year 1, the CE cash flow is calculated as Rs.5,400 which implies that the decision maker is indifferent between receiving the promised risky 6,000 a year from now or receiving 5,400 with certainty at the same time. The CE cash flows at the end of each year are calculated by multiplying the expected net cash flows with the CE factor. The riskfree rate taken in the above problem is 8%. Advantages of the Approach Each periods cash flow can be adjusted separately to account for the specific risk of those cash flows. The approach provides a clear basis for making decisions, because the decision makers can introduce their own risk preference directly into the analysis.

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The APT and the Certainty Equivalent Method The certainty equivalent in one factor APT can be calculated as follows: E(C) (1b1+ 2b2+ 3b3) Where, E(C) denotes the expected future cash flows b denotes the factor loading of the future cash flows denotes the risk premium of the factor Further the CE net present value can be calculated as: PV = [E(C) (1b1+ 2b2++ 3b3)]/(1+rf) Where, rf denotes the risk-free rate at which the cash flows are discounted. Implementing the Risk-free Scenario Method in a Multiperiod Setting Let us assume that the yields on one year, five year and ten year risk-free zero coupon bonds are respectively 5, 6, and 7 percent. Now in order to estimate the present value of the future three cash flows, it is important to estimate the cash flows occurring at the end of these three years. Take year one into account. In a risk-free situation say all the assets, along with the dividends, are reinvested at the end of year one. Now these are expected to grow by a 5% level given that the one year risk-free rate is 5%. Now suppose that the security is trading at Rs.100, then at the end of year one it will trade at Rs.105, given that the risk-free rate is 5%. Similarly over a period of five years the stock will trade at Rs.133.82, given that the stock appreciates at the five year risk-free rate, 6% per year. In ten years time the stock will trade at Rs.196.72, if it appreciates at the 10-year risk-free rate, 7% per year. It is assumed that the companys manager believes that the operating system is expected to generate a cash equal to 10 million times than the stock price of the firm. Thus the stock is expected to generate Rs.1.05 billion at the end of year 1, if the stock with dividend is reinvested it is then selling at Rs.105 per share, Rs.1.3382 billion at the end of year 5 if the stock sells for Rs.133.82 at that point, and Rs.1.9672 billion at the end of year 10 if the stock sells for Rs.196.72 at that point. Numerically it can be written as: PV = Rs.1.05/1.05 + Rs.1.3382/(1.06)5 + Rs.1.9672/(1.07)10 = Rs.3 billion. Certainty Equivalents from Prices in Financial Markets In certain conditions the prices from the financial markets can be used to project the future cash flows. It is a common practice to estimate the future spot prices of the different currencies and the commodities using the forward prices. Whenever there is the availability of the forward prices for estimating the future cash flows it is preferable to use the certainty equivalent method. Such forward prices conveniently translate the data from the risky cash flows to the risk-free cash flows.

Capital Rationing
Certain firms develop capital budgets based on a predetermined availability of investment funds. Capital rationing is used to describe such a situation and the process may involve modification of internal budgeting procedures so that the projects that are selected collectively add value to the market value of the company. Let us introduce the concept of profitability index in the following example. 35

Valuing Real Assets in the Presence of Risk

Project A B C D

Initial investment (000) 5 12 7 4

PV cash inflows (000) 8 15 10 7

NPV (000) 3 3 3 3 60

Profitability index, PI 1.6 1.25 1.43 1.75 3.0

E 30 90 The profitability index is actually calculated as: PI = PVcash inflows/PVcash outflows

The profitability index actually measures the projects contribution to the market value of the company per rupee of the capital invested in that project. Now based on the above PI the projects can be ranked and decision can be taken on which one of their combinations should be selected. Project E D A C PI 3.0 1.75 1.6 1.43 Initial investment (000) 30 4 5 7 NPV (000) 60 3 3 3 Cumulative investments (000) 30 34 39 46 Cumulative NPV (000) 60 63 66 69

So it can be said that with a budget of 1,00,000 one can invest in four projects, namely E, D, A and C with a total value addition of Rs.69,000. Though the capital rationing seems to be a practical approach in project appraisal, it is at the same time not devoid of certain shortcomings. These may include the situations in which the capital budgeting constraints may creep up in future years and in cases where the projects may be mutually exclusive. On the whole it may seem that capital rationing is a sensible way of discouraging the divisional and the product line managers from submitting the net present value analysis that is based on an optimistic cash flow forecast. But at the same time it is important to note that there is the existence of opportunistic costs associated with the capital rationing. These costs result due to not truly undertaking the positive NPV projects.

CAPITAL BUDGETING AND THE STRATEGIC POLICY

The strategic policy of a company describes the mission of the company and the way by which the company plans to achieve that mission, subject to the firms market, political and the cultural environment. These strategies actually call for high amount of capital expenditures. The value of the firm is actually its market value, and the financial valuation models do consider this particular fact. At the same time the managerial strategies that are derived from the financial models are in essence the managerial strategies for owner wealth maximization. On the contrast, the strategic planning models are primarily concerned with the survival of the firm. These are the normative strategies that consider the firm as an organic entity that is more interested in self preservation. Now this concept of self preservation at the expense of the stock holders has been a challenge to financial economists while trying to solve it. As a matter of fact, capital budgeting is more concerned with the allocation of the financial resources to the ongoing as well as the proposed projects on the basis of what the proposers of the project have to say about their future cash flows. In this process if the use of capital budgeting is not done in a proper way, it may lead to improper allocation of funds. The senior 36

Strategic Financial Management

management of the firm involves in deciding upon the future of the firm. These actually mean developing the new markets and the new research and development. These activities in turn call for a lot of funds in carrying them out. So it can be safely said that the senior management is actually looking for various options for the future of the firm. Till recently, the financial economists were lacking proper procedures in valuing these options. This was more importantly relevant in case of real investments which is the major focus in capital budgeting. As a result capital budgeting was rarely used for strategic planning. In todays world, several methods have evolved to price the options and these are extensively used for pricing of the financial assets and their derivatives. Box 3.2: Tracking Error Tracking error can be defined as the difference in performance of a particular fund relative to a benchmark portfolio. For past results, tracking error can be calculated easily by subtracting the total return of the portfolio for a given period (such as one month) from the total return of the benchmark for the same period. The standard deviation of the monthly differences can be calculated to summarize the results. For a given set of holdings, the future tracking error of the portfolio can be estimated based upon statistical analysis. This analysis is performed by evaluating the range of potential returns on each instrument and the relationship between the returns on the instruments. While these relationships are quite complex, it is possible to perform the necessary calculations in a relatively straightforward manner if certain simplifying assumptions are made. One such assumption is that the returns for individual securities in the portfolio reflect a joint normal distribution. This implies that if you know the means, standard deviations and correlations of the returns of each instrument you can calculate the mean and standard deviation of the portfolio as well as its tracking error relative to a benchmark portfolio. If the tracking error is expressed as a standard deviation, and the tracking error reflects the assumed normal distribution, then the portfolio return should not differ from the benchmark return by more than this amount approximately two-thirds of the time. In this way, tracking error provides a measure of how much the portfolio returns may differ from the benchmark returns. Source: gloriamundi.org

SUMMARY
There are basically two methods for computing the market values of the future cash flows of risky investment projects the certainty equivalent approach and the risk-adjusted discount rate (RADR) method. The RADR method, which obtain the discount rates (i.e. the cost of capital) from widely used theories of risk and return (such as the CAPM and APT) is impractical when the betas of the comparison firms are difficult to estimate. In cases where the comparison firms do not exist and scenarios are required to estimate risk, practical considerations require that certaintity equivalent approach is a better valuation tool. Tracking error refers to the difference between the cash flows of the tracking portfolios and the cash flows of the projects. The tracking portfolio approach seeks to develop tracking portfolios for which the present value of the tracking error is zero. Whenever a tracking portfolio for the future cash flows of a project generates tracking error with zero systematic (or factor) risk and zero expected value, the market value of such a tracking portfolio is equal to the present value of the projects future cash flows.

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Valuing Real Assets in the Presence of Risk

To compute the present value of the next periods cash flow using RADR Compute the future period cash flow. Compute the beta ( ) of the return from the project Compute the expected return of the project by substituting the beta (calculated above) with the tangency portfolio risk-expected return equation (RT) PV = Future period expected CF 1+ rf +(R T rf )

Cost of equity is given by re = rA + D/E (rA rD) re increases as the firms leverage ratio (D/E) increases. It increases linearly if the debt is default-free and if rA (the expected return of the assets) does not change as the leverage rises.

The certainty equivalent present value formula is given by PV = Where, CF = Expected future CF = Beta of the future CF (CF) (R T rf ) (1 + rf )

R T = Risk of the tangency portfolio. It is possible to estimate the expected future CF of an investment or project under a scenario where all securities are expected to appreciate at risk-free rate of return. The PV of the CF is then computed by discounting the expected CF for risk-free scenario at risk-free rate. Capital rationing in a process of developing capital budgets on the basis of pre-determined availability of funds.

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