Essay Examples - Finance Essays
Financial Market Company
Response to Business Finance Week
In a developed economy, financial markets have many participants. A company, like Algo Plc, is one of many such participants. Financial market participants frequently indulge not only in financial investments but also in real asset investments. Whereas financial investments(such as lending, borrowing or buying common shares) serve the purpose of reallocating resources across time, real asset investments(such as building a new factory or acquiring equipment to be used in production) can actually create new future resources that did not before exist. Lenders and borrowers must agree on the rate of exchange between present and future resources.
The financial markets, by setting market interest rates, make that decision for participants. Financial market participants would, ceteris paribus, generally choose the less risky of otherwise identical investments - in other words, they are risk-averse. Some investors are risk-neutral(see Scott et al. 1988; Barber et al. 2003; Hordahl and Vestin 2005); some are even risk-seekers (see Hartley and Farrell 2002; Mainelli 2007), but the standard assumption is that risk-averters dominate financial markets(Levy and Post 2005). There are many indications that this standard assumption is reasonable, three of them are: the size of equity premium (see Ibbotson Associates 2001); most institutional investors use various instruments (e.g. derivatives) in order to reduce risk; and the increasing popularity (and use) of mutual funds.
Risk-averse lenders require greater expected compensation in future resources from risky borrowers(Ross et al. 2007). Because the cost of capital to a firm is really the expected return to the investor, risk is positively related to cost of capital. Corporations raise money from lenders (also called capital suppliers) by issuing contracts/securities. Everyone holding contracts, formal or informal, with the corporation has claims upon the corporation's cash flows. Given any security, we find the present value of its future expected cash flows by simply discounting the cash flows. When market interest rates or opportunity rates of return are used as discount rates we obtain the market value or present value of the security. A wise investor chooses a positive net present value(NPV) investment; an unfortunate investor chooses a negative NPV investment. A positive NPV investment is desirable because NPV is a reflection of how much the investment differs from its opportunity cost. In other words, the NPV of an investment is the present value of all its present and future cash flows, discounted at the opportunity cost of those cash flows. These opportunity costs reflect the returns available on investing in an alternative of equal timing and equal risk. Correctly calculated NPVs (see Cigola 2005 for NPV calculation techniques) are always equal to the changes to the present wealths of participants who undertake the investments. Thus, Koubouros (2008) correctly posits that cost of capital (or the interest rate) is ''that opportunity cost which reflects the returns expected to be earned by investors from a similar investment carrying the same level of risk.'' Does the source of the capital for an investment Algo Plc wishes to undertake matter?
Because of the residual nature of their claim, the shareholders of a company will experience the corporate investment NPV as their increase in wealth. In other words, the existing (or 'old') shareholders of the company get a wealth increase equal to the investment's NPV regardless of who contributes the funds to undertake the investment. Ross et al. (2008) confirm this observation when they state that ''any project's cost of capital depends on the use to which the capital is being put―not the source''. (This means retained profits, for example, are not a 'cost free' source of funds, for shareholders would expect a rate of return from the profits reinvested comparable to the returns they would have received if they invested the funds in another opportunity of equal risk.) It is important to note that the overall rate or cost of capital is the average of the rates that all capital claimants require on the amounts they have invested in the project. And the amounts they have invested are not necessarily the amounts of cash they paid into the project but the market prices at which they could sell those claims. So the overall project rate is a market-value weighted average of the rates required by the various capital claims upon the investment. Intuitively, this rate reflects (1) the operating risks of the project; (2) project's proportional debt and equity financing with attendant financial risks; and (3) the effect of interest deductibility for the debt-financed portion of the project.
To evaluate new investments projects (capital budgeting) managers need to estimate the cost of capital. They can use stock valuation models to compute the cost of equity. (The top two methods commonly used by UK firms are CAPM and the dividend method according to Mclaney et al. 2004). Note that managers still need to estimate the cost of capital even where market valuations are absent.
Another area where the knowledge of cost of capital would be vital of course is company capital structure. Managers must decide what mix of debt (see Cookson 2001; Ross et al. 2008) and equity claims are appropriate for the firm to issue. Without knowledge of cost of capital, it would difficult (nigh impossible) to build a financial planning model let alone ask sensible 'what if' questions of it.
Funds available to a corporation are not unlimited. In instances where not enough money is available for all profitable investments a corporation wishes to undertake, it must use capital rationing. Capital rationing would nigh impossible without an understanding of cost of capital.
Reducing the cost of capital
Investing according to economist Keynes (1936) is an art - a good or wise 'artist', he believes, makes the best of what people think other people think about (stock) prices. Successful investing is the expression self-interest of the most fundamental Darwinian kind. Wide 'spreads' between buying and selling prices, for instance, are a sure symptom of market illiquidity. They represent market participants' attempts to protect themselves against what they fear to be a secret advantage enjoyed by the other party. If you assume the other party to a deal is armed with hidden information concerning an asset, then you will be seeking either a deep discount (if you are buying) or a steep premium (if you are selling) to counteract the edge enjoyed by the other side.
In addition to the bid-ask spread, the other costs are brokerage fees and market impact costs (Ross et al. 2008). These trading costs reduce the total return investors gets and the investors are therefore more inclined to want a higher compensation when stocks they are interested in have low liquidity - i.e. have high trading costs.
Cost of capital to a firm and expected return to the investor, as we saw earlier, are positively related. So what can a firm do to lower trading costs and therefore cost of capital? Amihud and Mendelson (2000) offer two suggestions both aimed at improving liquidity and later (2006) show that liquidity is a relevant factor in capital asset pricing. Stock splits, the first of their suggestions, simply makes the stock more affordable and matching sellers and buyers easier. It is hoped as Ross et al. (2008:361) note that ''expected return on the stock, and the cost of equity capital will fall as well''. The second suggestion is reducing information asymmetry. Many studies (see Haugen 1979; Hellwig 1989 ) indicate that the existence of information asymmetries can induce a gency problems and therefore agency costs. As we already noted earlier, a wide 'spread' is used as a defense mechanism. Research (see Coller and Yohn 1997; Bloomfield and Wilks 2000) indicates that as disclosure(in the form of, for example, management forecasts releases) improves liquidity also improves. Coller and Yohn(1997), in particular, show that bid-ask spread narrows following the release of management forecasts.
Conclusion
We have argued that cost of capital is a function of the use to which the capital is bring put - not the source. We have also argued that liquidity relevant to capital budgeting and that corporations must attempt to improve liquidity as it seems to be inversely related to the cost of capital. Understanding the concept of cost of capital is therefore indispensable for a financial manager.
References
Amihud, Y., Mendelson, H. (2006) ''Stock and Bond Liquidity and its Effect on Prices and Financial Policies'' Financial Markets and Portfolio Management
Vol 20, Number 1 / April, 2006
Amihud, Y., Mendelson, H. (2000) ''The Liquidity Route to a Lower Cost of Capital'', Journal of Applied Corporate Finance
Barber, B. M.,Heath,C.,Odean,T. (2003) ''Good Reasons Sell: Reason-Based Choice among Group and Individual Investors in the Stock Market'', Management Science Vol. 49, No. 12 (Dec., 2003), pp. 1636-1652
Bloomfield R. J., Wilks,T. J. (2000) ''Disclosure Effects in the Laboratory: Liquidity, Depth, and the Cost of Capital'',The Accounting Review, Vol. 75, No. 1 (Jan., 2000), pp. 13-41
Coller, M. and Yohn, T. (1997) ''Management and Information Asymmetry: An Examination of Bid-Ask Spreads'', Journal of Accounting Research
Cigola, M. (2005) "On the comparison between the APV and the NPV computed via the WACC" European Journal of Operational Research Mar2005, Vol. 161 Issue 2, p377-385
Cookson, R. (2001) ''Debt is Good For You'', The Economist, London, January 27th, 2001 Vol 358, Iss 8206
Hartley, R., Farrell,L. (2002) ''Can Expected Utility Theory Explain Gambling?'', American Economic Review pp. 613-624
Haugen, R. A. (1979) ''New Perspectives On Informational Asymmetry and Agency Relationships'', Journal of Financial & Quantitative Analysis Nov79, Vol. 14 Issue 4, p671-694
Hellwig, M (1989) ''Asymmetric Information, Financial Markets, and Financial Institutions'', European Economic Review Mar1989, Vol. 33 Issue 2/3, p277-285
Hordahl,P.,Vestin,D. (2005) ''Interpreting Implied Risk-Neutral Densities: The Role of Risk Premia'',Review of Finance 9(1):97-137
Ibbotson Associates (2001) Stocks, Bonds, Bills and Inflation: 2000 Yearbook, Chicago: Ibbotson Associates
Keynes, J.M. (1936) The General Theory of Employment of Money, New York: Harcourt Brace
Koubouros, M. (2008) 'Cost of capital', Business Finance Week 3 Lecture Notes 3a Laureate Online Education
Levy, H., Post, T. (2005) Investments, Prentice Hall
Mclaney, E., Pointon, J., Thomas, M. and Turcker, J. (2004) , 'Practitioners'
Perspective on The Cost of Capital', The European Journal of Finance,10,
pp.123-138
Mainelli.M (2007) ''Risk-seekers or rent-seekers?: Wholesale banking extracts value'', The Journal of Risk Finance; Vol: 8 Issue: 1; p79 - 83
Ross,A. S., Westerfield,R.W., Jaffe,J., Jordan,B.D. (2008) Modern Financial Management, 8th edn, McGraw-Hill Irwin
Scott,R.C.,Highfill,J.K.,Sattler,E.L. (1988) ''Advantage to a Risk Neutral Firm of Flexible Resources under Demand Uncertainty'',Southern Economic Journal, Vol. 54, No. 4 (Apr., 1988), pp. 934-949
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