CorporateFinanceTheory


		Written By Olusegun A. Williamson

	Introduction Understanding the structure and design of corporate financial theories is a difficult process. The creation of the design and structure is even a more difficult process, not only do the theories have to make sense, they have to be reliable and interpretable. Many of us make decisions on a daily basis, and most of these decisions have financial implications that directly or indirectly affect the outcome. In understanding the vast usage of financial theories, it would be appropriate to mention the forms of organizations that are involved. The three main forms of organizations are the sole proprietorship, partnerships, and corporations. Brigham and Ehrhardt (2002) observed that “Approximately eighty percent of business organizations operate as sole proprietorships, while the remaining twenty percent are evenly divided between partnerships and corporations. Even though most businesses operate as sole proprietorships, there is a huge separation in terms of their dollar value. About eighty percent of all businesses are conducted by corporations, about thirteen percent by sole proprietorships, and about seven percent by partnerships” (p. 6). A sole proprietorship, and as the name implies, is an unincorporated business owned by one person, a partnership is formed by two or more individuals, while a corporation is a legal entity created by a state and separate from its owners and managers. Various theories will be analyzed, compared and contrasted in order to determine their strengths and weaknesses. Description of the Theoretical Knowledge Base of Capital Budgeting Importance of Capital Budgeting Valid arguments could be made in concluding that capital budgeting is the most important task faced by financial managers. Perhaps the most heavily weighted factor that makes it such a difficult task is that the results of capital budgeting decisions continue for many years, and has it has been critically discovered, there is no definite predictability of what could happen tomorrow. Brigham and Ehrhardt (2002) define capital as “Operating assets used in the production of goods and services, while a budget is a designed strategy that illustrates projected cash flows during some future period. Thus, the capital budget is an outline of planned investments in operating assets, and capital budgeting is the whole process of analyzing projects and making a decision on the alternatives that will be included in the capital budget” (p. 502). Capital budgeting that are strategically assessed and analyzed can improve both the timing and the quality of asset acquisitions. Effective forecast for capital assets reduces the problem of shortages in the future, the reason being that capital budgeting involves a large amount of a company’s funds, this could be one of the reasons why expenditure programs are set up before any major spending is carried out. Project Classifications Since individual employees of a company create capital budgeting projects, ideas that will ultimately be implemented are generated from different departments of the company. Most of these ideas are generated out of the necessity to remain competitive, to improve the quality of an existing product, or to operate with better efficiency. These probable expenditures may take the form of replacement of worn out or damaged equipment that needs to be replaced if the company wants to continue doing business. A couple of questions normally arise in this situation. First, should the operation be continued and second, should we alter or continue with the existing process. Replacement of diminished efficient machinery is another project classification that companies are involved with. The goal of this analysis is to find a way to reduce the cost of labor, materials, and other inputs such as electricity. Companies continually embark on ways to diversify in order to stay afloat and competitive, and the most effective way is to expand into new markets. This too requires a careful analysis, which seems to be the most complex in all project classifications, because it involves a geographic area and target market not currently being served. Another form of project classification is the expenditure relating to government mandates, known as safety and/or environmental projects. On the most part, research and development is considered the largest and most important type of capital expenditure. Even though this expenditure can conceptually be analyzed like tangible asset investments, its relative uncertain cash flow prediction makes it more difficult. This uncertainty, and considering another fact that continuing a project depends on results at earlier stages, some other form of analyses other than capital budgeting are utilized to evaluate this project classification. Long-term contracts. Theses are contractual expenditures companies sometimes engage in to provide products or services to specific customers, this also require critical evaluation in part due to its multi-year characteristics. Relatively larger investment projects involve expert analysis and the approval of higher authorities within the organization. As an example, a plant manager maybe authorized to approve expenditure up to $10,000 on the basis of a relatively minor analysis, while expenditure in the excess of $1 million or an expansion into new markets or products may need the approval of the full board of directors. These decisions of course depend on characteristics such as the size of the firm, the hierarchy, and the industry the company falls under. Capital budgeting decisions The evaluation begins with the determination of the cost of the project, next is the analysis of the expected cash flows, including the salvage value of the asset at the end of its expected life, which is estimated by management including the risk of the projected cash flows. After the risk has been determined, management then determines the cost of capital at which the cash flows should be discounted. The next step is to put the expected cash flows on a present value basis to obtain an estimate of the asset’s value. Finally, a comparison is made between the present value of the expected cash flows and the required outlay. If the present values of the expected cash flows exceed the cost, it is normally recommended that the project should be accepted. Otherwise, it should be rejected. Alternatively, it is also recommended that if the expected rate of return on the project exceeds its cost of capital, the project should be accepted. Capital budgeting rules There are six methods used in identifying and ranking projects in deciding whether or not they should be accepted for inclusion in capital budget; (1) payback, (2) discounted payback, (3) net present value (NPV), (4) internal rate of return, (5) modified internal rate of return (MIRR), and (6) profitability index (PI). In evaluating a project using the payback method, the shorter the payback period, the better. The discounted payback period is very similar to the regular payback period, but the difference is that the expected cash flows are discounted by the project’s cost of capital. In other words, the discounted payback period is the number of years required to recover the investment from discounted net cash flows. In light of the deficiencies associated with both payback methods, they do provide information on the length of time funds will be tied up in a project. The shorter the payback period, other things held constant, the greater the project’s liquidity. In addition, since there is a higher risk involved with cash flows expected in the distant future as opposed to near term cash flows, the payback method is often used as an indicator of a project’s riskiness. The deficiencies in both payback methods led to the search for ways to improve the effectiveness of evaluating projects. One of the ways developed is the net present value (NPV) method, which is highly reliant on the discounted cash flow (DCF) technique. For a better understanding, the equation for the net present value (NPV) is defined as follows: This equation can be simplified when expressed in mathematical terms: As indicated by the formula, t is the expected net cash flow at period t, r is the project’s cost of capital, and n is its life. The ease of interpretation is one of the criteria that have made the net present value (NPV) widely acceptable. An NPV of zero is an indication that the project’s expected cash flow will cover the invested capital and will provide the required rate of return on that capital. A positive net present value (NPV) is an indication that the project will generate enough cash to cover the invested capital and provide the required return to shareholders. A negative net present value (NPV) on the other hand, signifies insufficient cash flows to cover the invested capital. Next in the evaluation techniques is the internal rate of return. Brigham and Ehrhardt (2002) define the internal of return (IRR) as the discount rate that equates the present value of a project’s expected cash inflows to the present value of the project’s cost (p.512). The equation for the internal rate of return is defined as follows: 0 = CF0 + CF1 + CF2 + CF3 + CFn (1 + r)1 (1 + r)2 (1 + r)3 (1 + r)n As it was indicated in the net present value formula, r is the project’s cost of capital, and n is its life. The obvious element is that the internal rate of return (IRR) is simply the net present value (NPV) formula, solved for the discount rate that will make the net present value (NPV) equal to zero. In mathematical sense, the net present value (NPV) and the internal rate of return (IRR) will always provide the same outcome for independent projects, because a positive net present value (NPV) means that the internal rate of return (IRR) must exceed cost of capital. The downside however, is that they can both give conflicting rankings for mutually exclusive projects. Like the net present value (NPV), the internal rate of return (IRR) on a project is its expected rate of return. An internal rate of return (IRR) that exceeds the cost of capital means there is a surplus. On the other hand, an internal rate of return (IRR) that is less than its cost of capital means there is a shortage to even cover its cost of capital. As it was implied by Brigham and Ehrhardt (2002), it is this “breakeven” characteristic that makes the internal rate of return (IRR) useful in evaluating capital projects. It was also observed by both authors that despite the fact that the academic community prefers the net present value (NPV) for capital budgeting, surveys indicate that many executives prefer the internal rate of return (IRR) to the net present value (p. 520). One reason that may have contributed to this bias may be because managers relatively prefer a percentage outcome technique as opposed to a dollar value technique. The need for a better percentage evaluator as an indicator of relative profitability led to a new technique called the modified internal rate of return (MIRR), and it is defined as follows: PV costs = PV terminal value TV PV of costs = ------------------ (1+ MIRR)n PV = Present value of the investment outlays when discounted at the cost of capital TV = Terminal value, the compounded value of the cash inflows MIRR = Modified internal rate of return, the discount rate that forces the present value (PV) of the terminal value (TV) to equal the present value (PV) of the costs Brigham and Ehrhardt (2002) conclude that “The modified internal rate of return (MIRR) is superior to the regular internal rate of return (IRR) as an indicator of a project’s “true” rate of return, or “expected long-term rate of return, “but the net present value (NPV) method is still the best way to choose among competing projects because it provides the best indication of how much each project will add to the value of the firm” (p.522). The last method that needs to be mentioned is the profitability index (PI), and the equation is as follows: PI = PV of future cash flows Initial cost In sum, Brigham and Ehrhardt (2002) maintains that “The net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and the profitability index (PI) methods will always give the same accept or reject decisions for independent projects: If a project’s net present value (NPV) is positive, its internal rate of return (IRR) and modified internal rate of return (MIRR) will always exceed k or cost of capital, and its profitability index (PI) will always be greater than 1.0” (p. 522). Capital asset pricing The capital asset pricing model (CAPM) gives us the definite prediction of the relationship that should observed between the risk of an asset and its expected return. The connection is to try and answer two important preconceived questions that were developed by William F. Sharpe. • It is a basis for evaluating rate of return for possible investments. An example to support this point is a security analyst who might want to know whether the expected return that was forecast is more or less than its fair return given its associated risk. • The model assists in making an educated prediction regarding the expected return on an asset that has never been traded in the market place. It enables investors or analysts to price an initial offering of a company’s stock. It also answers the question of how an investment project will affect the return investors require on a project. A component of the equation is the simultaneous purchase and sale of equivalent securities used to earn risk free profit otherwise known as arbitrage. To counterbalance the discrepancy, the most basic principle of capital market theory is that equilibrium market prices are rational in that they rule out arbitrage opportunities. This is a pricing relationship that guarantees the absence of arbitrage. Modigliani and Miller first introduced the concept of arbitrage. The alternative model to the capital asset pricing model (CAPM) is the arbitrage pricing theory (APT) that was developed by Stephen Ross, which also measures the relationship between expected return and risk, but with different assumptions. Assumptions of capital asset pricing model (CAPM) The basic fundamental assumption is that all individuals are alike in nature, with the exception of wealth and risk aversion. • There are many investors, and each individual’s wealth is relatively a fraction of the total wealth of all investors. Investors are price takers regardless of the effects on their individual trades, which is the position of perfect competition in macroeconomics. • All investors holding period are the same. • Investments are isolated and limited to publicly traded financial assets such as stocks and bonds, and to unlimited risk-free borrowing or lending arrangements, which excludes non-traded assets such as education (human capital), private enterprises, and governmental funded assets such as town halls and nuclear submarines. • Investors are excluded from paying taxes on returns and are also excluded from paying taxes on transaction costs (commission and service charges) on trades in securities. These assumptions could not be farther from the truth. In reality, investors are in different tax bracket, which ultimately affect their decision-making. Commissions and fees are also assessed based on the volume of investment and the reputation of the investor. • All investors are very well informed. • All investors technically analyze investments quantitatively in order to achieve the same expectations. Implications of assumptions • All investors will decide to hold the market portfolio of all assets in the universe. The proportion of each stock in the market portfolio equals the market value of the stock (price per share times the number of shares outstanding divided by the total market value of all stocks). • The market value will be on the efficient frontier, in addition to being the optimal risky portfolio, the tangency point of the capital allocation line (CAL) to the efficient frontier. Consequently, the capital market line (CML), the line from the risk-free rate through the market portfolio, M is also the also the best attainable capital allocation line (CAL). All the investors hold M as their optimal risky portfolio, the only difference is the amount invested by each individual investor compared to investment in risk-free asset. • The market portfolio’s risk premium is in proportion to the variance of the market portfolio and the market degree of risk aversion. E (rm) – rf = A* σ² M (mathematical representation) σ² M = standard deviation of the market portfolio A* = degree of risk aversion of the average investor • Individual’s asset risk premium is proportional to the premium on the market portfolio (M) and to the beta coefficient of the security on the market portfolio. This means that the rate of return on the market portfolio is the only determining factor of the security market. In contrast, beta then measures the extent to which returns on the stock responds to the returns of the market portfolio. Beta is the regression (slope) coefficient of the security return on the market portfolio return, which represents the riskiness and sensitivity of the stock given the foundations in the security market. Given these assumptions, every investor will derive identical efficient Frontier, and because each investor uses the market portfolio for the optima risky portfolio, the capital allocation is the capital market line (CML). E(r) CML M E(rm) E(rm) - rf Equilibrium risk premium rf of the market portfolio σM Using the capital market line (CML) as the optimal capital asset line (CAL) creates a powerful alternative strategy to an active strategy. Any investor that deviates from this formation will end on the capital asset line (CAL), which seems to be less efficient than the capital market line (CML) and contrary to the passive investors. This is called the “mutual fund theorem,” the implication that only one mutual fund of risky assets – the market portfolio – satisfies all investor demands. The individual investor with an average risk aversion A, will be willing to elect y, allocated to the optimal portfolio (M) such that: y = E (rm) – rf A σ² M The capital asset pricing model (CAPM) stipulates that the associated risk premium on an asset is determined by its contribution to the risk of investor’s overall portfolio. Investors are more interested in portfolio risk, which is what determines their risk premiums. Security market line The expected return-beta relationship can be viewed as a reward-risk equation. It is appropriate to view the beta of a security as its risk measurement due to the fact that beta is proportional to the risk that is contributed by the security to the optimal portfolio. Investors that are risk-averse utilize the standard deviation as a measurement of the risk of the optimal risky portfolio Bodie, Kane, and Marcus (1992) state “In this world, we would expect the reward, or the risk premium on individual assets to depend on the risk an individual asset contributes to the overall portfolio. Because the beta of a stock measures the stock’s contribution to the standard deviation of the market portfolio, we expect the required risk premium to be a function of beta” (p.247). This statement is confirmed by the capital asset pricing model (CAPM), that the premium of a security risk is directly proportional to both the beta and the risk premium of a market portfolio. The security market line (SML) is a basis for the evaluation of investment performance. Considering the risk of an investment as stipulated by its beta, the security market line (SML) provides the rate of return required to compensate investors for the risk of a particular investment, including the time value of money. Applications of the capital asset pricing model (CAPM) There is usefulness for capital asset pricing model (CAPM) in capital budgeting decisions. It can provide the needed return for a project, given its beta, for it to be acceptable to investors. This can also be used to assess the internal rate of return (IRR) for the project. The problem however, with the capital asset pricing model (CAPM) is the reliant on the theoretical market portfolio including assets like real estate, foreign stocks and so on and so forth. It also deals with the expected as opposed to the actual returns. Asset management Considering a reasonable amount of certainty, every company would hold a very small amount of current assets. Holding larger amounts would lead to the need for external funding with no profit increase. Smaller amounts would result to slow payments to suppliers coupled with lost sales due to shortages in inventory and a very tight credit policy. In the case of uncertainty, every company would require a set level of cash and inventories precipitated by expected payments, expected sales, expected order lead times, in addition to holdings, or safety stocks which will allow the deviation from expected values. In this case, as in the case with certainty, the level of accounts receivables are determined by credit terms, the lower the receivables for any given level of sales. Managing the components of working capital Cash, marketable securities, inventories, and accounts receivable are the four main components of working capital. Most companies are faced with a fundamental trade-off associated with each of these components. It is essential to hold a considerable amount of current assets in order to conduct business, and the greater the holdings of current assets, the smaller the danger of running out, thus reducing the firm’s operating risk. The downside to this philosophy, which lies in the cost for holding this working capital with large inventories, is the zero earnings or a negative return of an asset, if storage and spoilage costs are high. Knowingly, there is a need to acquire capital to purchase assets such as inventory, and since there is a cost connected to this capital, this increases the negative slope from excessive inventories, hence the amount of working capital that is held should be consistent with the operation of the business without any stoppage. The concept of zero working capital In determining a firm’s long-term direction, working capital may not seem as important as capital budgeting, dividend policy, and other decision making techniques, but in today’s direction towards global economy and competition, managers are increasingly paying close attention to working capital in order to increase efficiency. The objective of companies like American standard, Campbell soup, General electric, Quaker oats, and Whirlpool is to achieve zero working capital. The claims by the proponents of the concept are that enough cash will be generated in addition to expedited production process and improved efficiency. The concept is based on inventories plus receivables minus payables, and the underlying reason is that inventories and receivables are the keys to making sales and that inventories can be financed by suppliers through accounts payable. For each dollar received, companies only use about 20 cents of working capital, which implies on average that working capital is turned over five times per year. The reduction of inventories or variables, or increase in payables will result to contribution in cash flows plus an increase in company’s earnings. The application of the concept will lead to increased production and faster delivery, leading to increased business and allowable premium price charges. With efficient inventory process, the company will be able to shut down some of the warehouses, and there will a reduced need for labor and equipment handling. Increased speed is the most important element in achieving zero working capital. With a relatively fast production process, items can be produced as they are ordered as opposed to the reliance on forecast, which could lead to the accumulation of inventories. However, the reality is that achieving zero working capital is not possible for many companies. Reducing receivables and inventories, while maximizing payables will help lower the investment in working capital, hence financial and production economies. Cash management Brigham and Erhrardt (2002) maintain “Approximately 1.5 percent of the average industrial firm’s assets are held in the form of cash, which is defined as demand deposit plus currency” (p.846). Cash when held is referred to as a “nonearning asset.” It is used to pay for labor and raw materials, to purchase fixed assets, to pay taxes, to service debt, to pay dividends, and so on and so forth. Since cash in itself does not earn interest, the strategy is to hold as little cash as possible for daily operations without compromising the need for trade discounts, credit rating maintenance, and the unexpected need for cash. Reason for holding cash • Transaction reason. This is the daily cash held for business operations. Payments are made in cash, and receipts are deposited in cash amounts. These cash balances that are related to daily payments and collections are called transaction balances. • Compensation to banks for providing loans and services. Banks make profit by lending money that has been deposited by its customers. The larger the deposit, the better the bank is financially. For this reason, coupled with the services banks provide to their customers, they often require customers to maintain a minimum balance in their accounts, which is referred to as compensating balances. Other reasons for holding cash are precautionary and speculative motives. Precautionary balances are held by firms to deal with unforeseen circumstances. Firms also hold cash in order to take advantage of bargain purchases, but mostly depend on reserve borrowing capacity and/or marketable securities portfolios as opposed to cash for speculative reasons. 84.7 percent of companies that were surveyed in 1979 claim they were required to maintain specified balances to help pay for bank services. 13.3 percent of the respondents claim to pay direct fee for banking services, but in 1996 those findings were reversed, with only 28 percent claiming to pay for bank services with compensating balances, and 83 percent claiming to pay direct fees. Cash budget For general budgeting or forecasting process, firms often estimate their need for cash. Sales is forecast first, followed by fixed asset and inventory requirements and when scheduled payments will be made. These projections are then matched with accounts receivables, tax payment dates, dividend and interest payments dates, and so on, which is then summarized in the cash budget to show the firm’s projected cash inflows and outflows over a specific time period. Term structure of interest rates Term structure of interest rates is the relationship between long-and short-term rates. The structure is very essential to corporate managers with the responsibility of deciding whether to obtain funds by issuing long-or short- term debt and to the investors who have to decide whether to buy long- or short-term bonds. The idea is to understand how long-and short-term rates are related and the reason for shifts in their relative positions. History has shown that in most years, long-term rates have been above short-term rates, making the yield curve slope upward. Because of this reason, the upward sloping curve is often referred to as a “normal” yield curve and a downward slope yield curve as inverted or “abnormal” curve. What determines the shape of the yield curve? All else equal and considering the fact that maturity risk premiums are positive, long-term bonds would have higher interest rates than short-term bonds. It is also important to keep in mind that market interest rates also depend on expected inflation, default risk, and liquidity. Each of these factors can vary with maturity. To understand the underlying reason why expected inflation has an effect on the yield curve’s shape, let us consider the U.S. treasury securities. Because of the zero default or liquidity risk associated with these securities, the yield that matures in t years can be found using the following equation: Kt = K* + IPt + MRPt While a variation could occur in the real risk-free rate, K* because of these changes in the economy and demographics, these changes are rather random than predictable, so it makes sense to make the assumption that K* will remain constant. The inflation premium (IP) does have a significant variation over time, and it is somewhat predictable. The inflation premium (IP) is the average level of expected inflation over the life of the bond, so if there is an expectation in the market that inflation would increase in the future, the inflation premium will be higher, the longer the bonds maturity. On the same token, an expectation of a decline in inflation would lead to a smaller inflation premium. The yield curve for corporate bonds includes a default-risk premium (DRP) and a liquidity premium (LP). The implication here is that a corporate bond that matures in t years can be expressed as follows: Kct = K* + IPt + MRPt + DRPt + LPt A corporate bond’s default and liquidity risks are affected by its maturity. In addition, long-term corporate bonds are less liquid than short-term debt, making the liquidity premium rise as the maturity time increases, because short-term debt has less default and interest rate risk. Other factors influencing interest rate levels are Federal Reserve policy, budget deficit or surpluses, and international factors (Bodie & Kane & Marcus, 1992). Interest rates and business decisions Predicting interest rate with a reliable accuracy is almost impossible, which as a result makes effective financing decisions difficult if not impossible. The only accuracy that can be predicted is the guarantee that interest rates will fluctuate, which calls for a mix of long-and short-term debt, as well as equity, ultimately positioning the firm to stay afloat in any interest rate atmosphere. Risk management There is always that high probability that the actual future returns will be different from the expected returns. There is an expectation that all financial assets produce cash flows, and the risk of an asset is measured in relation to the risk of its cash flows. The risk of an asset can be analyzed on a stand-alone basis, or in a portfolio nature, where there is a combination of assets. In a portfolio nature, an asset risk can be reduced through diversification, the same cannot be said for a stand-alone asset. Investors are generally risk averse, so an asset with a relatively high risk is expected to produce a higher rate of return. Capital budgeting and risk management There is a dependency on the appropriate investment choices in order to maximize a firm’s value. Management must investigate sound investment choices and assess reliable tolls and techniques with the hope of alleviating the risk associated with poor investment decisions. The cash flows that are associated with the selection of an investment are exposed to daily changes in the international financial markets, multi-currency sovereign risk, privacy, movement in oil prices, other competitors, and most importantly, the trade cycle. Projects have to be strategically analyzed and correctly valued to realize the ultimate value of the firm. Historically, investments are valued by utilizing the discounted cash flow analysis (DCF), and the net present value (NPV) especially. Considering all the parameters involved in the net present value formula, it would be appropriate to include an additional parameter that would account for the flexibility of the changes in the market. This would fuse the direct cash flows from the original net present value (NPV) analysis and a real option value that would be a reflection of the operating and strategic adaptability. Banks are fundamentally known to invest in assets with high information characteristics, making it difficult to be traded in the capital market. An example is the credit-risk related to a foreign exchange swap. There is a possibility that the currency risk associated with the swap can be avoided, the same cannot be said for the credit risk, and because of this risk, and most banks are engaged in active risk management programs. Given a fixed capital structure, there are a couple of ways in which a bank can alleviate its exposure to risk. The first is by hedging transactions in the capital market, while the second is by changing its investment policies. Because of this illiquid risk, the banks capital budgeting and risk management functions become linked. As already mentioned, accurate forecast of unknown variables such as construction costs, inflation rates, cash flows, and so on and so forth are integral parts of capital budgeting. Ultimately, capital budgeting decisions are reduced to pricing the project risk. The discount rate is supposed to take into account all the associated risk of the project, including the volatility of the variables. Traditionally, there is a reliance on forecasting point estimates of the variables, which are then discounted to arrive at a single net present value (NPV) for the project. The bottom line is that there are inherent risks associated with capital budgeting, and especially with the cash flow forecasting process, depending on the specific project. It was also noted by Woodlock (2000), that “When there is an expectation that cash inflows from an investment would be largely offset by one or more streams of cash inflows with different sub-annual frequency, discounted cash flow analysis with the traditional end-of year assumption can yield misleading results” (p.53). This is based on the account that most of us have ignored the end-of-year basis with the belief that it does not have a significance in capital budgeting, and that it is so minimal that the net present value (NPV) estimated at the end-of-year basis always understate the outcome actually expected. In the matter of total risk, a firm’s value, and the value of the projects can be increased through hedging, which as a result makes risk management inseparable from project selection. In assessing a project with a hedgeable unsystematic risk, the value remains the same when capital budgeting rules are applied, because total risk is irrelevant. However, in a situation where total risk is costly, a project with an unsystematic risk that can be partially or totally hedged has a higher value because of its lower charge for its contribution to the firm’s total risk. It could be concluded that there is a possibility for an unhedged project to have a negative net present value (NPV), while the same project when hedged will have a positive net present value (NPV). The bottom line is that when the total risk is costly, hedging will increase value by decreasing total risk. There is even a greater risk involved in capital budgeting decisions when dealing with foreign investments, this would normally lead to a higher hurdle rate. The other side of the coin that should be considered when evaluating a project, is to approach it in a portfolio context and use a lower value than the normally computed corporate wide cost of capital in recognition of lower total portfolio risk. This portfolio approach is even more compelling when investments are in less developed countries. Capital budgeting and Capital asset pricing As previously mentioned, the rule for making a capital budgeting decision is to accept projects with a positive net present value (NPV), and to reject projects with negative net present value (NPV). With that in mind, let us consider a project with an annual real cash flow of $100,00 that will last forever, beginning next year, with an initial outlay of $1,600,000. In deciding whether to invest in the project or not, we discount all future cash flows and deduct the initial outlay to arrive at the net present value. With this information, the project is accepted if it has a positive net present value (NPV), and rejected if it has a negative net present value (NPV). Historically, the cost of capital is calculated by utilizing the capital asset pricing model (CAPM). The cost of capital of the project is the rate investors require to undertake the investment, and all future cash flows will be discounted at this rate. The cost of capital in the capital asset pricing model (CAPM) is equal to the risk-free rate plus a risk premium. The capital asset pricing model (CAPM) also implies that the only relevant risk measurement for a project is its beta. Jagannathan and Meier (2002) add, “The beta factor times the excess return of the market over the risk-free rate determines the risk premium of the investments” (p.55). The authors also observed that in “A recent survey by Graham and Harvey (2001) there was a finding that three out of four CFOs use the capital asset pricing model (CAPM) as the primary tool to assess the cost of capital” (p. 56). It was further stated that the “The capital asset pricing model (CAPM) became the preferred model for determining the cost of capital following the classic studies by Black, Jensen, and Scholes (1972) and fama and MacBeth (1973) showing strong empirical support for it. Combining all New York stock exchange (NYSE) stocks during the period 1931-65 into portfolios, Black et al. (1972) found that the data are consistent with the predictions of the capital asset pricing model (CAPM). Fama and MacBeth (1973) examined whether knowing other characteristics of stocks-in- particular, the squared value of beta and the idiosyncratic volatility of returns in addition to their betas would help explain the cross section of the stock returns better. Confirming the capital asset pricing model (CAPM), they found that knowledge of beta was sufficient, using return data for NYSE stocks from 1926 to 1968” (p.57). Regardless of skills and the overall limitations of managerial and organizational capital within a company, every manager is confronted with a set of alternative projects. Accepting a project today may prevent the assessment of another project in the future. For these reasons, deciding against a positive net present value (NPV) project might not be a bad idea, and the main question that arises from all of these is when should a manager accept or reject a project? Capital budgeting and asset management Recently, real estate management by corporations has increasingly become a topic of importance. Considering the constant value appreciation of industrial and commercial properties, coupled with leveraged buyouts and corporate takeovers, the productive use of real estate has been elevated as a very important factor of asset management. With corporations increasing their debt loads, and acquisition, management and disposition of assets has taken on a greater role of importance. Real estate assets have to be managed efficiently and effectively in order to produce grater firm value and cash flow. As stated by Redman and Tanner (1989), “Previous studies have examined the capital budgeting procedures of corporations regarding real estate assets. The studies however, failed to cover the methods managers use in evaluating the decision to get rid of a property. The disposition of assets, whether real estate or an entire division, has become very popular, due to the new merger environment. Managers have to make decisions by utilizing one of several techniques. If you consider the proportion of the real estate holding of some major corporations, it becomes very important to possess sound decision rules in determining purchases and sale of these assets. 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