Assessment 1: Read the paper by Graham and Harvey (2001).

Do a short write-up (a couple

of pages, 12 point font, double spaced) to highlight 3 insights from the survey results that

either support or challenge the concepts we studied in Semester 1. Remember to make

arguments rather than just stating your position and support your arguments using theory

and/or empirical findings.

Capital budgeting Method: NPV, IRR & Payback period

Capital budgeting method is used by companies to evaluate new projects or investments.

These techniques analyse project’s cash inflows and outflows to determine whether the

expected return meets a set benchmark. We know that managers use different capital

budgeting techniques to evaluate the projects and every techniques have their own

specification and limitations.

According to paper published by Graham and Harvey (2001), Firm CFO’s mostly used

Internal Rate of Return and Net present value techniques for evaluating major projects. As

per the finding of survey managers most frequently used Payback period techniques after

IRR and NPV method. As we know that Payback period ignores time value of money and

cash flow beyond the cut-off date. It also fails to consider riskiness of project and always

biased for long term projects. In spite of all shortcoming this method is most preferred

after NPV and IRR because it is easy to use and understand by firm CEO’s. This paper also

suggest that use of capital budgeting techniques depends on size and leverage of the firm.

Large and highly leveraged firms are more likely to use NPV and IRR techniques in

comparison to small and low leveraged firm and high levered firms are also likely used

sensitivity and simulation analysis.

As we know that Net present value is superior to other investment rules because it consider

time value of money and leads to value maximization decision. It also covering the benefits

that occurs after Payback periods or Discounted Payback period. In many cases where IRR

could mislead in decision making such as multiple rate of returns and reinvestment in

projects, NPV could provide the reliable solutions of decision making even for mutually

exclusive projects where PI fails NPV performs better. In some cases where NPV rules fails

(NPV<0) which can use adjusted net present value approach (APV). APV perform multiple

NPV calculations to find out adjusted net present value of levered firm. It captures the side

effects of debt financing such as tax subsidy to debt, cost of financial distress, cost of issuing

new securities and subsidies to debts financing. However as per studies after NPV and IRR,

Payback period is used most frequently used by firms in-spite of its limitations.

Cost of Capital - Project vs firm risk

The cost of capital of a company is the market’s required rate of return on capital invested

in that company. A firm cost of capital is the rate of return of the firm would earn if it

invested its capital in a firm of equivalent risk, whereas a project cost of capital is the

required rate of return on an project specific risk. According to Brealey and Myers (1996), a

company cost of capital should not be used for a new project which is less or more riskier

than the firm’s existing business and it should be evaluated at its own specific cost of

capital. But according to finding of Graham and Harvey (2001) et al, most companies (58.8%)

uses firm specific discount rate to evaluate the project even-if their hypothetical project is

most likely to have different risk characteristics. However, there are mixed outcome in the

study. According to which, large firms prefer to use more risk-matched discount rate as
compare with small firms. Whereas, firms with foreign exposer are more likely to use firm

wide discount rate to value an overseas project.

Capital structure: Trade off theory

According to MM preposition, chief benefit of debt financing is the advantage gained due to

tax-shield. As per Trade-off theory, a levered firm’s total value is equivalent to its value if all-

equity financed, plus present value tax-shield, minus present value of financial distress cost.

Thus two major factors those affect the company’s debt ratios are tax-benefit and financial

distress cost. But as per finding of Graham and Harvey (2001) et al, financial flexibility and

credit ratings are primary factors those affect firm’s debt policy. Company with high debt

ratio, is having lower credit rating. Firms always concerned about its credit rating, because a

good credit rating attracts the investors and ease of borrowing.

As per Pecking order theory firms do not target specific debt ratio, and use of external

financing only when internal funds are insufficient. For financing any projects managers

firstly prefer internal funds then they prefer to use debt after that issue equity as their last

resort.

Also, according to this survey result, 19% of firms having no target debt ratio, 37% having

flexible target, 34% having some-what tight target and 10% are having strict target debt

ratio. So, it supports the empirical finding that most of the firms are having target debt ratio.