The Theories And Implications On Corporate Financial Decisions Finance Essay

The Theories And Implications On Corporate Financial Decisions Finance Essay This paper concerns mainly on exploring the area of corporate valuation models and their implications in assessing the value of corporate firms. The models to be reviewed and analyzed are Economic Value Added (EVA), Capital Asset Pricing Model (CAPM) and Free Cash Flow (FCF). The selected models would be used on 5 publicly listed firms in the Bursa Malaysia. The aim of this study is to analyze the three models on how it can be utilized in helping a firm to create, sustain and access its corporate value. This paper consists of six parts, which are introduction, literature review, importance of theories and its implications on corporate financial decisions in Malaysia, application of concepts, tenets, fundamentals, technical issues, etc to the five chosen firms, methodology to analyze 5 years financial data of the selected firms and conclusion. Introduction In this paper, three corporate valuation models have been chosen as our main concern, which are Economic Value Added (EVA), Capital Asset Pricing Model (CAPM) and Free Cash Flow (FCF). We then apply the selected valuation models and methodologies to five publicly listed firms in the Bursa Malaysia from the food and beverage industry. The five companies are Dutch Lady Milk Industries, Fraser Neave Holdings Berhad, Nestle Ltd, QSR Brands Bhd and Yeo Hiap Seng (M) Berhad. Summary will be made by reviewing ten journal articles under the literature review part for a preliminary understanding of the models. This paper includes four journal articles for EVA as well as another seven journal articles for FCF and CAPM. In addition, we will identify the importance of the theories and describe its implication on corporate financial decisions in Malaysia. This study has provided us a great learning opportunity by accessing the company value of the real corporate firms. It also provides us a lear ning platform in how to utilize the valuation tools to evaluate companys performance for investment purpose in the future. Literature Review Economic Value Added (EVA) Economic Value Added (EVA) is a corporate valuation tool developed by Stern Stewart Co. to assist managers in their decision making by incorporate two basic principle of finance inside. The first principle is the financial goal of any company for shareholders wealth maximization and the second one is that a companys corporate value is based on the extent to which investors expect future earnings to exceed or fall short of the cost of capital. Another way to explain is that, EVA is developed to align decisions with shareholders wealth. According to Stewarts study in 1994, it is proved that EVA as the single best tool of measuring wealth creation on a contemporaneous basis and the result in describing changes in shareholders wealth is about 50 percent better than its greatest accounting-based rival of EPS, Return on Asset (ROA) and Return on Equity (ROE). EVA model assist managers in better investment decisions making, to identify improvement opportunities as well as to consider the short-term and long-term benefits for a firm. Based on Taubs study in 2003, it is observes that most of the valuation models used among industries focus only on the financial or accounting information. Unlike EVA, it combines factors like accounting, market and economy information in a companys performance evaluation. Various studies have proved the superiority of using EVA over other traditional models for evaluate companys performance due to its transparency and capacity to obtain more important information. According to Kudla and Arendts study in 2000, EVA can eliminate the arising conflicts and confusion when a company employs multiple measures like EPS, Return on Investment (ROI), Return on Equity (ROE) and Net Operating Profit after Tax (NOPAT). Furthermore, EVA can also be used as a tool to eliminate economic distortions of General Accepted Accounting Practice (GAAP) to focus decisions on the actual economic outcomes. It promotes better evaluation of decisions that have an impact on the income statement and balance sheet or trade-offs between each other. Also, EVA managed to cover every aspect of the managerial cycle through the use of the capital charge against NOPAT. There are also studies indicate that EVA is a superior measure of the managerial decisions quality. From Fishers study in 1995, EVA is suggested to be treated as a reliable pointer in estimating a firms value growth in the future. Also, according to Sterns study in 1989, the purpose of EVA is to change the management behavior as well as their performance, leading managers to act in the owners interest. It can be used as a motivation tool to encourage managers to create shareholder value by being a basis for management compensation. Importance of the theories and implications on corporate financial decisions in Malaysia As business grows wider and complex across the border, there is a demand for better valuation tool to evaluate the performance of the business. It is important to adopt more innovative performance metrics so that the companys management behaviors can be closely monitored to achieve the goal of maximizing the shareholders benefits. It is also important to access a firms value for any decision making regarding business expansion or contraction. According to the article of The Chartered Institute of Management Accountants (CIMA), Latest Trends in Corporate Performance Measurement (1992), many companies were experiencing difficulties in implementing measurement frameworks and these statements have been brought to today. There is a study conducted by Dr. Issham Ismail in Malaysia with the purpose to examine the relationship between EVA and the company performance in Malaysia. The study indicates that EVA has a strong relationship with stock return as compared to other measures due to its focus on long-term performance. EVA enhances stock performances by including more informational content in describing the stock returns. According to the study, EVA is considered as a better alternative to other traditional valuation tools such as EPS, ROE, etc. Its characteristic of transparency and capacity to provide more important information helps investors in Malaysia to make better investment decision as well as the resources allocations decisions. Besides that, EVA and MVA can be also treated as performance measures and signals for any strategic change (Lehn and Makhija, 1996). There is another study conducted by Norfarah, Suhaila and Wan Mansor in Malaysia regarding the adoption of EVA on real estate corporations in Malaysia. In Malaysia, real estate sectors have grown to become a large sector and continue to develop for the past two decades even through difficult economic period. Some has been performing well in the industry such as IOI Properties and Boustead Properties Bhd while some of them are experiencing hardship like Country Heights, Land General, and Damansara Realty. In order to identify the company potential of adding more shareholders value, an alternative corporate valuation model has been introduced, which is EVA, proposed by Stern Stewart Management Services. The adoption of EVA is considered to be more comprehensive as its measurement tool provides a clearer picture of whether a business is raising or reducing shareholder wealth. Most of the multinational companies such as Sony, Coca-Cola and Monsanto have formally announced their adoption and implementation of EVA as management systems in their quest of the value. On the other hand, EVA based performance plan produces positive result towards a company management. There is a study on the effects of adopting management bonus plans based on residual income measures. According to Wallaces study in 1997, EVA based performance plan motivates managers to utilize companys assets in a more productive and efficient way. This hence, reduce of the conflict between managers and shareholders interest and the decreasing agency cost eventually help the company to boost its profit after the adoption of the residual income based incentives plans. As a result, EVAs superiority is proved in encouraging managers for shareholder wealth creation. However, in order to work out the EVA compensation system, it requires large commutation effort and extensive training for both managers and their subordinates. Lastly, EVA and its practical applications as a management control system for performance measurement which helps manager to make better investment decisions. Methodology Economic Value Added is an evaluation tools used to examine a companys true economic profitability because it factors in net operating income after taxes interest minus the opportunity cost of capital deployed to earn that net operating income. In other words, EVA tells whether a companys financial performance is higher or lower than the minimum required rate of return for shareholders or business lenders. Besides that, EVA also tells investors if their amount of invested capital in the business is providing them a higher return than their minimum, or if it is better to shift their capital elsewhere. There are few steps required in calculating EVA and this is how Economic Value Added (EVA) is used by the financial analysts. Annual reports from the five selected firms have been sourced respectively in this report. First of all, we have to identify the earnings before interest and tax (EBIT) from the income statement. Next we have to calculate the Net Operating Profit after Taxes (NOPAT) by deducting the Income Tax Expenses from the EBIT. Afterwards, we need to determine the invested capital deployed in the business by deducting Non-interest Bearing Current Liabilities from Total Assets. Then, we need to calculate the Weighted Average Cost of Capital (WACC) using the Capital Asset Pricing Model (CAPM). WACC calculated by adding Risk Free Rate with Beta multiply by Market Risk Premium, where Market Risk Premium is calculated by deducting Risk Free Rate from Market Return. Take WACC multiply with the Invested Capital and finally, EVA can be found by deducting the multiplication of WA CC and Invested Capital from the Net Operating Profit after Tax. The calculation formulas for EVA are as follows: EVA = NOPAT (WACC * Invested Capital) where, NOPAT = Profit Lost Before Interest and Tax Income Tax Expenses and, Invested Capital = Total Assets Non-interest bearing Current Liabilities and, Cost of Equity, WACC is calculated by using CAPM Model where, WACC = Risk Free Rate + ( Beta * Market Risk Premium ) where, Market Risk Premium = Market Return Risk Free Rate Free Cash Flow Literature Review Free cash flow (FCF) refers to the cash generated by the assets of the business available for distribution to all the shareholders and it cant be affected by the businesss capital structure. A firms stock value is calculated by projecting the future free cash flow (FCF) that will be generated by the business assets and then compute the present value of FCF by discounting them at the appropriate required rate of return. FCF appeared to be an appropriate valuation model to be used when (1) the firm doesnt pay dividends at all or pays out lesser dividends than dictated by its cash flow, (2) free cash flow tracks profitability or (3) the analyst takes a corporate control perspective. The present value of FCF is the most fundamentally useful valuation tool used in assisting any investing decisions like investment opportunities appraisal and corporate valuation (Arumugam, 2007). It can also be used to measure the potential of investment opportunities as well as to forecast the firms future performance by accessing its corporate value. Based on an article written by Ben Lardes in March 2010, a companys free cash flow reflects a lot of information about the company performance. Obviously the higher the free cash flow of a business is, the more money you can expect to earn as the businesss shareholder. Every firm has different FCF, which is depends on how well is their performance over the periods. For instance, a well performing firm may have a good amount of positive cash flows. On the contrary, a firm may not have a positive cash flow at all if it has been struggling to succeed. A firm will have a negative FCF if its expenses are exceeding its income. By looking at the FCF, a company can decide whether to go on with its current business direction or to change its management operation. However, negative FCF does not always signify problems within a business. The negative FCF may be due to the preparation of business expansion in the future. The age of a company and its circumstances should always be in the consider ation before judging it purely based on its free cash flow. According to the study conducted by McClure, although FCF has its merits, it still has some limitations and the most significant one would be the garbage in, garbage out principle. Predicted FCF is used as the main input in DCF calculation to evaluate any investment decisions, thus the quality of FCF is very important in the valuation process in order to get an appropriate and reliable outcome. If all the FCF values have found to be inaccurate, then it will be useless in assessing the firms stock price. Therefore, the ability to make good future projections of FCF is critical. The more you confident about the future cash flow, the better project evaluation you can made, leading to a desirable profit from your investment. In this case, the forecast of potential cash flow appeared to be the tricky part, as you are required to prepare a full financial model to get a better estimation. This requires some serious analysis of the business, the macro-economic environment, the legal and regu latory framework and the competitive landscape (Cartmail, 2010). Importance of the Theories Implications on Corporate Financial Decisions in Malaysia Investing decisions can be made based on a simple analysis like selecting your desire firm with a product you expect to have high demand in the future. The underlying expectation is that the company will continue to produce and sell high-demand products and will generate cash flow back to the business. The second part is that the companys management will know where to spend this cash to continue its operations whereas the third assumption is that all of these expected future cash flows are worth more today than the stocks current price.   Free cash flow (FCF) tracks the remaining operating cash flow for the shareholders after laying out the money a firm required to expand or sustain its asset base. It is important as it allows business to pursue more opportunities that could enhance shareholders value. Present value of all free cash flows is the key indicator of a firms equity value. The growing FCF is often a prelude to increased profits. Firms that facing surging FCF as a result of revenue growth, debt elimination, improvement of operational efficiency and others, can reward their investors tomorrow. Thats the reason investors cherish FCF as a sound valuation metric. The odds are good when a firms FCF is increasing, it is believed that the firms share value will soon be increased as well. An important thing to note is that, negative FCF is not bad in itself, however it could represent a sign that a firm is engaging in large investments (Investopedia, n.d.). DCF is one of the favorable and sound tools to be used in corporate valuation because it can produce outcome, which has the closest value to an intrinsic stock value. Unlike other valuation tools like P/E ratio, DCF analysis relies on FCF. It is believed that FCF reflects a clearer view of a firms ability in generating cash, as profits can sometimes be clouded by accounting tricks, but cash flow cannot. The reason is because cash flow generation is hardly to be influenced by accounting assumptions and practices. Also, FCF is a trustworthy measure that eliminates most of the arbitrariness and guesstimates found in reported profits (Investopedia, n.d.). Other than that, FCF can be considered as a forward-looking metric because it depends more on future prospects rather than past results. In addition, it also enables expected operating strategies to be included in the valuation as it allows varies business components to be valued separately. On the other hand, free cash flow theory has important implications for the leverage effect on a firms investment financing decisions. The FCF model implies that for an over-investor, an increase in leverage should lead to a reduction in unprofitable investment spending. Additional leverage will leave less amount of free cash flow at the discretion of the managers at the same time that it increases the intensity level at which the companys activities can be closely monitored. Overall investment will become more efficient as the firm substitutes contractually obligated debt service for negative net present value investments. Empirically, the reduction in unprofitable investment spending should contribute to an increase in the firms stock price that reflects the improved efficiency of managerial investment decisions. Methodology Free Cash Flow (FCF) is the cash generated by the companys assets and it is available for distribution to all the shareholders. It is used to tracks the remaining operating cash flow available for the shareholders after laying out the money a firm required to expand or sustain its asset base. It is calculated by deducting Net Investment in Operating Capital from Net Operating Profit after Tax (NOPAT), where NOPAT is calculated by deducting Income Tax Expenses from the Profit Lost before Interest and Tax (EBIT) and Net Investment in Operating Capital is obtained by using the Operating Capital at time t to minus the Operating Capital at time t-1. Operating Capital is calculated by adding up Net Operating Working Capital (NOWC) and Net fixed Assets, where NOWC is calculated by deducting Non-interest Bearing Current Liabilities from Operating Current Assets. The calculation for FCF is as followed: Free Cash Flow (FCF) = Net Operating Profit after Tax (NOPAT) Net Investment in Operating Capital where, NOPAT = Profit Loss before Interest and Tax (EBIT) Income Tax Expenses and, Net Investment in Operating Capital = Operating Capital at time t Operating Capital at time t-1 where, Operating Capital = Net Operating Working Capital (NOWC) + Net fixed Assets where, NOWC = Operating Current Assets Non-interest bearing Current Liabilities Capital Asset Pricing Model Literature Review Basically, Capital Asset Pricing Model (CAPM) is based on Markowitz (1959) and Tobin (1958), who introduced the risk-return portfolio theory. The primary implication of the CAPM is the mean-variance efficiency of the market portfolio. The efficiency of the market portfolio implies that the positive linear relationship between expected returns and market betas is exists and only beta is playing a significant role in explaining the expected returns of stocks. Several attempts have been done to test the implications of the CAPM using historical rates of returns of securities and historical rates of return on a market index. The CAPM is relies on several assumptions with the fact that every investor wants to maximize the expected satisfaction of their wealth. An addition to the risk aversion is that all of them are having the same expectations towards the returns of the securities. The returns of the securities follow a normal distribution, which characterizes the phenomenon of homoscedasticity. Besides that, CAPM also assume that every investor is allowed to borrow any amount of money at the risk free rate. Finally, there are no taxes or other barriers which lead to an imperfection of every market, that is, the market is assume to be in equilibrium and have a perfect competition among all the participants in the market. According to Grigoris and Stavross study in 2006, one of the earliest empirical studies that support the theory of CAPM is that of Black, Jensen and Scholes [1972]. By using monthly data of return and portfolios rather than individual stocks, Black et al tested whether the cross-section of expected returns is linear in beta. By constructing a portfolio made up by an amount of securities, investors managed to diversify away most of the firm-specific risk, thus increasing the precision of the beta estimates and the expected rate of return of the portfolio. This approach eliminates the statistical problems that arise from measurement errors in beta estimates. The data found to be consistent with the predictions of the CAPM, at which the relationship between the average return and beta is close to linear and that portfolios with high (low) betas will have high (low) average returns. There is another classic empirical study that supports the theory conducted by Fama and McBeth in 1973. In the study, they examined whether there is a positive linear relation between average returns and beta. In addition, the author also investigated whether the squared value of beta and the volatility of asset returns can explain the residual variation in average returns across assets that are not explained by beta alone. There are several studies in the early 1980s suggested that there were deviations from the CAPM risk return trade-off due to other variables that affect this tradeoff. The objective of the studies was to find the missing components that CAPM omitted in explaining the risk-return trade-off and to identify the variables that created those deviations. Banz [1981] tested the CAPM by examining whether the size of firms can explain the residual variation in average returns across assets that remain unexplained by the CAPMs beta. CAPM is being challenged by indicating that firm size does explain the cross sectional-variation in average returns on a particular collection of assets better than beta. The author concluded that the average returns on stocks of small firms were higher than the average returns on stocks of large firms, vice versa. This study has known as the size effect. The general reaction to Banzs [1981] findings, that CAPM may be missing some aspects of reality, was to support the view that although the data may suggest deviations from CAPM, these deviations are not as significant to invalidate the theory. Importance of the theories and implications on corporate financial decisions in Malaysia CAPM, which is a theoretical representation of the financial markets behavior, can be used in the estimation of a companys cost of capital. Despite the limitations, the model can be a superior addition to the analytical tool kit of financial manager. The modern financial theory relies on three major assumptions. First, we assume the participants in the securities market are dominated by rational, at which all the investors are risk averse. Risk-averse person often seek to maximize satisfaction from the returns on their investment. CAPM also assume a perfect competitive market, which is in the equilibrium. It means that the financial market is populated with highly sophisticated and well informed buyers and sellers, meaning that the financial market has the characteristic of transparency. The third assumption implies that investors will choose to hold diversified portfolios, means that every investor wants to hold a portfolio that could reflects the stock market as a whole. Although i t is impossible to own the market portfolio, it is relatively easy and inexpensive for investors to eliminate specific or unsystematic risk and construct a portfolio that tracks the stock market through diversification. Another significant problem is that, it is not possible for investors to borrow at the risk-free rate in the real world. This is because the risk associated with individual investor is particularly higher than the risk associated with the Government. This inability to borrow at the risk-free rate means that the slope of the SML is shallower in practice than in theory. However, CAPM is generally considered as a better method to calculate the cost of equity and it explicitly takes into account the sensitivity of a companys security return to market risk. It is clearly superior to the WACC in providing discount rates to be used in investment appraisal. Research has shown the CAPM to stand up well to criticism, although the arguments against CAPM have been increasing in the recent years. Investment managers in Malaysia have widely applied CAPM as well as its sophisticated extension as the investment valuation metric. CAPMs application to corporate finance is the recent development. Although it has been employed in many utility rate-setting proceedings, it has yet to gain widespread use in corporate circles for estimating companies cost of equity. Methodology The Capital Asset Pricing Model indicates a simple linear relationship between expected rate of return and systematic risk or market risk of a security or portfolio. The model is an extension of Markowitzs (1952) portfolio theory. The researchers who are commonly credited with the CAPM development are Sharpe (1964), Linter (1965) and Black (1972) and that is the reason CAPM is normally referred as SLB model. Markowitz (1952) developed a concept of portfolio efficiency through the combination of risky assets that minimizes risk for a given return or maximizes return for a given risk. Variance of expected returns has been used as the measure of risk and then the efficient portfolio will be developed to minimize risk for a given rate of return. The equation of CAPM indicates the relationship between cost of capital and market returns. The general idea behind CAPM is that investors need to be compensated for two reasons: time value of money  and risk. The time value of money is represented by the risk-free rate, Rf  in the equation and investors are being compensated for the forgone opportunity cost and time value of money due to their investment over a period of time. The other half of the equation represents the risk and the risk premium is the compensation for the investors for taking on any additional risk. It is calculated by using a risk measure (Beta) to the market premium (Rm-rf). The calculation of CAPM is as followed: Ri = Rf + ( Beta * Market Risk Premium ) where, Market Risk Premium = Rm Rf where, Ri = return on equity or portfolio Rm = return on the market portfolio Rf = return on risk-free asset Beta = sensitivity of security or portfolio to the systematic risk The equation indicates that the expected rate of return on asset i is equal to the rate of return on the risk-free asset plus a risk premium. The risk premium is calculated by multiplying beta with the difference between the expected rate of the return of the market portfolio and the risk-free rate. Risk free rate can be obtained from the return on Malaysian Treasury bill at particular time of the stock trading while beta can be calculate from the historical prices of stock and the market and the market return can be calculated based on the market index. To calculate the beta value, we need to first calculate the covariance of the security and the market. Second, we need to calculate the variance from market return. Next, we need to divide covariance of the particular security and market by variance of market to obtain the value of beta.