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Capital Budgeting, Real Options, & Bending Grass

February 28, 2010 3 comments

Trees, no matter how well rooted they are, topple over from gusts of winds due to their inflexibility. But Confucius noted that “when the wind blows, the grass bends”. Thus, adaptability to the surrounding environment, plays a big role in survival. Against such backdrop, do I put into perspective the topic of Real Options; and how that aids management in better project selection; making them more adaptable.

Companies are established to generate wealth to its stakeholders. In doing so, a company must be working towards a vision; which is synonymous to the company’s central theme. By working towards their vision, companies take on and execute various projects. But since a company’s main object is to maximize the wealth of its stakeholders, management must have a way [or a tool] to help them select the most profitable projects. This is where Capital Budgeting comes into play.

In a nutshell, capital budgeting is the process of “making and managing expenditures on long-lived assets” (Ross et. al, 2008, p.2). Management must determine the cash inflows and outflows of a given project to determine its suitability relative to:

  • How the cash flows affect the stakeholders’ overall wealth
  • How the cash flows measure against the cash flows of other potential projects that management could undertake instead

Given that companies have limited funds (or fund sources), management must select those projects that create the most financial benefit to the shareholders.

But the process of selecting projects is not as trivial as portrayed above. A company exists in a complex environment, whereby a lot of factors are interconnected and in play. In fact, market environments are so complex, that they are semi-deterministic; they cannot be modeled with 100% accuracy, yet they are not chaotic. Thus uncertainty complicates the project selection process, as future cash inflows and outflows are only known with a given degree of accuracy.

In solving the project selection problem, various investment decision tools have been devised to assist managers; most prominent of which are:

  • Net Present Value (NPV): whereby the future cash inflows and outflows are discounted back to present money and all added up. The project with the highest NPV value will be the clear winner, as it maximizes shareholder’s wealth.
  • Internal Rate of Return (IRR): the IRR is the rate were a project does not contribute any gains or losses to the shareholders’ wealth – thus management would be indifferent about executing it. With this tool, managers compare the rate of return of a given project against its IRR to determine its level of profitability. The project that produces that highest profitability is selected.
  • Payback Period: Projects are determined on how quickly the cash inflows payback the initial investment [cash outflow]. The fastest project is selected.

Though this is by no means an exhaustive list, each method has its short comings. These methods were “designed for relatively stable environments… As a result, business strategy … turn out to be flawed because something outside their control doesn’t go as planned” (Trigeorgis et al., 2007). What was need is another method, that accounts for uncertainty and management’s ability to respond to future events; thus the method of Real Options came about.

“At its core, the real option perspective is like other theories of investment in that it is concerned with identifying the factors that influence the investor’s threshold —the point at which investors choose whether to invest or not” (Miller and Flota, 2002). What the real options method did differently, is that it introduced the concept of “the possibility of contingent decisions” (Amram and Kulatilaka, 1999). The method was a bit more chaotic compared to other methods, in the sense that it was more reflective of reality. Thus it accounted for situations of project expansion, contraction, abandonment, timing of events, and “sequential [growth] options [of other projects]” (Wyant, 2009). By explicitly accounting for the future flexibility inherent in capital investment opportunities, the real option method would better portray the real financial effect of a given project on shareholders’ wealth.

The main benefits of the real options method is that it facilities for better planning and in taking strategic decisions. Other methods might be too conservative in analyzing the benefits of a project, which would result in its rejection. The reason why the other methods suffer from such consevatism, is because they commit project decisions at the beginning stages, which results in “sacrificing flexibility and increasing exposure to … uncertainties of new markets” (Miller and Flota, 2002). Therefore with the real options method, better strategic modeling is conducted, which results in flexible project variability, a more informed management and lower costs [cash flows].

At my current place of employment, a financial leasing company, we constantly use the real options method. Since our funds are limited, we are selective with the clients we are willing to finance. In determining the risk profile of the client, we attach probabilities to our future relationship directions with the client: increase/decrease/or cap the exposure, perform repossession in the event of a payment defaults, file a lawsuit, etc. Based on such analysis, we are able “to better quantify the value of each contingency” (Trigeorgis et al., 2007) and effectively better handle our client base and overall company risk and returns.

~ Youssef Aboul-Naja

Why do companies need to understand risk?

February 22, 2010 2 comments

“If you have a pilot flying a plane who doesn’t understand there can be storms, what is going to happen?” (Nocera, 2009). Against this backdrop, I commence my discussion regarding the importance of understanding the nature of risk, and its profound effect on the returns of long and short term investments undertaken by businesses. The thought of escaping risk is an impossible feat. As with every action, there is an attached element of risk to it; ‘avoiding risk can itself be risky’ (Salzberg, 2010). Effectively, to survive and achieve growth, a business must learn to embrace risk by understanding its intricate elements, and the impact it brings about its operations. Thus risk, if handled properly, may very well be a source of opportunity. The Chinese captured such a concept, by denoting the symbol for risk as “a combination of two symbols—one for danger and one for opportunity (Damodaran, 2005).

What is risk? Though there is no verdict on an exact definition, Elroy Dimson proposed a rather interesting version, which states that “risk means more things can happen than will happen” (Farrell, 2007). So in that sense, risk is the anticipation of future events that will have an adversary effect on a given business; though not all events will take place. Also, not all events can be anticipated. If we can foretell the future, the element of risk would simply diminish to zero. Thus, risk is our interpretation of how the future events will unfold, given the current factors we have at hand.

From an Investment’s point of view, taking on risk will result in some form of return. How high or low the return is depends on how the predicted risk element pans out with the actual future events. Nonetheless, a return is composed of two elements: an expected part and a ‘surprise’ (Ross et. al, 2008, p.322) part. The expected part further breaks into a:
– Systematic element: a surprise element that is applicable to almost every asset
– Unsystematic element: a surprise element applicable only to a single asset

As companies go about their everyday business, they constantly engage with various activities; each having an element of risk. And as discussed earlier, each risk has a return associated to it. Thus, as companies go about their daily business, they are maintaining a portfolio of returns:
-> They must achieve a certain return to shareholders
-> They might have invested in other companies (thus they expect a certain return)
-> They might be undertaking a project (thus they need to achieve a certain return margin for the project to be profitable)
…etc
So for companies to survive, they must understand risk (the systematic and unsystematic elements), as this affects the returns generated, and would, in turn, affect the company’s return/investment portfolio on the short and long runs.

In understanding systematic risk, I bring upon an example from the company I currently work for. I work in a financing house in Saudi Arabia. Though it is a privately held company, they are constantly engaged in loan extending transactions, which bears an element of risk. The rates that are offered to the clients’ partly accounts for the systematic risk element [though it cannot be predicted precisely]. Examples include:
-> The prevailing SIBOR in the Kingdom
-> The death of King Fahd in 2005: “the market opened at a decline” (Akeel, 2005), which resonated across the whole Saudi economy, resulting in our company receiving delayed payments from its clients, and a lower overall return.
-> During the end of 2008 and throughout 2009, bearing in mind the global crisis, the oil prices fluctuated from “$98 per barrel, rose to $147 per barrel in July, then ended the year at $44 per barrel” (Anon, 2010). Such swings had an effect on government spending (especially in the early part of 2009), and effectively also affected client payments to our company.

Now, in understanding unsystematic risk, we continue upon the example of my company. Unsystematic risk examples include:
-> The change of our General Manager – the older one suddenly decided to resign. As the new GM is not tested [came from outside], this raised the risk factor to the company’s owners, thus requiring higher returns (meaning a higher cost of capital on our company) [short-term issue]
-> Changes in the leasing laws, as per directions from the Saudi Arabian Monetary Agency. This drove up the cost of doing certain parts of our business [short-term issue]
-> A conflict of interest issue, which required us to create two operational units (instead of one), and essentially drove the prices up [long-term issue]

Thus, in order to continue surviving, the company must understand how these systematic/unsystematic risks affect it – whether they are long or short term in nature. Once it understands, it will be able to minimize its risks [i.e. maximize its returns]. Also, by understanding how the various risks impacting the company and its effect on its overall returns [from current projects], they will be able to determine whether or not to “add a new project to its existing portfolio… [By] estimating the coefficient of correlation between the cash flows [returns] from the new project and the total cash flows [returns] from existing projects … it can [thus] determine the effect of the new project on the means and standard deviations of the total cash flows” (Hull, 1986) and decide on its overall benefit to the portfolio.

Understanding how risk [its systematic and unsystematic elements] impacts a company’s activities is of crucial importance to its survival in the short/long term. Failing to comprehend and incorporate such risk elements in business activity will lead to catastrophic results. Referring to the 2008/2009 global economic meltdown would suffice.

~ Youssef Aboul-Naja

Which Wealth should Corporations Maximize?

February 9, 2010 2 comments

In the sixteen hundreds, John Donne wrote his Meditation XVII poem, which included the ever infamous line of “no man is an island”. If I may draw similarities between corporations and individuals, given their environmental complexities, then one may adapt Donne’s line to: no corporation is an island. A corporation is set up by pooling resources of investors, known as shareholders, in order to create for them more wealth. But “money on its own produces nothing … it is only in combination with human, and at times, physical capital that a corporation comes alive” (Simpson, p.2). When Johnson & Johnson’s former CEO, Ralph Larsen, was asked “Do you serve shareholders, or do you serve stakeholders?” (Simpson, p.2), his reply was both; which emphasizes the fact that in order to create additional wealth for the shareholders, a corporation must keep a keen eye on the needs of the various stakeholders. But given the inescapable economic problem of scarcity, what should the corporate objective be? Maximizing the wealth of the shareholders, or that of the stakeholders?

When I was a young kid, my father once took me for a paddle boat ride at the lake. I wanted to take charge of the boat, by controlling the navigation rod; to which my father gladly agreed. The boat was drifting aimlessly, and all our paddling effort was going to waste; I was navigating, paddling, talking to my sister and feeding the ducks. It is when my father told me to focus on navigating, and aim for the far mountain, that the boat went in a straight line.

Using that story in the corporate world, we notice that by maximizing stakeholder wealth, a company must satisfy various constituencies [employees, suppliers, environment, communities, etc.], that the overall wealth-creation effect is dampened. There is no clear focus on how to chose amongst the various stakeholders; and what constitutes them in the first place. Yet, we must not forget that shareholders are also stakeholders. As a matter of fact, by corporations maximizing shareholder value, they are in effect also maximizing total stakeholder value. The reason is that shareholders only have claims to the “residual cash flows” (Sundaram); after all the stakeholders have been paid. Thus, by catering to the final link in the chain, the shareholders, all the other links would also been catered to in the process, resulting in the maximum wealth creation for all parties.

The above shareholder theory logic, have been contested by the stakeholder theory advocates, stating that, since Aristotle’s times, it has been known that “if you want to maximize a particular thing … you should perhaps not try to do it consciously … in a complex world, order [always] emerges” (Freeman, p.367). Thus their claim is that, by focusing on the stakeholders, the shareholder’s wealth will be maximized as a by-product.

In my opinion, such view is invalid, given that stakeholders are only interested in so far as getting their own benefits; why must a corporation engage in further risk after they [the stakeholders] get their cash flow? Entities are motivated only when “satisfiers (factors that cause satisfaction)” (Kotler and Keller, p.203) are present; as explained by Fredrick Herzberg. Thus given that shareholder wealth creation comes after that of the stakeholder, then the stakeholder rebuttal must be necessarily false. Stakeholder theory “politicizes the corporation” (Jensen, p.237), adding complexity to better defining a company goal; while shareholder theory, the goal is “single-valued metric … observable and measurable” (Sundaram, p.355).

Another argument that is often used against shareholder theory, is that such narrow view of wealth maximization will lead to greed, and eventually create value loss for stakeholders; one needs to look no further than the not so-long-ago corporate scandals such as Enron, Tyco and Worldcom. It should be understood that these scandals were a result of individuals trying to benefit themselves, regardless of which theory management has subscribed to. The individuals were playing outside the “rules of the game”; as Milton Friedman calls it. Enron’s CFO, Andrew Fastow, admitted to that; “I … engaged in schemes to enrich myself and others at the expense of Enron’s shareholders” (Sundaram and Inkpen).

At the end of the day, both shareholder and stakeholder theory “seek a path to a promised land in which accountable corporations managed by ethical decision makers create the greatest value for the greatest number of stakeholders” (Sundaram and Inkpen). There is an Arabic saying, that goes along the lines of: ‘the boat that does not have anything for God, will sink’; in that respect, the company’s main objective is to maximize shareholder wealth, while taking at a secondary level the requirements of the environment it engages with – the stakeholders.

~ Youssef Aboul-Naja