Jeff Madura (2005) states “Multinational Corporation should use a discount rate in capital budgeting that reflects its cost of capital adjusted for the proposed risk” in international Financial Management is realistic. The research focuses on the validity of the Madura statement. The statement is grounded on several prominent factors that may affect the cost of capital for a Multinational Corporation.
The availability of funds is one of the factors affecting cost of capital. The scarcity of the capital increases the interest and the risk free interest rate. A person who is in need of funds will agree to high risk interest rates. The person who does not need funds at the moment can easily ask for better risk-related cost of capital discounted rates.
Finance focuses on the time, money, and risk aspects of any business engagement. The Jeff Madura (2005) statement “Multinational Corporation should use a discount rate in capital budgeting that reflects its cost of capital adjusted for the proposed risk” in international Financial Management is realistic. Finance focuses on the time, money, and risk aspects of any business engagement. Bonds are debt instruments that can be sold to investors. The creditor or loan giver collects the debt from the debtor when the maturing serial payment dates arrive. The loan provider would not lend money if the provider does not earn something in return for borrowing another person’s money.
Normally, bonds are paid in regularly installments. The installments could be monthly, by quarterly, annually. The risk –related interest rate is grounded on the supply and demand economic theory. The supply theory shows that as the price of interest rate increases, the demand for the interest –based bonds decreases. On the other hand, there will be an increase in the demand for the interest –based bonds if the prices of bonds decrease.
Further, Stickney (2009) reiterated capital budgeting focuses on determining whether the investment in high value investments will generate a positive net present value. The net present value is possible if the cash inflows are higher than the cost of capital investment. If the cost amount is higher than the total cash inflows, negative net present value occurs. The investors should pursue a capital budgeting endeavor only if the net present value is positive.
Investments include cash outflows to set up a new production plant. Investments can come in the form of cash paid to purchase new production equipment. The new equipment will increase the production departments’ average daily production output. The increase in production output will translate to higher revenues. The higher revenues will translate to higher gross profits. The higher gross profits will translate to higher net income. The higher net income will precipitate to higher cash funds needed to pay currently maturing cost of capital payments.
Furthermore, Istemi Demirag and Scott Goddard (1994) emphasized the investors should forego a capital budgeting endeavor only if the net present value is negative. In terms of the net present value, the interest rate or discounted rate should reflect its cost of capital adjusted for the proposed risk. Any business endeavor must significant reflect include all risks in determining whether it is profitable to pursue a new product line, a new product launch, or a new business venture. The net present value is very important in the decision making process.
In addition, Brigham and Houston (2002) emphasized cost of capital focuses on the cost of using funds. Funds include both investments and borrowings. In terms of bonds, the borrower’s cost of capital is based on the amount of interest paid for the use of borrowed funds. On the other hand, the cost of capital of investments includes the amount of dividends received by the investors. Bonds are the legal documents indicating the interest and principal payment agreement entered into between the fund lender and the borrower. The stock certificate is the instrument indicating the investors are stockholder or owners of a portion of the company’s assets.
Also, Bryars (1991) insists the use of a discount rate in capital budgeting to reflect its cost of capital adjusted for the proposed risk is grounded on the degree and type of financial risk. The discounted interest rate includes in its financial risk all the risks of financing a business endeavor. For example, the unfavourable downside risk is the probable risk occurring when the actual return is less then the expected return. The risk can also represent the uncertainty of achieving the expected return. The cost of equity can be arrived at by adding the risk free rate of return to the sum of (beta x market rate of return risk free rate of return). The beta figure is significantly influenced by the fluctuations in the stock market and commodities prices.
On the other hand, Chapman (2007) proposed the cost of capital for debts is arrived at by focusing on the risk free bond that includes the terms of the corporate long term debt plus default premium. The default premium figure will rise in direct relationship with the increase in the amount of loans. Likewise, the default premium figure will decline in a similarly direct relationship with the decline in the amount of loans. In addition, some loans are sold by their creditors, especially banks.
Going deeper, Chapman (2007) insisted the discounting of interest rates portion of financial management, the cost of debt is arrived at by deducting the amount of tax paid to the government. The tax payments can be used as a deduction from the risk charge payments. The discounting of the rate should include the cost of the risk. The creditor should be paid for the risk he or she has to undertake for letting another person or organization borrow money.
The risk expense is to compensate for a certain percentage of borrowers who will not be able to pay their liabilities when on time. The creditor can place his or her funds in a bank. The money is safety tucked inside the bank vaults. The creditor can sleep soundly asleep because the funds are secured. The creditor does not have to worry that the money will be lost or stolen from the bank vaults. There is no risk because the bank funds are insured. Money that is forcibly taken away during bank heist will be reimbursed by the bank’s insurance company.
In terms of practicality, the creditor will make a background check on the borrower’s financial capacity. The creditor includes an interest amount based on the degree or risk of lending money to the borrower. A creditor will normally charge a higher interest on borrowers if the risk of nonpayment is high. On the other hand, the creditor charges borrowers a lower interest rate if they pay their loans on time. This is the very essence of the statement of the Jeff Madura in his scrutiny of the technical intricacies of the finance market.
In the real world, the creditor is normally willing to reduce the interest rate on long term loans if the borrower is willing and able to pay one’s principal loan before the regularly scheduled payment dates. In the same light, the creditor can choose between offering to charge interest without imposing a risk charge. This often occurs when the creditor feels that the borrower is able pay all loan installments on time. Consequently, this situation gives rise to the financial terminology known as risk-free premium rate.
In terms of management, management is normally willing to pay the risk amount in order to receive much-needed cash inflows needed in the business. To be able to pay for the principal amount of the loan and the risk-related amount, management strives to generate net profits. Management will pursue a loan contract to fund its current expansion within a new business endeavor if the cost of capital can be offset by the projected revenues generated from the cash borrowings.
Charlotta Groth (2010) evaluated the empirical evidence for costs that penalize changes in investment using U.S. industry data. Dividend decisions relate to the form in which returns generated by the firm are passed on to equity-holders. Investment decisions deal with the way funds raised in financial markets are employed in productive activities to achieve the firm’s overall goal; in other words, how much should be invested and what assets should be invested in. The author assumed that the objective of the investment or capital budgeting decision is to maximize the market value of the firm to its shareholders. The relationship between the firm’s overall goal, financial management and capital budgeting.
Borrowed funds can be invested in both short-term and long-term assets. Short term assets are those expire within one accounting period. Marketable securities are part of short term assets. Long term assets include those having a useful life of more than one year. Examples of long term assets are buildings, equipments, and vehicles.
Further, one of the most important principles of finance is that money has a time value. One reason for this is that a dollar today can earn interest while waiting for one year. For example, a given sum of money (say a cash flow of $5,500) should be valued differently, depending on when the cash flow is to occur. If the interest rate is 10% per annum, the present value of $5,500 received at the end of the first year is $5,000. This is due to the fact that $5,000 today can be invested at 10% to generate earnings amounting to $500 interest at the end of the year. If the $5,500 is received at the end of two years from today, its present value is less then $5,000; it is approximately $4,546. The net present value method can also be used to determine the discount rate needed to have a zero net present value.
Stickney (2009) theorized capital budgeting decisions deal with sizable investments in long-lived projects. The cash flows of a project are spread over many years. In many cases, large sums of money are invested in the first year and net operating cash flows are received over a number of years. At the termination of the project, terminal cash flows are realized. In addition to the initial investment in the first year of the project, capital expenditures may occur at later stages of the project, for example, upgrades to the plant and equipment. The cash flows occurring at different times have to be converted to a common denominator to assess if the cash inflows exceed the cash outflows.
The process can be done by translating all the cash flows into either their present or future values using a suitable ‘rate’ to represent the time value of money (Demirag & Goddard, 2004). A suitable proxy for the time value of money can be obtained from risk-free asset returns such as government bond yields or insured banks’ term deposit rates. These rates of return are generally termed ‘risk-free rates’. Using a risk-free rate, the cash flows occurring at different points of time can be converted into their present values at the beginning of the current year or future values at the end of the final year of the project’s planning horizon. The commonly used method in finance is to convert all the values into their present values using an appropriate discount rate (or interest rate) to represent the time value.
Whilst the present-value approach is the norm in project appraisal, the future-value approach may be useful at times. Cost of capital is part of the forecasting cash flows: quantitative techniques and routes. Forecasting is important in all facets of business. A super market needs to fore cast the demand for different types of cleaning agents, soft drinks and meat products. A car manufacturer has to forecast the demand for the different types of cars it produces. A farmer must forecast the demand for a variety of crops when deciding what to plant next spring. A government must forecast its tax revenue in the preparation of the next year’s cost of capital budget.
Mun (2005) reiterated a business corporation needs to forecast the future requirement of different types of labour inputs, raw materials, machines and buildings as an integral part of its business processes. All business firms should plan for the future. The success of a business firm is closely related to how well management is able to anticipate the future and develop suitable strategies. No business organization can function effectively without forecasts being done for the goods and services it offers.
In project evaluation, the ‘cash flows’ of a proposed project refer to expected future cash flows of that project. The reference is not to past or historical data, but to future data expected from the proposed project. Perhaps the most critically important task in project appraisal is the forecasting of expected cash flows. The cash flows form the basis of project appraisal. If the cash flow estimates are not reliable, the detailed investment analyses can easily lead, regardless of the sophisticated project appraisal techniques used, to poor business decisions.
Therefore, Stickney (2009) proposed reliable estimates of cash flows by careful and diligent forecasting are critically important. The estimation of cash flows for project appraisal may be viewed as having four main steps as follows: forecasting the capital outlays and operating cash inflows (e.g. cash proceeds from product sales) and outflows (e.g. expenses) of the proposed project; Adjusting these estimates for tax factors, and calculating the after-tax cash flows; determining the variables which have the greatest impact on the project’s net present value (sensitivity analysis); and allocating further resources, if necessary, to improve the reliability of the critical variables identified in the preceding stage.
Edward Flowers (1999) focused his research on determining why emerging capital markets are able to compete with the world’s major capital markets despite the fact that they have much higher costs of capital. To do this, Flowers compares the stock markets in Jamaica, Taiwan and the United States using general autoregressive conditional heteroskedasticity (GARCH) software and threshold general autoregressive conditional heteroskedasticity (TARCH) software risk forecasting models.
These models are used to describe the different qualities of capital market risk. His findings indicate there are differences in the qualities of risk in three nations’ stock market processing of financial information. The findings indicate different expectations and have different volatility responses to good and bad news. Computer software can generate the cost of capital. The financial calculator can also solve for the cost of capital. The software can compute for the cost of capital of bonds and stock investments.
In terms hedging the risks in financial investments, Lenos Trigeorgis (2004) reiterated the importance of using a numerical example to illustrate the interdependencies between options to wait-to-invest, to temporarily close shop, and to expand the scale of a project (growth option). It is confirmed that the incremental value of an option may increase or decrease when added to projects that already contain other operating options. Hedging occurs when an investor invests in two stocks or commodities. The investor normally chooses two opposite acting stocks. One stock has an upward market price trend. The other stock has a downward price trend. An investor gains when the stock market selling price is higher than the buying price.
The occurrence of operating flexibilities gives management an ability to revise decisions while the project is underway. The occurrence has been the focus of study in the growing literature on real options. Mun (2005) showed that the value of the option to wait-to-invest can be huge enough and that an investment standard criterion that ignores this option value can be very misleading. An option occurs when the current investors in a corporation are given the priority over new stock investors. The main goal is to retain the current stockholders’ percentage share of the company’s overall stocks.
Based on the above literature, the Jeff Madura (2005) statement “Multinational Corporation should use a discount rate in capital budgeting that reflects its cost of capital adjusted for the proposed risk” in international financial Management is realistic. The Madura statement is based on verifiable cost of capital theorems. The Madura statement is supported by basic finance theories. Indeed, the Madura statement is correct because it is grounded on the several prominent factors that may affect the cost of capital for a Multinational Corporation; lenders must be paid additional for the additional risks of clients not able to pay their liabilities on time (Cannice, 2008).
References
Brigham, E. and Houston, J. (2002) Fundamentals of Financial Management. London: Thomson South-Western.
Byars, L. (1991) Strategic Management. London: HarperCollins.
Cannice, M. (2008) Management. London: McGraw-Hill.
Chapman, C. (2007) Handbook of Management Accounting Research. London: Elsevier Press.
Demirag, I., Goddard, S., (2004) Financial Management for International Business. London: McGraw Hilll Press.
Flowers, E., (1999) Interlocking Global Business Systems: The Restructuting of Industries, Economies, and Capital Markets. Westport: Quorum Books Press.
Groth, C., (2010) Investment Adjustment Costs: An Empirical Assessment. London: Wiley Blackwell Press.
Meredith, G. “Improved Capital Budgeting Decision Making.” Management Decision 48, no. 2 (2010): 225-247.
Mun, J., (2005) Real Options Analysis: Tools and Techniques for Valuing Strategic Investments and Decisions. London, J. Wiley & Sons.
Stickney, C., (2009) Financial Accounting. London, Cengage Press.
Trigeorgis, L., (2004) Real Options in Capital Investment. London: Praeger Press.