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Management implications of net present value computation are investigated in comparison to computation of capital return rate, in the absence of periodic boundary conditions.
Abstract
Purpose
Management implications of net present value computation are investigated in comparison to computation of capital return rate, in the absence of periodic boundary conditions.
Design/methodology/approach
The initial state of experimental forest stands is measured in the field. Further development of the stands is investigated using a growth model.
Findings
The capital return rate strongly depends on cutting limit diameter, whereas net present value (NPV) is insensitive to it. The net present value also is indecisive whether or not frequent further thinnings should be implemented. In the absence of further harvesting, the net present value of growth declines rapidly, as does the capital return rate. With repeated diameter-limit cuttings, the net present value declines even if the capital return rate is retained. After a few decades, the NPV stabilizes even if the capital return rate declines. On stands previously thinned from below, greater NPV is gained without further thinnings, whereas capital return rate requires repeated diameter-limit cuttings.
Research limitations/implications
It appears difficult to formulate management instructions on the basis of NPV computations because of the indecisiveness of the results.
Practical implications
Regardless of the degree of decisiveness, NPV-based management results in losses of capital return.
Originality/value
Net present value of further growth is computed in the absence of periodic boundary conditions, and the outcome is compared with the statistically expected value of capital return rate.
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Sees the objective of teaching financial management to be to helpmanagers and potential managers to make sensible investment andfinancing decisions. Acknowledges that financial…
Abstract
Sees the objective of teaching financial management to be to help managers and potential managers to make sensible investment and financing decisions. Acknowledges that financial theory teaches that investment and financing decisions should be based on cash flow and risk. Provides information on payback period; return on capital employed, earnings per share effect, working capital, profit planning, standard costing, financial statement planning and ratio analysis. Seeks to combine the practical rules of thumb of the traditionalists with the ideas of the financial theorists to form a balanced approach to practical financial management for MBA students, financial managers and undergraduates.
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Textbooks often portray capital budgeting as a rather mechanical process: Top management decides whether or not to accept a project by requesting an estimate of net present value…
Abstract
Textbooks often portray capital budgeting as a rather mechanical process: Top management decides whether or not to accept a project by requesting an estimate of net present value from its staff and to see if the number is positive or negative. This paper suggests that the textbook net present value rule is not optimal if the competitive market assumption holds. Better decision rules state minimum acceptable safety margins and may take the form of stating a minimum acceptable profitability ratio.
This paper examines the appropriate term of the risk free rate to be used by a regulator in price control situations, most particularly in the presence of corporate debt. If the…
Abstract
This paper examines the appropriate term of the risk free rate to be used by a regulator in price control situations, most particularly in the presence of corporate debt. If the regulator seeks to ensure that the present value of the future cash flows to equity holders equals their initial investment then the only choice of term for the risk free rate that can achieve this is that matching the regulatory cycle, but it also requires that the firm match its debt duration to the regulatory cycle. Failure of the firm to do so leads to cash flows to equity holders whose net present value will tend to be negative, and will also inflict interest rate risk upon equity holders. This provides the firm with strong incentives to match its debt duration to the regulatory cycle.
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The purpose of this article is to determine the optimal use of collateral in order to maximize the borrower's wealth by reducing the interest rate payments. This analysis is to…
Abstract
Purpose
The purpose of this article is to determine the optimal use of collateral in order to maximize the borrower's wealth by reducing the interest rate payments. This analysis is to shed light on the fundamental question whether good or bad borrowers pledge more collateral.
Design/methodology/approach
The analysis bases on a simple firm value model similar to Merton's but with the additional feature that the borrower can bring in collateral. This article not only presents the case with perfect information between borrowers and lenders but also regards the consequences arising from asymmetric information.
Findings
A bad borrower, who is characterized by higher bankruptcy costs, riskier projects, and a lower contribution to the project value, typically pledges more collateral than a good borrower. These relationships base on the existence of perfect information between borrowers and lenders. If asymmetric information in terms of the project's riskiness or the contribution of the borrower to the project is present, these relationships invert and good borrowers tend to pledge more collateral. As a result, the allocation of information between a borrower and a lender is crucial for the optimal choice of collateral.
Research limitations/implications
This research underlines the potential for firms to add firm value by pledging collateral because collateral reduces interest rates and therefore results in more attractive terms of the loan. On the other hand, further empirical research can be done to verify our theoretical finding that under perfect information bad borrowers pledge more collateral, while under asymmetric information primarily good borrowers use collateral.
Originality/value
This paper introduces a new motive for the use of collateral and explains – in contrast to many other theoretical models – why bad borrowers tend to pledge more collateral.
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Florian Klein and Hato Schmeiser
The purpose of this paper is to determine optimal pooling strategies from the perspective of an insurer's shareholders underlying a default probability driven premium loading and…
Abstract
Purpose
The purpose of this paper is to determine optimal pooling strategies from the perspective of an insurer's shareholders underlying a default probability driven premium loading and convex price-demand functions.
Design/methodology/approach
The authors use an option pricing framework for normally distributed claims to analyze the net present value for different pooling strategies and contrast multiple risk pools structured as a single legal entity with the case of multiple legal entities. To achieve the net present value maximizing default probability, the insurer adjusts the underlying equity capital.
Findings
The authors show with the theoretical considerations and numerical examples that multiple risk pools with multiple legal entities are optimal if the equity capital must be decreased. An equity capital increase implies that multiple risk pools in a single legal entity are generally optimal. Moreover, a single risk pool for multiple risk classes improves in relation to multiple risk pools with multiple legal entities whenever the standard deviation of the underlying claims increases.
Originality/value
The authors extend previous research on risk pooling by introducing a default probability driven premium loading and a relation between the premium level and demand through a convex price-demand function.
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Public and private sector managers make investment decisions under uncertainty. Economic efficiency requires that managers who wish to maximize expected utility use NPV. A field…
Abstract
Public and private sector managers make investment decisions under uncertainty. Economic efficiency requires that managers who wish to maximize expected utility use NPV. A field test reports that a lower proportion of public managers (20%) utilize NPV than private managers (46%). This difference is significant at p = .01 in both logistic regression and chi-square tests for three competing, but not mutually exclusive, reasons. First, taxpayers are a primary source of capital. Taxation decisions are primarily political events and inefficiency is less likely to be disciplined by capital withdrawal. Second, it is more difficult to estimate expected benefits and costs. Third, investment decisions are often the result of political, not economic, processes. The objective may not be maximization of NPV.
George E. Pinches and Diane M. Lander
Interviews in South Korea, Taiwan, Singapore, and India indicate net present value (NPV) is not widely employed in making capital investment decisions in these newly…
Abstract
Interviews in South Korea, Taiwan, Singapore, and India indicate net present value (NPV) is not widely employed in making capital investment decisions in these newly industrialized and developing countries. It is not from lack of knowledge about net present value: rather, it is due to (1) widespread violation of the assumptions underlying NPV, (2) the high risk/high return nature of the capital investments, and (3) the decision‐making process employed in making capital investment decisions. These same three conditions exist for many capital investment decisions made by firms in developed countries. Only by abandoning the static NPV approach, building in real options, and understanding and building in the decision‐making process will further advances be made in capital budgeting decision‐making. One of the key paradigms in finance is net present value (NPV). In order to maximize value, managers should accept all positive NPV investment projects, and reject all negative NPV projects. The issue becomes more complex when uncertainty is introduced, or, as in recent years, when real options to defer, abandon, expand, etc. are incorporated into the decision‐making process [e.g., Dixit and Pindyck (1994) and Trigeorgis (1995 and 1996)]. However, with these exceptions, the state of the art in capital investment decision‐making revolves around the simple statement—take all positive NPV projects. In practice, evidence from surveys and discussions with corporate executives indicates the message taught for the last 30 years in business schools has been heard and, to a large extent, acted upon by larger U.S., Canadian, and British‐based firms. While larger firms in North America, and to a lesser extent Western Europe, generally employ the static, or traditional, NPV framework for making, or assisting in making, capital investment decisions, less is known about the decision‐making process employed by firms in other parts of the world. The question addressed in this study is: “Do firms in other parts of the world, especially in newly industrialized or developing countries in the Asia Pacific region, employ NPV for making capital investment decisions?” The purposes of this study are threefold: (1) to report the results of a series of open‐ended interviews conducted in South Korea, Taiwan, Singapore, and India about the capital investment decision‐making process employed; (2) to understand why NPV is not widely employed in making capital investment decisions in these newly industrialized and developing countries; and, most important, (3) to indicate that NPV and the capital budgeting decision‐making process need rethinking and refocusing to make them more effective—in all countries, whether developed, newly industrialized, or developing. The paper proceeds in the following manner. Section I provides an introduction to the study. In Section II the results of the interviews are presented. In Section III patterns that emerged during the interview process are presented, along with a number of specific examples of the types of capital investment decisions being considered. In Section IV the assumptions underlying NPV are examined, and then risk/return and the decision‐making process are considered. Section V contains the discussion and conclusions.
James S. Ang and Stephen P. Dukas
The Net Present Value (NPV) criterion of project evaluation has traditionally been accepted as the theoretically superior capital budgeting technique due to its concordance with…
Abstract
The Net Present Value (NPV) criterion of project evaluation has traditionally been accepted as the theoretically superior capital budgeting technique due to its concordance with the principal of value maximization. Recently, several authors have criticized the application of this criterion in that it understates the true value of an investment by ignoring 1. strategic growth opportunities, 2. the fact that management can discontinue the project before the end of its economic life, 3. the ability of management to delay the investment decision, 4. the arrival of information throughout the life of the project, and 5. management's option to temporarily “shut down” the production process. Through these omissions, it has been asserted that the use of net present value criteria has undermined the levels of real investment in this country, and stunted economic growth.
Valerie G. Caryer Cook and Ahad Ali
This paper aims to propose the use of net present value methods to derive the quality costs of quality improvement projects. The proposed methodology is then demonstrated in a…
Abstract
Purpose
This paper aims to propose the use of net present value methods to derive the quality costs of quality improvement projects. The proposed methodology is then demonstrated in a case study of a quality improvement to an inspection process in an automobile assembly plant.
Design/methodology/approach
The approach takes the form of application of accounting net present value methods to the cost of quality methods.
Findings
Quality improvements in the manufacture of durable goods do not usually have instantaneous results in warranty cost reductions, customer satisfaction or revenue expansion. The net present value method proposed gives a more accurate accounting of the expected results of quality improvement projects by considering the temporal effects of the change and the time value of money.
Research limitations/implications
The case study presented contains fictitious data to protect the confidentiality of the source. While it is useful in demonstrating the application of the net present value method, it should not be used as an indication of actual costs of plant operations.
Originality/value
The paper provides a unique approach to cost of quality analysis that is particularly useful in the assessment of quality improvement projects for durable goods. While much research is focused on cost of quality methods and philosophies, only a little provides the level of detail in the actual application of the methods found in the case study.
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