Good Investment Opportunities Research Articles

The Pitfalls of Capital Budgeting When Costs Correlate to Oil Price

Abstract This paper investigates the economic relationship that exists between oil price and operating costs in the E&P industry and its implications for the capital budgeting and decision-making processes. We present empirical evidence that there is a positive correlation between price and operating costs, and that overlooking this relationship has severe implications for the valuation of investment projects, both using a traditional Net Present Value (NPV) methodology or a Real Option approach. In the traditional NPV method, overlooking a price-cost correlation results in undervalued projects, and under Real Option Analysis, projects tend to be overvalued if such correlation is ignored. Introduction Any oil company manager involved in capital budgeting and decision-making is aware that the costs of exploration, appraisal, development and production have skyrocketed in the last five years due to increased demand for drilling rigs, specialized labor force and other resources. This dramatic change in costs is ultimately related to the increased activity in the E&P industry, reflecting the impacts of the rise in oil prices observed in the last number of years. This paper shows empirical evidence that the operating costs in the E&P industry are highly correlated to the price of oil. In the capital budgeting process, however, this correlation is often overlooked. When costs correlate to oil price, an increase or decrease in revenues is at least partially offset by a co-movement in costs. When this offsetting effect is ignored, the volatility of cash flow tends to be overestimated. This paper shows how this problem affects the valuation of oil prospects, both under the traditional NPV approach and a real option valuation technique, analyzing how decision-making processes may be flawed when the correlation between oil price, capital and operational expenditures are ignored. Under the traditional NPV approach, the overestimation of the volatility of cash flow causes projects to be seen as riskier than they really are. This causes a misperception of the firm's costs of financial distress. As a result, NPV is underestimated and, thus, the firm may pass over some good investment opportunities. If a real option approach is used, overestimated volatility results in an overvalued project since, as seen in the next section, the value of an E&P project is an increasing function of the volatility of its cash flows. This paper is structured as follows: the next section shows briefly how projects are evaluated under traditional NPV and real option approaches. Section 3 presents empirical evidence that costs correlate to oil prices. Section 4 discusses the differences between project valuation when a cost-price correlation is taken into account or not, including a numeric example. The last section brings some findings, conclusions and general implications of the results obtained for the decision-making process. Project Evaluation Under Traditional NPV and Real Option Approaches Valuation Using Traditional NPV The Net Present Value (NPV) of a project is given by the sum of annual cash flows yielded by the projects; each one discounted at a proper rate that reflects the systematic risks associated to these cash flows, i.e.:

Equity Overvaluation and Capital Misallocation? A Revealed Preference Approach

Many economists believe that the stock market plays an important role in efficiently allocating capital to its most productive uses. This standard story of the stock market was called into question by events in the late 1990s, when some observers believed that there was stock market misvaluation that led to a misallocation of capital. Both the standard and misallocation stories involve discount rates and, to differentiate between the two stories, this paper examines the discount rates used by firms in making their investment decisions. The most common story for how misvaluation might affect investment runs as follows. Investors become excited about particular firms. In their excitement, they bid up the prices of these firms. Overvalued shares lower the perceived cost of equity capital. If managers act on this lower perceived cost, they will issue new shares, lower the discount rate used in evaluating investment projects, and increase investment spending. This story could be wrong (or at least of minor importance). Firms with high stock market prices may simply be firms that have particularly good investment opportunities. The central core of the standard story of capital allocation involves rates of return and discount rates. Favorable shocks - an increase in demand or a technical improvement - raise returns to capital for the fortunate firm. A firm earning high returns (relative to its cost of capital or discount rate) increases its capital stock until the return on the marginal unit of capital again equals the discount rate. Absent externalities, capital is being allocated optimally. We use a revealed preference approach that relies on the pattern of investment spending - combined with investment theory - to estimate the discount rates used by managers. The standard story predicts that glamour firms should have discount rates equal to the risk-adjusted market rate. The misallocation story predicts that glamour firms should have discount rates below the market rate. The standard story also predicts the discount rates for glamour firms should have a flat time path, while the misallocation story predicts a U-shaped time path. Based on a panel dataset of over 50,000 firm-year observations, we find support for both stories. The behavior of glamour firms with good measured investment opportunities is best described by the standard story, while the misallocation story provides the most appropriate interpretation of the behavior of glamour firms with poor measured investment opportunities.

O uso de informações por analistas de investimento na avaliação de empresas: à procura de padrões

A informação é hoje um dos principais recursos dos trabalhadores do conhecimento na resolução de problemas, mas pouco se sabe sobre a natureza de sua utilização. O analista de investimentos é um trabalhador de conhecimento que utiliza e produz informações com o objetivo de avaliar empresas e setores produtivos para identificar boas oportunidades de investimento. No contexto do mercado de capitais, a literatura tem enfatizado a importância em utilizar informações disponíveis para identificar oportunidades, recomendar adequadamente investimentos e, com isso, apresentar bons retornos. É um enfoque que não evidencia todo o processo pelo qual as informações são adquiridas e, depois, processadas, interpretadas e integradas, num esforço para identificar um bom investimento. Há, portanto, necessidade de investigação para conhecer esse processo. O objetivo deste trabalho é mapear, através de um estudo de campo de natureza qualitativa, o processo de uso da informação por analistas de investimentos e verificar se há diversidade ou padronização nos seus procedimentos e decisões. O estudo acompanhou a atividade de 27 analistas de nível sênior durante a avaliação de uma empresa. São apresentados comentários sobre a aplicação dos resultados e a contribuição do estudo para o trabalho do analista de investimentos.

Economic growth and equity returns

It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900–2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.

Can Rational Investors Overreact?

This paper proposes a rational model to explain why asset prices can be different from fundamental values. Following Krep (1982), when uncertainties that affect asset returns accumulate into the future, intermediate trading prices will reveal more information about the states of nature than dividends. Consequently, short-term investors anticipating intermediate trading will set the price differently from the fundamental value that is calculated from future dividends, generating an (artificial) overreaction price pattern from an econometrician's point of view. The price deviation from fundamental values can lead to well-known phenomena such as the closed-end fund discount, bubbles, crashes, and excess volatility. Using dividend yield as a measure for uncertainty accumulation, the model further predicts that dividend premium generally exists but has exactly the opposite sign within firms with good or bad investment opportunities, that size and value premium are more significant for firms with zero or lower dividend yields, and that return volatility increases in book-to-market and decreases in size and dividend yield. Empirical tests have confirmed these predictions and demonstrated that mimicking portfolios of cumulative uncertainty can generate highly significant risk-adjusted returns.

Economic Growth and Equity Returns

It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900-2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.

Global Industry Analysis and the Quest for Comparability

International equity investing, contrary to what some people think, provides good opportunities for active management. The challenge is finding attractively priced stocks. Three traditional approaches can be used (global sector analysis, cash flow analysis, and local market and sector analysis), although the greatest benefit appears to come from using a multifactor sector and country approach. Harmonization of accounting practices across countries will further help investors identify good investment opportunities, so investors need to be on top of the International Accounting Standards Board's proposed changes.

Cross-Subsidies, External Financing Constraints, and the Contribution of the Internal Capital Market to Firm Value

We examine the link between the excess value of a diversified firm and the value of its internal capital market. Subsidies to small financially constrained segments with good relative investment opportunities significantly increase excess value, while transfers of resources from segments with good relative investment opportunities significantly decrease excess value. Of interest is that subsidies to small financially constrained segments with poor relative investment opportunities also significantly increase excess value. However, there is little evidence that this result depends on the diversity of a firm's investment opportunities. We conclude that financing constraints drive the relationship between the internal capital market and firm value. Copyright 2003, Oxford University Press.

An equilibrium analysis of information aggregation and fluctuations in markets with discrete decisions

This paper shows how the interaction between decentralized information gathering and discreteness of investment decisions at the individual level can generate random fluctuations in aggregate investment that involve occasionally large allocation errors. This interaction is illustrated in a model in which private information is costly to acquire and prices reveal information. The unique rational expectations equilibrium outcome of the model is shown to always be noisy and characterized by investment levels which may be high simply because uninformed investors are buying under the impression that the high price is a signal of good investment opportunities.

Discretionary Contracts and Bank-Firm Relationships

This paper provides a rationale for the use of discretion in bank loan contracts. Discretion allows banks which produce information on borrowers to optimally adapt contract terms to 'soft' or non-verifiable information in the course of lending. This facilitates investment efficiency and also allows for wealth redistributions in favor of firms with good investment opportunities. I show that the optimality of discretion depends critically on bank quality and the degree of lender competition. If bank quality is low and/or lender competition is limited, enforceable bank contracts and financial market contracts dominate discretionary contracts. I also show that the relative importance of bank vis-a-vis financial market financing is non-monotonic in borrower quality. The analysis has implications for the competitive position and the optimal organizational structure of banks, and emphasizes the value of relationship lending in an increasingly competitive environment.

Corporate governance, dividend payout policy, and the interrelation between dividends, R&D, and capital investment

This paper investigates the relationship between dividends and the ownership and control structure of the firm. For a panel of Austrian firms over the 1991/99 period, we find that state-controlled firms engage in dividend smoothing, while family-controlled firms do not. The latter choose significantly lower target payout levels. Consistently, state-controlled firms are most reluctant and family-controlled firms are least reluctant to cut dividends when cuts are warranted. The dividend behavior of bank- and foreign-controlled firms lies in between state- and family-controlled firms. This is consistent with the expected “ranking” of information asymmetries and managerial agency costs. The above results hold for firms with good investment opportunities. We find that firms with low growth opportunities optimally disgorge cash irrespective of who controls the firm.

A Dynamic Model of Diversification and Divestiture

Empirical studies show that a large portion of the diversification discount can be explained by controlling for firm-specific characteristics. Although these studies leave no doubt that there is a self-selection component in firm's decision to diversify, the failure to explain the entire discount implies that some conglomerates destroy value and raises a question: why firms choose to diversify and what prevent them from value-increasing divestitures. This paper provides an answer to this question. It argues that the agency cost in a conglomerate is positively related to the number of divisions with good investment opportunities. Therefore, benefits of conglomeration offset agency costs for conglomerates with a number of bad divisions and make diversification profitable for bad firms. However, when investment opportunities of some divisions improve, the agency cost increases and offsets the benefits of diversification. Unfortunately, if investors cannot correctly price all of the conglomerate's divisions, the conglomerate cannot receive the fair price for its good divisions and, therefore, cannot implement value-increasing divestitures. As a result, the paper predicts a negative relationship between the age of the conglomerate and the diversification discount, while a failure to control for the self-selection bias may lead to an incorrect conclusion that this relationship is positive. By looking at the exogenous shocks to the economy, the paper also predicts more refocusing activities and greater value-distortion of diversification during economic booms.

RISK MANAGEMENT FOR MIDDLE MARKET COMPANIES

This article reinforces the message of the one immediately preceding by showing that small to medium‐sized firms have even stronger (non‐tax) motives for hedging risks than their large corporate counterparts. Although middle market companies have traditionally been viewed as less sophisticated than their larger corporate counterparts in the risk management arena, the authors suggest that such companies have become increasingly receptive to new hedging strategies using derivative products. When used appropriately, such products allow companies to stabilize their periodic operating cash flow by eliminating specific sources of volatility such as fluctuations in interest rates, exchange rates, and commodity prices.Smaller companies recognize that a single swing in a budgeted cost can have a catastrophic effect on an entire budget, whereas a larger company can more easily absorb such a cost. Moreover, because the principal owners of mid‐sized firms often have a substantial part of their net worth tied up in the business, they are likely to have a far stronger interest than typical outside shareholders in using risk management to reduce the volatility of corporate profits and firm value. Perhaps most important to owners whose firms rely on debt financing, the greater cash flow stability resulting from active risk management significantly reduces the possibility of financial distress or bankruptcy.In this article, three representatives of Bank of America's risk management practice discuss three different exposures faced by middle market companies—those arising from changes in interest rates, foreign exchange rates, and commodity prices—and show how these risks can be managed with derivatives. Besides shielding companies from financial trouble, risk management is also likely to improve their access to the money and capital markets. By protecting the firm's access to capital, risk management increases the odds that the firm will not be forced to pass up good investment opportunities because of capital constraints or fear of getting into financial difficulty.

Cross Subsidies, External Financing Constraints, and the Contribution of the Internal Capital Market to Firm Value

This paper examines the link between the value of a diversified firm and the value of its internal capital. We construct measures of the value of internal capital market transactions based on the dollar flow of subsidies and transfers across segments, the relative investment opportunities of segments, and the likelihood that a segment receiving a subsidy would face external financing constraints if it were a stand-alone firm. We find that specific components of a diversified firm's internal capital market are important determinants of its excess value. Subsidies to small financially constrained segments with good relative investment opportunities significantly increase excess value, while transfers of resources from segments with good relative investment opportunities significantly decrease excess value. Surprisingly, subsidies to small financially constrained segments with poor relative investment opportunities also significantly increase excess value, albeit to a lesser extent than the subsidies to constrained segments with good relative investment opportunities. We conclude that financing constraints drive the relationship between the internal capital market and firm value.

Feasibility study of a combined electric power and water desalination plant in Jordan

The rapid growth in Jordan’s electrical and water needs cannot be addressed by the current and planned supply sources. A combined electric power and water desalination plant is proposed and studied in detail. The plant is designed to cover all of Jordan’s electrical and part of its water needs up to the year 2020. Sensitivity analysis of the plant’s profitability under several financing and fuel price scenarios was performed. The results show that such a plant represents a good investment opportunity under a wide range of conditions.

How Firms Make Capital Expenditure Decisions: Financial Signals, Internal Cash Flows, Income Taxes and the Tax Reform Act of 1986

This paper empirically assesses the determinants of future net capital expenditures for a broad cross-section of COMPUSTAT firms from 1973 to 1989. We explore three general categories of factors expected to affect investment: (1) external equity financing, (2) internally generated accounting information, and (3) tax incentives. We find that external financing and information plays a role in that both positive stock returns and equity issuances indicate future increases in investment. The results suggest that high stock prices not only lower the cost of capital, but also signal good investment opportunities. Accounting information about internal sources and uses of funds are also important in the investment decision. In particular, net income and depreciation are positive indicators of future investment while there is a tradeoff between the payment of dividends and investment. Further, positive changes in available cash liquidity also motivate future investment. While taxes are not important in the investment decision on average, we find that firms with previously higher income taxes invested substantially more in 1985 and 1986. This coincides with the repeal of the investment tax credit and the accelerated depreciation schedules in the Tax Reform Act of 1986. We view this as evidence that federal tax policy in the 1980's induced firms with high income tax obligations to accelerate capital expenditures just before the favorable tax treatment of capital expenditures was eliminated.

Financial development by learning

This paper analyzes financial development driven by accumulation of information through ‘learning by doing’. Financial intermediaries discover good investment opportunities by making loans to industrial projects; they thereby accumulate information that improves the allocation of savings. An initial equilibrium with poor information, and thus no industrial investment, may trap the economy in financial underdevelopment. Such a trap is informational and can be overcome by the remedies that resolve informational externality.

Leverage, investment, and firm growth

We show that there is a negative relation between leverage and future growth at the firm level and, for diversified firms, at the business segment level. This negative relation between leverage and growth holds for firms with low Tobin's q ratio, but not for high- q firms or firms in high- q industries. Therefore, leverage does not reduce growth for firms known to have good investment opportunities, but is negatively related to growth for firms whose growth opportunities are either not recognized by the capital markets or are not sufficiently valuable to overcome the effects of their debt overhang.

A test of the free cash flow hypothesis: The case of bidder returns

We develop a measure of free cash flow using Tobin's q to distinguish between firms that have good investment opportunities and those that do not. In a sample of successful tender offers, bidder returns are significantly negatively related to cash flow for low q bidders but not for high q bidders; further, the relation between cash flow and bidder returns differs significantly for low q and high q bidders. This result holds for several cash flow measures suggested in the literature and also in multivariate regressions controlling for bidder and contest-specific characteristics.

The Health and Safety of Workers: Case Studies in the Politics of Professional Responsibility ed. by Ronald Bayer

TECHNOLOGY AND CULT URE Book Reviews 149 knowledge” (p. 134). Neither they, nor any of the policy analysts, university administrators, or government officials they talked with, seem to have given any thought to what such a shift in orientation might mean for the quality and character of university science. Back at the turn of the last century, in The Higher Learning in America, Thorstein Veblen warned of the dangers to American universities of embracing what he called the “pecuniary culture”— turning trustees into boards of directors, presidents into “captains of erudition,” and education into industrial training. With the dramatic increase in federal funding of university science following the Second World War, such fears about business domination of higher education pretty much vanished, though the occasional scholar like Robert Nisbet could not help wondering if the “higher capitalism” of government science was any improvement. The troubling undercur­ rent of this book’s message is made all too clear in revealing passages like the one where the authors note that one of the reasons Baylor Medical Center has been so effective at getting down to business is that “it has no history or philosophy departments to challenge whether academic freedom would be compromised by commercial­ ization” (p. 86). That the absence of such a challenge to the selling of the American university should be cited as an advantage is an affront to the very notion of what a university is and should be. There are still those of us who believe it should stand for something more than just another good investment opportunity. Stuart W. Leslie Dr. Leslie teaches in the Department of History of Science at Johns Hopkins University. The Health and Safety of Workers: Case Studies in the Politics ofProfessional Responsibility. Edited by Ronald Bayer. New York: Oxford University Press, 1988. Pp. ix + 308; notes, index. $29.95. Quis custodiet ipsos custodes? This disturbing, disquietening book chronicles, in the form of detailed case studies of the lead, coal­ mining, and asbestos industries, the attempts to regulate the hazards associated with their operations. The reason for the feeling of disturbance is not that the hazards were unrecognized. Most people knew that lead was dangerous. What is so disquietening is, as the authors document so thoroughly as to make incontrovertible, the confidence with which many professionals either denied that there were any such hazards or claimed that the hazards were negligible in relation to the benefits. (Not that the benefits necessarily went to the workers in those industries.) Perhaps the authors are not always conscious enough of the difficulty of obtaining adequate evidence. What was not known 150 Book Reviews TECHNOLOGY AND CULTURE during the period covered by the survey, and is still not known today, is how much exposure to or intake of lead for how long from which source is safe. Even now, the fact that lead in drinking water is much more likely to be a serious environmental hazard than lead from gasoline comes as a shock to most people. The principal moral drawn in The Health and Safety of Workers is that professional employees cannot be relied on to behave professionally. That is, they do not follow the codes associated with their profession, whether it be the Hippocratic oath to be obeyed by physicians or the rules laid down by the engineering institutions. The authors conclude from this that professionals must be made acutely aware of the political and moral obligations of their work. This recommendation is insufficient. Professionals may be expected by the public to behave as independent advisers, but in practice they behave more nearly like any other employee. They have to: otherwise they lose theirjob and cannot readily get another. Even independent advisers have been known to give an answer that will secure them additional contracts with the organization that briefs them rather than the reply that a proper assessment of the evidence requires. So is it reasonable to demand that professionals, who are employees in industry and government, be trusted, in that 19th-century expression, to hold the ring? The book demonstrates that the principle of government regula­ tion is by itself insufficient. The only way of dealing with the problem is to ensure...