Research Proposal on "Efficacy of Different Mechanisms, Techniques"

Research Proposal 15 pages (4702 words) Sources: 1

[EXCERPT] . . . .

Shifts in the company's organizational design have included downsizing, new lines of business, and collaboration with other companies. Organizational design follows organizational strategy in the same way that architects are said to assert that "form follows function." For changes to be made in smart manner -- that benefits the organization, the shareholders, and the consumers -- the question of feasibility is paramount. Indeed, the first step in project management -- following initial conceptualization -- is feasibility.

Measures of Fiscal Feasibility

In my paper, I discuss several measures of fiscal feasibility when considering a new project. Below, I discuss Return on Equity, Return on Capital, Internal Rate of Return, and Net Present Value. My recommendations for use of financial ratios when evaluating the fiscal feasibility of a project follow, and it should be apparent that no single financial ratio is recommended as an absolute guide to project valuation.

Return on Equity definition. Return on equity (ROE) is the most commonly used yardstick of financial performance by executive managers and investors (Higgins, 2004). The return on equity ratio is determined by the following formula:

Return on equity = Net income / Shareholders' equity

ROE is a measure of the efficiency with which a company uses the business owners' capital. Higgins (2004) suggests a colloquial description of ROE may be as a measure of "bang for buck." In the simplest of terms, there are two ways to look at ROE: (1) A measure of how the earnings achieved per dollar of equity capital invested in a company; and (2) the percentage of return given to the owners' as a result of their investment (Higgins, 2004).

Return on Equity vs. Return on Capital. Return on invested capital (ROIC) [also referred to as return on net assets (RONA)] is a measure of the rate of return that is earned by all of the capital invested in the company -- but without consideration of the debt or equity labels attached to the capital in the financial statements (Higgins, 2004). Return on assets (ROA) is a "basic measure of the efficiency with which a company manages and allocates its resources" (Higgins, 2004). The fundamental difference between ROE and ROA is that return on assets (ROA) considers business profit as a percentage of money provided by creditors as well as money invested by owners (Higgins, 2004). Return on equity (ROE) and return on assets (ROA) do not reflect the capital structure of a company (Higgins, 2004). In other words, ROE and ROA do not contribute information to a financial analysis or company valuation about a business's financial leverage (Higgins, 2004).

Internal Rate of Return. The formal definition of internal rate of return (IRR) is as follows:

IRR = Discount rate at which the investment's NPV equals zero

NPV = Net Present Value

The Net present value subtracts the time dimension and permits a direct comparison of the present value of cash inflows against the present value outflows (Higgins, 2004). IRR is considered against the opportunity cost of capital. If the opportunity cost of capital equals the IRR, an investment is considered to be marginal. If, on the other hand, the IRR is greater than the opportunity cost of capital, an investment is considered to be attractive.

Net Present Value. Consideration of an opportunity can be thought of within the "call option" framework (Dixit & Pindyck, 1995). An investment decision to go or not to go with a project is like exercising an option (Dixit & Pindyck, 1995). Some circumstances will constrain a green and go decision -- for example if the market shows less demand for your product -- then the decision may be to wait until demand is up before going ahead with the project (Dixit & Pindyck, 1995). This is the same sort of thinking that is put in play to consider the time value or holding premium of an option (Dixit & Pindyck, 1995). If an option is "in the money" -- which means that there would be a positive NPV yield -- it doesn't necessarily mean that you should exercise the option -- that is, go ahead with the production (Dixit & Pindyck, 1995). The prudent course of action would be to wait until the option is deeper in the money -- that is, the project should be postponed until the net present value of proceeding with the project is large enough to offset any loss of value that the market will cost (Dixit & Pindyck, 1995).

Keep your eye on the ROE. In order to evaluate the benefits and risks of relying on ROE for valuation, it is necessary to consider the defining formula in greater depth. Given the formula for ROE,

Return on equity = Net income / Shareholders' equity, it is important to deconstruct the elements to show that:

Net income / Shareholders' equity =

Net income / Sales X Sales / Assets X Assets / Shareholders' equity

Alternately, these ratios can referred to in the following manner:

Return on equity = Profit margin X Asset turnover X Financial leverage

From this, it is apparent that there are three managerial levers for control of ROE (Higgins, 2004). These levers consist of the earnings that are rung from each dollar of sales (profit margin), the sales resulting form each dollar's worth of assets utilized (asset turnover), and the amount of equity that has been employed to finance the company's assets (financial leverage) (Higgins). A company can expect to increase ROE by increasing the ratio of any one of these financial levers (Higgins, 2004). That said, it is still fair to ask to what degree ROE a reliable measure of the financial performance of a company.

ROE should not be considered an unambiguous and absolute indicator of business performance since three important relatively obscure deficiencies impact the ROE measurement (Higgins, 2004). Higgins (2004) refers to these deficiencies as problems of timing, risk, and value. With regard to timing, ROE is a backward looking indicator that is focused on a single year (Higgins, 2004). What this means from a practical standpoint is that ROE does not fully capture decisions that have impact across multiple fiscal periods (Higgins, 2004). Another concern with ROE is that it considers only return without folding in the impact of risk on the numbers (Higgins, 2004). Two companies can have very similar ROE but the numbers can pose very different risk scenarios, which would certainly impact the quality of the numbers in a financial analysis (Higgins, 2004). Finally, ROE presents a value problem since it uses the book value and not the market value of shareholders' equity (Higgins, 2004). Book value is an historical measure, but market value represents the current and realizable share worth (Higgins, 2004). And high ROE in companies that are well-known are rapidly eroded by increases in the price of the stocks (Higgins, 2004).

Industry example. A comparison of Starbucks and Green Mountain coffee companies shows the following financial ratios. Explanations are provided in the text above about why simple comparisons of the financial ratios of businesses in a valuation are inadequate.

Starbucks Coffee Company

Green Mountain Coffee Roasters

Profitability

Profit Margin

10.67%

9.55%

Operating Margin

13.09%

14.68%

Management Effectiveness

Return on Assets (ROA)

13.77%

10.70%

Return on Equity (ROE)

28.45%

17.08%

Source: GMCR Yahoo! Financial and STBX Yahoo! Financial

The most popular approach to valuing potential investments employs the use of return on investment (ROI) (Higgins, 2004). But a second method warrants consideration: valuation through residual income (Edmonds, et al., 2012). Residual income is the essentially the amount of operating income less operating assets minus desired ROI (Higgins, 2004). Return on investment (ROI) is a measure of the productivity of a profit center or an investment as income divided by book value of the investment or profit center (Higgins, 2004). Return on investment is based on two ratios: margin (operational income) and turnover (operational assets). Residual income or residual profits is a measure of the profit center performance, which is defined as income less the annual cost of the capital employed by the profit center (Higgins, 2004).

Measures of Investment Feasibility

A residual income approach. When applied to valuation of investment in a potential project, residual income also includes a desired benchmark ROI (Edmonds, et al., 2012). That is, a company identifies a return on investment in a project to function as a benchmark for investments, and this desirable ROI benchmark is an element in the calculation of residual income (Edmonds, et al., 2012). The primary benefit to using residual income as a method of evaluating potential investment in projects is related to a concept termed sub-optimization (Edmonds, et al., 2012). Sub-optimization presents as a hazard to transparent valuation of investments in situations where the average profit of a division or business unit is superior to the average profit of the company overall -- and when going forward with an investment, under these conditions, the average… READ MORE

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