This explains why a project’s value is the same irrespective of the firm that undertakes it or of its contribution to the firm’s total risk. All valuable investment projects can be financed whatever the firm’s financial position. A similar type of reasoning is adopted under the CAPM efficient market hypothesis as shareholders are assumed to be investing directly into a project providing a required rate of return satisfying the one-period efficient market equilibrium conditions. Again, the economy is transparent and frictionless.
Such a rule has been proposed and adopted by academics for over 40 years even though Eugene Fama’s article (1970) demonstrates that the CAPM formula cannot generally be used for discounting cash flows in a multi-period framework. The CAPM decision rule states that any investment project with a positive expected NPV should be accepted, irrespective of its own volatility or of its contribution to the firm’s total risk, for only systematic risk is relevant. We may qualify such a point estimate or certainty equivalent approach as normative to the extent that market conditions under which the investment process is taking place as well as the required rate of return both represent idealised conditions and are not at all descriptive of the actual workings of the real economy. Obviously, the proposed CAPM certainty equivalent evaluation and decision rule aim at determining the market value of an investment project. However, the market to which it is referring is the one of a one-period transparent and frictionless economy abiding by the Modigliani–Miller paradigm. In the very same sense, the CAPM efficient market completely ignores the fact that the real economy is neither transparent nor frictionless.
Indeed, the legal system establishes a clear distinction as to the roles, the rights and obligations of debtholders, shareholders and managers. Such legal constraints imply informational asymmetries which explain why the financing of risky investment projects, even those profitable, is not easily obtained. The difficulty to finance risky investment projects is even exacerbated under conditions of financial distress as the total risk of the firm rapidly becomes the fundamental and dividing issue between the main stakeholders.
For instance, when the probability of financial distress or bankruptcy of a firm is not trivial, and, consequently, when its equity value is low, then funds provided by shareholders serve essentially to make safer the debtholders’ risky outstanding debt, in addition to providing at their own expense the rate of return that the new shareholders will be seeking (Myers, 1977). We may also add that when a firm’s probability of bankruptcy is significant, it becomes quite rational for shareholders to increase the total risk of the firm by accepting very risky investment projects that might very well rescue the value of their equity even if this implies increased risks at the expense of debtholders. The shareholders risk to lose little and to gain much for in the worst case scenario shares would become worthless anyway. The shareholders would be actually transferring part of their total risk to the debtholders and thus maximizing the wealth of shareholders instead of the value of the firm (Jensen and Meckling, 1976).
Also, as a firm’s probability of financial distress increases, investors might find it evermore difficult, due to asymmetrical information, to distinguish sound projects that might increase the shareholders’ value from pet projects that aim essentially at increasing the size of the firm and consequently the powerbase, perquisites consumption, salaries and stock options of top managers. As a consequence of informational asymmetries, valuable projects might be foregone in the process of capital budgeting given the cash shortage experienced by a firm under financial distress (Stulz, 1999).
The proposition according to which managers should be risk neutral and should be using theCAPMcertainty equivalent decision rule is therefore not applicable when a firm experiences financial distress. That such a certainty equivalent decision rule has been proposed and used by academics for the last 40 years is understandable given that under the Modigliani–Miller perfect market paradigm it is always feasible to finance any profitable project even when a firm is close to financial distress. It should surprise nobody to learn that the CAPM equilibrium share price equation exposes itself to large values of probability of loss (Laughhunn and Sprecher, 1977). Now, considering that the CAPM assumes no default risk, it is quite logical that such an efficient market would set security prices without regard to the risk of bankruptcy caused by any failure to meet legal debt claims. Under the MM assumption of perfect and costless contracting: the problems that crop up when a firm becomes close to financial distress disappear because the firm can always costlessly recapitalize itself so that it is no longer close to financial distress. In the real world, such costless recapitalization is a dream. As a result, total risk matters and has to be taken into account when a firm evaluates a project. (Stulz, 1999: 9)
When a risky investment project imposes an additional cost on a financially strained firm through an increase of its total risk, the decision makers must quantify the marginal increase in total risk. To take this cost into account, managers have to quantify their total risk and have to understand how a new project might impact the firm’s total risk. Being close to action, managers have both ex ante and ex post information advantage over shareholders and debtholders. They might therefore try to maximize their own welfare (as any typically rational person might do) at the expense of shareholders or debtholders. However, given appropriate incentives (this is what stock options aim at), managers will take decisions to the shareholders’ advantage.
However, when projects go astray, shareholders will hold project managers responsible for the failed project and will certainly not think about blaming the economy’s systematic risk for its failure, the more so when the firm is in financial distress. The probability of loss then becomes important information, not as a criterion but as a constraint, in the selection and management of investment projects. Contrary to the concept of systematic risk which is drawn from a normative paradigm, the concept of total risk is derived from a positive probabilistic paradigm and aims at assessing the effective probability of loss. Therefore, it is just comes as a logical consequence that the hurdle rate that should be used to assess investment projects in a positive probabilistic paradigm should not be the CAPM prescribed cost of capital but the effective weighted marginal cost of capital of the firm.
The cost of total risk depends, among other things (a) on how the project is incorporated or organized, and (b) on how the firm is financed. The conventional capital budgeting practice is to include the project within the firm. Such a practice may not always be efficient considering that the credit risk supported by creditors is related to the firm’s total risk, rather than just the project’s risk. Given that creditors have claims against the entire firm, this implies the obligation to assess the firm’s total portfolio of projects’ and operations’ risks, a costlier operation than assessing the risk of a single project (Shaw and Thakor, 1987). Furthermore, incorporating the project within the firm creates an asset substitution moral hazard whereby cash flows can be diverted from safe projects to riskier ones at the creditors’ expense. Unless covenants prevent such substitution, creditors would recognize such a moral hazard and adjust the marginal cost of capital accordingly thereby impacting the total risk of the firm. On the other hand, organizing the project as
a distinctive legal entity prevents such a substitution but generates its own types of risk. To the increased overhead costs and underinvestment moral hazard problem, one must consider the increased financial cost generated by the increased financial risk that must be supported by the incorporated project (Flannery, Houston and Venkataraman, 1993).
Contrary to what theMMparadigm asserts, the cost of total risk depends also on how the firm is financed. Debt financing improves the profitability of the firm by confering tax benefits and thus lowering its cost of capital, but makes the probability of financial distress and bankruptcy more likely. A highly levered firm must therefore assess the impact on the firm’s total risk. Debt financing has a cost, so has equity financing. Otherwise, as Stulz (1999) remarks, all firms would be all-equity financed with no probability of financial distress. Agency costs and asymmetrical information explains why equity financing is costly since there are few all-equity firms. The cost of equity financing is, at the margin, equal to the cost of total risk (Stulz, 1999). When total risk matters, the appropriate measure of risk is obviously not an equity return volatility index. A firm can increase at no additional cost its total risk when the probability of financial distress is unaffected by a risky project:
However, any increase in risk that increases the probability of distress is costly and should be accounted for when evaluating the costs and benefits of a project. Because the risk that is costly is the risk associated with large losses, the appropriate measures of risk are lower-tail measures of risk such as Value-at-Risk or Cash-flow-at-Risk rather than measures such as volatility of stock returns or volatility of cash-flows. (Stulz, 1999: 9) In other words, one needs to know the probability distribution of risky investment projects.
Read More: Total Risk And The Real Economy
