Corporate Risk Evaluation in the Context of Austrian Business Cycle Theory
Abstract: This paper expands Fuller’s (2013) analysis of the net present value and interest rate changes in the context of the Austrian Business Cycle Theory. During the boom phase of the business cycle, the economy shifts to a more risky position as the result of entrepreneurs’ profit targeting. To quantify this risk the duration, defined as the number of periods that elapse before the average present value dollar is received from a stream of cash flows, can be used. The new risk-adjusted net present value is created after applying the duration to capital asset pricing model determining the discount rate that should be used to calculate the present value of the project.
JEL Classification: B53, E22, E40, E52, G31, G32
Joanna Kruk ([email protected]) is a recent graduate of the Cracow University of Economics and Jagiellonian University.
The Austrian business cycle theory (ABCT) gained the interest and endorsement of non-Austrians as a valid theory shortly after the outbreak of the 2007/08 crisis. Then, major focus was placed on macrolevel aggregates such as the volume of loans, the threat of large scale bankruptcy or the supply of money. Little attention was paid to the analysis of corporate finance and the causes of companies’ erroneous decisions about initiating and carrying out unprofitable undertakings. One direct cause of the collapse was identified as cheap credit, which engenders a reallocation of resources between stages of production. That is inconsistent with the intertemporal preferences of consumers. In particular, lowering the interest rate below its natural level causes production to become more future-oriented. Artificially low interest rates are not only the cause of incurring new debts by companies, but are also the reason why less efficient companies enter the market. Due to the poor quality of their projects, these less efficient companies are more likely to mobilize necessary funds if funds are less limited, which is the result of expansionary monetary policy. Correspondingly, there are numerous entrepreneurs that will receive investment funds only when credit is “easy.” (Engelhardt, 2013) Moreover, erroneous decisions to engage more resources to projects which cannot be successfully completed are implemented, making the situation worse than it otherwise would be.
The aim of this paper is to analyze corporate finance from an ABCT perspective with a focus on the excessive risk-taking by companies. While the main literature about the business cycle focuses on the effects of certain policies on the aggregate and general shift of the economy to more risky positions, the motivation of financial decisions on a micro-level can shed new light on the foundations of the emergence of the business cycle. The vast difference between the profitability of an investment project relative to the interest rate change was previously discussed by Fuller (2013) using the net present value and the marginal efficiency of capital to show how interest rates affect the intertemporal allocation of capital and shift the resources to more roundabout projects. Enriching the analysis in risk assessment could lead to a further conclusion regarding the subject. One of the frequently used risk measures is duration, used in capital budgeting and precisely described by Blocher and Clyde (1979) and Johnson (2005).
In this paper, we plan to analyze previous work on the cycle effects on the microenvironment from the Austrian perspective, along with financial literature research on risk assessment, in order to try to capture the impact of interest rates changes based on financial decisions of firms with on numeric examples.
2. THE CORPORATE APPROACH TO THE AUSTRIAN BUSINESS CYCLE THEORY
The Austrian business cycle theory was developed in the first half of the 20th century, mostly by Ludwig von Mises and Friedrich von Hayek. The main focus of the theory was placed on the intertemporal coordination and allocation of resources. In the market economy, the role of price signals was emphasized, as it is the major indicator of entrepreneurs’ success in fulfilling their clients’ demands. Special attention was paid to interest rates since the core of the ABCT is how artificially low-interest rates, which are falling below their natural level, influence the economic activity of agents.
As formulated by Rothbard (1978), the unhampered market interest rate is determined only by the “time-preferences” of the agents. People choose money right now over a promise made in the present to receive the same amount of money in the future, which means that their time preference is positive. Time preference also indicates the distribution of people’s income between savings and consumption. When the interest rate falls as the result of government intervention, rather than as a change in people’s preferences, an artificial boom starts. Agents are deceived into thinking that there is a greater amount of savings available for their investment projects, so they begin to engage more capital, particularly in lengthy and time-consuming undertakings, which previously were unprofitable due to the higher cost of financing them.
The main focus of Austrian economists is placed on emphasizing the disruption of intertemporal resources allocated between stages of production, resulting in malinvestments. At the later stage, these projects turn out to be impossible to complete since there are not enough resources to finish all undertakings initiated during the boom episode. This argument was originally formulated by Ludwig von Mises: “Projects which would not have been thought profitable if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found profitable and can be initiated.” (Mises 1912, 26)
In the microscale during the expansionary phase of the business cycle, firms will prefer to expand production. Since the interest rate is regarded not only as a cost factor but also as a factor of capitalization, decreasing the interest rate creates an incentive for investments in fixed capital by way of capitalization of future yields (Machlup 1935). This is the effect of the increased present value of future return, which is capitalized at the new, lowest interest rate. This reasoning applies to both lowering interest rates directly by the central bank and to credit expansion. In the second scenario, the newly available funds push down the interest rate and create the impression that there are more resources available for investment in lengthy projects. At the same time, the decreased interest rate is the reason people are less willing to keep their income as savings, thus the further discrepancy between real and natural interest rate is created (Engelhardt 2012).
The main reason for keeping interest rates low is to boost the economic activity of agents. As a direct consequence, on a corporate finance level, it causes an increase in debt to capital ratio but also has an effect on capital budgeting decisions as described by Cwik (2008). Firms tend to not only increase the volume on investments but also replace investment in working capital with investment in fixed capital, widening the distance between real-time preference and the one imposed by the nominal interest rates. After the boom ends, these projects are abandoned as they are no longer able to generate positive cash flows. Some of the fixed capital used in undertaking can be moved to other projects, which was described by Wood (1984) as the illusion of depression: when companies decide to quit unprofitable undertakings, thus causing a decline in economic activity, but releasing the necessary resources for more effective projects. The resources which cannot be engaged in another project due to their specifics are considered sunk costs.1
3. INFLUENCE OF INTEREST RATE CHANGES ON THE NPV OF THE INVESTMENT PROJECT
Net Present Value is an indicator used in order to compare projects realized in different periods of time and with different lengths. It uses the discounted cash flow generated by the activity. The present value of delayed payoff can be found by multiplying the payoff by a certain discount factor, which is less than 1. If the value of the discount factor was greater it would mean that the dollar tomorrow is worth more than a dollar today, which denies positive time preference. Net present value is defined as follows:
CFt = a cash flow to be received in a period of time t,
r = discount rate.
Ludwig von Mises and Irving Fisher suggest using the present value approach to economic calculation since the price of an investment project is moving towards the present value of the project’s expected cash flows.2 Present value approach was also advocated by Rothbard (1962, 62–63):
It is clear that the higher the rate of discount, the lower the present value of the future good will be, and the greater the likelihood of abstaining from the investment. On the other hand, the lower the rate of discount, the higher the present value of future goods will be on the actor’s value scale, and the greater the likelihood of its being greater than the value of present goods forgone, and hence of his making the investment.
The consequences of interest rate changes and their effect on the valuation of projects were examined by Fuller (2013) and can be presented graphically:
Figure 1. Net Present Value Profile
Diagram from Fuller (2013).
There are three indications of the NPV profile shape: the NPV of the project increases as the interest rate falls, the chart is curved, so the NPV profile becomes flattened as the interest rate falls, meaning that the change in interest rates causes not proportional change in NPV and this dependence is explicit in long term investment projects in particular, since the longer stream of cash flows is discounted. Third, the NPV profile intersects the interest rate axis at the point where NPV is zero, indicating the positive NPV area on the right from the vertical axis (Fuller, 2013).
If the present value is used as an indicator of a project’s profitability, then the expected reinvestment rate should be used as a discount factor, since comparing two projects of a different outlays requires comparing in relative, rather than absolute terms. In that case, it is necessary to compare “present value per dollar of outlay” (Solomon, 1956). The valid comparison can be made not only with similar projects but also with two different courses of action, which can be brought to the same measure using NPV.
Wealth maximizing investors use NPV to rank their investment projects while competition in the market creates a tendency for the price of an investment project to equal the present value of expected cash flows. This is because investors will bid up the price when it is below the present value and bid it down when it is above, a simple arbitrag
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