Electronic Library of Scientific Literature
Electronic Library of Scientific Literature
Volume 46 / No. 5 / 1998
Martin MACHÁČEK
The modern neoclassical theory of business cycles is one of the most
influential economic theories of today, with many important and interesting
implications for the area of planning and implementing economic policy.
Its fundamentals come from the scientific work of Robert E. Lucas, Jr.
and others (Robert J. Barro, Thomas J. Sargent, Neil Wallace, Edward C. Prescott,
Finn E. Kydland, John B. Long, Charles I. Plosser) who together formed
the so-called New Classical School of Macroeconomics (NCM). This paper
is focused on the methodological elements of NCM, its models of economic
fluctuations, some problems of stabilization policies in a NCM environment
and a selective survey of empirical evidence.
The first section of the paper contains a short discussion of the so-called
Lucas paradigm of economic research which represents the core of NCM's
doctrine. The paradigm is based on two critical assumptions. First is that
econometric modelling is superior to a verbal description of theory; the
second is the necessity to construct an a priori equilibrium model. It
is stressed in this text that according to NCM's point of view, every reasonable
economic theory must be empirically verifiable and able to explain any
macroeconomic phenomenon as a result of the optimizing behaviour by rational
agents who continuously maximize their welfare function.
The second section presents some common features of NCM's business cycle
models, such as assumptions about market efficiency and the rational expectations
of market participants. After a short discussion of the market-clearing
mechanism and the role of contingent claims, it is concluded that a neoclassical
business cycle is, in fact, best viewed as an optimal growth curve for
an economy subject to stationary stochastic shocks. A simple classification
of NCM's fluctuation models follows.
The third and fourth sections explain the main principles of monetary and
real business cycle models (MBC, RBC). While MBC models employ changes
in the money supply and the price level as primary factors initiating macroeconomic
fluctuations, RBC models emphasize the importance of changes in input productivity
for explaining business cycles.
The underlying scheme of every MBC model - no matter how sophisticated
the model - is similar, and appears as follows: monetary disturbances lead
to unpredicted changes in the aggregate price level; the changes in prices
are temporary misperceived as relative price changes because of agent's
imperfect information about the state of the money supply in the economy.
This misperception causes an adaptive process in the labour and goods market
and although these real effects of money are neutralized in the long-run,
they persist for several periods. Anticipated money supply changes resulting
from systematic monetary policy do not lead to any imperfect information
and that is why agents do not cause any changes in real economic variables.
The above mentioned hypothesis is well demonstrated by the so-called Lucas
supply function, which is part of Lucas's prototype business cycle model.
In RBC models, real disturbances caused by technology shocks serve as the
dominant source of macroeconomic fluctuations. A swing of aggregate output
and other real variables is produced by fluctuations in potential output,
i.e. aggregate supply. RBC theory is essentially nothing more than a modification
of neoclassical growth theory expounded in the pioneering work of R. M.
Solow (1956) and T.W. Swan (1956). This work has been extended by others
by the inclusion of intertemporal substitution between consumption (leisure)
and work. Because RBC models are not yet empirically verifiable, RBC theory
is time and again refined by the incorporation of new elements such as
assumptions about the existence of the monetary sector, fiscal sector,
non-market household production and even imperfect competition.
NCM's approach to business cycles is very useful for the development of
economic policies that are intended to rationalize the evolution of the
macroeconomy. The policy impact of the approach is the subject of the fifth
section. Since NCM comprehends macroeconomic fluctuations to be a result
of stochastic disturbances that are inevitable from time to time, it is
then not surprising that there are no major roles for government and its
stabilization policies in NCM's theoretical world. The neoclassical approach
calls for observing simple, transparent and long-termed policies (rules)
that do not negatively impact the response of an economy to shocks and
do not generate shocks themselves. This view can be understood by looking
at the NCM models of monetary policy with and without symmetric information.
Some empirical tests of the models, together with the results of the tests,
are summarized in the sixth section.
The mixed outcomes of a number of different studies do not sufficiently
support or reject the NCM theory and its policy recommendations. Although
contemporary macroeconomics has accepted the research methodology advocated
by "new classics" (e.g., microeconomic foundations of macroeconomic
theories, dynamic programming of economic problems), there are still significant
controversies about the reasons for the existence of business cycles, the
best policy approach to cycles and, in general, the best approach of economics
as a social science to an economy as a social system. For the author of
the paper, the problem of rationality and application of stabilization
policies is complex and must be discussed with respect to fundamental methodological
questions.
Menbere WORKIE TIRUNEH
Although there are disputes among economists about the measurement of the speed at which the growth rates of different economies are approaching each other, there is no doubt that convergence has been a real world phenomenon. However, it would be naive to expect convergence between countries with substantial political, economic and institutional diffe-rences. The results of this paper have also confirmed the absence of empirical evidence in favor of gross (absolute) convergence in the cross sections of world economies at large (similar to that obtained by Barro and Sala-I-Martin). In contrast, while there was strong empirical evidence for convergence across OECD countries (an evidence for conditional convergence), the results for other regional and sub-regional economies have shown either divergence or unequivocal results. Moreover, since the data for SSA is unreliable, the results should be interpreted with caution.
Juraj NEMEC
An examination of the role of the state (government) in the economy
is a very frequent issue at numbers of public economics and public finance
discussions. However, no common agreement on economic functions of the
state in the developed market economy has yet been achieved. There exist
several, from some points of view contrary, approaches - we could mention
the classical theory, based on ideas of Adam Smith, and the activist approach,
characterised by the theories of John Maynard Keynes, among many others.
Because of this, and because of the extremely specific environment of transitional
processes in countries of Central and Eastern Europe, the examination of
the role of the state in transition is a ne-cessary, if very complicated,
issue.
The role of the state in transitional economies is in some principles similar,
but in others quite different, from what standard theory describes in the
case of developed market (mixed) economies. The transitional state has
two very important functions in the process of socio-economic transformation
- to be manager of the transformation process and to transform itself into
a modern 21. century state. From these, management of transition from a
centrally planned to mixed economy is something new, never described in
theory and never realised in practice. The second, reform of systems of
public administration, is the "theme of the day" in each developed
economy, but with limited concrete improvements and no patterns that may
simply be transferred to the conditions of the transitional state. Because
of this, realisation of the functions of the state during transition is
very complicated process with uncertain results. The specific environment
of transitional countries, where all most important players of the "transition
game" do not "play" as expected (compared to western patterns
and models), may cause a number of different and unexpected solutions and
results.
What are the basic specific features of the transitional economy? To describe
them, we may analyse the behaviour of the main "players" - the
bureaucracy, politicians, entrepreneurs and citizens.
Behaving economically rationally (at least from a short-term perspective)
producers try to maintain their monopolistic position, as the best way
to maximise profits. Politicians and the bureaucracy very frequently use
their monopolistic powers (as described by standard theory) to increase
the level of centralisation in the economy and society, to gain more tangible
and intangible benefits from executing their powers. Citizens do not perform
their roles (as expected from western conditions) connected with market
competition (as consumers) and political competition (as voters). In average,
producers, politicians and bureaucrats behave rationally from an economic
point of view, and benefit from the existing situation. Citizens are worse-off,
because unable to protect their rights in business and political markets
for several reasons - we could mention tradition, cultural background,
lack of information and risk - avoiding behaviour.
Very much could be done to increase the role of citizens in transition
processes, one of the most (if not the most important) precondition of
successful transformation. From the economic point of view more information
about possible benefits of individual actions could be given to each citizen,
in order to include a full scale of costs and benefits that may occur as
a result of individual activities, into his economic and political behaviour.
In the last part of this article, some general issues on the role of the
state and its relations to private markets in the transitional economy
are expressed. As mentioned, the state is responsible form management of
transformation processes. According to standard economic theory, the main
basic requirements for the transformation are price reform and free market
pricing, labour market change, imposition of hard budget constraints, stabilisation
and decentralisation of economic decision-making.
Besides these general management functions, according to our point of view,
the most important function of the state in transition is to guarantee
individual ownership rights - to create a functional legal base for market
competition.
The role of the state in redistribution (social policy) processes should
continuously change. Redistribution activities should become an instrument
of selective social (redistribution) policies, to stop (limit) subsidisation
of the richer social strata through public expenditures programmes.
The state should undertake a limited scale of activities in order to correct
the allocative failure of market forces. However, because of its non-experienced
and unstable structures, its allocative activities may very frequently
be ineffective. This is to be taken into the account whenever any decisions
on allocative action is prepared. To limit the possibility of large "government
failures" connected with realisation of allocative programs, allocative
activities of the state should be based on pluralistic ownership, pluralistic
financing of public services and decentralisation of state and its management.
Tatiana KLUVÁNKOVÁ
Most of environmental assets are defined as public goods. Market failure
in estimating market price for environmental goods can give an impression
that they have little value or are unimportant relative to the market prices,
thus most environmental values can be lost.
The main idea of this paper is to show that economic values of environmental
and resource services can be a valuable information supporting resource
and environmental management decisions.
The first part of the paper explain difficulties in understanding issue
of environmental valuation from the point of view of economics and the
environment. Secondly it explore the theory concerned with valuation of
non-market goods, stressing on different approaches to measuring environmental
values. Special attention is paid to the discussion on the theory of value
especially on non use values, e.g. intrinsic, bequest, philanthropic values
of the environment.
The paper also addresses most critical problems in decision making and
nature protection under the economy in transition of the Slovak Republic.
Decision making in pre-1989 Command and Control (CAC) regimes in Central
and Eastern Europe was made by political representation and based on ideological
or political principles rather than economic characteristics. Environmental
decision making was generally limited to a supplement of land use - planning
documentation with very low influence in the decision making process.
The key element missing in the former command and control approach to decision
making is consensus building and public involvement. Political changes
in 1989 and the economic transformation has resulted in a radical change
in environmental policy of the Slovak Republic. The major accomplishment
in the legal field today is a well developed legislative framework in environmental
decision making. On the other hand, implementation and law enforcement
is still inadequate. Citizens as individuals are not very active in environmental
decision making. Generally, there is a lack of interest in public matters
and apathy towards getting involved in community life. Information is not
transparent or accessible neither for the public nor for non governmental
organisations or research institutions. Decisions are usually based on
administrative principles without sufficient involvement of all interested
parties. Any involvement of the public or other interested parties occurs
in the late phases of the planning process when the detailed proposal already
exists and it is to late to initiate meaningful change. Nature protection
in the Slovak Republic is under the responsibility of the Ministry of Environment.
The key piece of legislation in the field of nature protection is the Act
on Nature and Landscape protection, according to which the protection of
nature is the fundamental priority within the protected areas. "Preservation
of biodiversity, conservation and rational use of natural resources, and
optimising the land use" is one of the five priorities of the State
Environmental Policy.
Following most crucial problems can be summarised:
- private property and economic interests versus nature protection
After the political change in 1989, all property that was seized by
the socialistic government in 1948 was returned to the previous owners.
Since all national parks in Slovakia were created after 1948, much of the
land within the parks is now privately-owned. However, the Nature Protection
Act states that the state will compensate private land owners for economic
losses associated with any hindrance on their ability to use their property
for economic gain but did not realised yet. In order to generate economic
profit within the shortest time period money generating activities e.g.
timber, intensive tourism with the resulting emphasis on natural resource
exploitation and over land use are provided.
- competence in decision making process
Under the present decision making structure, NPS serves as advisory
body to the state administration. Most decisions affecting national parks
are made by state administration and municipalities where most first hand
knowledge and the needs of local communities are concentrated but where
also private interests of local stakeholders are more visible. Hence professional
experience and skills concentrated within the NPS can not be fully applied
and their competence is limited to the assistance with illegal constructions
within the park or other radical activities instead of active management
of the park associated with sustainable land use.
Major part of the paper focus on the description of most common methods
used in valuation of environmental values focusing on traditional economic
methods based on real market observations as hedonic prices, opportunity
costs, travel costs methods as well as hypothetical market egg. contingent
valuation, etc. Special attention is paid to the description of methods
of complex environmental valuation, applicable directly for decision making
process (positional analysis).
Finally, possibilities for the application of methods of environmental
valuation under in transition economies are discussed in conclusion.
However research in valuation of environmental goods is relatively undeveloped
field in the Slovak Republic. Thus my hopes are, that this paper will help
to make these methods fully operational tools in policy and administrative
decision making.
Lam TRAN THANH
East- and South-east Asia had been, until the beginning of the financial
crisis in the second half of 1997, the most dynamic region of the world
economy for many decades. The economic development of the region was really
excellent and had changed several states in the region from developing-country
status to that of developed ones. The industrialisation process, which
began taking place in these economies some decades ago, hardly had an analogy
in the history of world development economy. The region was also notable
for its export expansion. Its economic prospect had been considered stable
and steady and there were high expectations for its future development.
The financial crisis, which happened suddenly in the second half of 1997,
has meant a breakpoint in the course of economic development of East- and
South-east Asia.
This paper is focused on providing a systematic overview of the economic
development of East- and South-east Asian economies in the 90s and the
outbreak of the financial crisis in the region in the 1997. It is also
an effort at revealing the causes of the crisis, as well as the knowledge
it can provide.
The crisis broke out in Thailand with the fall of the Thai baht in July
1997, after several speculative attacks against this currency from the
start of the year. Then, due to the strong ties between regional economies,
it spread quickly over East and South-east Asia. One after another, the
Philippines, Indonesia, Malaysia and later also South Korea became victims
of the crisis. In a short time, their currencies suffered a severe depreciation
and a large number of local firms, not only banks and financial corporations,
but also producers, were forced to shut down their operation.
The crisis also touched Hong Kong and Taiwan, but much less severely, thanks
to their generally favourable internal and external fundamentals.
Since the Japanese have traditionally had strong financial and production
linkages with their counterparts in emerging Asia, the developments in
East and South-east Asia have even worsened economic performance in Japan,
which had already experienced a period of slowdown since the early 90s.
The collapse of the local currencies was only the first consequence of
the financial turmoil, its further effects being much more serious to the
affected economies. There has been a sharp drop in working capital, leading
to a shrink in production as well as a drop in consumption. Falling consumption,
in turn, has affected a further deterioration in the field of production.
Furthermore, the crisis forced East- and South-east Asian countries to
raise interest rates to stop the weakening of currencies and to stabilise
the financial sector. This has consequently reduced investment and therefore
also hurt production.
Many economies in the region are now in recession and the same prospect
is awaiting them in coming years. Recession will probably be very deep
in Indonesia, Thailand and Korea. Other countries, such as Malaysia, the
Philippines, Singapore, even China and Vietnam, will experience a considerable
slowdown in economic growth.
In the state of strong interdependence of world economies, the financial
crisis in Asia will undoubtedly have a negative impact on the global economy.
OECD countries should be the major afflicted economies.
A look back at the economic development of East and South-east Asia during
the early 90s reveals that the crisis in Asia was not a result of a single,
but many, factors. The most significant among these are the following:
- Recent rapid growth, accompanied by a strong demand for consumer and
industrial goods, had increased trade as well as current account deficits
and exhausted international reserves in emerging economies, making them
more vulnerable to financial turbulence.
- Fast growth had also attracted large amounts of foreign capital into
these countries. Capital had become cheap, which led to overinvestment
in many sectors of industry and services. Especially, short-term foreign
capital had formed a big part of the inflows, heightening the risk of many
local firms' insolvency in the case of a sudden withdraw of capital.
- The loose credit policy implemented by domestic banks in the last period
had also stimulated overinvestment, especially in property and assets,
pushing their prices up to an extreme and unsustainable high. The inevitable
fall in demand for these commodities forced prices to drop. Many firms
operating in these fields then went into bankruptcy and others were found
in liquidity troubles.
- The local governments in East and South-east Asia had spent big packages
of money in public projects, making these economies even more overheated.
Changes in conditions then became much more sudden and the possibility
to regain equilibrium in the economy much smaller.
- Most the Asian currencies were in some way linked to the US dollar. When
the Japanese Yen was steadily depreciated against the dollar from April
1996 till the first half of 1997, Asian goods became more expensive in
relation to Japanese therefore exports to Japan also stagnated. This development
seriously hurt Asian economies, which are strongly orientated on exports.
- Asian manufacturers, especially electronics producers, suffered a dramatic
decline in prices for their products in the year 1996 (e. g. semiconductor
prices fell by 70%). Since the electronics sector made up 15_25% of manufacturing
production, this was a really considerable loss for these economies.
- Last but not least, international speculation activities on financial
markets contributed a great deal to the extent of the crisis.
The paper is closed with an analysis of the chances of the Asian economies
to overcome the unpleasant position they hold now. Aside from the factors
that could help the economies in crisis to get back to the past development
path, there is a large number of factors which hamper their efforts.
The East- and South-east Asian crisis brings forward several useful lessons.
It clearly demonstrates that too fast growth is not fully desirable, as
is also rigidity in exchange-rate policy. Much more importantly, it brings
to light the need for a certain supervision over short-term capital inflows,
especially those of a speculative character.
Eva HANULÁKOVÁ
Marketing principles are applicable to both profit-seeking and not-for-profit
organizations. Not-for-profit organizations operate in the public interest
or to foster a cause, and do not seek financial profits. Hospitals, museums,
universities, political parties, zoos, parks, etc. are examples of nonprofit
institutions. They purchase goods and services in order to run their organizations
and also buy items for resale to generate additional revenues to offset
costs. Whether a donation is made to a zoo, to a political campaign, or
to an antismoking effort, something is given and something is received.
Even though the "something received" may be intangible, such
as a feeling of image, goodwill, or a sense of satisfaction rather than
packaged goods, there has been a transaction between either an individual
and a group or between two individuals. In all these instances, marketing
can be found.
Nonprofit marketing is all marketing efforts conducted by firms or individuals
to accomplish nonfinancial goals. The emergence of organized and integrated
marketing efforts in not-for-profit organizations deserves special attention.
Especially in today's uncertain and competitive environment is it becoming
increasingly necessary for nonprofit organizations to apply appropriate
marketing concepts, strategies and tools.
Nonprofit marketing can be classified on the basis of tangibility, organization
structure, objectives and constituency. This four-way classification has
been shown most of all in literature.
It is important to recognize that there are a lot of significant similarities
between non-profit and profit-oriented firms with regard to marketing,
as well as many differences.
With both nonprofit and profit-oriented marketing, the consumer typically
can choose among the offerings of competing companies, the benefits provided
by competing organizations differ, consumer segments may have distinctive
reasons for their choices, consumers are attracted by the most desirable
marketing mix, and consumers experience either satisfaction or dissatisfaction
with performance.
There are also a number of basis differences in marketing between nonprofit
and profit-oriented organizations.
Nonprofit marketing is concerned with organizations, people, places, and
ideas, as well as goods and services. It is much more likely to promote
social programs and ideas than is profit-oriented marketing. Profit-oriented
marketing is largely concerned with goods and services.
Exchanges in nonprofit marketing can be in the form of votes in return
for better government, etc. Nonprofit marketing may not generate revenues
in day-to-day exchanges. Exchanges in profit-oriented marketing are generally
in the form of money for goods and services.
Nonprofit marketing objectives are sometimes more complex because success
or failure cannot be measured strictly in financial terms. But objectives
must include the number of clients served, the amount of service rendered,
and the quality of service provided. Profit-oriented marketing objectives
are generally stated in terms of sales, profits, and recovery of cash.
The benefits of nonprofit organizations are often not distributed on the
basis of consumer payments. This means that consumer benefits of profit-oriented
marketing are usually related to consumer payments.
Nonprofit organizations may be expected or required to serve economically
unfeasible market segments. Profit-oriented marketing seeks to serve only
those market segments that are profitable and lucrative.
Nonprofit organizations typically have two constituencies: 1. clients -
for whom they provide membership, elected officials, locations, ideas,
goods and services, and 2. donors - from whom they receive resources (which
may be time from volunteers or money from foundations, firms or individuals).
Clients (users) are interested in the direct benefits they obtain from
participation in an organization, such as improved health, education or
social welfare. Donors are concerned whit the efficiency of operations,
success rates, the availability of goods and services, and the recognition
of their contributions. For each constituency, a nonprofit organization
must accurately pinpoint its target market. There is often a little overlap
between clients and donors. Profit-oriented marketing has one constituency:
client (customer, consumer, etc.)
There are also many peculiarities of nonprofit marketing.
Nonprofit marketing differs from other areas of marketing primarily in
the intangible nature of the offer and the absence of a profit motive.
Nonprofit organizations have used marketing for a long time. The activities
of nonprofit marketing differ from "classical" marketing only
in terminology used. These marketers often develop programs that simply
cannot be applied in, or are outright wrong for, nonprofit institutions.
Most nonprofit institutions are financially weak, which often limits their
scope of operations and affects the extent to which they can employ certain
marketing tools. To counteract this problem, successful nonprofit organizations
apply their marketing skills to their public both "upstream"
and "downstream". Pricing presents special challenges in nonprofit
marketing. The price can be expressed in terms of the money, time and effort
it gives to support the cause. So not-for-profit marketers must take into
account not only the direct financial outlays involving their target consumers
(clients and donors), but also the time, effort, or psychic costs involved.
Nonprofit marketers deal with intangible offerings. They can use employers,
volunteers, churches, schools, and a variety of other organizations and
individuals in distributing their services to the public.
Nonprofit marketing is broad in scope and is often identified with social
marketing. Social marketing can be defined as the design, implementation
and control of programs seeking to increase the acceptability of a social
idea or cause in a target group. The role of social marketing is to increase
the acceptance of social causes, ideas, campaigns, or desirable behaviours.
Examples include highway safety, family planning, recycling, etc. Specific
strategies in social marketing are used to achieve aims in terms of social
changes.
The Narcissus Campaign is an example of a cognitive campaign in social
marketing organized by the Slovak League against Cancer every year in cooperation
with ad agencies, profit-oriented organizations, schools etc. The campaign
is aimed at the public to inform them about the illness. It is also aimed
at profit-oriented organizations, which provide money for the activities
of the League.
Nonprofit organizations face many problems. There is no doubt that a significant
tool to solve these problems may be represented by marketing.
Milo MAŘÍK
Company evaluation is one of the parts of the economic discipline which
undoubtedly is increasing in importance in the process of economic transformation
of the countries of the former East Bloc. A number of methods can be used
for evaluating companies. From a theoretical point of view, the most important
is the revenue system, and within it, the discount cash flow (DCF) method.
This system involves several partial methods. Primarily, these are the
DCF equity, DCF entity and APV DCF variants. These methods fundamentally
differ in their way of calculating their free cash flow, discount rate
and direct result following from revenue evaluation (i. e. concerning the
value of the whole company or the direct value of equity capital).
Within the DCF method, precedence is given, at least in the Anglo-Saxon
world, to the DCF entity style. The most important features of this method
are the following particularities:
l. The direct result of revenue evaluation is the value of adjusted assets
- therefore the company as a whole without regard to its way of financing.
Adjusted assets are understood as the sum of fixed assets and working capital.
2. The value of adjusted assets is calculated on the basis of "free
cash flow to firm" (FCFF). This free cash flow includes the payment
balance determined for stockholders (owners), therefore also for creditors
(i. e. the balance of newly accepted and paid debts and interest paid).
In the calculation of FCFF the usual procedure is operating profit minus
income tax rate, increased by depreciation and reduced by investments to
fixed assets and working capital.
3. Free cash flow is given to the present value by use of the discount
rate. Here its function is given by a known variable - weighted average
capital cost (WACC).
The specific calculation of the discount rate results from four basic steps:
1. Determine capital structure.
2. Fix expenses for outside capital, on the individual elements of external
capital, from which the average cost of external capital is determined.
3. Estimate expenses for own capital, usually regarded as the most problematic
part of the WACC calculation.
4. Calculate WACC according to sample as the weighted average of expenses
of individual capital elements, where the values are percentual shares
of the individual capital elements of the whole capital value.
In using this method it is necessary, among other things, to establish
forehand what will be the future development of capital structure. This
capital structure is realised from the financial plan, a part of which
is a planned balance sheet for each year.
The problem lies in that the planned schedule contains only accounted values,
while it is necessary that the WACC works with market values of internal
and outside capital. In the case of the latter, it can be assumed that
market and accounted values will not be very far apart, at least in firms
which enjoy long term liquidity. Differences may also appear in outside
capital under the form of bonds, which, however, is not often the case
in the Czech Republic. The situation of own capital is somewhat different,
where the difference between market and accounted valuations may be great.
So a cyclic situation develops - to calculate market values of own capital,
it is indispensable to know in advance the result.
In practice, this paradox is resolved in two ways, using for WACC calculations
either the predicted capital structure or the accounted capital structure.
The first variant is more often used, being more appropriate. Usually however
even this approach leads to the above-mentioned inaccuracies. The resulting
capital structure will accordingly be different from the initial estimation.
We recommend an iterative approach as a better resolution. In this case,
the evaluation is made according to the usual methodology, i. e. under
own capital expenses we include the predicted or accounted capital structure.
After obtaining the value of the company's overall and own capital, the
resulting capital structure is compared with the capital structure used
for the calculation of average weighted expense capital. If the two results
are markedly different, a calculation structure is used, then reapplied
to the calculation of average weighted expense capital. This reformulated
discount level is then used for calculation of the new valuation. It will
be necessary to repeat this procedure until the difference between calculated
and given capital structures is sufficiently minor.
Expansion of the above-mentioned problem is the focus of our article.
Its purpose is to:
- demonstrate the problem in numerical examples,
- show the amplitude of possible mistakes which may occur in standard approaches,
- analyze the factors influencing the size of possible valuation errors,
- show possibilities for eliminating errors.
Results of the above section show that the size of possible errors is
not negligible. As errors are considered the difference between capital
structure, which was assessed at the beginning of calculation and used
to determine WACC, and the final structure, which results from the assessed
calculation (i. e. the share of market value of own and outside capital
in the overall market value of the company). This can be measured as the
difference between the value of the company determined by the usual procedure
on the basis of the final structure and the value calculated by the recommended
iterative approach divided by the value ascertained through the iterative
value approach. The final value then shows the percent deviation from the
"correct" value of the company when not the real, but only the
final, capital structure is used.
From this it is clear, and the above calculations confirm it, that the
size of errors in evaluation procedure, can be significant. If the company
evaluator disregards the above approach, this may lead to a totally incorrect
valuation in assessing own capital. If for example this assessment is the
base for establishing an exchange relation for shares in a company merger,
it could result in significant losses to shareholders of the company whose
share assessment was undervalued.
With the aid of simulations, we further searched for an answer to the question
of which factors have the biggest influence on the final error. It was
shown that the error is most influenced by the level of taxed company profits
and also by the expense level of in-house capital. Therefore, the extent
of the error is relative to the amount of taxed profits and of in-house
capital expenses.
At the same time, a simple algorithm was constructed, by means of which
it became possible to carry out the above iterative calculations, the surest
way to eliminate errors in the procedure of evaluation following from the
initial assessment of the capital structure.
The solution of the capital structure problem depends on the approach to
company financing as reflected in the financial plan. Two basic cases can
be outlined:
l. The evaluator can begin from the stable capital structure throughout
the whole planned period.
2. The firm's financial policy is previously presented to the assessor,
and his procedure of evaluation must be adjusted to it.
The approach in the first of these cases is the more simple, but the above
algorithm can also be applied to the second alternative. This is important
because a financial policy under which the share of own and external capital
changes in individual years, is much closer to real practice than one which
would hold to the same structure in all circumstances throughout the years.
It is also worth mentioning the fact that, in keeping to the principle
according to which WACC are calculated only from market values, and this
yearly, one of the necessary conditions is fulfilled, to get the same result
from the three basic DCF method variants (equity, entity, APV). As long
as the problem of capital structure is not satisfactorily resolved, the
same results can not be expected. A practical suggestion would be: do not
use these three methods in one evaluation. On one side, all three are measuring
the same thing, but on the other, in practical evaluations the assumptions
often cannot be kept, which can lead to different results, and the evaluation
appearing at first glance undependable.