Electronic Library of Scientific Literature
Volume 46 / No. 5 / 1998
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.
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,
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.
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.
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.
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.