Financial in the Management of the Business - Assignment Example

?Question a) Financial accounting is very important in the management of business as financial management has a large number of functions. My role of being a CFO is very important as to classify the data appropriately in ledgers. It is not just mere recording of entries but it is also a way to interpret financial information and this should be adequately communicated to the CEO. All the recorded financial transactions should be able to be measured in monetary terms. The interpretation of the financial statements has a considerable influence on the business and its works. Accounting information should be modified in such ways so that it can be interpreted by the management to draw conclusions for the ultimate purpose of decision making. A business’s financial position is evident from its profit and loss account and the balance sheet. The balance sheet and the profit and loss statement should communicate the appropriate results of the firm to the CEO so that he can make decisions regarding investment. The financial statements of the firm should be made available to all so that they can make their own conclusions from the financial statements with respect to the operations in the firm. It is very important that the financial information provided must be reliable and authentic. The primary objective of my role as CFO is to interpret the firm’s accounts accurately and identify which of the investment methods could benefit the firm in the long as well as the short run. This could be achieved by making appropriate review of the financial statements as well as developing accurate interpretations. This is supposed to benefit the firm and its stakeholders. b) The company can use concise financial report, which consists of Consolidated Income Statement, Statement of Comprehensive Income, Balance Sheet, and Statement of Changes in Equity, Statement of Cash Flows so that all the third party investors and stakeholders could evaluate the firm’s business. Appropriate disclosures will be made in the financial statements with respect to payment of dividends, bringing in new capital, the debt capital of the firm and its return on equity. Such disclosures would enable the stakeholders to identify the financial position of the firm as it does not hide any discrepancies from the public. The taxation requirements of the government should be met with appropriate heads showing profits before tax and profits after tax. Similarly the employees can get an idea about the functioning of the firm by analyzing the financial statements. The creditors and debtors value in the balance sheet along with the bad debts gives a clear understanding about the total debtors and creditors of the firm. The shareholders can understand the way the firm is functioning through the payment of dividends and the return on equity, which is projected in the financial statements. Question 2 a) High dividend policy to the shareholders signifies that the firm is earning high profits and, thus, is paying high dividend to its shareholders. This creates anticipation among the shareholders that the firm will pay them a higher amount of dividend in the next financial year. High dividend also signifies that the portion of debt capital in the firm in comparison to its equity capital is less, which implies that the firm has its own financial stability. b) If there are negative profits in the firm then the firm will pay a lesser amount of dividend. If the firm chooses to retain a high portion of its earnings for investment activities, even then the dividend payment will be less. c) High dividend payouts are popular and well appreciated by all the shareholders. But the problem that arises here is that if the firm earns high profits and provides high dividend to its investors in one year and in the next financial year its profit is less comparatively and so it fails to pay high dividends, then the shareholders will be unhappy with the firm. This will affect the bond and relation they have with the firm. As the shareholders are the primary investors in the business, even a small amount should be given to them and they should be told everything about the company including the reasons for changes in percentage for the dividend paid. As the share holders have invested a part of their earnings into the business, it is the responsibility of the organization to give a nominal amount to their investment. This will enable the organization to have the support of the shareholders at all times. Decrease in the payment of dividends will harm the investor relations of the firm and the firm will have a negative image in the market which will ultimately affect its business. Question 3 a) Produce two alternative estimates of the likely growth rate in earnings for KAP. Explain the rationale for each estimate. Ans. One of the alternatives for estimating the likely growth rate in earnings for KAP is by multiplying the current price earnings ratio with the forecasted future earnings per share. Therefore, Industry average price-earnings ratio 4.05 3-year industry average earnings growth rate (p.a.) 0.0550 Or, 4.05 * 0.0126 = 0.05103 * 100 = 5.10% This is the most popularly used alternative and takes into account the price earnings ratio and the average growth rate per annum. It is used because it considers the average price earning ratio which can be used for future purposes. The other alternative is Growth rate = (1 – payout ratio) * return on equity = (1 – 0.55) * 0.1135 = 0.45 * 0.1135 = 0.051075 * 100 = 5.10 % This alternative is used because, here, the estimated earnings that can be obtained in the future are projected and through this way, both the estimated earnings as well as the current earnings are calculated which play a major role in future analysis. b) Estimate the return on equity capital for KAP using an appropriate equilibrium model. Ans. The return on equity capital is calculated by using the formula: [(Net profit after tax – preference dividend) / equity capital] * 100 Or, it can be calculated using another formula: Return on equity = net income / shareholders equity The return on equity capital for KAP using an appropriate equilibrium model can be calculated by: Return on equity = net income / shareholders equity The shareholder equity does not include preference shares. 0.1135 = 0.055/ shareholders equity Therefore shareholders equity = 0.484581 The Return on equity = 0.1135 c) Produce three estimates for the intrinsic value of the common stock of KAP using both a dividend-based valuation model and the price-earning (P/E) ratio data. Ans. The intrinsic value of a stock is the computation of the present values of all the cash flows projected from a stock. It is very difficult to determine the intrinsic value of a stock and the reason for this is because the dividend payments in a firm are not fixed. It is assumed that the stock will be held for an immeasurable time and that the stocks will provide dividend once every financial year. It is also assumed that the intrinsic value of the stock will be equal to the market value of the stock in equilibrium. The intrinsic value of a stock can be calculated by using the dividend discount model formula: Upcoming dividend / interest rate – growth rate = 0.55 / 0.055 = $10 Determining through the price earnings ratio: A firm’s price earning ratio also influences the decisions taken by the investors. For example, some investors like to invest in firms with high price earnings ratio because the stocks portray a high growth potential, whereas, the investors who invest in firms with low profit earning ratio consider the cheap price of the stock. The intrinsic value of a stock is found out using the price earnings formula in the following way: Price earnings ratio = earnings / interest rate = 0.55 / 0.055 = $10 d) Do you believe KAP to be currently overpriced or under priced? Justify your conclusion with reference to the calculations that you have performed in parts a) to c)? Ans. The current price of KAP is $6.95 and the intrinsic value of the stock is $10. The growth rate is seen to be 5.10%. Therefore, it is important to analyze whether KAP is currently under priced or over priced. KAP’s current price of $6.95 is currently under priced with reference to the intrinsic value of the stock. Question 4 a) The Weighted Average Cost of Capital stands for the rate a company is probable to pay in financing its assets. The WACC computes the company’s cost of capital by proportionately weighing the types of capital, each of which is probable in the form of debt or equity. The Weighted Average Cost of Capital for a company is the smallest amount that the company should earn on its possessions to satisfy its creditors and owners. “The formula for the WACC can be written as: WACC= (Cost of Equity) * (Market Value of Equity) / (Market Value of Equity Plus debt) + (Cost of Debt) * (Market Value of Debt) * (1 – Corporate Tax Rate) / (Market Value of Equity Plus Debt).” http://www.stockresearchpro.com/a-weighted-average-cost-of-capital-wacc-calculator Cost of equity capital 16.25% Cost of debt 8.75% Market value of equity 8.00 Market value of debt 3.00 Percentage of equity financing 72.73% Percentage of debt financing 27.27% Corporate tax rate 30.00 WACC 13.49% b) Debt service ratio measures the debt servicing facility of an industry as far as long-term loans are concerned. This ratio demonstrates how many times the interest charges are enclosed by the earnings. In this case, new projects requiring an expense of $690 million, will give net cash flows of $82.5 million in infinity, the debt service ratio being 8.36 times. Compared to the WACC, the debt service ratio is high. c) a) The return probable of any risky common stock must be formed of as a minimum three special return components, that is, a return commensurate with a risk-free security (Rf), a return that integrates the market risk connected with common stocks as a whole (Rm), and a return that includes the financial and business risks specific to the stock of the company. The firm’s existing WACC is 13.49%. Cost of equity capital is 16.25%, while the cost of debt is 8.75% and the market value of equity is 8.00 compared to the market value of debt that is 3.00. The percentage of equity financing is found to be 72.73% whereas, the percentage of debt financing is 27.27%. The calculated corporate tax rate is 30.00 and its Weighted Average Cost of Capital is 13.49%. In this case, the estimation of risk-free rate is 5.15% and expected market premium is 8.30%. Calculation of equity risk premium is given below: Equity Risk Premium = Exp. Return on Market - Risk Free Rate. =8.30%-5.15% =3.15%. Question 5 a) Financial costs of Steelform and Steelpress: Steelform Steelpress $000 $000 Purchase price 180 240 Annual operating cost 80 60 Annual maintenance cost 40 20 operational life 4 5 The required rate of return is an important element in many of the calculations and metrics used in equity valuation and corporate finance. It goes further than just recognizing the return of the savings and provides counter attacks on risks by providing one of the key thoughts to formative possible return. The required rate of return also puts the minimum return a shareholder must recognize, given every other choice obtainable and the capital arrangement of the firm. In this case, the company’s RRT is 11%. Analyzing the operational and maintenance cost as well as the life span of the two systems, the Steelpress is recommended as a much better choice. b) In this case, the company’s RRT is increased therefore, resulting in the increase of profit of the company, which will ultimately enhance the investment options available to the firm. Question 6 a) Comparative analysis: The above valuation of the two firms shows the comparison of value analysis. Here, Earning before Interest and Tax (EBIT) shows the same amount in firm A and firm B, that is, 120. Earnings after interest and taxes (EAIT), is found to be only 84 in firm A, whereas in firm B it has remained 120 itself. In firm A values of both equity and debt are same, which implies that both debt and equity capital are same. So this will be problem a problem for the firm because at the end of the financial year, the firm will have to sacrifice a large amount from its profits to satisfy the debts that it owes. Comparatively, in firm B, there is only equity capital, but no debt. The existence of no debt capital with such a high value of equity will also prove to have negative impacts, as it would harm the existence of the business. b) In finance, arbitrage is the process of taking benefit of a price difference among two or more markets. Here, Firm A losses money of about 14.2%, however, Firm B, on the counterpart, does offer an arbitrage chance by making a precise profit of 14%. Arbitrage, in other words, is the procedure of taking advantage of the mispricing of a monetary asset in a specific market. There are arbitrage chances in currencies, commodities, bonds and other assets. The stock market irregularly proves to be favorable as it provides arbitrage chances that would benefit the investors and provide them a chance to make easy money. In this case, an investor detained 20% of the shares in Firm A, the value of the earnings after interest and taxes are estimated to increase. So the Firm A’s profits will eventually increase as well. c) If the firm borrows $300m, then the firm has to gather an equity amounting to at least $240m. Therefore, the firm has to raise an equity capital of $240m or more, which would in turn, ensure that the firm maintains its balance and be stabilized at $540m through the arbitrage process. a) Read More