Profit Maximisation - Assignment Example

Answer a) Profit maximisation - The idea behind creating any company is to survive over the long run. Though profit maximisation may seem as the short term goal required to achieve that ultimate purpose, in reality it is not so. A company's value in the market is based on the market price of its stock. The market price also functions as an indicator of the level of performance of the company. The market price of the company's stock is a function of the quantum of cash flows from the investment in its stock, the timing of such cash flow and the risk associated with realization of the cash flow. Even though a company may be successful in maximising its profits, it does not necessarily follow that the company would be successful in maximising its Earning Per Share. So the benefit would not automatically flow to the shareholder. Also, though the company may earn higher profits, the same may not flow to the shareholder immediately. A shareholder may not find investment in the company as an attractive option taking into consideration the time value of money. Thus, profit maximisation does not provide any assurance with regard to the timing and risk associated with the cash flow either. It can be concluded that profit maximisation does not help in improving the value placed on the company by the shareholders. It is needless to say that it is the funds from the shareholder that mainly supports the operations of a company and shortage in such funds could affect the survival of the company in the long run. Therefore, profit maximisation should not be the ultimate goal of a financial manager. (b) Sales maximisation - Just like profit maximisation, sales maximisation would not bear an impact on the market value of the company. Sales maximisation does not even assure profit maximisation, leave alone enhancing the company's value. Sometimes, the cost involved in maximising the sales may even cancel out the benefit derived from it. Shareholders would not consider the sales level achieved by the company while making their investment decision. Therefore, sales maximisation should not be the ultimate goal of a financial manager. (c) Maximisation of benefit to employees and local community - In today's world, it is extremely important for every company to be socially responsible. Social responsibility includes maximising benefits to the employees and the society at large. In the long run, socially responsible actions taken by a company would also benefit the shareholders indirectly. However, social responsibility cannot be viewed as the main purpose of running a company. The company cannot put its social responsibility ahead of its own survival. Therefore, maximisation of benefit to employees and local community would not be the main goal of a financial manager. (d) Maximisation of shareholder wealth - Shareholders are the actual owners of a company. Shareholders investment is crucial for the survival of the company. The shareholders choose to invest in the company that can give highest returns on the investment made. Therefore maximisation of shareholder wealth should be the main goal of a financial manager. The financial manager should ensure that the resources are allocated in such a way that it results in maximisation of shareholders wealth. Answer 2:- (a) Net Present Value (NPV): Conversion of uncertain cash flow to certain cash flow Year Uncertain Cash Flow() Certain Cash Flow () (Uncertain CF x 0.75) 1 103,750 77,812 2 113,750 85,312 3 123,750 92,812 4 133,750 100,312 5 123,750 92,812 6 105,750 79,312 7 103,750 77,812 8 98,750 74,062 Computation of Net Present Value (NPV): [NPV = Present Value of Cash Inflow - Present Value of Cash Outflow] Year Certain Cash Flow () Discount Factor* Present Value of Cash Flow (t) (Discount Rate@ 20%) (Cash Flow x Dis. Factor) 0 (800,000) 1.000 (800,000) 1 77,812 0.833 64,817 2 85,312 0.694 59,206 3 92,812 0.579 53,738 4 100,312 0.482 48,350 5 92,812 0.402 37,310 6 79,312 0.335 26,570 7 77,812 0.279 21,710 8 74,062 0.233 17,256 328,958 NPV = 328,958 - 800,000 = - 471,042 *The formula used to compute the discount factor is as follows: Discount factor = 1 / (1 + 0.20)t t: Time or the year Conclusion: Since the NPV of the total cash flow is negative (-471,042), it would not be advisable for Global Mining Corp. to invest in purchasing the machinery. (b) Pay back period method: [Pay back period is the period over which the investment would be recovered by the investor] Computation of year in which the investment is paid back: Year Cash Inflow () Cumulative Cash Inflow () 1 103,750 103,750 2 113,750 217,500 3 123,750 341,250 4 133,750 475,000 5 123,750 598,750 6 105,750 704,500 7 103,750 808,250 8 98,750 907,000 Investment paid back in 6.5 years = 704,500 + (103,750 x 6/12) = 756,375 Period required to pay back entire investment of 800,000 = 6 + [12 x (800,000 - 704,500) / 103,750] = 6.92 years Conclusion: Global Mining Corp. can recover its investment in the machinery only after 6.92 years. Therefore, it would not be advisable for it to invest in the machinery if a pay back period of 6.5 years is stipulated. (c) Internal Rate of Return (IRR): [IRR is the rate at which the present value of cash inflow would be equal to present value of cash outflow] Computation of present value of cash inflows if discount rate is 12% Year Cash Flow () Discount Factor # Present Value of Cash flow () 1 103,750 0.893 92,649 2 113,750 0.797 90,659 3 123,750 0.712 88,110 4 133,750 0.636 85,065 5 123,750 0.567 70,166 6 105,750 0.507 53,615 7 103,750 0.452 46,895 8 98,750 0.404 39,895 567,054 # Discount Factor = 1/(1+0.12)t Computation of present value of cash inflows if discount rate is 20% Year Cash Flow () Discount Factor Present Value of Cash flow () 1 103,750 0.833 86,424 2 113,750 0.694 78,943 3 123,750 0.579 71,651 4 133,750 0.482 64,468 5 123,750 0.402 49,748 6 105,750 0.335 35,426 7 103,750 0.279 28,946 8 98,750 0.233 23,009 438,615 Computation of IRR: Present Value of cash outflow = 800,000 Present Value of cash inflow when discounted @ 12% = 567,054 Present Value of cash inflow when discounted @ 20% = 438,615 20% 12% 567,054 - 438,615 800,000 - 567,054 = 128,439 = 232,946 IRR = 20 - [232,946 x 8 / 128,439] = 20 - 14.5 = 6.5% Since the IRR (6.5%) does not exceed the required rate of return (20%), it would not be advisable to purchase the machinery. Using IRR may lead to flawed investment decisions in the following cases: i. Where there are more than one cash outflows interspersed between the cash inflows, there can be multiple IRRs which would make the interpretation very difficult. ii. Where two projects having different inflow outflow patterns are being compared. iii. IRR assumes that positive cash flows during the project are reinvested at the same calculated IRR. When positive cash flows cannot be reinvested back into the project, IRR overstates returns. Answer 3:- Inflation refers to increase in the general level of prices of all goods and services in an economy. It can also be described as a decline in the real value of money. In order to understand the effect of inflation on investment appraisal, it becomes necessary to understand two terms - Nominal (Money) value and Real value. Nominal values are the actual amount of money making up cash flows. Real values reflect the purchasing power of the cash flows. Real value of a cash flow can be derived by adjusting the nominal value of the cash flow for incorporating the rate of inflation. Mathematically, (1 + Nominal Rate) = (1 + Real Rate) x (1 + Inflation Rate) Or (1 + Real Rate) = (1 + Nominal Rate) / (1 + Inflation Rate) Inflation effect two aspects of investment appraisal while computing the present value of an investment - the projected cash flows and the rate at which the cash flow should be discounted. Under the Nominal term approach, if the projected cash flow is in nominal terms, the discount rate used should also be a nominal rate. The nominal term approach takes inflation into consideration while expressing both. Under the Real term approach, if the projected cash flow is in real terms, the discount rate used should also be a real rate. This approach does not consider inflation while expressing either. It would be misleading if the cash flow series is expressed in one term and the discount rate is mentioned in the other. Answer 4:- "The rule that the investor does (or should) maximize discounted expected, or anticipated, returns is rejected both as a hypothesis to explain, and as a maximum to guide investment behaviour." I would agree with this statement to a very large extent. Though it may seem theoretically that rational investors always intend to maximize their returns, in reality it may not be so. Different investors have different objectives behind their investment decisions and they act accordingly, maximizing expected return being just one of them. There can be many factors that determine investment decisions. Risk is one such important factor. A risk averse investor would look for security rather than higher returns. Such an investor would go for a low risk investment that provides higher assurance of returns though it gives a low return. On the other hand, an aggressive investor would be willing to take higher risks to achieve higher returns. Duration of investment is another factor that determines investor behaviour. A person making a long term investment would choose a security that has shown a constant growth rate in the past. A short term investor would go for an investment expecting a high rate of return from it in the near future. Another factor that determines investor behaviour to a very large extent in the real world is the investors' hunch or intuition. For instance, logically speaking, the timing for purchase of a share should be such that the investor buys when the price of the share is low and sells it when it is high. But in reality, this does not always happen. It is the general psychology of an investor that makes him buy when the prices are rising and sell as they begin to fall. Most investors make their investment decisions based on their perception of the market. It is probably due to this reason that when an investor thinks that it is time to sell a particular stock, there is some other investor thinking that it is time to buy that same stock. Therefore, the rule that the investor does maximize discounted expected returns cannot be considered as a maxim to guide investment behaviour. Answer 5:- Standard deviation of a security represents the total risk associated with that security. Beta of a stock measures the sensitivity of the stock with respect to a broad based market index. In other words, Beta is a measure of systematic risk. Where an investor makes decisions based on standard deviation and not based on beta, the investor would be ignoring the difference in the systematic and unsystematic components of the total risk. The investor can avoid the unsystematic risk (diversifiable risk) involved through diversification. Therefore, a risk averse investor would base his decision on systematic risk involved, that is beta. In this case, share A has higher beta (0.8) than share B (0.7). Therefore, a risk averse investor would choose to invest in share B rather than A since it would be less risky. Answer 6:- Given: Expected Return () Standard Deviation () X 25% 15% Y 35% 20% Formulae to be used: (1) Expected Return of a portfolio = WxRx + WyRy Where W: Proportion of investments R: Expected return of respective shares (2) Standard Deviation of portfolio (p) = (Wx x)2 + (Wy y)2 + [2(Wx x)(Wy y) r(xy)] Where W: Proportion of investment in shares x and y : Standard deviation of respective shares r(xy): Correlation co-efficient between return from Share x and Share y (a) Wx = 0.5, Wy = 0.5 and r(xy) = -0.7 Expected Return of the portfolio = WxRx + WyRy = (0.5 x 25) + (0.5 x 35) = 12.5 + 17.5 = 30% Standard Deviation of the portfolio = (Wx x)2 + (Wy y)2 + [2(Wx x)(Wy y) r(xy)] = (0.5 x 15)2 + (0.5 x 20)2 + [2(0.5 x 15)(0.5 x 20) (-0.7)] = 56.25 + 100 + [2 x 7.5 x 10 x -0.7] = 51.25 = 7.16% (b) Wx = 0.3, Wy = 0.7 and r(xy) = 0.5 Expected Return of the portfolio = WxRx + WyRy = (0.3 x 25) + (0.7 x 35) = 7.5 + 24.5 = 32% Standard Deviation of the portfolio = (Wx x)2 + (Wy y)2 + [2(Wx x)(Wy y) r(xy)] = (0.3 x 15)2 + (0.7 x 20)2 + [2(0.3 x 15)(0.7 x 20) (0.5)] = 20.25 + 196 + [2 x 4.5 x 14 x 0.5] = 279.25 = 16.71% (c) Summary: Option (a) Option (b) Percentage Increase Expected Return 30% 32% = (32-30)/30 = 6.67% Standard Deviation 7.16% 16.71% = (16.71-7.16)/7.16 = 133.38% Though investment under option (b) gives a higher return, it would not be advisable to opt for option (b) since the percent by which the risk involved in (b) as compared to (a) increases by 133.38% whereas the expected return from (b) as compared to (a) increases only by 6.67%. The higher risk involved in option (b) is not justified by similar increase in expected return. Therefore it would be advisable to invest as per option (a). Answer 7:- Option A - Invest in a security paying interest at 6% per year for two years Option B - Invest in a security paying interest at 8% per year and matures in one year. Reinvest in the same security at the end of first year. Computation of return from the above investment options: Option A (6%) Option B (8%) Computation Amount () Computation Amount () Return at end of Year 1 50000 x 0.06 3000 50000 x 0.08 4000 Return at end of Year 2 (50000+3000) x 0.06 3180 (50000+4000)x0.08 4320 Total 6180 8320 Since option B assures higher returns from investment of same amount and over same period as in option A, it would be rational for any investor to choose option B. Read More