Financial Management: Internal Rate of Return and Capital Structure - Assignment Example

Financial Management Question Revenue (forecast) Year ended 31st Dec. Sales Units Price per unit Total Revenue 2008 100,000 70 7,000,000 2009 110,000 70 7,700,000 2010 120,000 70 8,400,000 2011 90,000 70 6,300,000 2012 80,000 65 5,200,000 34,600,000 Direct Costs Labour & Material and overhead - total GBP 45.00 Year ended 31st Dec. Sales Units per unit Total Direct costs 2008 100,000 45 4,500,000 2009 110,000 45 4,950,000 2010 120,000 45 5,400,000 2011 90,000 45 4,050,000 2012 80,000 45 3,600,000 22,500,000 Outlay of funds Plant and Machinery 31.12.2007 (five years) 3,375,000 Additional working capital 31.12.2007 1,000,000 Additional working capital (one year later) 400,000 Overheads Additional Overheads each year 1,350,000 Sale after five years - 375,000.00 A discount factor of 13% is used. The cost of 1,125,000 developing a range of solar and wind powered lighting systems is sunk cost and not considered in the evaluation. Allocation of overheads to projects on the basis of 50% of the cost of the wages is not considered. Year Inflows Outflows Net DF@13% PV DF@7% PV DF@7.25% PV 2007 0 (4,375) (4,375) 1.00 (4,375) 1.00 (4,375) 1.00 (4,375) 2008 7,000 (6,250) 750 0.8850 663.75 0.9346 700.90 0.9324 699.30 2009 7,700 (6,300) 1,400 0.7831 1,096.34 0.8734 1,222.80 0.8694 1,217.12 2010 8,400 (6,750) 1,650 0.6930 1,143.45 0.8163 1,346.90 0.8106 1,337.49 2011 6,300 (5,400) 900 0.6133 551.97 0.7629 686.60 0.7558 680.23 2012 5,575 (4,950) 625 0.5428 339.25 0.7130 445.60 0.7047 440.45 NPV ( 580.24) 27.90 -0.41 IRR = 7% + ( 27.90 ) x .75 = 7.74% 27.90+.041 NPV is an indicator of how much value an investment or project adds to the value of the firm. With a particular project, if Ct is a positive value, the project is in the status of discounted cash inflow in the time of t. If Ct is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV may be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. The following sums up the NPVs in various situations. The internal rate of return (IRR) is a capital budgeting metric used by firms to decide whether they should make investments. It is an indicator of the efficiency of an investment (as opposed to NPV, which indicates value or magnitude).The IRR is the annualized effective compounded return rate which can be earned on the invested capital, i.e. the yield on the investment. A project is a good investment proposition if its IRR is greater than the rate of return that could be earned by alternative investments (investing in other projects, buying bonds, even putting the money in a bank account). Thus, the IRR should be compared to an alternative cost of capital including an appropriate risk premium. Mathematically the IRR is defined as any discount rate that results in a net present value of zero of a series of cash flows. In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project will add value for the company. NPV of the discounted cash flows of the project is negative. The project will not add value. IRR is below the discounted rate. Therefore the returns from the project will earn less than returns which the company expects. Therefore, the project is not recommended. 2. Question 2 a. Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. A measure of a company's financial leverage calculated by dividingits total liabilitiesbystockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets. Note: Sometimes onlyinterest-bearing, long-term debt is usedinstead of total liabilities in the calculation. A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If a lot ofdebt isused to finance increasedoperations (high debt to equity), the company could potentially generate more earningsthan it would have without thisoutside financing.If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit asmoreearnings are being spread among the same amount of shareholders. However, the cost of this debt financing mayoutweigh the return thatthe companygenerates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing. The debt/equity ratio also depends on the industryin which the company operates. For example, capital-intensive industries such as automanufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5. Given the company's nature of earnings and the projected earnings he best option will be to finance with 60% equity and 40% debt. b) The advantages and disadvantages of takeover to the shareholders of Wandering Lights Limited Pros: 1. Increase in sales/revenues (e.g. Procter & Gamble takeover of Gillette) 2. Venture into new businesses and markets 3. Profitability of target company 4. Increase market share 5. Decrease competition (from the perspective of the acquiring company) 6. Reduction of overcapacity in the industry 7. Enlarge brand portfolio (e.g. L'Oral's takeover of Bodyshop) 8. Increase in economies of scale Cons: 1. Reduced competition and choice for consumers in oligopoly markets 2. Likelihood of price increases and job cuts 3. Cultural integration/conflict with new management 4. Hidden liabilities of target entity. 3. Question 3 Risk is a concept that denotes a potential negative impact to an asset or some characteristic of value that may arise from some present process or future event. In everyday usage, risk is often used synonymously with the probability of a known loss. Paradoxically, a probable loss can be uncertain and relative in an individual event while having a certainty in the aggregate of multiple events (see risk vs. uncertainty below). Risk is the possibility of an event occurring that will have an impact on the achievement of objectives. Risk is measured in terms of impact and likelihood. Risk communication and risk perception are essential factors for all human decision making. Risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources. The strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. Some traditional risk managements are focused on risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents, death and lawsuits). Financial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments. Objective of risk management is to reduce different risks related to a preselected domain to the level accepted by society. It may refer to numerous types of threats caused by environment, technology, humans, organizations and politics. On the other hand it involves all means available for humans, or in particular, for a risk management entity (person, staff, organization). Like so many things, smart decision-making can benefit from the addition of structure, focus, and a bit of metaphor. While imperfect in their own ways, the kinds of tools that support this mental corralling can help tremendously in quieting the chaos, surveying the available options, and then collecting and evaluating the information you need to choose the best course of action. The always-informative Mind Tools shares eight of the most popular and reliable tools for decision making. 1. Pareto Analysis - Often better known as "The 80/20 Rule," Pareto helps you locate where you can derive the greatest benefit by expending the least relative effort (or cost or resources or what have you). In the go-go dotcom days, the bizdev guys used to call this "low-hanging fruit." Ew. (Seriously, though, once you learn about the 80/20 rule, you start seeing instances of it everywhere). 2. Paired Comparison - Compose a table that pits each option directly against each other option, mano a mano, cage-match-style, and weighting each for relative importance. It's a fast and bloodless way to plow through what would otherwise be a huge mess to evaluate. 3. Grid Analysis - Evaluate a larger set of options based on numerous criteria, then weight the importance of each criterion to derive the best choice. Given the complexity and arithmetic required, this one really benefits from using good old Excel. 4. Decision Trees - I've never personally used this, but it looks kind of promising. Basically you build a set of "what-ifs" based on a tree of possible options, assigning the estimated value, cost, or savings associated with each choice. 5. PMI - One of my favorites that I actually use quite a lot. List all the pluses, minuses, and implications behind any decision (I've also seen this "I" column referred to interesting or intriguing data points). Then assign a + or - numerical value to each based on the positive or negative impact. Tally up the columns, and your better option emerges. Takes the emotion and guesswork out of complex decisions, with the side benefit of forcing a brain dump. By the way, although you can totally do this in Excel (or on paper), I made a template for OmniOutliner that works like a champ for more lengthy or detailed option sets. 6. Force Field - I've never completely gotten this one, but I know some folks swear by it. You identify all the forces for and against a theoretical change, weighted for amount of force exerted by each "side." I suppose I could see this being useful for touchy political decisions or any time a well-established more is going to be challenged. Might help in mitigating risk and knowing where best to allocate your resources and influence. 7. Six Thinking Hats - Recently added de Bono's book on this subject to the left rail (See it Over there by all my hippie meditation books). It's a method for seeing an issue from all perspectives by forcing yourself (or more often your team) to-one at a time-adopt different "thinking hats" that reflect opposing and orthogonal points of view (analytical, positive, negative, creative, etc.). I'd be curious to hear how this has worked for folks in real-world projects. Seems like it could get tedious in the wrong hands. 8. Cost/Benefit - This is an evergreen you've probably used a dozen or more times; estimate the costs and the benefits and decide if the delta is worth the hassle. As ever, be sure to account for all the costs of a change, including the meta stuff. Treasury management (or treasury operations) includes management of an enterprise' holdings in and trading in government and corporate bonds, currencies, financial futures, options and derivatives, payment systems and the associated financial risk management. In corporations, the Treasurer is the head of the corporate treasury department. They are typically responsible for liquidity risk management, cash management, issuing debt, foreign exchange and interest rate risk hedging, securitization, oversight of pension investment management, and capital structure (including share issuance and repurchase). They also typically advise the corporation on matters relating to corporate finance. They could also have oversight of other areas, such as the purchase of insurance. Treasury management can make a significant contribution to supporting the achievement of an organisation's business and service goals. The precise nature of this contribution will depend largely on the type of organisation concerned, the statutory and regulatory regimes under which it operates, and the scope, complexity and objectives of its treasury-management function. Commercial organisations may properly anticipate that, within appropriate risk exposure criteria, their treasury-management activities will make a contribution towards their profits or surpluses. On the other hand, the essentially more cautious nature of many organisations, particularly those in the public services, will lead to the focus of treasury management falling largely on the effective control of risk. Whatever the organisation, the achievement of optimum performance consistent with its risk exposure criteria in its treasury management activities is an important indicator of effective corporate management. 4. Question 4 Insider trading is the trading of a corporation's stock or other securities (e.g. bonds or stock options) by corporate insiders such as officers, key employees, directors, or holders of more than ten percent of the firm's shares. Insider trading may be perfectly legal, but the term is frequently used to refer to a practice, illegal in many jurisdictions, in which an insider or a related party trades based on material non-public information obtained during the performance of the insider's duties at the corporation, or otherwise misappropriated. Security analysts gather and compile information, talk to corporate officers and other insiders, and issue recommendations to traders. Thus their activities may easily cross legal lines if they are not especially careful. The CFA Institute in its code of ethics states that analysts should make every effort to make all reports available to all the broker's clients on a timely basis. Analysts should never report material nonpublic information, except in an effort to make that information available to the general public. Nevertheless, analysts' reports may contain a variety of information that is "pieced together" without violating insider trading laws, under the mosaic theory. This information may include non-material nonpublic information as well as material public information, which may increase in value when properly compiled and documented. "These are our findings from our comprehensive survey of stock markets around the world. We find that at the end of 1998 there were 103 countries that had stock markets. They exhibited a bewildering diversity. The ages of the stock markets ranged from a few months (1998, Tanzania) to hundreds of years (1585, Germany). Volume of trade ranged from 0.0003 billion USD (1998, Tanzania) to 5777.6 billion USD (1997, New York Stock Exchange). The number of listed firms ranged from 2 (1997, Macedonia) to 5843 (1997, India). There was also a wide variation in the existence and enforcement of insider trading laws. Insider trading laws existed in 87 of them, but enforcement -- as evidenced by prosecutions -- had taken place in only 38 of them. Before 1990, the respective numbers were 34 and 9. This leads us to conclude that the existence and the enforcement of insider trading laws in stock markets is a phenomenon of the 1990s." (The World Price of Insider Trading, Utpal Bhattacharya and Hazem Daouk, 1999) Decided cases A briefing provided by Wilson Sonsini Goodrich & Rosati An Analysis of the Supreme Court's Decision in United States v. O'Hagan By the end of September 1988, James O'Hagan owned more Pillsbury options than any other individual investor. O'Hagan was not a professional investor, however, he was a lawyer. In July 1988, Grand Metropolitan PLC hired O'Hagan's Minneapolis law firm, Dorsey & Whitney, to represent it in a contemplated tender offer for Pillsbury. Although O'Hagan never personally worked on the deal, he started buying up Pillsbury stock and call options soon after Dorsey & Whitney began representing Grand Met. When Grand Met announced its tender offer for Pillsbury in early October, the value of O'Hagan's stock and options holdings skyrocketed. All told, O'Hagan pocketed more than $4 million in profits. When O'Hagan's trading was discovered, he was indicted on 57 counts of mail fraud, securities fraud and money laundering. He was convicted on all counts and sentenced to 41 months in prison. On appeal to the Eighth Circuit, O'Hagan argued that he could not be liable for insider trading because, quite simply, he was not a Pillsbury insider and owed no fiduciary duty to the company or its shareholders. The Eighth Circuit agreed with O'Hagan and reversed his convictions, rejecting the SEC's theory that O'Hagan was nonetheless liable for "misappropriating" the information entrusted to his law firm. The Eighth Circuit's decision dealt a blow to one of the SEC's most powerful enforcement weapons and exacerbated a split among the Circuits, with two (the Eighth and Fourth Circuits) invalidating the "misappropriation theory" of insider trading and three (the Second, Seventh and Ninth Circuits) embracing the doctrine. On June 25, 1997, by a six to three vote, the Supreme Court resolved the circuit split by upholding the misappropriation theory and reinstating O'Hagan's insider trading convictions. In doing so, the Court endorsed an expansive definition of "insider" which goes beyond traditional corporate insiders. Justice Ginsburg's opinion stressed that while O'Hagan had no duty to Pillsbury or its shareholders, he did have a duty to the source of his information. "It was O'Hagan's failure to disclose his personal trading to Grand Met and Dorsey, in breach of his duty to do so, that made his conduct 'deceptive' under 10(b) [of the Securities Exchange Act of 1934]." United States v. O'Hagan, 97 C.D.O.S. 4931 (decided June 25, 1997). References: 1. http://en.wikipedia.org/wiki/Internal_rate_of_return 2. http://en.wikipedia.org/wiki/Capital_structure#Capital_Structure_in_the_real_world 3. http://www.investopedia.com/terms/d/debtequityratio.asp 4. http://en.wikipedia.org/wiki/Takeover#Perceived_pros_and_cons_of_takeover 5. http://www.43folders.com/2005/09/01/eight-tools-for-streamlined-decision-making 6. http://en.wikipedia.org/wiki/Risks 7. http://en.wikipedia.org/wiki/Treasury_management 8. http://www.cipfa.org.uk/pt/download/treasurySOPP.pdf 9. Utpal Bhattacharya and Hazem Daouk, The World Price of Insider Trading, 1999, http://faculty.fuqua.duke.edu/charvey/Teaching/BA453_2005/BD_The_world.pdf 10. A briefing provided by Wilson Sonsini Goodrich & Rosati, An Analysis of the Supreme Court's Decision in United States v. O'Hagan http://www.law.com/regionals/ca/briefing/wilson/wilson21.html Read More