Business Market Value in the Absence of Taking Over Possibilities - Assignment Example

Finance Policy Affiliation with more information about affiliation, research grants, conflict of interest and how to contact Finance Policy Part A 1 (a). Estimate market value of Gibson ltd in the absence of any take over possibilities. The Market value of a firm is its ­­value in the market. Market value refers to a price which the seller of a firm is bound to receive from a buyer which is inclusive of both the firm’s assets and liabilities that the firm intends to acquire or sell. It is very important to assess the market value of a firm especially when there is a merger or acquisition. The market value of a firm is dependent upon the capital structure of the company. The firm Gibson ltd is equity financed, therefore, the beta of assets as well as of equity is the same. The total operating cash flows for the period of four years in the division are as follows: North - $60,000,000 South - $32,000,000 The taxable operating profits for the period of 4 years in the divisions are as follows: North - $60,000,000 South - $32,000,000 The planned capital expenditure of $ 8 million and its tax consequences has not been incorporated in the north division. The corporate tax rate is 30%. 8,000,000*30% = 2,400,000 8,000,000-2,400,000 =5,600,000 Therefore the taxable operating profit in the north division is $60,000,000 - $5,600,000 = 54,400,000. The salvage value for North division - $ 24 million South division - $ 12 million Therefore the operating net cash flows North = 46,000,000 South = 20,000,000 The total net cash flows of both the divisions together are : 66,000,000 Interest rate is 18%. The market value of the firm is 66,000,000 * 18% = 11,880,000 The market value of the firm is 66,000,000-11,880,000 =54,120,000 (b) Advise Alresford ltd. on the maximum amount it should be prepared to pay for Gibson if the strategic planning manager’s suggestions are completely ignored. When the strategic planning manager’s suggestions are completely ignored then Alresford has to pay the market value of Gibson ltd. in order to acquire the firm. When the strategic planning manager’s suggestions are completely ignored then the firm Alresford ltd. as its market value could acquire the firm Gibson, which is $ 54,120,000. The strategic planning manager is entitled to reduce the acquisition amount so that the firm Alresford could take over Gibson at more profit and at a price less than the market price. The firm Alresford aims to take over Gibson ltd at a reduced price, which is less than the market value of the firm in order to obtain profits. c) Determine which of the strategic planning manager’s suggestions should be undertaken and specify the optimum life of the south division. Advise Alresford ltd. of the maximum amount it should now be prepared to pay for Gibson. The strategic planning manager’s suggestion of using the Alresford’s transport rather than the north division’s transport which could save the transport expenses by $ 600,000 annually results in a savings of $ 2,400,000 in four years. Even though such a change would increase the replacement cost by $ 1.6 million, yet such a type of system will result in a savings of $ 800,000 which the firm can use for other business restructuring processes. When the strategic planning manager’s suggestions are undertaken, then the maximum amount that Alresford ltd should pay for Gibson is calculated as below: North: Operating net cash flows – transport department’s expense for four years – advertising expense for three years North – 46,000,000 – 2,400,000 – 3,600,000 – 4,800,000 = 35,200,000 South: Operating net cash flows – increase in annual cash flows until termination South – 20,000,000 - 4,000,000 - 3,000,000 = 13,000,000 North + south = 48,200,000 The maximum amount that Alresford should be prepared to pay for Gibson if the strategic planning manager’s suggestions are completely undertaken is $ 48,200,000. d) What difference would it make to calculations if we assumed that Alresford ltd was fully integrated into the Australian dividend imputation system? The system of dividend imputation was introduced in Australia in 1987 in order to avoid double taxation with respect to the income of a company. Before the introduction of the dividend imputation in Australia, there was double taxation because the companies paid tax on their earning income and the shareholders also had to pay tax on the dividends at a marginal tax rate, which provided the government double tax on a single company’s earnings. Here the difference with respect to dividend payment if the firm Alresford implemented the Australian dividend imputation system could not be clearly calculated as no provisions with respect to payment of dividend are provided. Therefore, there is no change in calculations with respect to payment of dividend if the Australian dividend imputation system is used. The system of Dividend Imputation allows the shareholders of the firm to obtain more profits with respect to the Australian tax system. The system of using Dividend imputation formulates the income from franked dividends to be tax effective and this reduces the burden on companies as well as shareholders. Part B a) List and explain costs and benefits of debt? Debt is an interest bearing liability which is either short or long term. There are many costs and benefits of debt. There are a number of benefits of debt which are as follows: Tax benefits It is easier for firms to finance with debt rather than equity capital. The tax benefits of debt are the advantages which the firm has when the firm procures through debt capital. Firms find it easier to finance through the debt capital, which is more clearly explained through the following example. Suppose a firm finances through equity capital. The firm has to pay tax both on its corporate earnings as well as the earnings, which it provides, to the shareholders in the form of dividends. Thus the tax liability of the firm increases by financing with equity capital rather than financing with debt capital. When the firm fiancés through debt capital, then it pays tax only on its profits and does not have to pay tax on any distribution as dividend. Adds discipline to management – Debt financing adds discipline to management since financing is done through debt capital, therefore, the firm always has the obligation to pay back the debt as soon as possible. Such a type of financing through debt always exerts a caution on the management to handle the business with more discipline. There are a number of costs of the debt which are as follows: Bankruptcy costs – there are a number of costs associated with debt capital. Bankruptcy costs are one of the important costs associated with debt financing. There is always a threat of a firm going to bankruptcy when it is unable to earn enough profits and satisfy its liabilities. Loss of future flexibility – another cost associated with debt financing is the firm’s loss of its opportunity of working with its own flexibility when it is debt financed. The firm always works within its boundaries and thus it losses future flexibility. b) Identify the variables that are relevant to the capital structure optimization exercise. Explain how the capital structure is adjusted and why. The variables that are relevant to capital structure optimization are the firm’s categories of asset classification. Its decisions are related to its liability as well as the capital structure decisions. “A strategic optimization model provides the ideal setting for allocating the scarce capital of a financial intermediary such as an insurance company. The goal of management is to maximize shareholder value. Capital allocation serves three primary purposes: to compare managerial performance across business units, to provide a risk indicator for regulators and other stakeholders, and to develop a common basis for major decisions, including investment and underwriting strategies, and setting the corporate structure” (Mulvey., et al. 1999, p. 1). The capital structure of a firm can be adjusted after the firm undergoes a serious research process. The firm needs to investigate whether it should procure capital through debt or equity or a mixture of both. The other set of variables is the credit period, which it would provide for payment to its customers, its suppliers etc. Reference List Mulvety, J. M., Belfatti, M. J., & Madsen, C. (1999). Integrated Financial Risk Management: Capital Allocation Issues. Princeton University. Retrieved July 08, 2011, from http://www.casact.org/pubs/forum/99spforum/99spf221.pdf Read More