Financial Assessment on Shareholders, Interest Rates and Cash Flows - Assignment Example

Question a) The agency problem can seriously restrain the economic success of a company. What avenues are available to shareholders to bring theirgoals and those of management into alignment? Agency problem is difficult but extremely important and recurrent organizational design problem of how organizations can structure incentives so that people ("agents") who are placed in control over resources that are not their own with a contractual obligation to use these resources in the interests of some other person or group of people actually will perform this obligation as promised -- instead of using their delegated authority over other peoples resources to feather their own nests at the expense of those whose interests they are supposed to be serving (their "principals"). Enforcing such contracts will involve transaction costs (often referred to as agency costs), and these costs may sometimes be very high indeed. The more autonomy that agents have to have in order to do their particular kind of work effectively and efficiently, the less useful coercive sanctions are likely to be, and the more important it becomes for agents moral and material incentives to be appropriately aligned with their broader obligations to their principals. That is, organizations need to be structured in such a way so the agent will expect that diligently serving the interests of his or her principals will also be in his or her own long-run best interests. In order to accomplish this, the principals need to be reasonably clever in setting up the initial rules of the game that are set in the employment contract , sufficiently vigilant in keeping track of their agents quality of performance over time, and willing to bear at least some minimum level of "agency costs" in order to provide the necessary incentives (b) Should investors be concerned about the ethics of the firms in which they invest? Why or why not? If most of investors worry about it, how wills that affect corporate behaviour? There are many definitions for the term ethical investment, and what this term entails. Ritsie Lowry, maintainer of the GoodMoney site1 suggests that “In one sense, ethical investment is just like traditional investment. Ethical investors pursue the same economic goals as all investors: capital gains, higher income and/or preservation of capital for future needs. However, ethical investors want one additional thing. They don’t want their investments going for thing that cause harm to the social or physical environments, and they do want their investments to support needed and life-supportive goods and services”. From this certain definition we are able to realize that ethical investment is similar to the conventional investment, but differs to the fact that it needs one more requirement. Ethical Investors are very strict as far as the kind of business their money is going to fund. Many researches have proved that the ethical investors prefer to invest their money ethically although they know beforehand that the investment will not be as lucrative as a traditional investment. Russell Sparkes 2 in his book mentions “Repeated surveys (the last by Minitel in 1991) have shown that around 40% of the public want their money invested ethically. Interestingly enough, most of those in favor said that they would make ethical investments even if they knew that the returns would be lower than on conventional investments”. Nevertheless there exist some facts which prove that ethical investment is quiet lucrative and in some cases more lucrative than the traditional investment. Weidner Investments3, point out four reasons, why the ethical investment is more profitable: 1) Management of the ethical company can focus on genuine growth without worrying about public reactions 2) Legal and hassle related costs are minimal 3) Brand loyalty is less expensive to maintain 4) Active ethical investors and consumers will give the firm free advertising again and again All these points seem quiet rational and representative of reality. We can assume that ethical companies, are companies that are “built to last” so there is some kind of warranty for the money of ethical investors. (c) Can a firm go out of business while making an accounting profit? Think about a company that buys a lot of inventory, starts a factory running and then sells most of the product (at a price far above cost) to a customer who is slow in paying. Exactly why may the company fail? A firm can go out of business while making an accounting profit once a company does not have an adequate cash to keep a business running. If the company runs out of available cash, it runs the risk of not being able to meet current obligations such as payroll, accounts payable and loan payments. Perhaps the most common reason there is a discrepancy over cash flow and profit is the difference in timing between the making of a sale and actually receiving the money. In its most simple form a business may sell something on credit, but not collect the money until the next month or two or three. In these instances, the revenue from the sale is recognized for accounting purposes in when the product or service was sold. In financial statement terminology, it is added to the “Income Statement” or P&L Statement. Companies with savvy management teams generate profit and loss statements monthly so that they can examine the total sales, cost of goods sold, total operating expenses and net profit, and the interrelationship of these buckets. (d) ‘In order to compare two or more interest rates, they must be expressed on a suitable common scale’. Explain the meaning of this statement and give a few numerical examples to illustrate. Nominal interest rate is laid down in contracts between involved parties. Real interest rates somehow adjust the nominal ones to keep inflation into account. For instance if inflation was 15%, in the previous example the real interest rate can be said to be 20%-15% = 5%, in a simplified way of computation. There exist several nominal interest rates, depending on the following elements: 1. the institution offering the credit; 2. the organization receiving the loan, which can be more or less trustworthy; 3. the funds use and the aims of the financed plan (consumption, investment, working capital,...); 4. the time length of the loan with the broad difference between short-term interest rate and long-term interest rate; 5. the ex-ante flexibility of the contract with the alternative between a fixed interest rate or a variable interest rate; 6. the number, the frequency and the amounts of reinbursement actions; 7. the conditions under which the loan is agreed, for example regarding guarantees and collateral; 8. the presence or absence of a market for converting loan conditions and for changing the parties involved in the contract. For instance, the fixed interest rate paid to a bank by private firms for financing an industrial investment, characterized by a payback period of 3-7 years, exerts a crucial importance in the economy. In fact, it may influence overall investment, thus the business cycle. (e) Contrast standard deviation and beta as two measures of risk. Under which circumstances is standard deviation the appropriate measure of risk? When is beta the most appropriate measure of risk? Beta and standard deviation are two tools commonly used to measure stock risk. Beta is a statistical measure of the impact stock market movements have historically had on a stocks price. By comparing the returns of the Standard & Poors 500 (S&P 500) to a particular stocks returns, a pattern develops that indicates the stocks exposure to stock market risk. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market and has a beta of 1. A stock with a beta of 1 means that, on average, it moves parallel with the S&P 500 - the stock should rise 10% when the S&P 500 rises 10% and decline 10% when the S&P 500 declines 10%. A beta greater than 1 indicates the stock should rise or fall to a greater extent than stock market movements, while a beta less than 1 means the stock should rise or fall to a lesser extent than the S&P 500. Since beta measures movements on average, you cannot expect an exact correlation with each market movement. Standard deviation, which can also be found in a number of published services, measures a stocks volatility, regardless of the cause. It basically tells you how much a stocks short-term returns have moved around its long-term average return. The most common way to calculate standard deviation is to figure the deviation from an average monthly return over a three-, five-, or 10-year period and then annualize that number. Higher standard deviations represent more volatility. In statistical terms, 68% of the time the stocks range of returns will fall within one standard deviation of the average return, while 95% of the time the stocks range of returns will fall within two standard deviations. These two measures can provide important information about a stocks volatility. (f) Stocks and bonds are traded in separate markets, and interest rates are set in bond (debt) markets. Why then does there seem to be an inverse relationship between the movements of stock prices and interest rates (they move in opposite directions)? The concept that stock price and interest rates enjoy an inverse relationship is actually quite theoretical rather than absolute. An inverse relationship seems to exist between stock prices and interest rates because interest rates are closely tied to discount rates, therefore a rise in interest rates do (frequently, but not always) have a negative impact on stock prices (and vice-versa). The strange relationship between stocks and interest rates is explained this way: “To obtain a fair value, multiply P, the probability that the money will be paid in the future, by the Present Value of a stock given its interest rate (I) over time (T). $1 / (1 + I)T In an ideal world, the price of a stock would equal the present value (PV) from adding up the expected dividends from each year in the stocks future. Because of expected future impact, when interest rate rises 1%, a stocks price (PV) drops by more than that percentage. Thus, stock prices and interest rates have an inverse relationship. Interest rates usually come down at the end of a normal business cycle, which is also the beginning of the next cycle.” (g) Some financial analysts focus on earnings per share (EPS) as a major determinant of the companies share price. Explain the link between EPS and the share price and can you think of any limitations in this approach to share valuation? EPS is a good measure of a companys profitability, as it shows how many pence is being earned for every share held. It is a ratio calculated by dividing a companys net income by the current number of shares in issue, and is one of way of determining what value the shares should trade at. For example, if a company makes £10m and has 100m shares in issue, its EPS is 10 pence. (g) When might two mutually exclusive projects having unequal lives be incomparable? How should managers deal with this problem? When comparing mutually exclusive alternatives, it is well known that differences in the timing of cash flows can result in a conflict between the ranking of projects using NPV and IRR. The two projects differ in that one of the projects has a higher IRR and has the bulk of its cash inflows occurring early in the projects life, while the other project has a lower IRR with the bulk of its cash inflows occurring in the more distant future. For a range of discount rates the lower IRR project has the higher. No ranking conflict would occur if the project having the higher IRR also had the bulk of its cash inflows coming "in the later years." While some of the relationships between NPV, IRR, and cash-flow timing seem intuitive--indeed, they are discussed in popular introductory textbooks--until now a precise mathematical link has not been established. Nor has there been adequate formal development of the role of duration in explaining ranking conflicts between projects. Question 2 Question 3 a. Consider the following cash flows and interest rates (5 marks) Time Cash flows Time period Annual Interest rates Yrs 1 – 3 5.50% Yrs 4 – 7 8.00% Year 8 onwards 7.15% i. Draw a time line to show cash flows and interest rates ii. What is the value of the cash flows at T0? 5,000 iii. What is the value of the cash flows at T6? 19,253 iv. What is the value of the cash flows at T12? 1,000,675 v. Would you rather receive the cash flows described above, or $4,200 today? Based o the CF its still better to receive the above cash flow instead of 4,200 Explain your choice. b. If the nominal rate is 10.5% per annum, what is: (5 marks) 10.50% i. The effective annual rate compounded quarterly? = ((1+10.5%/4)^4)-1 = 10.92% ii. The effective annual rate compounded monthly? =((1+10.5%/12)^12)-1 = 11.02% iii. The effective annual rate compounded cont?=(1*EXP(10.5%*1))-1 = 11.07% iv. If the effective annual rate, compounded monthly, is 8.3%, what is the annual nominal rate? =((1+8.3%/12)^12)-1 = 8.62% Question 4 You are considering starting up a stained glass window business in your garage. In order to obtain a loan, you have prepared the following schedule of net cash flows for your bank manager. Annual cash flow Initial outlay was (a) Given a required rate of return of 14%, what is the value of the cash flows from T6 onwards, as at T5? (4 marks) (b) What is the value today (T0) of this enterprise? (3 marks) The value of the enterprise today is £ 4,785. (c) If you were the bank manager, what would be your recommendation? What other information would you like? (3 marks) As a bank manager the first question I would ask would be for how many Question 5 You want to save $20 000 for a world trip in five years’ time. The annual interest rate is 8%. (a) If you make five annual deposits, the first being in one year, how much will each deposit have to be to realise your dream? (4 marks) (b) If you make five annual deposits, the first being today, how much will each deposit have to be? (4 marks) (c) How would your answer to (b) change if you made 10 semi-annual deposits? (2 marks) Annual interest rate 8% Periods you plan on saving 10 Amount you want to have save in 10 periods 20,000 Amount to save each period to have 20,000 at the end of 10th period -£2,121.30 Formula =PMT(D18/12,D19,D20,0,1) Question 6 Today is your 45th birthday and you have decided that it is time to get serious about organising the finance for your retirement. To this end you make the following decisions: I Starting today, you will deposit $5000 annually in an account that earns 6%pa for 10 years (10 deposits) and then increase the deposit size to $10 000 for the remaining 10 years (10 deposits). II You have a beach house that is currently valued at $400 000. The net rent from this property will be deposited into an account that earns 6%pa. Assume that annual rental is received in advance, the first rental for deposit being received today. Annual rental is estimated to be 5% of the market value of the property, and the property is expected to increase in value at a steady rate of 3% pa. III On your 65th birthday you intend to sell the family home for $1.5 million and move into the beach house. IV On your 65th birthday, you will place all savings including the proceeds from the sale of the family home, into a fund that earns 7.5%pa. (a) Draw a time line of the above cash flows. (b) How much will you be depositing into the fund on your 65th birthday? (10 marks) (c) As you anticipate living until you are 90, how much can you withdraw annually from the fund if you want $250 000 left in the account – in case you live longer than predicted. Your first withdrawal will be on your 66th birthday, and the last one on your 89th birthday. Read More