The Main Objective of Any Company - Coursework Example

The objective of any company is to create and maximize the wealth of its shareholders who are the direct owners of the company and any investment decision taken up by the company is to reap benefits which would maximize their wealth. Accordingly, many techniques of financing decisions like calculating the NPV’s, IRR’s, the decision tree analysis etc. have become popular. While these calculations indirectly maximize the shareholder’s wealth, they are of a long term view because any company in itself is based on the going concern concept. As such, the benefits of today’s investments bear fruit only after a certain period of time. In the meanwhile, the short term benefit of wealth maximization of the shareholders for a period of one year or so is created by the increase in the share prices which are traded in the stock exchanges. A company’s shares gain if the company creates a value of its own and vice versa. As such, the dividends disbursed by the company and the incremental benefits of the share prices of any company suffix to the wealth maximization of the shareholders. For untraded stocks, the value depends on the subjective decision of the seller and the buyer (tutor2u, 2008). It would be of interest to know the wealth a shareholder would accumulate by purchasing the shares of a particular company explained by many models and theories namely: The Dividend Discount Model, The P/E Ratio Approach, CAPM, APT and the Rolls Ross Five Factors which try to evaluate the intrinsic valuation of a security following which, their market prices fluctuate randomly (not following a particular pattern). A critical analysis of all the above said models is attempted to analyze the effectiveness of these theories in the pattern of the share prices. In the Dividend discount model, dividend expected, the present share price and the growth rate determine the intrinsic value of a share. This model is based on the assumption of annual disbursement of dividend which is received after one year of the share purchase. Further modifications are made to calculate the share price under different growth scenarios of zero growth, normal growth, two-stage growth and an H-model (high growth in the start which normalizes later). In these models, there is an assumption of growth of dividends which is driven by the plough back ratio and the return of equity. Under circumstances of low growth, the dividend yield is high; the capital gains yield is low as also the price-earnings implying limited growth prospects. Similarly high growth implies low dividend yield, high capital gains, price-earnings and high growth prospects. In this way, the shareholders can evaluate the share price. Though the theory looks to be simplistic and used as a thumb-rule, the credibility was questioned in the recent Citibank case wherein the company was paying in the dividend more than its growth prospects and almost went bankrupt. It was only in this financial year, the company announced a dividend pay cut by almost 50%. So, the intrinsic value of the shares of the Citibank based on the dividend expected on the last year’s estimates could be misleading (Gasparino, 2008). The P/E ratio approach is an extension to the dividend discount model that it takes the determinants of dividend discount model as the basis for valuing stocks. The P/E ratio is determined by the dividend payout ratio, the required rate of return and the expected growth rate. This approach explains the empirical relationship of the P/E ratio to plough back ratio, interest rates, risk and liquidity. According to this approach, a higher Return on Equity (ROE) than the required rate of return (r), which implies higher plough back ratio (b) and P/E. Thus, there is an indirect proportion between (r) and P/E as well as share prices. Similarly, (r) has a direct correlation with the risk associated implying that an increase in r and risk pulls back the P/E and share prices. The phenomena though quite understandably acceptable was not experienced in the markets in the recent circumstances when the Fed was trying to pull up the value of securities by decreasing the interest rates based on the assumptions of this approach. Instead, inflation attacked the economy instead of the pull-back in the market value, clarifying that these conditions apply only in market equilibrium cases which are rather very rare. A more recent theory of security valuation is the Capital Asset Pricing Model (CAPM) which is based on some assumptions of market and arbitrage efficiency. Market efficiency implies that the players in the market are devoted to news gathering and evaluations as such react to wealth maximization techniques. The arbitrage efficiency implies that the traders try to maximize their wealth by buying the cheaper securities selling short the expensive ones. This will continue till the arbitrage opportunities are exploited to the ultimate extent and the other stock which was sold short also becomes attractive owing to lower pricing. The efficient market hypothesis existence is somewhat questionable when there is a crash in the stock markets and the securities of the entire sectors decline on a free fall due to inadequate measurement of risk. The recent stock market fall in the month of June is one such example. CAPM is based on the risk nature of every investor. In the basic model, the assumptions are zero transaction costs, negligible restrictions on investment, zero taxes, and no big investor to influence the markets. Though these assumptions may sound to be unreal, these are drawn for deriving the equality of perceptions by the investors towards opportunities presented by risky securities. There are two kinds of investment opportunities viz. the risk-free and the market portfolio which comprise of risky investments. The premium earned by the risky securities over and above the risk-free securities is the expected return. For comparison, historical data or the current date based on the analysts view can be utilized. However, assuming that the relationship between the securities will continue, as it was earlier, historical data can be used to plot the excess returns in a graph which form the characteristic line. The graph reveals a direct relationship between the expected return for the market and the stock. Three measures namely the alpha – the intercept, the beta - the slope and the relative distance of the dots from the characteristic line which is the unsystematic risk are studied. The alpha is assumed to be nil because, if it is less than zero, investors sell the stock and make it to zero and vice versa. Beta, the slope, is in line with the market returns if its value is equal to one. It is unavoidable, irrespective of any number of diversifications in the investor’s portfolio. Any higher value of beta speaks of its aggressiveness while, lower value suggests defensive stocks. Historical betas of a stock have great predictability of the stocks movements in the future. The unsystematic risk which represents the risk of holding one particular stock, on the other hand, can be avoided if there is a diversified portfolio of some 15-20 stocks randomly selected. For any stock usually, 75 percent of the variance of risk occurs due to the unsystematic risk which can reduced to almost zero by diversification. As such, the important measure to be evaluated is the systematic risk wherein a higher beta implies higher risk and higher expectations of return and so on. Here the beta can be calculated differently by accounting for the covariance of the security with that of market returns. By substituting the beta value thus arrived in the CAPM formula, one can interpret that unsystematic risk being diversified, the price of the systematic risk as demanded by the market is equal to the slope of the characteristic line which implies that the premium on risk borne is equal to the product of the security’s systematic risk and the market’s risk price. Alternatively, by following the covariance measure, the relative beta of the security can be used for measuring the systematic risk. In conditions of market equilibrium, the rate of return expected will be linearly inclined to the beta of the security called the security market line (SML). The premium on risk is the inducement for the investors to buy a risky security wherein risk-return relationship drifts over the SML for the stock to be undervalued and become attractive. The same holds good in the reverse cases also. The CAPM approach determines the appropriate rate of return which can be used for determining the share price under the dividend discount model sans the various unrealistic assumptions. Certain issues of disagreement in this approach are the values to be considered for terms like risk free rate, risk premium for the market, no interest rate differences for borrowing and lending, no effect of transaction costs, uncertainty about the true market portfolio. Beta as a measure of risk was questioned by Fama French (FF)) suggesting that stocks of lower capitalization offer better returns owing to their lower price and possibility of higher liquidity in comparison to stocks of large capitalization. Return realizations as such are related to the size and market to book value of the stocks making them better measures of risk. FF focuses on the return realization considering that beta only gives an underlying estimate of the return to be earned. With all the issues, CAPM is still popular owing to its working simplicity and non-availability of better versions. Further extensions of this approach dwell into issues of considering factors like effect of taxation, inflation, liquidity effect, and capitalization size of the stock in the market, P/E to market to book value observations, industry and seasonal effects etc. which focus on answering the issues which earlier rose in the basic model. All these factors transform the approach into a three-dimensional effect for a two factor model depicting that the risk premium of the security is affected by all the above factors which appears to be true in the current market conditions. However, strong evidence for this phenomenon is still questionable. In contrast to CAPM where the basic model was introduced with factors which need to be analyzed for explanation, a reverse technique of specifying various factors theoretically has been developed in the Arbitrage Pricing Theory (APT). Arbitrage means an opportunity of maximizing returns by buying the cheaper of the two equivalent stocks and selling short the expensive one. The underlying principle is that traders always are in search of arbitrage opportunities until they are fully exploited to form market equilibrium. Thus arbitrage forms the basis of return maximization and market equilibrium which is in sharp contrast to the CAPM wherein market equilibrium gives opportunities to realize returns. The traders try to arbitrate the prices after considering various factors acting for and against a particular stock and as such determine the pricing. The controversial issue of this approach is the assumption of approximation to the reasonable extent which is not two sided. In adverse market conditions, the opportunities of good returns are skeptically examined by the investors which may lead to lower return realization while the bad news is highlighted thereby implicating higher than required negativity in the stock. To quote, the bail out of the housing mortgage institutions Freddie Mac and Fannie Mae by the Fed is a classic example (Aversa, 2008). When these institutions went bankrupt, they had a rub off effect on their peers taking the market to 3-year low levels instead of arbitraging effect. Later on, when the Fed assured of a bail out, the rub off effect on the positive side looks to be capped for the FTSE for only 300 points or so after which, a major sell-off was inevitable. Thus we can conclude that even in favorable market conditions, good news only realizes lower degree of returns in comparison to degree of losses occurring due to bad news. Hence, the degree of arbitraging is more tilted towards the risk side than the reward side not ignoring the influence of rub-off effect and other headwinds like inflation, commodity prices etc. One more approach towards wealth maximization concept is the Roll-Ross five factors. The five factors being unexpected changes in: inflation, industrial production, yield differential in low-high yield bond comparison, long-short term yield differential; and unexpected inflation. Investors design their portfolio depending on their risk preferences which are influenced by the above mentioned five factors. The beta as a measure of risk in CAPM is too restricted to give a correct picture of the expected return of a stock. If we go by the current market trends, this approach appears to be holding to be true that the markets have slipped to new lows the degree of slipping equal to that level of the great economic depression only because of the above said five factors. The markets slip only if the stocks traded fall below their yearly lows drastically. With more experimentation, more investors may drift towards the Roll-Ross model. Conclusion: Though different theories and models of shareholder wealth maximization have been developed, empirical evidence suggests that there is an inter-relationship between these models. The beta of the CAPM approach suffixes to the required rate of return in the dividend discount model, the P/E approach has been included in the modification of the CAPM, the APT theory is almost a reverse of the CAPM and like APT, and the Roll-Ross model is also based on the factors of return realization. Thus, with slight deviations here and there, a matured study of all the above theories can help an investor to maximize his wealth successfully in the short term. References Aversa. J, Member of Forbes.com, 14 July, 2008, US spells out Fannie-Freddie backstop plan, Forbes.com, 14 July, 2008, http://www.forbes.com/feeds/ap/2008/07/14/ap5210072.html Gasparino, CNBC on air editor, 14 Jan, 2008. citigroup’s layoff could reach 24,000 this year. CNBC.com. 14 July, 2008. http://cc.msnscache.com/cache.aspx?q=73636567056521&mkt=en-IN&setlang=en-US&w=c991583e,22269a18&FORM=CVRE7 Bibliography: Chandra. P, 2004, Financial Management Theory and Practice, Delhi, Tata Mc. Graw Hill. Van Horne C. James, 1995, Financial Management and Policy, Delhi, Prentice Hall. £ Hotel 40000000 50 years depreciation 800000 Depreciation Renovation 10000000 5 years depreciation 2000000 Depreciation Rooms 100 Single / Double 70 70% occupancy 35 single + 70 in double 105 persons per day. Annual Running Costs (ARC) Advertising 400000 Maintenance 300000 Salaries & Wages 59000 Heat & Light 1500000 Administration 291000 Total ARC 2550000 Variable Costs / night Breakfast 2 included in Room Rent Evening Meal 6 included in Room Rent Cleaning and Laundry 7 Not required Total VC 8 Bar - Drink Cost 1.5 Bar - Drink Selling Price 5 3 members in Bar / 8 hours a day - Minimum Wage of 5.52 pounds per hour day. Accomodation offset of 4.30 pounds per day per person. Customer is expected to spend 10 per night on drinks. Bar Members 3 Minimum Wage / hour 5.52 Total Hours / day 8 Wages per Day for 3 members 132.48 Accommodation Offset for 3 members 12.90 Total Wages per Day for 3 members 145.38 Number of Working Days 364 Total Bar Wages / annum for 3 members 52918.32 Cost Sales Margin Drink Cost 1.5 5 3.5 Drinks per customer 2 2 2 single and double bedrooms - 70% implying 70 rooms comprising 35 single beds and 35 double beds. No. of customers - 35 + 70 105 105 105 Working Days 364 364 364 Total Drink Cost / Sales per annum 114660 382200 267540 Margin per Guest 7 Assumptions: Straight Line method of depreciation charged. National minimum wage policy being followed effective from Oct. 1, 2007. What price will the hotel need to charge per guest night to achieve a break even? Hotel will be open for 364 Days Occupancy - 70% of 100 Rooms = 70 rooms of 35 single and 35 double beds- 105 guests Total 38220 Nights Total ARC 2550000 Hotel Depreciation 800000 Renovation Depreciation 2000000 Total Costs 5350000 Fixed Cost / Night 139.98 Variable Cost / Night 8.00 Less: Margin on Drinks / Night -7.00 Room Tariff / Guest / Night 140.98 Break Even Price Assuming they achieve their ROCE target, what will be the NPV & IRR of the project over the first ten years? The Company WACC is 12% Outflow Hotel Cost 40000000 Renovation 10000000 Total 50000000 Inflow for ten years 10000000 per year NPV for an annuity for 10 years @ 12% = 5.65 Present value of total inflows = 56500000 Net inflow 6500000 Assumption 1) No direct or indirect taxes considered in the above calculations. 2) The balance outflow of 23848500 has to be recouped in the coming years as the project life is of 50 years. Calculation of IRR with the assumption of recouping the whole outflow within 10 years: Outflow Hotel Cost 40000000 Renovation 10000000 Total Outflow 50000000 Inflow for ten years 10000000 PVIFA value for 10 years at 15% is 5.019 Present value thus arrived at 15% is 50190000 NPV at 15% is 190000 PVIFA value for 10 years at 16% is 4.883 Present value thus arrived at 16% is 48830000 negative NPV at 16% is 1170000 Hence the IRR rate should be between 15% and 16% For accurate estimate we use the formula for interpolation which is as follows: Base rate + Base NPV/ sum of both the NPVs. Hence the accurate Internal rate of return is 15 plus 0.139706 IRR = 15.13970588 or 15.14% Q Evaluate the possibility of the hotel charging £80 per night on Fridays and Saturdays. A Weeks 52 Fri&Sat 2 Total Nights 104 Per Night 80 The break even cost/ per guest/ per night as calculated earlier is 140.98 If the hotel charges only 80 pounds per guest, the differential of 60.98 per day has to be recouped in the remaining 5 days. differential cost 60.98 No. of days 2 cost to be recouped 121.96 Remaining no. of days 5 additional cost per day 24.392 The hotel needs to charge additional cost of 24.392 pounds on the remaining days which makes the tariff to 165.372 However, it is not advisable for the hotel to reduce the cost of the tariffs below the break-even point. Cost leadership can be profitable only if the price is quoted above the break-even point. Base rate + Base NPV/ sum of both the NPVs. Advice the management of the hotel how they may generate additional revenue? Every management is concerned with generating additional revenue and profit maximization for delivering better results to its share holders. It is the business level strategy which helps the firm to formulate a strategy and position itself firmly in the market. The important points to be considered while designing a business level strategy are the customers, their needs and the competencies which the firm can exhibit to satisfy their needs. In this context Generic Business Level strategies prove to be best strategies which could be utilized by any firm in any sector (Porter, 1980). Generic strategies namely: Cost Leadership, Differentiation Strategy, and Focus, pin point the approaches which the firm needs to follow to attain competitive advantage. For the hotel management, we have observed that trying to attain cost leadership was of no point as the input costs are high and as it would be a new organization it would not have any large scale economies. Moreover with falling occupancy rates because of the companies trying to reduce their accommodation spends due to the ongoing recession, if the strategy of cost leadership would be adopted, it would be nothing than leaving money on the table and self-deprivation of profits. Other than these, if the hotel considers maintaining cost-leadership strategy, it should provide no frills products like no bar facilities etc. which would again dent their financials. Hence, this strategy is not advisable. The strategy of differentiation emphasizes that firms need to create a competitive advantage of their own against their peer groups. They have to be able to service the customer with more valued products which are premium priced. The customer also needs to experience the superiority of the service they offer and that should be maintained if not improved further. High price can be demanded for this superior service depicting the service to be exclusive and prestigious. Other than the management, the customer should also recognize this supremacy and as such, he must not be reluctant to shell out that extra money for that personalized service. This strategy sounds to be better, as the management is going for investing in hotel business wherein, exclusivity can be achieved by training of hospitality given to the staff, good food provision, no adulterated drinks etc. Wherein, the intangible goodwill increases thereby improving their future profitability. The third strategy available to the hotel management is to stay focused on the segment of the customers to whom the management wishes to service. It needs to have a clear view of whether it would target the high-end customers, the middle-level or the low-end customers. Accordingly, improvements and further renovations if necessary need to be carried on and later, when the service is according the management’s expectations, then, the firm can start the business. While selecting this strategy, it is to be borne in mind that relentless hard work is essential to ensure that no other bigger player is entering into the firm’s area of niche. If any such thing is predicted, they need to overhaul their capacities and gain the recognition against those well-known players also failing which, the business may be dampened. Sometimes, it so happens that managements though start with a particular strategy drift away to some other extent due to various reasons of higher profitability, better goodwill etc. As long as, the main objective of return maximization is intact, any strategy can be followed given that the management is clear of its end results. This type of strategy is called hybrid strategies. Cautiousness need to be followed while taking up these types of strategies failing which, the management may be stuck in a position wherein it has no competitive advantage nor can it dream of having one in the future. Conclusion It is observed that, any strategy taken up, the benefits of such plans can be reaped only if the management is cautious about its standing in the market and devise plans to secure better positioning in the future. Any action without a clear cut plan is bound to go hay-wire and no one can save such a project from collapse that too in the present scenario of high competition. References: Department for Business Enterprise & Regulatory Reform, 07, National Minimum wage, Employment Matters, 15 July, 2008, http://www.berr.gov.uk/employment/pay/national-minimum-wage/index.html Porter Michael, (1980), Competitive Advantage, In: Gupta, Gollakota, Srinivasan, ed. Business Policy and Strategic Management, New Delhi, Prentice Hall of India, pp:61-65. Read More