Financial Management - Report Example

Question 15 Marks) (a) You have told me that as a financial manger I should seek to maximise the firm’s market value. But if the market value of the firm is the PV of the cash flows from its investment in productive assets, why do I need to concern myself with the value of the various securities issued by the firm? Comment on this question. (5 marks) It is true that the present value of the cash flows from the investment in the productive assets constitute the market value for the firm. However, knowing the right combination of debt and equity, or an optimal capital structure will have an impact on the market value of the firm as being regarded by investors according to the respective required rates of return of the firm’s choice of financing. Capital structure pertains to how a company finances its assets. One approach to capital structure is its default structure which utilizes an all-equity financing. This equity financing, as the company grows will not be sufficient in order to provide for some other activities such as expansion. Thus, the utilization of debt financing is necessary. The combination of debt and equity financing is another approach. The use of debt does not only provide an alternate financing for the company. In the world where there are no market distortions such as taxes, the utilization of debt would just be like the utilization of equity if we are talking about the effect of capital structure on the profitability of the company, or its return on equity. But in this world where there are taxes, debt financing provides a significant advantage to an organization. This is called the financial leverage, which increases the return on equity because of the tax shield that debt financing provides. This tax shield arises because interest payments are tax deductible. However, the combination of debt-equity as an approach to capital structure in order to provide financial leverage for the company only provides the firm benefits up to a certain point. When the company’s debt reaches a certain level, its credit rating falls because of the issue of sustainability of the business supported by the company’s own internal financing. Therefore, the company becomes riskier and higher costs of debts are required by creditors in order to compensate for the added risks. This offsets the benefits to the company of financial leverage. (b) Financial engineering has been disparaged as nothing more than paper shuffling. Critics argue that resources used for rearranging wealth (that is, bundling and unbundling financial assets) might be better spent on creating wealth (that is, creating real asset). Evaluate this criticism. (5 marks) This bundling and unbundling of financial assets is a major consideration in finance in finding the optimal capital structure. The choice of capital structure also has an effect on the shareholder value that real assets provide in turn. Therefore, it is important to note that the resources that are expended for this rearranging wealth is also a significant decision in order for the company to satisfy its investors in terms of creating wealth. Capital structure determines WACC in such a way that the proportion of debt versus equity determines their relative combination given the different costs for each financing. When a company uses all-equity financing, the cost of capital that it uses is the cost of its equity. While the cost of debt is lower than the cost of equity, the utilization of debt decreases the cost of capital up to a certain point. This difference in choice of combination of the funding, or the capital structure therefore, affects WACC in that the different choices of financing have different costs in using them, respectively. Optimal capital structure is the combination of debt and equity that maximizes shareholder value. In order to maximize shareholder value, WACC has a role to play. Minimum WACC, usually the lowest weighted average cost of capital among all the combinations of debt and equity is used by the company to determine the required return to investors. In order to create value, the company has to create projects with returns that will surpass the cost of capital. The higher the cost of capital, the fewer the projects the company can accept in order to create value. Therefore, weighted average cost of capital, which is a function of the combination of debt and equity in terms of proportion, and the costs of each of the two financing have to be considered when determining an optimal capital structure. While the optimal capital structure is the rational thing to adopt in order to maximize shareholder value, it is usual that the structure will depend on the sentiments of the investors, or how conservative they are in taking risks. Availing more debt will prove to be riskier, and only up to a certain point will it give the company some advantages over the lower WACC. Higher debt also means to equity holders a lower EPS in times of recession and hard times for the company, as debt holders are first when it comes to the company’s payment of financing. Therefore these are some of the considerations when determining the capital structure. All these lead us to the point that the resources that are expended on reshuffling wealth, in terms of the choice of financing for the company is also a significant decision as creating real assets. When real assets are already created, the choice of financing has an impact on the value these real assets provide to the company. (c) Define an efficient market. What are the implications for the valuation of securities? (2 marks) The stock market has always been referred to as an efficient market by economists. According to Brealey, Myers and Marcus, “the competition [in this market] to find misvalued stocks is intense. So when new information comes out, investors rush to take advantage of it and thereby eliminate any profit opportunities (2004, 165).” An efficient market, according to Samuelson and Nordhaus in their book “Economics” is defined as “one where all new information is quickly understood by market participants and becomes immediately incorporated into the market prices (2004, 534).” This characteristic of the stock market as an efficient market is attributed to the availability of timely information which is incorporated in the prices of the stocks. The stock market indeed needs investors who believe that the market is inefficient in order to make the market efficient. As investors think that there is a certain degree of inefficiency in the market, these investors’ notion of the stock prices are that they are underpriced, and there is a chance to profit from this situation. Therefore, as investors believe in this inefficiency, and the possible reward of profiting from these undervalued stocks, they are driven to action. When investors are driven to action, they look for more sources of information, analyze the information and push the prices up or down depending on the value of the information as regards the certain stock. When investors are prompted to take action either by driving the prices of the stocks up or down depending on the information, the direction of the prices tend to be that which incorporates the value of the information—thus, eliminating the possible profits from buying and selling the stocks. (d) If asset prices impound investor’s judgments that reflect all publicly available information, why would an investor expend resources to produce other information? (3 marks) The theory of efficient market also has some exceptions. And these exceptions have implications on mergers and insider trading, which are evidences have been starting to appear for the two to have been correlated for some companies. This reason creates a gap of inefficiency between the price that reflects the current information that is available, as well as the true value of the firm. Thus, there are undervalued and overvalued stocks in the market, which the investor needs to be informed about. According to Morgenson in an article from the International Herald Tribune, a study has found some correlation to insider trading and mergers for some companies. The study is done by Measuredmarkets, an analytical research company in Toronto for New York Times. As some companies have been probed, abnormal trading prior to merger announcements has been found out. “NEW YORK: The boom in U.S. corporate mergers is creating concern that illicit trading before deal announcements is becoming a systemic problem. It is against the law to trade on inside information about an imminent merger.But an analysis of the biggest U.S. mergers over the past 12 months indicates that trading in the securities of 41 percent of the companies receiving buyout bids was abnormal and suspicious in the days and weeks before those deals became public. For those who bought shares during these periods of unusual trading, quick gains of as much as 40 percent were possible (Morgenson 2006, 1).” Mergers can create value to the company, and therefore while not all mergers guarantee this value, investors expect future benefits of mergers which drive up the prices of a certain stock. Because insiders can gain so much only from the information that they hold regarding the development in the companies, regulatory commissions in stock exchanges have enacted laws in order to curb insider trading in order to make the trading fair to most investors. When an insider has information that could bring benefit to her or another person because of the future anticipation of higher prices of the stock of the company due to a recent news regarding the company’s operations, she could profit a lot solely on that information. Laws are enacted in order to prevent those from the inside to disclose any information about the developments within the company in order to level the playing field; and this insider information is mostly applicable to companies who are undergoing negotiations for buyouts or mergers, and who are about to have a public announcement of the buyout. “Moreover, many investors are troubled by what they now see as rampant insider trading, saying it fosters the perception that insiders can profit in the markets at the expense of outsiders (Morgenson 2006, 2).” It is therefore necessary to consider what the article reports according to many investors who are concerned about insider trading. Also, as according to the article, “some economists and academics assert that insider trading is essentially a victimless crime and not worth deploying regulatory armies to battle. But there are losers, including small investors who may miss out on gains when such trading moves markets (Morgenson 2006, 1).” When there are mergers and insider trading is present, the small investors tend to miss out the gains. When insider trading happens prior to a public announcement of mergers, the stock market loses its efficiency first before it becomes efficient again in the process. This is the major reason why investors need to know more even if they have to expend much. Question 2 (20 Marks) (A)Mr. Jones expects his meat pie business will produce the following cash flow stream: Year $ 1 0 2 1000 3 -2000 4 1500 5 onwards 2000 per annum The interest rate is 10% per annum compounded annually. (i) What is the discounted value of the constant income stream at the beginning of the fifth year? (3 marks) Since the meat pie business scenario does not include a definite end for the project, the cash flow stream on the fifth year is considered a perpetuity, which is assumed to go on forever. Therefore, we must compute the present value of the perpetuity: Present value of perpetuity=C/r=2000/.10 or 20000 However, this income stream will start five years from now, so in Year 4, the endowment will be an ordinary perpetuity with the payments to start in one year. The delayed perpetuity is worth: 2000 * 1/r * 1/(1+r)4 = 20000 * 1/(1.10)4 = 13660.27 Present value of perpetuity = 13660.27 (ii) What is the present value of the whole income stream? (2 marks) (B) Round One Sports Centre has had great success since first going public and issuing ordinary shares three years ago. Earnings and dividends have increased by 50% in each year and are expected to do so for 2 more years. Starting with the 3rd year, growth is expected to fall to a more normal 6%. During the year just completed, the firm paid dividends of $1 .00 per share. The required rate of return on Round One is 15%.) (i) What is the maximum price an investor should pay for a share of Round One? (5 marks) P0=DIV1/(r-g) DIV1=DIV0 (1+g) DIV1=1.00 (1+.06) DIV1=1.06 P0=DIV1/(r-g) P0=1.06/(.15-.06) P0=11.78 (ii) What would the answer be for (a) above, if the 50% growth would last only one year rather than two? (5 marks) Scenario 1: 50% increase lasted for two years Scenario 2: 50% increase lasted only for one year, 6% in subsequent years DIV0 would be equal to 0.706666 instead of 1.00. Hence, P0=DIV1/(r-g) DIV1=DIV0 (1+g) DIV1=0.70666 (1+.06) DIV1=0.74906596 P0=DIV1/(r-g) P0=0.74906596/(.15-.06) P0=8.322955; the current price should be lower due to the lower growth rate in the second year, hence lower dividends in the subsequent years. (iii)What does the difference between (a) and (b) above, illustrate? (5 marks) The difference between answers in (a) and (b) lies in the growth rate; the growth rate plays a huge role in the growth of dividends, which is an important element in determining the current price of the stock. Question 3 (20 Marks) (A)What would happen to the value of a three-year debt security, with a face value of 0 and a coupon rate of 10% (interest paid quarterly), if the required rate of return was: (i) 12%? Because the rate is compounded quarterly, the required rate of return to be used is .003. The number of periods when the rate would be compounded is 12, or 4 periods every year for three years. Therefore the quarterly interest payment for the $100 security is 2.5, and the present value is $125.89. (ii) 8%? But with $100 face value, the present value of the debt security is higher at $127.24 (disregard the negative sign) than its value at 12%. The required rate of return is 0.002 for every period as the 8% is divided into four. How would you explain these results? (5 Marks) The higher the discount rate, the lower the present value becomes. Therefore, lower discount rate is, the higher the present value of the bond is. (B) Consider the time line below that shows periodic cash flows and different interest rates per period. (15 Marks) For interest : 0 to 3 year ( 3 years) 5.5% pa 3 to 6 year (3 years) 8.5% pa 6 to 10 year (4 years) 6% pa 0-----1----2-----3------4----5-----6-----7----8----9----10 time (years) Cash flow : at 0 (start) was positive $4000 at 3rd yr was negative $2500 at 4th yr was negative $1000 at 7 th yr was positive $7000   i. What is the value of the cash flows at T0? The total value of cash flows at T0 is 7247.94-- the present value of cash flows at T0 combined with the discounted cash flows of T3, T4 and T7. ii. What is the value of the cash flows at T3? The total value of cash flows at T3 is 8663.23-- the future value of cash flows at T0 in T3, combined with the present value of cash flow in T3, and discounted cash flows of T4 and T7. iii . What is the value of the cash flows at T10? The value of cash flows in T10 is the future value of cash flows in T0, T3, T4, and T7 at T10 or 13164.46. iv. Would you rather have the cash flows described above, or 7,500 at T8? Explain your choice. The present value of cash flows in T8 (the combination of future value of all the cash flows) is 11677.2 which is higher than 7500 offered in the same year. Therefore, the obvious choice should be the cash flows described above. bi i. If the nominal annual interest rate is 13% compounded weekly, what is: • the weekly effective rate • the annual effective rate • the monthly effective rate ii. If the effective annual interest rate is 15.865%, compounded quarterly, what is the nominal annual rate? 1+effective annual rate = (1+quarterly rate)4 1+0.15865 = (1+quarterly rate)4 Quarterly interest rate= 0.0375 Hence, nominal interest rate = 0.0375*4 or 0.15 iii. You buy some shares for $20,000 and sell them 68 days later for $20,874. What is the effective annual interest rate assuming a 365 day year? A=P(1+ni) 20874=20000*(1+(68/365)*x/1) X=23.4566%, the effective annual interest rate Question 4 (20 Marks) Big Deal Industries is considering the expansion of its operation by introducing a plant extension. The new plant is expected to have a life of ten years and will cost $1,000,000 to erect and make operational on some existing land owned by the company. The land is has an estimated market value of $500,000. Additional spare parts of $100,000 and additional inventory of $400,000 will be required to support the new operation. The annual revenue and expenses associated with the project are estimated to be as follows: Revenue $1,500,000 Operating Expenses 950,000 Increased Overhead expenses 100,000 Increased interest expense 75,000 Head-office expense loading 150,000 Allocated depreciation 100,000 The weighted average required rate of return appropriate to the project is 15% and the corporate tax rate is 40%. Evaluate the project for Big Deal Industries Interest expense is a financial expense therefore not to be included in the discounted cash flow analysis. Also, the head office expense loading is not included in the project as it is not a relevant cash flow for the project’s operations. The decision should be based on the analysis of cash flow with or without the project, and then should be compared against the other alternatives. The three sets of relevant cash flow in the project are: the initial outlay which costs $1,500,000 in year 0, as the combination of the plant costs and the additional spare parts, as well as accounting for additional investment in working capital; the annual operating cash flows, which are derived by subtracting both the operating expenses and the overhead expenses from the revenues—that is, revenues are assumed to be cash revenue figures—and after getting the after tax profit by deducting the 40% tax from the taxable profit, we add the depreciation which results all in all in a yearly cash flow of 310,000; lastly, the terminal cash flow which is comprised of the plant’s salvage value as well as the recovery of working capital—all in all amounting to 400,000 in year 10. When these cash flow figures are computed, they are discounted by using the 15% weighted average cost of capital. By getting the yearly cash flows from the project and discounting them to get their net present value, we get an NPV of $179,428. This is the figure if Big Deal pursues the project. Without the project, Big deal would not have the $179,428 and therefore the land that it owns is free for other purposes. Since the net present value of the project is way smaller than the alternative, which is selling the land which has a market value of $500,000, the new plant project is not a good investment alternative. Question 5 (25 Marks) Rebound Ace Pty Ltd is considering the replacement of a new machine with a new improved model. You have been given the information below and asked to undertake an economic evaluation of the proposal. What would be your recommendation and why? Required rate of return (after tax) 10% pa Company tax rate 40% Tax allowable depreciation $4,000 pa Cost of a new machine $31,000 If a new machine is undertaken: Increased sales value of output / cash $1,500 pa Decreased cash operating costs $7,000 pa Life of a new machine 6 years Estimated salvage value new machine $5,000 Remaining life of old machine 6 years Current salvage value of old machine $4,000 Estimated salvage value of old machine (in 6 years) $0 Current book value of old machine $3,000 Depreciation of old machine $500 pa Because the operating costs for the old machine is not given, the analysis for this replacement decision cannot be decided as to choose between the two machines, where the equivalent annual annuity method can be used in order to measure the value that the two contribute to the firm. Thus, this replacement decision delves with how much value the purchase of new machine will bring to the company. The first cash flow to consider is the proceeds from the sale of the old machine, since it will be replaced by the new machine in the current year or year 0. The first thing to note is the difference between the salvage value and the book value of the machine, which has implications on the taxes the firm must pay from the sale because the selling price is higher than the depreciated value. By computing the gains and deducting the 40% taxes from the sale of the old machine, then adding back the book value, the net proceeds from the sale amounts to 3600, which should be included in the analysis. The other significant cash flow is the initial outlay, which amounts to 31,000 as the cost of the new machine. Because there is no mention of increase in additional working capital requirements, working capital is not included in the analysis. Then, the operating cash flows are computed by adding the incremental revenue from the increase in value of sales output, and the decrease in costs for the company, which should be treated as cash inflow. After the depreciation has been deducted and the pre-profit tax has been computed, taxes amounting to 40% are deducted in order to derive the after-tax profit figures. Then the depreciation is added back to the profits in order to get the after-tax cash flow figures amounting to 6700. The last significant cash flow figure for the analysis is the terminal cash flow. It is indicated that the full salvage value for the new machine is 5,000. However, the depreciated value of the new machine in year 6 is greater than the salvage value, which results in a loss from the sale transaction. This loss therefore gives the firm a tax incentive of 800 for the loss, which is considered a cash inflow. Therefore, the terminal cash flow for this project is 5800. After discounting the cash flows by the 10% discount rate, the net present value for the replacement project amounts to 5759. With a positive net present value like this, the firm must replace its new machine, although the analysis is limited because the NPV for the new machine is not determined for comparison. Works Cited Brealey, R. A., Myers, S. C., & Marcus, A. J., Fundamentals of Corporate Finance. Philippines: McGraw Hill, 2004 Keown, A. J., Martin, J. D., Petty, J. W., Scott, Jr., D. F., Financial Management: Principles and Applications. New Jersey: Pearson Education, Inc, 2005 Morgenson, Gretchen. “Signs of insider trading match surge in mergers.” International Herald Tribune. (2006 August 27) Available from http://www.iht.com/articles/2006/08/27/yourmoney/mergers.php?page=2 [Accessed 11 January, 2009] Samuelson, Paul and William Nordhaus. Economics. International ed. Philippines: McGraw Hill, 2004, 496. Read More