Corporate Finance - Term Paper Example

london School of business and finance Corporate Finance Programme: MBA/MSc Finance Table of Contents Cost of Capital for the Project 3 Net Present Value Calculation 6 Capital Budgeting 8 Methods of Capital Allowance 9 Options 10 Forwards 11 Futures 12 Swaps 13 Payoff Diagram – Seller of a Put Option 15 Black-Scholes Option Pricing Model 16 References 18 Q1.a. Calculate the cost of capital for the project. Cost of Capital for the Project To calculate the cost of capital for the project, the betas need to be re-geared and de-geared. This can be done by using this formula: Where; Asset Beta = Market Value of equity = Market Value of Debt t= corporation Tax rate = Debt Beta = Equity beta The first step towards the calculation of the cost of capital would be to calculate the appropriate equity beta, de-gearing it and then re-gearing it to ascertain the appropriate asset beta that would reflect the project’s gearing level but as this project is within the normal area of its business the prescribed asset beta would be used to calculate the equity beta. 1.15 = [16/ (16+6(1-0.3))*] + [6(1-0.3)/ (16+6(1-0.3) * 0.25] 1.15= 0.792 * + 0.052 (1.15 – 0.052)/0.792 = 1.39 This equity beta would be used to calculate i.e. the cost of equity. The cost of equity would be calculated using the Capital Asset Pricing Model (CAPM). Where; = Risk free rate = Expected return on the market = project equity beta = Systematic risk of the investment compared to the market. is simply regarded as the market risk premium. Using the Equity Beta figure in the CAPM formula would give the Cost of Equity. = 0.046 + 1.39 * (0.06) = 13% (rounded off) Assuming that the debt taken to finance the company bears a risk free interest rate, the cost of debt would be: = 0.046 * (1- 0.3) = 0.0322 or 3.22% Now, both the and the can be used to ascertain the cost of capital of the project to the company. WACC = 0.13*[16/ (16 + 6)] + [6/ (16 + 6)] * 0.0322 WACC = 0.095 + 0.0088 WACC = 10.37 ≈ 10% Source: (Pratt, 2002; Pratt et al, 2008; Ben McClure) Q1.b. Lay out the cash flows for the project, with explanations as to why you have included or excluded certain cash flows. Calculate the NPV. Should the project be accepted? Net Present Value Calculation Year Cash Flows 0 (£) 1 (£) 2 (£) 3 (£) 4 (£) 5 (£) 6 (£) Capital Costs (400,000) Disposal Proceed 90,000 Installation costs (50,000) Working Capital Requirement (65,000) (65,000) (65,000) (65,000) (65,000) 325,000 Revenue less cost 320,000 400,000 480,000 300,000 200,000 Marketing Costs (50,000) (40,000) (40,000) (40,000) (40,000) Overhead Costs (40,000) (40,000) (40,000) (40,000) (40,000) Manager Costs (80,000) (80,000) (80,000) (80,000) (80,000) Cash Flows (360,000) 85,000 175,000 255,000 75,000 (25,000) 325,000 Discount Factor @ 10% 1 0.909 0.826 0.751 0.683 0.621 0.564 Discounted Cash Flow (360,000) 77,265 144,550 191,505 51,225 (15,525) 183,300 NPV = +£287,845 Explanations Disposal proceed is assumed to be taken in Year 0 because the old machinery would be sold if the new project is started. The working capital requirement would be calculated as follows: Current Assets – Current Liabilities [(Stock + Accounts Receivable) – Accounts Payable] This would be the yearly working capital requirement which is assumed to be recovered at the end of the project. Revenue Less Costs Calculated as follow: Year 1 (80,000units * (£12 – £8) = £320,000 Year 2 (100,000units * (£12 – £8) = £400,000 Year 3 (120,000units * (£12 – £8) = £480,000 Year 4 (100,000units * (£12 - £9) = £300,000 Year 5 (100,000 units * (£12 - £10) = £200,000 The existing manager costs are not taken because they are already sunk cost of the parent company and no matter what these £50,000 would be paid to those managers even if the project is cancelled, hence this £50,000 is an irrelevant cost. The £40,000 is a relevant cost as it is incurred only because of the project. The discount factor used is the above calculated cost of capital of 10%. (Peterson Drake et al, 2002; Agarwal et al, 2007) All in all, the project should be accepted on the basis that it has a positive Net Present Value and it will produce good return for the company in the future. Q1.c. Explain what biases there might be in a capital budgeting project and explain how they might be overcome. Capital Budgeting Capital Budgeting is “the way in which organisations decide whether to take up any investment project. This can be affiliated with the purchase of a large machinery to starting a new project which requires a new investment. This process analyses all the prospective cash inflows and the outflows associated worth a project. Capital budgeting, in simple terms can be termed as a cost-benefit analysis in which the benefits and the costs of any project are ascertained and only those projects are initiated whose benefits outweigh their costs. This benefits adn costs are mostly monetary in terms. (Investopedia.com). Capital budgeting is sometimes also referred to as Investment Appraisal Technique. Capital Budgeting involves many issues that may lead to biased decisions. The major issue with capital budgeting is time (Inflation being one matter of concern). It is really difficult to ascertain the dynamic changes in the business environment with accuracy, hence to reduce such impact, techniques such as Net Present Value and IRR are used. These techniques do take account of the time value of money based upon the discounting factor or the Weighted Average Cost of Capital (WACC) of the project. Although the techniques use relevant time value of money there are other reasons that may lead to bias and treachery while applying the capital budgeting technique onto any project. One reason for the failure of many businesses to use NPV is that its long-term goals might coincide with its short term profits. One major bias may arise where the manager’s remuneration might be based upon the level of annual profits, hence they might not be willing to take upon projects with good return only because of the high initial expenditure in the beginning and the return following over a long period of time. The measure that can be taken to reduce this bias is to pay remuneration not based upon such profits or on the contrary use different technique such as Residual Income (RI) to analyze the project. (Van Horne et al, 1971) Q1.d.Describe the different methods of capital (depreciation) allowance that are allowed and explain what impact they will have on the NPV of a project. Methods of Capital Allowance Depreciation is an irrelevant cost when a capital budgeting technique such as a Net Present Value (NPV) is used. NPV only uses appropriate cash flows in the calculation, depreciation is not a cash flow, hence it is added back to the accounting profit to adjust and show the real cash position of a particular project. The only issue that is relevant to the NPV of a project is the Capital allowance that any particular asset or a project attracts. The capital allowance is usually a relevant cost that needs to be worked upon the during the NPV calculation. Capital allowances are used to reduce taxable profits; hence they would reduce the tax payments. This reduction in tax payments due to the capital allowances is treated as cash saving from the acceptance of a particular project or a purchase of any particular asset in a project. These capital allowances are calculated as per the tax authorities and it is further multiplied with the tax rate to ascertain the tax saving from the acceptance of a project. The relevant tax savings of each year are added upon in the cash inflows of that particular year. The remaining value or the left over balance is regarded as the balancing allowance. Depreciation on the other hand only relates to accounting information. Depreciation is calculated using different methods. The most common methods are the Straight Line Method and the Reducing balance method. (Baxter, 1971; Murray, 1971) Question 2 Q2.a. Describe and explain when you would be likely to use Options Options are derivative instruments that give the owner the right and not the obligation to fix a future price. These options are designed in such a manner so at to reduce the risk of the owner when the markets are deemed to fall in the future. “Options are essentially securities and provide the holder with the right to trade an asset on certain time and value. On the other hand the holder is not bound to do the trade and the whole process of trading depends on the opinion of the holder” (Maps of World.com). There are two broad categories of options: American Options: A type of option that can be exercised on any day until the time it expires European Options: Those type of options that can only be exercise on the last day of expiry. Options are only exercised when there are adverse movements in the market for the holder of the option. The option gives the right to the holder of the option to exercise it if the holder of the option faces any loss or adverse movement i.e. the worst case scenario. There are two types of Options: Call Options: Call options are those options that give its holder a right to buy Put Options: Put Options are basically a right to sell. With respect to Finance, there are two types of options available in the market, one are the currency options, the other are the interest rates options. Besides the financial management aspect, there are share options that are usually given to the employees in an organization. These share options are a good way of aligning the interest of the employees with that of the shareholders. Currency or Interest rate options on the other hand are usually bought at a premium and the basic aim is to avoid an adverse movement in the market. (Swan, 1994) Forwards “A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future”. (WikiInvest.com). Forwards are contracts that are traded in a forward market. The forward market is the place where the buying and selling of a particular currency is done at a fixed future date for a predetermined date i.e. the forward rate of exchange. Forward contracts are basically a way of mitigating and hedging risk like other derivative instruments. Forward cover is the most frequently employed hedging technique. The only issue with forward contracts is that they are usually not available for unpopular currencies. Forward contracts are Over the Counter contracts; hence they can be matched exactly to the future sums involved. There is no transfer of cash or any asset until the time of maturity or expiry of that particular contract. At that particular expiry date, forward contracts can be settled by the transfer of cash or any other asset, etc. (Coyle, 200) Futures A futures contract is an obligatory financial contract which enables the buyer/seller to buy/sell any particular asset at a predetermined future date for an agreed price. There are two ways of closing the position To deliver the underlying asset at the maturity date. If futures contracts are bought, an equivalent number of contracts can be sold before the expiry data to get a profit or a loss for the company. Futures can be used either to hedge or to speculate on the price movement of the underlying asset e.g. a sugar grower looking to sell white sugar in the near future would try and fix the price via futures contract. The problem of dealing in futures is that having made a profit, the counter party of the futures contract makes a loss; there might be a risk that the counter party defaults on his payment part. This is known as the counter party credit risk. To avoid such risk the buyers and the seller of the futures contract do not enter into a transaction directly, rather it is done through the members of the market. Therefore the markets clearing house is the formal counter party to every transaction. This transaction with the market clearing house reduces the counter party default risk for those dealing in futures contract. (Catlere, 2009) Swaps Swaps are “traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps” (Swap, Investpedia.com). In a swap agreement, the parties agree to exchange asset, currency, etc having almost equivalent value. A swap agreement is usually taken up by parties to make a benefit for them. This benefit or advantage is taken in such a condition when other ways of getting the benefit are no available. The parties of the contract agree to a swap agreement and benefit as a whole. As first, such arrangements may seem beneficial to one party at the detriment of the other party but as a whole, such arrangements are beneficial for all the parties to the contract. There are different swap agreements available such as: Foreign Exchange (FOREX) Swaps: In a Forex swap, the parties agree to swap equivalent amount of a currency for a prescribed period of time and then re-swap the same amount of currency at predetermined agreed rate. This way the parties to the swap gain access to those particular currencies that would have been impossible for them to grab. Forex swap are beneficial when dealing in countries that have a volatile exchange rate. Currency Swaps: This sort of swap allows the two counter parties to swap interest rate commitments on borrowings in different currencies. Such an agreement is helpful for both the parties as both parties might get better interest rates if they are powerful parties in the country that they borrow. Hence it saves them both on transferring the interest rate between them. (Financial management Association, 1972) Q2.b.Draw and clearly label the payoff diagram for a seller of a put option. Payoff Diagram – Seller of a Put Option Share Price £50 £60 £70 £80 £90 £100 £110 Exercise Price £80 £80 £80 £80 £80 £80 £80 Option Value 30 20 10 0 0 0 0 This would be the Scenario for an Option Seller, the higher the share price, the higher the option would be profitable for the option seller. The lesser the share price, the lesser would be the option value for the option seller. Q2.c. Identify the five variables that go into the Black-Scholes option pricing model and explain how movements in these variables affect the price of a put option. Black-Scholes Option Pricing Model The five variables that form the basis of the Black-Scholes Option pricing model are: Share Price Exercise price Interest Rate Time to expiry Volatility of the Share Price Each of these variables affects the option pricing model. These five variables are the determinants of the call and the put option prices. (Jarrow et al, 1983) The affect of these variables on the price of a put option would be as follows: Share Price: The share price and the exercise price are the two elements that determine the intrinsic value of the option. If the share prices increase, it would decrease the price of a put option. A rise in the share price would make a put option unattractive for the buyer of the put option; hence he would try to sell his asset in the market at a higher price rather than exercising the put option. Exercise Price: An increase in the exercise price would increase the price of the put option. If an exercise price is higher than the share price, it would definitely be an attractive option for the put option holder to exercise it rather than to sell his asset in the market at a lower price. An increased exercise price is bound to bear a high premium as well. Interest Rates: A higher interest rate reduces the present value of deferred receipts. This reduces the put option value making the option less valuable as an alternative to selling it at present. Time to expiry: Time to expiry has the same affect on both the put and the call options. As the period of maturity increases, the chance of grabbing a profit from the option increases. This as a result, increases the price of the put option as well as the call option. Volatility of the share price: Volatility is the change in the share price of a particular company. The trend of these changes in the share price is referred to as the volatility of the share price. The greater the volatility the better, as this increases the probability of a valuable increase in the share price. (Chriss, 1997) References AGARWAL, N. P., & MISHRA, B. K. (2007). Capital budgeting. Jaipur, India, RBSA Publishers. BAXTER, W. T. (1971). Depreciation. London, Sweet and Maxwell Top of Form CATLERE, P. N. (2009). Financial hedging. New York, Nova Science Publishers. Bottom of Form Capital Asset Pricing Model, Value Based Management.net http://www.valuebasedmanagement.net/methods_capm.html Capital Budgeting, Investopedia.com http://www.investopedia.com/terms/c/capitalbudgeting.asp CHRISS, N. (1997). Black-Scholes and beyond option pricing models. New York, McGraw-Hill. http://www.netlibrary.com/urlapi.asp?action=summary&v=1&bookid=51958. Corporate Finance, Quick MBA.com http://www.quickmba.com/finance/cf/ Top of Form COYLE, B. (2000). Hedging currency exposures. Financial risk management. Chicago, Glenlake Pub. Co. Bottom of Form FINANCIAL MANAGEMENT ASSOCIATION, & FINANCIAL MANAGEMENT ASSOCIATION INTERNATIONAL. (1972). Financial management. Atlanta, Ga, Financial Management Association. http://www3.interscience.wiley.com/journal/118902563/home. Forward Contract, WikiAnalysis, Wikiinvest.com http://www.wikinvest.com/wiki/Forward_Contract Top of Form HENNING, C. N., PIGOTT, W., & SCOTT, R. H. (1978).International financial management. McGraw-Hill series in finance. New York, McGraw-Hill. Bottom of Form How to calculate the Weighted Average Cost of Capital (WACC), by waccawacca, eHow Member http://www.ehow.com/how_4835017_average-cost-of-capital-wacc.html Investors Need A Good WACC, by Ben McClure, Investopedia.com http://www.investopedia.com/articles/fundamental/03/061103.asp JARROW, R. A., & RUDD, A. (1983). Option pricing. Homewood, Ill, Dow Jones-Irwin KALLIANPUR, G., & KARANDIKAR, R. L. (2000). Introduction to option pricing theory. Boston, Mass, Birkhäuser. MURRAY, A. P. (1971). Depreciation. Tax technique handbook. Cambridge, International Tax Program, Harvard Law School. Net Present Value (NPV), Business Ed 101.com http://businessed101.com/finance/net-present-value-npv/ Options (Finance); Map of World.com http://finance.mapsofworld.com/option/ PETERSON DRAKE, P., & FABOZZI, F. J. (2002). Capital budgeting: theory and practice. Frank J. Fabozzi series. New York, NY, Wiley. Top of Form PRATT, S. P. (2002). Cost of capital estimation and applications. Hoboken, N.J., John Wiley & Sons. http://site.ebrary.com/lib/liberty/Doc?id=10304594. Bottom of Form PRATT, S. P., & GRABOWSKI, R. J. (2008). Cost of capital: applications and examples. Hoboken, N.J., John Wiley & Sons Top of Form Top of Form SHIM, J. K., & SIEGEL, J. G. (2000). Financial management. Barrons business library. Hauppauge, N.Y., Barrons. http://www.netlibrary.com/urlapi.asp?action=summary&v=1&bookid=52346. Bottom of Form Top of Form SWAN, E. J. (1994). Derivative instruments. London, Graham & Trotman/M. Nijhoff. Bottom of Form Bottom of Form Swap, Investpedia.com http://www.investopedia.com/terms/s/swap.asp VAN HORNE, J. C. (1971). A Note on Biases in Capital Budgeting Introduced by Inflation. Journal of Financial and Quantitative Analysis. 6, 653-658.   Read More