Intermediate Financial Management - Assignment Example

Question i. Projected dividend D1= D0 g) Where: D1= dividend next period D0= current dividend Therefore D1= 4 0.05)=£4.2 ii. CAPM R = Rf + (beta) x (Market Risk Premium) Where: Market Risk Premium = (Rm –Rf) R= required return on stock R f= risk free rate Rm=the required return on the market portfolio Therefore R= 5%+ (1.10 x 7%) = 12.7% iii. Gordons growth model V0=D0 (1+g)r-g=D1r-g Where: V0= equal to the dividend next period D1= dividend next period D0= current dividend g= constant growth rate for dividends r=required return on common equity Therefore V0 = 4(1+0.05)0 .127-0.05=4.20.127-0.05=£54.54 iv. 36=4.20.127-g Therefore g =0.01 g =1% Question 2 i. Categories of financial ratios a. Liquidity ratio: this is the ability of a business to meet its current obligations using its assets. This information is important to the employees, creditors and banks. Key measures of liquidity include; current ratio, quick ratio, cash ratio and the cash conversion cycle. b. Profitability ratios: it is the ability of a business to make profits for the shareholders. Some of the profitability ratios include; net profit margin, return on assets, return on capital and gross profit margin. c. Activity ratios: it is the level of efficiency of an investment. This can be used to measure the benefits produced by a certain asset or the benefits produced collectively by all the assets. Examples of this include accounts receivable turnover and inventory turnover. d. Solvency ratio: solvency is the measure used to evaluate the long-term financial viability of an investment that means, for example, the long-term capability to pay its loans. Examples of solvency ratios are debt to capital ratio, times interest earned ratio and debt to equity ratio. e. Financial leverage ratios: this is used to measure how much financial risk a business has. When a company takes a debt from a creditor or a bank, it involves a financial risk, since the company is obligated to repay the debt or loan with the interests agreed upon. Examples of this ratio include coverage ratios and component percentages. f. Shareholder ratio: these ratios evaluate the overall operations of the business in comparison with the share of stock. The measures used are earnings per share, book value equity per share and dividends per share. ii. Gross profit margin It is the percentage of gross profit to the sales revenue generated from the total sales. Gross profit margin measures the percentage of money remaining to pay the overhead cost and provide the investor with a profit. For a manufacturing investment, the difference between the value of goods sold to consumers and the cost of the raw materials, labor cost and factory overheads incurred in the production of the goods is the gross profit. Net profit margin It shows how much money is left after the deductions of the direct and overhead costs from the gross profit are made. Net profit margin is expressed as a percentage of the money left after subtracting all the expenses of the cost of sales and other expenses with the exclusion of tax. iii. Many traders use these averages to measure whether to take risks that is to enter or exit a certain position. A 50-day moving averages corresponds to the average price that all investors have bought an asset for a period of 10 weeks. Similarly a 200-day moving average takes a period 40 weeks. When the prices fall below these averages it acts as resistance and the investors who have taken position may consider closing the positions so as not to make huge loses. When the prices go above the averages then it is time to take more positions in the investment. iv. Dow Theory forecasts the length of the market movement. Dow Theory came up with three major movements in the market namely primary trend, a secondary trend and minor trend. These movements were developed from the comparisons made from the ocean movements as observed from a sandy beach. Primary trend is a major trend hence its the most important and should be determined. It affects the other trends that are the secondary and the minor trends within the market. Dow determined that the primary trend will last between one to three years, but it can vary in some other instances. It is very difficult to determine the duration of price movement within a primary trend. It is essential to determine the direction of the trend and to trade e with it until there is evidence of reversal. There are phases in the primary trend three in total that is the accumulation phase, public participation phase and panic phase. Secondary trend is the trend that moves in the opposite direction to the primary trend, and it serves as a correction to the primary trend. For example as a primary trend move down the secondary trend moves upwards but from a consecutively lower to a point of a higher low. Typically this type of trend lasts between three weeks and three months. The movement of this type of trend is more volatile than the primary trend. Minor trend is defined as the market movement and lasts less than three week. It is a corrective within the secondary trend. Due to its short-term duration it is of less concern though it should be watched closely since the price movements form part of the secondary or primary trend. When too much attention is paid to minor trends, it leads to irrational trading. In a bull market the reversals might be due to too much speed in advance, an excessive volume of loans to brokers and a lot of inadequately protected accounts. In a bear market, the reversals may be caused by an oversold market. Some of the characteristics of the reversals may include the movement of the averages that is rapider in reversal than in the primary trend, and the duration of time taken is shorter compared to the preceding primary movement. Question 3 A. Considering the action that follows every bad debt or loss due to bankruptcy the investors, suppliers, consumers and the employees are the ones who are adversely affected. It is, therefore, important to try and predict the distresses that might occur in a company in order to employ strategies that are necessary to either prevent the distress or prepare them adequately. The indicators of distress might include financial statements warning signs. The profitability or the losses encountered by a firm or business can be easily determined from just looking at the cash flow statements. In instances where the cash payments exceed cash income this implies the cash flow is negative. The debt-to-equity ratio can be used for gauging the debt default risk of an investment. For a fully comprehensive analysis to be determined it is necessary to employ auditors to analyses the financial statements. Business and management warnings are seen when a company makes drastic changes away from its traditional management policies. The changes might come caused by cut costs that are made to improve the profit margin of the company. Employment of temporary workers might also indicate distress in the company. B. Industry life cycle Introduction phase Emerging industries originate from technological innovations, changes in relationships between relative costs or new customer need. The structural elements that distinguish this phase are technological innovations, subsidies to business, newly established businesses entering the industry and high initial costs. The strategic choice made at the point of entry into a new field makes the entrepreneur a pioneer in that industry. It ensures that they enjoy big market shares. Research has shown that pioneers can attain and sustain their edge in the industry through the quality of the products or services and the range of production lines. The late entry strategy can also be employed in the introduction phase. Growth phase With the evolution of new technological innovations, the industries can improve on the quality of their products and services. The technologies help the production costs to be significant while at the same time improving the quality. In this phase, the business slowly transforms into mass production. Market leader strategy presents a benchmark for all the competitors to match up to. Challenger strategy is employed by the company or the business that is second, and this can be achieved by attacking the leading company. Maturity phase Many industries get to experience the transition from the period of high growth to a modest growth level. This growth can be due to entry of more competitors into the industry. There are three approaches that can be employed to the company during this phase this include cost leadership, qualitative differentiation and focus. Cost leadership strategy aims at lowering the production cost either by mass production, mass distribution and economies of scale. Qualitative differentiation strategy is enhanced by creation of products or services that will be perceived as unique to the consumers. It is achieved through branding, superior technology and diversified distribution network. Focus strategy targets the specific group of consumers. Decline phase It is characterized by a decrease in sales over a lengthy period. This phase can be identified with shrinking profit margins, reduction in production lines and lower investments in research and development. At this phase, harvesting strategy is employed it is acceptable where the competitive edge of the company is on the decline and the process cannot be reversed. The current customers will keep the level of their purchases even when the market support from the producer is diminishing. Other strategies should be put into consideration in this phase that is the strategy of market leadership and market nicher. C. Accounting profit is given as the total revenue subtracting the explicit loss of the investment. The explicit loss is the payments made for purchases including resources and products from other firms. It is easy to compute and compare across different firms, unlike economic profit. Economic profit, on the other hand, is the difference the companys total revenue and the sum of the explicit and implicit losses it is also referred to as excess profits. The implicit losses are the opportunity costs of the resources supplied by the firms owners. The economic profits needs evaluation so as to help an investor determine whether the profit margins are reducing that is shrinking profits or he is making economic losses. The value of a firm is related to the present values of is Economic Profits (EP) and the Future Cash Flows (FCF). Methods for calculating the EP include: Cash accounting Accrual accounting simplified method Question 4 A. Fundamental analysis examines the macroeconomic indicators, asset markets and takes into account the political considerations of one nation’s currency as opposed to another. Political considerations influence the level of confidence in the foreign investors as well as assure all the investors of certainty in business environment. Conversely, technical analysis is the analysis of past price data to try and establish the future price movements. It includes principles such as the trending nature of prices , confirmation and divergence and support and support coupled with resistance. B. Dow Jones Theory A stock market trend is not significant until either Dow Jones Industrial average and Dow Jones Transportation indices rach new highs or lows. The theory had many assumptions. The first assumption was that manipulation of the primary trends cannot be achieved. Secondly the market represents all the available information that is the prices present all the expectations of the participants. Dow noted that there are price movements in the market that is the primary movements, secondary movements and the daily fluctuations. The primary movements are trends that last for a few months to many years and are referred to as bull and bear markets. The secondary movements act in the opposite direction to the primary movements and they try to counter the actions of primary movements. Daily fluctuations are random and change from day to day. They can be dangerous collectively but present no threat when they appear in singularity. C. Categories of performance evaluation There are categories that are provided when doing a performance evaluation of the human resource in the company. Some of the categories are exceeds expectations, meets expectations and needs improvement. Exceeds expectations are the depository institutions that consistently surpass the requirements of their positions and perform at maximum levels of effectiveness. They posses leadership qualities consistent with the companies values. They are innovative and come up with new ideas to solve issues. The financial ratios for this may be profitability ratios. Meets expectations are the institutions that perform to the standards that are required from them and are reliable. Their performance does not fluctuate and they enhance a departments needs to achieve the goals. Liability ratios can be used to evaluate the performance of these institutions. Needs improvement are the ones that are inconsistent in achieving the standards that are set for them and regularly they may fail to meet their obligations or the goals set for them. This category may include new employees that are on training for their positions in the institution. Activity ratios offer a good evaluation tool for such institutions Question 5 A. The Altman’s Z-score is a statistical tool that is employed to determine the bankruptcy of a company. It is a test carried out using five financial ratios that can be calculated from the annual financial report of a company. A score lower than 1.8 depicts that the company is headed for bankruptcy while a score above 3.0 shows the company is unlikely to go bankrupt. Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.99T5 T1 =  Working capital = current assets – current liabilities = 28000 – 125000 = (97000) T1 =  = - 0.63 T2 =  =  = 0.23 T3 =  =  = 0.10 T4 =  =  = 1.13 T5 =  =  = 0.17 Z = (1.2 × 0.63) + (1.4 × 0.23) + (3.3 × 0.1) + (0.6 × 1.13) × (0.99 × 0.17) = 2.25 The score of the company is way above 1.8 and therefore the possibility of going bankrupt is minimal. Therefore it has a low credit risk. B. Alternative Z-score distress analysis approaches (i) Benjamin Graham Formula. Was proposed by Professor Benjamin Graham to assist investor to determine how rational their stock pricing were. The formula proposes to determine the company’s intrinsic value (V) as follows. Where V: intrinsic value EPS: the company’s latest earnings per share. 8.5: a constant representing an appropriate P-E ratio of a no-growth company as suggested by Graham g: the company’s long-term earnings growth estimates (ii) Modern Portfolio Theory.it is a financial attempt to maximize the expected returns of a given portfolio risk by choosing the correct proportions of several assets. C. Pros: The proven predictive accuracy of the method is high ranging from 80-90%. The model is relatively easy to use as the calculations are easy to carry out and the required information can be obtained from the annual financial reports. Cons: The model was initially conceived for use by manufacturing firms hence it is industrial specific. The model is less suitable for other sectors such as banking where the firms holds lower shares of assets on their balance sheets. Question 6 Profit and Loss Account £ Revenue 25500 Cost of goods sold 25500 × 65% (16575) Earnings before interest and tax 8925 Total operating expenses (1000) Interest Payment 0 Earnings before tax 7925 Tax 7925 × 40% (3570) Net Income 4355 Net Operating Profit after Tax 4355 Aggregated Balance Sheet Vote head £ Assets 4 × 8000 32000 Liabilities 8000 × 4.5% 360 Equity
 8000 Total Asset 40000 Total Liability & Equity 40000 Weighted average cost of capital (WACC) WACC = Where D is the total debt, E is the total equity of the shareholders, Ke is the cost of equity while Kd is the cost of debt. WACC = = 0.15 B. (i) Economic Value added = NOPAT  = 4355- (360÷0.045) = £ (3645) Work Cited Larrabee, David T, and Jason A. Voss. Valuation Techniques: Discounted Cash Flow, Earning Quality, Measures of Value Added, and Real Options. Hoboken: John Wiley & Sons, 2013. Print. Brigham, Eugene F, and Phillip R. Daves. Intermediate Financial Management. Mason, Ohio: South- Western, 2013. Print. Read More