Corporate Finance - Assignment Example

Corporate Finance Customer Inserts His/Her Name Customer Inserts Grade Course Customer Inserts Tutor’s Name 04, 09, 2011 Question One Part a According to Dividend Growth Model with constant Growth; Po = Div1/(R-G) and rearranging this model we get; R = ((Div1/Po) + G) Where Po = price of a stock Div1 = Dividend per share R = required rate of return G = Dividends growth rate With reference to Burwood Green Inc. given the current price of the stock (Po) being $125 Dividend paid (Div1) being $5 and dividend growth rate being 3% the expected rate of return (R) will be; R= (($5/$125) +3%) = 7% Present Value of Growth Opportunities (PVGO) equals to P0 – (EPS/R). This performance measurement assesses the market perception of the growth opportunities available in a company (Atrill, 2008). It is measured by the difference between the price of owners’ equity with a constant growth and that with no growth. If the market perceives that a company has no growth potential then its PVGO will be zero and its market price reflects only it’s no growth component, which equals EPS/R. A positive PVGO increases a company’s stock value. PVGO = Po- EPS/R = $125- 7.14/7% = $125 – 98 = $27 Part b The expected dividend at the end of year 5 Div5 = Div0 (1+G)5 = 5/7(1.03)5 = $0.83 The expected dividend at the end of year 6 Div6 = Div5 (1+G) = (0.96*7)(1.03) = $5.97 The expected price of the stock at the end of year 5 (immediately after the year 5 dividend) P5 = Div6/(R-G) = $5.97/(.07-.03) = $ 149.26 The present value of this stock today therefore is the Present value of all the cash inflows discounted using the calculated rate of return calculated in part a. this is done as follows; Year Dividend Stock price at the end of year 5 PVIF R= 7% Present value of all cash inflows 0 5.00 1 0.74 0.93 0.69 2 0.76 0.87 0.66 3 0.78 0.82 0.64 4 0.80 0.76 0.61 5 0.83 149.26 0.71 106.42 Current Market price of stock 109.02 The current market price of the stock has been discounted at the company’s required rate of return. This will establish the present value of long term stock consequently providing the potential investors information necessary to establish the value of the stock and also assist in decision making with regards with investing on the stock or not. It is therefore imperative that any serious investor must establish the value of a stock using discounting valuation methods. Question Two Part a A futures contract is an agreement to buy or sell an asset at a certain time in the future for a stated price. Option on futures gives the buyer the right (but not the obligation) to buy or sell a futures contract at a later date at a price agreed upon today. The writer of the call option on futures, upon exercise, establishes a short position in the futures contract at the exercise price. A call option is an option to purchase asset at the strike price and with reference to the one year European option this relates to purchase of the property at the expiration of the period. Call options as very important financing instruments for high risk investments and therefore a very critical financing and working capital management instrument. Black-Scholes option pricing model allows us to calculate the price of a call option before maturity (and, no put price is needed. Value of call option according to Black-Scholes formula is as follows; Value of call option = ((delta * share price) - (Bank loan)) = ((Nd1*P) – (Nd2 * PV (EX))) Where D1 = ((log ((P/PV (EX))/α√t) + ((α√t)/2) D2 = d1- α√t Nd= cumulative normal probability density function EX – exercise price option Pv (Ex ) – present value of exercise price option discounted at risk free interest rate T = number of periods to exercise the option P – Current market price .α- standard deviation per period of rate of return of stock Value of the option for the case of European call option on one acre of Gippsland real estate with therefore is as follows; Given; (EX)-exercise price option = $3m T = number of periods to exercise the option= 1 year P – Current market price = $3.7m .α- standard deviation per period of rate of return of stock = 20% .r = interest rate 10% Then the value of the option will be D1 = ((log ((P/PV(EX))/α√t) + ((α√t)/2) D1 = ((log (($3.7M/PV($3m))/0.2√1) + ((0.2√1)/2) = ((log (0.2467) + (0.1) = -0.5079 And D2 = d1- α√t D2 = -0.5079- 0.2√1 D2 = -0.7079 Given that; Value of call option = ((delta * share price)- (Bank loan)) = ((Nd1*P) – (Nd2 * PV (EX))) Therefore = ((N-0.5079* $3.7M) – (N-0.7079* $3m)) = $1,131,332 – $718,520 = $412,822 Part b Value of call option = ((delta * share price)- (Bank loan)) = ((Nd1*P) – (Nd2 * PV(EX))) In the case of the second scenario where call option has revenue of $200,000 has been introduced then; Where D1 = ((log ((P/PV(EX))/α√t) + ((α√t)/2) D2 = d1- α√t Nd= cumulative normal probability density function EX – exercise price option Pv (Ex ) – present value of exercise price option discounted at risk free interest rate T = number of periods to exercise the option P – Current market price .α- standard deviation per period of rate of return of stock Value of the option for the case of European call option on one acre of Gippsland real estate with therefore is as follows; Given; (EX)-exercise price option = $3m T = number of periods to exercise the option= 1 year P – Current market price = $3.9m .α- standard deviation per period of rate of return of stock = 20% .r = interest rate 10% Then the value of the option will be D1 = ((log ((P/PV(EX))/α√t) + ((α√t)/2) D1 = ((log (($3.9M/PV($3m))/0.2√1) + ((0.2√1)/2) = ((log (6.5) + (0.1) = 0.8129 And D2 = d1- α√t D2 = 0.8129- 0.2√1 D2 = 0.6129 Given that; Value of call option = ((delta * share price)- (Bank loan)) = ((Nd1*P) – (Nd2 * PV (EX))) Therefore = ((N0.8129* $3.7M) – (N0.6129* $3m)) = $2,929,890 – $2,190,086 = $ 739,804 Question Three Part a Assessing the viability of the investment projects usually is a process that does not depend only on the cash flows during the last of a project but all the cash flows throughout the life of the project. As much as investments targets future benefits and not losses and consequently exchanges current funds for future benefits, investment decisions may involves firm's decisions to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefit over a series of years. This implies that all the cash flows of the life of the project shall be used in assessing the viability of the project. Investment appraisal therefore involves the use of various techniques to assess the viability of a project especially the discounted cash flow method but also some analyst shall use non discounted methods like payback and Accounting rate of return. Proper investment appraisals shall involve reference to the time value of money which is a core variable in investing decisions. Net present value- NPV calculations do appraise the time value for money concepts appropriately consequently making it a favorable investment appraisal methodology. In the case of Elgar Science project Inc., the expected future cash flows over the life of the project shall be very critical in determining its viability consequently they should be discounted at the cost of capital for Elgar as calculated using Weighted Average cost of capital. The acceptance criteria for the project based on the NPV methodology shall be to accept the project if the NPV is positive and reject the project if NPV is negative and where NPV = 0, then other methods shall be used to make the decision. Cost of Capital This will be the discounting factor to be used in NPV analysis. Cost of capital refers to the cost financing to the project. Usually the cost of debt is lower than the cost of equity. This is so because debt is a fixed obligation while equity is not. However, firms cannot operate on debts alone since this will subsequently increase the risk of associated with leverage. A project with relatively unstable earnings will be reluctant to adopt a high degree of leverage since conceivably it might be unable to meet its fixed obligations at all and this might make it susceptible to receivership and bankruptcy. For the case of Elgar Science Inc. project the following are the sources of capital; Common stock $2.5 million Retained earnings $0.75 million Corporate bonds 15% interest rate $2 million Bank loan 12% interest rate 2 million Local loan 20% Interest rate 0.75 million In order to establish Elgar Science Inc.’s cost of capital the weighted average cost of capital (WACC) will be appropriate. WACC is the overall cost of using the various forms of fund and will be calculated as follows; WACC = Net operating Earnings (NOE) Total Market Value of the firm Cost of Debt: The cost of debt to a firm can be given by the following formulae: Kd = Annual interest charges Market value of outstanding debt Kd is the before tax cost of debt. However, the effective cost of debt is the after tax cost because interest on debt is tax deductible. The effective cost of debt (Kb) therefore is Kb = Kd (I - T) Where Kb is the effective (after tax) cost T is the corporate tax rate For the case of Elgar Science Inc., Cost of debt will be calculated for Corporate bonds with 15% interest rate worth $2 million, Commonwealth Bank loan of 12% interest rate worth 2 million and Local lenders loan with 20% Interest rate worth 0.75 million. Corporate bonds 15% interest rate $2 million Kb for bonds = Kd (I - T) = 0.3/2 (1-.35) = 9.8% Kb for Bank loan with 12% interest rate worth 2 million = Kd (I - T) = 0.24/2 (1-.35) = 7.8% Kb for Local lenders loan with 20% Interest rate worth 0.75 million = Kd (I - T) = 0.15/2 ( 1-.35) = 4.9% Cost of equity and Retained earnings The cost of retained earnings is the rate of return shareholders require on the firm's common stock. This is an opportunity cost that the firm should earn on its retained earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk (Correia, 2008). In this case, Elgar science Inc., has the expected rate of return to be 22%. WACC will be the firms discounting rate that will be used to will be used to assess the project and this will be; WACC = Net operating Earnings (NOE) Total Market Value of the firm For easy analysis we since the firm use only combination of debt and equity in the project financing then; the overall cost of capital will therefore be given by: Ko = Kd (D/V) + Ke(E/V) = 9.8( 2/8) + 7.8(2/8) + 4.9( 0.075/8) + 22(3.25/8) Ko = 13% Question 3 Project Cashflows ($ 'millions) Yr. 0 1 2 3 4 5 6 7 8 9 10 Cash Flows -8 3.00 4.00 3.00 3.00 4.00 2 3.00 2.00 2.00 (22.00) Interest on debt 0.56 0.56 0.56 0.56 0.56 0.56 0.56 0.56 0.56 0.56 Operating expenses 0.56 0.56 0.56 0.56 0.56 0.56 0.56 0.56 0.56 0.56 Profit before tax 2.45 3.45 2.45 2.45 3.45 1.45 2.45 1.45 1.45 (22.56) Tax 0.86 1.21 0.86 0.86 1.21 0.51 0.86 0.51 0.51 - Profit After Tax 1.59 2.24 1.59 1.59 2.24 0.94 1.59 0.94 0.94 (22.56) Add back salvage value 0 Net cash in (out)flows 1.59 2.24 1.59 1.59 2.24 0.94 1.59 0.94 0.94 (22.56) Capital outlays & Receipts Initial cost 8 Total Annual cash flows - 8 1.59 2.24 1.59 1.59 2.24 0.94 1.59 0.94 0.94 (22.56) Part A Project Evaluation Total Annual cash flows - 1.59 2.24 1.59 1.59 2.24 0.94 1.59 0.94 0.94 (22.56) PVIF @13% 1 0.88496 0.7831 0.69305 0.61332 0.54276 0.48032 0.42506 0.37616 0.33288 0.294588 PV of cash flows -8.00 1.41 1.75 0.97 0.86 1.08 0.40 0.60 0.35 0.31 (6.64) Net present value -6.91 Recommendation The project should not be taken since NPV of the cashflow is opportunity cost of capital - accept the project - IRR < opportunity cost of capital - reject the project - IRR = opportunity cost of capital - be indifferent Discount rate is the cost of borrowing or lending capital for investment projects. According to McLaney (2009), the decision to accept or reject a project or investment purchase depends on the whether the internal rate of return is higher than the discount rate or the opportunity cost. The decision criteria for these projects are simple; accept the project if the IRR is higher than the discount rate or the accepted rate of return. There are also financing decisions, where there are cash inflows followed by cash outflows. For the case of Elgar Science Inc. project, this the calculated IRR using excel IRR function is 6.49%. Compared to the expected rate of return of 13%, it is much lower consequently indicating that the project should henceforth be discontinued as it is not a viable project. IRR is an indicated for the growth potential consequently a project with a substantially higher IRR value compared to others would provide a better chance of strong growth. References Atrill, P., 2008. Financial management for decision makers. Boston: FT Prentice Hall. Bowyer, W., 2010. Investment analysis and management. Michigan, MA: University of Minnesota. Brigham, E., & Ehrhardt, M., 2008. Financial management: theory and practice. Texas: Cengage Learning. Brealey, R., & Myers, S., 2003. Principles of corporate finance. New York: McGraw-Hill. Correia. C., 2008. Financial management. Johannesburg: Juta and Company Ltd. Fabozzi, F., & Peterson, P., 2003. Financial management and analysis. New York: John Wiley and Sons. Helfert, E., 2001. Financial analysis: tools and techniques: a guide for managers. New York: McGraw-Hill. Kochis, T., 2006. Wealth Management: A Concise Guide to Financial Planning and Investment Management for Wealthy Clients. London: CCH. Lim, P., 2007. Financial Planning Demystified. New York: McGraw-Hill. McLaney, E., 2009. Business finance: theory and practice. Toronto: Pearson Education Peirson, G., 2008. Business Finance. Canberra: McGraw-Hill. Read More