Modern Financial Management - Assignment Example

MINI CASE #1 Mini Case #1 Customer Inserts His/Her Name Customer Inserts Grade Course Customer Inserts Tutor’s Name 21, 01, 2012 Mini Case #1 Question 1 (Answer) The fundamental areas of finance include; corporate finance, investments, financial institutions, and international finance. Corporate finance is concerned with the problem of identifying and assessing a firm’s investments that need to be implemented over a long period of time (long-term investments). It also deals with the modalities of securing funding to recompense for the investment costs. Corporate finance is also concerned with the management of day-to-day financial activities of a firm. The investment of a firm includes work and value financial assets such as stocks and bonds. Risk assessment is a crucial part of investment where return on capital invested, asset composition and allocation of resources are all considered. Commercial banks have curved a long-established niche that deal with financial services that target a wide range of savers and borrowers. A person who has majored in finance may get employment opportunities as a security analyst, portfolio manager, financial advisor or stockbroker among others. Question 2 (Answer) It is not possible to do a good job in one area of finance without proper knowledge of the other areas. For example a brokerage firm or an investment bank may be an efficient financial institution but will also need to be proficient in matters such as exchange rate (a requirement of international finance), risks (mostly assessed in investment) among others. Although exchange rates and risk assessment are prerequisites of international finance and investment respectively, yet the brokerage firm and investment banks cannot grow or even perform efficiently without a command of these areas. Besides, the firms may not expand. Question3 (Answer) It is important because it impacts mangers with the necessary skills required in recognizing and choosing the corporate plan as well as projects that facilitate in the growth and development of their firm. The skills acquired through corporate finance also enable the managers to forecast the financial support required by their company and therefore work out the plan for acquiring the money. Question 4 (Answer) The main objective of the manager should be to maximize the wealth of the shareholders. In doing this, the manager should ensure that the firms do not deviate from the normal business ethics. Question 5 (Answer) A financial market is one in which people can trade financial securities, commodities, and other fungible items of value at a market price determined by supply and demand. The securities include stock and bonds while commodities include precious metals or other goods. Financial markets are different from the physical asset markets because unlike the financial market, the physical market trades in real or tangible goods. On the other hand, financial markets trade in financial securities. Money markets trade in debt securities which have short maturity period normally of less than one year. Examples of major players in the money market include New York, London, and Tokyo. The capital market on the other hand trades in long-term securities including stocks and bonds. Examples of capital market and money market are the NYSE and the New York commercial paper and Treasury bill respectively. Question 6 (Answer) Family units are savers of capital while governments constitute the borrowers. Financial institutions are slight borrowers but they breakeven almost quickly. There are three methods of transferring capital between savers and borrowers; direct transfer, investment banking house, and financial intermediary. The first method of capital transfer involves a business selling its assets directly to investors. In this case, the business borrower obtains funds from the investors (savers), and the investors receive securities (bonds or stock) from the business borrower in return. The second method of capital transfer involves a middleman who acts as the liaison between the borrower and the savers. The investment banking house plays the role of the middleman as a link to the two trading parties. The borrower trades its securities with the middleman (investment bank), who in turn trades them to the savers. This double trading is considered as one complete transaction in the primary market. The third method of capital transfer involves savers investing their money with a financial intermediary such as a bank. The intermediary then issues its own securities in exchange of the savers’ investment. Banks are one kind of intermediary which trades in the money that is received from numerous small savers by lending the money to borrowers, businesses and government units at an interest. The bank acknowledges deposit by issuing a deposit receipt or certificate. The savers’ investment may accrue some interest or deposit maintenance cost depending on terms of agreement and the amount or type of investment. Other categories of intermediaries include; mutual funds, insurance companies, and pension funds. Question 7 (Answer) A creditor unlike the shareholder does not own any stock in the firm. The only claim that the creditor has over the firm is his or her money and the accruing interest if there was any agreement on interests. If a company is making profits company, a shareholder unlike the creditor can participate in the earnings of the company through dividends and capital gains. A creditor has no participation in the profits. His participation is only in any interest on his money owed that he might have been promised if any. Question 8 (Answer) The three main forms of business organization are; sole proprietorships, partnerships, and corporate. The first form is owned by a single person and has three important advantages: it is easy to form and does not require huge start-up capital, it does not require many government licenses and permits in order to operate, and the business does not pay corporate income taxes. On the other hand, the single owner business has three disadvantages; it is not easy for a single owner to amass high capital for start-up and expansion, the proprietor personally liable for the business’s debts, and the proprietorship may not survive after the demise of the owner. The main benefit of a partnership is that it is easy to start. The main limitations of partnership include; unlimited liability, the business may collapse incase of death or withdrawal of one partner, and difficulty of transferring ownership. The partnership just like the sole proprietorships is taxed only once as personal income. This is an advantage. Unlike the sole proprietorships and partnership, the corporate business has three key advantages; unlimited life (business life is not dependent on life of one individual), easy to transfer rights of ownership, and the liability is limited (the corporate business is an entity that can be sued separately from the shareholders). Although these are significant advantages of the corporate form over proprietorships and partnerships, it does have two main shortcomings; taxed twice, and starting this kind of business and fulfilling the many required government rules and regulations is more difficult and protracted than for a proprietorship or a partnership. Although the limited partners have the advantage of being partially liable to the liability of the business only for the sum of their investment in the partnership, the limited partners normally have no control over the affairs of the business. This kind of organization form enjoys a mix of the advantages of limited liability of a corporation and tax advantage of a partnership. Despite corporations providing nearly all of the benefits of incorporation, they do not relieve the members of professional liability. S corporations are analogous to the in limited liability partnerships in many ways. Question9 (Answer) The summation of value of operations, value of nonoperating assets, and value of growth options forms the total corporate value of a corporation. Saleable securities and tenure of non-controlling interest in another company constitutes the nonoperating assets. The growth options are intangible and include activities such as Research and Development (R&D) and strengthening customer ties. The first claim is usually reserved for the debt holders with the preferred stockholders having the next claim. The remaining value if any belongs to the stockholders. Question 10 (Answer) In most cases the stockholders push for the increase in the value and price of the firm and stock respectively. The firm manager on the other hand may be interested in increment of personal salary and job security. This may result into a conflict of interests. In some instances the firm managers may make choices that may not be in the best interest of the shareholders. For instance, managers may attempt to block a merger or takeover bid with the aim of increasing job security. Conversely, a successful takeover of the firm may be in the best interest of a shareholder (Ross et al. 2008). When realized profits surpass the expected profits, and therefore the corporation has a cash surplus, the managers spearhead demands for financial bonuses claiming compensation for extra efforts that resulted in increased profits. The shareholders on the other hand will claim the money as dividend basing his argument on the basis of his initial capital investment that has enabled the firm to grow to the point of realizing the current super profits. The divergent arguments where each party claims to be the force behind the profits and hence seek reward are a sure recipe for conflict. The issue of allocation of the surplus funds becomes a serious issue of conflict. When managers are also shareholders this may result in conflicts. The manager who owns some shares of the corporation may decide and even push for actions contrary to what a normal manager in his or her position would take. A shareholder manager may push for a decision that favors him or her. For example he may vote for stock dividend instead of a bonus if he believes that this will mean more money for him. This may be a very bad decision especially if the other managers are not shareholders and miss out on the bonus because one of their own voted for dividends. This scenario poses various challenges and calls for an intricate balance of reward system that will satisfy both parties. Disgruntled shareholders may undervalue the stock and make it a less attractive purchase if not rewarded with dividend. Failure to reward the managers with a bonus may result in exodus of managers or demotivates them resulting in less effort input than normal of them. Since most managerial positions are contractual, continued employment is dependent on good job performance. Conversely, if there is no reward or recognition for the hard work put in, a manager is not motivated to stay on the job. There exists potential conflict between the stockholders and creditors. The corporation riskiness, its capital structure and its potential capital structure are the factors used by the creditors to arrive at loan related decisions. The aforementioned factors are the main concern of the creditors because they singly and jointly affect the company's potential cash flow. Because the firm’s manager is an indirect appointee of the shareholder, the shareholder has control over the aforementioned factors that are of high concern to the creditors. The tendency of the stockholders to make decisions that are in their own self interest results in agency problems between the stockholders and creditors. The shareholder may instruct the manager to borrow money to repurchase shares already sold. This will reduce the firm’s share base and increase shareholder return. Although the stockholders will benefit, the increase in debt might affect future cash flows which is unfavorable to the creditors (Ross et al. 2008). The most balanced action that would yield greatest economic advantage might involve rewarding both parties with little money. Question 11 (Answer) If the surplus is as a result of profitability of the corporation, there are several ways of dealing with it. Priority should go to settling any short-term debts, and then the remainder may be used to give bonus and dividend to the firm’s staff and stakeholders respectively. The CFO must not forget to set a portion of the profit for emergencies and if there is still money, a portion should be reinvested in the firm to help in the growth and expansion of the corporation. Question12 (Answer) The three aspects are; quantity of expected cash flows, timing of the cash flow stream, and riskiness of the cash flows. Question 13 (Answer) It is the decrease in the value of assets due to tear and wear and the passage of time. This expense must be included in the income statements as it shows reduction in capital and affects cash inflow. Depreciation reduces the firm’s cash inflow. Question 14 (Answer) Pro forma used in balance sheet preparation, cash flow and present value preparation (Ross et al. 2008). Question 15 (Answer) (i)Forecast sales revenues for the time horizon in question (P/L) (ii)Forecast the level of asset resources required to support forecasted sales volumes (Year-end B/S value of Total Assets) (iii)Forecast the internal funds available to finance the forecasted levels of assets (Year-end B/S value of Liabilities & owners equity) (iv) Forecast the external financing requirements for the firm’s operating activities by subtracting forecasted levels of assets from internally available funds (Total Liabilities & Owner’s equity). Question16 (Answer) Increase in sales will increase AFN. Dividend payout will reduce AFN, while the increase in profit margins will also increase AFN. The increase in capital intensity ratio will increase AFN. Payment of the suppliers earlier will result in reduction of AFN. Question 17 (Answer) The starting point is collection of the historical sales data contained in the firm’s Income statements covering usually a time horizon of ten years. The selected historical data contained in past ten years Financial Statements converted into percentages. The historical percentages to forecast liabilities and owners equity (net worth) for the pro-forma B/S statements at the forecasted sales level. It is assumed that borrowing (short & long term), and owner’s equity remain unchanged and only current liabilities are affected. Regarding R/E they will change by the net Income less dividend. Mini Case #2 Question 1(Answer) Real interest rate is the expected interest for an investment after allowing for inflation. It is almost equal to the result of subtracting the inflation rate from risk free rate. The interest rate that is not adjusted to take care of inflation is called nominal rate. Question 2 (Answer) Systematic risk is the part of an asset’s risk that cannot be eliminated through diversification. It is also called market risk or undiversifiable risk. Question 3 (Answer) The expected rate of return depends on the percentage investment. High risk projects usually yield high returns. Question 4 (Answer) It is a mathematical tool which relates the expected return on an asset to its systematic risk. The Security Market Line (SML) equation summarizes this relationship. Beta is the measure of risk factor in the Model (CAPM). Question 5 (Answer) The corporate budgeting is concerned with risk assessment and looking at future costs in the present contest to determine viability of projects. Mgrs are similar to the corporate budgeting as it bases decisions on real value of money. Question 6 (Answer) It allows future cash flows to be estimated and discounted to give their present value. Question 7 (Answer) i. Project unlevered Financial Cash Flows (UFCFs) ii. Select an appropriate discount rate iii. Compute the total value (TV) iv. Work out the value of the enterprise (EV) by marking down the projected UFCFs and TV to net present value and calculate the equity value by subtracting net debt from EV Question 8 (Answer) The present value of an asset is arrived at by discounting each cash flow back to the present and then totaling these present values up. Question 9 (Answer) It refers to the value of the next best alternative that is forgone as a result of making a decision. Question10 (Answer) This is when buying and selling do not affect the market prices. The decisions of buyers and sellers have no effect on market price in a capital market. Question 11 (Answer) The bond value is given by the sum of current value of coupon and current value of face value. It is also given by the total of current value of an asset and current value of lump sum. Question 12 (Answer) This is a theory that postulates that stocks are always in equilibrium and that it is impossible for an investor to consistently “beat the market.” This hypothesis states that securities are typically in equilibrium—that they are fairly priced because all publicly available information is reflected in the price of each security. There are three forms of market efficiency; the weak, semistrong, and the strong. The weak form of the EMH states that all information contained in previous stock price movements is fully reflected in current market prices. The semistrong form of the EMH states that current market prices reflect all publicly available information. The strong form of the EMH states that all the important information whether publicly available or privately held is reflected in the current market prices. Question 13 (Answer) Preferred stockholders have a greater claim to a company's assets and earnings. The dividends of preferred stocks are different from and usually larger than those of common stock. Question 14 (Answer) The project’s NPV is the difference between an investment's market value and its cost. A positive NPV means a project should be accepted. Question 15 (Answer) Capital budgeting is a decision-making process that assesses the viability of a project for investment purposes. Capital budgeting is essentially concerned with the validation of expenditures. Question 16 (Answer) Stand-alone risk is the total risk of a project that is operated alone. This risk ignores both the corporation’s diversification among projects and investors' diversification among firms. The risk is measured either by the project's standard deviation (sNPV) of NPV or its coefficient of variation of NPV (CVNPV). Corporate risk is the total riskiness of the project in consideration to the firm's other projects. It is the contribution of the project to the firm's stand-alone risk, and it is a function of (a) the project's standard deviation of NPV and (b) the correlation of the projects' returns with those of the rest of the firm. Corporate risk is measured by the project's corporate beta, which is the gradient of the regression line formed by plotting returns on the project versus returns on the firm. Market risk is the riskiness of the project to a well-diversified investor; therefore, it considers the diversification inherent in stockholders' portfolios. It is measured by the project's market beta, which is the slope of the regression line formed by plotting returns on the project versus returns on the market. Because management's primary goal is shareholder wealth maximization, the most relevant risk for capital projects is market risk. (Ross et al. 2008). Question 17 (Answer) It is important to consider all the risks before the final decision. The most important risk is the market risk. . Reference List Ross, SA, Westerfield, RW, Jaffe, J, Jordan, BD2008, Modern Financial Management, 8th edn, McGraw-Hill/Irwin, New York, NY. Read More