Financial Management - Investment Analysis and Portfolio Management - Assignment Example

Financial Management

Question 1

1.1

The financial manager is in charge of the financial resources of a company. For this reason he has an important role to play in aligning the company’s resources to the strategic plans. To ensure smooth alignment, the manager first communicates to inform employees of what is required of them. Proper and effective communication is important because to make sure everyone understands their role since the manager cannot be physically present to provide supervision at all times. The manager thus needs to be able to pass his ideas to junior employees in a clear and concise manner.

The second role that the financial manager plays is to ensure that the company has enough resources required to finance the strategies. He makes sure there will be a steady stream of finances to facilitate each step of the strategies by raising funds. The manger also performs advisory roles to the company. He advises on the best financial practices in terms of the strategies (Hope, 2006:17). He also allocates funds to different projects and units optimally. Finally, the financial manager plans profits to ensure that they are used economically.

1.2

Profit maximization is concerned with increasing the yearly profits of an organization. It is achieved when the firm uses minimum in put to produce maximum output. On the other hand, wealth maximization purposes to increase the general worth of the enterprise. It is achieved when the market price of a company’s stock increased.

Profit maximization is a short-tern goal. Profits are computed on a regular basis and therefore activities aimed at increasing profits have to be short term (Cubbin & Leech, 1986:123).

Wealth maximization can be increased through improved sales and services, higher quality of products, and increase in goodwill. These are not factors that can be achieved over a short period of time (Cubbin & Leech, 1986:124). They need strategic planning and implementation, which takes a long period thus they are long term.

Strategic financial management encompasses both short-term and long-term goals through proper management of resources to meet objectives and to maximize the value.

Question 2

2.1 Profitability

McDonalds was victim to the aftermath of the global economic all of 2007 which first manifested in the United States real estate industry and went on to affect all industries across 85% of Europe and the whole of the United States as well as the Middle East and most parts of Asia. The carry-over of this crisis manifested in the form of a mild sales drop in 2012, the first to have been registered by the company since 2003. This drop did not impede revenue growth because the company went on to register a 3.1% increase in comparable sales, 2% increase in revenue and 1% increase in operating currency at the close of the fiscal year (McDonalds Cooperation, 20212, p.13).

In addition to the abovementioned figures, the company registered cash provided by operation to be in excess of $7 billion dollars with a 10% increase in the cash dividend per share up to $3.08 per share. All in all, the hard economic condition of the time did not seem to take any serious toll on McDonalds given that the company was able make profits across most of its markets hence a cumulative profit (McDonalds Cooperation 13).

2.2 Asset Management

The company owns and leases real estate, a good amount of which leasing goes hand in hand with the restaurant business. Most of the real estate is leadeLong-term sales and profit potential to McDonalds forms the main point of focus in establishing the locations for real estate assets. Despite slightly low investment inputs in the 2008 and loses following the global economic crisis, McDonalds seems to have maintained its asset expenditure budget an upward growth curve with the asset management budget rising from rising from $2136 in 2008 to a projected $2800 million dollars at the end of the year 2013 (McDonalds Cooperation 2012, p. 17).

Against a backlash of economic losses due to the suffering economy, rent seems to have been one of the key investment-based revenue sources offsetting the effect of the toll of the business sources that McDonald’s was suffering. In that regard, today, in the period between 2008 and 2013 has seen tremendous investment benefits from the real estate sector with the 2012 statement of financial position indicating that up to 18% of the company’ total revenue was being obtained from the rents and related income earners. Despite real estate being the main revenue earner for McDonald so far, however, the company has made it clear in past conferences and shareholder briefings that it has no intentions of setting up an REIT (Real Estate Investment Trust) for its property given the high volatility ration of properties in this kind of trust and taking heard examples from the 2008 – 2011 recesions (Ayrapetova, 2014. P. 34)

2.3 Liquidity

As of the close of the 2011 fiscal year, McDonalds had posted a revenues figure of $27.006 million US dollars of against a net property and equipment figure of $22.834 million US dollars. The liquidity ratio as at the start of the 2012 – 2013 fiscal year was, therefore 1:18. With this kind of liquidity ratio—a very stable figure—one can understand the rather easy manner in which McDonalds was able to register a generally positive change in revenue stream through the tremulous economic times of 2008 through 2010 (Ayrapetova 2010, p. 37). In addition to the figure quoted above, McDonanlds also had a Next Fixed Asset Turnover (NFAT) of 1.883 in the travel and leisure sector and a figure of 3.88 for the NFAT in the entirety of the consumer services industry.

From the figure above, one can see that through the recession, the Net Fixed Asset Turnover (NFAT) of McDonalds had somewhat grown. Seeing as an increase in the Fixed Assets leads to a corresponding rise in the liquidity ratio, McDonald’s liquidity gradually improved through the five years although projections at the end of 2013 fiscal year indicated possible drops in the liquidity ratio in the 2014-2015 fiscal year (Ayrapetova 2014).

2.4 Solvency

Making sense of and extrapolating from the liquidity rations above-quoted, the solvency of the company improved through the 2009 – 2013 period, a factor that can be attributed to the huge -contribution of the rent in offsetting some loses made by the company and in an impeccable marketing system that ensured only negligible sales drops against a market landscape that was supposed to be performing at its all-time low. The solvency was further improved through the positive figures posted by the company’s consolidated selling model which, despite going up against increased work force maintenance costs (which went up 3% in 2012) and general and administrative cost which went up 4% (McDonalds 2016, p. 22). Summarily, the solvency of McDonalds increased by a slight but noticeable margin, a feat that not many companies shared given the economic times prevalent at the time. It is off the essence to note that if the company registered a genera positive trend in growth in 2009-2013, it is likely to grow exponentially.

Question 3

3.1

Risk aversion can simply be defined as an investors dislike for investments whose returns are not certain. The investor may consider the value of a certain investment with a lower yield to be higher than the value of an uncertain investment with higher returns. This is because risk averse people care about possible losses in addition to being interested in the possible returns. Risk aversion depends on the size of the risk in relation to the size of the assets or wealth of the individual (Holt & Laury, 2002:3). For instance, a person with $450,000 in assets will be less averse to a $7,000 risk as compared to one with assets amounting to $15,000. The latter has a lot to lose in case the risk materializes than the former. In the case of a firm, it’s attitude towards risk is pegged on the attitudes of the managers and the employees. If the workforce is risk averse because their remunerations are based on the profitability of the firm, then the company will minimize on risky ventures to secure their pay. On the other hand, if the workers are risk neutral, the firm will make more risky investments. Risk aversion is relative as it is a matter of personal preferences and traits.

3.2

Diversification is the concept of an investor spreading their assets across several investments such that their investment portfolio cuts across different industries. This is done to manage risks, which are part of investing and cannot be eliminated. Diversification is useful because it reduces the volatility of the portfolio. In the event of sharp rises or drops in stick prices, a well-diversified portfolio smoothens out the effects such that the overall effect is not volatile. This is because the different types of investments in the portfolio respond differently, or at varying degrees, to the changes in the market. For instance, market conditions may cause a boom in one industry and a decline in another. Diversification thus balances out the different stock reactions.

Systemic risk, also known as market risk, is the risk that is generated by the normal mechanisms of the market. They are beyond the control of the investor. If the market is doing badly, even stocks that are strong will go down. Alternatively, if the market is doing well, even stocks that are considered weak will improve. Non-systemic risk is specific to a particular stock or to an industry. It can be managed through diversification.

The diagram below depicts systemic and un systemic risks

Diversification seeks to reduce the risk to be as close as possible to the systemic risk, which cannot be mitigated through diversification. Diversifying an investment portfolio across industries reduces exposure to un-systemic risks that are industry related. Addition of more stocks reduces the risks exponentially. For this reason, it does not take a lot of investments to create a well-diversified portfolio. It takes about 20 investments to create a diversified portfolio (Reilly & Brown, 1997:227).

Question 4

4.1

Pay back period

The pay back period is the time it takes for the project to return the initial investment. Always, the project with the shorter pay back is preferred.

Where A= the last period with a negative cash flow

B= the absolute value of the cumulative cash flow in period A

C= cash flow of the period after A

Xerox ColorQube 9301

Year Cash flowsCumulative cash flows

0(250 000)(250 000)

190 000(160,000)

293 000(67 000)

397 00030 000

496 000126 000

595 000221 000

Pay back period is 2.69 years/ 2years 8 months 1 week

Bizhub C552

Year Cash flows Cumulative cash flows

0(300 000)(300 000)

191 000(209 000)

294 000(115 000)

399 000(16 000)

4120 000104 000

5115 000219 000

Pay back period = 3.133 years or 3 years 1 month 2weeks

Decision

The company should buy the Xerox ColorQube 9301 because it has a shorter pay back period.

Net present Value (NPV)

The net present value takes into consideration all the expected cash flows from the project. It is the discounted value of these cash flows less the initial investment. A project with a negative NPV should be rejected because its returns do not as much as offset the initial investment. If all projects have a positive NPV, the one with a higher value is preferred.

Xerox ColorQube 9301

Year Cash flow Discounting factorPresent value

190 000(1+0.15)-178 261

293 000(1+0.15)-270 321

397 000(1+0.15)-363 780

496 000(1+0.15)-454 888

595 000(1+0.15)-547 232

520 000(1+0.15)-59 944

324 426

Less initial investment(250 000)

NPV74 426

Bizhub C552

YearCash flow Discounting factorPresent value

191 000(1+0.15)-179 130

294 000(1+0.15)-271 078

399 000(1+0.15)-365 094

4120 000(1+0.15)-468 610

5115 000(1+0.15)-557 175

525 000(1+0.15)-512 429

353 516

Less initial investment(300 000)

NPV 53 516

Decision

The company should go with the Xerox ColorQube 9301 since it has a larger net present value.

Internal rate of return (IRR)

This is the discount rate that equates the NPV to zero. The higher the IRR value the more attractive the project. When evaluating a single project, it should only be accepted if the IRR is higher than the targeted internal rate of return.

The general formula for calculating IRR is

Where ra= the lower discount rate

Rb= the higher discount rate

NPVa= NPV at ra

NPVb= NPV at rb

XEROX COLORQUBE 9301

Year Cash flow Discounting factorPresent value

190 000(1+0.15)-178 261

293 000(1+0.15)-270 321

397 000(1+0.15)-363 780

496 000(1+0.15)-454 888

595 000(1+0.15)-547 232

520 000(1+0.15)-59 944

324 426

Less initial investment(250 000)

NPV74 426

Since the NPV is positive, we use a higher discount rate, say 28%

Year Cash flow Discounting factorPresent value

190 000(1+0.28)-170 313

293 000(1+0.28)-256 763

397 000(1+0.28)-346 253

496 000(1+0.28)-435 763

595 000(1+0.28)-527 647

520 000(1+0.28)-55 820

242 559

Less initial investment(250 000)

NPV (7 441)

The IRR is 0.268/ 26.82%

BIZHUB C552

YearCash flow Discounting factorPresent value

191 000(1+0.15)-179 130

294 000(1+0.15)-271 078

399 000(1+0.15)-365 094

4120 000(1+0.15)-468 610

5115 000(1+0.15)-557 175

525 000(1+0.15)-512 429

353 516

Less initial investment(300 000)

NPV 53 516

We use 25% as the discount rate since the NPV is positive

YearCash flow Discounting factorPresent value

191 000(1+0.25)-172 800

294 000(1+0.25)-260 160

399 000(1+0.25)-350 688

4120 000(1+0.25)-449 152

5115 000(1+0.25)-537 683

525 000(1+0.25)-58 192

278 675

Less initial investment(300 000)

NPV (21 325)

The IRR for the second machine is 0.2215/ 22.15%

Decision

Both machines have an IRR that is above the discount rate but the Xerox ColorQube 9301 has a higher IRR and thus is preferential over Bixhub C552

4.2

In the case of independent projects, where the selection of one project does not mean the other project cannot be selected, NPV and IRR do not clash. They will both suggest the same projects. However, when the projects are dependent and mutually exclusive, there is bound to be conflict between IRR and NPV.

IRR and NPV may yield different decisions if the scales of investments differ significantly. Taking two projects, NPV favors the project with a bigger investment because it yields higher cash flows. On the other hand, IRR favors the smaller project.

Conflict may also arise when the timing of the expected cash flows are different even when the size of investments are the same. In this case, IRR will identify the project whose cash flows are more in the nearer periods as the best alternative while NPV will identify the project whose cash flows are delayed.

The third source of conflict is the size of the terminal value. This is known as the horizon problem. The terminal value is the value assigned to the cash flows that occur beyond the period under forecast. If the terminal value is large, the project will be favored by NPV while IRR favors projects with low terminal values.

In all the cases when IRR and NPV identify different projects as the best alternative, the project identified by NPV sit he one taken into consideration. NPV is taken to be superior to IRR because it reflects the main goal of any company, which is to increase the wealth of the owners. NPV considers all the expected cash flows, which better reflects the wealth that will be created from the project than IRR (Dudley, 1972:910-914).

Question 5

5.1

Cost of equity is the cost to the company for using equity capital.

Cost of equity= risk free rate + beta coefficient * (market rate of return – risk free rate of return)

= 0,07 + 1.5 *(0.15-0.07) =0.19 /19%

5.2

WACC

Cost of preference shares

Where Kp= cost of preference shares

Dp= dividends payable

Po= market price of the shares

Cost of preference shares = 8.33%

Cost of debt

Cost of debt = I (1-T)

Where I is the interest payable (YTM)

T is the tax rate

Kd = 0.1 (1-0.28) = 0.072 / 7.2%

WACC formula

Where Ke= cost of ordinary shares

E= portion of ordinary shares

Kp= cost of preference shares

P= portion of preference shares

Kd= cost of debt

D= portion of debt

V= total cost of capital

WACC = 12.25%

5.3

Weighted average cost of capital is the summed and averaged cost that the company has to pay for the equity and debt capital that it uses. It can also be defined as the least rate of return on investments that the company should earn in order to have created value for the owners.

WACC is important in the evaluation of proposed investments. When a company is faced with two or more similar projects or projects that are different in material but mutually exclusive, WACC is used to determine the project that yields the highest returns. However, WACC is only applicable in project evaluation if the projects have the same risks and the same capital structure. If the risks are different, the risk adjusted WACC is used.

WACC is also applicable in the valuation of projects because it is the discount rate that is used in the determination of the net present value, which is used to determine the viability of projects. Valuation of a company as well as future potential also depends on WACC. The future expected cash flows are discounted using the WACC and the result divided by the number of outstanding equity shareholders to determine the real value of the firm. Finally, the management uses the WACC to determine the economic value added (EVA) in the company. EVA is determined by subtracting the average cost of capital (WACC) from the net profits.