Liquidity, the Value of the Firm, and Corporate Finance - Assignment Example

• Corporate Finance Assignment
• Question one:

According to Orhangazi (2008), the role of financial manager is very complex because the financial manager must understand how the business functions and assist in decision-making process which will add value to shareholders’ wealth. The structure of a company generally varies but the main function of the financial manager remains the same – maximization of shareholders’ wealth.

According to the arguments of Schipper (2007), the objective of ‘profit maximization’ is not suitable for contemporary firms because this concept is detrimental to the interest of shareholders. The financial managers have access to more information than any other stakeholder and hence they could act in self-interest and conceal important red flags (or areas of concerns).

According to Jensen (2010), the concept of ‘sales maximization’ is also not appropriate because in order to push sales volume and improve profit margins, the financial managers will cut cost. It is likely that in order to minimize cost of production, the firm could use low quality goods. However, in long-term the process will create a negative impression with the customers.

According to the arguments of Birth et al (2008), the current activities of businesses determine the scope of future generations. For a manufacturing or industrial firm it is important to develop a sustainable business environment considering the impact on internal and external stakeholders (including local community). In relation to this argument it can be said that financial managers should strive to maximize benefits of the local community by incorporating strategic goals into sustainable business environment. However, if the financial managers only aim to maximize employee benefits without regarding for other group of stakeholders including the investors and creditors then the business will not get the support of the investors in long-term (Peloza and Papania, 2008).

Hence, from the above discussion it can be said that the main corporate objective of a financial manager should be maximization of shareholders’ wealth. Therefore, all financial decisions should be taken in such a way that the shareholders’ wealth increase. This can happen in two ways – 1) Through interim or annual dividends issue; 2) Increase in market capitalization (Martin et al, 2009). According to Yahanpath and Joseph (2011), market price is also an indicator of performance, productivity, profitability and future prospects of the business. This concept is superior to profit maximization approach because it considers accounting as well as non-accounting aspects. This concept has many advantages including,

• The value addition is quantifiable
• Considers cash flows which is not covered by profit maximization approach
• Considers time value of money
• It considers uncertainties and risk factors
• Question two:

The discount rate of project for Net Present Value (or NPV) decision is 12%. The NPV of the three projects are calculated as follows:

Table 1

(Source: Author’s creation)

Hence, the NPV of project A is £509.

Table 2

(Source: Author’s creation)

Hence, the NPV of project B is £6,201.

Table 3

(Source: Author’s creation)

Hence, the NPV of project C is £1,019.

From, the above calculation it is clear that the NPV of project B is highest and hence the company should accept project B.

• Question three:

It is given that the initial cash outflow of the firm is £13,000 and the risk-free rate of interest is 10 percent. Based on these assumptions, the net cash flows (NCFs) and NPV for the project are:

Table 4

“Woodpulp” project

Year

Probability

Net cash flows (£)

PVIF (10%, n yrs)

Discounted cash flows

Incorporating uncertainties

1

0.90

£ 8,000

0.9091

£ 7,272.73

£ 6,545.45

2

0.85

£ 7,000

0.8264

£ 5,785.12

£ 4,917.36

3

0.80

£ 7,000

0.7513

£ 5,259.20

£ 4,207.36

4

0.75

£ 5,000

0.6830

£ 3,415.07

£ 2,561.30

5

0.70

£ 5,000

0.6209

£ 3,104.61

£ 2,173.22

6

0.65

£ 5,000

0.5645

£ 2,822.37

£ 1,834.54

7

0.60

£ 5,000

0.5132

£ 2,565.79

£ 1,539.47

TPV

£ 30,225

£ 23,779

less:

ICO

-£ 13,000

-£ 13,000

NPV

£ 17,225

£ 10,779

(Source: Author’s creation)

From the above table it is clear that the NPV of the project is £17,225 without considering the risks of uncertainties. However, after considering uncertainties in the NPV calculation it has been found that the profitability of the project declined by £6,446. However, as the NPV is still positive the project may be accepted.

• Question four:

The CEO of the firm is contemplating on the estimates of cost of equity which is calculated by using the data of Folten plc, similar sized company in same industry whose shares are listed on AIM. The critical analysis of the two methods namely, Capital Asset Pricing Model (or CAPM) and Dividend Growth Model is discussed below:

• • Answer a)

According to Nag and Chen (2007), the most important determinants of CAPM are risk-free rate, market return and company’s beta. According to the authors the significance of beta coefficient is that it determines whether or not the target firm is volatile than the market. If the value of beta is more than (which is in case of Folten plc) then the movement of stock is more volatile than the market and vice-versa. The market return used for cost of equity calculation is 18% and the risk-free rate is estimated from the Treasury bill yield, which is 12%. The formula of CAPM is,

Cost of equity = rf + beta x (rm – rf); where,

Risk free rate = rf

Market return = rm

Now, the main assumption in the cost of capital is wrong because market return is used instead of using risk-free rate in the given calculation (18% + (18% - 12%) x 1.4 = 26.4%). However, the correct calculation for cost of equity should have been as follows:

K = 12% + (18% - 12%) x 1.4 = 20.4%

It is given that the current rate of inflation is 6% and hence inflation-adjusted cost of equity is 26.4% (that is, 20.4% + 6%).

It is also given that Wemere agreed to a fixed rate bank loan at 13% and this should also be included in cost of capital calculation to determine the Weighted Average Cost of Capital (or WACC). According to Fernandez (2010), the WACC is the total cost of the firm considering all long-term sources of finances including debt and equity. The formula for WACC is,

(E/V)*k + (D/V)*rd*(1-t); where,

E = Total equity = £2,000,000

D = Total debt = £2,400,000

V = Total value = E+D = £4,400,000

D/V = weight of debt = 0.55 and E/V = weight of equity = 1- 0.55 = 0.45

Tax rate = t and rd = 13% x (1 - .35) = 8.5%

Therefore, inflation adjusted cost of debt = 8.5% + 6% = 14.5%

WACC = (20.4% * 0.45) + (8.5% * 0.55) = 13.9%

Therefore, inflation-adjusted WACC = 13.9% + 6% = 19.9%.

The estimates made using the Dividend Growth Model is not correct because the formula did not use cost of equity in the model. According to Campbell and Thompson (2008), the Dividend Growth Model formula is,

P = D1 / (k – g); where, P = current stock price, k = cost of equity (calculated earlier) = 20.4%, g = expected growth of dividends = 9%, and D1 = 130 x (1 + 9) = 14.20 pence.

Therefore, P = expected share price of Wemere = 14.20 / (20.4 – 9) = 124.59 pence and the total value of firm is determined by multiplying with ordinary shares. The total ordinary shares of the company are 800,000 (that is, 2,000,000 pence/25 pence). The market value of the firm is product of share price and number of ordinary shares, that is, 124.59 x 800,000 = £9,966,807. The cost of debt should also be included in the calculation because any firm which is interested to acquire Wemere will also has to assume the liabilities of the firm. Hence, the total market value of Wemere should be, 10.2 million (that is, £9,966,807 + £2,400,000).

The cost of equity can also be calculated using the Gordon Growth Model by using the following formula:

Cost of equity = [(D1/P0) x g] = [(14.20/124.59)x9] = 20.4% (or 26.4% when inflation is adjusted).

• • Answer b)

The revised estimates show that the cost of equity of the firm should be 20.4% or 26.4% when the inflation has been adjusted. However, the earlier estimate was 32.4% which was not correct because of various errors of principle made in the two methods.

According to the arguments of Magni (2007), the WACC is a better estimate for actual cost of finance because it considers all the sources of finance including debt. Since, Wemere recently agreed to a fixed rate bank loan it is important to consider the effect of this loan on its overall cost of capital. The cost of equity calculated using the Gordon Growth Model does not consider cost of debt and hence CAPM is a better choice. There are other disadvantages of this model like,

• The dividend growth rate might vary according to economic conditions especially when the firm is reconsidering dividend payouts due to availability of good investment choices.
• This model is very sensitive to inputs and hence all values must be precise for accuracy.
• This model does not consider market risk, uncertainties and stock volatility which are duly considered in CAPM (Amihud and Mendelson, 2008).

Hence, the CEO of Wemere should use the discount rate ascertained by CAPM for capital investment decisions.

• Reference list

Amihud, Y. and Mendelson, H., 2008. Liquidity, the value of the firm, and corporate finance. Journal of Applied Corporate Finance, 20(2), pp.32-45.

Ang, A. and Chen, J., 2007. CAPM over the long run: 1926–2001. Journal of Empirical Finance, 14(1), pp.1-40.

Birth, G., Illia, L., Lurati, F. and Zamparini, A., 2008. Communicating CSR: practices among Switzerland's top 300 companies. Corporate Communications: An International Journal, 13(2), pp.182-196.

Campbell, J.Y. and Thompson, S.B., 2008. Predicting excess stock returns out of sample: Can anything beat the historical average?. Review of Financial Studies, 21(4), pp.1509-1531.

Fernandez, P., 2010. WACC: Definition, Misconceptions, and Errors.Business Valuation Review, 29(4), pp.138-144.

Jensen, M.C., 2010. Value maximization, stakeholder theory, and the corporate objective function. Journal of applied corporate finance, 22(1), pp.32-42.

Magni, C.A., 2007. Project valuation and investment decisions: CAPM versus arbitrage. Applied Financial Economics Letters, 3(2), pp.137-140.

Martin, J., Petty, W. and Wallace, J., 2009. Shareholder value maximization—is there a role for corporate social responsibility? Journal of Applied Corporate Finance, 21(2), pp.110-118.

Orhangazi, Ö., 2008. Financialisation and capital accumulation in the non-financial corporate sector: A theoretical and empirical investigation on the US economy: 1973–2003. Cambridge Journal of Economics, 32(6), pp.863-886.

Peloza, J. and Papania, L., 2008. The missing link between corporate social responsibility and financial performance: stakeholder salience and identification. Corporate Reputation Review, 11(2), pp.169-181.

Schipper, K., 2007. Required disclosures in financial reports. The Accounting Review, 82(2), pp.301-326.

Yahanpath, N. and Joseph, T., 2011. A brief review of the role of shareholder wealth maximisation and other factors contributing to the global financial crisis. Qualitative Research in Financial Markets, 3(1), pp.64-77.