Medical Associates - Research Paper Example

 1. Calculate Medical Associates’ cost of equity estimate using the DCF method.  The cost of equity using DCF method can be calculated as follows: Where: = Cost of Equity = Dividend per share (for next year) = Current Market Value of Stock g = Growth Rate of Dividends Hence the cost of equity will be; = 2 * (1 + 0.07) = $2.14 = (2.14 ÷ 23) + 0.07 = 0.163 or approximately 16% (Investopedia.com) 2. Calculate the cost of equity estimate using CAPM. The cost of equity using the Capital Asset Pricing Model (CAPM) can be calculated as follows; Where; = Risk free rate or the rate on Government Bonds E(= Expected return on the market = Project beta = systematic risk of the investment compared to market. = 0.154 or approximately 15% 3. On the basis of your answers to #1 & #2, what is your final estimate for the firm’s cost of equity? The Capital Asset Pricing Model (CAPM) provides the required return based on the perceived level of systematic risk of an investment. The CAPM contends that shares move accordingly with the market. If the market moves by 1% and a share has a beta of two, then the return on the share would move by 2%. The beta indicates the sensitivity of the return on shares with the return on the market. The beta value of 1 is the benchmark against which all share betas are measured, theses shares usually follow the market trend. If the beta value is more than 1, the shares are considered to be aggressive, these type of shares have the tendency to move faster than the market in a rising (bull) market and fall more than the market in a declining (bear) market. If the beta is less than 1, it is deemed to be a defensive share, these shares generally experience smaller than average gains in a rising market and smaller than average falls in a declining market. (Brigham, 2010) Research has shown that CAPM is a widely practiced valuation model. For Medical Associates, the cost of equity according to the DCF method is around 16% whilst it is lower when calculated in accordance with the Capital Asset Pricing Model. If the cost of equity is higher, it would definitely increase the Weighted Average Cost of Capital or the Corporate Cost of Capital. Hence the value calculated in accordance with the CAPM is a better and a good estimation of the cost of the equity for the company. 4. Calculate the firm’s estimate for corporate cost of capital. The cost of equity figure calculated as per the CAPM technique can further be used to find the Corporate Cost of Capital. Corporate Cost of Capital can be calculated as follows: Where: = Value of equity = Value of debt = Cost of debt = 0.105 or 10% approximately. 5. Describe the four (4) steps of capital budgeting analysis. Capital budgeting is the process of identifying, analyzing, prioritizing different sources of funds to finance a particular project. It is further explained as “the process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark”. (Investopedia.com)   Capital budgeting is also branded and known as “Investment Appraisal”. The four major steps in the capital budgeting process are: Estimating the cash flows; The cash inflows and the outflows associated with the proposed project are to be estimated and evaluated. The cash flows should be estimated with accuracy, although it is always a matter of prediction and may not be completely accurate. All monetary costs and benefits associated with the project are to be analysed. Some costs may not be included in the capital budgeting technique e.g. Sunk costs. The riskiness of the cash flows should be assessed; The risk associated with the project should be assessed and proper measures should be taken to address that particular risk. The main cash flow risks affiliated with any business venture are inflation risk, interest rate risk, volatility of the cash flows, etc. Determine the appropriate discount rate The discount rate calculated addresses the costs of individual sources of capital for a company e.g. in the form of debt or equity finance. Each of the sources of fund acquired for the initial and the subsequent financing of a project would have certain costs and for that reason the discount rate should be ascertained. Find the Present Value of the Expected Cash flows The expected cash flows would be multiplied accordingly with the discount rate and the present values would be ascertained. Present value is the current value of a sum of money which would be incurred or received in the nearby future. The expected cash flows are discounted at the discount rate, the higher the discount rate, the lower the present value of the future cash flows. After all these steps, it is finally decided whether to progress with a particular project or not. 6. Describe how project risk is incorporated into a capital budgeting analysis.  Risk simply means that the future actual return may vary from the expected return. The total risk of a project comprises of systematic and the unsystematic risk. Unsystematic risk refers to the impact on a company’s cash flows of largely random activities e.g. Industrial relation problems, equipment failure, etc. Systematic risk on the other hand are general economic factors that affect the cash flows of companies, this type of risk can occur from factors such as inflation, tax rate increase, interest rate factors, etc. such project risk are incorporated into the capital budgeting analysis to give a better picture of the project e.g. inflation rates are estimated and measured and all cash flows which are subject to inflation changes are calculated accordingly. The inflation rate is multiplied with the necessary cash flows with regards to the time period as well. Once all the cash flows are inflated by its specific inflation rates, the resulting cash flows are converted into money flow i.e. they are discounted using the money rate. Except the inflation issue the other issue is the tax issue. Corporation tax is calculated on the cash inflows and besides that, any capital allowances or tax savings are also ascertained and added up in the capital budgeting analysis. (Brigham, 2010) References Brigham, E. F. (2010). Financial management: Theory and practice. Toronto: Nelson Education Capital Budgeting, Investopedia.com http://www.investopedia.com/terms/c/capitalbudgeting.asp Cost of Equity, Investopedia.com http://www.investopedia.com/terms/c/costofequity.asp Read More