Investment Analysis and Explanations - Essay Example

Investment analysis on seven considerations This study analyzes investment policies set in six different scenarios. Each topic requires investment analysis and explanations. Question 1. All other things being equal, the longer the time to maturity, the greater the interest rates risk of bond value. The table of computation below proves this statement to be true. This is especially true for discounted bonds which are set as an example below. Bond yield at 10%,15% & 5% at 10yrs and 20 yrs maturity Purchase value 950 950 950 950 950 950 Face value 1000 1000 1000 1000 1000 1000 Years of maturity 10 yrs. 20 yrs. 10 yrs. 20 yrs. 10yrs. 20 yrs. Coupon rate 10 % 10% 15% 15% 5% 5% Current yield 10.526 10.526 15.789 15.789 5.263 5.263 Yield to maturity YTM 10.843 10.612 16.036 15.836 5.669 5.415 From the table, we could see that the YTM is greater than the current yield, and in turn is greater than the coupon rate. In our example, bond sells at 950 and has a coupon rate of 10%, and matures at 10 yrs, the YTM (Calculations from the Bond Yield Calculator) In buying bonds, you will see that the market price is different from the bond’s par value. There are three things that you have to see. Coupon Rate:  Annual payout as a percentage of the bonds par value Current Yield:  Annual payout as a percentage of the current market price youll actually pay Yield-to-Maturity:  Composite rate of return off all payouts, coupon and capital gain (or loss) Source: Money Chimp (The capital gain or loss is the difference between par value and the price you actually pay.) The best measure to of the return rate is the yield to maturity since it considers all areas of the investment. The formula for the Yield to maturity is explained below: :In an equation, 1. c(1 + r)-1 + c(1 + r)-2 + . . . + c(1 + r)-Y + B(1 + r)-Y = P     where c = annual coupon payment (in dollars, not a percent) Y = number of years to maturity B = par value P = purchase price Source: Money Chimp Example:   Suppose your bond is selling for $950, and has a coupon rate of 7%; it matures in 4 years, and the par value is $1000. What is the YTM? The coupon payment is $70 (thats 7% of $1000), so the equation to satisfy is 2 70(1 + r)-1 + 70(1 + r)-2 + 70(1 + r)-3 + 70(1 + r)-4 + 1000(1 + r)-4 = 950 With the use of bond yield calculator, find the r that is 8.53% YTM is 10.843% which is >current yield of 10.526 % which >coupon rate of 10% Source: Money Chimp Question 2. Photochronograph Corp. manufactures time series photographic equipment. It is currently at its target debt-equity ratio of 1.3. It is considering building a new 45million manufacturing facility. This new plant is expected to generate after-tax cash flows of 5.7 million to perpetuity. There are three financing options. 1. A new issue of common stock. The flotation costs of the new common stock would be 8 percent of the amount raised. The required return on the company’s new equity is 17 percent. Required return on investment at new equity 17% Flotation charges for new common stocks 8% Firm’s net proceeds per share 9% It will be noted that the flotation charges made from issuing common stock has caused the shortage on the required investment for the new building. Initially, the firm has considered raising funds to finance new building construction, but it seems this option needs some mix re-alignment or additional financing either thru bonds or bank borrowings. 2 A new issue of 20 year bonds, flotation cost would be 4 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 9 percent, they will sell at par. Flotation cost is defined as the costs associated with issuance of new securities. It is the portion of the proceeds associated with the size of the spread. It includes costs incurred by the underwriting company in marketing the stocks. Annual coupon rate 9% YTM 20 yrs. Purchase value $950.00 Face value $1000.00 Current yield 9.474% Yield to maturity 9.570% $950 x YTM 9.570% Yield $90. 915 per bond Investment in bonds has no flotation cost, and pays no interest and in municipal bonds, pays no taxes. 3. Increase the use of accounts payable financing with the same amount of 45million. What is the NPV of the new plant? Cost of bank borrowings The cost to bank borrowing in this example is 9%. It represents the interest paid on the loan from the bank of an Initial cash outlay $45 million Interest rare 9% Term 20 yrs. Discount factor 9.1285 Multiply by 5.7M $52,032M Subtract initial outlay $45M We get an NPV $7.032M A criterion for evaluation of NPV is when NPV is more than zero, accept the project when it is positive, and when the NPV is negative, reject the project. NPV also gives us an idea if the total net present value can finance the project cost. (Van Horne) Accounts payable financing has a tax advantage as interest payments are tax deductible, no dividend payments and no flotation charges. Question No. 3. 1. Explain the Miller and Modigliani proposition of irrelevance capital structure and the MM proposition with corporate taxes. The diagram below illustrates how M & M describes the irrelevance of capital structure. The diagram shows two firms with the similar capital structure and assumes a perfect market condition. M & M contends that capital structure is irrelevant, and that the value of the firm depends on its total asset and not by its capital structures. In the diagram above of two firms, both are levered by equity and debt and have similar financial capital structure. The only difference that could be observed is how they finance their operation. In diagram A, 70% is levered by stock equity, and 30% by bonds, and on diagram B, displays the opposite. In this proposition therefore how debt and equity is structured in the corporation is irrelevant. (Finance Scholar) M & M proposition with corporate taxes. The second proposition re-examines the theory of irrelevance because the interest payments is tax deductible while dividend payments are not, Leverage lowers the weighted average after tax cost of capital as found in MM proposition. Let us take the following illustration of two firms. Suppose that the expected value of annual net operating income for the 2 firms is $2000 before taxes, the corporate income tax rate is 50%, the after-tax capitalization rate is 8 percent for both companies, and the Company A has no debt, Company B has $8,000 in bonds. According to MM proposition, the total values of the two companies would be: Company A Company B 1. Net operating income $2,000 $2,000 2. Taxes 1,000 1,000 3. Profit before interest, after taxes 1000 1,000 4. After tax capitalization rate for debt-free company .08 .08 5. Capitalized value of (3) $12,500 $12,500 6. Interest on debt 0 400 7. (1- Tax Rate) (6) 0 200 8, Tax savings on interest 0 $ 200 9. Interest rate .05 10. Capitalized value of (8) 0 4,000 11. Total value of firm (5) + (10) $12,500 $16,500 Source: Van Horne, J. p 250. This means that there are advantages for firms to be levered, since corporations can deduct interest payments. The higher value of Company B is due to the deductibility of interest payments. Because of the tax benefits, MM proposition says. The firm can increase its total value by leverage. 2. Westman Co, has no debt but can borrow at 10 percent. The firm’s WACC is currently 14 percent, and the tax rate is 35% a. What is Westman’s cost of equity?. WACC of Westman is 14% which means that this is the required rate of return when company considers the new project. The cost of equity is the required interest or return of money to the investors, The formula for cost of equity is; For example, Westman requires 14% rate of return on an asset investment. The stock is currently trading at $10 and will pay a dividend of $0.30. Dividends and share appreciation requires $1.40 return on every $10.00 investment. Therefore, the stock will have to appreciate by 1.10 which combined with $0.30 from dividends gives the 14% cost of equity. b. If the firm considers 25 percent debt, what would be the cost of equity? The debt/equity ratio is a calculation of the company’s financial leverage computed by dividing its total liabilities by stockholder’s equity. It is the proportion of debt and equity company is using to finance its assets, and is measured by . In this case, Debt/Equity = 25%/75% = 33% Where 25% is the debt, and 75% is the shareholders equity. In this case the cost of equity is way above the WACC of 14% Question 4. Explain the following situations. a. Is it possible that dividend policy is irrelevant? What are the two important real-world factors that managers should take into account when making dividend policy? M & M theory of irrelevance on dividend policy is based on a perfect financial market where there are no taxes, or transaction cost, all investors has “homogeneous expectations” and that the investment policy of the company is well defined. MM’s assumption is that investors are not indifferent as to how the earnings stream is split between dividends and retained earnings, Some financial analysts feel also the same way in that the consideration of a dividend policy is irrelevant because investors have the ability to create "homemade" dividends (Investopedia) In real world, policy decisions are affected by the company objectives. Its decision depends upon the magnitude of acceptable investment opportunities and the perceived value to investors of dividends. Dividend policy is affected also by the cost of common stock financing and use of retained earnings. b. Whether the desire for current income a valid explanation for preference for high current dividend policy as investors can always create homemade dividends by selling a portion of their stocks? There are two explanations for investors preference on current dividend policy. First, a high dividend policy attracts investors who are looking for investments with a secure current income. For investors, a dividend shows financial stability of the company, and the initial question of an investor is the pay-off. On the other hand, high current dividend policy may not be an important consideration, as investors can always make a “home made dividend.” For instance, an investor can always adjust his investment portfolio in many preferences. He can sell part of his stocks and invest in bonds which promise a stream of payments and do not have to worry about dividend policy of a company. c.. If increase in dividends tend to be followed by immediate increase in share prices, how can it be said that dividend policy is irrelevant? Increases in dividends such as stock dividends are an irrelevant dividend policy as it does not add any wealth to the shareholder. Each share holder keeps the same fraction of a combined net worth that does not change as a result of stock distribution. The only effect is that there are more shares of stock, with each having a lesser value. In another instance, it is assumed that the company needs financing and the sale of new shares of stock at new prices offsets payment of dividends, and the real cost of equity will be the same. d. d. National business Machine Co. has million of extra cash. NBM has two choices to make use of this cash. One alternative is to invest the cash in financial assets. The resulted investment income will be paid as a special dividend at the end of three years. In this case, the firm can invest in Treasury bills yielding 7% or an 11% preferred stock. Only 30% of the dividends from investing in preferred stock would be subject to corporate taxes. Another alternative is to pay out the cash as dividends and let the shareholders invest do their own Treasury bills with the same yield. The corporate tax is 35%, and the individual tax rate is 31%. Should the cash be paid today or in three years. Which option should the firm take to maximize the welfare of the shareholders. What are the important points can you draw from this case? Options for investment of National Business Machine Co. Invest at Treasury bills Invest at preferred stocks Pay-out to shareholders Coupon rate 7% Int. rate 11% Reinvested to Treasury Maturity 3 yrs Corp. tax 35% Bills, same coupon rate Face value $1000 $1M x 11% $110,000 Same maturity Par value $1000 30% x 110,000 = $ 33,000 35% x $33,000 = $ 11,550 YTM 8.11% $110,000-$11,550 = 98.500 YTM 8.11% $1M investment yields $98,500- 31% = 30,519.50 No tax $98450-$30,519.50 = No tax Special dividend $81.100 Special dividend $67,930 Special div. $81,100 Under the three options, investment in municipal bonds would be the best choice as this gives a steady stream of interest income annually to stockholders. Investing with Treasury Bills, at 7%, maturity 3 years, yields 8.11% Ytm, would provide $81,100 as special dividend. This is assumed to be tax free investment. Investing on preferred stocks at 11%, 35% subject to corporate tax and 31& of % individual tax has double taxation effect to share holders as it has been charged to corporate tax and individual tax. It is assumed to have same 3 yrs. Maturity. Pay out cash dividends and let shareholders invest on their own Treasury bills at same rate and yield at YTM 3 yrs. of 8.11% which is higher than the current yield of 7%. Question 5. Who owns the corporation. Describe equity and debt as contingent claims A corporation is a legal entity that is considered separate and distinct from its owners. The corporation can enter into contracts and incur debts on its account. The shareholders of the corporation are its owners. Shareholders elect the board of directors who hires managers to operate the business Equity. This represents the interest of the shareholders in the corporation in the form of common or preferred stocks. In financial statements, it is the total assets minus the liabilities, which gives the shareholder’s equity and states the net worth or book value. (Investor Words) Debt is explained as an obligation or liability to pay or render something to something else, such as money, goods, or services. Debt in corporation represents liabilities which are obligations of the corporation to repay the interest and principal at a specified time. In comparing equity and debt, equity holders will receive residual cash flows or dividends that is, the portion that remains after creditors of the corporation have been paid. Debt to creditors in the corporation is settled first. 1. What is the main goal of a corporation, why is profit maximization considered incomplete as the definition of what most business seek to achieve? A corporation can set short term and long term goals that will benefit everyone concerned. Among possible goals are survival, profit maximization, sales maximization, return on investment, among others. While profit maximization is regarded as a major corporation goal, it does not maximize shareholders wealth. The explanation for this is that a firm could always raise total profits by issuing stocks and investing the proceeds in Treasury Bills, but it does not fully achieve profit maximization because of timing of expected returns. The time patterns of return must be taken into account as few stockholders would consider receiving its first return in 20 yrs, 30 yrs, even if it is a large return. 2. What is the main reason that an agency relationship exist in the corporate form of organization? In this context, what kind of problem can arise? How are managers bonded to shareholders. An agency relationship exists in the corporation because stockholders are not involved in the day-to-day operations of the firm. Managers are hired to make decisions in behalf of the stockholders. A corporation has Treasurer and Controller that provides the financial function of the business. The Treasurer takes charge in the preparation of cash flows, making capital expenditure decisions and making financial plans. The Controller handles the accounting function, such as taxes, cost and financial accounting and information system. Financial managers are bonded to shareholders in such a way that his decisions should be for the best interest of stockholders, and to increase the value of the stock. So the goal of financial managers in a corporation should be to maximize the current price of the existing stock. (Lacson R. & Santos E.) 3. Corporate ownership varies around the world. Historically, individuals have owned majority of shares in public corporation in the US and the UK. In Germany and Japan, however, other large financial institutions and other companies own most of the stock in public corporations. Comment on whether agency problems are likely to be more or less severe in Germany and Japan than in the US The German speaking countries, Germany, Austria, Switzerland and Liechtenstein has two forms of corporation, which are patterned after US corporations and similar to the limited liability company. Corporations in Japan for both the state and local public entities falls under the Law of Local Autonomy which belong to the prefectures and municipalities, and must be registered under this jurisdiction. Non-profit corporations are established under the provisions of the Civil Code. Germany’s system of governance separates management and supervisory bodies, that of the Executive Board and Supervisory Boards. German governance provides the inclusion of employee participation, such that the Supervisory Board includes employee members. The German corporate governance also provides the inclusion of a third body in the corporation, as provided by the German Stock Corporation. This is shareholders organization known as the General Shareholder’s Meeting.(SAP) In the US, companies are formally incorporated according to the laws of a particular state may be called a corporation. Purposes of these corporations are either for profit making or non-profit objectives. Non-profit corporations are tax exempt companies. There are certain companies that can be chartered, as in banks. Articles of incorporation are registered with their particular state as part of registration process. There are government corporations formed by government itself. The government has the power to create corporate entities for the federal government, as in Federal Deposit Insurance Corp. Corporations differ in their objectives and are created to fit their purposes. Many corporations in the US chose to register in states where laws favor their business interests. For example, many large corporations chose to be incorporated in Delaware, without being physically located there because of favorable corporate tax and disclosure laws. Unavailable sources of comparative studies on corporate governance in Japan and other countries have limited this study to give a responsible argument. Question 6. Compare and contrast capital market line and security market line by addressing the following Issues a. Risk and return trade off Fig. 1 The capital market line.(source: (Wikipedia) Pt. red at the middle (A) shows the efficient portfolio, investors expected returns and risk exposure. Red pt. at left side (B) is the point where investment is risk free. Any deviation from pt. B would mean higher risk but a larger expected return. A capital market line is a line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.(Investopedia). Let us assume that in fig. 1, that borrowing and lending at the risk free rates, the straight line passing thru the risk free rate on the vertical axis and the expected return-standard deviation for the market portfolio is the capital market line. This line describes the trade off between the expected return and the risk for various holdings of the risk free security and the market portfolio. The slope of the line represents the market price of risk. This tells us the amount of additional expected return that is required of an increment in standard deviation. b. Markowitz portfolio theory to develop CML Fig.2. Markowith Portfolio Theory. Source: Wikipedia According to Markowitz portfolio theory, an investor seeks a portfolio of securities that lies on the efficient frontier. A portfolio is an efficient if there is another portfolio with a higher value of expected return and the same standard deviation. If an investor’s portfolio is not efficient, he can increase the value of expected return without increasing the risk, decrease the risk without decreasing the expected value of return, or obtain a combination of portfolios to achieve his required objective. b. Notion of risk and relevant risk, problem with CML In M & M’s proposition, capital structure is irrelevant in a perfect market situation. But in real world situation, there are imperfections which could make capital structure relevant, which is contrary to MM. Some imperfections affecting capital market structure are trade off theory of capital structure, pecking order theory, agency costs, arbitrage and others. Trade-off finds benefit with debt financing and mentioned tax benefits while at the same time considers the cost of financing A Wikipedia article explained that as debt increases, the marginal benefits in debt declines while the marginal cost increases. So that in this situation, a firm will have a trade-off in choosing how much debt and equity will be needed to finance a project. The Pecking Order theory prioritizes their sources of financing, using internal financing and turns to equity as “last resort’. In this set up, business prefers internal financing when available and uses equity whenever necessary. Agency costs affect capital market in asset substitution, underinvestment and free cash flow. In asset substitution, management has investment decisions of undertaking risky projects, because when project is successful, shareholders get an upward reward; likewise if project is unsuccessful, debt holders get all the downside. Analysts say that if the projects are undertaken, there is a chance of firm value decreasing and the wealth transfer from debt holders to share holders. The problem with underinvestment is that if the debt is risky, the gain from the project will accrue to debt holders and not to the share holders. When free cash flow is not returned to investors, management can destroy firms value through “empire building, perks, etc, thus increasing leverage. c. Development of capital asset pricing model with its underlying assumptions and shortcomings. A capital asset pricing model is defined as model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.(Investopedia) Looking at Fig. 1 of the Capital Market Line, the CAPM means the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. The underlying assumption is if the expected return does not meet the required return, then the investment should not be continued. The security market line in Fig. 2 shows the results of the CAPM for all different risks. As seen in Investopedia, the following example uses CAPM model to arrive at the expected return of a stock: Using the CAPM model in Fig. 2 and the following assumptions, we can compute the expected return of a stock: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)). Question 7. Explain/comment on the following situation a. The University of the East pays no taxes on capital gains, dividend income, or interest payment. Would you expect to find low dividend, high growth stock in the university’s portfolio. Would you expect to find tax free municipal bonds in the portfolio? When an investment pays no taxes and interest payments, more likely, funds are invested in municipal bonds. Municipal bonds are often tax-exempt bond issued by a city, county, state, or other government for the financing of public projects and pays a semi-annual interest. When UE declares no dividend income, it is possible that UE declares stock dividend, as it would seem they need internal cash for projects. Low dividend, high growth stock. Dividend growth is an idea of investment most popular for conservative investors. This is a policy of increasing dividends over time most commonly found in “blue chips” companies. If UE is a conservative company, most likely it would invest in this kind of benefit program started by mature companies like beverage companies, cigarette manufacturers, pharmaceuticals, financial groups, giant retailers and big oil. Starting with low dividends, they raise it every year, a system that adopts stock growth over time. (Investment, 2006) Apart from these special situations, happiness for the yield-seeker is finding a high-yielding stock with a low payout ratio. A low pay out ratio has a distinct advantage for shareholders.. According to the advice of Carla Pasternak, an editor of High Yield Investing, a company with low pay-out ratio has “enough room” to increase its pay out ratio in the future, and an investor is sure that investments in that company is safe and dividends are more likely to come. (2006). b. The bird-in-the-hand argument which states that a dividend today is safer than the uncertain prospects of a capital gain tomorrow is often used to justify high dividend pay-out ratio. Bird-in-the-hand argument can be explained in investment in bonds that provide callable provisions usually for a shorter period of time than its maturity. This means investor can redeem his bond investment at say 3 or 5 years instead of waiting for a long period of maturity. Investor may be in need of immediate cash that he would rather cash in on his capital gains than wait. Proceeds of his investment and capital may be reinvested at a higher interest market rate. The yield that investor he gets now is better than a yield that has to wait for long years to receive. c. The desire for current income is not a valid explanation for preference for high current dividend policy as investors can always create homemade dividends by selling a portion of their stocks. The arguments for high-yielding dividends is that the higher the yield, the higher the risk. Investors who choose high risk current dividend policy are bold enough to accept possibility of loss if the company loses its profitability. It is not a valid reason for preference of risky high yields as investor’s portfolio has many options like homemade dividends. Under this set up an investor can sell his current stocks or bonds which will give a higher yield, and then re-invest it. The investor can take advantage of his current yield which could then be re-invested in other investments. d. Flying Ambitions Inc. has been paying out regular quarterly dividends ever since 1996. It just slashed the dividend by half in the current fiscal quarter and a more severe cut is underway. Its stock price dropped from .25 to .75 when the dividend cut was announced. Explain the possible reasons for this price drop. Company policies and behavior affects stock prices and may be the reason for decline. Investors review financial statements and earning announcements, and would worry if the company’s gross margins have fallen dramatically from last quarter, or the company’s position has weakened as compared with previous financial figures. This situation signifies some internal problem, as in Flying Ambitions Inc. who suddenly slashed dividends by half, and more reduction is expected. This would necessarily mean that stockholders will lose their confidence to FAI, such that stock prices fall significantly. FAI may be spending too much on administrative, selling and general expenses which are left unexplained. Any large decline on net income without profitable assumptions should be looked out. Investors should look at company growth earnings estimates provided in financial statements and find out how the company grows and use its funds as any shortfall will reflect on the value of share price. List of references Investor words. Equity. [online] Available from Accessed on 01 Dec. 2008 Investopedia. Capital Asset Pricing Model. {Online} Available from Accessed 30 Nov. 2008. Finance Scholar. Modigliai & Miller Proposition I & II. Capital Structure of Corporation. [Online] Available from . Accessed 30 Nov. 2008./ Lacson R. & Santos E. Corporation. Financial Management. International Academy of Management & Economics, Makati, Philippines. Pp. 5-6 Money Chimp. Bond Yield Calculator.[online] Available from http://www.moneychimp.com/calculator/bond_yield_calculator.htm Accessed on 30 Nov. 2008. Pasternak, C. 01 Jan. 2006. Advice to the Yield-Hungry, Check Out Payout Ratios. Dividend Growth Stock Investing. [Online] Available from Accessed 01 Dec. 2008. SAP. Corporate Governance. [Online] Available from Accessed 01 Dec. 2008 Van Horne, J. Corporate Income Tax. Financial Management & Policy, Prentice Hall, 4th ed. p. 250. Wikipedia – The Free Encyclopedia. Capital Structure. [Online] Available from http://en.wikipedia.org/wiki/Capital_structure. Accessed 30 N0v. 2008. Read More