Sunday, December 20, 2015

Module Name: Managerial Finance



OPEN UNIVERSITY MALAYSIA
FACULTY OF BUSINESS MANAGEMENT
BMMF 5103
Managerial Finance


Name: Adam Khaleel


Lecturer: Shimad Ibrahim
Learning Centre: Villa College



Trimester:  September 2014

Contents



1.0 Question 1

(a). A firm’s financial management may often have the objectives of the maximization of firm’s profit and the maximization of firm’s value. The value of a firm is defined as the market price of the firm’s stock. The market price of a firm’s stock represents the focal judgment of all market participants as to what the value of the particular firm is. It takes into account present and prospective future earnings per share, the timing and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the market price of the stock.  
The maximization of profit is often considered as an implied objective of a firm. To achieve the aforesaid objective various type of financing decisions may be taken. Options resulting into maximization of profit may be selected by the firm’s decision makers. They even sometime may adopt policies yielding exorbitant profits in short run which may prove to be unhealthy for the growth, survival and overall interests of the firm. The profit of the firm in this case is measured in terms of its total accounting profit available to its shareholders.
Even though shareholder wealth maximization is the fundamental, firms are not being able to reject the profit perspective goals, because there are stakeholder groups who is interesting about financial activities in a firm. Profit can be seen as the medium to pursue the long-term goal of the firm which is to enhance its value. A company that can consistently sustain high growth in its net profit would be able to improve on its earnings per share (EPS). It is also in a better position to pay high dividend payout thus triggering interest among investors to invest in the company’s stock. This will result in an increase in the stock price, thus enhancing the value of the firm. In addition to shareholders, Managers, Employees, Customers, Suppliers, finance providers and the community at large are included in the typical stakeholder group. Therefore it's essential to take account of profit maximization within the firm. As a result of these multiple objectives managers can easily pursue their own interest. In short, the companies should focus on maximizing their profit. It helps the companies to maximizing their business value which will maximize other worth. It is a subset of wealth and being a subset, it will facilitate wealth creation. It can be considered as a part of the wealth maximization strategy (Ukessays.co.uk, n.d.).
(b). Debt is a device that helps reduce the agency costs arising from the separation of ownership from control. Managers may not always act in the best interest of the shareholders and this situation creates an agency problem.
Debt financing can be a partial solution to this agency problem because the service of the debt will reduce the amount of cash that could be spent by managers for their own benefit. Debt is a device that allows current owners to retain control. If the firm needs outside funding and the current owners wish to retain control and avoid dilution of the firm’s equity, they will prefer that the firm borrow rather than issue new shares, regardless of tax shield considerations.
Agency costs arise in a corporation as a result of principal-agent problems. For example; managers may not act in the best interests of the shareholders while making decisions. Hence the shareholders incur monitoring costs that are called agency costs. It also arises as result of informational asymmetry between managers and other stakeholders of a firm. Agency costs tend to reduce the value of a firm. The use of debt will require the management of the company to be more prudent in spending the financial resources as the company is now obliged to pay mandatory interest on the amount of debt used. Companies could not risk engaging themselves in high risk endeavors as that may affect the return to the companies. Consequently, this may have negative repercussion on the ability of the company to pay back its debt. Instead, the management of the company must now work in line with the shareholders’ desire which is to maximize the latter’s value.
Management and shareholders could collude to expropriate lenders. In response, the suppliers of capital require protection in the form of restrictive covenants to their lending. The more debt is used, the more restrictive are the covenants and the higher the associated costs. These agency costs eventually reach a point where they offset the benefit of the interest tax shield. The agency costs of debt financing and the agency costs of equity have opposite effects on the firm’s value. Using debt financing provides managers with incentives to focus on maximizing the cash flows that the firm produces and limits the ability of bad managers to waste the stockholders’ money on negative-NPV projects (Hawawini & Viallet, n.d).
(c). Corporate social responsibility (CSR) is a doctrine that promotes expanded social stewardship by businesses and organizations. CSR suggests that corporations embrace responsibilities toward a broader group of stakeholders (customers, employees and the community at large) in addition to their customary financial obligations to stockholders. A few examples of CSR include charitable giving to community programs, commitment to environmental sustainability projects, supporting education, paying fair wages to employees and providing safe workplace. As more attention is being paid by outsiders to the social impact of businesses, corporations have acknowledged the need for transparency regarding their social efforts.
Modern theoretical and empirical analyses indicate that firms can strategically engage in socially responsible activities to increase private profits. Given that the firm’s stakeholders may value the firm’s social efforts, the firm can obtain additional benefits from these activities, including: enhancing the firm’s reputation and the ability to generate profits by differentiating its product, the ability to attract more highly qualified personnel to extract a premium for its products, can enhance employee loyalty and attract better personnel to the firm. CSR activities focusing on sustainability issues may lower costs and improve efficiencies as well. An added advantage for public companies is that aggressive CSR activities may help them gain a possible listing in the FTSE4Good or Dow Jones Sustainability Indexes, or other similar indices. This may enhance the company’s stock price, making executives’ stock and stock options more profitable and shareholders happier. Also the legitimate concerns of the firm’s various stakeholders can attain its ultimate goal of maximizing shareholder wealth (Robins, 2011 & Murillo & Martinek 2009).
(d). The term ‘globalization’ means integration of economies and societies through cross country flows of information, ideas, technologies, goods, services, capital, finance and people. The growth of globalization was mainly led by the technological forces in the fields of transport and communication. There were less barriers to flow of trade and people across the geographical boundaries.
The imperfections in financial markets can generate bubbles, herding behavior, speculative attacks, and crashes among other things. For example, if investors believe that the exchange rate is unsustainable they might speculate against the currency that can lead to a self-fulfilling balance of payments crisis regardless of market fundamentals. Imperfections can also deteriorate fundamentals. For example, moral hazard can lead to over borrowing syndromes when economies are liberalized. The root of herding behavior is asymmetric information. Information is costly so investors remain uniformed. Therefore, investors try to infer future price changes based on how other markets are reacting. Additionally, in the context of asymmetric information, what the other market participants are doing might convey information that each uniformed investor does not have. This type of reaction leads to herding behavior and panics.
The regulation and supervision can be done to ensure that banks are sufficiently capitalized with appropriate loan classification and adequate loan loss provisions. Transparency for investors and depositors through mandatory public disclosure of audited financial statements will help enforce market discipline. The removal of explicit or implicit government guarantees and sharing risk with investors will decrease the potential for moral hazard.
The policies should be accompanied by the right incentives for sound corporate governance. Clear rules and adequate financial disclosure help regulators and market participants monitor corporations, what pushes corporations to achieve good practices. Clear governance rules help prevent insider and group lending not subject to loan evaluation and creditworthiness standards. Developed corporate bond and equity markets help companies obtain external financing, become more transparent, and be subject to market discipline (Schmukler, 2004).

2.0 Question 2

 (a). Workings


As a result of these transactions, my company’s current ratio will increase and competitor’s current ratio will decrease.
(b). The company's tax liability will fall. If the debt is higher, the interest expense will increase and the net income decline. This results in a lower ROA. Net income and equity decline but net income declines less than equity, because the earning power exceeds the cost of debt. So the ROE will go up. EBIT and total assets will stay the same.
(c)   
Debt Ratio = 
Total Liabilities
Total Assets
                        
   
Equity Ratio = 
Equity
Total Assets
   


Return on Equity = 
Return
Equity
 
 
              


Return on Assets = 
Return
Assets
Therefore Return on Assets (ROA) = 10.8%
(d) Workings
 

Therefore, the amount of cash on the balance sheet is RM 68493.

3.0 Question 3

(a)
Advantages of common stock over debt.
It does not have to be paid back. Dividends are paid only if the company earns sufficient income.
Advantages of long-term debt over common stock.
Stockholder control – creditors do not elect directors. Tax effects - interest is tax deductible.
Financial leverage – after interest is paid, all excess earnings accrue to stockholders.
Disadvantages of Debt Financing
Cash is required to make periodic interest payments and to pay back the principal amount. Company can become overcommitted. Financial leverage can work against a company if the earnings from its investments do not exceed its interest payments.
Disadvantages of common stock
Since common stock represents ownership of a business, stockholders are the last to get paid, like all other owners. Any money left can then be distributed among its owners. While shareholders are company owners, they do not enjoy all of the rights and privileges that the owners of privately held companies do. Investors have limited information which can sometimes cause investment decision-making to be difficult. Stock prices tend to be volatile. Prices can be erratic, rising and declining quickly. Stock values can sometimes change for no apparent reason, which can be quite frustrating for the investor (Needles, Powers & Crosson, 2002).
(b)
Price is equal to present value of all future dividends.
Step 1: Use the SML equation to solve for rs.
rs = 0.0625 + (0.05)(1.75) = 0.15 = 15%.
Step 2:
Calculate dividend per share, D0:
(EPS0)(Payout ratio) = D0 (RM2.50)(0.4) = RM1.00.
Step 3: Calculate the dividend and price stream (once the stock becomes a constant growth stock):
D0 = RM1.00; D1 = RM1.00 × 1.25 = RM1.25; D2 = RM1.25 × 1.20 = RM1.50; D3 = RM1.50 × 1.15 = RM1.725; D4 = RM1.725 × 1.07 = RM1.8458Gordon Growth Model

Constant growth D5 = 1.8458 ÷ (0.15 – 0.07) = 23.0725
Step 4: Use the cash flow register to calculate PV:
Cash flows D1 = 1.25; D2 = 1.50; D3 = (23.0725 + 1.725) = 24.7975; I = 15%.
Solve for NPV to get Price.
P0 = 1.25(1.15)-1 + 1.50(1.15)-2 + 24.7975(1.15)-3 = RM18.53.
Therefore, the current price of the stock is RM18.53.
(c) The company will pay 0.62 dividend for the coming years, so the price of one share of this stock = D/r, D = 0.62, r = 14%
Share price = 0.62 ÷ 14% = RM 4.43

(d) Workings


Therefore, it will be worth RM 68.41 for one share of this common stock after ten years from now.

4.0 Question 4

(a)
(i) YTM is the rate of return earned on a bond held to maturity.

http://www.zenwealth.com/businessfinanceonline/BV/images/YTM.gif

RM961.88 = (RM1000 × (7.5%÷2)) × 
1 − (1 + r)−12×2
 + 
RM1000
r
(1 + r)12×2
961.88 = 37.5 × 
1 − (1 + r)−24
 + 
1000
r
(1+r)24
The price is RM961.88 which is lower than the par (which is RM1, 000). This suggests that the yield to maturity must be higher than the coupon rate (which is 3.75%). By using trial and error method we can start with discount rates above 3.75% and narrow down to until the present value is almost equal to the price. By keep narrowing down until the discount rate which exactly reduces the left hand side of the bond price equation to current bond price and this rate is 4%. Yield to maturity is expressed as an annual rate so it equals 8% (=4%×2).
YTM
=
37.5 + (1000 – 961.88) / 24
(1000 + 961.88) / 2
YTM
=
39.08833
080.94
    YTM = 0.0398478 × 2 = 0.079696 × 100 = 7.97% or 8%
(ii)
RM1,030.32 = (RM1000 × (7.5%÷2)) × 
1 − (1 + r)−12×2
 + 
RM1000
r
(1 + r)12×2
By keep narrowing down until the discount rate which exactly reduces the left hand side of the bond price equation to current bond price and this rate is 3.56%. Yield to maturity is expressed as an annual rate so it equals 7.12% (=3.56%×2).
YTM
=
37.5 + (1000 – 1030.32) / 24
(1000 + 1030.32) / 2
YTM
=
36.2366
1015.16

YTM = 0.03569 × 2 = 0.07139 × 100 = 7.14%

(b) Bonds provide two types of cash flows: interest payments and the principal payment. Interest payments occur each period, usually annually or semi-annually. Periodic interest payments are also called coupon payments. Thus this forms an annuity. Principal payment occurs at the time of maturity of the bond and is a lump sum payment (Alexsanda28, n.d.).
(c) Like most fixed-income securities, bonds are highly correlated to interest rates. When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have what's called an "inverse relationship" – meaning, when one goes up, the other goes down. The answer lies in the concept of "opportunity cost." Example: Now let's suppose that later that year, interest rates in general go up. If new bonds costing $1,000 are paying an 8% coupon ($80 a year in interest), buyers will be reluctant to pay you face value ($1,000) for your 7% ABC bond. In order to sell, you'd have to offer your bond at a lower price – a discount – that would enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about $875 (Campbell, 2014).
A bond trades at a premium when its coupon rate is higher than prevailing interest rates. A bond trades at a discount when its coupon rate is lower than prevailing interest rates. For example, if a bond with a par value of $1,000 is selling at a premium when it can be bought for more than $1,000 and is selling at a discount when it can be bought for less than $1,000. For a bond to sell "at par" means that it is selling at full face value. When a bond sells at full face value, the coupon rate (or the bond yield) is the same as yield to maturity since bond interest does not compound (Kenny, 2014).
(d)
Bond price = 100 × 6.4177 + 1000 × 0.4224 = 1064.17
Total for 10 bonds = 1064.17 × 10 = 10641.7
Extra amount needed to buy these 10 bonds = 10641.7 – 10000 = 641.7
No. Since the required rate of return (9 percent) is less than the bond’s coupon rate (10 percent), the bond’s price is greater than its par value ($1,000). Thus, the total price of 10 bonds is greater than $10,000. Therefore, Raul does not have enough money to buy 10 bonds if the required rate of return is 9 percent.

5.0 Question 5

(i)
(a) The firm’s beta increases: will increase required return to compensate shareholders for increasing risk.
(b) The firm’s required return decreases: will increase share value or firm’s stock value.
(c) The dividend expected next year decreases: The value of shares decrease.
(d) The rate of growth in dividends is expected to increase: The value of shares increases (Gitman, 2009).
(ii)
(a)    ks = 0.10 + 1.4(0.16 – 0.10) = 0.184
Growth rate of dividends = RM3.40/RM2.70 = 1.259 FVIF3, k = 8%
Po = RM3.40 (1.08)/(0.184 – 0.08) = RM35.31
(b)    ks = 0.10 + 1.6(0.16 – 0.10) = 0.196
Po = RM3.40 (1.08)/(0.196 – 0.08) = RM31.66

(iii) Our basic principle of stock valuation is that the value of a share of stock is simply equal to the present value of all of the expected dividends on the stock. According to the dividend growth model, an asset that has no expected cash flows has a value of zero, so if investors are willing to purchase shares of stock in firms that pay no dividends, they evidently expect that the firms will begin paying dividends at some point in the future.
(iv)
Kc  =  Rf  + β(Km - Rf)
Kc  =  8  + 1.3(12 - 8) = 13.2%
Expected return = 7 + 7 = 14%  (i.e. 7% for earnings and 7% for dividend growth)
Expected return (14%) is greater than the required rate (13.2%). The stock should be bought because the expected return is larger than required rate.

6.0 Question 6

(a)
i = 7%, PMT = $5,000, n = 15
At the beginning of retirement he will have:
FVA = 5,000(FVIFA) = 5,000 × (25.129) = $125,645
Annual retirement benefit:
i = 7%, n = 10, P = $125,645
PMT = PVA ÷ PVIFA = 125,645 ÷ 7.024 = $17,887.96
Therefore the annual retirement benefit will be $17,887.96


(b) PMT= 3,500,000/2.487 = $1,407,318.05
 


(c) A bank would rather advertise the annual percentage rate on loans since this rate appears to be lower and the effective annual rate, With respect to savings accounts, the bank would rather advertise the effective rate since this rate will be higher than the annual percentage rate with compounding frequency greater than annually. As a consumer, the effective rate is the more important rate since it represents the rate actually paid or earned (Gitman, 2009).
(d)
PV Factors:
(2.5771 For the first three years),
(10.371-2.5771=7.7939 for the next 20 years), &
(11.925-10.371=1.554 for the last 17 years).

(2.5771× 25) + (7.7939×30) + (1.554×A) = 360.39
64.4275 + 233.817 + 1.554A = 360.39
1.554A = 360.39 – 298.2445
A = 62.1455 ÷ 1.554
A = 39.991 = RM 40.
Therefore, the equal annual payment to be received from Year 24 through Year 40 is RM 40.

7.0 References

Alexsanda28. (n.d.). Alexsanda28的博客. Retrieved August 07, 2014, from http://blog.sina.com.cn/s/blog_6ec0abf60100puri.html
Campbell, K. (2014). A Guide to the Relationship between Bonds and Interest Rates. Retrieved August 09, 2014, from http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2014/05/29/a-guide-to-the-relationship-between-bonds-and-interest-rates
Gitman, L. J. (2009). Principles of Managerial finance (11th Edition). India: Dorling Kindersley Pvt. Ltd.
Kenny, T. (2014). Premium Bonds and Discount Bonds: Definition and Explanation. Retrieved August 08, 2014, from http://bonds.about.com/od/bonds101/a/Premium-Bonds-And-Discount-Bonds-Definition-And-Explanation.htm
Murillo, R. H. & Martinek, C. J. (2009). Corporate Social Responsibility Can Be Profitable. Retrieved August 11, 2014, from https://www.stlouisfed.org/publications/re/articles/?id=1258
Robins, R. (2011). Does Corporate Social Responsibility Increase Profits? Retrieved August 13, 2014, from http://business-ethics.com/2011/05/12/does-corporate-social-responsibility-increase-profits/
Ukessays.co.uk. (n.d.). Shareholders: Analysis. Retrieved August 13, 2014, from http://www.ukessays.co.uk/essays/accounting/shareholders-different-objectives-achievement.php











   
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