Financial Asgmt 3.doc

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INTRODUCTION

As a financial manager of Glee Plc., I have to estimate the cash flows of thecompany for all periods in the future where the decision under consideration has animpact on the cash flows.

Moreover, I have to use some investment appraisal method in order to analyzedecisions which are positive for some periods, and negative for others. I have tounderstand the time value of money in order to proceed correctly.

The incremental cash flows estimated here are typically uncertain, and I have totake into account that some cash flows are certain, whereas others depend on the state of the economy.

SOURCES OF FINANCE

Definition

Debt financing means when a business owner, in order to raise finance, borrowsmoney from some other source, such as a bank. The business owner has to pay back thisloan or debt within a pre-determined time period along with the interest incurred on it.The lender has no ownership rights in the borrower's company. Debt financing can be both, short term as well as long term.

Equity financing means when a business owner, in order to raise finance, sells a

part of the business to another party, such as venture capitalists or investors. Under equityfinancing, the financier has ownership rights equivalent to the investment made by him inthe business, or in accordance with the terms and conditions set between him and the business owner. This is the main difference between debt financing and equity financing.In equity financing, the financier has a say in the functioning of the business as well.

Differences between Debt Financing and Equity Financing

a) Process: Procedure of raising money through debt financing is easier, than raisingmoney through equity financing. In equity financing, there are a number of securitylaws and regulations, which have to be complied by the business. Such rules are notapplicable for debt financing.

b) Ownership Rights: In debt financing, the business owner has full control andownership of the business. In equity financing, the investor or the venture capitalisthas ownership rights, as well as decision making power, in running the business.

c) Rights over Profit: In debt financing, the lenders only have a right over the principalloan and the interest incurred on it. They have no rights over the profits or revenues



generated by the business. Once the loan is repaid, the relationship between the lender and the business owner also, ends in debt financing.

d) Ease of doing Business: In debt financing, decisions and rights regarding running the business, solely lie with the owner. Whereas in equity financing, the shareholders and

investors have to be updated and consulted about the business regularly. So, it iseasier to do business with debt financing, than with equity financing.

e) Repayment: In debt financing, the business debt has to be paid back within a given period of time. If for some reason, the business does not make enough profits or isgoing through a loss, there is a lot of pressure on the business owner to repay, as anincreased time period of repayment means an increased interest on the loan. As far asequity financing is concerned, the pressure to repay is comparatively lesser. Therevenue which the business makes is used to repay the lenders.

f) Cost to Company: In debt financing, the loan amount is already known and fixed, so

the business owner can make a provision for it beforehand. Also, the interest incurredon loan in debt financing can be deducted from the corporate tax . Thus, cost tocompany in debt financing is easy to forecast, plan and reimburse. On the other hand,in equity financing, if the business generates huge profits, the investor and the venturecapitalist have to be paid back money, which is much in excess of the amount theyinvested.

g) Future Funding: If the investors are backing the business, there will be no problemin arranging finance for the business in future, as investors lend credibility to a business and lenders will have no reservations in giving loans to such businesses.Thus, equity financing improves the scope of arranging financing for the business infuture. However, if the business has taken too much loan, that is, its debt to equityratio is on a higher side, the investors will not like to invest in such a business as it's a"high risk" venture.

Thus, after comparing debt financing and equity financing, it can be concludedthat both have their pros and cons. Ideally, a business should have a mix of debt andequity financing with the debt amount comparatively low, so that debt management becomes easy. However, it's up to the owner of the business to decide where his preferences lie. A business owner, who wants full authority over the business, shouldchoose debt financing .While an owner who is willing to share his risks and profitsshould opt for equity financing.

Equity shares, preferences shares and debentures

A company which required capital on a huge amount will have to take on a capitalstructure consisting of equity shares, preferences shares and debentures. Thus, thecompany is able to attract all curriculum of investor.



Advantage

• A company among this pattern of capital structure can benefit from advantage of the

entire pattern started above.

• The market of the company’s securities is significantly widened; debentures can draw

the most traditional investors. Preference shares can pull towards you those investors

who are prepared to face a few risks if returns are a little high. Equity shares cantempt those investors who are venturesome and bold enough to bear all risks of business.

• Full reimbursement of trading on equity can be understood from this type of capital

structure. Dividend rate on preference shares and rate of interest on debentures beingrelatively small, high dividend rate can be offered to the equity shareholders.

• This is a very supple model of capital structure. Supplementary capital can be without

difficulty raised when required and burden of interest expense can be abridged byreimbursement to debentures holders when possible.

• It is the majority inexpensive pattern of capital structure.

Disadvantage

• Throughout despair, interest payment on debentures and dividend payment on

preference shares is a trouble on the company.

• This is a most difficult prototype of capital structure and makes financial management

difficult.

• The executives are not free to contract with the earnings of the company as they hope.

• Surprising problems cannot be met by raising added finance, if the company is burden

with debt.

• Equity shareholders earn no dividend when company’s earnings are low. Whatever

profit is earned, it gets distributed among preference shareholders and debenture

holders.• It follows that, though this type of capital structure is the best, different kinds of

securities must be carefully and cautiously used for raising finance.

CAPITAL STRUCTURE

Traditional Approach

Traditional approach is an intermediate approach between the net income approachand net operating income approach. According to this approach,a) An optimum capital structure does exist. b) Market value of the firm can be increased and average cost of capital can be reduced

through a prudent manipulation of leverage.c) The cost of debt capital increases if debts are increases beyond a definite limit. This is

because the greater the risk of business the higher the rate of interest the creditors



would ask for. The rate of equity capitalization will also increase with it. Thus thereremains no benefit of leverage when debts are increased beyond a certain limit. Thecost of capital also goes up.

Thus at a definite level of mixture of debts to equity capital, average cost of capital

also increases. The capital structure is optimum at this level of the mix of debts to equitycapital. The effect of change in capital structure on the overall cost of capital can bedivided into three stages as follows;

a) First stage

• In the first stage the overall cost of capital falls and the value of the firm increases

with the increase in leverage. This leverage has beneficial effect as debts as debts areless expensive. The cost of equity remains constant or increases negligibly. The proportion of risk is less in such a firm.

b) Second stage

•A stage is reached when increase in leverage has no effect on the value or the cost of capital, of the firm. Neither the cost of capital falls nor the value of the firm rises.This is because the increase in the cost of equity due to the assed financial risk offsetsthe advantage of low cost debt. This is the stage wherein the value of the firm ismaximum and cost of capital minimum.

c) Third stage

• Beyond a definite limit of leverage the cost of capital increases with leverage and the

value of the firm decreases with leverage. This is because with the increase in debtsinvestors begin to realize the degree of financial risk and hence they desire to earn ahigher rate of return on equity shares. The resultant increase in equity capitalization

rate will more than offset the advantage of low-cost debt.• It follows that the cost of capital is a function of the degree of leverage. Hence, an

optimum capital structure can be achieved by establishing an appropriate degree of leverage in capital structure.

M&M Proposition I

M&M Proposition I states that the value of a firm does not depend on its capital structure.For example, think of 2 firms that have the same business operations, and same kind of assets. Thus, the left side of their Balance Sheets looks exactly the same. The only thing

different between the 2 firms is the right side of the balance sheet, i.e. the liabilities andhow they finance their business activities.



In the first diagram, stocks make up 70% of the capital structure while bonds (debt) makeup for 30%. In the second diagram, it is the exact opposite. This is the case because theassets of both capital structures are the exactly same.

M&M Proposition 1 therefore says how the debt and equity is structured in a corporationis irrelevant. The value of the firm is determined by Real Assets and not its capital

structure.

M&M Proposition II

M&M Proposition II states that the value of the firm depends on three things:a) Required rate of return on the firm's assets (Ra) b) Cost of debt of the firm (Rd)c) Debt/Equity ratio of the firm (D/E)

The formula for Weighted Average Cost of Capital (WACC) is:

The WACC formula can be manipulated and written in another form:

The above formula can also be rewritten as:

This formula #3 is what M&M Proposition II is all about.

WACC = [Rd x D/V x (1-5)] + [Re x E/V]

Ra = (E/V) x Re + (D/V) x Rd

Re = Ra + (Ra - Rd) x (D/E)



Analysis of M&M Proposition II Graph

• The above graph tells us that the Required Rate of Return on the firm (Re) is a linear

straight line with a slope of (Ra - Rd)

• Why is Re linear curved and upwards sloping? This is because as a company borrows

more debt (and increases its Debt/Equity ratio), the risk of bankruptcy is even morehigher. Since adding more debt is risky, the shareholders demand a higher rate of return (Re) from the firm's business operations. This is why Re is upwards sloping:

• As Debt/Equity Ratio Increases - > Re will Increase (upwards sloping).

• Notice that the Weighted Average Cost of Capital (WACC) in the graph is a straight

line with NO slope. It therefore does not have any relationship with the Debt/Equityratio. This is the basic identity of M&M Proposition I and II, that the capital structureof the firm does not affect its total value.

• WACC therefore remains the same even if the company borrows more debt (and

increases its Debt/Equity ratio).

Implication of Cost of Capital on Capital Structure

Capital structure can be determined on the basis of an estimate of the cost of various sources of finance. Since the rate of interest on debentures is comparatively lowand interest payments are tax deductible, the cost of debentures is quite low. The cost of preference share capital is also low, though not as much as that of debentures. As against



this, the cost of equity share capital is relatively high. The cost of retained earning islower than that of equity share capital, if it is used to finance business operations.

This is because it does not give rise to floatation cost. But if cost of capital is thesole consideration, then only debts would have to be regarded as the most preferable

source of capital. This implication is not tenable. Because, in practice, various sources of capital are so interrelated that the use of one invariably affects the other. For instance, if debts are used to a large extent, the company will have to face greater risk and it will loseall chances of taking advantage of debts as a source of finance in cost of entire capitalfunds while deciding the capital structure of the company.

With the increase in fixed obligations, the degree of risk of default increases and astage if reached when creditors ask for a high return. Also the equity shareholders beginto expect a higher rate of dividend. Consequently, if debts are used beyond a safe limit,the market value of company’s shares declines and cost of capital goes up. The point atwhich safe limit of debts is reached may be called the point of optimum capital structure.

Every company would try to adhere to this point of safe limit making proper adjustmentsin capital structure according to changing circumstances.

APPRAISAL TECHNIQUE

Net Present Value (NPV)

The investment appraisal measure I wish to propose here is the net present value,or NPV. The NPV of a project is defined as the present value of all future cash flows produced by an investment, less the initial cost of the investment.

Let Xt denote the dollar cash flow in time t and N the number of such cash flows.In addition let r p denote the required rate of return and I the initial investment outlay. The NPV is defined as:

In determining whether to accept or reject a particular projected, the NPV

decision rule isAccept a project if its NPV > 0;Reject a project if its NPV < 0;

In other words, we accept all and only those proposals that have a positive net present value, and reject all others.



Meanwhile, there are several alternatives to the NPV rule. These evaluation techniquesinclude:

• Internal Rate of Return (IRR)

• Payback Period

• Profitability Index

Internal Rate of Return (IRR)

The internal rate of return, IRR, of a project is the rate of return which equates the net present value of the project’s cash flows to zero; or equivalently the rate of return whichequates the present value of inflows to the present value of cash outflows. The internalrate of return (IRR) solves the following equation:

In determining whether to accept or reject a particular project, the IRR decision rule is

Accept a project if IRR > r pReject a project if IRR< r p

Here r p is the required return on the project. Hence, the IRR rule reverses the logicof the NPV rule. When we compute NPVs, we calculate the NPV for a given discountrate on the project, and accept a project whenever the NPV is positive. If we use the IRR rule, we calculate that discount rate that makes the NPV equal to zero. Both methods arerelated.

A typical investment proposal will have cash outflows from capital expenditure at

the beginning, followed by cash inflows. Then the NPV is a decreasing function of thediscount rate. Hence, if the NPV is zero for some discount rate, it is positive for alldiscount rates below that, and negative for all discount rates above this. In this case bothmethods come to the same conclusion.

Payback Period (PP)

The payback period, PP, is the length of time it takes to recover the initialinvestment of the project. To apply the payback period criterion, it is necessary for management to establish a maximum acceptable payback value PP*. In practice, PP* isusually between 2 and 4 years. In determining whether to accept or reject a particular project, the payback period decision rule is:

Accept if PP < PP*Reject if PP > PP*

For mutually exclusive alternatives accept the project with the lowest PP if PP<PP*



The pay back method has the advantage of being quick and simple, but it has two major disadvantages as well.

• It considers only cash received during the pay back period and ignores anything

received afterwards.

• It does not take into account the dates on which the cash is actually received. So, it is

possible to have two projects both costing the same, with the same payback period, but with different cash flows, such that one has a better, earlier cash flow than theother.

Payback Period: accounting for money at risk

One of the attractions of the payback period is that it provides some measure of the "money at risk". At the start of the project we are presented with a lot of uncertaintyabout future cash flows, and the economic environment and our cash flows may turn outmore or less favourable than we initially anticipated, with uncertainty being larger for

those cash flows in the more distant future. However, the payback criterion is the wrongmethod to account for that. There are two tools for analyzing the risk associated withmore distant cash flows. The first concerns the setting of discount rates. We shall seelater that discount rates can be decomposed into a risk-free rate, which is a compensationfor the time value of money, and a risk premium, which rewards investors for risk.

Hence, the discount rate is:Discount rate = Risk free rate + Risk premium

In addition to this, we know much less about the more distant future than theimmediate future, and we would typically change the design of a project if circumstances

change in the future. Hence, we need to reflect the fact that one project commits our money for a short period of time and another one for a long period of time in our analysis, because projects with longer time horizons give us somewhat less flexibility.We shall see later in the course that this argument has also some merit, because flexibilityhas economic value.

However, the appropriate tool for analyzing flexibility is decision tree analysis or option analysis (so-called "real options"). We can extend NPV analysis and allow us toquantify the value of flexibility and of "money at risk" by using decision trees and realoption analysis. Using payback period is an illegitimate shortcut.

CONCLUSION

Recommendation



It is essential for Glee Plc. to make with an evaluation of the margin starting fromthe investment of the funds the plans of company to increase it. If the funds must beincreased by obligations, the company should support a burden of payment of theinterests. Consequently, the margin in the future must be enough large to make it possible

the company to carry out the payment of the interests without any difficulty. If the marginis unsatisfactory, the company will not be able to pay the interest regularly andconsequently it will have to face financial insolvency. Consequently invested capitalshould be envisaged on the basis of evaluation of future margins.

Glee Plc. which in the future does not hope to have great margins should not use agreat number of debts in their invested capital. Somebody suggested that the margin of the company under very unfavourable conditions should be examined. The debts should be radiated in such an amount that the farm can be to invoice them with fixed interest of able gathering even under adverse conditions such as a recession, and at the same time itcan have a minimum balance of treasury.

APPENDICES

Weighted Average Cost of Capital (WACC)

Glee Plc. has issued 10,000 units of bonds that are currently selling at 98.5. The couponrate on these bonds is 6% per annum with interest paid semi-annually. The maturity lefton these bonds is 3 years.

The company has 2,000,000 common shares outstanding with the current stock price at£10 / share. The stock beta is 1.5, risk free rate for government bonds is 4.5% and theExpected Return on the Stock Market is 14.5%.

The tax rate for the corporation is 30%

Bond Calculations Stock Calculations

N = 3 x 2 = 6I/Y = ? (Rd)PV = 0.985 x 10,000 x $1000 = $9,850,000 (D)PMT = (-10,000,000 x 0.06) / 2 = $-300,000

FV =$

-10,000,000P/Y = 2C/Y = 2Solution: I/Y = 6.56%

Re = Rf + B[Rm - Rf]Re = 0.045 + 1.5 [0.145 - 0.045]Re = 0.045 + 0.15 = 0.195 (19.5%)

Market Value of Equity = E

Stock price x common shares O/S$10 x 2,000,000 = $20,000,000



V = Total Capital Structure

V = 9,850,000 (bonds debt) + 20,000,000 (equity of common shares)V = 29,850,000

Summary of Important Terms

Rd = 6.56% = 0.0656D = 9,850,000V = 29,850,000D/V = 9,850,000 / 29,850,000

Re = 0.195E = 20,000,000E/V = 20,000,000 / 29,850,000 = 0.67(1-T) = (1 - 0.3) = 0.7

WACC = [Rd x D/V x (1-5)] + [Re x E/V]

[(0.0656) (0.33) (0.7)] + [(0.195) (0.67)]= 0.01515 + 0.1307 = 0.1458 -> 14.58%

Interpretation of WACC

A WACC of 14.58% means Coco Corp. must earn a return of 14.58% on all its assets and business operations in order to MAINTAIN the current stock price at $10 per share. If Coco Corp. wants its stock price to go higher, it must achieve a return rate greater than14.58%

Net Present Values (NPV)

In order to illustrate the computation of Net Present Values, we consider an example of Glee Plc. with the following investment proposal:

Assuming that the required rate of return for this project is r p = 10%, is this a worthwhileinvestment for Glee Plc.?

Applying the NPV rule here requires the calculation of the present value of the futurecash flows followed by a comparison with the investment cost of £100million.



Since NPV < 0 we reject this proposal.

Internal Rate of Return (IRR)

Suppose Glee Plc. whose required rate of return is 10% is considering a project with thefollowing cash flows:

Is this a worthwhile investment?The internal rate of return of this project is the rate of return that solves:

Note that we have to interpolate or use an iterative technique such as Excel’s Solver tofind the IRR in this case.The internal rate of return of this project turns out to be 21.86%. Applying the decisionrules above, we would accept the project since

IRR > r p (i.e., 21.86% > 10%).

The graph below shows the NPV of this project using various discount rates.



We can see that the NPV of the project decreases as you increase the discount rate. The NPV-function cuts the horizontal axis at the IRR of 21.86% in this case. For all discountrates above 21.86% the NPV of the project is negative, for all discount rates below theIRR the NPV of the project is positive, and since the discount rate is 10%, the project

should be accepted. Both decision rules come to the same conclusion.

Payback Period (PP)

Suppose Glee Plc. is considering two mutually exclusive projects, C and D, where thefirm’s required rate of return is 10% and the projects’ cash flows are:

The payback method dictates that project C should be accepted, however the NPVindicates that if C is accepted, the share price will fall. It appears that the payback methodis not consistent with the goal of shareholder wealth maximization. The problems withthe payback method are that:

• It ignores the time value of money

•

It ignores the cash flows that occur after the payback period• It ignores the scale of investment

Payback Period: accounting for money at risk

Suppose the risk free rate of Glee Plc. is 10% and the required risk premium is 5%. Thenwe obtain the following relationship between the discount rates and the time horizon:

The picture emerges quite clearly: the risk premium reduces the value of one dollar at theend of period 1 from $0.91 to $0.87, or by 3.95 cents or 4.35%. However, dollars at theend of period 2 are reduced substantially more by 7.03 cents or 8.51%, and the reduction



increases with the time horizon. Hence, our NPV criterion, with appropriately setdiscount rates already accounts for the fact that risk increases with the time horizon.

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