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Managerial Finance Essay

ASSIGNMENT

BMMF5103
MANAGERIAL FINANCE

15 July 2013

QUESTION 1

a) Maximizing shareholder wealth is a “moral imperative” for financial manager means managers are supposed to work for shareholders who are the actual owners of a company or corporation. Shareholders elect company directors who in turn hire managers to run the company on day to day basis with the view to make profit for the company. Managers are paid for their services rendered to the company whereas the shareholders own the company. As such morally managers should pursue policies that enhance shareholder value with the primary objective focused on stockholder wealth maximization.

b) Managers make key day-to-day decisions to maximize shareholder value. But how do the owners of a business know that managers are operating to maximize shareholder value? This lack of information is known as the principal-agent problems. The agent performs the tasks on shareholders’ behalf yet the shareholders cannot ensure that the agent performs precisely the way the shareholders would like.

Agency costs as related to a corporation refers to the costs of preventing agents (e.g. managers) pursuing their own interests at the expense of shareholders. There might be conflicts between shareholders and the company managers. Shareholders who are owners want the managers to make decisions which will increase the share value. Managers who receive salaries prefer to expand the business with the view to increase their salaries which may not necessarily increase the share value. Thus, agency costs tend to decrease the value of a corporation because the rising costs make the share price low when there is substantial debt involved. Costs of monitoring will increase and thus reduce wealth maximization of shareholders.

c) Business ethics is the acceptable set of moral values and corporate standards of conduct in running a business organization. It includes proper business policies and practices such as corporate governance, as a check against insider trading, bribery, discrimination and covers corporate social responsibility and fiduciary responsibilities. Business ethics is a basic framework providing proper conduct, it may be guided by law or put in placeso as to gain public confidence and acceptance.

An example of business ethics is when an employee lie to a potential client to get him to sign for services or purchase the product offered.

Business ethics is important to a corporation because it will determine its reputation. It will give public confidence towards the corporation. It is essential for the long-term survival and success of the corporation in business. Implementing an ethical program will foster a successful corporation culture, values and enhanced profitability. Business ethics will also influence the way the corporations conduct its business and affect all including customers, employees, suppliers, competitors, etc.

d) Advantages

i) There is no maturity period in common stock. Thus, eliminating future repayment obligation and enhances the desirability of common stock financing. ii) There is no obligation for repayment of the funds. Instead, there are others to share the risk of the business investment with. Since there is no debt obligation, there is no finance fee. iii) Issuing common stock can increase firm’s borrowing power.The more common stock is sold, the larger the firm’s equity base. Therefore, the more easily and cheaply long-term debt financing can be obtained. iv) Once capital is raised through stock, the corporation is free to use the proceeds in any way it pleases.

Disadvantages
i) Involves high cost.It may be the most expensive form of long-term financing. Dividends are not tax-deductible and common stock is a riskier security than either debt or preferred stock.

ii) Potential effects of dilution on earnings and voting power. When a company or corporation issues more shares, its financial results must be divided by a larger number of shares, causing dilution. This is because selling of shares of the company means giving each investor a piece of ownership. Because they own the share of the company, the investors have the right to demand explanations and justifications for business decisions.

iii) Market perception that management think. Management issues involve examining perceptions about management and perceptions by management. It includes various judgments regarding the competence of current and future management team as well as issues related to insider buying such as future strategies to increase operations and market share.When management makes large purchases of their own stock with private funds, investors may feel that the company is undervalued or that a favorable company event will occur soon.

e) The three main users of ratio analysis

i) Owners:
The owners of a firm are mainly interested in the firm’s profitability, liquidity and hence survival. Therefore, they need financial ratios to test the performance of their company such as profitability ratios to find outwhether management is able to convert sales dollars into profits and cash flow. The common ratios are gross margin, operating margin and net income margin. The gross margin is the ratio of gross profits to sales. The operating margin is the ratio of operating profits to sales and net income margin is the ratio of net income to sales. The return-on-asset ratio, which is the ratio of net income to total assets, measures a company’s effectiveness in deploying its assets to generate profits. The return-on-investment ratio, which is the ratio of net income to shareholders’ equity, indicates a company’s ability to generate a return for its owners. These ratios are useful to owners of companies.

ii) Creditors
Creditors are interested in a firm’s ability to pay their debts over a short period of time.The ratio analysis will evaluate the firm’s liquidity position. Creditors use liquidity ratio, which is the ratio of current assets to current liabilitiestogauge the ability of the company to pay its short-term bills. A ratio of greater than one is usually a minimum because anything less than one means the company has more liabilities than assets.

iii) Management
Management team comprising financial managers regularly use ratio analysis to evaluate financial policies and decisions they have made. It is the overall responsibilities of the management team to make sure available resources are used most effectively and efficiently and that the financial positions of the company is sound.Management uses profitability ratios to analyze the company’s ability to convert sales dollars into profits and cash flow. For example, the return-on-investment ratio, which is the ratio of net income to shareholders’ equity, indicates a company’s ability to generate a return for its owners.

Examples of ratio formula:
Example 1: Gross margin ratio
Gross Margin =
Gross Profit

Revenue
Gross profit and revenue figures are obtained from the income statement of a business. Alternatively, gross profit can be calculated by subtracting cost of goods sold from revenue. Thus gross margin formula may be restated as: Gross Margin =

Revenue − Cost of Goods Sold

Revenue

Example 2: Operating margin ratio
Operating income is same as earnings before interest and tax. Operating income and revenue figures is available from the income statement of a company. Operating Margin =
Operating Income

Revenue

QUESTION 2

a) There are five different categories of financial ratios. They are:

i) Liquidity ratio is used to measurecompany’s ability to pay its short-term debt obligations. As such, they focus on the firm’s current assets and current liabilities on the balance sheet.The most common liquidity ratios used is the current ratio mainly to give an idea of the company’s ability to pay back its short-term liabilities such as debt and payables with its short-term assets such as cash, inventory and receivables.

ii) Debt ratio is used to measure company’s ability to meet its long-term debt obligations. The ratio indicates what proportion of debt a company has relative to its assets. The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its debt-load.

iii) Financial leverage ratio measure the extent to which a business or investor is using the borrowed money. A company having high leverage is considered to be at risk of bankruptcy in the event the company is unable to repay the debts. The most common financial leverage ratio is the debt-to-equity ratio calculated as total debt divided by shareholders equity

iv) Asset efficiency or turnover ratios measure the efficiency a company uses its assets to produce sales. The most common asset efficiency ratios are the inventory turnover ratio, the receivables turnover ratio, the days’ sales in inventory ratio, the days’ sales in receivables ratio, the net working capital ratio, the fixed asset turnover ratio, and the total asset turnover ratio.

v) The profitability ratios measure the company’s ability to generate a
profit and an adequate return on assets and equity. The ratios measure how efficiently the firm uses its assets and how effectively it manages its operations. An example is the Net profit margin ratio is a ratio of profitability calculated as after-tax net income (net profits) divided by sales (revenue). It shows the amount of each sales dollar left over after all expenses have been paid.

Limitations of financial ratios
i) Although financial ratios can be effective tools for gauging financial performance and managerial effectiveness, they rarely provide answers. Ratios will not say why something is going wrong and what to do about a particular situation; they only pinpoint where a problem is.

ii) There is no international standards on the use of financial ratios. Limitation of ratios interpretation emerges when a particular set of ratios of a company is compared to other company or business. For example, for calculating the inventory turnover one company may use the cost of goods sold as the numerator, while another may use its sales figures. A company may use the operating profit to calculate its total assets turnover, while another may use the net income after taxes.

iii) Benchmark for assessing company’s financial position is needed. Different operating methodologies may be employed to run a company may render the comparison of financial ratios irrelevant. Example, a company prefers to lease most of its assets while another company may own them. Thus, some of the ratios, such as debt to total assets, fixed-charge coverage, total assets turnover, and return on total assets, would be unrelated.

iv) The inflation factor can make the ratio of a particular company look good or bad. Inventory turnover may have deteriorated over a three-year period; the problem may not due to the increase in physical inventory, but rather, to increase in the cost of the goods.

b) Effect of an increase in a company’s debt ratio to its return on equity.

An increase on debt-ratio will be increase in the return of equity. If a company finances itself through debt, the creditors shoulder the risk. If the debt results in increased earnings, the return on shareholder investment is exponential. Total liabilities include both the current and non-current liabilities. The formula to calculate the debt ratio is: Debt Ratio =

Total Liabilities

Total Assets
Return on Equity is expressed as a percentage and calculated as:

ROE = Net Income/Common Equity

c) Long-term interest rate = (RM13,000,000) (8/100) = RM1,040,000 Short-term interest rate = RM1,300,000 – RM1,040,000 = RM260,000 Short-term interest rate = RM260,000/RM1,546,000 = 0.168
Rate of interest on notes payable is 16.8%

d) Changes in value of equity (in millions)

(RM in millions)
Shareholders’ beginning equity
537
Shareholders’ ending equity
485
Difference beginning & ending equity
52
Net income
128
Less: Paid dividends
57
Difference
71
Stock/shares purchased in the year (52+71)
123

Shares purchased throughout the year is RM123 million

e) If the current ratio of corporation is 5.65 when industry average is 1.42, this disparity means that the corporation is having:

i) an excess build-up in inventory. When the corporation holds a high level of inventory, it ties up business funds that could have been used in other areas such as in development or marketing. The cost of the inventory is not recovered by the corporation until it sells the inventory.

ii) aged account receivables which is the amounts owed to the company by its customers. The corporation’s account receivables reports will identify problems with receivables management process and identify accounts that require collection action.

QUESTION 3

a) Although ownership of stock represents ownership in a company, not all stock is created equal. Therefore there are two basic types of stock: common stock and preferred stock. Preferred stock is sometimes referred to as a hybrid security because it has features of common stocks and bonds. A company’s preferred stock trades independently of its common stock and offers preferred stockholders a different set of benefits. Preferred stocks paid amount of dividends just as fixed interest bond. It is not debt but equity like common stocks.

b) Preferred stock par value of RM100 with annual dividend 10%. Annual rate of return is 11.5%. i) RM100 X10/100% = RM10.

Yield of 11.5%
11.5%/100 = 0.115
= RM86.96

ii) As the risk-free rate increases, the required rate of return will increase and the price will drop. When rates increase, the price of the preferred stock will likely fall. If price falls, the issuer will likely call the preferred stock and replace it with a new preferred stock issue at a lower rate, conventional debt, or perhaps even common stock

c) RM4.63(1+0.05)/(0.12-0.05) = 4.8615/0.07 = 69.46
The value of the company’s stock if the required rate of return is 12% is RM69.46

d) Before change in price per share, r =5% + (8% -5%) beta 1.3 = 8.9%

After change in price per share, r = 4% + (10% – 4%) 1.5 = 13%

Therefore, the change in price per share is RM4.87

e) Formula for constant growth is rs = r RE + (rm – rRE)b
= 6% + 5% (1.4) = 13%
2013 = RM0 dividen
2015 = RM1.00
2016 = RM1.00 (1.2) = RM1.20
2017 = RM1.00 RM1.44
2018 = RM1.00 RM1.728
2019 = RM1.00 RM1.849
Calculate growth between constant rate
=

The price of the stock is RM20.16
QUESTION 4

a) Needs RM40,000/year during retirement period
n = 10 yrs, i = 9 %
PVA = PMT (PVIFA) = RM40,000 (9.129) = RM365,160
PV = RM365,160 (0.422) = RM154,097.52

The Mirians should deposit RM154,097.52

b) Model A: PV = PMT (PVIFA) = RM5,000 (3.993) = RM19,965
Model B:
Year
Payment (RM)
PVIF
PV
1
7,000
0.926
6,482
2
6,000
0.857
5,142
3
5,000
0.794
3,970
4
4,000
0.735
2,940
5
3,000
0.681
2,043
Total:
20,577

I would purchase/buy model A because it is cheaper by RM612 compared to model B.

c) Which option to be chosen?

Option 1
PMT = RM3,500/2.487 = RM1,407,318.05
Option 2
PMT = RM3,500/3.102 = RM1,128,304.32
Option 3
PMT = RM3,500/3.605 = RM970,873.79

The company should choose option 3 because lower by RM157,430.53 compared to option 2 which is second lowest

d) Present value is exact invest of the compound interest calculations. Applying compound interest calculation is to find the future value of a present amount. Using the present value calculation a present value amount is found to be received in future.

e) Over certain period the principle amount increases as a result of the installment payments resulting in lower amount of interest that is charged by the bank.

QUESTION 5

a) When an investor buys a bond, the investor is lending money to the bond issuer, which could be a government, corporation, etc. The issuer promises to pay a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it “matures,” or comes due after a set period of time. Thus bonds provide interest payment and principal payment. Payment of interest is done annually or semi-annually. Coupon payments are paid periodically. When bond matures a principal sum is paid which is a lump sum payment.

b) Bond prices and interest rates are related. Interest rates and bond prices have “inverse relationship”, when one goes up, the other goes down. If interest rates is high enough, bond prices would fall. If interest rates is low, bond prices would rise. Prices of short-term bonds do not fluctuate more often compared to long-term bond. Premium bond is sold when the stated rate of interests exceed the required rate of return.

Example, if rates dropped to below original coupon rate of 7% for RM1,000 bond, it would be priced at a premium since it would be carrying a higher interest rate than what was currently available in the market. A bond will sell at a discount when the stated rate of interest is less than the required return. Bond is sold equal to the par value when the stated rate of interest is equal to the required return.

c) Param does not have enough money to buy 10 bonds if the required rate of return is 9%. This is because the required rate of return which is 9% is less than the coupon rate of the bond which is 10%. The price of the bond is greater than the par value of RM1,000. Considering there are 10 bonds, the total price is greater than RM10,000. That is the reason why Param would not have enough money to buy the 10 bonds.

d) FV = RM1,000
PMT =150
N = 10
PV = RM1,250
1/YR = 10.79%

e) Interest rate risk is the risk of decline in bond values due to the increase in interest whereas reinvestment risk is the risk of an income decline due to a drop in interest rates. Bond holders who bought long-term bond is greatly at risk to the interest rate risk.

QUESTION 6

a) [(RM18+RM4+RM3+RM2-RM24)/24] X 100% = 12.5%.
Therefore, Billie jean’s realized rate of return during the three years holding period is 12.5%

b) (i)
Stock 1
8 + 0.8 (12 – 8) = 11.2%
Stock 2
8 + 1.2 (12 – 8) = 12.8%
Stock 3
8 + 0.6 (12 – 8) = 10.4%

(ii) Stock 3 is undervalued due since E (R) ≥ RR

c) Beta is the measurement for market risk which is non-diversifiable. The risk must be dealt with by the portfolio manager. Diversifiable risk should be diversified away by portfolio manager so that it would not pose a problem to the investment. As such all market risks is all relevant to the portfolio manager since it is his job and responsibility in balancing the likely risk and return.

d) The situation suggest that investors are more risk adverse compared to before the shift taking place. On the portfolio, a risk premium of 11% (16% – 5%) is required whereas previously 10% (15% – 5%). If slope were to change downward, it means investors are less aversion to risk.

e) Expected return: 0.9(12%) + 0.1 (20%) = 12.8%
Beta: 0.9(1.2) + 0.1(2.0) = 1.28%


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