Corporate Finance Report: Financial Analysis and Recommendations

This report provides a detailed analysis of corporate finance principles. It begins with an introduction and table of contents, followed by an in-depth examination of key concepts. Part 1 analyzes the relationship between volatility and returns, the calculation of required returns using treasury b...Read More

CORPORATE FINANCE

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................3
MAIN BODY..................................................................................................................................3
PART 1............................................................................................................................................3
1...................................................................................................................................................3
2...................................................................................................................................................3
3...................................................................................................................................................3
4...................................................................................................................................................3
5...................................................................................................................................................3
6...................................................................................................................................................3
PART 2............................................................................................................................................3
7...................................................................................................................................................3
8...................................................................................................................................................4
9...................................................................................................................................................6
10.................................................................................................................................................7
REFERENCES..............................................................................................................................10

INTRODUCTION
MAIN BODY
PART 1
1.
a.
b.
d.
2
b.
3
a
d
4.
b.
c.
5
a.
b.
c.
6.
d.
PART 2
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(a)
The chart depicts that the volatility of the stocks and the returns are positively relate in the case
of large portfolios because of the n large portfolios the risk element is comparatively higher and
it can be said that the higher risk indicates higher return as well. Hence, the volatility is
positively related to the larger portfolios. The individual stocks on the other hand are the ones
where the volatility is comparatively lower because the risk and the movement in the market are
also lower. Therefore, the volatility is not positively related to the returns form individual stock.
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(b)
The required return on the combination of treasury bills and S&P 500 stock is equivalent to the
return that will be earned on the world stock. Therefore, it can be termed that the expected return
of the individual i.e. me is equivalent to that of the world stock and can be termed as 10%. Now
the complete portfolio can be calculated in the following manner:
Expected return: WA * RA + WB * RB
Here,
WA = Weight of security A i.e. treasury bills
RA = Expected return of security A i.e. treasury bills
WB = Weight of security B i.e. S&P 500 stock
RB = Expected return of security B i.e. S&P 500 stock
Therefore in such manner the weights of the two different stocks and security can be identified
as:
10% = WA * 4% + WB * 12%
0.10 = 0.04 WA + 0.12 WB
0.10 = 0.04 (WA + 0.3 WB)
2.5 = WA + 0.3 WB
Now since the weight collectively will total to 1, the weights can be ascertained on the basis of
the fact that WB = 1 – WA
Hence, this can be substituted in the equation above:
2.5 = WA + 0.3 (1 – WA)
2.5 = WA + 0.3 – 0.3 WA
2.8 = 0.7 WA
WA = 4 i.e. 40%
WB = 1 - WA i.e. 1- 40% = 60%
Now this concludes that the weight of security A i.e. treasury bills should be 40% and that of
S&P 500 stock should be 60%.
8.
a.
It is right to say that cost of debt is cheaper than cost of equity since the debt is less risky
is easy to compensate the debt investors as the firm is required to return lower in comparison to
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the equity investors. Debt is less risky in comparison to equity because the fixed amount is being
paid which is compulsory in nature which is also being paid in priority to the dividends. Another
important fact is that of different corporate tax treatment in respect to interest and dividends. In
profit and loss account, interest is deducted prior to tax calculation therefore, companies get the
advantage of tax benefit or relief on interest.
It is true that increasing debt in the capital structure leads to lower cost of capital. It is
always advisable to replace the most expensive equity with the debt through issue of bonds of
buy back of shares which will help in reducing the weighted average cost of capital. However,
issuing more debts would mean that company ahs to pay more fixed amount of interest which
leads to increase in volatility of the dividend payment as in case of poor year, the company
would be obliged to payment interest and this will affect its ability to pay dividend to its
shareholders. This will lead to increasing the volatility of dividend payment also referred to as
increase in the financial risk to the shareholders. If this risk to shareholders increases then the
company would be required to provide greater return to compensate them and therefore, cost of
equity will increase leading to increase in cost of capital. Thus, CEO needs to know that issuing
more debt will lead to reduction in WACC but more debt would increase the WACC because of
increase in gearing and financial risk as well as beta equity and cost f equity for WACC.
b. Yes, the issuance of bonds will be beneficial to the company, its shareholders and the owner as
well. The excess of equity for financing the capital requirement will lead to the fall in the
earnings per share as the number of shareholders will increase. Debt on the other side, will help
the company in taking the advantage of leverage which result in increase in earnings per share
and return on equity for the shareholders. It is beneficial only if the return on investment is more
than the cost of debt. Some of the key benefits of it are stated below.
Enhance return to shareholders
Issuing bonds will lead to increasing the return to shareholders as the interest on bonds is
less than the interest on the bank loans which will lead to higher net profits resulting into higher
earnings per share. Issuing bonds will not increase the shareholders base hence the profits will be
distributed among the existing shareholders.
Lower tax liability
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Interest paid on the bonds is tax deductible which will result into reducing the taxable
income of the company which lowers the tax liability as well. This was not possible in case of
equity and the dividends are paid post taxing the net profits.
Lowers cost of capital and ownership protection
Issuing bonds will reduce the cost of capital of the company and also helps in managing
the existing ownership and controlling interest of the company. Company can raise capital
without compromising on the controlling interest of the existing shareholders.
9.
Information provided:
Number of shares = 1 million
Excess cash available = £1 million in year 0
Funds required to invest in year 2 is £11.5 million in return of £11.9 million in year 3.
a.
The firm is raising money through issuing new shares at the price of £8.11 per share.
Value of fixed asset is A = £12 million
Since the value of assets is £12 per share which implies that the 1 million shares will amount to
£12 each share as compared to 8.11 per share. Thus, it is not beneficial for the firm to invest in
the plan by raising money through issuing new shares at the rate of £8.11 per share as it will
lower the value of the company at the end of year 3.
In case the fixed assets, A, amounts to £6 million then the company can invest in the project as
the 1 million shares will amount to £6 per share which is beneficial for the company as it
increases its value of the company.
b.
It is assumed that in case (a), the firm issues new shares of £10.5 million at the price of £8.11 per
share. But it does not invest and comes up with the plan to repurchase its shares.
Repurchase price = £11.55 per share
Number of shares = £10.5 million/£8.11 = 1.29 million shares
Total repurchase cost amount = 1.29 million * £11.55 = £14.9 million
Here, it incurs the loss of £4.4 million (£14.9-£10.5).
Issuing new share
Amount raised = £11.5 million
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Issue price = £8 per share
Number of share issued = £11.5/£8 = 1.44 million shares
Firms existing assets = £12 million
Value per share = £12 million / 1.44 shares = £8.3 per share
Since, the value per share is almost equal to the issue price of the shares, thus, it is
notfavourable to invest in the project.
From the given alternatives it is better to choose option (iii), that is, do nothing in the year two.
In case if A = £6 million
Value per share = £6 million / 1.44 shares = £4.28 per share
In case if A = £9 million
Value per share = £9 million / 1.44 = £6.25 per share
Under both the above conditions, firm can invest in the project as the issue price is more
than the asset price per share.
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(a)
After tax WACC
WACC = (E/ V * Re) + [D/V * Rd * (1 - Tc)]
Where,
E = Equity value of firm
D = Debt value of firm
V = E + D
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate
Here, in the present scenario, this can be calculated as:
E = 2
D = 1
V = 3
Re = 15%
Re = 9%
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Tc = 40%
Ultimately,
WACC = (2 / 3 * 15%) + [ 1 / 3 * 9% * ( 1 – 40%)]
WACC = (0.1) + [ 0.03 * (0.6)]
WACC = (0.1) + 0.018
WACC = 0.118 i.e. 11.8% is the WACC after tax for the company
(b)
Value of a company = Present value of the future cash flows which are discounted using the
WACC rate.
Year Cash Inflow PV of 11.8% Present Value
2019 2000 0.8944 1788.8
Total value at the start of 2020 1788.8
Therefore, the value of the company using the WACC method at the start of the year 2020 is £
1788.8 million.
(c)
Company stock pricing = Equity value of the company / The shares outstanding
The equity value is basically the value of the market capitalization i.e. the total value of existing
equity in the company.
The shares outstanding can be termed as the stock of a company that is currently being help by
the shareholders. These are basically the restricted shares that are in possession o the
shareholders in the form of share blocks.
In order to calculate the stock price of the company, the equity value i.e. the total value in the
form of equity shares can be divided by the outstanding shares as these are the only shares that
the company currently owns.
Now the company’s equity value can be calculated as:
Market value of total assets – market value of total liabilities
These can be ascertained from the balance sheet of the company.
It can be identified that in the beginning of the year 2020, company had £ 200 million of excess
cash in the company. Additionally the company incurs the working capital of 10% of the sales
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for the next year and this remains constant. Now the working capital is itself not included in the
balance sheet, but there are several current assets and liabilities in the working capital that are
included in the balance sheet of the company. Now since the company is incurring the positive
working capital balance f 10% of the sales of the next year, it can be ascertained that the sales of
the year 2020 would be £ 2300 million. Therefore the working capital of the company would be
10% of £ 2300 million i.e. £ 230 million. Therefore collectively the assets of the company in the
balance sheet would be depicted at £ 230 million + £ 100 million i.e. at £ 330 million. Now the
liability of the company lies at the level of £ 100 million in the company. Therefore the equity
value can be ascertained as:
Equity value = £ 330 million - £ 200 million
= £ 130 million
Now ultimately the stock pricing of the company can be ascertained as:
Company stock pricing = E. V / Outstanding shares
= £ 130 million / £ 100 million
= £ 1.3 per share
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REFERENCES
Books and Journals
Online
[ONLINE] Available through :<>
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