MGT201 Final Term Subjective 2012

MGT201:::Final Term Subjective

Why firms not prefer Debt financing

Based on CORPORATE TAXES, FIRMS should prefer to raise Capital using DEBT Financing rather than equity as there is saving associated with capital raised through this source.

WHY WE USE WACC?

It is the best way to calculate the net present value of a project because it takes into consideration all the sources of capital. For example, for a project to be desirable it has to first need to satisfy the desired rate of return of different fund providers. But we know that there are different sources of funds. It doesn't just come from one source. We know that NPV/Initial Cost Outlay = % rate of return. A project may for example provide a 10% rate of return. The company's banker may nod on it if its minimum rate of return before it lends the company some money is only 5%. But how about if the stockholders want as much as 15%? WACC based on market value is the best way to solve these variations in interests and costs of providing funds. If you use WACC, you are deemed to consider both the cost of debt and equity. So in a way your question is wrong.

WHAT IS MERGER? IS IT HARMFUL OR BENEFICIAL? EXPLAIN AND JUSTIFY. STRATEGIES TO PROTECT FIRM FROM EXCHANGE RATE RISK

Definition of 'Merger'

The combining of two or more companies, generally by offering the stockholders of one company securities in the acquiring company in exchange for the surrender of their stock. Basically, when two companies become one. This decision is usually mutual between both firms

Firm A has to decide whether to maintain large amount of current assets or small amount. What can be the possible benefits the firm can enjoy from both of these?

Advantages of Large Current Assets: less risk of shortages & interruptions and less loss of sales due to availability of funds for loan payments and purchases and inventory. High Liquidity so better CREDIT Rating. Advantages of Small Current Assets: Less investment in current assets means less amount of money tied to the assets which are generating no return. So lower Opportunity Cost of Capital.

Split from dividend stock=3

When a company decides to issue a stock split (or stock dividend), a couple of possibilities could occur concerning what would happen to an upcoming cash dividend. The most important factors are the time the stock split happens and the time of the cash dividend's record date. Typically, a cash dividend will not be issued to new shares that were created from a stock split if the split date occurs after the dividend's date of record. This is similar to how an investor does not receive dividends for stocks that he purchased after the dividend's record date.

Difference between Capital Market and Money Market. 3 Marks

Capital Markets: These are the markets for the long term debt & corporate stocks. Money Markets Money market generally is a market where there is buying and selling of short term liquid debt instruments. (Short term means one year or less). Liquid means something which is easily en-cashable; an instrument that can be easily exchanged for cash.

Discuss one of the financial instruments “Option”. 3 Marks

Gives the buyer the right, but not the obligation, to buy or sell an asset at a set price on or before a given date. Investors, not companies, issue options. Buyers of call options bet that a stock will be worth more than the price set by the option (the strike price), plus the price they pay for the option itself. Buyers of put options bet that the stock's price will drop below the price set by the option. An option is part of a class of securities called derivatives, which means these securities derive their value from the worth of an underlying investment.

Business converts from old to new capital structuring and tax shield. What affect of this tax shield on following:

 Earning before interest and Tax (EBIT)

 Net Income

Advantage of Financial lease respective of lessee. (5 Marks)

•  If factory needs to buy new machine urgently and does NOT have enough finances.
•  Leased Assets (and lease liabilities) can sometimes be treated OFF THE BALANCE SHEET ITEMS. Accounting Standards (i.e. FASB USA) in some countries restrict this so generally speaking, Lease DOES affect DEBT RATIO & Capital Structure in similar way as Loan on Balance Sheet.
•  If Company can NOT justify an increase in Assets on the Balance Sheet based on historical earnings. Capital expenditure in Leased Asset can be “Expensed” out gradually.
•  Lease Rental is a TAX-DEDUCTIBLE EXPENSE just like interest payments.
•  As long as IRR from leased equipment is higher than cost of lease financing.

Differentiate forward market and future market. The forward market is the over-the-counter financial market in contracts for future delivery, so called forward contracts. Forward contracts are personalized between parties (i.e., delivery time and amount are determined between seller and customer). The forward market is a general term used to describe the informal market by which these contracts are entered into. Standardized forward contracts are called futures contracts and traded on a futures exchange. A futures market or derivatives exchange is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future.

Calculate tax shield from the given information. Corporate tax rate is 35% and amount of debt is Rs. 20, 000 and rate of return is 8%. Tax Shield =(income-(debt*interest rate))*tax rate Tax shield = (20,000 * 8%)* 35% = 560 Rs

How can a manager calculate the opportunity cost of capital for a project? Give answer in bulleted form only.

•  The opportunity cost of capital is the return that investors give up by investing in the project rather than in securities of equivalent risk.
•  Financial managers use the capital asset pricing model to estimate the opportunity cost of capital
•  The company cost of capital is the expected rate of return demanded by investors in a company.

Suppose you are a financial manager of XYZ Corporation and you have been assigned the task to calculate the numerical value of your firm’s WACC (Weighted Average Cost of Capital), what procedure would you follow keeping in mind that the firm is using NOI (Net Operating Income) approach?

Tax shield for the calculation of cost of debt but not for the calculation of the equity stock. Why? Give reason. Because you can get tax exemption on the interest payment, in case of debt financing. But you are not entitled for any Tax shield in case of equity. Rd (1T)

Ahsan Enterprises, an all-equity firm, is considering a proposal of new capital investment. Analysis has indicated that the proposed investment has a beta of 0.5 and will generate an expected return of 7%. The firm currently has a required return of 10.75% and a beta of 1.25. The investment, if undertaken, wills double the firm's total assets.

Requirement:

If rRF is 7% and the market risk premium is 3%, should the firm undertake the investment?

Beta = .5 Expected Rate of return = 7% Required rate of return = 10.75 Beta = 1.25% Ahsan Enterprises uses only equity capital, so its cost of equity is also its corporate cost of capital, or WACC. WACC = 10.75 % “The investment, if undertaken, wills double the firm's total assets” tell us that exactly same amount will be injected. So after the injection of new investment with beta of .5, impact on overall beta will be .5 * (1.25) + .5*(.5) = .875 Now we will calculate the Required Rate of return with new beta RR = WACC = risk free rate of return + (Market rate of return - risk free rate of return)*beta WACC = 7% + (7% - 3%)*.875 = 10.50% = .5*10.50 + .5*7 = Due to new investment cost of capital reduced from 10.75% to 10.50% Overall expected rate of return must be more then 10.50% but new investment is giving us the expected rate of return of 7% Now we will see expected return after injection of new investment .5(10.75) + .5(7) = 8.87% as it is less then 10.50 so we should drop it.

Mergers can be classified in two broad categories i.e. Financial and Operating merger. Differentiate between these two.

Financial Merger

Operating Merger

The operations remains independent The operations are integrated and changed and synergies expected.