MG T 201 Subjective by Us Man Attari

MGT 201 :::Final Term Subjective
By:::: USMAN ATTARI

Why firms not prefer Debt financing
Based on CORPORATE TAXES, FIRMS should prefer to raise Capital using DEBT Finaning rather than
e!uit" as there is sa#ing assoiated $ith apital raised through this soure%
WHY WE USE WACC?
It is the &est $a" to alulate the net present #alue of a pro'et &eause it ta(es into onsideration all the soures
of apital% For e)a*ple, for a pro'et to &e desira&le it has to first need to satisf" the desired rate of return of
different fund pro#iders% But $e (no$ that there are different soures of funds% It doesn+t 'ust o*e fro* one
soure% ,e (no$ that -P./Initial Cost Outla" 0 1 rate of return% A pro'et *a" for e)a*ple pro#ide a 231 rate
of return% The o*pan"+s &an(er *a" nod on it if its *ini*u* rate of return &efore it lends the o*pan" so*e
*one" is onl" 41% But ho$ a&out if the sto(holders $ant as *uh as 2415 ,ACC &ased on *ar(et #alue is
the &est $a" to sol#e these #ariations in interests and osts of pro#iding funds%
If "ou use ,ACC, "ou are dee*ed to onsider &oth the ost of de&t and e!uit"% So in a $a" "our !uestion is
$rong%
WHAT IS MERER? IS IT HARM!U" #R $E%E!ICIA"? E&'"AI% A%D (USTI!Y) STRATEIES
T# 'R#TECT !IRM !R#M E&CHA%E RATE RIS*
Definition of 'Merger'
The o*&ining of t$o or *ore o*panies, generall" &" offering the sto(holders of one o*pan" seurities in
the a!uiring o*pan" in e)hange for the surrender of their sto(%
Basiall", $hen t$o o*panies &eo*e one% This deision is usuall" *utual &et$een &oth fir*s
Question No: 52 ( Marks: 5 )
!irm A has to +eci+e ,hether to maintain -arge amo.nt of c.rrent assets or sma-- amo.nt) What can be
the possib-e benefits the firm can en/oy from both of these?
Ad#antages of 6arge Current Assets7 less ris( of shortages 8 interruptions and less loss of sales due to
a#aila&ilit" of funds for loan pa"*ents and purhases and in#entor"% 9igh 6i!uidit" so &etter CREDIT Rating%
Ad#antages of S*all Current Assets7 6ess in#est*ent in urrent assets *eans less a*ount of *one" tied to the
assets $hih are generating no return% So lo$er Opportunit" Cost of Capital%
Sp-it from +i0i+en+ stoc123
,hen a o*pan" deides to issue a sto( split :or sto( di#idend;, a ouple of possi&ilities ould our
onerning $hat $ould happen to an upo*ing ash di#idend% The *ost i*portant fators are the ti*e the sto(
split happens and the ti*e of the ash di#idend+s reord date% T"piall", a ash di#idend $ill not &e issued to
ne$ shares that $ere reated fro* a sto( split if the split date ours after the di#idend+s date of reord% This is
si*ilar to ho$ an in#estor does not reei#e di#idends for sto(s that he purhased after the di#idend+s reord
date%

Difference bet,een Capita- Mar1et an+ Money Mar1et) 3 Mar1s
Capital Markets:
These are the *ar(ets for the long ter* de&t 8 orporate sto(s%
Money Markets
Mone" *ar(et generall" is a *ar(et $here there is &u"ing and selling of short ter* li!uid de&t instru*ents%
:Short ter* *eans one "ear or less;% 6i!uid *eans so*ething $hih is easil" en<asha&le= an instru*ent that
an &e easil" e)hanged for ash%
2
Disc.ss one of the financia- instr.ments 4#ption5) 3 Mar1s
>i#es the &u"er the right, &ut not the o&ligation, to &u" or sell an asset at a set prie on or &efore a gi#en date%
In#estors, not o*panies, issue options% Bu"ers of all options &et that a sto( $ill &e $orth *ore than the prie
set &" the option :the stri(e prie;, plus the prie the" pa" for the option itself% Bu"ers of put options &et that the
sto(+s prie $ill drop &elo$ the prie set &" the option% An option is part of a lass of seurities alled
deri#ati#es, $hih *eans these seurities deri#e their #alue fro* the $orth of an underl"ing in#est*ent%
$.siness con0erts from o-+ to ne, capita- str.ct.ring an+ ta6 shie-+) What affect of this ta6 shie-+ on
fo--o,ing7
Earning before interest an+ Ta6 8E$IT9
%et Income
A+0antage of !inancia- -ease respecti0e of -essee) 8: Mar1s9
If fator" needs to &u" ne$ *ahine urgentl" and does -OT ha#e enough finanes%
6eased Assets :and lease lia&ilities; an so*eti*es &e treated OFF T9E BA6A-CE S9EET ITEMS%
Aounting Standards :i%e% FASB ?SA; in so*e ountries restrit this so generall" spea(ing, 6ease DOES
affet DEBT RATIO 8 Capital Struture in si*ilar $a" as 6oan on Balane Sheet%
If Co*pan" an -OT 'ustif" an inrease in Assets on the Balane Sheet &ased on historial earnings%
Capital e)penditure in 6eased Asset an &e @E)pensedA out graduall"%
6ease Rental is a TAX<DED?CTIB6E EXPE-SE 'ust li(e interest pa"*ents%
As long as IRR fro* leased e!uip*ent is higher than ost of lease finaning%
Differentiate for,ar+ mar1et an+ f.t.re mar1et)
The forward market is the o#er<the<ounter finanial *ar(et in ontrats for future deli#er", so alled for$ard
ontrats% For$ard ontrats are personaliBed &et$een parties :i%e%, deli#er" ti*e and a*ount are deter*ined
&et$een seller and usto*er;% The for$ard *ar(et is a general ter* used to desri&e the infor*al *ar(et &"
$hih these ontrats are entered into% StandardiBed for$ard ontrats are alled futures ontrats and traded on
a futures e)hange%
A futures market or deri#ati#es e)hange is a entral finanial e)hange $here people an trade standardiBed
futures ontrats= that is, a ontrat to &u" speifi !uantities of a o**odit" or finanial instru*ent at a
speified prie $ith deli#er" set at a speified ti*e in the future%
Ca-c.-ate ta6 shie-+ from the gi0en information)
Corporate ta6 rate is 3:; an+ amo.nt of +ebt is Rs) <=> === an+ rate of ret.rn is ?;)
Ta) Shield 0:ino*e<:de&tCinterest rate;;Cta) rate
Ta) shield 0 :D3,333 C E1;C F41
0 4G3 Rs
Ho, can a manager ca-c.-ate the opport.nity cost of capita- for a pro/ect? i0e ans,er in b.--ete+ form
on-y)
The opportunit" ost of apital is the return that in#estors gi#e up &" in#esting in the pro'et rather than in
seurities of e!ui#alent ris(%
Finanial *anagers use the apital asset priing *odel to esti*ate the opportunit" ost of apital
The o*pan" ost of apital is the e)peted rate of return de*anded &" in#estors in a o*pan"%
D
S.ppose yo. are a financia- manager of &Y@ Corporation an+ yo. ha0e been assigne+ the tas1 to
ca-c.-ate the n.merica- 0a-.e of yo.r firmAs WACC 8Weighte+ A0erage Cost of Capita-9> ,hat proce+.re
,o.-+ yo. fo--o, 1eeping in min+ that the firm is .sing %#I 8%et #perating Income9 approach?
Ta6 shie-+ for the ca-c.-ation of cost of +ebt b.t not for the ca-c.-ation of the eB.ity stoc1) Why? i0e
reason)
Beause "ou an get ta) e)e*ption on the interest pa"*ent, in ase of de&t finaning% But "ou are not entitled
for an" Ta) shield in ase of e!uit"% Rd :2< T;
Ahsan Enterprises> an a--CeB.ity firm> is consi+ering a proposa- of ne, capita- in0estment) Ana-ysis has
in+icate+ that the propose+ in0estment has a beta of =): an+ ,i-- generate an e6pecte+ ret.rn of D;) The
firm c.rrent-y has a reB.ire+ ret.rn of E=)D:; an+ a beta of E)<:) The in0estment> if .n+erta1en> ,i--s
+o.b-e the firmFs tota- assets)
Requirement:
If rR! is D; an+ the mar1et ris1 premi.m is 3;> sho.-+ the firm .n+erta1e the in0estment?
Beta 0 %4
E)peted Rate of return 0 H1
Re!uired rate of return 0 23%H4
Beta 0 2%D41
Ahsan Enterprises uses onl" e!uit" apital, so its ost of e!uit" is also its orporate ost of apital, or ,ACC%
,ACC 0 23%H4 1
@The in#est*ent, if underta(en, $ills dou&le the fir*+s total assetsA tell us that e)atl" sa*e a*ount $ill &e
in'eted% So after the in'etion of ne$ in#est*ent $ith &eta of %4, i*pat on o#erall &eta $ill &e
%4 C :2%D4; I %4C:%4; 0 %EH4
-o$ $e $ill alulate the Re!uired Rate of return $ith ne$ &eta
RR 0 ,ACC 0 ris( free rate of return I :Mar(et rate of return < ris( free rate of return;C&eta
,ACC 0 H1 I :H1 < F1;C%EH4 0 23%431
0 %4C23%43 I %4CH 0
Due to new investment cost of capital reduced from 10.75% to 10.50%
O#erall e)peted rate of return *ust &e *ore then 23%431 &ut ne$ in#est*ent is gi#ing us the e)peted rate of
return of H1
-o$ $e $ill see e)peted return after in'etion of ne$ in#est*ent
%4:23%H4; I %4:H; 0 E%EH1 as it is less then 23%43 so $e should drop it%
Mergers can be c-assifie+ in t,o broa+ categories i)e) !inancia- an+ #perating merger) Differentiate
bet,een these t,o)
!inancia- Merger #perating Merger
The operations re*ains
independent
The operations are integrated
and hanged and s"nergies
e)peted%
F
Question No: 5 ( Marks: !" )
Using the Capita- Asset 'ricing Mo+e- 8CA'M9> +etermine the reB.ire+ ret.rn on eB.ity for the
fo--o,ing sit.ations7
Sit.ations E6pecte+ ret.rn on
mar1et portfo-io
Ris1C free
rate
$eta
2 2G1 2D1 2%33
D 2E1 E1 3%E3
F 241 2J1 3%H3
#$at genera%i&ation 'an (ou make)
Re!uired Rate of return 0 ris( free rate of return I :*ar(et return< ris( free rate;C &eta
2% 0 2D1 I :2G1<2D1;C2 0 2G1
D% 0 E1 I :2E1<E1;C%E 0 2G1
F% 0 2J1 I :241<2J1;C%H 0 2J%H1
>eneraliBation7 as &eta of 2 in ase of our seurit" -o%2 It is full" di#ersified and its return is 2G1 $hih
e)atl" e!ual to *ar(et portfolio return% An" #alue of &eta a&o#e the 2 an inrease the rate of return &ut sa*e it
$ill inrease the Ris( as $ell%
Question No: 5* ( Marks: !" )
What are stoc1 +i0i+en+s an+ stoc1 sp-its? E6p-ain ,ith the he-p of e6amp-es an+ ho, +o these affect
stoc1 prices? 83G3GH mar1s9
+to'k Di,idend7 The" are used to ontrol the share prie if it rises too fast% The" &ring share prie do$n to
$ithin an opti*al prie range so that *ore in#estors an afford to trade in it and trading #olu*e rises%
Eample: Co*pan" offers 231 sto( di#idend to all shareholders% It *eans that if "ou o$n 233 shares than
o*pan" $ill gi#e "ou 23 *ore shares free of ost% -u*&er of shares inreases &ut total #alue of fir* is
unhanged%
+to'k +-%it: The" are used to share prie if it rises too fast% -u*&er of share outstanding inrease% The" are used
to inrease Float%
Eample: Co*pan" $ith 2333 shares outstanding to outside shareholders delares D<for<2 sto( split% Means
that the nu*&er of shares outstanding $ill inrease to D333 shares :i%e% 2331 inrease;% -u*&er of shares rises
&ut fir* #alue unhanged%
Effect of Stoc1 Di0i+en+ an+ Stoc1 Sp-its on prices7
Pries rises i**ediatel" after$ards &eause in#estors ta(e the* to &e positi#e signals a&out the o*pan"Ks
future% But if o*pan" does not delares higher earnings and di#idends in near future, prie $ill o*e &a(
do$n again%
Question No: .! ( Marks: 5 )
What are the rea- mar1ets effects of -e0erage on WAAC? 8Ans,er the B.estion in b.--ete+ form on-y9)
Inrease in le#erage auses a a large inrease in ost of e!uit"
Inrease in le#erage auses relati#el" s*all inrease in ost of de&t as o*pared to ost of e!uit"
As le#erage inreases ,ACC 2st falls &eause of ta) sa#ing shield%
,ith further inrease in le#erage ,ACC fall to its *ini*u* point $hih is the opti*al point for apital
struture
Further inrease in le#erage auses inrease in ,ACC &eause of &an(rupt" ris(
Question No: .2 ( Marks: 5 )
S.ppose a !irm A$C has Tota- Assets of Rs)E=== an+ is E==; EB.ity base+ 8i)e) UnC-e0ere+9) There ,ere
E= eB.a- #,ners an+ : of them ,ant to -ea0e) So the !irm ta1es a $an1 "oan of Rs):== 8at E=;pa Mar1C
.p9 an+ pays bac1 the EB.ity Capita- to the : #,ners ,ho are -ea0ing) %o,> ha-f of the EB.ity Capita-
has been rep-ace+ ,ith a "oan from a $an1 8i)e) Debt9) What impact +oes this ha0e on R#E?
As the fir* replaes e!uit" $ith de&t it is inreasing finanial le#erage $hih is a ause of finanial ris(% The
i*pat of de&t on ROE is that ROE $ill inrease &ut $ith the greater unertaint" hene greater $ill &e the ris(%
J
Question No: .3 ( Marks: !" )
Stoc1 & has a beta of =):> stoc1 Y has a beta of E)=> an+ stoc1 @ has a beta of E)<:) The ris1 free rate is
E=; an+ the e6pecte+ mar1et ret.rn is E?;)
a/ !in+ the e6pecte+ ret.rn on stoc1 &
0/ !in+ the e6pecte+ ret.rn on stoc1 Y
'/ !in+ the e6pecte+ ret.rn on stoc1 @
d/ S.ppose that yo. constr.ct a portfo-io consisting of H=; &> <=; Y an+ H=; @) What is the beta of the
portfo-io?
a) rM 0 2E1
rRF 0 231
L 0 3%4
r 0 rRF I : rM < rRF ; L
0 231 I :2E1<231; 3%4
0 231 I J1
0 2J1
&% rM 0 2E1
rRF 0 231
L 0 2%33
0 231 I :2E1<231; 2%33
0 231 I E1
0 2E1
C% rM 0 2E1
rRF 0 231
L 0 2%D4
0 231 I :2E1<231; 2%D4
0 231 I 231
0 D31
d% Beta of portfolio 0 LP 0 X LX I M LM I N LN
0 :J3/233;3%4 I :D3/233;2%3 I :J3/233;2%D4
0 3%J)3%4 I 3%D)2%3 I 3%J)2%D4
0 3%D I 3%D I 3%4
0 3%O
If interest ta6 shie-+s are 0a-.ab-e> ,hy +onFt a-- ta6paying firms borro, as m.ch as possib-e?
Ta) shield gi#e us &enefit up to ertain le#el &ut as le#erage inreases Fir* &eo*es *ore Ris(" so 6enders and
Ban(s Charge 9igher Interest Rates and >reater Chane of Ban(rupt"%
There are +ifferent metho+s to raise capita- ,ithin the organiIation) $rief-y e6p-ain the a+0antages of
eB.ity financing into the b.siness)
E!uit" finaning gi#es the fle)i&ilit" $e donKt need to pa" fi) a*ount% In ase of &ond or de&t $e need to pa"
fi)ed interest in ase of failure there is threat of Defaulter% Mostl" the ad#antages of e!uit" finane are reaped
&" the s*all &usiness enterprises% In so*e ase de&t rate is too high that ti*e e!uit" help "ou to get heaper
apital finaning%
4
What is -ongCterm financing? E6p-ain the factors that can affect the +ecision of a manager ,hi-e +eci+ing
abo.t -ong term financing?
6ong ter* finaning is a (ind of finaning $hih is pro#ided for a period of *ore than one "ear%
Per*anent Finaning o*es in t$o for*s7
P 6ong<ter* 6oans < Bonds It has 6o$ Ris( for Fir* &ut has 9igh Cost nor*all" *ore than one "ear%
P Co**on E!uit" or Sto( its 6ess Ris( for Fir* &ut 9ighest Cost%
If a o*pan" is using long<ter* finaning it has higher ost of finaning due high interest ost of long ter*
loans despite high ost $e ha#e lo$ ris(, due to suret" of aess to *one" for a longer period% Current lia&ilities
as a soure of finaning are not relia&le as "ou ha#e no suret" $hether "ou $ill ha#e sa*e a*ount of *one"
a#aila&le ne)t *onth for finaning or not%
If capita- str.ct.re changes from eB.ity to +ebt then ,hat ,i-- be the effect on capita- str.ct.re)
Fir* $ill &eo*e le#eraged fir*% De&t e!uit" ratio $ill inrease earning per share is also inrease% There $ill
&e a ta) sa#ing on interest e)penses pa"a&le on de&t%
Ho, are +i0i+en+s pai+> an+ ho, +o companies +eci+e on +i0i+en+ payments?
Di,idend are -aid in t$e fo%%owing wa(s
2; Delaration date
Dividend Declare in two ways
Sta&le di#idend per share poli"
Constant di#idend pa"out ratio
D; Date of reord
F; E) Qdi#idend date
J; Date of pa"*ent
De'ision on di,idend -a(ment
Cash di#idend7 if funds are a#aila&le $ith the o*pan" then di#idend paid in ash
Sto( di#idend 7 if the funds are not a#aila&le $ith the o*pan" then sto( di#idend is paid to
shareholders in the for* of additional shares
Write a note on capita- str.ct.re of organiIations an+ cost of capita-)
Capital structure of t!e company comprises on t!e followin" components
2% e!uit" apital
D% de&t
F% preferred shares
J% retained earning
Cost of capital comprises of t!e followin"
2% ost of e!uit" apital i%e% Re
D% after ta) ost of de&t i%e Rd
F% ost of preferene share i%e Rp
J% ost of retained earning i%e% Rr
,hen *ultipl" these osts of apital $ith their $aits and add up, its &eo*es $eighted a#erage ost of apital
Write a short note on rea- asset mar1ets an+ a-so gi0e some e6amp-es)
The real asset *ar(et $here the real ph"sial asset are traded %for e)a*ple, "ou ha#e $heat *ar(et, otton
*ar(et, $here real *aterial hange hands%
E)a*ples7 >old Mar(et, Propert" :land, house;
G
Company &Y@ ,ants to iss.e more Common Stoc1 of !ace Ja-.e Rs E<) %e6t Year the Di0i+en+ is
e6pecte+ to be Rs) 3 per share ass.ming a Di0i+en+ ro,th Rate of E=; pa) The "a,yerAs fee an+ Stoc1
$ro1ersA Commissions ,i-- cost Rs E per share) In0estors are confi+ent abo.t Company A$C so the
Common Share is f-oate+ at a Mar1et 'rice of Rs E? 8i)e) 'remi.m of Rs K9) If the Capita- Str.ct.re of
Company A$C is entire-y Common EB.ity> then ,hat is the CompanyAs WACC? Use %e, Stoc1 Iss.ance
Approach to ca-c.-ate the res.-ts)
DI.2 0 D
>0 231
6a$"er fee and o**% 0 2 Rs
Po 0 2G
Capital struture is e!uit" &ase 2331
As o*pan" is 233 e!uit" it *eans ?nle#earged Co*pan" so itKs ,ACC $ill &e re!uired rate of return on
e!uit"%
Re!uired ROR for Co**on Sto( using >ordonKs For*ula
r 0 :DI.2/Po; I g
Po 0 *ar(et prie 0 2E
Di#2 0 -e)t Di#idend 0 F
> 0 gro$th rate 0 231
r 0 :F/2E;I231 0 DG%GG1
-o$ If o*pan" $anted to issue the sto( #ia ne$ float then it has to pa" the la$"er fee and &ro(er
o**ission $hih 2 Rs%
-et proeed 0 2E Q 2 0 2H
r 0 :F/2H;I231 0 DH%GJ1
Why may payo.t +ecisions be .se+ by management to signa- the prospects of the firm? i0e ans,er in
b.--ete+ form)
If a o*pan" seleted the high pa" out poli" $ithout the ash flo$ to &a( it up%
The" $ill find that it ulti*atel" has to either redue the in#est*ents or turn to apital *ar(ets for
additional de&t or e!uit" finaning%
As it is ostl", *anagers $ill not inrease di#idends unless the" are onfident that the fir* $ill get enough
ash to pa" the*%
It is *ain reason that $e sa" that there is an infor*ation signal attahed to di#idends pa"out poli"%
So an" hange in the di#idend pa"out poli" send signals of a hange in the fir*+s prospets%
In#estors ta(e it positi#el" that a o*pan" plans to repurhase its sto(%
If the" are $orried that the o*pan" has *ore ash than it an profita&l" e*plo", the" *a" &e pleased to
see the ash gi#en &a( to the shareholders%
Question No: 5" ( Marks: 3 )
Management $.yo.ts is a form of b.yo.ts) E6p-ain this term in yo.r o,n ,or+s)
Manage*ent &u"outs are si*ilar in all *a'or legal aspets to an" other a!uisition of a o*pan"% The partiular
nature of the MBO lies in the position of the &u"ers as *anagers of the o*pan", and the pratial
onse!uenes that follo$ fro* that% In partiular, the due diligene proess is li(el" to &e li*ited as the &u"ers
alread" ha#e full (no$ledge of the o*pan" a#aila&le to the*% The seller is also unli(el" to gi#e an" &ut the
*ost &asi $arranties to the *anage*ent, on the &asis that the *anage*ent (no$ *ore a&out the o*pan" than
the sellers do and therefore the sellers should not ha#e to $arrant the state of the o*pan"%
H
Question No: 5! ( Marks: 5 )
Company &Y@ ,ants to iss.e more Common Stoc1 of !ace Ja-.e Rs E<) %e6t Year the Di0i+en+ is
e6pecte+ to be Rs) 3 per share ass.ming a Di0i+en+ ro,th Rate of E=; pa)
The "a,yerAs fee an+ Stoc1 $ro1ersA Commissions ,i-- cost Rs E per share) In0estors are confi+ent abo.t
Company A$C so the Common Share is f-oate+ at a Mar1et 'rice of Rs E? 8i)e) 'remi.m of Rs K9)
If the Capita- Str.ct.re of Company A$C is entire-y Common EB.ity> then ,hat is the CompanyAs
WACC? Use %e, Stoc1 Iss.ance Approach to ca-c.-ate the res.-ts)
DI.I 0 F
Po 0 2E
g 0 231
r 0 :DI.2/Po; I g
r 0 F/2E I 3%23
r 0 3%2GGG I 3%2
r 0 3%DGGG C233
r 0 DG%GH1
-et Proeeds 0 Flotation Prie < Flotation Costs
-et Proeeds 0 2E Q 2
-et Proeeds 0 2H
DI.I 0 F
-P 0 2H
g 0 231
r 0:DI.2/-P; I g
r 0 F/2H I 3%23
r 0 3%2HG I 3%2
r 0 3%DHG C233
r 0 DH%GJ1
What is the p.rpose of resi+.a- +i0i+en+ mo+e- an+ ,hat is the proce+.re to be fo--o,e+ ,hi-e .sing this
mo+e-?
Residua% Di,idend Mode%
P Residual Di#idend Model7 Best Pratial Model for nu*erial alulations of opti*al Di#idend Poli"% Sets
6ong<Ter* Target Di#idend Pa"out Ratio fro* $hih to &a(<alulate short<ter* Di#idends%
# $teps in %esidual Dividend Model &%DM':
Q Foreast Capital Budget, Earnings, Cash Flo$s :for ne)t 4 "ears;
P Conser#atis*7 To &e on safe side, underesti*ate the Free Cash Flo$s
Deter*ine Target opti*al Capital Struture :or Pratiall" Spea(ing, @RangeA for De&t Ratio; and foreast
re!uired E!uit" :for ne)t 4 "ears;
?se Retained Earnings :internal apital; to finane *ost of the re!uired E!uit" &eause
RE is less ostl" than e)ternal finaning :higher transation osts;% Retained earnings ost less than loans
to a!uire finane%
6efto#er or @ResidualA Earnings an &e safel" paid Out as Di#idends in 6ong Ter*%
Then di#ide this into S*all Met Regular :*a" &e !uarterl"; and Steadil" Inreasing Di#idend Pa"outs%
Question No: .* ( Marks: 3 )
Why +o firms nee+ to in0est in net ,or1ing capita-?
E
There is a need to in#est in net $or(ing apital &eause net $or(ing apital represents the surplus $or(ing
apital left $ith the o*pan" after pa"*ent of urrent lia&ilities= hene *ore net $or(ing apital *eans
o*pan" has surplus *one" for its da" to da" operations
What 1in+ of +i0i+en+ po-icy is the best one for a firm? 8i0e ans,er in b.--ete+ from on-y9
Most *anagers &elie#e the &est di#idend poli" is one that *ini*iBes the $eighted a#erage ost of apital%
This poli" should pro#ide sta&le pa"*ents%
This poli" should *aintain in#estorKs onfidene%
This poli" should gi#e good signals to in#estors a&out the a&ilit" of the fir* to *aintain and inrease its
$ealth
It should &e onser#ati#e enough to hold the unertaint" of future pa"*ents to a *ini*u*% C"lial fir*s
should pa" lo$ di#idends regularl", and an @e)tra di#idendA $hen eono*i ondition are fa#ora&le and
profits are high
What are the a+0antages an+ +isa+0antages of raising capita- thro.gh eB.ity financing?
1d,antages
The right &usiness angels or #enture apitalists an lead and steer the &usiness to profits and gro$th% The" an
add preious #alue to the e)isting pro'et and $ith their e)pertise and e)periene the" an pro#ide #alua&le
suggestions and ad#ie not to *ention the ontats% The" an aid in deision *a(ing and planning of strategies%
The in#estors $ould &e e!uall" onerned and responsi&le sine it is their *one" at sta(e and an" progress
$ould reflet in their e!uit" #alue%
Disad,antages
Rising of e!uit" finane is a ti*e onsu*ing tas( and also #er" e)pensi#e% All in all "ou need to spend #alua&le
ti*e satisf"ing their &a(ground he(s, pro'et understanding and on#ining the* to ris( their apital in "our
&usiness% Moreo#er, one the" are in the" e)erise ertain ontrol o#er the *anage*ent of the &usiness *ostl"
due to their in#est*ent rights in the &usiness% E!uit" finane leads to dilution of o$nership and the legal and
regulator" rules assoiated $ith finane is #er" u*&erso*e and deliate% Mou need to alloate preious ti*e
into e)plaining the progress of "our &usiness to the finaners so that the" an *onitor it%
Economists categoriIe mergers into fo.r types) E6p-ain these types ,ith the he-p of e6amp-es)
( $pecific )ypes of Mer"ers:
P 9oriBontal Merger7 *erger of D o*petitors < an lead to Monopol"
P .ertial Merger7 *erger of a supplier $ith a &u"er
P Co generi Merger7 *erger of fir*s in sa*e industr"
P Conglo*erate Merger7 *erger of fir*s in unrelated industries
If interest ta6 shie-+s are 0a-.ab-e> ,hy +onFt a-- ta6paying firms borro, as m.ch as possib-e?
Ta) shield gi#e us &enefit up to ertain le#el &ut as le#erage inreases Fir* &eo*es *ore Ris(" so 6enders and
Ban(s Charge 9igher Interest Rates and >reater Chane of Ban(rupt"%
Where +o firms in0est e6cess f.n+s .nti- they are nee+e+ to pay bi--s?
Solution7<
Fir*s an in#est idle ash in the *one" *ar(et, the *ar(et of short ter* finane assets% These assets tend to &e
short ter*, lo$ ris(, and highl" li!uid, *a(ing the* ideal instru*ents in $hih to in#est funds for short period
for the ti*e &efore ash needed%
O
What prob-ems a firm can face if it faces a shortfa-- or s.rp-.s of in0entories)
Follo$ing are the Pro&le*s related to shortfall and surplus of in#entories faes &" an" fir*%
P Shortfall in In#entories7 interruptions in prodution and loss or sales orders
P Surplus In#entories7 high arr"ing osts, $astage, and depreiation
Compare aggressi0e ,or1ing capita- financing ,ith conser0ati0e ,or1ing capita- financing)
*""ressive
P Ma)i*u* Short<ter* finaning at lo$ ost :&ut ris( of non<rene$al;
P ?se short<ter* finaning for Te*porar" Current Assets and e#en partl" to &u" Per*anent Current
In#entor"
+ Conservative
P Ma)i*u* 6ong<ter* finaning% Safe &ut higher interest osts%
P ?se long<ter* finaning for Fi)ed Assets, entire Per*anent Assets, and e#en part of Te*porar"
Current Assets
Ahma+ Corporation> a sma-- b.siness man> pro0i+e+ the fo--o,ing information abo.t the pro+.ction -e0e-7
!i6e+ operating cost 2 Rs) <>:==> Sa-e price per .nit is Rs)E= an+ its operating 0ariab-e cost per .nit is Rs) :)
a9 Yo. are reB.ire+ to ca-c.-ate the brea1e0en B.antity from the abo0e information)
b9 If 0ariab-e cost has change+ an+ it is increase+ .p to Rs) K then ,hat ,i-- be the effect of this change on $rea1
e0en B.antity)
a) Sales per unit < #aria&le per unit 0 Contri&ution *argin per unit
23 Q 4 0 Contri&ution *argin per unit
Contri&ution *argin in units 0 4
Brea( e#en in unit 0 Fi)ed Cost / Contri&ution *argin per unit
Brea( e#en in units 0 D433 / 4
Brea( e#en in units 0 433
0) Sales per unit < #aria&le per unit 0 Contri&ution *argin per unit
23 Q G 0 Contri&ution *argin per unit
Contri&ution *argin in units 0 J
Brea( e#en in unit 0 Fi)ed Cost / Contri&ution *argin per unit
Brea( e#en in units 0 D433 / J
Brea( e#en in units 0 GD4
A$C Corporation e6pects to ha0e the fo--o,ing +ata +.ring the coming year)
Assets Rs) <==>=== Interest rate ?;
DebtLAssets> boo1 0a-.e K:; Ta6 rate H=;
E$IT Rs) <:>===
ReB.ire+7
What is the firmFs e6pecte+ R#E?
Return on e!uit" 0 net profit / e!uit"
As de&t / asset 0 G41
So G41 0 de&t / asset
De&t 0 G41 C D33,333 0 2F3,333
If de&t : 2F3,333; is G41 then F41 $ould &e e!uit"
: 2F3,333 / 3%G4 ; C 3%F4 0 H3,333 0 e!uit"
23
EBIT 0 D4333
6ess interest pa"*ent E1 of 2F3,333 0 : 23J33;
2JG33
6ess ta) SJ31 of 2JG33 0 :4EJ3;
-ET I-COME 2 76"
ROE0 : EHG3 / H3,333 ; C 233
2 !2/5 3
There are +ifferent metho+s to raise capita- ,ithin the organiIation) $rief-y e6p-ain the a+0antages of
eB.ity financing into the b.siness)
E!uit" finaning gi#es the fle)i&ilit" $e donKt need to pa" fi) a*ount% In ase of &ond or de&t $e need to pa"
fi)ed interest in ase of failure there is threat of Defaulter% Mostl" the ad#antages of e!uit" finane are reaped
&" the s*all &usiness enterprises% In so*e ase de&t rate is too high that ti*e e!uit" help "ou to get heaper
apital finaning%
What is -ongCterm financing? E6p-ain the factors that can affect the +ecision of a manager ,hi-e +eci+ing
abo.t -ong term financing?
6ong ter* finaning is a (ind of finaning $hih is pro#ided for a period of *ore than one "ear%
,ermanent -inancin" comes in two forms:
6ong<ter* 6oans < Bonds It has 6o$ Ris( for Fir* &ut has 9igh Cost nor*all" *ore than one "ear%
Co**on E!uit" or Sto( its 6ess Ris( for Fir* &ut 9ighest Cost%
If a o*pan" is using long<ter* finaning it has higher ost of finaning due high interest ost of long ter*
loans despite high ost $e ha#e lo$ ris(, due to suret" of aess to *one" for a longer period% Current lia&ilities
as a soure of finaning are not relia&le as "ou ha#e no suret" $hether "ou $ill ha#e sa*e a*ount of Mone"
a#aila&le ne)t *onth for finaning or not%
What is a cre+it po-icy an+ ,hat factors an organiIation sho.-+ consi+er ,hi-e +esigning its cre+it po-icy
an+ ho, can a firm .se :LE=> net 3= basis an+ carrying charges in its cre+it po-icy?
Credit Poli"7 It is the redit ad'usted gi#en to usto*er &ased upon pa"*ent histor"%
-actors considered for credit:
Assess*ent of Credit<$orthiness of eah redit usto*er
Mini*iBe duration of redit and .alue%
>i#e inenti#es to Custo*ers to pa" ash and to pa" !ui(l"
Suppose if so*eone pa"s later then last date of pa"*ent he/she $ill pa" e)tra 21 et%
@Sell on 4/23%net F3 &asisA
F3 &asis Means usto*er $ill pa" full ash #alue $ithin F3 da"s% 4/23%net *eans 41 disount for usto*ers
$ho $ill pa" $ithin 23 da"s% It $ill &e li(e inenti#e to usto*er $ho $ill pa" earl"% I*post so*e e)tra harge
in the for* of arr" harges in ase of later pa"*ent
!irms A an+ $ are i+entica- e6cept their .se of +ebt an+ the interest rates they pay) !irm A has more +ebt
an+ th.s m.st pay a higher interest rate)
Requirement:
$ase+ on the +ata gi0en be-o,> ho, m.ch higher or -o,er ,i-- be the AFs R#E that of $> i)e)> ,hat is
R#EA C R#E$?
22
App-icab-e to $oth !irms !irm AFs Data !irm "DFs Data
Assets Rs% F,333,333 De&t ratio H31 De&t ratio D31
EBIT Rs%433, 333 Int% rate 2D1 Int% rate 31
Ta) rate F41
For o*pan" A D31 le#erage so e!uit" $ill &e F31 of F,333,333 0 O33333
EBIT 0 433,333
Interest :2D1 of 433,333; 0 :G333;
EBT JOJ,333
Ta) :F41 of EBT; :2JED33;
-et ino*e 3.54""
E)peted ROE :0-I/E!uit"; FJ4,E33/ :O33333; 0 FE%JD1
For o*pan" B D31 le#erage so e!uit" $ill &e E31 of F,333,333 0 DJ33333
EBIT 0 433,333
Interest :231 of 433,333; 0 :4333;
EBT JO4,333
Ta) :F41 of EBT; :2JE433;
-et ino*e 3.645""
E)peted ROE :0-I/E!uit"; FJG433/ :DJ33333; 0 2J%JF1
ROEA Q ROEB 0 FE%JD Q 2J%JF
223/**3
M"ease is /.st -i1e Co--atera-iIe+ "oanM) E6p-ain this statement)
It is 'ust li(e a CollateraliBed 6oan :$here the leased asset is the ollateral;%
6ease Contrat is 'ust as serious as a loan agree*ent% Failure to pa" lease rental is 'ust li(e failure to pa"
interest% Can &an(rupt the 6essee :Borro$er;% 6essor :6ender or 6easing Co*pan"; an seiBe the leased asset
and, if the lai* is larger, also de*and up to 2 "ear lease rental%
Q The t$o parties of lease agree*ent are7
P 6essor :6easing Co*pan";
P 6essee
!rom the gi0en information ca-c.-ate the %et income) E$IT is Rs) :=> ===> fraction of +ebt in capita-
str.ct.re is <=> ret.rn on +ebt is E=;> amo.nt of +ebt is Rs) <=> === an+ ta6 rate is 3:;)
E)peted EBIT 43333
6ess Interest :231 on De&t; :D333;
EBT JE333
6ess Ta) :F41 on EBIT; :2GE33;
-et Ino*e 3!2""
Differentiate stoc1 sp-its from stoc1 +i0i+en+s)
+to'k Di,idends
Q ?sed to ontrol the share prie if it rises too fast% Brings share prie do$n to $ithin an
@Opti*al Prie RangeA so that *ore in#estors an afford to trade in it and trading #olu*e rises% This is a
o**onl" held &elief%
Q Pa"*ent in the for* of sto( to e)isting shareholders% Can &e delared fre!uentl"%
Q E)a*ple7 Co*pan" offers 231 sto( di#idend to all shareholders% Means that if "ou o$n 233 shares than
o*pan" $ill gi#e "ou 23 *ore shares free of ost%
2D
-u*&er of shares inreases &ut Total .alue of Fir* is unhanged%
+to'k +-%its
Q Also used to ontrol share prie if it rises too fast% -u*&er of shares outstanding inrease%
?sed to inrease @FloatA
56am-%e: Co*pan" $ith 2333 shares outstanding to outside shareholders delares D< for<2 Sto( Split% Means
that the nu*&er of shares outstanding $ill inrease to D333 shares :i%e% 2331 inrease;% -u*&er of shares rises
&ut Fir* .alue unhanged
Aamir Corporation has a capita- str.ct.re of +ebt an+ eB.ity ,ith the percentage of H= an+ K=
respecti0e-y) Ta6 rate for the company is 3:;) #n companyAs o.tstan+ing bon+s it pays N;) Aamir has
ca-c.-ate+ the WACC for his company is N)NK;) What ,o.-+ be the cost of eB.ity capita- of Aamir
Corporation?
J31 De&t
G31 Co**on e!uit"
rd 0 O1
T 0 F41
,ACC 0 O%OG1
rs 0 5
,ACC 0 :$d;:rd;:2 Q T; I :$;:rs;
3%3OOG 0 :3%J;:3%3O;:2 Q 3%F4; I :3%G; C rs
3%3OOG 0 3%3DFJ I 3%G C rs
3%3HGD0 3%G C rs
rs 2 !2/73/
,hat is Operating 6ease5 E)plain $ith the help of e)a*ple%
Operating 6ease :or Ser#ie 6ease;
Q Operating 6ease offers Finaning A-D MAI-TE-A-CE7 often the 6essor is the
Supplier / .endor of the Asset i%e% IBM
Q Operating 6ease is -OT F?66M AMORTINED A-D IS CA-CE66AB6E
P E)a*ple7 Car rental o*pan" :6essor; harges "ou Rs%2333 per da" for renting out a ne$ 9onda Ci#i $ith
dri#er% Mou an lease the ar for D da"s% Mou $ill pa" the 6essor Rs%D333% B?T= the #alue of the ar *ight &e
Rs%2 *illion% 6essor does -OT e)pet "ou to pa" that entire a*ount for using the ar for 'ust D da"s% The ar
rental o*pan" $ill ser#ie and *aintain the ar in good ondition so it an rent it out to other people% This
$a", the" an reo#er the #alue of the ar fro* 2333 da"s of lease rent :0 #alue / dail" rental 0 2,333,333 /
2333;TT This is the Pa"&a( Period :$ithout ta(ing their *aintenane osts and profit *argin;% Mou an Canel
the lease and return the ar after 2 da"%
-o$ "ou 'ust ha#e to pa" Rs%2333%
Q Other E)a*ples of Operating 6ease7 IBM for Co*puter 9ard$are, Boeing for Airplanes
B" not full" a*ortiBing operating lease *eans the leasing o*pan" does not e)pet to reo#er the $hole
a*ount or #alue of asset fro* "ou%
What are the factors affecting signa-ing theory? 8i0e the ans,er in b.--ete+ form on-y ,ith brief
+escription9
This theor" onsider that all In#estors not ha#e e!ual a*ount of infor*ation%
All in#estors are not rational%
Insider ha#e *ore infor*ation o*pare to general pu&li
A Fir*Ks O$ners 8 Managers :Insiders; (no$ *ore a&out it than Ordinar" outside In#estors%
2F
,hen *anage or o$ner (no$s that there are &etter hanes of high ash flo$ or so*e pro'et $hih an
&ring good profit or earning% The" tr" to finane the apital #ia de&t or &ond% The" a#oid use the e!uit"
issuane% Beause the" donKt $anted to share the profit $ith nu*&er share holders% The" ta(e apital #ia
de&t &" pa"ing s*all a*ount of interest &" this the" an earn huge profits%
,hen Fir*Ks Outloo( loo(s &ad or so*e ris(" pro'et, then Managers $ill hoose to raise apital &"
Issuing E!uit" &" doing this the" $ill &e a&le to share the 6i(el" 6osses a*ongst *ore Shareholders% If
the" too(
De&t and ouldnKt repa" it, the" *ight Default and &e fored to go Ban(rupt%
B" doing this in#estor also get signal that if o*panies is finaning its apital #ia de&t then li(el" it $ill &e
so*e good prospet in the o*pan"%
B" loo(ing at these praties &" *anage*ent $e an so *angers are in a &etter position to deide a&out
the fir*%
Stoc1 & has a beta of =):> stoc1 Y has a beta of E)=> an+ stoc1 @ has a beta of E)<:) The ris1 free rate is
E=; an+ the e6pecte+ mar1et ret.rn is E?;)
a9 OO !in+ the e6pecte+ ret.rn on stoc1 &
b9 OO !in+ the e6pecte+ ret.rn on stoc1 Y
c9 OO !in+ the e6pecte+ ret.rn on stoc1 @
+9 OO S.ppose that yo. constr.ct a portfo-io consisting of H=; &> <=; Y an+ H=; @) What is
the beta of the portfo-io?
1 rM 0 2E1
rRF 0 231
0 3%4
r 0 rRF I : rM I rRF ;
0 231 I :2E1<231; 3%4
0 231 I J1
2 !.3
0/ rM 0 2E1
rRF 0 231
0 2%33
r 0 rRF I : rM I rRF ;
0 231 I :2E1<231; 2%33
0 231 I E1
2 !3
'% rM 0 2E1
rRF 0 231
0 2%D4
r 0 rRF I : rM I rRF ; U
0 231 I :2E1<231; 2%D4
0 231 I 231
2 2"3
d/ Beta of portfolio 0 UP 0 X UUUUUUUUM I NUUU
The A$C company is in the 3:; margina- ta6 brac1et) The c.rrent mar1et 0a-.e of the firm is Rs) E<
mi--ion) If there are no costs to ban1r.ptcy7
2J
OO What ,i-- be A$CA ann.a- ta6 sa0ings from interest +e+.ctions be if it iss.es Rs) < mi--ion of fi0e years
bon+s at E< ; interest rate?
What ,i-- be the 0a-.e of the firm?
Annual Coupon pa"*ent eah "r 0 2D1 of D,333,333
0 D333333 ) 2D/233
0 DJ333
Ta) sa#ing for 4 "rs 0 4 :F4 1 of DJ333;
0 4 :DJ333 ) F4/233;
0 4 ) EJ33
0 JD333
What ,i-- A$CA ann.a- ta6 sa0ings from interest +e+.ctions be if it iss.es Rs) < mi--ion of se0en years
bon+s at E< ; interest rate? What ,i-- be the 0a-.e of the firm?
Annual Coupon pa"*ent eah "r 0 2D1 of D,333,333
0 D333333 ) 2D/233
0 DJ333
Ta) sa#ing for H "rs 0 H :F4 1 of DJ333;
0 H :DJ333 ) F4/233;
0 H ) EJ33
0 4EE33
Ta6 shie-+ for the ca-c.-ation of cost of +ebt b.t not for the ca-c.-ation of the eB.ity stoc1) Why? i0e
reason)
Beause "ou an get ta) e)e*ption on the interest pa"*ent, in ase of de&t finaning% But "ou are not entitled
for an" Ta) shield in ase of e!uit"% Rd :2< T;
Ahsan Enterprises> an a--CeB.ity firm> is consi+ering a proposa- of ne, capita- in0estment) Ana-ysis has
in+icate+ that the propose+ in0estment has a beta of =): an+ ,i-- generate an e6pecte+ ret.rn of D;) The
firm c.rrent-y has a reB.ire+ ret.rn of E=)D:; an+ a beta of E)<:) The in0estment> if .n+erta1en> ,i--
+o.b-e the firmFs tota- assets)
ReB.irement7
If rR! is D; an+ the mar1et ris1 premi.m is 3;> sho.-+ the firm .n+erta1e the in0estment?
Beta 0 %4
E)peted Rate of return 0 H1
Re!uired rate of return 0 23%H4
Beta 0 2%D41
Ahsan Enterprises uses onl" e!uit" apital, so its ost of e!uit" is also its orporate ost of apital, or ,ACC%
,ACC 0 23%H4 1
@The in#est*ent, if underta(en, $ill dou&le the fir*+s total assetsA tells us that e)atl" sa*e a*ount $ill &e
in'eted So after the in'etion of ne$ in#est*ent $ith &eta of %4, i*pat on o#erall &eta $ill &e
%4 C :2%D4; I %4C:%4; 0 %EH4
-o$ $e $ill alulate the Re!uired Rate of return $ith ne$ &eta
RR 0 ,ACC 0 ris( free rate of return I :Mar(et rate of return < ris( free rate of return;C&eta
,ACC 0 H1 I :H1 < F1;C%EH4 0 23%431
0 %4C23%43 I %4CH 0
Due to ne$ in#est*ent ost of apital redued fro* 23%H41 to 23%431
O#erall e)peted rate of return *ust &e *ore then 23%431 &ut ne$ in#est*ent is gi#ing us the e)peted rate of
return of H1
-o$ $e $ill see e)peted return after in'etion of ne$ in#est*ent
%4:23%H4;I %4:H; 0 E%EH1 as it is less then 23%43 so $e should drop it%
24
E)plain the follo$ing onditions7
V IRR W,ACC
V IRR X,ACCX SM6
V IRR WSM6
V IRR W,ACCW SM6
7RR 8#199
Mou should not in#est in this pro'et as rate of return is less then ,ACC% In other $ords "our returns are less the
ost of apital%
7RR :#199: +M;
,e should ta(e this pro'et as its rate of rerun is higher then the ,ACC and it offers &etter return then an
effiient *ar(et offers% Due to IRR is higher then SM6
7RR 8+M;
It is sho$ing rate of return $hih is lo$er than SM6 $e should not in#est in suh pro'et &eause it is not
gi#ing as *uh return as effiient *ar(et is returns
7RR 8#1998 +M;
IRR lo$er than ,ACC and SM6 o*pan" should not in#est as IRR is not enough to o#er the ,ACC : not
enough to o#er the ost of apital; plus its returns are lo$er then returns offered &" effiient *ar(et%
$C in+.stries ha0e a beta of E):) The ris1 free rate is ?; an+ the e6pecte+ ret.rn on the mar1et portfo-io
is E3 ;) The company present-y pays a +i0i+en+ of P: a share> an+ in0estors e6pect it to e6perience a
gro,th in +i0i+en+s of E= percent per ann.m for many years to come)
a) What is the stoc1As reB.ire+ rate of ret.rn accor+ing to the CA'M?
b) What is the stoc1As present mar1et price per share> ass.ming this reB.ire+ ret.rn?

A9 Beta 0 41
Rf 0 E1
R m2 !33
Re!uired rate of return 0 Rf I :R* Q Rf; C &eta
Re!uired rate of return 0 E1I:2F1<E1;C2%4 0 24%41

$9 > 0 231
Di#2 0 4
Re 0 :Di#2/ Po;I g
Re 0 :4/Po;I 231
24%41 < 231 0 4/Po
Po 0 4/24%41
2 32/5" Rs
2G

MG T 201 Subjective by Us Man Attari

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

MG T 201 Subjective by Us Man Attari

Uploaded by

Copyright:

Available Formats

MGT 201 :::Final Term Subjective

By:::: USMAN ATTARI

You might also like