FM Assignment 2 Final

FINANCIAL MANAGEMENT FMT 5001 Md ASHIQUZZAMAN-PGUOS/000541

Assignment-2. Financial Management.

Introduction.

It is an individual assignment. In this course work it will be answered and discussed two

questions. By the answering of question no 1, at first it will be solved the problem of

Christy Berhad, a successful fashion retailing company with the financial data of this

company. After that we explain why managers need to know the cost of equity capital of

their companies and we Briefly discuss the major functions performed by the capital

market and will explain the importance of each function for corporate financial

management. However, we also find out the answer how does the existence of a well

functioning capital market assist the financial management function?

Moreover, by answering the question no 2, it will be solved all the problems and

questions of Shrieves Casting Company.

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Answer The Question No-1.

(a) Estimating the cost of equity Capital

i. The Dividend Growth Model

Ke= Di/ Po +g, where Ke= cost of equity, Di= dividend for next period, g=growth, Do= Current dividend

From the calculation, the growth (g) has been found to be 22.66%

Price Eraning Ratio= Price per share/ Earnings per share

Price Per share= 28*35.8

Price per share= 1002.4

Ke= 11.0 (1+0.2266)/1002.4+0.2266

Ke= 24%

ii. Capital Asset Pricing Model

Ke= Rf+risk (Rm-Rf)

Where Rf= risk free return, Rm= market return

Ke= 0.10+0.8(0.09)

Ke= 17.2%

(b) The dividend growth model and the capital asset pricing models are all important

models for calculating the cost of equity capital. The dividend growth model indicates

that the value of a share of stock is the present value of its future dividend. Thus, it

indicates the current price of the stock by dividing its dividend next year by the discount

rate less the growth rate (Ross, Westerfield and Jordan, 1995). The assumptions

underlying the dividend growth model are presented below.

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(i)The constant dividend growth model assumes that earnings and dividends are growing

at the same rate in the long term. Thus, the model assumes that the growth rate is constant

over time, which therefore makes it flawed. Thus, dividend may grow as a company as a

company is able to change its dividend policy corresponding to an increase in company's

profit. Thus, the model is most applicable to matured industry. However, this may not be

applicable to an industry in the growth, decline stages of the life cycle.

ii. Moreover, this model is applicable to public traded companies. If this is not the

case, then analysis would usually use historical data and other subjective way of

analyzing the cost of capital. This therefore will create problems for such

companies, as historical share prices may not be a good indicator.

With regards to the Capital asset pricing model, it is a ceteris Para bus model indicates

that, the expected returns that investors will demand is equal to the rate on a risk free

security. If the expected return is not greater or equal to the required return, the investor

will refuse to invest. The underlying assumptions are identified below.

i) Investors are risk averse individuals who maximize the expected utility of their end of

period wealth. The implication of this is that the model is a one period model. An

investor will only invest in less risky investments if this is the case. However, the model

is flawed in the sense that, investors recognize the payoff associated with risky

investments. Therefore, they tend to invest in these securities.

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ii. Investors have homogeneous expectations about asset return: All investors have

the same information at the same time. However, in the real world, investors

differ with respect to the nature of information they hold. This therefore flaws

the assumption.

iii. There are no market imperfections such as taxes, regulations or restrictions.

However, in the real world, this is not possible. There is nothing like a perfect

market. Capital markets are regulated; taxes are imposed on returns a s well as

capital gain on the investment.

c). Cost of Equity CapitalCalculating the cost of equity for any company is important as it determines the cost of

equity financing. A high cost of equity would then indicate a higher cost and then a

higher return to compensate investors. Thus, the cost of equity will help the company to

determine the proportion of equity capital or debt capital to be used to finance the

company.

If the cost of equity is high, the weighted average cost of capital to the company will also

increase. This will cause the overall cost of financing to increase. Thus, calculation of

this therefore gives the company the ability to manage their cost of financing.

d. Broadly, the capital market is categorized into equity market and debt market. The

money market is a wholesale market in which trades are for large valued assets (Hunt and

Terry, 2008). This market deals with both short term debt and long term debt. The share

market on the other hand organizes trading in shares. This is done on the stock market.

The major functions performed by the capital market are outlined below.

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I. It contributes to the flow of funds by providing several securities with different risk and maturities.

II. Provides companies risk market for their liquid reserves, thus enhancing the

function of the banking system

III. Serves as a reference rate, which helps in determine the respective interest rates

that enhances a company's borrowing efforts.

The capital market provides several assistance and advantages to financial management

in their quest to achieve the objective of Shareholders wealth maximization. The

achievement of this objective or goal therefore requires that financial managers to embark

on three main functions identified as financing decision, investment decision and

dividend decisions (Ross, Westerfiled and Jordan, 1995).

Firstly, the flow of funds function helps to achieve the objective of financial

management. Thus, the flow of funds therefore indicates that, there would be access to

funds on the capital market that a firm can borrow to enhance its investment decision.

Thus, when a company is able to gain access to several funding sources within the capital

market, it will enhance its ability to embark on its investment needs.

Secondly, the capital market provides companies with liquid reserves that assist in the

attainment of its dividend decision. Thus, since internal equity is a cheaper source of

finance, the company can therefore embark on retaining enough reserves. These reserves

will therefore be deposited in the capital market. This function therefore helps financial

management to invest and save its liquid reserves.

Finally, the capital market reveals the current level of interest rates. Thus, by serving as a

reference rates, financial managers will understand the range of interest in the market and

compare this to achieve a lower cost of capital.

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Answer The Question No- 2.

1.

2. Calculating the Annual Sales Revenue and Cost

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3. Calculating Annual Incremental cash flow

4. After Tax salvage value

5. Risk relates to the uncertainty associated with a project's future probability. The

three types of risk associated with capital budgeting projects are identified as the

standalone risk, corporate risk and market risk.

The standalone risk is referred to as the projects risk if it were the firm's only asset and

there were no shareholders. It ignores both firm and shareholder diversification. Thus, the

firm needs to calculate the risk that affects the project in question. Since a company's core

project usually correlates with the market, standalone risk will reflect the market.

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The second risk reflects a projects effect on corporate earnings. It considers

diversification within the firm, and depends on the projects standard deviation, its

correlation with project other assets. This risk is measured by the projects Beta versus

corporate total earnings. Thus, if Project X is correlated to the projects other assets, if r is

less than 1, then diversification provides a benefit to the company, if r=1 some

diversification benefits. Thus, suppliers, customers are all affected by corporate risk.

Market risk reflects the projects effect on a well diversified stock portfolio. It takes

account of stock holder other assets. This risk depends on the projects standard deviation

and correlation with the stock market. Thus, when a project standard deviation is high

relative to the stock market, then there is an indication that the project is risky.

6. You need to re-calculate the investment using a different rate of return and tax effects and depreciation.

ii) You need to consider other non-monetary factors that might influence their decision on this investment.

A firm’s risk profile can be divided into two components. The first is termed systematic

risk and the second specific risk, or risk that is unique to the firm. Financial portfolio

theory concludes that investors require a return for accepting systematic risk 4(and only

systematic risk) because firm-specific risk can be diversified away. This means that firms

that reduce their systematic risk are rewarded with a lower cost of financial capital, and

for a given cash flow, a higher stock price. A firm’s systematic risk is measured by its

“Beta.” Beta is a measure of a given stock’s volatility relative to the overall market, with

the market’s Beta being assigned a value of 1. The higher a firm’s Beta, the greater it’s

systematic risk; stocks with a Beta greater than 1 are more volatile than the market,

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while those with a Beta of less than 1 are less volatile. Both theoretical developments and

empirical evidence (i.e., historical market returns) suggest that Beta is not constant, but

changes over time. These changes are related to a number of factors, including changes in

the firm’s debt to asset ratio (financial leverage), fixed cost base of operation (operating

leverage), customer markets served, and product lines, as well as mergers and

acquisitions, to name a few. Our empirical model adds to this list another set of variables,

described briefly below, designed to measure environmental risk. Thus, as a firm’s

environmental risk declines (increases) for example, we should expect its Beta, all else

equal, to decline (increase).

Conclusion.

After exploring this course work, in conclusion it is said that Systematic, or market, risk

reflects factors that affect all firms in the market simultaneously. These factors include

inflation, changes in interest rates, recessions, wars, and the like. Because all firms

participating in the market are affected by these factors, the risks that they pose cannot be

eliminated by investing in a more diversified portfolio.

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List of References.

Hunt and Terry, 2008, Financial Institution and Markets, 5th Ed, Thompson Jhon D. Martin, J. William Petty, Arthur J. Keown, & David F. Scott, (1991), Basic Financial Management, 5th edu. Prentice Hall, USA.

Keown, Arthur J., Martin, Jhon D., Petty, William J. & Scott, David F. (2007), Financial Management –Principles and applications, 10th edu. Pearson Education Ltd. UK.

Keown, Arthur J., Martin, Jhon D., Petty, William J. & Scott, David F. (2006), Foundation of Finance – The logic and practice of financial management, 6th edu. Prentice Hall USA.

Ross, Westerfield and Jordan, (1995) Basic Financial Management, 5th ed. Prentice Hall, USA.

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FM Assignment 2 Final