You are on page 1of 17

Corporate Finance

Assignment

March,
2009
Page 1 of 17
Q.1.What are the major advantages and disadvantages of the
corporate form of organization as compared to sole
proprietorship and partnership?

Answer. Corporations enjoy many advantages over partnerships and sole


proprietorships. But there are also disadvantages.
Advantages:
Stockholders are not liable for corporate debts. This is the most important
attribute of a corporation. In a sole proprietorship and partnership, the owners are
personally responsible for the debts of the business. If the assets of the sole
proprietorship or partnership cannot satisfy the debt, creditors can go after each
owner's personal bank account, house, etc. to make up the difference. On the
other hand, if a corporation runs out of funds, its owners are usually not liable.
Note that under certain circumstances, an individual stockholder may be liable
for corporate debts. This is sometimes referred to as "piercing the corporate veil."
Some of these circumstances include:

• If a stockholder personally guarantees a debt.

• If personal funds are intermingled with corporate funds.

• If a corporation fails to have director and shareholder meetings.

• If the corporation has minimal capitalization or minimal insurance.

• If the corporation fails to pay state taxes or otherwise violates state law
(like defrauding customers).

Self-Employment Tax Savings. Earnings from a sole proprietorship are subject to


self-employment taxes, which are currently a combined 15.3% on the first
$97,500 of income for tax year 2007. With a corporation, only salaries (and not
profits) are subject to such taxes. This can save thousands of dollars per year.

For example, if a sole proprietorship earns $80,000, a 15.3% tax would have to
be paid on the entire $80,000. Assume that a corporation also earns $80,000, but
$40,000 of that amount is paid in salary, and $40,000 is deemed as profit. In
this case, the self-employment tax would not be paid on the $40,000 profit. This
saves you over $5,000 per year.

Continuous life. The life of a corporation, unlike that of a partnership or sole


proprietorship, does not expire upon the death of its stockholders, directors, or
officers.

Easier to raise money. A corporation has many avenues to raise capital. It can

Page 2 of 17
sell shares of stock, and it can create new types of stock, such as preferred stock,
with different voting or profit characteristics. Plus, investors are assured that they
are not personally liable for corporate debts.

Ease of transfer. Ownership interests in a corporation may be sold to third parties


without disturbing the continued operation of the business. The business of a sole
proprietorship or partnership, on the other hand, cannot be sold whole; instead,
each of its assets, licenses, and permits must be individually transferred, and
new bank accounts and tax identification numbers are required.

Disadvantages

Higher cost. Corporations costs more to set up and run than a sole proprietorship
or partnership. For example, there are the initial formation fees, filing fees and
annual state fees. These costs are partially offset by lower insurance costs.

Formal organization and corporate formalities. A corporation can only be created


by filing legal documents with the state. In addition, a corporation must adhere to
technical formalities. These include holding director and shareholder meetings,
recording minutes, having the board of directors approve major business
transactions and corporate record-keeping, if these formalities are not kept the
stockholders risk losing their personal liability protection. While keeping corporate
formalities is not difficult, it can be time-consuming. On the other hand, a sole
proprietorship or partnership can commence and operate without any formal
organizing or operating procedures - not even a handwritten agreement.

Unemployment tax. A stockholder-employee of a corporation is required to pay


unemployment insurance taxes on his or her salary, whereas a sole proprietor or
partner is not. Currently, the federal unemployment tax is 6.2% of the first $7,000
of wages paid, with a maximum of $434 per employee.

Page 3 of 17
Q.2. Explain the importance of understanding Cost of
Capital?

Answer. The cost of capital determines how a company can raise money (through
a stock issue, borrowing, or a mix of the two) hence cost of Capital is the required
rate of return that a firm must at least earn to cover the cost of raising funds from
its investors namely the debt and equity holders. It is therefore represents the
overall cost of financing to the firm. It is always associated with risk in the sense
that it is the rate that must be earned by the firm at a given level of risk hence it is
normally used as the discount rate in analyzing investments or capital budgeting
proposal. In the event the rate of return to be earned from the investment is higher
than the firm’s cost of capital, the wealth of the shareholders will then be
maximized.

The reason to know a firm’s cost of capital is because a firm’s cost of capital is
the rate of return which links the firm’s investment and its financing decision. Put
it simply, if a firm has an overall cost of capital/financing rate of 10% but
invested in projects that earned less than 10%, then shareholders’ wealth will be
eroded.

Weighted Average Cost of Capital The Company’s cost of capital is actually its
“weighted average cost of capital (WACC) which is simply the average of the
firm’s cost of funds from all investors including all types of lenders/debts
borrowing and stockholders. This weighted average cost of capital weighs each
category of source of financing proportionately. A firm’s weighted average cost of
capital is a composite of the individual costs of financing weighted by the
percentage of financing provided by each source. Businesses often discount cash
flows at WACC to determine the Net Present Value (NPV) of a project, using the
formula:
NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Broadly speaking, a company’s assets are financed by either debt or equity.


WACC is the average of the costs of these sources of financing, each of which is
weighted by its respective use in the given situation. By taking a weighted
average, we can see how much interest the company has to pay for every dollar it
finances. A firm's WACC is the overall required return on the firm as a whole and,
as such, it is often used internally by company directors to determine the
economic feasibility of expansionary opportunities and mergers. It is the
appropriate discount rate to use for cash flows with risk that is similar to that of
the overall firm.

Illustration:

Page 4 of 17
Company XYZ Ltd. has the following sources of capital and has also determined
its individual cost of capital:

Sources of $ Cost of
Capital/Financing Capital
Bonds 300,000 10%
Preferred stock 100,000 13%
Common stock 600,000 16%
1,000,00
0

The Management intends to invest in a $500,000 investment project with an


expected rate of return of 12.5%.

Should the firm make the investment?

Step 1: Determine the individual cost of financing

In this illustration, it has been given.

Step 2: Determine the weightage (%)

Sources of $ Capital
Capital/Financing Structure
(%)
Bonds 300,000 30%
Preferred stock 100,000 10%
Common stock 600,000 60%
1,000,00 100%
0
Step 3: Compute
the company’s WACC by multiplying the individual cst of financing with the
weightage % of financing.

Sources of Capital Cost of WEIGHTED


Capital/Financing Structure Capital COST%
(%)
(A) (B) (A) X (B)
Bonds 30% 8% 2.4%
Preferred stock 10% 14% 1.4%
Common stock 60% 18% 10.8%
100% 14.6%
Page 5 of 17
Final Step: Compare the firm’s weighted average cost of capital (WACC) with the
proposed rate of return from the capital investment:

Firm’s WACC = 14.6% Versus Rate of Return from Investment=12.5%

Reject the investment proposal as the firm’s WACC is higher than the project’s
rate of return otherwise shareholders wealth will be eroded.

Q.3.Critically evaluate factors affecting corporate dividend


policy. Should the company follow a stable dividend policy?
Page 6 of 17
Answer. In Corporate finance dividend policy, is a decision made by the directors
of a company. It relates to the amount and timing of any cash payments made to
the company's stockholders. The decision is an important one for the firm as it
may influence its capital structure and stock price. In addition, the decision may
determine the amount of taxation that stockholders pay.

There are three main factors that may influence a firm's dividend decision:

Free-cash flow

Dividend clienteles

Information signaling

The free cash flow theory of dividends.

Under this theory, the dividend decision is very simple. The firm simply pays out,
as dividends, any cash that is surplus after it invests in all available positive net
present value projects.

A key criticism of this theory is that it does not explain the observed dividend
policies of real-world companies. Most companies pay relatively consistent
dividends from one year to the next and managers tend to prefer to pay a
steadily increasing dividend rather than paying a dividend that fluctuates
dramatically from one year to the next. These criticisms have led to the
development of other models that seek to explain the dividend decision.

Dividend clienteles. A particular pattern of dividend payments may suit one


type of stock holder more than another. A retiree may prefer to invest in a firm
that provides a consistently high dividend yield, whereas a person with a high
income from employment may prefer to avoid dividends due to their high
marginal tax rate on income. If clienteles exist for particular patterns of dividend
payments, a firm may be able to maximize its stock price and minimize its cost of
capital by catering to a particular clientele. This model may help to explain the
relatively consistent dividend policies followed by most listed companies. A key
criticism of the idea of dividend clienteles is that investors do not need to rely
upon the firm to provide the pattern of cash flows that they desire. An investor
who would like to receive some cash from their investment always has the option
of selling a portion of their holding. This argument is even more cogent in recent
times, with the advent of very low-cost discount stockbrokers. It remains possible
that there are taxation-based clienteles for certain types of dividend policies.

Information signaling.

Page 7 of 17
A model developed by Merton Miller and Kevin Rock in 1985 suggests that
dividend announcements convey information to investors regarding the firm's
future prospects. Many earlier studies had shown that stock prices tend to
increase when an increase in dividends is announced and tend to decrease when
a decrease or omission is announced. Miller and Rock pointed out that this is
likely due to the information content of dividends.

When investors have incomplete information about the firm (perhaps due to
opaque accounting practices) they will look for other information that may provide
a clue as to the firm's future prospects. Managers have more information than
investors about the firm, and such information may inform their dividend
decisions. When managers lack confidence in the firm's ability to generate cash
flows in the future they may keep dividends constant, or possibly even reduce
the amount of dividends paid out. Conversely, managers that have access to
information that indicates very good future prospects for the firm (e.g. a full order
book) are more likely to increase dividends.

Investors can use this knowledge about managers' behavior to inform their
decision to buy or sell the firm's stock, bidding the price up in the case of a
positive dividend surprise, or selling it down when dividends do not meet
expectations. This, in turn, may influence the dividend decision as managers
know that stock holders closely watch dividend announcements looking for good
or bad news. As managers tend to avoid sending a negative signal to the market
about the future prospects of their firm, this also tends to lead to a dividend policy
of a steady, gradually increasing payment.

Should the company follow a stable dividend policy?

A number of companies follow the Policy of paying a fixed amount per share or
fixed rate on paid-up capital as dividend every year. Irrespective of the
fluctuations in the earnings, this Policy does not imply that the dividend per share
or dividend rate will never be increased. When the company reaches new levels
of earnings and expects to maintain it, the annual dividend per share may be
increased. It is easy to follow this policy when earnings are stable. If the earnings
pattern of a company shows wide fluctuations, it is difficult to maintain such a
policy.

Stability or regularity of dividends is considered as, a desirable policy by the


management of most companies. Shareholders, also generally favor this policy
and value stable dividends higher than the fluctuating ones. All other things
beings the same, stable dividend may have a positive impact on the market price
of the share. With the stability policy, companies may choose a cyclical policy that
sets dividends at a fixed fraction of quarterly earnings, or it may choose a stable
policy whereby quarterly dividends are set at a fraction of yearly earnings. In
either case, the aim of the dividend stability policy is to reduce uncertainty for
Page 8 of 17
investors and to provide them with income.

Q.4. Write research report on:

A. Corporate Control and Governance.


Page 9 of 17
B. Options.

Answer. Corporate control & governance is a term in which directors and auditors
handle their responsibilities towards shareholders and other company
stakeholders. It’s a system by which corporations are directed and controlled.
Typical corporate governance measures include appointing non-executive
directors, placing constraints on management power and ownership
concentration, as well as ensuring proper disclosure of financial information and
executive compensation.
Surprisingly, corporate governance has been considered a secondary factor
impacting a company's performance. That is, as opposed to a company's financial
position, strategy, and operating capabilities, the effectiveness of governance
practices was largely seen as important only in special circumstances like CEO
changes and merger and-acquisition (M&A) decisions.
But recent events prove that governance practices are not merely a secondary
factor, when the company's share price sank because of an accounting scandal,
the importance of good governance practices become obvious. Corporate disasters
show that the absence of effective corporate controls puts the company and its
investors at tremendous risk.
What the Studies Prove:
For years, investors ignored corporate governance because academic research
found no clear causal link between governance and financial performance. But
that is starting to change. A paper by Harvard and Wharton business professors
entitled “Corporate Governance and Equity Prices” concludes that investors that
sold U.S. companies with the weakest shareholder rights and bought those with
the strongest shareholder rights earned an additional return as high as 8.5%.
The study analyzes 1,500 companies and ranks them based on 24 corporate
governance provisions. Those companies with the lowest rankings were less
profitable and had lower sales growth. Moreover, the returns on these companies
lagged far behind those of higher ranked firms. The paper also shows that for
each one-point increase in shareholder rights, a company's value increased by a
whopping 11.4%.
Meanwhile, a study produced in 2000 by global consultancy McKinsey found
that 75% of the 200 institutional investors it surveyed regard board practices as
important as financial metrics for assessing companies. The study showed that
companies that moved from the worst to the best governance practices could
expect a 10% increase in market valuation.

Investors Are Starting to Take Notice


Amid all the hand wringing about corporate governance, investors are getting help
in steering clear of misgoverned companies and finding well-governed ones.
Governments, stock exchanges, and securities watchdogs are coming up with
new rules and regulations that try to put a stop to some of the worst cases of
corporate failure. Proposals at the New York Stock Exchange and the SEC that
Page 10 of 17
push for more boardroom independence and greater financial expertise in audit
committees certainly accelerate improved practices and reassure investors.
At the same time, a veritable cottage industry has sprung up among ratings
agencies and consultants issuing corporate governance ratings. Investors can
turn to standard & Poor’s Corporate Governance Score and Institutional
Shareholder Services Corporate Governance Quotient. Both of them report and
grade public companies' governance practices. In addition, the Investor
Responsibility research Centre, along with corporate governance watchdogs like
the Corporate Library and Governance Metrics provide governance performance
ratings.
While new regulatory proposals and rating systems are valuable to investors,
they are no guarantee that companies are well run. Investors need to evaluate
corporate governance for themselves.

Here is a quick list of key issues for investors to consider when analyzing
corporate governance: Board Accountability – Boards of Directors (BODs) are
the links between managers and shareholders. As such, the BOD is potentially
the most effective instrument of good governance and constraint on the top
managers. Investors should examine corporate filings to see who sits on the
board. Make sure you seek out companies with plenty of independent directors
who have no commercial links to the firm and who demonstrate an objective
willingness to question management choices. A minority of independent directors
make it difficult for the board to operate outside the sphere of management
influence. Do directors own shares in the company? If not, they may have less
incentive to serve shareholders' best interests. What are directors' attendance
records at board and committee meetings? Finally, does the board adhere to a set
of published governance principles?
Financial Disclosure and Controls - Investors should insist that corporate
structure includes an audit committee composed of independent directors with
significant financial experience. Ideally, the committee should have sole power to
hire and fire the company's auditors and approve non-audit services from the
auditor. Persistent earnings restatements or lawsuits challenging the accuracy of
financial statements provide a clear signal to investors that financial disclosure
and controls are not functioning properly. Top management compensation should
be determined by measurable performance goals (shareholder return, ROE, ROA,
EPS growth), and, if possible, the compensation rate should be set by an
independent compensation committee and fully disclosed.
Shareholder Rights - Be wary of companies with dual-class stock. Class A and
B shares can place major constraint on shareholder rights, enabling insiders to
accumulate majority power by virtue of owning vote-tilted class B shares. Voting
should always be routine through mail, telephone and Internet, and shareholders
should have the right to approve major transactions, including mergers,
restructuring and equity-based compensation plans.
Market for Control - Management power can become entrenched by strong
takeover defense provisions, such as poison pills or the issue of blank check
Page 11 of 17
preferred stock. These mechanisms protect against hostile takeovers and
subsequent management change, but investors should cheer poison-pill plans
only when fully trusting and supporting management.
Be aware also that directors - especially executive board directors - have a habit
of granting generous stock options to top managers. While stock options offer
management an incentive to perform well, overloaded stock-option accounts
create the possibility of unwanted share value dilution. The more stock options
management owns, the bigger the drop in share value will be when these options
are exercised. Because the quality of corporate governance determines how a
company allocates shareholder rights and aims to maintain the value of shares,
investors should vigilantly analyze and evaluate the governance of their current
and potential investments.

Options.

Currently, many investors' portfolios include investments such as mutual


funds, stocks, and bonds. But the variety of securities at investor’s
disposal does not end there. Another type of security, called an option,
presents a world of opportunity to sophisticated investors. The power of
options lies in their versatility. They enable investors to adapt or adjust their
position according to any situation that arises. Options can be as speculative or
as conservative as required. This means investors can do everything from
protecting a position from a decline to outright betting on the movement of a
market or index. This versatility, however, does not come without its costs.
Options are complex securities and can be extremely risky. This is why, when
trading options, a disclaimer like the following is seen: Options involve risks
and are not suitable for everyone. Option trading can be speculative in
nature and carry substantial risk of loss.

What Are Options?

An option is a contract that gives the buyer the right, but not the obligation, to buy
or sell an underlying asset at a specific price on or before a certain date. An
option, just like a stock or bond, is a security. It is also a binding contract with
strictly defined terms and properties. An option is merely a contract that deals
with an underlying asset. For this reason, options are called derivatives, which
mean an option derives its value from something else. Most of the time, the
underlying asset is a stock or an index.

Calls & Puts

The two types of options are calls and puts: A call gives the holder the right to
buy an asset at a certain price within a specific period of time. Calls are similar to

Page 12 of 17
having a long position on a stock. Buyers of calls hope that the stock will increase
substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific
period of time. Puts are very similar to having a short position on a stock. Buyers
of puts hope that the price of the stock will fall before the option expires.

Call holders and put holders (buyers) are not obligated to buy or sell. They have
the choice to exercise their rights if they choose. -Call writers and put writers
(sellers), however, are obligated to buy or sell. This means that a seller may be
required to make good on a promise to buy or sell. Selling options is more
complicated and can be even riskier

Why Use Options? There are two main reasons why an investor would use
options: to speculate and to hedge.

Speculation, the advantage of options is that you aren't limited to making a


profit only when the market goes up. Because of the versatility of options,
investors can also make money when the market goes down or even sideways.
Speculation is the territory in which the big money is made - and lost. The use of
options in this manner is the reason options have the reputation of being risky.
This is because when option is bought; investors have to be correct in determining
not only the direction of the stock's movement, but also the magnitude and the
timing of this movement.

Hedging, Think of this as an insurance policy. Just as we insure our house or


car, options can be used to insure our investments against a downturn.

How Options Work

An example of how options work. We'll use a fictional firm called M.M.J
Company. Let's say that on May 1, the stock price of Company is $67 and the
premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is
the third Friday of July and the strike price is $70. The total price of the contract
is $3.15 x 100 = $315. A stock option contract is the option to buy 100 shares;
that's why we must multiply the contract by 100 to get the total price. The strike
price of $70 means that the stock price must rise above $70 before the call option
is worth anything; furthermore, because the contract is $3.15 per share, the
break-even price would be $73.15. When the stock price is $67, it's less than the
$70 strike price, so the option is worthless. But thing to remember here is that we
paid $315 for the option, so we are currently down by this amount. Three weeks
later the stock price is $78. The options contract has increased along with the
Page 13 of 17
stock price and is now worth $8.25 x 100 = $825. Subtract what we paid for the
contract, and our profit is ($8.25 - $3.15) x 100 = $510. Money almost doubled in
just three weeks! Investor could now sell his options, which are called “closing
position” and take profits - unless, of course, investor thinks the stock price will
continue to rise. For the sake of this example, let's say investor did not sell. By
the expiration date, the price drops to $62. Because this is less than our $70
strike price and there is no time left, the option contract is worthless. We are now
down to the original investment of $315. To recap, here is what happened to our
option investment:

Expiry
Date May 1 May 21
Date

Stock Price $67 $78 $62

Option Price $3.15 $8.25 worthless

Contract Value $315 $825 $0

Paper Gain/Loss $0 $510 -$315

In our example the premium (price) of the option went from $3.15 to $8.25. These
fluctuations can be explained by intrinsic value and time value. Basically, an
option's premium is its intrinsic value + time value. Intrinsic value is the amount
in-the-money, which, for a call option, means that the price of the stock equals the
strike price. Time value represents the possibility of the option increasing in
value. So, the price of the option in our example can be thought of as the
following:

Intrinsic Time
Premium = +
Value Value
$8.25 = $8 + $0.25
In real life options almost always trade above intrinsic value.

Types of Options

There are two main types of options:

Page 14 of 17
American options can be exercised at any time between the date of purchase
and the expiration date. The example about Cory's Tequila Co. is an example of
the use of an American option. Most exchange-traded are of this type.

European options are different from American options in that they can only be
exercised at the end of their lives.

The distinction between American and European options has nothing to do with
geographic location.

Long-Term Options There are also options with holding times of one, two or
multiple years, which may be more appealing for long-term investors. These
options are called long-term equity anticipation securities (LEAPS).

Q.5. Explain the importance of Budgeting in working Capital


Management?
Answer. Proper decision on capital budget will increase a firm’s value as well as
shareholders’ wealth. Capital budgeting is critical to a firm as it helps the firm to
stay competitive as it is expanding its business like proposing to purchase
equipments to produce additional or new products, renting or owning premises for
opening new branches, etc.

Page 15 of 17
Capital budgeting is the allocation of funds among projects. Various units within a
firm are constantly vying for funding. For example, the operations department
may want to purchase new equipment, the marketing staff may want to run a
new advertising campaign, while engineering may want to test a new product
design that they expect will reduce production costs. Senior executives must
determine which of these projects should receive funding and which should not.
To do this, executives utilize capital budgeting techniques. There are several
methodologies used in capital budgeting. These include payback, discounted
payback, NPV, IRR, and MIRR.

In other words working capital management is a managerial accounting strategy


focusing on maintaining efficient levels of both components of working capital,
current assets, and current liabilities, in respect to each other. Working capital
management ensures a company has sufficient cash flow in order to meet its
short-term debt obligations and operating expenses.

Working capital management entails short term decisions - generally, relating to


the next one year period - which is "reversible". These decisions are therefore not
taken on the same basis as Capital Investment Decisions (NPV or related, as
above) rather they will be based on cash flows and or profitability. One measure
of cash flow is provided by the cash conversion cycle - the net number of days
from the outlay of cash for raw material to receiving payment from the customer.
As a management tool, this metric makes explicit the inter-relatedness of
decisions relating to inventories, accounts receivable and payable, and cash.
Because this number effectively corresponds to the time that the firm's cash is
tied up in operations and unavailable for other activities, management generally
aims at a low net count.

In this context, the most useful measure of profitability is Return on Capital (ROC).
The result is shown as a percentage, determined by dividing relevant income for
the 12 months by capital employed; Return on equity (ROE) shows this result for
the firm's shareholders. Firm value is enhanced when, and if, the return on
capital, which results from working capital management, exceeds the cost of
capital, which results from capital investment decisions as above. ROC measures
are therefore useful as a management tool, in that they link short-term policy with
long-term decision making.

Management of working capital

Management will use a combination of policies and techniques for the


management of working capital. These policies aim at managing the current
assets (generally cash and cash equivalents, inventories and debtors) and the
short term financing, such that cash flows and returns are acceptable.

Page 16 of 17
Cash management. Identify the cash balance which allows for the business to
meet day to day expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for


uninterrupted production but reduces the investment in raw materials - and
minimizes reordering costs - and hence increases cash flow.

Debtor’s management. Identify the appropriate credit policy, i.e. credit terms
which will attract customers, such that any impact on cash flows and the cash
conversion cycle will be offset by increased revenue and hence Return on Capital
(or vice versa).

Short term financing. Identify the appropriate source of financing, given the
cash conversion cycle: the inventory is ideally financed by credit granted by the
supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to
"convert debtors to cash" through “factoring”.

Page 17 of 17