Corporate Finance - Question 1

A: As depicted in the given case, the CEO of a company is considering entering into an agreement to buy another company. However, the price is perceived to be too high but gives an opportunity to the CEO for leading and managing a much bigger company that is associated with higher pay and prestige. As such, it can be clearly seen that there is presence of an agency conflict in the preset business scenario. This is because there is an ethical dilemma for the CEO of the company to either choose increased pay and power for fostering the personal growth or meet the objective of maximizing the shareholder welfare. The agency theory of corporate governance has argued that business leaders and managers are the agents acting on the behalf of the principal mainly the shareholders and owners and creating higher value for them. The agency conflict occurs when there goals are not mutually aligned with each other and business managers tend to place emphasis on meeting his/her personal objectives rather than meeting the responsibility of maximizing a firm performance to create high value for the shareholders.

As such, in given case also there is an agency conflict if the CEO places emphasis on driving his/her personal growth by buying another company to achieve higher pay and authority and ignoring its long-term implications on the performance of a firm. The CEO knows that price of buying another company can be too high and this can have a negative impact on the profit position of the firm in long-term and resulting in creating less return for the shareholders. The agency conflict can be regarded as ethical one in which CEO can take unobservable actions for increasing their own utility at the expense of the shareholders. The relevant ethical considerations that need to be taken for addressing this type of conflict is maintaining trust relations between the shareholders and the managers, increasing transparency in the business operations and aligning the goals of the business managers with that of the shareholders to avoid the occurrence of such type of conflict.

B: As per the theory of agency, it is highly necessary for the aligning the interest and objectives of the business managers with that of the shareholders to overcome the possible occurrence of any type of conflict. The strategies that can be used for ensuring that managers are motivated to act in the direction of promoting the interest of the shareholders is creating a mutual relation of trust and faith between them by developing the mutually aligned goals and beliefs. The non-alignment of the goals of the shareholders and managers can result in occurrence of fraudulent activities in which managers tend to take unethical course of action for increasing their personal growth and thus ignoring the value created for the shareholders. This can results in negatively impacting the goodwill and performance of the organization and thus shareholders need to ensure that managers are motivated to act in their best interest by ensuring the adoption of adequate strategies in place.

The executive compensation system is one of the best strategies that is available to the shareholders in this context for ensuring that managers are motivated to increase the return created for the shareholders by taking actions that enhances the long-term performance of a company. The performance related pay system in which business managers receives additional incentives or rewards in the context of placing higher efforts and achieving the stated goals helps in resolving the agency conflict issues. The incentives can be used to align management and shareholders interest because these payments motivates managers to place in their best efforts as per their personal growth and pay is linked to achieving the long-term goals and objectives of an organization. Therefore, it can be said that increase in the log-term performance of an organization creates higher returns for the shareholders and ensuring that their interest and objectives are protected.

Corporate Finance - Question 3

Part a:

Given

Amount

Relevant/Irrelevant

Treatment

Cost paid for feasibility study

 $ 25,000.00

 Irrelevant

It is sunk cost, so not been considered for investment appraisal purpose

Machine Cost

 $ 350,000.00

 Relevant

Initial investment and Cash flow at year 0

Life of machine

4 years

 

So, machine will depreciated using straight line depreciation method as depreciation rate is not given

Sale value of machine

 $ 100,000.00

 Relevant

This cash flows will generated in year 5 and will be considered for tax purpose as book value of machine is zero and all this amount will attract tax expense

Sale produced each year

 $ 135,000.00

 Relevant

Cash flow from year 1 to year 5

Investment in account receivable

 $ 35,000.00

 Relevant

Will be treated as working capital investment in year 0

Investment in inventory (Average value)

($25000+$95000)/2 = $60000

 Relevant

Will be treated as working capital investment in year 0

Loan Repayments each year

$57,700

 Relevant

Cash outflow from year 1 to 5

Use of old equipments (Sale value at year 0)

 $ 63,000.00

 Relevant

Will be treated as cash outflow at Year 0

Tax rate

30%

   

 

Statement of cash flows

Particulars

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Cash flows at year 0/start

           

Cost of machine

 $ (350,000)

         

Investment in account receivable

 $ (35,000)

         

Investment in inventory

 $ (60,000)

         

Use of old machine

 $ (63,000)

         
             

Cash flows over the life

           

Sale produced each year

 

 $ 135,000

 $ 135,000

 $ 135,000

 $ 135,000

 $ 135,000

Less: Loan repayments each year

 

 $ (57,700)

 $ (57,700)

 $ (57,700)

 $ (57,700)

 $ (57,700)

Less: Depreciation of the year

 

 $ (70,000)

 $ (70,000)

 $ (70,000)

 $ (70,000)

 $ (70,000)

Earnings before depreciation and tax

 

 $ 7,300

 $ 7,300

 $ 7,300

 $ 7,300

 $ 7,300

Less: Tax @ 30%

 

 $ (2,190)

 $ (2,190)

 $ (2,190)

 $ (2,190)

 $ (2,190)

Earnings after depreciation and before tax

 

 $ 5,110

 $ 5,110

 $ 5,110

 $ 5,110

 $ 5,110

Add: Depreciation

 

 $ 70,000

 $ 70,000

 $ 70,000

 $ 70,000

 $ 70,000

Earnings before dep and after tax

 

 $ 75,110

 $ 75,110

 $ 75,110

 $ 75,110

 $ 75,110

             

Cash flow at the end

           

Sale value of machine

         

 $ 100,000

Less: Tax expense on sale

         

 $ (30,000)

Add: Inventory recovered

         

 $ 60,000

Add: Account receivable recovered

         

 $ 35,000

             

Total cash flows

 $ (508,000)

 $ 75,110

 $ 75,110

 $ 75,110

 $ 75,110

 $ 240,110

Part b: Calculation of inflation adjusted cost of capital

Approach: Use of constant prices and real rate

Given:

  • Nominal cost of capital = 12% p.a.
  • Inflation rate = 3% p.a.

Calculation of real cost of capital

  • 1+ r = (1+nominal cost of capital)/(1+inflation rate)
  • 1+r = 1.12/1.03
  • r = 1.08738-1 = 0.8738 or 74 %

Statement to calculate the NPV of the project

Year

Cash flows

PVF @ 8.74%

PV

0

 $ (258,000.00)

1.000

 $ (258,000.00)

1

 $ 75,110.00

0.920

 $ 69,073.02

2

 $ 75,110.00

0.846

 $ 63,521.26

3

 $ 75,110.00

0.778

 $ 58,415.73

4

 $ 75,110.00

0.715

 $ 53,720.55

5

 $ 240,110.00

0.658

 $ 157,929.63

   

NPV

 $ 144,660.18

Part c:  Grand Touring Ltd can go with the project as it has positive present cash flows of $144660.18 and it will help the company to earn higher rate of return than the required rate of return of 12% adjusted to inflation.

Corporate Finance - Question 4

(a): Weighted Average Cost of Capital (WACC) method is used for measuring the cost of capital and determines the optimal debt and equity sources to be used in capital structure of a firm. As such, it determines the risk level of a company s perceived by the market through assessing the return of its assets so that the investors earn an required rate of return.

(b): The assumptions used in determining WACC does not hold true in the following conditions:

  • The firm is investing within a project within the same industry but also has its branches or divisions in the different industry then the assumption that the market risk associated with a project is equal to the average market risk of the investment of a firm does not hold true
  • Also, the assumption that there is limited impact of extent of leverage does not hold true in the case of firms having high WACC

Corporate Finance - Question 5

(a) The five steps to be followed in establishing a credit policy are stated as follows:

  • Establishing credit term: This is the first step in establishing credit policy that involves taking decisions regarding length of time for extending credit and cash discount period that helps in attractive customers and sellers.
  • Developing Credit Standards and limits: The management of a company must primarily take decision regarding the credit standard and limits that involves deciding on the matters such as extent of credit risk to be taken. The decision is crucial in determination of the amount of money a company ties up in its receivables. The development of a restrictive policy can result in lowering down the sales but also significantly reduces the risk of bad debt. However, less restrictive policies can result in creating higher sales and receivables balance but more risk of bad-debt losses. Also, it involves deciding on the creditworthiness of an individual or business that can be determined by past behavior, credit agencies and financial statement analysis of businesses.
  • Accounts Receivable management policy: The step involves analyzing whether benefits exceed cost in extending a credit policy. The benefit mainly relates to increased sales revenue while the cost includes administrative expenses, risk of bad debt and opportunity cost of funds tied up in the working capital. The optimal credit policy is decided on the basis of comparing the marginal costs of credit extension vs marginal cost of increased sales and also determining the Net Present Value (NPV) of extending credit.
  • Determination to extend credit: The credit policy needs to be implemented only when NPV comes out to be positive in the condition when incremental sales exceed the incremental costs.
  • Credit Extension: The final decision of extending credit policy by a firm need to be taken by considering the factors of creditworthiness of clients, incremental sales vs incremental costs and establishing a collection policy which determines the amount of time provided for repaying the credit amount. 

(b): In this case Sagun Ltd entered in purchase contract with supplier with term “1/10, net 25”. In order to avail the discount company needs to enter in the loan agreement to fulfill the financing needs. Bank interest rate is 12% on borrowed funds.

Given:

  • Purchase term: 1/10, net 25
  • Bank loan interest rate is 12% per annum on the amount of loan borrowed

Need to calculate the effective interest rate of given credit term and compare it with bank interest rate:

Let us assume that the amount payable to supplier is $100, which mean there is option to pay $99 after 10 days or complete $100 in 15 days after that

  • The interest when discount is not chosen: $1/$99 = 0.0101 interest for 15 days
  • Total number of periods in a year = 365/15 = 24.33 periods in a year
  • Nominal interest rate = 24.33 * 0.0101 = 0.2457
  • Effective interest rate = (1.0101)33-1 = 0.2769

Recommendation: So, if discount is not being taken that than company has to bear interest rate of 27.69% while company can easily avail the discount through taking a bank loan at 12%, so it is advised to enter the loan agreement with the bank and avail the discount.

(c): Formula to calculate the operating cycle= Days in inventory + Days in account receivables

Given:

  • Account payable days = 20 days
  • Inventory days = 50 days
  • Accounts receivables days = 30 days

So, operating cycle of Rameshwor will be = 50 days + 30 days = 80 days

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Accounting and Finance Assignment Help

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