Corporate Finance

Assignment

March, 2009
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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

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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.

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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:

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

Sources of Capital/Financing Bonds Preferred stock Common stock

$ 300,000 100,000 600,000 1,000,00 0

Cost of Capital 10% 13% 16%

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/Financing Bonds Preferred stock Common stock Capital Structure (%) 300,000 30% 100,000 10% 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%

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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.

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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

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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

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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

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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

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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

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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: Date Stock Price Option Price Contract Value Paper Gain/Loss May 1 $67 $3.15 $315 $0 May 21 $78 $8.25 $825 $510 Expiry Date $62 worthless $0 -$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 + Value Value $8.25 = $8 + $0.25 In real life options almost always trade above intrinsic value. Premium = Types of Options There are two main types of options:

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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.

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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.

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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”.

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