Financial Management Principals and Applications

Question: Describe about the Financial Management for Principals and Applications. Answer: 1. The NPV of the given projects based on the cash flow expected over the project life is computed below using 10% as the discount rate (Damodaran, 2008). Discounted cash flows ($) Year A B C D E F 0 -100000.00 -150000.00 -60000.00 -100000.00 -50000.00 -100000.00 1 18181.82 -45454.55 18181.82 54545.45 18181.82 27272.73 2 33057.85 82644.63 33057.85 49586.78 33057.85 24793.39 3 45078.89 75131.48 30052.59 75131.48 45078.89 22539.44 4 54641.08 95621.88 0.00 0.00 27320.54 20490.40 NPV ($) 50959.63 57943.45 21292.26 79263.71 73639.10 -4904.04 Cumulative NPV 50959.63 108903.08 130195.34 209459.05 283098.15 278194.11 It is apparent from the above table, that cumulative NPV is increasing with every project except project F. Thus, project F is not acceptable as it leads to reduction of the total NPV arising from the investment. However, it is known that the company has a capital of only $ 300,000 to invest. The projects are divisible and hence allocation must be done in accordance with the highest NPV generated per dollar invested (Shim and Siegel, 2008). NPV generated per dollar invested Amount ($) A 0.51 B 0.39 C 0.35 D 0.79 E 1.47 Hence, firstly allocated would be made to project E ($50,000), D ($100,000), A ($100,000) and remaining $ 50,000 would be invested in project B since part investment in the project is also feasible. NPV generated from E =$ 10 NPV generated from D = $ 79263.71 NPV generated from A = $ 50,959.63 NPV generated from B = (50000/150000)* 57943.45 = $ 19,314.48 Total NPV generated from allocated projects = $ 223,176.92 Now, investment cannot be divided and hence the capital allocation would be made on the basis of highest NPV that is derived from the project keeping in mind that all the capital is used and no capital stays idle. Hence, the chosen projects should be B, D and E since these generate the highest amount of NPV and are also able to completely utilise the initial capital of $ 300,000 (Petty et. al., 2015). The total NPV of the acquired projects = $ 57943.45 + $ 71 + $ 73639.10 = $ 210, 846.3 It is known that projects A and E are exclusive. Since projects are divisible, hence selection would again be done on NPV generated per dollar of investment. NPV generated per dollar invested Amount ($) A 0.51 B 0.39 C 0.35 D 0.79 E 1.47 Between A and E, it is apparent that E is preferable since it offers higher returns per unit investment and also in absolute terms (Parrino and Kidwell, 2011). Hence, investment in project E = $ 50,000 Then, investment of $ 100,000 would be made in project D due to second highest value of NPV generation. Since, A cannot be chosen, hence investment of $ 150,000 would be made in project B which would exhaust the available capital completely (Brealey, Myers and Allen, 2008). Total NPV of the projects acquired = $ 57943.45 + $ 71 + $ 73639.10 = $ 210, 846.3 2. The NPV of the given projects is estimated assuming the discount rate to be 10%. Present value Year Cash flow A ($) Cash flow B ($) PV Factor Project A Project B 0 -100000 -140000 1.00 -100000 -140000 1 30000 53000 0.91 27272.73 48181.82 2 35000 53000 0.83 28925.62 43801.65 3 40000 53000 0.75 30052.59 39819.68 4 45000 53000 0.68 30735.61 36199.71 5 55000 53000 0.62 34150.67 32908.83 NPV 51,137.22 60,911.7 The IRR may be defined as that rate at which the NPV of the project becomes zero (Damodaran, 2008). Project A The IRR comes out to be 26.46% as shown below. Year Cash flow A ($) PV Factor Project A 0 -100000 1.00 -100000 1 30000 0.79 23723.86 2 35000 0.63 21887.51 3 40000 0.49 19781.2 4 45000 0.39 17598.24 5 55000 0.31 17009.19 NPV 0 Project B The IRR comes out to be 25.88% as shown below. Year Cash flow B ($) PV Factor Project B 0 -140000 1.00 -140000 1 53000 0.79 42103.78 2 53000 0.63 33447.71 3 53000 0.50 26571.23 4 53000 0.40 21108.48 5 53000 0.32 16768.81 NPV 0 The relation between discount rate and NPV for the two projects is summarised in the table below. Discount Rate (%) NPV (Project A) NPV (Project B) 0 105,000.00 125,000.00 10 51,137.22 60,911.70 20 16,259.36 18,502.44 25.88 1,296.80 0.00 26.46 0.00 -1,630.20 The requisite diagram is shown below. It is apparent that both the projects are feasible and commercially viable. However, the exact acceptability would depend upon the cost of capital. Assuming the cost of capital of 10% per annum, project B would be more preferable as compared to A since it delivers a higher NPV although the investment is also higher in this case. However, with regards to IRR as the decision making tool, preference would be given to project A as it has a higher value of IRR. Clearly, there is a conflict between the two metrics and in such situations preference is given to NPV instead of IRR (Brealey, Myers and Allen, 2008). 3. In the given case, the range of financing for the various sources and also their corresponding cost after tax has been provided. Also, it is known that the target capital structure for the firm is the one it currently has. Contribution of long term debt through debentures = $ 1,500,000*(245.33/200) = $ 1,839,975 Contribution of share equity = $ 1,500,000 * (23/15) = $ 2,300,000 Contribution of preference shares = $ 400,000 *(5.75/5) = $ 460,000 Total capital = $ 4,599,975 Weight of long term debt = (1839975/4599975)*100 = 40% Weight of share capital = (2300000/4599975)*100 = 50% Weight of preference shares = (460000/4599975)*100 = 10% Using the above information, the breaking points may be determined as shown below (Shim and Siegel, 2008). Breaking point (Long term Debt) = 300000/0.4 = $ 750,000 Breaking point (Preference Shares) = 100000/0.1 = $ 1,000,000 Breaking point (Equity shares) = 500000/0.5 = $ 1,000,000 There are the following ranges of financing that are viable based on the calculation above. Case 1: 0 to $ 750,000 Source of Finance Optimum Weight Amount Long term debt 40% 300,000 Equity 50% 375,000 Preference Share 10% 75,000 Case 2: 750,000 -$ 1,000,000 Source of Finance Optimum Weight Amount Long term debt 40% 400,000 Equity 50% 500,000 Preference Share 10% 100,000 Case 3: $1,000,000- $2,00,000 In this case, the contribution of equity would exceed more than $ 500,000 and hence the cost of capital would change. Case 4: $2,000,000- $ 2,400,000 In this case, the contribution of equity would exceed more than $ 1,000,000 and hence the cost of capital would change. Case 5: More than $ 2,400,000 In this case, the contribution of debt would be more than $ 600,000 and hence the cost of capital would change The corresponding WACC for the various cases presented above are as follows (Petty et. al., 2015). Case 1: 0 to $ 750,000- WACC calculation is shown below. Source of Finance Optimum Weight Post tax cost Effective cost Long term debt 40% 6.5 2.6 Equity 50% 11 5.5 Preference Share 10% 9.5 0.95 Total 9.05 Case 2: 750,000 -$ 1,000,000 WACC calculation is shown below. Source of Finance Optimum Weight Post tax cost Effective cost Long term debt 40% 7.5 3 Equity 50% 11 5.5 Preference Share 10% 9.5 0.95 Total 9.45 Case 3: $ 1,000,000 - $ 2,000,000 - WACC calculation is shown below. Source of Finance Optimum Weight Post tax cost Effective cost Long term debt 40% 7.5 3 Equity 50% 12.5 6.25 Preference Share 10% 10 1 Total 10.25 Case 4: $ 2,000,000 - $ 2,400,000 - WACC calculation is shown below. Source of Finance Optimum Weight Post tax cost Effective cost Long term debt 40% 7.5 3 Equity 50% 14 7 Preference Share 10% 10 1 Total 11 Case 5: More than $ 2,400,000 - WACC calculation is shown below. Source of Finance Optimum Weight Post tax cost Effective cost Long term debt 40% 9 3.6 Equity 50% 14 7 Preference Share 10% 10 1 Total 11.6 The IRR associated with the various investment opportunities is given below, Investment Opportunity IRR A 14% B 12% C 11% D 10% E 9% F 8% The requisite plot is shown below (Parrino and Kidwell, 2011). From the above, it is apparent that the projects that would be funded are A,B and C. This is because the total amount of funding required for these in $ 1,000,000. For D, the marginal cost of capital would be higher than the IRR delivered, hence it would not be chosen. Project E and F are not feasible due to lower IRR (Damodaran, 2008). If project C is not available, then investment opportunity D can be pursued instead of it as the IRR of this would be greater than the marginal cost of capital (Shim and Siegel, 2008). 4. The various risks that tend to impact the shareholders and/or financial managers are highlighted below (Petty et. al., 2015). Business Risk Every business has an underlying risk which would be driven by the nature of business model. This business risk may be compounded due to adverse economic conditions and other factors which may undermine the stability of the business. Financial Risk Typically, all business have obtained some level of credit and it is imperative that the money should be returned in a timely fashion along with the requisite interest payments. Delays in this regards or inability to meet the payments may lead to insolvency. Liquidity Risk This risk is primarily faced by the shareholders of the company when there is not enough liquidity for the securities of the company and hence there is a high liquidity premium which may be charged. Market Risk The value of the share of the company is driven by a plethora of factors and is exposed to systematic risk or market risk which the shareholders have exposure to due to underlying fluctuations in the stock price. Tax and Exchange rate Risk Any unfavourable alterations in the tax regime or exchange rate could have impact on the earnings of the firm and impact its growth and market value. Hence, this is a risk factor for both managers and shareholders. References Brealey, R., Myers, S. and Allen, F. (2008), Principles of Corporate Finance (Global edition), New York: McGraw Hill Publications Damodaran, A. (2008), Corporate Finance, London: Wiley Publications Parrino, R. and Kidwell, D. (2011), Fundamentals of Corporate Finance, London: Wiley Publications Petty, J.W., Titman, S., Keown, A.J., Martin, P., Martin J.D. Burrow, M. (2015), Financial Management: Principles and Applications, Sydney: Pearson Australia, Shim, J.K. and Siegel, J.G. (2008), Financial Management, New York: Barrons