ms-42 jan june 2017
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SAMPLE MS-42 FIRST SEMESTER 2017
Course Code MS - 42 Course Title Capital Investment and Financing Decisions Assignment Code MS-42/TMA/SEM - I/2017 Assignment Coverage All Blocks
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KIAN PUBLICATION
School of Management Studies INDIRA GANDHI NATIONAL OPEN UNIVERSITY
MAIDAN GARHI, NEW DELHI – 110 068
1. What is cost of Capital? How is it calculated for different sources of Capital? How is average weighted cost of Capital measured?
“The cost of capital is simply the return --------------------------------------------------------------------------------------------------------------------------------------------------------------- stock and debt holders who buy ------------------------------------------------------------------------------------------------------------------------------------------------------------can be repaid.
You may be wondering if this is the same as ------------------------------------------------------------------------------------------------------------------------------------------------------------calculation done by the finance people. Then the management team takes that number and decides on the -------------------------------------------------------------- to justify an investment,” he says.
In many businesses, the cost of capital is ------------------------------------------------------------------------------------------------------------------------------------------------------------or 11% as the discount rate. “They’re building in a cushion,” says Knight, which is not a bad thing. And how much they pad it will ------------------------------------------------------------------------------------------------------------------------------------------------------------, they might lower the rate, even if just for a period of time.
What do companies typically use it for?
There are two ------------------------------------------------------------------------------------------------------------------------------------------------------------company’s equity.
Let’s look at that first instance. ------------------------------------------------------------------------------------------------------------------------------------------------------------department has determined what the rate is, managers know that is the number to beat if they want to win support for their projects or proposals. “If you make investments that don’t get a return that exceeds the cost of capital, you’re encouraging investors ------------------------------------------------------------------------------------------------------------------------------------------------------------with the help of finance — take a close look at potential projects to make sure they exceed the cost of capital
Now for the second instance. Although this use is less common, investors will look at an aspect of the cost of capital — the beta or volatility (more on this in the next section) — which will help them understand if a stock is a risky investment or not.
HOW IT WORKS (EXAMPLE):
Cost of capital is determined by the ------------------------------------------------------------------------------------------------------------------------------------------------------------ the one providing the higher return.
Let's assume Company XYZ is considering ------------------------------------------------------------------------------------------------------------------------------------------------------------is some risk that the renovation will not save Company XYZ a full $10 million per year. Alternatively, Company XYZ ---------------------------------------------------------------------------- return 12% per year.
Because the renovation is ------------------------------------------------------------------------------------------------------------------------------------------------------------ could have gotten by taking the same risk elsewhere.
The return an investor receives on a company ------------------------------------------------------------------------------------------------------------------------------------------------------------creditors and stockholders. This is often called the weighted average cost of capital and refers to the weighted average costs of the company's debt and equity.
How do you calculate the cost of capital?
In reality, few managers ------------------------------------------------------------------------------------------------------------------------------------------------------------be opaque.” Here’s a brief overview (based on the example in Knight’s book, Financial Intelligence):
The first step is to calculate the cost of debt to ------------------------------------------------------------------------------------------------------------------------------------------------------------has a credit line with a rate of 7%, a long-term loan at 5%, and bonds that it uses to make acquisitions at 3%, you add that -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The formula looks like this:
Cost of debt = average ------------------------------------------------------------------- x (1 – tax rate)
So you take your 6% and ------------------------------------------------------------------------------ the cost of debt = 4.3%.
Now, set that number ------------------------------------------------------------------------------------------------------------------------------------------------------------interest rates.
The formula looks like this:
Cost of equity = --------------------------------------------------------- – risk-free rate)
Beta measures the volatility of the ------------------------------------------------------------------------------------------------------------------------------------------------------------rate as the market, the beta will be close to 1. If it tends to rise and fall more than the market, it might have a beta closer to 1---------------------------------------------------------------------, it might be closer to 0.75.
The market rate is the expected return on the ------------------------------------------------------------------------------------------------------------------------------------------------------------on a risk-free investment, such as a treasury bill (somewhere between 1-3%). This figure can also be debated.
Let’s ------------------------------------------------------------------------------------------------------------------------------------------------------------ calculation:
2% + 1 (11% – 2%) = 11%
Note how ------------------------------------------------------------------------------------------------------------------------------------------------------------difference.
Now the next step is to take your two ------------------------------------------------------------------------------------------------------------------------------------------------------------uses to finance its operations. Let’s assume the company uses 30% debt and 70% equity to run its business. So you’d do the following final calculation:
(0.3 x 4.3%) + (0.7 x 11%) = 8.99%
This is the company’s WACC.
Keep in mind that this is a ------------------------------------------------------------------------------------------------------------------------------------------------------------return and there’s an implicit assumption that your current beta will be the same going forward. In a volatile market, that’s never true,” explains ------------------------------------------------------------------------------------------------------------------------------------------------------------. It may look like a hard, fixed number — but it’s far from that.”
AVERAGE WEIGHTED COST OF CAPITAL
Weighted cost of capital, also -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------by the firm, properly weighted by the proportion they hold in the capital structure of the firm.
Computation of the Average Weighted Cost of Capital
2. Discuss the various components of project planning. Explain the application of work breakdown structure in monitoring and controlling a project. The term ‘project’ has a wider meaning to include a set of activities. For example, ------------------------------------------------------
------------------------------------------------------------------------------------------------------of roof, fixing of doors and windows,
fixing of sanitary fitting, wiring etc. Further, project is the non-routine nature of activities. In fact, a project is an organized
programme of pre-determined group of -----------------------------------------------------------------------------------------------------------
-------------------------------------------------, financial and technical performance goals.
Project Planning Sequence is as follows:
Project planning as represents a --------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------decisions about what will be achieved (project objectives) and by whom.
Preliminary plans serve as the basis for a -------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------- very act of engaging in the preliminary planning
process increases the members’ commitment to the project.
These work plans are used for the third and fourth sequences, -----------------------------------------------------------------------------
-------------------------------------------------------------------------------detail description of projects tasks. The fifth planning
sequence is a precise-description of all project status reports, when they are to be produced, what they must contain, and to
whom they will be sent.
Finally, plans must be developed that deal with project termination, ----------------------------------------------------------------------
-------------------------------------------------------------------------------------- been completed.
But before we begin, we assume that the ---------------------------------------------------------------------------------------------------------
---------------------------------------------------covered here are intended to smooth the path from idea to accomplishment. It is a
complicated process to manage a project, and plans act ----------------------------------------------------------------------------------------
--------------------------------------------------------------------not lost in a welter of minutiae.
Components are as follows-
Problem and Mission Statements- Develop a statement that defines the problem to solve. For example, a problem
statement ----------------------------------------------------------------------------------------------------------------------------------------------
--------------smaller related ones.
Objectives and Deliverables- Objectives and ----------------------------------------------------------------------------------------------
-------------------------------------------------------------- measurable and time-bound.
Specifications- Provide -------------------------------------------------------------------------------------------------------------------------
-----------------------------------codes and government regulations.
Work Breakdown Structure- The work ----------------------------------------------------------------------------------------------------
--------------------------------------------------------activity is included in the project. The WBS also determines the sequence of
project tasks. This is known as task dependencies. For example, --------------------------------------- starting a dependent task.
Resources- Use the WBS to determine -------------------------------------------------------------------------------------------------------
-----------------------------------------------------that should contain a contingency amount, which normally is based on a percent of
the estimated project cost. --------------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------ these issues will not be available.
Schedule- Based on the WBS and -------------------------------------------------------------------------------------------------------------
-----------------------------------------------. It should take into account circumstances that affect the project schedule, such as
political climate, bad weather, constraints related to other projects and the economy.
Application of Work Breakdown structure in monitoring and controlling a project-
A work breakdown structure -----------------------------------------------------------------------------------------------------------------------
-------------------------------------, a project must fulfill the stakeholder needs it was designed to address. The project management
has to plan for the schedule, the fixed -------------------------------------------------------------------------------------------------------------
-----------------------------------------------project execution.
Tasks- The main purpose of a WBS ----------------------------------------------------------------------------------------------------------
--------------------------------------------------the complex activities. Tasks must be measurable and independent, with clearly
defined limits. All the --------------------------------------------------------------------- must not include any non-project work.
Costs- Because the WBS tasks -----------------------------------------------------------------------------------------------------------------
-------------------------------------------packages linked to the tasks and check to make sure that the task costs in total don't exceed
the total project cost.
Schedule- The WBS is --------------------------------------------------------------------------------------------------------------------------
----------------------------------project is by checking which of the tasks are finished. Even within each task, the project
management can check for percent completion because each task is measurable.
Scope- One of the key functions ---------------------------------------------------------------------------------------------------------------
---------------------------------------------out any extra work. The WBS helps define scope by listing individual tasks that make up
the project. The project team completes all the listed tasks but no additional work.
Function- A major criterion for project ------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------function. When all tasks are finished, all the partial --
----------------------------------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------ons add up to a fully functional project.
Responsibility- An important part of ---------------------------------------------------------------------------------------------------------
---------------------------------------------------task manager is responsible for completing the full scope of the project on time,
within the budget and with all of its planned functionality intact.
There are three reasons to use a WBS in your ---------------------------------------------------------------------------------------------------
---------------------------------------------------------is by using a hierarchical tree structure. Each level of this structure breaks the
project deliverables or objectives down to more specific and measurable chunks. The second reason for using a WBS in your
projects is to help with assigning responsibilities, -----------------------------------------------------------------------------------------------
-------------------------------------------------------------knows exactly what has to be accomplished within each deliverable. This also
allows for better estimating of cost, risk, and ----------------------------------------------------------------------------------------------------
--------------------------------------------------------and make sure there is nothing missing or overlapping.
3. What are major global sources of financing? Distinguish between Foreign Direct Investment and Portfolio Investment. Financing is needed to start a business ------------------------------------------------------------------------------------------------------------
------------------------------------------------much money you need and when you will need it.
The financial needs of a business will vary according to the type and size of the business. For example, processing businesses
are usually ------------------------------------------------------------------------------ usually require less capital.
Debt and equity are the two major sources of financing. ---------------------------------------------------------------------------------------
---------------------------------------------------------------------and/or encourage activities in particular industries.
1. Equity Financing
Equity financing means exchanging a portion of the ownership of the business for a financial investment in the business. The ownership stake resulting ------------------------------------------------------------------------------------------------------------------------------------------------------------the company at a later date.
The investment should be properly ------------------------------------------------------------------------------------------------------------------------------------------------------------or in the form of common or preferred stock as in a corporation.
Companies may establish different classes of stock to control voting rights among shareholders. Similarly, companies may use different types of preferred stock. For example, ------------------------------------------------------------------------------------------------------------------------------------------------------------or bankruptcy. Preferred stockholders receive a predetermined dividend before common stockholders receive a dividend.
Personal Savings
The first place to look for ------------------------------------------------------------------------------------------------------------------------------------------------------------insurance policies.
Life insurance policies - A standard ------------------------------------------------------------------------------------------------------------------------------------------------------------the cash value of the policy.
Home equity loans - A ------------------------------------------------------------------------------------------------------------------------------------------------------------value of your home.
Friends and Relatives
Founders of a start-up business ------------------------------------------------------------------------------------------------------------------------------------------------------------the business. However, these investments should be made with the same formality that would be used with outside investors.
Venture Capital
Venture capital refers to financing that ------------------------------------------------------------------------------------------------------------------------------------------------------------an ownership share of the business. Venture capital firms usually don’t want to participate in the initial financing of a business unless ------------------------------------------------------------------------------------------------------------------------------------------------------------from the founders and are already profitable.
Venture capital firms are usually ------------------------------------------------------------------------------------------------------------------------------------------------------------. They may look for annual returns of 25 to 30 percent on their overall investment portfolio.
Because these are usually high-risk ------------------------------------------------------------------------------------------------------------------------------------------------------------others will fail, it is hoped that the overall portfolio will return 25 to 30 percent.
More specifically, many venture capitalists subscribe ------------------------------------------------------------------------------------------------------------------------------------------------------------investment), and two will fail.
Angel Investors
Angel investors are individuals ------------------------------------------------------------------------------------------------------------------------------------------------------------. Although angel investors often have somewhat of a mission focus, they are still interested in profitability and security for their investment. So they may still make many of the same demands as a venture capitalist.
Angel investors may be interested in the ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------than venture capitalists.
Government Grants
Federal and state -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- start-up or expanding businesses.
Equity Offerings
In this situation, the business sells ------------------------------------------------------------------------------------------------------------------------------------------------------------take many forms and requires careful oversight by the company’s legal representative.
Initial Public Offerings
Initial Public Offerings (IPOs) are used when ------------------------------------------------------------------------------------------------------------------------------------------------------------companies have been in business for several years. To get to this point, they usually will raise funds privately one or more times.
Warrants Warrants are a special type of ------------------------------------------------------------------------------------------------------------------------------------------------------------upside potential. For example, warrants can be issued to management in a start-up company as part of the reimbursement package.
A warrant is a security that grants the ------------------------------------------------------------------------------------------------------------------------------------------------------------is the relationship of the market price of the stock to the purchase price (warrant price) of the stock. If the market price of the stock ------------------------------------------------------------------------------------------------------------------------------------------------------------opportunity to purchase the stock at a price below current market price.
2. Debt Financing Debt financing involves ------------------------------------------------------------------------------------------------------------------------------------------------------------), the reward for providing the debt financing is the interest on the amount lent to the borrower.
Debt financing may be secured ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------not have collateral and places the lender in a less secure position relative to repayment in case of default.
Debt financing (loans) may be --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------is used to finance assets such as buildings and equipment.
Friends and Relatives
Founders of start-up businesses may look ------------------------------------------------------------------------------------------------------------------------------------------------------------, if you borrow from relatives or friends, it should be done with the same formality as if it were borrowed from a commercial lender. This --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------on the projected cash flow of the start-up business), and collateral in case of default.
Banks and --------------------------------------- Lenders
Banks and other ------------------------------------------------------------------------------------------------------------------------------------------------------------These are usually hard to come by for a start- up business. Once the business is underway and profit and loss statements, cash flows budgets, ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- additional funds.
Commercial ----------------------------------------
Commercial finance companies ------------------------------------------------------------------------------------------------------------------------------------------------------------the quality of the collateral to repay the loan than the track record or profit projections of your business. If the business does not have ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------is usually higher than other commercial lenders.
Government Programs
Federal, state, and local ------------------------------------------------------------------------------------------------------------------------------------------------------------of the repayment of a loan from a conventional lender. The guarantee provides the lender repayment assurance for a loan to a business that may ------------------------------------------------------------------------------------------------------------------------------------------------------------USDA Rural Development programs.
Bonds Bonds may be used to raise financing ------------------------------------------------------------------------------------------------------------------------------------------------------------other debt financing instruments because the company specifies the interest rate and when the company will pay back the principal (-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------the specified maturity date. The price paid for the bond at the time it is issued is called its face value.
When a company issues a bond it ------------------------------------------------------------------------------------------------------------------------------------------------------------to access financing without having to pay it back until it has successfully applied the funds. The risk for the investor is ------------------------------------------------------------------------------------------------------------------------------------------------------------ ahead of equity holders for company assets.
Lease A lease is a method of obtaining the ------------------------------------------------------------------------------------------------------------------------------------------------------------conditions for the rental use of a tangible resource such as a building and equipment. Lease payments are often due ------------------------------------------------------------------------------------------------------------------------------------------------------------providing the assets. When the lease ends, the asset is returned to the owner, the lease is renewed, or the asset is purchased.
A lease may have an advantage ------------------------------------------------------------------------------------------------------------------------------------------------------------a period of years. However, lease payments often come at the beginning of the year where debt
payments come at the end of the year. So, the business may have more time to generate funds for debt payments, although a down payment is usually required at the beginning of the loan period.
Distinguish between Foreign Direct Investment and Portfolio Investment-
FDI is an acronym that stands ----------------------------------------------------------------------------------------------------------------------
--------------------------------------in a foreign country with long term realization of goals in the enterprise. FPI stands for Foreign
Portfolio Investment where an international -----------------------------------------------------------------------------------------------------
------------------------------------------------------- in the management of those financial holdings.
FDI typically involves -------------------------------------------------------------------------------------------------------------------------------
-----------------------------in one country and an affiliate in another country which would together form a multinational company.
All kinds of capital contributions are --------------------------------------------------------------------------------------------------------------
----------------------------------------------just direct lending by a subsidiary company. It is not easy to withdraw from FDI so it is
common to have --------------------------------------------------------------------------------------------------------------------------------------
----------------------major strategic decisions.
FPI usually aims at short ----------------------------------------------------------------------------------------------------------------------------
--------------------------------routes compared to FDI, where an investor can easily withdraw from a foreign portfolio either when
targets --------------------------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------foreign investments.
Unlike FPI, FDI --------------------------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------------------------------------------------
--------------be adjusted as the business conditions fluctuate.
Summary:
1. FDI tends to yield more --------------------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------to adjust to short term
environmental changes, there’s generally less returns realized, making this a favorite investment route for smaller firms looking
for flexibility and lower investment specific costs other than bigger returns.
2. FDI and FPI investment --------------------------------------------------------------------------------------------------------------------------
----------------------------------in a year. It is therefore harder to make estimates for FPI portfolio flows especially if a FPI
investment is made for one year or less as they contain various instruments, so a definite value is hard to estimate.
3. However on a whole, -----------------------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------. The two models coincide in part with each
other in this case and it may go down to choosing between flexibility and returns on investment.
4. What are the major factors that are taken into consideration for determining the dividend policy of a company? Compare Walter’s Model with Gordon’s Model and examine their rationality. The corporate, institutional and legal ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------alternative forms of financing concerns about the managerial control of the firm, the existence of external (largely legal) restriction and the impact of inflation of cash flow.
Growth and Profitability:
The amount of growth a ------------------------------------------------------------------------------------------------------------------------------------------------------------) cannot issue additional equity.
Firms with strong growth prospects maintain low target payout ratios. In fact all the firms that experience above-average growth rates are expected to have low dividend ------------------------------------------------------------------------------------------------------------------------------------------------------------being equal in a greater need for earnings retention.
This interrelationship among the firm’s growth, its profitability, and its investment, financing, and dividend decisions cannot be overemphasized.
Liquidity:
The liquidity position of a ------------------------------------------------------------------------------------------------------------------------------------------------------------liquidity of the firm, the greater is the firm’s ability to pay (and maintain) a cash dividend.
A growing, profitable firm may not ------------------------------------------------------------------------------------------------------------------------------------------------------------up its permanent working capital position.
Likewise, firms in cyclical industries ------------------------------------------------------------------------------------------------------------------------------------------------------------dividend policy is being assessed.
Cost and Availability of Alternative Forms of financing:
The ability of a firm to raise ------------------------------------------------------------------------------------------------------------------------------------------------------------conveniently and economically raise funds in a number of alternative ways, will have greater latitude in setting dividend policy than a firm that has to rely heavily on earnings retention as a source of financing.
In essence, the key question ------------------------------------------------------------------------------------------------------------------------------------------------------------than those that cannot.
Two aspects that tend to work ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------as the cost of financing is relatively low.
However, when interest ------------------------------------------------------------------------------------------------------------------------------------------------------------ratios, since they raise the cost of financing.
This is particularly true when ------------------------------------------------------------------------------------------------------------------------------------------------------------as the size of an issue declines.
Managerial Control:
In some cases, control of the ------------------------------------------------------------------------------------------------------------------------------------------------------------group, and the remainder of the stock is publicly held. Under these circumstances, the higher the payout ratio, the more likely that a -------------------------------------------------------------------------- capital expenditures.
Those in control might prefer to ------------------------------------------------------------------------------------------------------------------------------------------------------------ownership position.
Hence, they would prefer a low ------------------------------------------------------------------------------------------------------------------------------------------------------------way to keep the firm from being acquired in a merger or acquisition.
Legal constraints:
The legal rules act as boundaries within ------------------------------------------------------------------------------------------------------------------------------------------------------------by the corporations after providing for depreciation. However, a company may be permitted to pay dividend in any financial year out of the profits of thecompany without providing for depreciation.
Though the dividends should be paid in ------------------------------------------------------------------------------------------------------------------------------------------------------------shares (stock dividend).
Access to the Capital Market:
Another matter for --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------negotiating for a bank overdraft limit or having access to other short-term sources of funds.
However, if a company’s ------------------------------------------------------------------------------------------------------------------------------------------------------------which has ready access to funds from the capital market.
Companies which are likely to ------------------------------------------------------------------------------------------------------------------------------------------------------------capital fields.
Inflation:
Inflation must be ------------------------------------------------------------------------------------------------------------------------------------------------------------because of inflation.
But from the firm’s viewpoint, ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------. Thus, in inflationary times, there may be a tendency to hold down cash dividends.
External Restrictions:
The protective ------------------------------------------------------------------------------------------------------------------------------------------------------------the firm’s ability to service its debt.
These restrictions ------------------------------------------------------------------------------------------------------------------------------------------------------------payout. Growth and Profitability:
The amount of growth a -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------constraints) cannot issue additional equity.
Firms with strong growth ------------------------------------------------------------------------------------------------------------------------------------------------------------ratios since, in line with the residual theory of dividends, a greater number of profitable investment opportunities should result (other things being equal in a greater need for earnings retention.
This interrelationship ------------------------------------------------------------------------------------------------------------------------------------------------------------decisions cannot be overemphasized.
Gordon’s model relating to dividend policy.
One very popular model -------------------------------------------------------------------- by Myron Gordon.
Assumptions:
Gordon’s ---------------------------------------------------- assumptions.
1. The firm ----------------------------------------------------------------- firm
2. No external financing is available
3. The ------------------------------------------------------ firm is constant.
4. The --------------------------------------------- remains constant.
5. The firm and its -------------------------------------- are perpetual
6. The --------------------------------------------------------- not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is constant forever.
8. K > br = g if this ---------------------------------------- cannot get a meaningful value for the share.
According to Gordon’s ------------------------------------------------------------------------------------------------------------------------------------------------------------the share. Thus:
The above equation explicitly ------------------------------------------------------------------------------------------------------------------------------------------------------------of the value of the share (P0).
Theories of Dividend: Walter’s model, Gordon’s model 1. Walter’s model: Professor James E. Walter ------------------------------------------------------------------------------------------------------------------------------------------------------------between the firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that will maximize the wealth of shareholders.
Walter’s model is based on the following assumptions: 1. The firm finances all investment through retained earnings; that is debt or new equity is not issued;
2. The firm’s internal ------------------------------------------------------ of capital (k) are constant;
3. All earnings are ---------------------------------------------------- reinvested internally immediately.
4. Beginning earnings and dividends ------------------------------------------------------------------------------------------------------------------------------------------------------------values of E and D are assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.
Walter’s formula to determine the market price per share (P) is as follows: P = D/K +r(E-D)/K/K
he above equation ---------------------------------------------------------------------------------------------------------------------------------------------------------------- value of two sources of income: i) The present value --------------------------------------------------------------------- dividends, (D/K) and
ii) The present --------------------------------------------------- of stream gains.
[r (E-D)/K/K]
Criticism: Walter’s model is quite useful to ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------the model can lead to conclusions which are net true in general, though true for Walter’s model.
The criticisms on the model are as follows: 1. Walter’s model of share valuation ------------------------------------------------------------------------------------------------------------------------------------------------------------earnings only and no external financing debt or equity is used for the purpose when such a situation exists either the firm’s investment or ------------------------------------------------------------------------------------------------------------------------------------------------------------investment in made.
2. Walter’s model is based on ------------------------------------------------------------------------------------------------------------------------------------------------------------made first and then the poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimise the wealth of the owners.
3. A firm’s cost of capital or ------------------------------------------------------------------------------------------------------------------------------------------------------------cost of capital. By assuming that the discount rate, K is constant, Walter’s model abstracts from the effect of risk on the value of the firm.
2. Gordon’s Model: One very popular model ------------------------------------------------------------------------ is developed by Myron Gordon.
Assumptions: ---------------------------------- the following assumptions. 1. The firm is ------------------------------------ firm 2. No external -------------------------------------------------- 3. The internal ------------------------------------------------ of the firm is constant. 4. The appropriate ------------------------------------------ firm remains constant. 5. The firm and its stream of earnings are perpetual 6. The ------------------------------------------- not exist. 7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is constant forever. 8. K > br = g if this ---------------------------------------------------------- we cannot get a meaningful value for the share. According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is equal to the present value of an infinite stream of dividends to be received by the share. Thus:
The above equation explicitly --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------determination of the value of the share (P0).
5. What is financial engineering? Briefly discuss the financial engineering process that you will follow while developing new products or solutions. Financial Engineering is a ------------------------------------------------------------------------------------------------------------------------
------------------------------------the use of simple stochastic models to price derivative securities in various asset classes including
equities, fixed income, credit and mortgage-backed securities.
In general, engineering is the process -------------------------------------------------------------------------------------------------------------
-----------------------------------------------of engineering, we can say financial engineering is the process through which finance
managers or intermediary institutions in financial markets add value to existing plain vanilla products that satisfy the users need.
John Finnerty (1988) offers a comprehensive and ----------------------------------------------------------------------------------------------
--------------------------------------------------------------financial instruments and processes, and the formulation of creative solutions
to problems in finance". The -----------------------------------------------------------------------------------------------------------------------
-------------------------------------, suppliers, consumers, employees and government.
Financial engineering is a -------------------------------------------------------------------------------------------------------------------------
-----------------------------------as the application of technical methods, especially from mathematical finance and computational
finance, in the practice of finance. Despite its name, financial engineering does not belong to any of the fields in
traditional engineering.
Financial engineering draws ------------------------------------------------------------------------------------------------------------------------------------------------------------called a financial engineer, for example any computer programmer in a bank or any statistician in a government economic bureau. However, most ------------------------------------------------------------------------------------------------------------------------------------------------------------It is sometimes restricted even further, to cover only those originating new financial products and strategies.
Computational finance and ------------------------------------------------------------------------------------------------------------------------------------------------------------arise in financial modeling. Mathematical finance is the application of theoretical mathematics to finance.
FINANCIAL ENGINEERING PROCESS IN DEVELOPING NEW PRODUCT Financial engineering process is no ------------------------------------------------------------------------------------------------------------------------------------------------------------needs. Sometime ------------------------------------------------------------------------------------------------------------------------------------------------------------without expecting them to formally communicate such needs. Like car manufacturers, mutual funds managers ------------------------------------------------------------------------------------------------------------------------------------------------------------is quiet possible that you may add one more feature to the existing products, which increase its value to users. For example, an open-end fund ------------------------------------------------------------------------------------------------------------------------------------------------------------formalities relating to redemption and provide instance liquidity. Corporate finance managers have to look for ways to reduce cost of capital ------------------------------------------------------------------------------------------------------------------------------------------------------------is identified, an initial sketch of the product is developed. At this stage, depending on the ------------------------------------------------------------------------------------------------------------------------------------------------------------ The next stage is testing of the product so check whether the desired result is achieved. Sometime it involves simple verification with ------------------------------------------------------------------------------------------------------------------------------------------------------------under various simulated future scenario. Once the product is perfected, the next ------------------------------------------------------------------------------------------------------------------------------------------------------------. So, the product may be restructured again so as to make it attractive to the users. Finally, the product is launched or solutions are provided either directly or after some test marketing.
As stated above financial, engineering ------------------------------------------------------------------------------------------------------------
------------------------------------------------of such needs will be useful to appreciate the role of financial engineering and the
products and solutions that -------------------------------------------------------------------------------------------------------------------------
-----------------------------------factors are briefly discussed below:
1. Tax Advantage: If there is a way to save tax or ---------------------------------------------------------------------------------------------
---------------------------------------------------------------the secondary market, the difference between the redemption value and the
purchase price is treated as capital gains whereas interest received from interest paying bonds are treated as regular income.
Since the tax rate for capital gains is substantially ----------------------------------------------------------------------------------------------
--------------------------------------------------------------), it make sense for companies to issue zero-coupon bonds. Small investors
wanting to show the income as regular income will buy the same in primary market whereas high net worth investors will buy
from secondary market. Mutual funds ------------------------------------------------------------------------------------------------------------
------------------------------------------------fund, which in turn invest the money in bonds and receive interest income, you can still
show the income as capital gain by choosing certain schemes. You can convert capital gains into dividend and vice versa.
Thus, mutual fund is a financially ------------------------------------------------------------------------------------------------------------------------------------------------------------are several other examples. While operating leasing is a plain vanilla product, financial leasing is an engineered product, which often ------------------------------------------------------------------------------------------------------------------------------------------------------------subsequently. Similarly, a non-tax paying company and tax paying investors can save tax by investing in preference ------------------------------------------------------------------------------------------------------------------------------------------------------------debenture on default of dividend.
2. Reduced Transaction Cost: Financial products ---------------------------------------------------------------------------------------------
---------------------------------------------------------------invariably it has to approach the market again with another bond issue in the
near future since growth demands fresh funds. An alternative is issue of fairly a long-term bond, say 99-years with call and put
options and in that process tremendous -----------------------------------------------------------------------------------------------------------
-------------------------------------------------product to handle transaction cost. Mutual funds and several products of derivative
markets are aimed to reduce either transaction cost or at least recurring transaction cost to a large extent.
3. Reduced Agency Cost: Agency relationship -------------------------------------------------------------------------------------------------
-----------------------------------------------------------product, which swaps part of salary for equity such that the value of equity
increases only if mangers perform well. Leveraged Buyout (LBO) through issue of junk bonds is a financial process through
which inefficient management is replaced --------------------------------------------------------------------------------------------------------
----------------------------------------------------take action against defaulting companies except initiating time consuming court
action and in meanwhile productivity of assets are deteriorate further.
4. Risk Reallocation: Financial -------------------------------------------------------------------------------------------------------------------
-----------------------------------------the risk to different parties and of course such reallocation comes with a price. For instance,
fixed interest rate bond is plain instrument -------------------------------------------------------------------------------------------------------
-----------------------------------------------------issuers are exposed to higher cost of borrowing. A swap transaction can shift such
risk from company to counter party. --------------------------------------------------------------------------------------------------------------
----------------------------------------------examples in subsequent sections.
5. Increased Liquidity: Liquidity reduces the cost and ---------------------------------------------------------------------------------------
---------------------------------------------------------------------compared to financial assets. Land is not as liquid as bonds issued by a
company dealing in buying and selling of land. Equity and bonds of leasing companies are more liquid than assets funded by
leasing companies. Loan ----------------------------------------------------------------------------------------------------------------------------
--------------------------------can improve the liquidity. Another example, is openend mutual funds, which give option to enter and
exit at anytime and of course with certain cost (entry and exit load).
6. Regulatory or Legislative Factors: -----------------------------------------------------------------------------------------------------------
-------------------------------------------------and the cost of compliance of such regulations is high. ADR and GDR are financially
engineered products, which allow companies to issue ------------------------------------------------------------------------------------------
------------------------------------------------------------------, which reduces level of risk and also transaction cost. Mutual funds are
introducing several new products within ---------------------------------------------------------------------------------------------------------
---------------------------------------------------If regulation puts certain restrictions, you have to be more innovative to keep the
interests of investors. If regulation removes certain ---------------------------------------------------------------------------------------------
---------------------------------------------------------------on companies raising deposits from public.
7. Level and Volatility of Interest Rates: Interest rate influences --------------------------------------------------------------------------
----------------------------------------------------------------------------------creates problem for several players in the market but there
are people who like volatility of interest rates ---------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------------------- All interest rate
derivatives are outcome of such volatile behaviour of interest rates.
8. Level and Volatility of Prices: Producers ----------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------such price risk from those riskaverse players to
those who are willing to take up such risk.
9. Academic Work: Sometime --------------------------------------------------------------------------------------------------------------------
----------------------------------------and subsequently someone finds it useful.
10. Accounting Benefits: Accounting regulation -----------------------------------------------------------------------------------------------
-------------------------------------------------------------salary by converting a part of salary into stock option (ESOP) but not
recognized as expense. In that process, -----------------------------------------------------------------------------------------------------------
-------------------------------------------------price that is going to be offered in the future;
11. Technological Developments and other Factors: A complex exotic derivative structure was neither in demand nor life was
as complicated as today requiring -----------------------------------------------------------------------------------------------------------------
-------------------------------------------trade risk and return.
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