In this report, the Coca-Cola Company is an example for the question on goal maximization of shareholder's wealth. The Coca-Cola Company uses their profit for sporting as FIFA World Cup, European Championship, London 2012 Olympic, etc. In London 2012 Olympic, the Coca-Cola Company sponsors the games to the tune of around £64 million through the International Olympic Committee. Besides, they sponsors for entertainment like music show, game show on TV, etc. The Coca-Cola Company carried out all above examples like non-profit activities. The aims of Coca-Cola Company are advertises their product to customer who pay attention on this event sport.
Either the profit margin or reducing cost is increasing; it will lead the common stock price of a company to maximum value. By reducing cost, it might be eliminating an existing operation or cutting some essential ingredient in a product. In the long time, customers do not want to purchase the product with lower quality. Hence, the value of the firm and the stock market price will be decreased by these actions. The firm should not use illegal methods that will injure its employee, its shareholders stake, its customers and the environment. So the firms should take the actions that will maximization shareholder's wealth and it will bring benefit to the society at the same time.
Some firms adopt a social purpose as a corporate social responsibility to maximize shareholder's wealth. The Coca-Cola Company's "Commitment 2020" aims are getting ambitious goal in the areas of energy conversation, water stewardship, diverse and sustainable recycling. This is the way for employees contribute to the society as gives them an opportunity to be charitable. Besides, the firms may be improving working conditions for their employees, providing healthy product for their customers. Indirectly, it will increase employees' faith to service the firms for a long time and thus creating human experience holding in the company. The firms have skilled employees thus attracting more talented people. With a high-skilled employee base, the firms can provide the best variety of products which can increase its profit margin.
In conclusion, although firms cannot get profit by implementing projects, they still are able to maximize the shareholder's wealth.
Question 2:
In the allocation of investment funds, we can use many methods to evaluate projects, and each method has its own disadvantages and advantages. In this report, we will compare Net Present Value and Internal Rate of Return to appraise the feasibility of a project.
Net Present Value (NPV) is the difference between the total present values of the cash flow in each year of the project with invested money to build the current project at the time of analysis. Internal Rate of Return (IRR) is defined as the discount rate at which prices recover of an investment is equal to 0.
Actually, there is no conflict between these methods when an independence investment project with formal cash flows is being evaluated. With mutually exclusive investments, it is importance to select which method will be used. Suppose two mutually exclusive projects A and B. If project A has higher NPV but lower IRR, and project B has lower NPV but higher IRR, the best decision is chosen project A with higher NPV. Because the value of the company will be leaded by the NPV to maximization shareholder wealth, the IRR is only relative measure of return.
When an investment project has non-conventional cash follow which have different sign in successive periods, it may have more than one IRR. In this case, the best method should be applied is NPV. For example, the project has two internal rate of return, IRR1 and IRR2. When IRR1 and IRR2 are greater than the cost of capital RA, the project will be denied by NPV method. It will lead a negative NPV and decrease shareholder wealth at this discount rate. On the other hand, the cost of capital RB is between IRR1 and IRR2, and then the IRR method cannot give any advice. NPV method can be applied at this discount rate because of a positive NPV. To embrace, the NPV method can give the right investment option.
Both NPV and IRR method have two different reinvestment rate assumptions. The IRR method assumes that the project will reinvest cash flow at IRR's rate of return during its lifetime. The IRR exceeds the cost of capital if the reinvestment rate is being feasible. On the opposite side, at the cost of capital, NPV method assumes that during the life of project, cash flow can be reinvestment. The cost of capital represents an opportunity cost so the reinvestment assumption seems to be reliable. During the lifetime of investment project, NPV method gives different recommendations if there are changes in the cost of capital. The IRR method cannot give the right decision because it always gives the same recommendation.
An overview, the Net Present Value method has more helpful than Internal Rate of Return method. However, IRR method which managers tend to be better understand the concept. Because, IRR is represent the percentage return that a firm expects the capital project to return.
Question 3:
A. (1) WACC means Weighted Average Cost of Capital, which uses mainly for making long-term capital investment decisions. Especially, it also uses for capital budgeting purposes. In the general rule, if the finance is being used to pay for long-term investment of a company, such as medium- and long-term debt, preferred stock (if it used), common stock, leasing and equity finance, it should be calculated. For short-term sources comprise spontaneous, non interest-bearing liabilities like accounts payable and accruals, and short-term interest-bearing debt such as notes payable, the entire above are not included in calculating in WACC. The short-term debt also included in WACC, if the short-term interest-bearing debt acquire as fixed asset, for example, bank overdraft, rather than finance working capital needs. When the investment needs are determined, the cost of capital estimate is write out, so the non interest-bearing is actually not included in this fund.
(2) Cash flows are used by stockholders to pay dividends or reinvestment. Those cash flows are available for stockholders use. Because dividends are paid when reinvestment is made after-tax, all cash flow and rate of return should be calculated on an after-tax basis.
(3) The cost of capital always uses mainly to make decisions that relevant in raising new capital. So the involve component are marginal cost rather than historical costs.
B. Coupon rate = 12%
Face value of bond = $1,000
Time period = 15 years
Price = $1,153.72
Interest rate payments are made semi-annually
The interest payments are done semi annually so rate is:
The interest payments are done semi annually so time period is:
n = 15 x 2 = 30
According to the formula of The Payment:
PMT =
We have the payment of bond:
PMT
The market interest rate on Stenigot's debt means pre-tax cost of debt is calculated by formula:
Kib = YTM =
With: FV is face value
PV is par value
PMT is payment
n is time period
So the pre-tax cost of debt is:
Kib
Because this coupon is paid semi annually, this Kib must be multiplied by 2. Therefore, the YTM pre tax cost of debt is 10%.
From the formula for component cost of debt: Krb (after-tax) = Kib(1-CT)
With: Kib is pre-tax cost of debt
CT is corporate taxation rate
The Stenigot component cost of debt is:
Krb = 10%(1- 30%) = 7%
C. (1) According to the formula of cost of preferred stock:
Kps =
The cost of preferred stock is:
Kps =
(2) Normally, investors can have 70 percent or 80 percent of preferred dividend which received from corporations are non-taxable. By the same company, the before-tax yield on debt has a higher than before-tax yield on preferred. However, the preferred stock on debt is lower than the after-tax cost to the issuer and to the investor. It means preferred stock get higher risk.
D. (1) Earnings of the company can be either paid out as dividend or reinvested in the business. The firm's shareholders are instead of received cash, they reinvested it in bonds, stock, real estate, etc. when earnings are retained. If stockholders could earn other investment like equivalent risk, for example, buying more Streniot's stock, Streniot should get its more retained earnings at least the same with stockholder's forfeit. Furthermore, the stock can be purchased by the company and they will earn return of cost of share (ks). An overview, the opportunity cost of retained earnings is equal to the rate of return that investors expect on the common stock of firm.
(2) Using the Capital asset pricing model (CAPM), the cost of common equity is given by the formula:
Rj = Rf + [(
Where: Rj is the rate of return of share j predicted by the model
Rf is the risk-free rate of return
β is the beta coefficient of share
Rm is the return of the market
So the Steigot's estimated cost of common equity is:
Rj = 7% + (1.3 x 7%) = 16.1%
