Q1. Describe the objective of the firm. Conventional theory of firm assumes maximization of profit is the sole objective of business firms. But recent researches on this issue reveal that the objectives the firms pursue are more than one. The main objective of the firm thus can be summarized as 'maximizing the value of the firm."
This can be achieved through:
(a) Maximization of the sales revenue
(b) Maximization of firm's growth rate
(c) Maximization of Managers utility function
(d) Making satisfactory rate of Profit
(e) Long run Survival of the firm
(f) Entry-prevention and risk-avoidance
Profit Business Objectives:
Profit means different things to different people. To an accountant "Profit" means the excess of revenue over all paid out costs including both manufacturing and overhead expenses. For all practical purpose, profit or business income means profit in accounting sense plus non-allowable expenses.
Economist's concept of profit is of "Pure Profit" called 'economic profit' or "Just profit". Pure profit is a return over and above opportunity cost, I. e. the income that a businessman might expect from the second best alternatives use of his resources.
Sales Revenue Maximisation: The reason behind sales revenue maximisation objectives is the Dichotomy between ownership & management in large business corporations. This Dichotomy gives managers an opportunity to set their goal other than profits maximisation goal, which most-owner businessman pursue. Given the opportunity, managers choose to maximize their own utility function. The most plausible factor in manager's utility functions is maximisation of the sales revenue.
Maximisation of Firms Growth rate: Managers maximize firm's balance growth rate subject to managerial & financial constrains balance growth rate defined as:
G = GD - GC
Where GD = Growth rate of demand of firm's product & GC= growth rate of capital supply of capital to the firm.
In simple words, A firm growth rate is balanced when demand for its product & supply of capital to the firm increase at the same time.
Maximisation of Managerial Utility function: The manager seeks to maximize their own utility function subject to the minimum level of profit. Manager's utility function is express as:
U= f(S, M, ID)
Where S = additional expenditure of the staff
M= Managerial emoluments
ID = Discretionary Investments
The utility functions which manager seek to maximize include both quantifiable variables like salary and slack earnings; non- quantifiable variables such as prestige, power, status, Job security professional excellence etc.
Long run survival & market share: according to some economist, the primary goal of the firm is long run survival. Some other economists have suggested that attainment & retention of constant market share is an additional objective of the firm's. The firm may seek to maximize their profit in the long run through it is not certain.
Entry-prevention and risk-avoidance, yet other alternative objectives of the firms suggested by some economists are to prevent entry-prevention can be:
Profit maximisation in the long run
Securing a constant market share
Avoidance of risk caused by the unpredictable behaviour of the new firms
Q2. Is profit maximization consistent with wealth maximization? Why or why not?
Answer 2
The traditional approach of financial management was all about profit maximization. The main objective of companies was to make profits.
The traditional approach of financial management had many limitations:
1. Business may have several other objectives other than profit maximization. Companies may have goals like: a larger market share, high sales, greater stability and so on. The traditional approach did not take into account so many of these other aspects.
2. Profit Maximization has to define after taking into account many things like:
a. Short term, midterm, and long term profits
b.Profits over period of time
The traditional approach ignored these important points.
3. Social Responsibility is one of the most important objectives of many firms. Big corporate make an effort towards giving back something to the society. The big companies use a certain amount of the profits for social causes. It seems that the traditional approach did not consider this point.
Modern Approach is about the idea of wealth maximization. This involves increasing the Earning per share of the shareholders and to maximize the net present worth.
Wealth is equal to the difference between gross present worth of some decision or course of action and the investment required to achieve the expected benefits.
Gross present worth involves the capitalised value of the expected benefits. This value is discounted at some rate, this rate depends on the certainty or uncertainty factor of the expected benefits.
The Wealth Maximization approach is concerned with the amount of cash flow generated by a course of action rather than the profits.
Any course of action that has net present worth above zero or in other words, creates wealth should be selected.
Q3. Describe the three main decisions in Corporate Finance.
Answer 3
Investment Decision
Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future. Two important aspects of the investment decision are:
(a) The evaluation of the prospective profitability of new investments, and
(b) The measurement of a cut-off rate against that the prospective return of new
Investments could be compared. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision for investment managers do see where to commit funds when an asset becomes less productive or non-profitable.
There is a broad agreement that the correct cut-off rate is the required rate of return or the opportunity cost of capital. However, there are problems in computing the opportunity cost of capital in practice from the available data and information. A decision maker should be aware of capital in practice from the available data and information. A decision maker should be aware of these problems.
Financing Decision
Financing decision is the second important function to be performed by the financial manager. Broadly, her or she must decide when, where and how to acquire funds to meet the firm's investment needs. The central issue before him or her is to determine the proportion of equity and debt. The mix of debt and equity is known as the firm's capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firm's capital structure is considered to be optimum when the market value of shares is maximized. The use of debt affects the return and risk of shareholders; it may increase the return on equity funds but it always increases risk. A proper balance will have to be struck between return and risk. When the shareholders' return is maximized with minimum risk, the market value per share will be maximized and the firm's capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility loan convenience, legal aspects etc. in deciding its capital structure.
Liquidity Decision
Current assets management that affects a firm's liquidity is yet another important finances function, in addition to the management of long-term assets. Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. Investment in current assets affects the firm's profitability. Liquidity and risk. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid. But it would lose profitability, as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound techniques of managing current assets. He or she should estimate firm's needs for current assets and make sure that funds would be made available when needed.
Various financial functions are intimately connected with each other. For instance, decision pertaining to the proportion in which fixed assets and current assets are mixed determines the risk complexion of the firm. Costs of various methods of financing are affected by this risk. Likewise, dividend decisions influence financing decisions and are themselves influenced by investment decisions. In view of this, finance manager is expected to call upon the expertise of other functional managers of the firm particularly in regard to investment of funds. Decisions pertaining to kinds of fixed assets to be acquired for the firm, level of inventories to be kept in hand, type of customers to be granted credit facilities, terms of credit should be made after consulting production and marketing executives.
Financial management is looked on as cutting across functional even disciplinary boundaries. It is in such an environment that finances manager works as a part of total management. In principle, a finance manager is held responsible to handle all such problem: that involve money matters. But in actual practice, as noted above, he has to call on the expertise of those in other functional areas to discharge his responsibilities effectively.
Q4. What is a "hurdle rate"? Why is it important?
Answer 4
The hurdle rate is the minimum acceptable rate of return on a capital investment project. The term is usually associated with one particular method of analysis - the net present value method of capital budgeting the hurdle rate is equal to the company's cost of capital plus the project's risk premium, i.e.,
Hurdle Rate = Cost of Capital + Risk Premium
If the company borrows a sizable amount of money to finance the project, the debt-to-equity ratio of the company will increase. And as the debt-to-equity ratio increases, the risk to the stockholders increases. After all, if the company should default on its debt and/or the company goes into bankruptcy, the debt will have to be paid in full before the common shareholders receive anything. In other words, as the debt level increases, the risk of the shareholders increases as well.
Obviously, the shareholders expect to be compensated for this increase in risk. We are going to have to pay the shareholders a higher rate of return if we finance the project entirely with debt. But how does this affect what we did in the previous section, which was to use the cost of debt as the minimum rate of return for our project?
If we use just the cost of debt as the project's minimum rate of return, then we are overlooking the effect that the higher debt level has on the stockholders. To incorporate both the debt's cost and the stockholders' higher requirements, we need to take a weighted average of the two. In other words, we need to use the overall weighted cost of capital.
What can we do to protect ourselves from accepting an investment project that, in retrospect, will end up losing us money because our estimates turn out to be erroneous? There are several ways to manage this risk, but one common way is simply to add a risk premium to the company's cost of capital and to use this rate as the project's minimum required rate of return. (A risk premium is an extra return that is earned for accepting added risk.)
The higher the risk of our cash inflow estimates, the higher the risk premium. If we have a great deal of confidence that our estimates will prove to be accurate, the risk premium may be very small (probably less than 1.00%). If we don't have faith in the accuracy of our estimates, we may use a risk premium of several percentage points.
By adding a risk premium to the cost of capital, we are requiring a higher rate of return on the project. If we invest in the project because it meets this higher hurdle, some of the actual cash flows can be less than our estimates and we will still make money on the project. In other words, by adding the risk premium, we will eliminate some marginally profitable projects from consideration and improve our odds of investing only in truly profitable projects.
In fact, the analyses of most capital budgeting proposals are structured in such a way that it tilts the result in this direction - to avoid investing in an unprofitable investment. The company is willing to accept a reasonable risk that it will reject some marginally profitable investments, if it can lower the risk of accepting a project that will end up losing money. Consider that the company faces four possibilities for the outcome:
1. The project is profitable, and the company invests in it. (A good decision.)
2. The project is profitable, and the company rejects it. Borrowing a term from statistics, this is known as a Type 1 error - realizing an opportunity loss by failing to invest in a profitable investment.
3. The project will lose money, and the company chooses to invest in it. This is known as a Type 2 error - realizing a real loss that leads to a decrease in the company's cash position.
4. The project will lose money, and the company rejects it.
By using the hurdle rate (i.e., cost of capital + risk premium) as the project's minimum acceptable rate of return, we increase the likelihood that any projects that we accept will indeed be profitable, even if some of our estimates turn out to be inaccurate. In other words, if we set the hurdle high enough and the project is profitable enough to clear it, then we can be wrong on some of our estimates and still be feasible
Q5. . What are the main components of a discount rate?
Answer 5
Wide variety of methods can be used to determine discount rates, but in most cases, these calculations resemble art more than science. Still, it is better to be generally correct than precisely incorrect, so it is worth your while to use a rigorous method to estimate the discount rate.
A good strategy is to apply the concepts of the weighted average cost of capital (WACC). The WACC is essentially a blend of the cost of equity and the after-tax cost of debt. (For more information, see Investors Need A Good WACC.) Therefore, we need to look at how cost of equity and cost of debt are calculated.
Cost of Equity
Unlike debt, which the company must pay at a set rate of interest, equity does not have a concrete price that the company must pay. But that doesn't mean that there is no cost of equity. Equity shareholders expect to obtain a certain return on their equity investment in a company. From the company's perspective, the equity holders' required rate of return is a cost, because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop.
Therefore, the cost of equity is basically what it costs the company to maintain a share price that is satisfactory (at least in theory) to investors. The most commonly accepted method for calculating cost of equity comes from the Nobel Memorial Prize-winning capital asset pricing model (CAPM), where: Cost of Equity (Re) = Rf + Beta (Rm-Rf).
Let's explain what the elements of this formula are:
Rf - Risk-Free Rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The interest rate of U.S. Treasury bills or the long-term bond rate is frequently used as a proxy for the risk-free rate.
ß - Beta - This measures how much a company's share price moves against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold mining company), which means the share price moves in the opposite direction to the broader market. (To learn more, see Beta: Know The Risk.)
(Rm - Rf) = Equity Market Risk Premium - The equity market risk premium (EMRP) represents the returns investors expect, over and above the risk-free rate, to compensate them for taking extra risk by investing in the stock market. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has gone up due to the notion that holding shares has become riskier.
Cost of Debt
Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated. As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. Therefore, the after-tax cost of debt is Rd (1 - corporate tax rate).
Capital Structure
The WACC is the weighted average of the cost of equity and the cost of debt based on the proportion of debt and equity in the company's capital structure. The proportion of debt is represented by D/V, a ratio comparing the company's debt to the company's total value (equity + debt). The proportion of equity is represented by E/V, a ratio comparing the company's equity to the company's total value (equity + debt). The WACC is represented by the following formula: WACC = Re x E/V + Rd x (1 - corporate tax rate) x D/V.
A company's WACC is a function of the mix between debt and equity and the cost of that debt and equity. On the one hand, in the past few years, falling interest rates have reduced the WACC of companies. On the other hand, corporate disasters like those at Enron and WorldCom have increased the perceived risk of equity investments.
Q6. Define the "Efficient Market Hypothesis"
Answer 6
The meaning of financial market efficiency
Financial market is a market for the exchange of capital and credit, which consists the money markets and the capital markets. Money market is the market for short-term debt securities, which is a typically safe and highly liquid able investment, while capital market is the market where long-term debt or securities are traded.
Market efficiency refers to a condition, in which current prices reflect all the publicly available information about a security. The basic idea underlying market efficiency is that competition will drive all information into the price quickly.
In the financial market, the maximum price that investors are willing to pay for a financial asset is actually the current value of future cash payments that discounted at a higher rate to compensate us for the uncertainty in the cash flow projections. Therefore, what investors are trading actually is information as a "commodity" in financial market for the future cash flows and information about the degree of certainty.
Efficient market emerges when new information is quickly incorporated into the price so that price becomes information. In other words the current market price reflects all available information. Under these conditions the current market price in any financial market could be the best-unbiased estimate of the value of the investment.
The theory relating to Efficient Market Hypothesis (EMH)
The Efficient Market Hypothesis (EMH) has been consented as one of the cornerstones of modern financial economics. Fama first defined the term "efficient market" in financial literature in 1965 as one in which security prices fully reflect all available information. The market is efficient if the reaction of market prices to new information should be instantaneous and unbiased. Efficient market hypothesis is the idea that information is quickly and efficiently incorporated into asset prices at any point in time, so that old information cannot be used to foretell future price movements. Consequently, three versions of EMH are being distinguished depends on the level of available information.
Q7. Describe the three forms of efficiency
Answer 7
Types of Efficiency
The weak form EMH stipulates that current asset prices already reflect past price and volume information. The information contained in the past sequence of prices of a security is fully reflected in the current market price of that security. It is named weak form because the security prices are the most publicly and easily accessible pieces of information. It implies that no one should be able to outperform the market using something that "everybody else knows". Yet, there are still numbers of financial researchers who are studying the past stock price series and trading volume data in attempt to generate profit. This technique is so called technical analysis that is asserted by EMH as useless for predicting future price changes.
The semi strong form EMH states that all publicly available information is similarly already incorporated into asset prices. In another word, all publicly available information is fully reflected in a security's current market price. The public information stated not only past prices but also data reported in a company's financial statements, company's announcement, economic factors and others. It also implies that no one should be able to outperform the market using something that "everybody else knows". This indicates that a company's financial statements are of no help in forecasting future price movements and securing high investment returns.
The strong form EMH stipulates that private information or insider information too, is quickly incorporated by market prices and therefore cannot be used to reap abnormal trading profits. Thus, all information, whether public or private, is fully reflected in a security's current market price. That's mean, even the company's management (insider) are not able to make gains from inside information they hold. They are not able to take the advantages to profit from information such as take over decision which has been made ten minutes ago. The rationale behind to support is that the market anticipates in an unbiased manner, future development and therefore information has been incorporated and evaluated into market price in much more objective and informative way than insiders.
Q8. What is the difference between Technical Analysis and Fundamental Analysis?
Answer 8
Technical analysis uses past patterns of price and the volume of trading as the basis for predicting future prices. The random-walk evidence suggests that prices of securities are affected by news. Favourable news will push up the price and vice versa. It is therefore appropriate to question the value of technical analysis as a means of choosing security investments.
Fundamentals analysis involves using market information to determine the intrinsic value of securities in order to identify those securities that are undervalued. However semi strong form market efficiency suggests that fundamentals analysis cannot be used to outperform the market. In an efficient market, equity research and valuation would be a costly task that provided no benefits. The odds of finding an undervalued stock should be random (50/50). Most of the time, the benefits from information collection and equity research would not cover the costs of doing the research.
For optimal investment strategies, investors are suggested should follow a passive investment strategy, which makes no attempt to beat the market. Investors should not select securities randomly according to their risk aversion or the tax positions. This dose not means that there is no portfolio management. In an efficient market, it would be superior strategy to have a randomly diversifying across securities, carrying little or no information cost and minimal execution costs in order to optimise the returns. There would be no value added by portfolio managers and investment strategists. An inflexible buy-and-hold policy is not optimal for matching the investor's desired risk level. In addition, the portfolio manager must choose a portfolio that is geared toward the time horizon and risks profile of the investor.
Q9. . Do you believe markets are efficient?
Answer 9
Implications of EMH and market efficiency
1. Trust market prices.
• Buying and selling assets are zero NPV activities, giving
only risk-adjusted returns.
• Market prices give best estimate of value for projects.
• Firms receive "fair" value for securities they issue.
2. Read into prices.
• If market price reflects all available information, we can
extract information from prices.
3. There are no financial illusions.
• Market price reflects value only from an asset's payoff.
• It is not easy to trick the market.
4. Value comes from economic rents such as
superior information
superior technology
access to cheap resources
Q10. Which of the following statements are true if the efficient market hypothesis holds?
a. It implies that future events can be forecast with perfect accuracy.
b. It implies that prices reflect all available information.
c. It implies that security prices change for no discernible reason.
d. It implies that prices do not fluctuate.
ANSWER: b. It implies that prices reflect all available information.
