The main financial objective of the firm is stated to be the maximization of shareholder wealth. Shareholder wealth is decided by dividend payment and capital gains that increases in the value of their shares. Maximizing shareholder wealth is maximizing the value of dividend and capital gains that they receive over time. Now, in addition to invest in the financial projects in order to raise profit for businesses, a number of companies involved in some social project such as sporting or entertainment events as sponsors. It has spread and been becoming a trend with many large firms around the world. Many people believe that these projects contradict the goal of maximization of shareholder wealth. However, in my opinion, the sponsoring of these events not only does not conflict with the goal, but also contribute to increasing the wealth of shareholders.
In the fact, today, sponsoring activities are seen as an effective marketing tool that brings better effects rather than other forms of advertising. By supporting events that target market finds attractive, companies could improve their image, prestige and creditability with customers. Moreover, sponsorship provides great opportunities of broadening the company's competitive edge. It helps to differentiate the company from many other competitors, and build better and closer relationships with both existing and potential clients. Additionally, the firm has opportunities to gauge customer's responses to products and services immediately. In general, sponsoring of sport events are the most popular and it is unlimited for local or international.
For example, McDonalds is one of the top sponsors in London 2012 Olympics and Paralympic Game. McDonalds has been a sponsor of the Olympics since 1976 and its sponsoring contract will be extended to 2020. During the Game period, images of McDonalds were seen everywhere. Moreover, the Olympics is expected to welcome more than 6 million people around the world, thus McDonalds had a chance to serve over 1.75 million meals to athletes, spectators, the Game's staffs, and audients. Another example, at Euro 2012, Hyundai sponsored total 336 cars to serve throughout the tournament. Benefits of taking part in this event were that Hyundai was allowed to promote its images on the streets through activities outside the pitch. In the stadiums, banners of Hyundai were full. Thus, communication effects of it at Euro 2012 were huge. This investment of Hyundai had helped to raise the name of South Korean car manufactures in Europe.
To sum up, sponsorship of events is good way to improve the firm's brand name, as well as could raise its goodwill, and enable more profits in the future. However, financial and marketing managers need to build a sponsoring campaign that is for right target market, at the right time, using affordable funds, and in developing company's strategy. Hence, shareholders' wealth will be increased.
QUESTION 2:
The net present value (NPV) and internal rate of return (IRR) methods are two of the many methods that are used to analyze capital investment projects of a corporate. Both methods use the cost of capital or required rate of return to test projects. The difference is that NPV method discounts all cash outflows and inflows to their present value, and IRR method discounts cash flows to the zero net present value. Commonly, if analyzing independent projects, both methods lead the same decisions. However, in some situations, they give different decisions. When the decisions from two methods are conflict, NPV method is preferred to choose for some follow reasons.
The NPV and IRR methods will reach different results if they evaluate mutually exclusive projects. Frequently, each company has many investment projects. However, financial capital is limited, so the company chooses only one project which has highest NPV. For example, there are two investment projects A and B. When comparing NPV, A is preferred, but when comparing IRR, B would be chosen. In this case, the correct decision for financial manager is to choose the higher NPV project. The reason is that the higher NPV will lead to the greatest increase in the value of the company while IRR ratio is only relative return matters. Thus this decision would support for the main purpose of company that is maximizing shareholder wealth.
Sometimes, there are several investment projects that cash flows go with different signs in whole periods, for instant, a mineral extraction project with highly initial investment in land and infrastructures. In these projects, the direction of cash flows often change such as a cash outflow is followed by a cash inflow, next is cash flow again, and further more. It is called non-conventional cash flows. In this case, using IRR method will have two IRR. So which IRR should be used while the NPV method works easily with this kind of cash flows? The best answer is that using NPV method to evaluate projects.
NPV also will be preferred than IRR in the case of changing discount rate. Whereas discount rate changes over the project life, NPV could accommodate easily, IRR cannot mention of the fact that the discount rate is different. In the case of reinvestment, the NPV method assumes that cash flows that are generated from project life could be reinvested at the cost of capital, while the IRR method says that it can use internal rate of return to reinvest these cash flows. When using NPV method, if the firm's cost of capital is constant, there is an opportunity cost. The firm could use cash inflows from these projects to pay for shareholders and investors, or use to substitute outside capital. It means that the firm can save interest expense if outside capital is not used, so the best return would be gained. When using IRR method, if the gap between IRR and cost of capital is too far, it is unrealized to obtain alternative returns. To sum up, the reinvestment assumption under NPV method is more realistic than under IRR method.
Generally, although both methods often used by financial managers rather than others, sometimes, the NPV method would be in favor of because it support for the primary objectives of a corporate.
QUESTION 3:
A. (1) Generally, the weighted average cost of capital (WACC) is mainly used for long-term investment decisions of a company. Thus, the WACC should include types of capital sources for long-term rather than short-term. Therefore, for example, some long-term sources should be included are loan, equity finance, preference shares, and long-term debts, and financial leasing. Short-term capital often does not be used because it is relative to short-term assets. However, if the firm uses short-term sources to acquire long-term assets or fix assets, they could be included in the WACC calculation such as bank overdraft and note payable.
(2) The component costs of capital of a company include cost of debt, preference shares, and equity. Cash flows in the company which are available to pay dividend or reinvest are main objective of shareholders and they are measured in after-tax dollar. Thus, all corporate cash flows and rate of returns of the component cost should be made with an after-tax basic. For example, interest payment is deductible, and it has both before-tax and after-tax cost of debt, so the return that investors can get should be measured for tax deductibility.
(3) The marginal cost is the cost of addition raised capital, while the embedded cost is estimated as necessary and required capital. In the financial management, WACC increases if company raises more capital, thus the cost of capital is used to make raising new capital decisions. To sum up, the relevant component costs of capital should be made in new (marginal) costs rather than historical (embedded) costs.
B. Stenigot's 12% coupon, semiannual payment, with 15 years to maturity is currently selling for $1,153.72
PMT = coupon payment * par value of bond
$1,000
$60 $60 $60 $60 $60 $60
0 1 2 3 4 … 29 30
$1,153.72
We have
Thus, the market interest rate on Stenigot's debt is 10%
The pre-tax cost of debt is
This cost of debt is the semiannual rate, thus the before-tax cost of debt is
Because interest payment is tax deductible, Stenigot's component cost of debt is the after-tax cost of debt
C. (1) Current price of 10% preferred stock, $100 par value, is $111,10. Thus, cost of preferred stock is estimated as follow:
(2) When the firm goes to liquidation, in priority, it has to pay debts to creditors, and pay dividend to the preference shareholders later, so the cost of capital of debt is lower than of preferred shares. However, in this case, the preferred's yield to investors 9% is lower than the yield to maturity on the debt 10%, and 10% is the before-tax rate. In addition, interest payment of debt is tax deductible, thus the firm should estimate to the corporate tax, and the cost of debt is used in WACC is the after-tax (7%). Whereas, preference dividends are taxable, so they are distributed to after-tax profit. Conclusion, though Stenigot's preferred stock is riskier than debt, the cost of it 9% is lower than the before-tax cost of debt 10% and higher than the after-tax one 7%.
D. (1) After a firm makes capital gains, they are often used to pay dividend to shareholders or retain earning to reinvest. When it is used to reinvest, it is considered as alternative source of capital with no cost. It is true because the firm does not pay anything for that finance. However, gains are assets of shareholders, thus, though it is none paying for using, it is not free money because they expect to get returns from the firm's reinvestment. It is cost of retained earnings. For example, if retained earnings are paid out as dividend, shareholders could achieve return from personal investment. As a result, there is an opportunity cost associated with retained earnings.
(2) Cost of common equity using CAPM approach
Hence, the cost of equity is 16.1%
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