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FINA6000 Managing Finance

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FINA6000 Managing Finance

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Course Code: FINA6000
University: Laureate International Universities

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Country: United States

Question:

Analyse financial information and evaluate financial performance of a business.
Apply time value of money to the valuation of a variety of cash flows, securities and projects leading to sound investment and financing decisions.
Analyse risk and return associated with investments.
Apply various capital budgeting techniques to investment decision making.
Analyse the cost of capital and explore its link to the capital structure of an organisation.
Analyse working capital and payout policies and their impact on the liquidity position of a business.

Instructions:
(a) From the list of ASX200 companies below choose any 2 companies NOT from the same sector. Evaluate the capital structures of the two companies over the most recent 5 years and discuss how similar or different they are from their industry average capital structures. Critically comment on what factors could have influenced the capital structures of both firms over the period. What theory of capital structure do you think closely describes the capital structure of each of the companies?
(b) Having examined the capital structures, determine the weighted average cost of capital (WACC) of the companies.
(c) To what extent has taxes influenced the WACC?
(d) You have inherited $5 million from your late grandfather and are considering investing in shares of one of the two companies. Perform a valuation of the two stocks using two approaches, a discounted cash flow approach and the other a relative valuation approach.
(e) Using the results of the valuation above, together with an analysis of how the two companies have fared with regards to risk and return over the most recent 5 years, decide which one to invest in. You should use more than one metric of risk and return in your analysis.
(f) Would your decision change if you consider other factors (qualitative or otherwise) that pertain to these companies?
(g) Critically evaluate the use of standard deviation as a measure of risk of investing in shares. From your research suggest better methods than standard of measuring risk.

Answer:

Introduction
This study is the reflection of a detailed analysis carried out with the help of two ASX200 listed companies naming Alumina Limited and AMP Limited whose last five year financial status starting from the Financial year ending as on 31st December 2013 and ending as on 31st December, 2017 have been taken into consideration to evaluate the relevance of their Capital structure, corresponding cost of capital and significant risk ad returns associated with them and how these considerations have significant influence on the decisions to be made by the proposed investor in these companies (Boccia & Leonardi, 2016). In order to carry out this evaluation an attempt has been made to bring into light the relevant theories of capital structure, the procedure to compute the Weighted Average cost of Capital, the effect of taxes on the computation of cost of capital, the payout policy of the companies in terms of dividend, computation of cost of equity, the measurement of the risk and corresponding return and other corresponding relevant factors while making the decision relating to investment have been discussed along with the standard deviation as a method of measurement of risk and other methods for the computation of measurement of risk (Werner, 2017).
Evaluation Of Capital Structure Of Alumina Limited And Amp Limited
There are various sources of fund available with any corporate entity with a view to financing its operations with the objective of future growth, which can basically be categorized under the head debt fund and equity fund including the preferred stock though both have some merits and demerits associated with it (Alexander, 2016). The appropriate proportion of these funds in the capital structure of company helps it to achieve the optimum cost of capital for increasing productivity of the entity as a whole. The following table provides a brief description of the capital structure of Alumina Limited and AMP Limited for last five years that shall assist us to make a comprehensive study of the same.
Alumina Limited

 
Year

Source of capital

Number in issue

Price per share

Market Value
US$ Million

Proportion to total long term capital

 

Ordinary shares

2760518829

10.10

2789

96.23%

2013

Long Term Debt

 

109.2

3.77%

 

 

 

 

Total

100%

 

 

 

 

 

 

 

Source of capital

Number in issue

Price per share

Market Value
US$ Million

Proportion to total long term capital

 

Ordinary shares

2805745467

14.66

4114

97.25%

2014

Long Term Debt

 

116.1

2.75%

 

 

 

 

Total

100%

 

 

 

 

 

 

 

Source of capital

Number in issue

Price per share

Market Value
US$ Million

Proportion to total long term capital

 

Ordinary shares

2824328800

8.856

2418

95.06%

2015

Long Term Debt

 

125.7

4.94%

 

 

 

 

Total

100%

 

 

 

 

 

 

 

Source of capital

Number in issue

Price per share

Market Value
US$ Million

Proportion to total long term capital

 

 

 

 

 

 

2016

Ordinary shares

2879843498

13.20

3802

97.21%

 

Long Term Debt

 

109.2

2.79%

 

 

 

 

Total

100%

 

Source of capital

Number in issue

Price per share

Market Value
 

Proportion to total long term capital

 

Ordinary shares

2879843498

24.30

7.0( US$ billion)

98.49%

2017

Long Term Debt

 

107.2(US$ Million)

1.51%

 

 

 

 

Total

100%

AMP Limited

 
Year

Source of capital

Number in issue

Price per share
AUD $

Market Value
AUD $million

Proportion to total long term capital

 

Ordinary shares

2929000000

4.39

12858.31

61.77%

2013

Long Term Debt

 

7957

38.23%

 

 

 

 

Total

100%

 

 

 

 

 

 

 

Source of capital

Number in issue

Price per share
AUD $

Market Value
AUD $million

Proportion to total long term capital

 

Ordinary shares

2945000000

5.50

16197.5

77.15%

2014

Long Term Debt

 

 

4796

22.85%

 

 

 

 

Total

100%

 

 

 

 

 

 

 

Source of capital

Number in issue

Price per share
AUD $

Market Value
AUD $million

Proportion to total long term capital

 

Ordinary shares

2938000000

5.83

17128.54

72.34%

2015

Long Term Debt

 

 

6548

27.66%

 

 

 

 

Total

100%

 

 

 

 

 

 

 

Source of capital

Number in issue

Price per share
AUD $

Market Value
AUD $million

Proportion to total long term capital

 

 

 

 

 

 

2016

Ordinary shares

2948000000

5.04

14857.92

74.91%

 

Long Term Debt

 

 

4976

25.09%

 

 

 

 

Total

100%

 

Source of capital

Number in issue

Price per share
AUD $

Market Value
AUD $million

Proportion to total long term capital

 

Ordinary shares

2918000000

5.19

15144.42

69.42%

2017

Long Term Debt

 

 

6669

30.58%

 

 

 

 

Total

100%

From the figures reflected through the above table it is quite evident that the major similarities noticed in the capital structure of both o the companies is explained hereunder:

That both have kept the percentage of equity fund higher in comparison to the debt fund (Choy, 2018).
That both have shown a fluctuation in the proportion of debt fund incorporated in the financial statement of last five years, as at times they were increased and subsequently decreased too.

The difference in the capital structure is that the component of debt is much higher in case of Amp limited. Both the companies are maintaining their component of debt and equity similar to that of the material and financial industry.
 Two of the major capital structure theories are discussed hereunder.

Static Theory of capital structure : This theory is based on the fact that while choosing the debt as a mode of financing has the benefit in terms of tax shield earned on the interest paid/payable on such debt, but at the same time the firm may have to bear the cost of bankruptcy too, in case it is overburdened with such debt, hence the firm while choosing the appropriate proportion of debt in its capital structure should always keep in mind the trade off between the equity and the debt so that to ensure the maximization of the value of the firm (Jefferson, 2017).
Pecking order theory of capital structure: This theory clearly enumerates the fact that while choosing for the mode of finance a firm always maintains a hierarchy or order of preference in accordance with which first preference is given to the internal fund, next is the debt and the last source being resorted to is the equity. In other words, a firm shall always give priority to internal financing over debt and debt over equity, only when external financing requirement is being felt(Heminway, 2017).

Weighted Average Cost Of Capital Of Alumina Limited And Amp Limited
Weighted average cost of Capital is being calculated using the following formula:
WACC = [(E / V) * RE] + [(D / V) * RD * (1 – TC)]
Where,
E =Market Value of Equity
V= Total value of equity Plus debt
RE= Return on equity
D= Market value of debt
RD= Return on debt
TC= Tax Rate
In Our calculation we have computed the WACC for both the companies for the financial year ending 31st December 2017.
WACC for the Alumina Limited
Let the return on equity in both the cases be 10%, Tax rate = 40% and after tax cost of debt be 8%
WACC (Alumina Limited)
= 7000/7107.2*10%+107.2/7107.2*8%
=9.84%+.12%
=9.86%
WACC (AMP Limited) = [(E / V) * RE] + [(D / V) * RD * (1 – TC)]
                                       =15144.42/21813.42*10%+6669/21813.42*8%
                                       =6.94%+2.44%
                                       =9.38%
Influence Of Taxes On Cost Of Capital
The tax effect on cost of capital varies depending upon the sources of fund being utilized for financing. This is because use of debt fund provided tax shield (i.e. Tax savings ) as the interest that is paid or payable on such debt is being considered as a tax deductible expenditure, hence the tax component on such amount of interest being saved by the firm, on the other hand neither equity nor preferred stock provide any such savings to the firm as whatever payment in form of dividend is made to the shareholders in form of dividend is not considered as a tax deductible expenditure, hence tax does not effect in determining the cost of equity or preferred stock (Belton, 2017).
An Evaluation Of Investment Decision Using Capital Budgeting Techniques
In order to make the decision relating to investment a number of capital budgeting techniques have been provided though in this case decision to be taken is based on the two major criteria or evaluation techniques to be used are mentioned hereunder:

Discounted Cash Flow Technique
Relative Valuation Approach
Discounted Cash Flow Technique

It is one of the method of evaluation of the opportunity to make the future investment for which the decision is to be taken in present based on the reasonable estimate of free cash flows expected to be generated in future. Under this approach the future cash flows to be generated are discounted at a rate which is generally nothing but the weighted average cost of capital of the entity (Visinescu, Jones, & Sidorova, 2017). There are basically three factors which determines the discounted rate that are cost of equity, cost of debt and the risk free rate of return. The moment the sum of discounted cash flows to be generated exceeds the present cost of investment then the investment opportunity is considered acceptable.

Relative Valuation Approach

As per this Capital budgeting technique an attempt is made to evaluate the value of a business or an entity in relation to the value of business or entity’s owned by its competitor’s or its industry peers, so that a comparative position can come to the picture (Linden & Freeman, 2017). The various tools used to obtain the relative valuation rather than absolute valuation by this technique are ratios, benchmark, average or multiples etc. In our calculation the multiple used is the price earning ratio, that is calculated dividing the per unit price of the stock by the earning per share, so that to know the stock’s price multiples of its earnings. The entity having the higher P/E ratio is being traded at a higher price in comparison to the price of the stock of its competitors or peers is considered as overvalued stock and vice-versa.
Analysis Of Factors Other Than Capital Budgeting Techniques In Making Investment Decision
The following are the major factors other than the capital budgeting techniques discussed above while making investment decision in an entity:

Stability Factor
Management or Leadership
Relative Strength of the Industry
Stability factor is one of the most important factor to be considered while making investment decision especially when if there is large amount of uncertainty shall increase the amount of risk, whereas every prospective investor has different risk bearing capacity(Meroño-Cerdán, Lopez-Nicolas, & Molina-Castillo, 2017).
It is the management whose strategic decision is going to decide how profitably the funds acquired through various means of financing are going to be utilized considering the optimum balance of required rate of return and risk. An effective management can enhance the value of the firm ensuring the optimum utilization of funds. Their decision making capacity is one of the key factor to determine the future of the organization.
The industry in which we are gong to make the investment its relative position in the economy along with contributions are also the major factors to be considered while making investment decision(Solicitors, 2016).

Evaluation Of The Effectiveness Of Standard Deviation In Measurement Of Risk And Other Options To Compute The Measurement Of Risk
 Standard deviation only measures the risk associated with the individual stocks, as it is basically the measurement of volatility (Goldmann, 2016). It is actually the beta that measures the risk of the market as a whole or in other words it can be told that the beta measures the market risk premium. Use of standard deviation as a measurement of risk can be found suitable for determination of the stand-alone risk or for those assets which are held in isolation. In other words such risks are either unsystematic or diversifiable or unique in nature. Standard deviation is the measurement of volatility.
The other options for measurement of risks are as follows:
i). Beta
ii). VaR (Value at Risk)
iii). Conditional VaR

VaR – It is one of the statistical measurement of risk to determine the amount of risk associated with the company or the portfolio(Gerlach, Mora, & Uysal, 2018).

Conditional VaR measure the amount of risk to ascertain what shall happen in a case when the value of an investment reaches beyond its maximum threshold limit of loss.

Conclusion
From the above analysis it is quite evident that the concept of capital structure is a key factor while making investment decision of the company (Farmer, 2018). We can see that there are many variables which needs to be taken care off while calculating the weighted average cost of capital and for the given 2 companies, it is almost the same with very less difference. The proportion of the debt and equity in the company plays a very important role in the outcome of the return of the company.
References
Alexander, F. (2016). The Changing Face of Accountability. The Journal of Higher Education, 71(4), 411-431.
Belton, P. (2017). Competitive Strategy: Creating and Sustaining Superior Performance. London: Macat International ltd. Retrieved from https://www.routledge.com/Competitive-Strategy-Creating-and-Sustaining-Superior-Performance/Belton/p/book/9781912128808
Boccia, F., & Leonardi, R. (2016). The Challenge of the Digital Economy: Markets, Taxation and Appropriate Economic Models. Springer.
Choy, Y. K. (2018). Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis. Ecological Economics, 145. doi:https://doi.org/10.1016/j.ecolecon.2017.08.005
Farmer, Y. (2018). Ethical Decision Making and Reputation Management in Public Relations. Journal of Media Ethics, 1-12.
Gerlach, J., Mora, N., & Uysal, P. (2018). Bank funding costs in a rising interest rate environment. Journal of Banking and Finance, 87, 164-186.
Goldmann, K. (2016). Financial Liquidity and Profitability Management in Practice of Polish Business. Financial Environment and Business Development, 4, 103-112. Retrieved from https://doi.org/10.1007/978-3-319-39919-5_9
Heminway, J. (2017). Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and Organic Documents. SSRN, 1-35.
Jefferson, M. (2017). Energy, Complexity and Wealth Maximization, R. Ayres. Springer, Switzerland . Technological Forecasting and Social Change, 353-354.
Linden, B., & Freeman, R. (2017). Profit and Other Values: Thick Evaluation in Decision Making. Business Ethics Quarterly, 27(3), 353-379. doi:https://doi.org/10.1017/beq.2017.1
Meroño-Cerdán, A., Lopez-Nicolas, C., & Molina-Castillo, F. (2017). Risk aversion, innovation and performance in family firms. Economics of Innovation and new technology, 1-15.
Solicitors, S. (2016). The Principles of Contract. Contract, 13.
Visinescu, L., Jones, M., & Sidorova, A. (2017). Improving Decision Quality: The Role of Business Intelligence. Journal of Computer Information Systems, 57(1), 58-66.
Werner, M. (2017). Financial process mining – Accounting data structure dependent control flow inference. International Journal of Accounting Information Systems, 25, 57-80.

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