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Financial management is concerned with making decisions about the provisions and use of a firm's finances. A rational approach to decision-making necessitates a fairly clear idea of what the objectives of the decision maker are or, more importantly, of what are the objectives of those on behalf of whom the decisions are being made.
There is little agreement in the literature as to what objectives of firms are or even what they ought to be. However, most financial management textbooks make the assumption that the objective of a limited
company is to maximize the wealth of its shareholders. This assumption is normally justified in terms of
classical economic theory. In a market economy firms that achieve the highest returns for their investors will be the firms that are providing customers with what they require. In turn these companies, because they provide high returns to investors, will also find it easiest to raise new finance. Hence the so called invisible hand theory will ensure optimal resource allocation and this should automatically maximize the overall economic welfare of the nation.
This argument can be criticized on several grounds. Firstly it ignores market imperfections. For example it might not be in the public interest to allow monopolies to maximize profits. Secondly it ignores social needs like health, police, defense etc.
From a more practical point of view directors have a legal duty to run the company on behalf of their
shareholders. This however begs the question as to what do shareholders actually require from firms.
Another justification from the individual firm's point of view is to argue that it is in competition
with other firms for further capital and it therefore needs to provide returns at least as good as the
competition. If it does not it will lose the support of existing shareholders and will find it difficult to raise funds in the future, as well as being vulnerable to potential take-over bids.
Against the traditional and legal view that the firm is run in order to maximize the wealth of
ordinary shareholders, there is an alternative view that the firm is a coalition of different groups: equity shareholders, preference shareholders and lenders, employees, customers and suppliers. Each of these groups must be paid a minimum return to encourage them to participate in the firm. Any excess wealth created by the firm should be and is the subject of bargaining between these groups.
At first sight this seems an easy way out of the „objectives? problem. The directors of a company
could say Let's just make the profits first, then we'll argue about who gets them at a later
stage. In other words, maximizing profits leads to the largest pool of benefits to be distributed among
the participants in the bargaining process. However, it does imply that all such participants must value
profits in the same way and that they are all willing to take the same risks.
In fact the real risk position and the attitude to risk of ordinary shareholders, loan creditors and employees are likely to be very different. For instance, a shareholder who has a diversified portfolio is likely not to be so worried by the bankruptcy of one of his companies as will an employee of that company, or a supplier whos main customer is that company. The problem of risk is one major reason why there cannot be a single simple objective which is common to all companies.
Separate from the problem of which goal a company ought to pursue are the questions of which
goals companies claim to pursue and which goals they actually pursue.
Many objectives are quoted by large companies. Sometimes these are included in their annual accounts.
Examples are:
To produce an adequate return for shareholders;
To grow and survive autonomously;
To improve productivity;
To give the highest quality service to customers;
To maintain a contented workforce;
To be technical leaders in their field;
To be market leaders;
To acknowledge their social responsibilities.
Some of these stated objectives are probably a form of public relations exercise. At any rate, it is possible to classify most of them into four categories which are related to profitability:
Pure profitability goals eg, adequate return for shareholders.
(ii) Surrogate goals of profitability eg, improving productivity, happy workforce. Constraints on profitability eg, acknowledging social responsibilities, no pollution, etc.
Dysfunctional goals.
The last category are goals which should not be followed because they do not benefit in the long
run. Examples here include the pursuit of market leadership at any cost, even profitability. This may
arise because management assumes that high sales equal high profits which is not necessarily so.
In practice the goals which a company actually pursues are affected to a large extent by the management.
As a last resort, the directors may always be removed by the shareholders or the shareholders could vote for a take-over bid, but in large companies individual shareholders lack voting power and information. These companies can, therefore, be dominated by the management.
There are two levels of argument here. Firstly, if the management do attempt to maximize profits, then they are in a much more powerful position to decide how the profits are „carved up? than are the shareholders.
Secondly, the management may actually be seeking „prestige? goals rather than profit maximization.
Such goals might include growth for its own sake, including empire building or maximizing turnover for its sake, or becoming leaders in the technical field for no reason other than general prestige. Such goals are usually dysfunctional.
The dominance of management depends on individual shareholders having no real voting power, and in this
respect institutions have usually preferred to sell their shares rather than interfere with the management of companies. There is some evidence, however, that they are now taking a more active role in major company decisions.
From all that has been said above, it appears that each company should have its own unique decision model.
For example, it is possible to construct models where the objective is to maximize profit subject to first fulfilling the target levels of other goals. However, it is not possible to develop the general theory of financial management very far without making an initial simplifying assumptions about objectives. The objective of maximizing the wealth of equity shareholders seems the least objectionable.
Kavungya answered the question on April 21, 2021 at 21:00
- Discuss how government actions can influence the tasks of the financial manager and explain how these actions can affect the attainment of financial objectives.(Solved)
Discuss how government actions can influence the tasks of the financial manager and explain how these actions can affect the attainment of financial objectives.
Date posted: April 21, 2021. Answers (1)
- Maltec plc is a company that has diversified into five different industries in five different countries. The investments are each approximately equal in value. The...(Solved)
Maltec plc is a company that has diversified into five different industries in five different countries. The investments are each approximately equal in value. The company's objective is to reduce risk
through diversification, and it believes that the return on any investment is not correlated with the return on any other investment. The estimated risk and return (in present value terms) of the five investments are shown below:
Required:
(a) Estimate the risk and return of the portfolio of five investments, and briefly explain the significance of your results.
(b) Discuss the validity to investors of Maltec's objective of risk reduction through international
diversification.
Date posted: April 21, 2021. Answers (1)
- Discuss the main features of:
(i) Corporate share repurchases (buy-backs); and
(ii) Share (stock) splits;
and why companies might use them. Include in your discussion comment on the...(Solved)
Discuss the main features of:
(i) Corporate share repurchases (buy-backs); and
(ii) Share (stock) splits;
and why companies might use them. Include in your discussion comment on the possible effects on share
price of share repurchases and share (stock) splits in comparison to the payment of dividends.
Date posted: April 21, 2021. Answers (1)
- The finance department of Beela Electronics has been criticized by the company's board of
directors for not undertaking an assessment of the political risk of the...(Solved)
The finance department of Beela Electronics has been criticized by the company's board of
directors for not undertaking an assessment of the political risk of the company's potential
direct investments in Africa. The board has received an interim report from a consultant that provides
an assessment of the factors affecting political risk in three African countries. The report assesses key variables on a scale of –10 to +10, with –10 the worst possible score and +10 the best.
The consultant suggests that economic growth and political stability are twice as important as the
other factors.
The consultant states in the report that previous clients have not invested in countries with a total weighted score of less than 30 out of a maximum possible 100 (with economic growth and political stability double weighted). The consultant therefore recommends that no investment in Africa should be undertaken.
Required:
(a) Discuss whether or not Beela electronics should use the technique suggested by the consultant in
order to decide whether or not to invest in Africa.
(b) Discuss briefly how Beela might manage political risk if it decides to invest in Africa.
Date posted: April 21, 2021. Answers (1)
- Give the reasons on why mergers and acquisitions should be undertaken to achieve corporate diversification
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Give the reasons on why mergers and acquisitions should be undertaken to achieve corporate diversification
only.
Date posted: April 20, 2021. Answers (1)
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Date posted: April 20, 2021. Answers (1)
- Explain the possible synergies that might occur in mergers and acquisitions.(Solved)
Explain the possible synergies that might occur in mergers and acquisitions.
Date posted: April 20, 2021. Answers (1)
- Assume that your company has invested in 100,000 shares of Unglow plc, a manufacturer of light bulbs. You are concerned about the recent volatility in...(Solved)
Assume that your company has invested in 100,000 shares of Unglow plc, a manufacturer of light bulbs. You are concerned about the recent volatility in Unglow's share price due to the unpredictable weather
in the United Kingdom. You wish to protect your company's investment from a possible fall in
Unglow's share price until winter in three months time, but do not wish to sell the shares at present. No dividends are due to be paid by Uniglow during the next three months.
Market data:
Uniglow's current share price: Sh.20
Call option exercise price: Sh.20
Time to expiry: 3 months
Interest rates (annual): 6%
Volatility of Uniglow's shares 50% (standard deviation per year)
Assume that option contracts are for the purchase or sale of units of 1,000 shares.
Required:
(i) Devise a delta hedge that is expected to protect the investment against changes in the share price
until winter. Delta may be estimated using N(d1).
(ii) Comment upon whether or not such a hedge is likely to be totally successful.
Date posted: April 20, 2021. Answers (1)
- Briefly discuss the meaning and importance of the terms 'delta', 'theta' and 'vega' (also known as
kappa or lamba) in option pricing.(Solved)
Briefly discuss the meaning and importance of the terms 'delta', 'theta' and 'vega' (also known as
kappa or lamba) in option pricing.
Date posted: April 20, 2021. Answers (1)
- The managers of Strayer plc are investigating a potential Sh.25 million investment. The investment would be a diversification away from existing mainstream activities and into...(Solved)
The managers of Strayer plc are investigating a potential Sh.25 million investment. The investment would be a diversification away from existing mainstream activities and into the printing industry. Sh.6 million of the investment would be financed by internal funds, Sh.10 million by a rights issue and Sh.9 million by long term loans. The investment is expected to generate pre-tax net cash flows of approximately Sh.5 million per year, for a period of ten years. The residual value at the end of year ten is forecast to be Sh.5 million after tax. As the investment is in an area that the government wishes to develop, a subsidized loan of Sh.4 million out of the total Sh.9 million is available. This will cost 2% below the company's normal cost of long-term debt finance, which is 8%.
Strayer's equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by value. The average
equity beta in the printing industry is 1.2, and average gearing 50% equity, 50% debt by market value.
The risk free rate is 5.5% per annum and the market return 12% per annum.
Issue costs are estimated to be 1% for debt financing (excluding the subsidized loan), and 4% for
equity financing. These costs are not tax allowable.
The corporate tax rate is 30%.
Required:
(a) Estimate the Adjusted Present Value (APV) of the proposed investment.
(b) Comment upon the circumstances under which APV might be a better method of evaluating a
capital investment than Net Present Value (NPV).
Date posted: April 20, 2021. Answers (1)
- Summarized financial details of Jetter plc are shown below:
Reserves ...(Solved)
Summarized financial details of Jetter plc are shown below:
Reserves 122
12% debentures June 2006 71
243
The company's ordinary shares are currently trading at Sh.22.00, and the debentures at
Sh.105.50. The debenture is redeemable at its par value of Sh.100.
The company's equity beta is 1.25.
Jetter plc is considering investing in one of three projects. The company has Sh.50 million that is currently earning 5.8% in short-term money market deposits. Any surplus funds after the investment in one of the projects will continue to be invested in the money market.
The company has employed an external consultant to estimate risk/return data relevant to the three projects.
Required:
(a) Evaluate which project should be selected. Do not use information provided later in the question
requirements in your evaluation.
State clearly any assumptions that you make in all parts of this question.
(b) Estimate Jetter's cost of capital prior to undertaking the investment. Briefly discuss (do not
calculate) what effect the project selected in (a) is likely to have on Jetter's cost of capital.
The profitability index of 1.3 also relates to this part of the question.
(c) The consultant has suggested that beta estimates should be adjusted by using the formula: [(0.67 x
unadjusted beta) + 0.33] in any estimate of required returns.
Briefly discuss the reason for using an adjusted beta such as this:
Date posted: April 20, 2021. Answers (1)
- Summarized financial data for TYR plc is shown below:
TYR's cost of equity is estimated to be 11%.
Required:
(a) Explain, with supporting evidence, the current dividend policy...(Solved)
Summarized financial data for TYR plc is shown below:
TYR's cost of equity is estimated to be 11%.
Required:
(a) Explain, with supporting evidence, the current dividend policy of TYR plc, and briefly discuss
whether or not this appears to be successful.
(b) Identify and consider additional information that might assist the managers of TYR in assessing
whether the dividend policy has been successful.
(c) Evaluate whether or not the company's share price at the end of 2001 was what might have
been expected from the Dividend Growth Model. Briefly discuss the validity of your findings.
Date posted: April 20, 2021. Answers (1)
- Components Manufacturing Corporation (CMC) has an all-common-equity capital structure. It has 200,000 shares of Sh.2 par value common stock outstanding. When CMC's founder, who has...(Solved)
Components Manufacturing Corporation (CMC) has an all-common-equity capital structure. It has 200,000 shares of Sh.2 par value common stock outstanding. When CMC‟s founder, who has also its research director and most successful inventor; retired unexpectedly to the South Pacific in late 2000, CMC was left suddenly and permanently with materially lower growth expectations and relatively few attractive new investment opportunities. Unfortunately, there was no way to replace the founder's contributions to the firm.
Previously, CMC found it necessary to plow back most of its earnings to finance growth, which averaged 12 percent per year. Future growth at a five percent rate is considered realistic, but that level would call for an increase in the dividend payout. Further, it now appears that new investment projects with at least the 14 percent rate of return required by CMC's stockholders (ks= 14%) would amount to only Sh.800,000 for 2001in comparison to a projected Sh.2,000,000 of net income. If the existing 20 percent dividend payout were continued, retained earnings would be Sh.1.6 million in 2001, but as noted, investments that yield the 14 percent cost of capital would amount to only Sh.800,000.
The one encouraging thing is that the high earnings from existing assets are expected to continue, and
net income of Sh.2 million is still expected for 2001. Given the dramatically changed
circumstances, CMC's management is reviewing the firm's dividend policy.
(a) Assuming that the acceptable 2001 investment projects would be financed entirely by earnings
retained during the year, calculate DPS in 2001 if CMC follows the residual divided policy.
(b) What payout ratio does your answer to part a imply for 2001?
(c) If a 60 percent payout ratio is maintained for the foreseeable future, what is your estimate of
the present market price of the common stock? How does this compare with the market price
that should have prevailed under the assumptions existing just before the news
about the founder's retirement? If the two values of P0 are different, comment on why.
(d) What would happen to the price of the stock if the old 20 percent payout were continued? Assume
that if this payout is maintained, the average rate of return on the retained earnings will fall to 7.5
percent and the new growth rate will be
g = (1.0 – Payout ratio)(ROE)
= (1.0 – 0.2)(7.5%) = (0.8)(7.5%) = 6.0%
Date posted: April 20, 2021. Answers (1)
- Lancaster Engineering Inc. (LEI) has the following structure, which it considers to be optimal:
LEI's expected net income this year is Sh.34,285.72; its established dividend payout...(Solved)
Lancaster Engineering Inc. (LEI) has the following structure, which it considers to be optimal:
LEI's expected net income this year is Sh.34,285.72; its established dividend payout ratio is 30
percent; its marginal tax rate is 40 percent; and investors expect earnings and dividends to grow at a
constant rate of nine percent in the future. LEI paid a dividend of Sh.3.60 per share last hear, and its stock currently sells at a price of Sh.60 per share.
LEI can obtain new capital in the following ways:
Common: New common stock has a flotation cost of ten percent for up to Sh.12,000 of new stock and
20percent for all common stock over Sh.12,000.
Preferred: New preferred stock with a dividend of Sh.11 can be sold to the public at a price of Sh.100
per share. However, flotation costs of Sh.5 per share will be incurred for up to Sh.7,500 of preferred stock, and flotation costs will rise to Sh.10 per share, or ten percent, on all preferred stock over Sh.7,500.
Debt: Up to Sh.5,000 of debt can be sold at an interest rate of 12 percent; debt in the range of Sh.5,001 to Sh.10,000 must carry an interest rate of 14 percent; and all debt over Sh.10,000 will have an interest rate of 16 percent.
LEI has the following independent opportunities:
(a) Find the break points in the MCC schedule
(b) Determine the cost of each capital structure component.
(c) Calculate the weighted average cost of capital in the interval between each break in the
MCC schedule.
(d) Calculate the IRR for Project E.
(e) Construct a graph showing the MCC and IOS schedules.
(f) Which projects should LEI accept?
Date posted: April 20, 2021. Answers (1)
- Summarized below are financial data in respect of Kevinko Ltd:
As a result of recent capital expansion, market analysts expect pre-tax earnings to increase at the...(Solved)
Summarized below are financial data in respect of Kevinko Ltd:
As a result of recent capital expansion, market analysts expect pre-tax earnings to increase at the rate of 25% for the next two years before reverting to the company's existing growth rate.
The company's overall beta is 0.763 while the beta for debt is 0.20. The risk free rate is 12%
and the market return is 17%. Currently, the shares of the company are selling at Sh.21.70 on the stock
exchange cum 1996 dividend. The debentures are selling at Sh.8 9.50 ex-interest.
The corporate tax is 35%.
Required:
a) Using the dividend growth model, estimate what a fundamental analyst might consider to be the
intrinsic value of Kevinko's shares. Comment on this value.
b) If interest rates were to go by 5% what would be the effect of this increase on the company's share
price?
c) What is the difference between fundamental analysis and a chartist's analysis in the valuation of
shares?
Date posted: April 20, 2021. Answers (1)
- Dove Construction Company Ltd made a Sh.100 million bondage 5 years ago when interest rates were
substantially high. The interest rates have now fallen and the...(Solved)
Dove Construction Company Ltd made a Sh.100 million bondage 5 years ago when interest rates were
substantially high. The interest rates have now fallen and the firm wishes to retire this old debt and replace it with a new and cheaper one. Given here below are the details about the two bond issues:
Old Bonds: The outstanding bonds have a nominal value of Sh.1,000 and 24% coupon interest rate. They
were issued 5 years ago with a 15-year maturity. They were initially sold a their nominal value of Sh.1,000 and the firm incurred Sh.390,000 in floatation costs. They are callable at Sh.1,120.
New Bonds: The new bonds would have a Sh.1,000 nominal value and a 20% coupon interest rate. They
would have a 10-year maturity and could be sold at their par value. The issuance cost of the new bonds
would be Sh.525,000.
Assume the firm does not expect to have any overlapping interest and is in the 35% tax bracket.
Required:
a) Calculate the after-tax cash inflows expected from the unamortized portion of the old bond's
issuance cost.
b) Calculate the annual after-tax cash inflows from the issuance of the new bonds assuming the 10-year
amortization.
c) Calculate the after-tax cash outflow from the call premium required to retire the old bonds.
d) Determine the incremental initial cash outlay required to issue the new bonds.
e) Calculate the annual cash-flow savings, if any, expected from the bond refunding.
f) If the firm has a 14% after-tax cost of debt, would you recommend the proposed refunding and
reissue? Explain.
Date posted: April 20, 2021. Answers (1)
- Explain the types of political risks that face multi-national firms in foreign countries.(Solved)
Explain the types of political risks that face multi-national firms in foreign countries.
Date posted: April 20, 2021. Answers (1)
- Your firm is considering the acquisition of a new fork lift truck. It is uncertain about whether to purchase the truck outright or to finance...(Solved)
Your firm is considering the acquisition of a new fork lift truck. It is uncertain about whether to purchase the truck outright or to finance it through a leasing arrangement with Kasneb Bank Ltd. The purchase price is Sh.5,200,000 and it will have a salvage value of Sh.400,000 at the end of its 8-year useful life. The annual lease cost would be Sh.996,000 for 8 years.
The company uses the straight-line method for analysis investment decisions.
The company can borrow funds (to purchase the forklift) at 22% and it has an effective tax rate of
35%. Its after tax cost of capital is 12%.
Required:
a) Analyze the decision situation and advise the firm about the appropriate acquisition method.
b) If the company could get a 20% investment allowance on this investment, how would this affect
your answer in (a) above?
Date posted: April 20, 2021. Answers (1)
- Mr. Upendo, a director of Yote Limited met Mr. Mapenzi, a director of Toa Limited during a conference
in Mombasa. They had some discussion about their...(Solved)
Mr. Upendo, a director of Yote Limited met Mr. Mapenzi, a director of Toa Limited during a conference
in Mombasa. They had some discussion about their various companies. After flying back to Nairobi, Mr.
Upendo proposed to his board of directors acquisition of Toa Limited.
During his presentation to the board he stated that: “As a result of this takeover we will diversify
our operations and our earnings per share will rise by 13%, bringing great benefits to our shareholders.
No bid has yet been made and Yote Limited currently owns only 2% of Toa Limited.
A bid would be based on an exchange of shares between the two companies which would be one Yote
share for every six Toa shares. Financial data for the two companies include the following:
Required:
a) Explain whether you agree with Mr. Upendo when he says that the takeover would bring great benefits to our shareholders. Support your explanation with relevant calculations. State clearly any
assumptions made.
b) On the basis of information provided, calculate the likely post acquisition price of a share of Yote
Limited if the bid is successful.
c) What alternative forms of payment are available in a bid?
Date posted: April 20, 2021. Answers (1)
- EMC Ltd has a paid up share capital of 1.2 million shares of Sh.20 each. The current market price per share
is Sh.36. The company has...(Solved)
EMC Ltd has a paid up share capital of 1.2 million shares of Sh.20 each. The current market price per share
is Sh.36. The company has no loan capital. Maintainable earnings before tax are forecast at Sh.4.8 million.
The company‟s effective tax rate is 40%. The company requires to raise a further Sh.15
million in order to achieve additional earnings of Sh.2.2 million per annum and proposes doing this by
means of a rights issue. Suggested alternative prices for the rights issue are Sh.32 and Sh.25 per share.
Required:
a) Calculate, when the price is Sh.32 per share, the theoretical market price per share of the enlarged capital after the issue (the ex-rights price) and also the market value of a right.
b) Calculate as in (a) above when the price is Sh.25 per share.
c) Suggest, with reasons, what issue price is most likely to be adopted by the company.
d) What factors might, in practice, invalidate your calculations?
Date posted: April 20, 2021. Answers (1)