Corporate Finance- 5NC01

Assignment Type

Individual Coursework
2022

Student ID: 200090

Student Name: Ujjwal Ghimire
Section: L5BG3
Module Leader: Junu Hada
Submitted on: 20th February
 Task 1: Numerical
Given, growth rate= 7% pa
Common stock sold= $23 per share
Last dividend(Do)= $2
Current dividend(D1) = $2.14
Internal equity= 40%
Debt= 60%
Before tax cost of debt= 9.5%
Marginal tax rate= 35%

Year Project A Project B

0 (2500000) (2500000)
1 700000 600000
2 700000 800000
3 700000 900000
4 700000 400000
5 700000 300000

a) Answer,
Cost of debt= Before tax (1-tax rate) x debt of 25 lakh divided by 25 lakh
= 9.5%(1-.35) x 60% of 25lakh/ 25 lakh
= (0.06175x0.6) x100
=3.705

Cost of equity= (annualized dividend per share/ current stock price) + dividend
growth rate x equity of 25 lakh/ 25lakh
= (2.14/25) + 0.07x 40% of 25 lakh / 25 lakh
= (0.163x 0.4)
= 6.52

WACC= Kd+ Ke
= 3.705+ 6.52
= 10.225
 b) Project A
Year Project A Cumulative cash flow
0 (2500000) (2500000)
1 700000 700000
2 700000 1400000
3 700000 2100000
4 700000 2800000
5 700000

Payback period= 3 years + 400000/700000=3.57 years

Year Project B Cumulative cash flow

0 (2500000) (2500000)
1 600000 600000
2 800000 1400000
3 900000 2300000
4 400000 2700000
5 300000

Payback period = 3 years +200000/400000= 3.5 years

Therefore, Project B is preferred because payback period is only 3.5 years which is less
than project A.

C) Answer,
For Project A
Average profit= 3500000/5= 700000
Net investment = 2500000

Accounting rate of return(ARR)= (Average Profit/ Net Investment) x 100

= (700000/2500000) x 100 = 28%

For Project B
Average profit= 3000000/5= 600000
Net investment = 2500000

Accounting rate of return(ARR)= (Average Profit/ Net Investment) x 100

= (600000/2500000) x 100 = 24%

Therefore, Project A is preferred because ARR of project A is higher than Project B.

 D) Answer,
Project A
Year Project A [email protected] Present value
0 (2500000) 1 (2500000)
1 700000 0.91 637000
2 700000 0.83 581000
3 700000 0.76 532000
4 700000 0.69 483000
5 700000 0.63 441000
NPV 174000

Project B
Year Project B [email protected] Present Value
0 (2500000) 1 (2500000)
1 600000 0.91 546000
2 800000 0.83 664000
3 900000 0.76 684000
4 400000 0.69 276000
5 300000 0.63 189000
NPV (141000)

Project A is better because it has positive net present value

E) Answer,
Project A
Year Project A [email protected] Present value DF@13 PV
0 (2500000) 1 (2500000) 1 (2500000)
1 700000 0.91 637000 0.88 616000
2 700000 0.83 581000 0.78 546000

3 700000 0.76 532000 0.69 483000

4 700000 0.69 483000 0.61 427000
5 700000 0.63 441000 0.51 378000
NPV 174000 (50000)

IRR =9.5+ [ 174000

174000+50000 ]
× ( 13−9.5 ) = 12.21%
Project B

Year Project B [email protected] Present Value Df@6 Present value

0 (2500000) 1 (2500000) 1 (2500000)
1 600000 0.91 546000 0.94 564000
2 800000 0.83 664000 0.89 712000
3 900000 0.76 684000 0.84 756000
4 400000 0.69 276000 0.79 316000
5 300000 0.63 189000 0.747 224100
NPV (141000) 72100

IRR =6+ [ 721 00

721 00+1410 00 ]
× ( 9.5−6 ) = 7.184%

Task 2: Long Question Answer

Question:1

“Profit Maximization is the weak statement of goal than wealth maximization

goal.” Do you agree? Explain

Profit maximization would probably be the most commonly accepted goal. The term
profit maximizations mean maximizing the rupee income of a firm by generating excess
revenue over cost. Main aim of any kind of economic activity is earning profit. A
business concern is also functioning mainly for the purpose of earning profit. Profit is the
measuring techniques to understand the business efficiency of the concern. Profit
maximization is understandable and it provides the motivation to start and run the
business. Profit maximizations is also the traditional and narrow approach, which aims
at, maximizes the profit of the firm.
Profit maximization consists of the following important features:

 Profit maximizations is also called as rupee per share maximization. It leads to

maximize the business operation for profit maximization.
 Ultimate aim of the business concern is earning profit; hence, it considers all the
possible ways to increase the profitable of the firm.
 Profit is the parameter of the measuring the efficiency of the business concern.
So, it shows the entire position of the business firm.
 Profit maximization objectives help to reduce the risk of the business.

Wealth maximization goals avoids the limitations associated with profit maximization.
So, this goal seems to be clear, complete and unambiguous. It considers both long run
and short run issues. Wealth maximizations is one of the modern approaches, which
involves latest innovations and improvements in the field of the business concern.
Wealth maximization is also known as value maximization or net present worth
maximization. This objective is widely accepted concept as standard criteria for the
financial decision. Wealth maximization means maximizing the net present value of a
course of action. The net present value is the different between the present values of its
benefit and present value of its cost. For maximizing value, takes time value of money
into account. Profit maximization considers the current size of the cash flow or profit of
the company but value maximization considers both size and timing of the cash flows. It
counts that sometimes we need to accept the lower profit or cash flow to get more in
future. That means, value maximization considers the impact of the time value of money
on its cash flow.

Yes, I agree wealth maximization is superior to profit Maximization due to

following reasons:

Clarity:

Stock price maximizations means maximizing the net present value of course of action.
The net present value of a course of action is the difference between present value of
benefit to present value of cost. As this gap increases the stock price maximization also
increase. So shareholder’s wealth refers to increase in return on equity.
It considers time value of money

Stock price maximization take the account to time value of money. For example,

Projects Year 1 Year 2 Total

A Rs 60 Rs 40 Rs 100
B Rs 40 Rs 60 Rs 100
In the above example both the projects have same cash flow. From profit
maximizations, it is indifferent between two projects but if the rational investors always
invest on project A because present value of 1-rupee fund is greater than future value of
1-rupee. If we calculate NPV then we get highest NPV in project A. Therefore, it accepts
the time value of money.

It considers the risk

Business is done in future which is covered with risk so before accepting any project
first risk should be measured and shareholders price maximization accepts low risk
project.

It is complicated

Without profit, there is no demand of the share so the market price of share increases
where there is huge profit but if we are not able to divide the profit into retained earnings
and dividend then there is no possibility to increase the market price for ever. So it
shows the complete figure of profit maximization on stock price.

Difference between value maximization and profit maximizations

Both the goals are related with the firm. Without of profit no any goal is achieved but
followings are some differences of these goals.

Profit Maximization Stock price Maximization

Profit maximization means increasing the It is shareholder oriented. Shareholder
revenue income. It is owner oriented. wealth maximizations means increasing
the market price per share.
 It ignores the time value of money. It considers the concept of time value of
money.
It does not consider the risk factor It considers the risk factor
It gives more emphasis on short term It gives more emphasis on long term
objective objective
It is quantitative and oriented on EPS It is qualitative and oriented on MPS
It is not concerned with welfare of It is concerned with welfare of investors,
investors, creditors, government and creditors, government and society.
society.
It is narrow and micro in approach. It is wide and macro in approach

To summarize, profit maximization is a weak statement of objective compared to wealth

maximization because it solely focuses on maximizing a firm's profit and ignores other
factors such as benefit quality and temporal worth of benefits. It's also inappropriate in
today's business world because it creates a conflict of interest among stakeholders.

Question:2

Conflict arises between the shareholders and managers and managers and
creditors. In the light of this statement explain the causes of conflicts and ways to
resolve it.

An agency problem is a contract under which one or more people (The Principals) hire
another person (The Agent) to perform some series and delegates decisions making
authority to that agent. Agency problem or relationship may be defined as a potential
conflict for own interest between shareholder versus managers and shareholders
versus creditors.

Business firms are owned, financed and managed different group of people. They
certainly have their own personal interest. Owners interest is to maximize the value of
the firm so that the worth of their investment would be maximized creditors interest will
be to maintain sufficient liquidity and to safeguard their fund similarly, the board of
members and manager’s employee interest may be reduced in working hour and
maintain better standard of living for them. In this way increases the operating expenses
and reduced the profitability, which is against the interest of common stockholders;
therefore, in every firm, there is possibility of conflict among different interest group. It is
called agency problem. Important agency relationship exists.

Shareholders vs managers

If a firm is owned and managed by the same person, the owner manager will take every
possible action to improve his/ her own welfare. But, when firm is owned by the number
of people (shareholders) under company/corporate act then it would be difficult to
manage a firm by the group of people together. In such corporate business the
shareholder appoints the managers from among the shareholders or outsiders and
delegate the decision making authority to them. Whenever a firm is owned by the
number of people and managed by few among them then there exit conflict of interest
between them. Here, owners interest is to maximize the value of the firm so that the
worth of their investment would be maximized and managers interest is to take higher
salary and more perquisites to improve their personal welfare. Thus a different situation
comes into the picture at which the interest of these two groups conflicts. Such agency
problems are of two types (i) the interest of the managers may be reduction in working
hours and maintain better standard of life as well as higher salaries and fringe benefits.
But shareholders interest will be to maximize their wealth. The interest of these two
groups is quite contradictory and the fulfillment of the interest of one group adversely
effects on the interest of the other group. (ii) The shareholders engage in management
may like to purchase outstanding shares at lower price either through tender offer or
from the market. For this purpose, the management(managers) may take managerial
decision with a view to reduce the market price of the stock, till they purchase the
outstanding shares. This is also a case of conflict in the interest of two groups i.e.
managers are concerned more on the fulfilment of their own interest instead of the
fulfilment of the firm’s objective. The following measures can be used to avoid the
agency problem between managers and shareholders.
1. The threat of firing: The existing management can be ousted and replaced by
the new people by the shareholders at the annual general meeting of the firm.
Everybody who are in the managerial post knows this reality (threats of firing), so
they are supposed to work in the best interest of the shareholders. The threat of
firing is supposed to check the agency problems automatically, but it is not as
effective as assumed because the managerial people are capable to collect
proxy votes.
2. The threat of take over: relatively poor managerial performance of the firm
invites hostile takeover. After the takeover (either friendly or hostile) the people at
management of the acquired firm are generally fired, even if not fired they lose
their position and autonomy that they had prior to the acquisition. Therefore, the
threat of takeover is a strong incentive to the managers to work for maximizing
the stock price but the effectiveness of this measure is also limited because the
management may use some tactics to avoid such take over. Such tactics are: -
(a) Poison pill: - It is an action taken by the management to kill the firm practically
and hence showing less attractive to the potential buyers(suitors). (b) Greenmail:
- It is a kind of blackmail under which the management buy the shares from the
potential raider (shareholders who are playing role for takeover) at a price above
the existing market price with a view to avoid the takeover.
3. Monitoring the managerial activities: under this method each and every
managerial actions are referred to monitor and identify whether their working is in
line with the interest of the shareholders or they are working for their own
welfare. If their action found out of track, then some remedial measures can be
applied.
4. Imposing restriction on some activities: The agency problem can also be
solved, to some extent, by imposing restrictions on those activities of the
management which may help to fulfill their personal interest.
5. Structuring managerial incentives: It is a positive method of motivating
managerial people to work in the best interest of the shareholders. Under this
method the firm may offer performance based incentives to its managerial
people. Such incentives are: (i) Executive stock option and (ii) Performance
 shares. An option given to the executive people for buying certain number of
shares within a specified period of time at a specified price is stock option and a
plan in which managers are awarded certain number of shares on the basis of
their performance within a given period of time is performance shares.

In monitoring the agency problem, a firm has to incur agency costs like; monitoring
expenditures, costs to restructuring the organization and opportunity cost of limiting the
actions of the managers. From the view point of cost and effectiveness, agency
problems measures have two extreme i.e. monitoring each managerial action certainly
increase organizational effectiveness but it increases cost and practically it is infeasible
too. Similarly, stock option and performance shares scheme incurs low cost but its
effectiveness is limited. Therefore, we have to apply optimum measure for the solution
of the agency problem which lies between these two examples.

Managers vs Creditors

Another agency problem may create between managers and creditors(debtholders).

Creditors lend funds to the firm and set their rate of return on the expectation regarding
several factors including.

 The riskiness of the firm existing assets

 Expectations concerning the risk ness of factor assets additions
 The firm exists capital structure
 Expectations concerning future capital structure change.

These are the factor that determine the risky ness of the firm’s debt, so creditors base
the interest rate they change expectations regarding these factors. Creditors do not
want to take high risk because they do not receive additional return for taking high risk.
On the other side, managers emphasize maximizing the value of the investment by
taking high risk. Such types of agency problem can be solved by providing higher risk
premium to creditors for higher level of risk. Developing understanding between two
parties can solve such type agency problem.

Now suppose the firm decides to take on new ventures that have much greater risk than
was anticipated by the creditors. This increased risk will cause the valued of the
outstanding debt to fall. If the risky venture is successful, all the benefit goes to the
shareholder because creditors returns are fixed at the old, low risk rate. However, if the
firm venture is unsuccessful, the creditors may have to share in the loss. Similarly, if the
firms increase its use debt in an effort to boost the return to shareholder, the value of
debt will decrease. In both the riskier assets and the increase additional debt situation,
stockholders tend to gain the expenses of creditors. Thus conflict arises between
managers and creditors.