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Corporate Finance

Question 1a

The primary objective of management according to financial theory is to maximize the wealth of the firm’s stakeholders. This means that the objective of management in financial theory is to maximize the common stock price. Success is usually judged or determined by the value of the firm. Shareholders feel better and accept any decisions that increase the value of their worth in the firm. The secret of excellence in any financial management efforts is to maximize value. There are several reasons why traditional corporate finance managers emphasize on optimizing the wealth of the firm’s stakeholders. The prices of the stock of a firm are constantly updated and observable unlike other performance measures, which might not be observed easily, and not constantly updated. If the investors in a firm are rational, the prices of the firm’s stock reflect the appropriateness of the decisions made, long term and short term. As it follows, expert belief that markets discounts all the available information that exists as market share price.

The wealth or value maximization objective is widely a method that is widely acknowledged through which a business performance can be measured or evaluated. Wealth or value of an enterprise refers to the net present value or worth of a company. Therefore, value or wealth maximization can be understood as the net present value or worth of a firm. As it is, the objective of wealth maximization as a management objective suggests that any financial action that leads to wealth or that has a present value not less than zero is a desirable action, and the company should accept it. The management can also make use of this objective to make sound investment decisions.

Question 1b

One can use the primary objective identified above of corporate management to satisfy the requirements of a diverse set of stakeholders. Although the basic objective of corporate management is to maximize shareholder wealth, one can expand this objective to cover the interests of the stakeholders, and shareholders, as well. Stakeholder is a term inclusive of such entities as customers, employees, creditors, suppliers, and owners who have some sort of linkage to the enterprise. Customers purchase the services and products of the enterprise, employees get wages for their labor, suppliers are paid for the services and materials they provide the enterprise, owners provide the firm with equity financing and creditors provide the firm with debt financing. A firm that includes a stakeholder focus in its activities consciously avoids activities that would be disadvantageous to the stakeholders by damaging or reducing their value or wealth through the transfer of their wealth to the enterprise. The objective in this case would be to preserve the stakeholder well being rather than to maximize it.

The view of stakeholders in the firm might tend to limit the actions of an enterprise so as to preserve their wealth. This view can be taken as part of the social responsibility of the enterprise, and the management should utilize it to provide long- term benefits to all stakeholders by maintaining relationships that are positive among the firm’s stakeholders. These positive relations are useful in increasing the turnover of stakeholders, litigation and conflicts. Clearly, the enterprise can achieve its objectives of maximizing shareholder wealth and value by cooperating this, rather than conflicting the interests of other stakeholders.

Question 2

There are two observations that finance experts have always observed. One is that managers are usually reluctant to make major adjustments to the dividend payment level. The other is that the stream of dividends is slow to adjust when it comes to changes in earnings. There are a number of complimentary dividend policy theories that are consistent with the observations above. For instance, the first observation about managers being reluctant to make decisions is almost consistent with the dividend irrelevance theory. This theory argues that dividend policy is irrelevant with no bankruptcy costs or without taxes. This theory argues that there is no effect on the capital structure of a company or on its stock price from dividends. Miller and Modigliani formulated this theory, and it generally argues that investors can influence their stock’s return regardless of the dividend of the stock. For instance, suppose from the perspective of an investor that the dividend of a company is large.

The same investor can purchase more stock using the dividend that exceeds the expectations of the investor. Just the same, if from the perspective of an investor, the dividend of a company is insignificant or small, the same investor could sell some of the stock of the company to replicate the flow of cash he expected. This is the reason why the theory argues that the dividend of a company is never relevant to an investor, meaning that they do not care much for the dividend policy of the company since they have the ability to simulate their own policy. The reason why this theory is almost complimentary to the first observation is that the managers do not have the ability to simulate dividend policies the same as investor, and thus are reluctant to make decisions about dividend policies because such policies will not matter or make sense to investors.

The other observation comes close to another dividend policy theory called bird- in- the hand theory. This theory argues that dividends are relevant unlike the theory described above. For one to better understand this theory, it is appropriate to note that the total return of the company’s stock is equal to the yield of the company in addition to its gains. Gordon and Lintner adopted this equation and assumed that the total return would decrease as the payout of the company increased. As it follows, as a company’s payout ratio increases, investors become more concerned with the future of the company’s capital gain by assuming that they will dissipate because the retained earnings that the firm reinvests into the enterprise will decrease.

The theory argues that the investors hold dividends more valuable than the capital gains of the firm when coming into decisions about the company’s stock. This theory relates more to the observation that the stream of dividends is slow to adjust when it comes to changing earnings of the dividends because it emphasizes more on the equation of the total return of the stock of the company and the yield of the dividends combined with capital gains, and puts it more into consideration . The theory emphasizes more on the long- term earnings of the dividends more that the abilities both the managers and the investors have in making decisions.

Question 3a

In calculating rate of return, there are two types of risks that one can identify. These two are portfolio risks and stand- alone risks. Investment risk is associated with the probability of earning an actual return that is either negative or low. The bigger the chance of returns that are negative or lower than expected, the riskier the investment. Portfolio risks are the risks that are relevant in determining the cost of capital. Numerous investors do not hold or store their stocks in isolation. They instead choose to hold or store a portfolio for a number of stocks. In the event that an investor chooses to hold his stock as such, a portion of their individual stock’s risk can be eliminated or diversified away. This kind of risk has two kinds of risks that can affect the investor’s stock. The first is the systematic risk, which is the kind of market risk that an investor cannot do away with or diversify. Some examples of these risks include war, recession and interest rates. The other kind of risk associated with portfolio risk is the unsystematic risk, which is specific or particular to individual stocks, and an investor can do away with them or diversify them away.

Question 3b

The investor can calculate the expected rate of return of a new project using the dividend capitalization model. This model argues that the investors will expect a return that does not have a risk in addition to sensitivity security to risks in the market times the risk premium in the market. The risk premium changes constantly and according to places. The sensitivity to the risk in the market is unique for each organization and it is determined by a lot of factors such as the capital structure of the enterprise, the business, and the management of the company. Though one cannot estimate this value beforehand, it can be calculated r estimated from past experiences and returns from similar enterprises. This model does not consider risks according to the portfolio model. This is because it expects a return devoid of risks and security sensitivity to market risks. Portfolio risks deals with risks by holding on to individual stocks that can enable an investor to diversify away some risks.

Question 3c

There are situations that would validate the utilization of an existing estimate of the cost of a firm’s estimate to determine the cost of equity of other new projects. One of these instances is when the two projects have similar entities such as similar returns and similar experiences. In cases were such critical factors are the same between the new project and a past project, then it might be possible to utilize an existing estimate of the cost of equity of one firm to estimate the cost of equity of another new project of the firm. However, in cases where these critical factors are not similar, it is usually not advisable to use one project’s existing rates to determine the rates of another. In addition to this, when other circumstances like the conditions in the market, price and costs are different in the time of putting up a new project from the time an existing project was put up, and then it would be advisable not to use the same rate for the same projects. There are several implications that can result from using the firm’s current costs of equity on a new project with different risks. One of the major implications is that it can lead to the malfunctioning of the new projects due to under- investment or over- investment.

Question 4a

According to the theory of Modigliani and Miller, in the absence of bankruptcy costs, taxes, and asymmetric information, and an a market that is efficient, how a company is financed would not affect the value of a company regardless of whether the capital of the company has debt or equities or a combination of both, or what the policy on dividends is. A number of arguments support this theory. For instance, if there are no taxes, increasing the number of leverage adds no benefits to the company in terms of creating value. The other argument is that in the absence of taxes, such advantages, by the way of a shield on interest tax, accrue at the introduction of leverage.

Question 4bi

Imposition of taxes on such a firm, however, would alter its returns. This is to mean that the returns of a firm with taxes are different from the returns of the firm with no taxes. For instance, if the same firm is operated in the absence of taxes, then its returns are the same as those of the firm that is operated in the presence of taxes given that the amount of the taxes imposed on the firm are subtracted from its returns. Thus, the returns of a non- taxed company must be equal to the price of a taxed company minus the taxed amount, which is the value of the non- taxed company’s debt.

Question 4bii

The addition of the government taxes changes the total value of the company in addition to the size of claims over the company’s cash flow. The value of the company is altered because the amount of its returns decreases by the amount of the taxes the government imposes on the company. A higher equity debt leads to the increase of the return on equity, because the larger the risk involved for the holders of the equity in the firm with debt. In this case, there are advantages to be levered for the firm because corporations can subtract interest payments.

Question 4c

Financial distress is a large determinant of the level of gearing a firm can attain. If the firm is in a significant financial distress then it gears more for leverage. However, if its financial distress is bearable, the level of leverage it gears for is also low. This is to mean that firms gear more for leverage through debt when they are in financial distress and when they need to be financed by outside sources and less leverage when they are comfortable with their financial conditions. Leverage that a company accumulates is limited by both the presence of a financial distress and the incurred costs. For instance, if a company has incurred a lot of costs, then it gears more for leverage. Just the same, if a firm is financial distress, it gears more for advantage. However, when it incurs less costs and when it is not under a lot of financial distress it does not gear a lot for leverage because it can manage independently.

Work cited

Brealey R., Myers S., and F. Allen. Principles of Corporate Finance, 10th ed., McGraw-Hill Irwin, 2011. Print