Corporate Financial Managers, Primary Market And Working Capital
Goals of Corporate Financial Managers
here is a wide range of goals of corporate financial managers. They are primarily concerned with the financial growth and survival of the company. Their main objective is to maximise the profits of the company so that any situation of financial distress and solvency could be avoided. They also aim at achieving the goal of maximising the wealth of shareholders.
The corporate form of business organisation has various advantages over sole- proprietorship and partnership form of business organisation. The advantages are:
As the companies are separate legal entities, the personal assets of the shareholders are not held in risk for the company’s debt.
It is easier for the corporations to arrange funds for the business. Companies have the option of raising funds through the issue of shares to the potential investors. Such option is not available with other forms of business.
As corporate bodies have to file separate tax returns from its shareholders, these bodies avails various tax benefits on the salaries and dividends they pay out.
However, it has some disadvantages also such as the incorporation of company form of business involves a huge span of time and heavy costs.
The connection between the company’s owners i.e. its shareholders and managers is of principle and agent and hence such relationship is called agency relationship. The shareholders desires the management to enhance the company’s value but the managers desires to achieve their personal benefits from the company’s operations. These conflict of interests results in agency problems (Ahmed, Billings, Morton, Stanford-Harris, 2002). Due to such problems the company has to incur various direct and indirect agency costs.
The main role that primary market plays is to facilitate the capital growth of the country by allowing the individuals to convert their savings into investments on which return can be earned. These markets exists to facilitate corporate and governmental bodies in issuing new securities to the investors directly.
These markets plays most pivot role in the economy’s growth as they facilitate subsequent trading of securities issued by the corporate bodies in the initial public offerings. They help in determining the interest rates and prices of shares and securities traded in the stock market (Mishkin & Eakins, 2006)
If the current ratio is increased and quick ratio is fallen it shows that the liquid assets such as inventories and prepaid expenses of the company has decreased. No the liquidity position has not improved.
Working capital is the excess of company’ current assets over its current liabilities. A positive working capital of the company shows that it has sufficient amount of funds to continue its basic business operations and meeting its operational expenses as well as short term debt (Brigham & Ehrhardt, 2013).
Advantages of Corporate Business Organization
The main components of working capital investment are:
Current assets which includes inventories, cash and bank balance, prepaid expenses, trade receivables etc.
Current liabilities which includes trade payables, short term borrowings, outstanding expenses etc.
Simple interest is the interest determined as a percentage of principle amount whereas compound interest is the interest that is determined as a percentage of both principle amount and the accrued interest thereon. Compound interest keeps on increasing every year whereas simple interest remains uniform for every period.
Illustration: Alex has borrowed loan of $1000 at 10% interest rate for 3 years.
Now, if simple interest is to be paid by him, the interest will be calculated as =$1000 x 10% = $ 100 for all the three years but if interest is to be compounded annually then interest payment will be calculated as follows:
1000 x 10% = $ 100
(1000+ 100) x 10% = $110
(1100+110) x 10%= $ 121.
This shows that interest amount is rapidly increasing every year.
As an investor, compound interest scheme will be preferred as it will have higher returns.
The difference between the annuity and perpetuity lies in the ending period. In annuity, the payment of anything last for a particular period whereas in case of perpetuity payment lasts forever (Brigham & Houston, 2012).
Debt is the amount of funds owed by any firm to any party whereas equity is the amount of funds raised through the issue of shares by the company.
Common stock entitles the holders to possess a share in company’s ownership as they get voting rights whereas the holders of preferred stock of the company do not hold any voting rights in the company but have greater claim on assets of company (Heaton, 2002).
As an investor, preferred stock will be preferred as it will provide regular and fixed income.
Interest rate of bonds and their prices are inversely related as with the increase in one, the other declines.
Both the techniques are used in capital investment appraisal. But, Net present value is the aggregate of all the cash flows of the project and is denoted in amount terms and PI is denoted in terms of percentage. NPV is more reliable than PI.
There are various kinds of risk involved in finance such as
Market risk: It arises due to price fluctuations of financial instruments.
Credit risk: It arises when one party fails to fulfil its financial obligations towards its counter party.
Agency Problems
Liquidity risk: It arises due to inability to execute any financial transaction.
|
Year |
Returns |
PVF @ 8% |
PV of cash flows |
|
1 |
$ 100.00 |
0.926 |
$ 92.59 |
|
2 |
$ 100.00 |
0.857 |
$ 85.73 |
|
3 |
$ 100.00 |
0.794 |
$ 79.38 |
|
4 |
$ 200.00 |
0.735 |
$ 147.01 |
|
5 |
$ 300.00 |
0.681 |
$ 204.17 |
|
6 |
$ 500.00 |
0.630 |
$ 315.08 |
|
Present Value of Investment |
$ 923.98 |
a)
|
Present Value |
$ 400.00 |
|
Terms (In Years) |
5 Years |
|
Terms (In Months) |
10 |
|
Rate |
6% |
|
Future Value= |
Present Value (1+ r)^t |
|
Future Value= |
$ 5,272.32 |
b)
|
Present Value |
$ 200.00 |
|
Terms (In Years) |
5 |
|
Terms (In Months) |
15 |
|
Rate |
3% |
|
Future Value= |
Present Value (1+ r)^t |
|
Future Value= |
$ 3,719.78 |
c) The future values of the above annuities are not same even after paying same amount because of the reason of different number of times of compounding.
Perpetuity of $100 at the discounting rate of 7%= 100/.07
= $1428.571
Perpetuity of $100 at the discounting rate of 14%= 100/.14
= $ 714.29
The present value of perpetuity will decrease with the increase in the discounting rate of return.
Compounding is the process of earning or paying interest on interest on any financial instrument. Interest calculated in previous year is added to the principle and the new interest is calculated on such amount.
|
Amount |
100 |
||
|
Terms |
5 |
||
|
Interest |
10% |
||
|
Year |
Opening Balance |
Interest |
Closing Balance |
|
1 |
$ 100.00 |
$ 10.00 |
$ 110.00 |
|
2 |
$ 110.00 |
$ 11.00 |
$ 121.00 |
|
3 |
$ 121.00 |
$ 12.10 |
$ 133.10 |
|
4 |
$ 133.10 |
$ 13.31 |
$ 146.41 |
|
5 |
$ 146.41 |
$ 14.64 |
$ 161.05 |
|
Future Value of $100 at the compounding interest rate of 10% =$161.05 |
|
Terms |
3 Years |
||
|
Interest |
4% |
||
|
Year |
Opening Balance |
Interest |
Closing Balance |
|
1 |
$ 2,000.00 |
$ 80.00 |
$ 2,080.00 |
|
2 |
$ 2,080.00 |
$ 83.20 |
$ 2,163.20 |
|
3 |
$ 2,163.20 |
$ 86.53 |
$ 2,249.73 |
|
Interest |
5% |
||
|
Year |
Opening Balance |
Interest |
Closing Balance |
|
1 |
$ 2,000.00 |
$ 100.00 |
$ 2,100.00 |
|
2 |
$ 2,100.00 |
$ 105.00 |
$ 2,205.00 |
|
3 |
$ 2,205.00 |
$ 110.25 |
$ 2,315.25 |
|
Interest |
6% |
||
|
Year |
Opening Balance |
Interest |
Closing Balance |
|
1 |
$ 2,000.00 |
$ 120.00 |
$ 2,120.00 |
|
2 |
$ 2,120.00 |
$ 127.20 |
$ 2,247.20 |
|
3 |
$ 2,247.20 |
$ 134.83 |
$ 2,382.03 |
|
Interest |
20% |
||
|
Year |
Opening Balance |
Interest |
Closing Balance |
|
1 |
$ 2,000.00 |
$ 400.00 |
$ 2,400.00 |
|
2 |
$ 2,400.00 |
$ 480.00 |
$ 2,880.00 |
|
3 |
$ 2,880.00 |
$ 576.00 |
$ 3,456.00 |
When CD matures at the end of 3 year at the interest rate of 4%, the holder of CD will have $ 2,249.73.
When CD matures at the end of 3 year at the interest rate of 5%, the holder of CD will have $ 2,315.25
When CD matures at the end of 3 year at the interest rate of 6%, the holder of CD will have $ 2,382.03
When CD matures at the end of 3 year at the interest rate of 20%, the holder of CD will have $ 3,456
|
Terms |
6 Years |
||
|
Interest |
7% |
||
|
Year |
Opening Balance |
Interest |
Closing Balance |
|
1 |
$ 90,000.00 |
$ 6,300.00 |
$ 96,300.00 |
|
2 |
$ 96,300.00 |
$ 6,741.00 |
$ 1,03,041.00 |
|
3 |
$ 1,03,041.00 |
$ 7,212.87 |
$ 1,10,253.87 |
|
4 |
$ 1,10,253.87 |
$ 7,717.77 |
$ 1,17,971.64 |
|
5 |
$ 1,17,971.64 |
$ 8,258.01 |
$ 1,26,229.66 |
|
6 |
$ 1,26,229.66 |
$ 8,836.08 |
$ 1,35,065.73 |
When CD matures at the end of 3 year at the interest rate of 20%, the holder of CD will have $ 135,065.73.
|
Coupon Rate |
7% |
||
|
YTM |
8% |
||
|
Maturity |
7 |
||
|
Face Value |
1000 |
||
|
Year |
Cash Flows |
PVF |
PV OF Cash Flows |
|
1 |
70 |
0.926 |
64.815 |
|
2 |
70 |
0.857 |
60.014 |
|
3 |
70 |
0.794 |
55.568 |
|
4 |
70 |
0.735 |
51.452 |
|
5 |
70 |
0.681 |
47.641 |
|
6 |
70 |
0.630 |
44.112 |
|
7 |
70 |
0.583 |
40.844 |
|
7 |
1000 |
0.583 |
583.490 |
|
Market Price of bond |
947.936 |
Market price of bond is $947.94.
(Acharya & Carpenter, 2002)
|
Cash Ratio= |
Cash + Cash Equivalents |
|
|
Current Liabilities |
||
|
= $ 1,05,000.00 |
||
|
$ 2,30,000.00 |
||
|
=0.46 |
|
Current Assets |
|
|
Merchandise Inventory |
$ 240.00 |
|
Cash and equivalents |
$ 275.00 |
|
Accounts receivable |
$ 1,150.00 |
|
Accrued expenses |
$ 830.00 |
|
Total Current Assets |
$ 2,495.00 |
|
Working Capital |
|
|
Total current assets |
$ 2,495.00 |
|
Less: Total current liabilities |
$ 345.00 |
|
Working Capital |
$ 2,150.00 |
Working Note:
|
Total current liabilities |
|
|
Accounts payable |
$ 225.00 |
|
Current portion of long-term debt |
$ 120.00 |
|
Total Current Liabilities |
$ 345.00 |
|
Year |
Dividend |
PVF |
Present value of dividend stream |
|
1 |
$ 11.00 |
0.893 |
$ 9.82 |
|
2 |
$ 11.00 |
0.797 |
$ 8.77 |
|
3 |
$ 11.00 |
0.712 |
$ 7.83 |
|
4 |
$ 11.00 |
0.636 |
$ 6.99 |
|
5 |
$ 11.00 |
0.567 |
$ 6.24 |
|
6 |
$ 11.00 |
0.507 |
$ 5.57 |
|
7 |
$ 11.00 |
0.452 |
$ 4.98 |
|
8 |
$ 11.00 |
0.404 |
$ 4.44 |
|
9 |
$ 11.00 |
0.361 |
$ 3.97 |
|
10 |
$ 11.00 |
0.322 |
$ 3.54 |
|
11 |
$ 11.00 |
0.287 |
$ 3.16 |
|
12 |
$ 11.00 |
0.257 |
$ 2.82 |
|
13 |
$ 11.00 |
0.229 |
$ 2.52 |
|
14 |
$ 11.00 |
0.205 |
$ 2.25 |
|
15 |
$ 11.00 |
0.183 |
$ 2.01 |
|
Current share price |
$ 74.92 |
Therefore the current share price is $74.92.
|
P(0) |
D1 |
|
Ke-g |
|
|
D(0) |
$ 6.00 |
|
Growth Rate |
5% |
|
D(1) |
6.30 |
|
Ke |
18% |
|
P(0) |
$ 48.46 |
Therefore, the current share price is $48.46.
Question 25
- Payback Period
Project A
|
YEAR |
CASH FLOWS |
CUMULATIVE CASH FLOWS |
|
0 |
$ -1,75,000.00 |
$ -1,75,000.00 |
|
1 |
$ 22,500.00 |
$ -1,52,500.00 |
|
2 |
$ 32,500.00 |
$ -1,20,000.00 |
|
3 |
$ 32,500.00 |
$ -87,500.00 |
|
4 |
$ 2,20,000.00 |
$ 1,32,500.00 |
|
Payback Period |
3.40 |
Project B
|
YEAR |
CASH FLOWS |
CUMULATIVE CASH FLOWS |
|
0 |
$ -25,000.00 |
$ -25,000.00 |
|
1 |
$ 12,000.00 |
$ -13,000.00 |
|
2 |
$ 11,000.00 |
$ -2,000.00 |
|
3 |
$ 9,750.00 |
$ 7,750.00 |
|
4 |
$ 7,300.00 |
$ 15,050.00 |
|
Payback Period |
2.21 |
The payback period of Project B is lower than A and hence it can recover the initial cost of project in less time. Therefore, it must be accepted.
- Discounted payback period:
Project A
|
YEAR |
CASH FLOWS |
PVF |
PV of Cash Flows |
Cumulative Cash Flows |
|
0 |
$ -1,75,000.00 |
1.000 |
$ -1,75,000.00 |
$ -1,75,000.00 |
|
1 |
$ 22,500.00 |
0.885 |
$ 19,911.50 |
$ -1,55,088.50 |
|
2 |
$ 32,500.00 |
0.783 |
$ 25,452.27 |
$ -1,29,636.23 |
|
3 |
$ 32,500.00 |
0.693 |
$ 22,524.13 |
$ -1,07,112.10 |
|
4 |
$ 2,20,000.00 |
0.613 |
$ 1,34,930.12 |
$ 27,818.02 |
|
DISCOUNTED PAYBACK PERIOD (YEARS) |
3.79 Years |
Project B
|
YEAR |
CASH FLOWS |
PVF |
PV of Cash Flows |
Cumulative Cash Flows |
|
0 |
$ -25,000.00 |
1.000 |
$ -25,000.00 |
$ -25,000.00 |
|
1 |
$ 12,000.00 |
0.885 |
$ 10,619.47 |
$ -14,380.53 |
|
2 |
$ 11,000.00 |
0.783 |
$ 8,614.61 |
$ -5,765.92 |
|
3 |
$ 9,750.00 |
0.693 |
$ 6,757.24 |
$ 991.32 |
|
4 |
$ 7,300.00 |
0.613 |
$ 4,477.23 |
$ 5,468.55 |
|
DISCOUNTED PAYBACK PERIOD (YEARS) |
2.85 Years |
The discounted payback period of Project B is also lower than A and hence it must be accepted.
- Net present value:
Project A
|
YEAR |
CASH FLOWS |
PVF |
PV of Cash Flows |
|
0 |
$ -1,75,000.00 |
1.000 |
$ -1,75,000.00 |
|
1 |
$ 22,500.00 |
0.885 |
$ 19,911.50 |
|
2 |
$ 32,500.00 |
0.783 |
$ 25,452.27 |
|
3 |
$ 32,500.00 |
0.693 |
$ 22,524.13 |
|
4 |
$ 2,20,000.00 |
0.613 |
$ 1,34,930.12 |
|
NPV |
$ 27,818.02 |
Project B
|
YEAR |
CASH FLOWS |
PVF |
PV of Cash Flows |
|
0 |
$ -25,000.00 |
1.000 |
$ -25,000.00 |
|
1 |
$ 12,000.00 |
0.885 |
$ 10,619.47 |
|
2 |
$ 11,000.00 |
0.783 |
$ 8,614.61 |
|
3 |
$ 9,750.00 |
0.693 |
$ 6,757.24 |
|
4 |
$ 7,300.00 |
0.613 |
$ 4,477.23 |
|
NPV |
$ 5,468.55 |
The NPV of project A is higher than that of project B. Hence, it must be accepted as it will genenate higher returns.
- Internal rate of return
Project A
|
YEAR |
CASH FLOWS |
|
0 |
$ -1,75,000.00 |
|
1 |
$ 22,500.00 |
|
2 |
$ 32,500.00 |
|
3 |
$ 32,500.00 |
|
4 |
$ 2,20,000.00 |
|
IRR |
18.14% |
Project B
|
YEAR |
CASH FLOWS |
|
0 |
$ -25,000.00 |
|
1 |
$ 12,000.00 |
|
2 |
$ 11,000.00 |
|
3 |
$ 9,750.00 |
|
4 |
$ 7,300.00 |
|
IRR |
24.08% |
IRR of project B is greater than that of Project A and hence it must be accepted.
- Profitability Index
|
Profitability Index= |
1+ |
Net present values |
||||
|
Initial Investment |
Project A
|
Project A |
1+ |
27818.02 |
|||
|
175000 |
|||||
|
1.16 |
|||||
|
Project B |
1+ |
5468.55 |
|||
|
25000 |
|||||
|
1.22 |
|||||
Project with higher profitability index must be accepted hence project B must be accepted (Drake, 2006).
- On the overall basis project B must be accepted as it has favourable results from maximum capital investment techniques.
References:
Acharya, V.V. and Carpenter, J.N., 2002. Corporate bond valuation and hedging with stochastic interest rates and endogenous bankruptcy. The Review of Financial Studies, 15(5), pp.1355-1383.
Ahmed, A.S., Billings, B.K., Morton, R.M. and Stanford-Harris, M., 2002. The role of accounting conservatism in mitigating bondholder-shareholder conflicts over dividend policy and in reducing debt costs. The Accounting Review, 77(4), pp.867-890.
Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage Learning.
Brigham, E.F. and Houston, J.F., 2012. Fundamentals of financial management. Cengage Learning.
Drake, P.P., Capital budgeting techniques. Online (datum poslední revize: 29.6. 2006): www. fau. edu/~ ppeter/fin3403/module6/capbudtech. pdf.
Mishkin, F.S. and Eakins, S.G., 2006. Financial markets and institutions. Pearson Education India.
Heaton, J.B., 2002. Managerial optimism and corporate finance. Financial management, pp.33-45.
