Finance

Question I
An agency problem does exist between Shareholders, who are the actual owners of any organization, and its agents or the management of the organization. Both the parties involved, the Shareholders and the management have different perspectives of creating wealth and distributing the same, and it is important to understand their respective perspectives to understand d the perennial problem between them. The agency problem is even more evident when the management is in the hands of a select few, who have large control over management, but have lesser control on the overall value of the organization. This creates a case of mistrust among the shareholders or the principals.
The perspectives of all shareholders are not alike, but the majority of shareholders are the large investors who invest with the sole purpose of capital maximization, as they are less bothered by divided paid out by the company, on which tax is payable at a higher rate than on long term capital gains. On the contrary, smaller investors prefer to have cash in hand based on the bird in hand theory of dividend. They prefer profit to be the motive of the management, and the same profit instead of being reinvested should be distributed.
When dividend is reinvested, wealth maximization occurs, which should be the motive of the management of any organization as abundant wealth can help a company to invest into newer ventures when the need arises.
Modigliani  Miller have propounded two theories on dividend payout and capital structure, which have the following assumptions.
There are no corporate taxes
No brokerage charges exists
Investors can borrow at the same rate as corporations
Information available to investors is the same as the information available to the management.
The dividend indifference theory proposed by Miller- Modigliani , believes in one implication that whatever be the dividend policy of the management, there would be no change on the market value of the organization or its cost of capital, in the longer run. They argue that dividend policy is a passive residual, which is purely dependent on an organizations need for investment funds.
They believe that an optimal dividend payout theory does not exist and management need not agonize themselves to either distribute profits or to retain them. The MM theory claims that if a shareholder is in need of cash, he would sell his existing stock, rather than depend on dividend payout, which is not under his control. Similarly, if he has a surplus of funds he would reinvest them into the company, hence maximizing his wealth. They go on with the argument that the value of a firm depends only on the earning power of the organization and its business risk. Hence, what matters according to Miller- Modigliani is the income earned by assets of the organization and not on how the income is divided between dividends and retained earnings.
Similarly, Miller- Modigliani state in another theory, that the capital structure of an organization has no effect on its value. As given in the above assumptions, individual investors can borrow as freely and at the same rates, as organizations can. As a result, the investor would prefer to invest into a less levered firm, by borrowing from a financial institution. The eventual returns to either of investing in a levered or an unlevered firm would be the same. Therefore, the price of the unlevered firm would be the same as the price of the levered firm, minus the money borrowed by the individual, to invest in the unlevered firm.
However, the Miller- Modigliani is unrealistic with most of its assumptions and does not help the management in solving the agency problem. The management though acting as an agent of the shareholders in many ways works against the motives of the principals, i.e. the shareholders. A company that reduces the amount of dividend per year, can significantly lose the number of investors, and hence companies make extra efforts to keep a standard level of dividend instead of increasing or decreasing constantly. By increasing the dividend payout, the company would attract more smaller investors and lose out on the larger investors. And, by decreasing dividend payout, the company would lose the faith of smaller investors.
Similarly, when the company is highly leveraged, it increases risk that might occur due to high interest payments, causing a severe cash crunch, leading ultimately to bankruptcy. Hence, shareholders prefer a lower levered firm, while the management prefers higher leverage so that wealth maximization can occur.

Question II
 A business has continuous requirements for funds, and several factors need to be kept in mind while choosing the right source of financing
The amount of funds required
The quickness of the funds required
Cheapest options available
The amount of risk involved in the purpose of borrowing
The length of time of the fund requirement, short term or long term
There are several sources of funds that a company can employ to gain funds, which include Ordinary shares, Preference shares, Bonds and banks. The merits of the sources are discussed below
Ordinary shares Shares holders are the last paid after interests on bonds and loans, and preference shareholders. Hence, the company with low cash or profit can choose this method of raising funds. Also, raising share capital for listed companies is relatively easy.
Preference Shares These shareholders would only get a fixed amount of dividend per annum, when compared to equity shareholders. Also, profits need not be shared when the company is in losses.
Bonds Bonds are issued to individual investors for a fixed annual interest. The company has only to pay the annual interest and has no capital repayments due within the term of the bonds.
Bank loans Banks loans are easy to procure for large organizations and generally have the lowest interest rate, when compared to bonds or preference capital.

 A Bond holder is secured about his investment, when compared to equity shareholders or preference shareholders. Bond holders are assured of income even when the company has profits or losses, and hence the company faces more risk to pay interests under whatever circumstances. On the contrary, shareholders might receive income only when the company has profits.
When the company is under the process of bankruptcy, even then the bond holders are the most preferred and are assured of receiving their investments, as they are treated equal to creditors. The company has to payout to bond holders under whatever circumstances, causing a great risk to the organization.
Solution
Facts of the Problem
Amount of capital to be raised by rights issue  GBP 40 million
Current market price of share  GBP 4.23
Offer ratio for rights issue is, 1 share at GBP 3.2 for each 3 shares owned
Required to find expected value of the shares after rights issue the Ex right price
Solution
Ex rights price  (Total Value of original shares  value of rights share) total number of shares after rights issue.
Assume that a customer holds 300 shares of the company at GBP 4.23
His Value of shares  4.23300  GBP1269
When he accepts the rights issue, he would gain 100 share, which implies that the value of rights gained  GBP 3.2  100 shares  GBP 320
Ex rights price  (1269320) 400
         GBP 3.9725
 The pecking order theory by Gordon Donaldson suggests that companies prefer financing their investments in a particular manner, which is
Internal financing or retained earnings
Bank loans or any other pure debts
Preferred stock
Hybrid securities that include convertible bonds
Equity
One of the strongest factors that causes such an attitude from the management, is the ease or convenience of borrowing. The management of an organization find it difficult to approach a third party for financing and prefer to use their own accumulated resources first. Equity is chosen last as it is the most difficult process to acquire funds, especially if an organization needs to do so for the first time. As a result, of the pecking order of financing, the capital structure of an organization would be filled with more debt and less equity, as equity becomes the last choice of raising funds.
Question III
Solution

ParticularsYearCash Flow
( 000s)PV Factor
(11)Discounted CashflowInitial investment0(30000)1(30000)117800.9116198223800.8119278Net Present Value of investment 5476
Workings
Expected cash flow of investment for Year 1 
((Cash flow of probability 1 Probability 1)  (Cash flow of probability 2  Probability 2)) Total Probability
 (15000.6)  (22000.4)1   17800
Expected cash flow of investment for Year 2 
((Cash flow of probability 1 Probability 1)  (Cash flow of probability 2  Probability 2)) Total Probability
 (22000.7)  (28000.3)1   23800
Calculation of Standard deviation of NPV
  of year 1  prob of case1(cash flow of case1- Mean of cash flows)2  prob of case 2(cash flow of case 2- Mean of cash flows)212
 .6(15000-18500)2.4(22000-18500)212
 (.612250000)(.4 12250000)12
 7350000490000012
  of year 1  3500
  of year 2  prob of case1(cash flow of case1- Mean of cash flows)2  prob of case 2(cash flow of case 2- Mean of cash flows)212
 .7(22000-25000)2.3(28000-25000)212
 (.7900000)(.3 900000)12
 900000 12
  of year 2  3000
  of Project      (SD of year 1(1disc factor))  ((SD of year 2(1disc factor)2)
         (35001.11)  (3000(1.11)2)
         2702.7 2434.9   5137.6    
c. Calculate probability of possibility of NPV being negative
Mean NPV  - (Initial Investment)  (mean Cash flow for 1st Year)1.11  (mean cash flow for II year)(1.11)2
            -30000  (185001.11)  (250001.2321)
             -30000  16667  20291
Mean NPV           6958
Standardized difference      (Expected NPV  Mean NPV) Standard Deviation of NPV
                 (0-6958)5137.6
                 1.35
Probability of NPV (0)      .885 ( According to probability distribution tables)
Hence, there is 88.5 chance of the NPV being lower than zero for the given problem
D.      FINDINGS
    There are a few interesting facts that can be found from the above workings. Firstly, the NPV is  5476, while the standard deviation is about  5137.6. Hence, one thing that can be ascertained clearly is that there level of deviation is quite high when compared to the actual NPV. This indicates high volatility in the cash flow stream of the organization.
Another scary piece of information for the management is the fact that there is a .885 chance of the NPV being lesser than zero or negative. Hence, Cloaca PLC has a mere 11.5 of getting a positive NPV. The investment has a positive NPV, but minor deviations in the actual cash flow can affect the viability of the investment. The organization should identify means to increase its cash inflows or decrease the cash outflow, to make the investment not just viable, but more safe.

Question IV
Solution
Required Rate of Return on Equity  Ke
Ke       Risk free rate of return  (expected return- Risk free rate)Beta of portfolio
         .04  (.1-.04)1.1
         .04  0.066
         .106 or 10.6
Required Rate of Return on Preferred Stock   Kp
Kp      Annual dividend on preferred stock Sale proceeds or Market price of preferred share
     (7.5  100 share) 108
     7.5108
     0.06944  6.94 returns on preferred stock
Required Rate of Return on Debt  Kd
Kd      k(1-t) , where k is the actual cost of debt, and t is the effective corporation tax rate
     5(1-.3)  5.7
    3.5  is the cost of debt
Weighted average cost of capital of Riquiqui PLC
Ko (Ke  (ET))  (Kp  (PT)  Kd  (DT), where
E  Equity Capital, T  total of debt and capital, P  preferred capital, D Debt
Ko      (10.6(4080))  (6.94 (1080))  ( 3.5  (3080))
     (10.6.5)  (6.94 .125)  ( 3.5  .375)
     5.3 .8675  1.3125
Ko     7.48 is the weighted cost of capital of the Riquiqui PLC
The expected rate of return on a companys security is called the cost of capital of that security. The weighted average cost of capital is the weighted average of all the securities in the portfolio of the company. For any investment to be worthwhile, the cost of capital should be lesser than the expected rate of return. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk
The cost of debt is easy to calculate as it composed of the rate of interested paid and the existing corporate tax rate. Thecost of equityis more difficult to ascertain, as equity shareholders are not guaranteed fixed returns annually. The cost of equity is broadly defined as the risk-weighted projected return required by shareholders, where the return is largely unknown.
The reason the marketing manager found Interest paid to be higher on a percentage basis on the dividend declared is because, interest is a pre-tax, pre- amortization and pre preference dividend expense. All these expenses would need to be met, to declare the amount of dividend. Hence, actual dividend declared would be lower as a percentage basis when compared with interest.
It is more difficult to assess the cost of equity of a unlisted company than a listed company. This fact can be ascertained by the formula of cost of equity.
Ke       Risk free rate of return  (expected return- Risk free rate) Beta of portfolio
Out of the elements required to ascertain the cost of equity, risk free rate or return and expected return can be easily ascertained. However, calculating the Beta of an unlisted company is more difficult to ascertain, as the Beta is a description of the return of a particular stock in relation with financial market as a whole. IT would be difficult to compare an unlisted market, with the financial market as a whole.

Question V
Free cash flow statement of Gryphon PLS
ParticularsYear 1Year 2Year 3EBIT391039884500(Less) Taxes(1400)(1430)(1600)(less) Working Capital changes(60)100(80)(less) increase in fixed assets(1450)(1785)(2100)(Add) Depreciation800825875(Add) Increase in provisions450450500Free Cash Flow225021482095
Assumptions
 In calculating Free Cash flow for an organization, depreciation and provisions do not cause a cash flow change and hence are added to the EBIT
Taxes, changes in fixed assets, and changes in working capital are to be adjusted to EBIT by either adding or subtracting.
Valuation of Gryphon PLC
Weighted average Cost of Capital given  8.82
Market value of firm  PV of expected future free cash flows of the organization
 (2250 (1.0882))  (2148 (1.0882)2)  (2095 (1.0882)3)  (2300 (1.0882)4)  (2300 (1.0882)5)  (2300 (1.0882)6)
 (22501.0882)   (21481.1842)  (20951.2886)  ( 23001.4022)  ( 23001.526)  (23001.6606) 
 2067.63  1813.88  1625.8  1640.28  1507.21  1385.04
  10, 039, 880 is the Market Value of the firm
If the Free cash flow increases by 4 from the 5th year onwards, the 5th and 6th years cash flow would be  2392 (000s) and  2488 (000s )
Market value of firm  PV of expected future free cash flows of the organization
 (2250 (1.0882))  (2148 (1.0882)2)  (2095 (1.0882)3)  (2300 (1.0882)4)  (2392 (1.0882)5)  (2488 (1.0882)6)
 (22501.0882)   (21481.1842)  (20951.2886)  ( 23001.4022)  ( 23921.526)  (24881.6606) 
 2067.63  1813.88  1625.8  1640.28  1567.5  1498.25
  10, 213, 340 is the Market Value of the firm when the cash flows for the 5th and 6th years have been adjusted incrementally by 4 every year.
 The WACC defines the value of a firm as a sum of PV of expected future free cash flows of the organization. However, the assets and liabilities of the organization are completely ignored, which include tangible and intangible assets. Also, the business model of the company might not provide a correct picture of the valuation, if the valuation is with the WACC method. Some business have a longer gestation period than others, and such businesses would have lower present value of cash flows. Such organizations would have lower value as per the WACC method, which is deceptive.
    The method ignores the importance of systemic risk and the relationship between risk and return in valuing the organization. While the WACC method uses only the WACC of the organization, it ignores the causes of inflation and the importance of realistic discounting factors that are considered by the CAPM method. Due to these reasons and others, the WACC is not a holistic method to ascertain the value of an organization.

Question VI
Facts of the problem
Ocean PLCs current valuation   60 million, with 30 million shares
Sea PLCs current valuation   30 million, with 45 million shares
Expected valuation of both companies post merger   110 million
Transaction costs   3 million
Net Present Value of Acquisition  Gains from acquisition  Cost of Acquisition.
NAV of the acquisition  Vab  (VaVb)  P  E
    Where    Vab      combined value of the 2 firms
        Vb     market value of the shares of firm B.
        Va     As measure of its own value
        P       premium paid for B
        E     expenses of the operation
NAV of the acquisition          110-(6030)  20  3
                     - 3 million   
Hence, the acquiring firm, Ocean PLC would not be creating value in monetary terms through the acquisition. However, it is wrong to equate value as the sole reason for a merger, which might create synergistic business solutions beyond value.
 In the case of a cash merger, the rights of the acquired companys shareholders are bought over with the use of cash alone. As a result, the acquiring company only pays for the purchase price with any premium to the shareholders of the acquired company.
Hence, if the purchase is made in cash, the price offered for each of Sea PLCs shares will be
  (Market value of shares of PLC Premium offered on merger) Total no of Sea PLC shares
 ( 30 million   20 million    ) 45 million
  1.11 per share would be the price offered by Ocean PLC to the shareholders of Sky PLC.
Post merger value of Oceans share  (Pre-merger Value of Both firms  Synergy added) (Post merger no. of shares)
Share price of Ocean PLC before merger   2
Share price of Sea PLC before merger   .67
Hence, 3 shares of PLC would be allotted 1 share in Ocean PLC post merger.
Post merger value of Oceans share  (( 60 million   30 million)   20 million)  75 million   1.47 per share
Total Value of Ocean PLC post acquisition   110 million
If Sea PLC owns 13rd of the merged entity, the value of Sea PLC would be  36.3 million
Value of Ocean PLC  Total Value of firm  Value of Sea PLC
              110 million -  36.3 million
              63.7 million
Value of shareholder wealth lost for Ocean PLC  Shareholder loss without 13rd stake  additional loss due to this change
  3 million  6.3 million (increased value in Sea PLC due to percentage change)
  9.3 million is the total value lost by the shareholders of Ocean PLC by the merger.
When a merger purchase is done in cash or stock, there are advantages for the shareholders of both the acquiring company Ocean PLC and the acquired company Sea PLC. 
When merger purchase is done in cash
Ocean PLC would have greater control of the organization as the shareholders of Sea PLC and its management, lose complete control over management and control.
For a cash surplus organization, this is a cheaper investment, as Ocean PLC can bargain tougher in the negotiating process and get a more favorable deal.
For Sea PLC, it would be favorable if the organization has a significant debt liability that needs to be cleared once and for all.
When the merger purchase is done in Stock
Sea PLC would be the biggest gainer as Ocean PLC would need to purchase the stock of the company at significant premium.
Unlike, in the case of a cash buyout, Sea PLC gains by the increased value of shareholder wealth.
For Ocean PLC, this method is most suited if it is cash strapped and would not be able to raise fund requirements within a short period.
Most of the times the advantages are shared to both the companies, though not always in equal proportion.

QUESTION VII
The following are the conditions for a perfect market in shares to exist
There are no transaction costs, including brokerage costs
No taxes of any kind exist.
All assets are perfectly divisible and marketable.
 No regulations exist that govern the markets operations
There is no cost for acquiring information and all participants of the market have equal access to information.
All participants in the market are rational, logical and sensible, who expect utility maximization
Management works purely for the fulfillment of shareholders objectives
The market is perfectly competitive, with large number of buyers and sellers
Since there are large number of buyers and sellers, no individual would be able to influence price
Though the assumptions or conditions that make up a perfect market are unrealistic, they are very important in the understanding of financial theory. There are several aspects about the capital markets that make them impossible to study, if not for the assumptions of a perfect market. Technically, a perfect market is one where there is no possibility for arbitration. In the presence of arbitration or speculation, it would be impossible to measure the growth of the financial market, or individual stocks, as the motives of growth or decline are beyond logical explanation.
A second important implication of the perfect market is the absence of transaction costs.
In the presence of transaction costs, the decisions of buying and selling can be dependent on the cost of such transactions, instead of the opportunity that lies in the transaction.
    When a market is perfect or efficient, it implies transparent information to all the buyers and sellers in the market. Unlike till few decades ago, where information was limited to a select few about the stock market, todays stock markets around the world share information almost transparently with everyone around the world. When certain buyers or sellers have selective access to information, there is a great possibility that they might misuse the same for personal gain and hence it is important for perfect capital markets to exist, at least in theory.
    Several financial theories are based upon the assumption of a perfect market. Theorists like Miller-Modigliani have built several theories on this sole assumption and how capital structure, dividend policy of an organization can be decided. In the absence of these theories, managements would find it very tough to take important capital decisions.