Finance

Question 1
(a) What are the main issues an entrepreneur ought to consider when deciding whether to take hisher company public and make an initial public offering (IPO)

Answer1
Going public is when an entrepreneur sells of the ownership of His or Her company on the public market say a stock exchange. Selling shares of a company in an initial public offering (IPO) is an elaborate process that takes considerable months of planning.  After entrepreneurs sell their shares, they no longer work for themselves but they work for shareholders, a myriad of unseen investors who have a vested interest in the success of the company. As it has been observed, IPO share prices may ride like a roller-coaster thus may not be easy. In addition, going public may not be the right strategy for most Small Medium Enterprises (SMEs) or midsize companies. The stock market is nothing short of a fickle. However, successful IPOs fundamentally share some characteristics. When an entrepreneur has decided that going public is the right strategy, the following common denominators are resourceful when preparing a company for an IPO

There should be a strong network of the major stakeholders of the company. These include loyal customers, industry allies, and the community. These pools of individuals and institutions are the most probable shareholders for the company.

Second, the entrepreneur needs to have an excellent management team, this boots investors confidence.  Manager(s) should have remarkable track record in strategic management specifically financial management, expertise in operations management and excellent marketing strategies. Thirdly, the entrepreneur should protect the companys goods and services with trademarks and patents. Fourthly, the entrepreneur should standardize key business processes. For example, having a sole price structure that is applicable to all customers and suppliers. Another significant point to consider before going public is that, the entrepreneur should have a well built employment structure rather than banking on independent contractors.

Most companies use the option of an initial private placement with venture capitals when initializing an IPO. Entrepreneurs need teams that believe in their capability based on the above fundamentals, these teams should be willing to offer guidance in addition to capital required for expansion. This important partner helps entrepreneurs to establish contacts within the investment community and the banking community. Investment bankers and financial analysts will offer their professional advice on implementing the IPO. These may be through the provision of information on trends in the industry and on potential customers.  However, it is up to the entrepreneur to convince investors that they are worth to be counted among the big fish.

Finally, if the entrepreneur makes the cut, heshe will have to select underwriter s(these are simply the sponsors the IPO- investment banks). Underwriters help entrepreneurs to find the initial buyers for the shares. It is imperative to note that, product development, creation of new markets and all-around development are significant in the period of grooming for an IPO. Entrepreneurs should work with their managers together with advisers when setting specific financial goals.

(b) What are the main issues the CEO of a quoted company ought to consider when deciding whether to take hisher company private

Recent events such as the precipitous crashing of the stock market, the going-public euphoria have been replaced by a delisting act. The number of U.S. companies delisting stood at 188 in 2004. But what should a company consider before going private

Going private may buy time for a company since it avoids the public display of collapse. The company is but in a quieter setting. However, CEOs should know that going private requires enough money to buy out current shareholders. This is a very expensive proposition even when in a depressed market.  CEOs should know that going private reduces investor confidence, in as much as it saves costs since a company does not have to be Sarbanes-Oxley compliant. Companies that experience no organic growth then such companys can go private.

Question 2
(a) What is the main difference between a residual and a managed payout policy
Provide a numerical example to highlight this difference

Answer 2(a)
Residual payout policy is where firms use internally generated equity to fund their investment projects. Thus, dividend payments are only made when there is residual (leftover) equity after all after all capital projects requirements are satisfied. These firms usually attempt to stabilize their  HYPERLINK httpwww.investopedia.comtermsddebtequityratio.asp debtequity ratios.

For example, assume we have a firm named ABC Life. ABC has recently earned 10,000 and is attempting to maintain a debtequity ratio of 0.5. Now, suppose ABC has a project with a capital project requirement of say 9000. In order to keep the debtequity ratio at 0.5, ABC will need to finance the project by borrowing 3000 (one-third) and by using 6000 (two-thirds) from equity. This leaves a residual amount of 4000 i.e. 1, 0000 - 6000 for dividends. In addition, if the capital project had a demanded 15,000, ABC will have to borrow, 5,000 and the equity requirement is 10,000, implying that no dividends will be paid. If any case a project requires an equity portion that is higher than ABCs available levels, ABC opt to issue new stock.

Managed dividend payout policy is where firms choose a policy that is rather cyclical which sets dividends at a fixed portion of quarterly earnings. Alternatively, firms may choose a more stable policy whereby quarterly dividends are fixed as a portion of yearly earnings. In both cases, a managed dividend payout policy is aimed at reducing uncertainty for stockholders and in essence providing them with an income.

For example, lets assume we have a company named STABLE D. Suppose that STABLE D realized earnings totaling to 10,000 for the year 2009 (with quarterly earnings of 3000, 2,000, 1,000, 4,000). If STABLE D uses a stable policy of 10 of annual earnings, i.e. 10  10,000, it would pay 250 (1,0004) to stockholders every quarter. Alternatively, if STABLE D decided on a cyclical policy, the payments would be adjusted every quarter to be 300, 200, 100 and 400 respectively. In either case, firms utilizing this policy are not searching for capital projects to invest their extra cash but are rather attempting to share their earnings with shareholders.

(b) Briefly describe Lintners findings published in 1956 on the dividend policy of US corporations, and state whether they show that US companies follow a residual or a managed dividend payout policy.
Answer 2(b)

John Lintner (1956) established the foundation for the modern comprehension of dividend policy. In his research, Lintner (1956) conducted an interview on managers from 28 corporations. From his findings, the scholar concluded that dividends are directly associated to long-term sustainable earnings, dividends are paid by mature companies, are averaged from year to year, and that firms desire a long-term payout ratio when it comes to the adoption of a dividend policy. In essence, Lintners model proposes that, if a firm sticks to its targeted payout ratio, the firm would be able to change its dividend in tandem with changes in its earnings. However, in his survey Lintners (1956) found that managers were reluctant to implement the above principle. Most of them believed that shareholders prefer stable progression in dividends. Regardless of the increase in dividends, firms will partially move towards their targeted dividend (Lintner 1956, pp. 97-113).

The dividend policy that a firm chooses may determine profitability of its dividend payments for investors - and stability of their income. In practice, US companies use residual payout policies.
(c) Does payout policy affect firm value when there are differences in taxation between dividends and capital gains

Answer 2(c)
Modigliani and Miller suggested that, as long as there are no changes in the investment policy, changing the mix of retained earnings and payout policy does not alter a firms value. This means that if the choice of a dividend payout policy affects a firm, it does so through changing tax liabilities, changing investment incentives, and changing contracting costs.  If there is a higher tax on dividends than on capital gains, and stockholders have no alternative dynamic trading strategies that minimize the higher taxation, then the strategy of reducing dividends is optimal. Using the tax preference theory, we can argue that investors prefer capital gains over dividends, since capital gains taxes are deferrable and in most cases are lower than taxes on dividends.  In the U.S conventionally, dividends were taxed like ordinary income while capital gains are taxed at a relatively lower rate than the ordinary income. Thus, taxes promoted share repurchases over dividends. This meant that taxes affected the choice of a payout policy since, investors with low marginal taxes and appetite for current income preferred Companies with high dividends and vice versa. Thus through the clientele effect, firms will choose a policy that caters to a particular payout clientele. Currently, repurchases have lost their effect since the taxes on dividends and capital gains are now the same. However, the tax advantage of capital gains over dividends is that tax on capital gains is deferrable (Miller  Modigliani 1961, pp.411-413).
 (d) What do academics mean when they say that companies cater to a particular
Payout clientele when paying out cash to their shareholders

Answer 2(d)
The clientele effect states that investors will hold stocks whose dividend policy is most preferable. That is, investors will prefer certain dividends over unknown future earnings, or others will prefer having a current income over capital gains. These investors will tend to hold stocks that they perceive as having a relatively high dividend payout, and vice versa. This means that a particular dividend policy will influence a particular clientele attraction to its stock. Given these conditions, the stability of the dividend policy becomes more relevant than the dividend policy itself.  Thus, when academics say companies cater to a particular Payout clientele, they mean that companies will implement a dividend policy that is more stable with regard to the clientele effect. The policy is designed to attract clientele whose needs are best served by those policies. Thus, high dividend companies will cater for a clientele of investors with low marginal tax rates and good appetite for current income. Similarly, companies with low dividends cater for a clientele with low appetite for current income, and who exhibit high marginal tax rates (Encyclopedia of Business, 2010, para.16).

Question 3
Hawk is interested in acquiring the Southern Hotel Company. The company, which is privately owned, operates a small chain of city centre hotels in the United States. Its founder and owner Dorothy Murphy is considering retirement and is interested in selling, as she does not consider any of her family member wishes to work in the business.

Hawk has asked your advice in setting a price for the companys equity. You have gathered the following information
Similar companies have the following characteristics

You also note that
The return on the market (Rm)  11
The risk free interest rate (Rf)  4

Southerns latest earning figures (before deduction of interest) are 2.6 million. Income has remained stable at about this level over the past five years and Mrs. Murphy had no plans for further developments.
You may ignore taxation and inflation.

Required
Calculate the mean weighted average cost of capital (WACC) for the companies that are similar to the acquisition target. (You may assume that all the companies in the sample are approximately the same size as each other and the Southern Hotel Co.)

Answer 3(a).

Company A

WACC  Weight of Debt  Cost of Debt (1-Tax Rate)  Weight of Equity  Cost of Equity
Assume a tax rate of 35

And Weight of Debt  Debt-Equity Ratio  (1  Debt-Equity Ratio)

2773 (12773)
27100
.27 or 27
Also, Weight of Equity  1  (1  Debt-Equity Ratio)
1(12773)
.73 or 73
Cost of Equity
 Risk-free Rate  (Market Return -Risk-Free Rate)  Beta
 .04  (.11-.04) 1.11
 .1177 or 11.77
Therefore, WACC
 .27 .08  .73.1177
.0216.085921
.1075or 10.75

Company B

Weight of Debt.251.25
.2 or 20
Weight of Equity
11.25
.8 or 80
Cost of Equity
.04  (.13-.04)1.18
.1226
Therefore, WACC
.2.07  .8.1226
.014.09808
.1121 or 11.21

Company C
Weight of Debt.331.33
.2481
Weight of Equity
11.33
.7519
Cost of Equity
0.4  (.07)1.17
.1219

Therefore, WACC.2481.09 .7519.1219
.022329.09166
.114 or 11.4

Company D

Weight of Debt.331.33
.2481
Weight of Equity
11.33
.7519
Cost of Equity
.04  (0.07)1.23
.1261

Therefore, WACC
.2481.07  .7519.1261
.017367.094815
.1122 or 11.22

Company E
Weight of Debt.251.25
.2
Weight of Equity
11.25
.8
Cost of Equity
.04  (.07)1.15
.1205
Therefore, WACC
.2.07  .1205.8
.014.0964
.1104 or 11.04

Now the Mean WACC (.1075.1121.114.1122.1104)5
.1112 or 11.12

Using the above required rate of return, value the company and its equity and debt (Murphys debt equity ratio is 1090).

Weight of Debt.111.11
.0991 or 9.91
Weight of Equity
.9001 or 90.01

3) If Murphys cost of debt is 8 what is its cost of equity and its equity beta
Given that,
WACC  Weight of Debt  Cost of Debt (1-Tax Rate)  Weight of Equity  Cost of Equity
Then, .1112.0991.08(.65)  .9001Cost of Equity
Therefore, Cost of Equity
 (.1112-.0051532).9001
.1179 or 11.79
Since, Cost of Equity
 Risk-free Rate  (Market Return -Risk-Free Rate)  Beta
.04  (.07)Beta
Then, Equity Beta
 (.1179-.04).07
1.113

Where a company proposes to significantly increase its use of debt capital what will be the impact on its asset beta, its equity beta and its debt beta

A firms asset beta is dependent solely on the assets it is not influenced by the amount of changes in debt. However, a firms equity beta depends on its risk-free debt. Most financial analysts overlook the linkage between a firms debt equity mix and its equity beta. It is clear that equity beta rises with the rise in debt. Thus more increase in debt increases a firms riskiness. Thus increase in debt capital increase the debt beta of a firm.