Theory and Practice of Investment Management - Essay Example

? Question1 2 Part 2 Part 2 2 Part 3 3 Question 2 4 Question 3 6 Question 4 9 Part B chosen 9 Reference List 12 Question1 Part I. The company must choose the contract March 2013 in order to hedge its exposure. Usually, it is recommended that the hedge instrument to have a maturity greater with at least one month than the hedged asset. II. The company must have a short position (i.e. sell) ASX 90 days interest rate futures contract because it would be a future borrower on the spot market. III. Number of contracts is computed as: contract amount*hedge ratio/ price of the futures contract. The computations are shown in the following table. Table no.1 Number of contracts necessary to be hedged Contract Amount $ 7,500,000.00 Hedge Ratio 0.5 Price 97 No of contracts 38660 Part 2 I. In order to close the position, the company should buy futures contracts for March 2013, at the price 97.6. II. The transaction on the futures market brought a loss equal to: no of contracts *(selling price-buying price). The computations are shown in the following table. Table no.2 Final position from the futures transaction Price (short position) 97 Price (long position) 97.6 No of contracts 38660 Loss $ - 23,195.88 Part 3 I. The relationship between the price of the future contract and the interest rates on the market is an inverse relationship. So, for this example, the price of the future contract has raised implying a decline in the interest rate. II. The company has fixed its borrowing cost only for 50% of the exposure. The effective borrowing cost is computed as: r= 100- 97= 3% So, the company will borrow money at 3%. III. The company did not hedge all the risks involved by the transaction above. Firstly, it only hedged 50% of its interest rate exposure. Secondly, risks related to changes in the principal borrowed, or the currency in which this one is expressed are not hedged. Question 2 There are various theories related to dividend policies. One of the most important theories in this matter is the irrelevance thesis of Modigliani and Miller (Fabozzi and Drake, 2009). Under certain assumptions, Modigliani-Miller argues that dividend policy is irrelevant (no taxes, no transaction costs, no issuance costs, no insider information, a fixed investment policy). In other words, the management’s decision to change dividend value does not determine a shift in firm value too because the shareholder wealth is determined by the income generated through the investment policy of the firm, and not the way the firm distributes the income (Miller and Modigliani, 1961). Another theory is based on the “bird - in – the- hand” hypothesis. This assumes that the financial markets are characterized by uncertainty and imperfect information, and because of this, dividends should be considered differently than retained earnings. Moreover, all investors would want to receive dividends i.e. cash (“bird-in-the-hand”) rather than future capital gains from the evolution of the stock (“two in the bush”). So, a firm which offers a high dividend ratio would deliver good signals to the market, boosts the stock market, and finally increases the firm’s value (Walter, 1963). A theory which contradicts the “bird-in-the-hand” theory is based on the tax-effect hypothesis. This theory states that a lower dividend policy would lower the cost of capital of the firm and in this way increase the stock value and the shareholders wealth (Bajaj and Anand, 1990). The starting point for this conclusion is considering the higher taxation of dividends compared to capital gains. Furthermore, the dividends are taxed right after are paid, whereas capital gains are taxed until the moment of sell. This consideration of tax advantages of capital gains compared with receiving dividend determine investors to be attracted of companies with higher retained earnings than a higher dividend policy (Pettit, 1977). Considering the company Swan Dane Ltd., which is keeping constant a high dividend policy, can be supported by the “bird-in-the-hand” theory previously described. A reason for keeping constant the dividend payout ratio even in times of financial crises can give a good signal to the market and investors, that the management is confident in future cash-flows of the firm and it would be able to maintain the same high dividend payout ratio (Baker and Powell, 1999). Although, this strategy could give results, it is also risky because the company is not using its profits to invest in positive NPV projects, but distributes it to the shareholders. Question 3 I. The main consideration when deciding between using Forward contract and Options contract is related to their definitions. A forward contract is an agreement which states the obligation to sell or buy a financial asset, whereas in the case of the option, the holder has the right but not the obligation to sell or buy the financial instrument (Howells and Bain, 2007). Secondly, in the case of the option, the holder must pay the premium no matter of its decision to exercise or not the option. The forward contract does not require any upfront payments. Also, related to this idea is that options are used for hedging higher exposures, because the premium is usually sufficiently high. Another consideration is that in the case of the option, the loss is limited to the premium, whereas in the case of forwards the downsize payments can be unlimited (Wall, Minocha, and Rees, 2010). So, by considering this, a forward is more risky than an option. Finally, a difference can also be related to the maturity of these instruments, while forwards are used for shorter periods of time, options can have maturities with range of years. In the case of longer period’s exposures, a hedge with an option can be more appropriate than a forward contract. III. First of all, conflicts of interest between stockholders and investors arise because of the first’s category incentive in choosing risky projects, associated with high returns, compared to the lenders’s no interest in taking risk, because of their fixed portion of cash- flow to be received in any case. The following problems may arise between debt and equity holders: a) Underinvestment problem - refers to the shareholders’s choice of high risk, profitable projects that increase the firm’s value, instead of low risk projects, with safe cash- flows, which would provide more security for the lenders. Equity holders choose to reject the safer project in the detriment of the riskier one, with higher possibilities of increasing their wealth (Bodie, Kane, and Marcus, 2009). b) Asset substitution problem – is related to the fact that shareholders always want to increase their firm’s value, even if that means bearing a lot of risk. For that, they would invest borrowed funds even in a project with a negative NPV, which would add higher profits to the firm, compared to another project with a positive NPV and a lower risk (Ross, Westerfield, and Jordan, 2009). Therefore, the debt holders bear a lot of risk, their interests being compromised, while the equity holders would profit more, for a lower risk. c) Claim dilution problem - The claims of the existing lenders can be diluted by divident payments and by issuing new debt (Brigham and Ehrhardt, 2010). First, divident payments lead to an increase in the proportion of debt, thus determining a higher risk and a lower value of the debt. For that, an increase in the risk of the company’s assets means an increase in the shareholders wealth. Second, issuing new debt determines a reduction of the chances that existing debt holders will receive their claims. Higher risk means a lower value of the existing debt, i.e. a benefit for the stockholders. These conflicts can be fixed by ensuring covenants on debt, and also by reconsidering the debt interest rate in the case of lenders. IV. Debt is considered to be cheaper than equity because interest rates on debt are usually much lower than the required rates of return on equity. Equity holders demand a higher rate of return as a consequence of their riskier claims compared to those of debt holders. Beside the cost advantage of debt, it also increases the shareholders value through return-on-equity. Although a high leverage ratio is considered attractive for companies, given the advantages just described, an excessive level of leverage can also cause disadvantages. For instance, it can lead to financial distress; because a high levered company will become risky for various stakeholders (e.g. it will encounter problems in selling the products, get inputs from suppliers and attract employees). Another disadvantage is related to the risk- shifting problem and also to debt overhang (i.e. in the presence of a large risky debt, firms might be unable to finance projects that would increase their total value). Although, Modigliani and Miller’s proposition with taxes imply that if the amount of leverage increases to finance new projects, the overall cost of capital decreases following the tax advantage of debt (Reilly and Brown, 2002), but due to the bankruptcy costs and the possibility of default, it may be observed an increase in the cost of capital. Question 4 Part B chosen 1. In table no. 2 are provided the cash-flows for the purchasing of the diesel engine, by taking into account the probabilities (Mayes and Shank, 2012). Table no. 3 Cash-flows from diesel engine Cost Revenue Y0 $ (230,000.00) Y1 $ 72,000.00 Y2 $ 225,800.00 CF1= 0.6*90000+0.4*45000 CF2= 0.6*(0.8*260000+0.2*175000) +0.4*(0.6*220000+0.4*170000) Table no. 4 Cash-flows from petrol engine Cost Revenue Y0 $ (180,000.00) Y1 $ 50,000.00 Y2 $ 209,200.00 CF1= 0.6*70000+0.4*20000 CF2= 0.6*(0.8*240000+0.2*150000) +0.4*(0.6*210000+0.4*160000) Table no. 5 Net Present Value Diesel engine Petrol engine Cost $ (230,000.00) $ (180,000.00) Discounted for the first year $ 69,565.22 $ 48,309.18 Discounted for the second year $ 210,786.72 $ 195,290.44 NPV $ 50,351.93 $ 63,599.62 NPVdiesel = -230000+72000/1.035 + 225800/1.0352= $50,351.93 NPVpetrol= -180000+50000/1.035 + 209200/1.0352= $63,599.62 By using the NPV criterion and by considering the probabilities for the two years, the purchasing of a petrol engine would be the most appropriate investment decision. NPV criterion supposes to choose the project with the highest net present value (Fabozzi and Markowitz, 2002). By considering the requirement, which states that the business would be be high in the first year, the NPV would take the following amounts: NPVdiesel = -230000+90000/1.035 + 225800/1.0352= $67,743.24 NPVpetrol= -180000+70000/1.035 + 209200/1.0352= $82,923.29 Also in this case the most appropriate decision would be to buy the petrol engine because it has a higher NPV. 2. In order to take the most appropriate investment decision, incremental cash-flows (i.e. the difference between investment in a diesel engine and investment in a petrol engine) were considered (Grinbalt and Titman, 2002). Table no. 6 Incremental Cash-Flows Incremental CF Y0 $ (50,000.00) Y1 $ 22,000.00 Y2 $ 16,600.00 NPV $ (13,247.68) NPVincrementalCF= (-230000+180000)+(72000+50000)/1.035+ (225800-209200)/1.0352= $ (13,247.68) From the result obtained, the most appropriate decision would be to buy the petrol engine. Reference List Bajaj, M. and Anand, M., 1990. Dividend Clienteles and the Information Content of Dividend Changes. Journal of Financial Economics, 26(1), pp. 193-219. Baker, H. and Powell, G., 1999. How Corporate Managers View Dividend Policy. Quarterly Journal of Business and Economics, 38(3), pp. 17-35. Bodie, Z., Kane, A. and Marcus, A., 2009. Investments. 8th ed. New York:McGraw-Hill/Irwin. Brigham, E, F. and Ehrhardt, M., 2010. Financial Management Theory and Practice. 13th ed. Connecticut: Cengage Learning. Fabozzi, F. and Drake, P., 2009. Capital Markets, Financial Management, and Investment Management. New Jersey: John Wiley & Sons. Fabozzi, F. and Markowitz, H., 2002. The Theory and Practice of Investment Management. New Jersey: John Wiley & Sons. Grinbalt, M. and Titman, S., 2002. Financial Markets and Corporate Strategy. 2nd ed. New York: McGraw-Hill/Irwin. Howells, P. and Bain, K., 2007. Financial Markets and Institutions. Harllow: Pearson Education Limited. Mayes, T. and Shank, T., 2012. Financial Analysis with Microsoft Excel. 6th ed. Mason: South Western, Cengage Learning. Miller, M. and Modigliani, F., 1961. Dividend Policy, Growth, and the Valuation of Shares. Journal of Business, 34(1), pp. 411-433. Pettit, R., 1977. Taxes, Transactions costs and the Clientele Effect of Dividends. Journal of Financial Economics, 5(7), pp. 419-436. Reilly, F. and Brown, K., 2002. Investment Analysis and Portfolio Management. 7th ed. Boston: South-Western College Pub. Ross, S., Westerfield, R. and Jordan, B., 2009. Fundamentals of Corporate Finance. 9th ed. New York: McGraw-Hill/Irwin. Wall, S., Minocha, S. and Rees, B., 2010. International Business. 3rd ed. Harlow: Prentice Hall. Walter, J., 1963. Dividend Policy: It’s Influence on the Value of the Enterprise. Journal of Finance, 18(2), pp. 280-291. Read More