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INDIVIDUAL ASSIGNMENT Question 1. There are a few companies with negative beta. Assuming that you find a company with a beta = 2.5. a. What will the stock profitability ratios change if the market profitability ratio increases 5%? If the market profitability ratios decreases 5%? b. You have USD 1 million to invest in a share portfolio that is well diversified. Now you receive an additional USD 20,000 from the will. Which of the following actions will bring safety for the profitability ratios portfolio? i. Invest USD 20,000 in Treasury Bonds (with beta = 0). ii. Invest USD 20,000 in the Stocks with beta = 1. iii. Invest USD 20,000 in the Stocks with beta = 0,25. Answer: In the stock market in the countries with developed market economy, the information about listed companies such as profits, risks and other important
TRAINING PROGRAM Global Advanced Master of Business Administration INDIVIDUAL ASSIGNMENT CORPORATE FINANCE Lecturer: Professor Soren Kirchner mmm Leaner: mmm Class : GaMBA4.C165 Ho Chi Minh City, 2012 Student: INDIVIDUAL ASSIGNMENT Question There are a few companies with negative beta Assuming that you find a company with a beta = -2.5 a What will the stock profitability ratios change if the market profitability ratio increases 5%? If the market profitability ratios decreases 5%? b You have USD million to invest in a share portfolio that is well diversified Now you receive an additional USD 20,000 from the will Which of the following actions will bring safety for the profitability ratios portfolio? i Invest USD 20,000 in Treasury Bonds (with beta = 0) ii Invest USD 20,000 in the Stocks with beta = iii Invest USD 20,000 in the Stocks with beta = -0,25 Answer: In the stock market in the countries with developed market economy, the information about listed companies such as profits, risks and other important information are published daily in the market to help investors review, consider which suitable investment plan will offer them the best results One of the most important parameter reflecting the risk is the beta coefficient (β) provided by the professional financial research organizations Risk beta coefficient (β) is defined as a coefficient to measure the level of volatility, also known as a measure of systematic risk of a security or a portfolio relative to the overall market Beta is used in the capital asset pricing model (CAPM) to calculate the expected profitablity ratios of an asset based on its beta coefficient and profitablity ratios in the market Formual of beta coefficient : Beta = Covar (RI, Rm)/Var (Rm) In which: • Ri: profitablity ratios of the stock Student: • Rm: profitablity ratios of the market (the VN-Index) • Var (Rm): Variance of profitability ratios of the market • Covar (Ri, Rm): Sum of Variance of profitability ratios of the stock and profitablity ratios of the market Estimate β in reality In fact, the stock traders use regression models based on historical data to estimate β In countries with developed financial markets, there are some companies specializing in identifing and providing information about β coefficient For example, in the U.S., people can find information about β from the service provider such as Value Line Investment Survey, Market Guide and Standard & Poor's Stock Reports In Canada, information about β is provided by Burns Fry Limited The relationship between Risk and Return Expected profit of stock has a direct variable relationship with the risk of that stock, it means that investors expect high risk stock will have high profit and vice versa In other words, investors hold risky stock only when the expected profit is large enough to offset the risks In the previous section, we discussed β coefficient is used to measure the risk of a stock Therefore, the expected profit of a stock has a direct variable relationship with its coefficient β Assuming that financial market is efficient and investors diversify the investment portfolio so that the risk of the system is negligible Thus, only systemwide risks affect the profits of the stock The stocks with the greater beta, the greater the risk is, therefore, it requires high profits to offset the risk According to the CAPM model, the relationship between profit and risk is expressed by the formula: r = β x (rm – rf) + rf hay (r - rf )= β x (rm – rf) (1) Student: In which: • r: expected profitability ratios of the stock • rf : profitability ratios without risks (profitability ratios of short-term bonds ) • rm : profitability ratios of market portfolio • β : the sensitivity of the profitability ratios of the stock with the market fluctuation • Thus the profitablity ratios requirements of investors are affected primarily by the risks If a stock has a beta coefficient: • = 1: the fluctuation of the stock price will be equal to the fluctuation of the market • 1 1: the level of stock price fluctuation is greater than the fluctuation of the market Specifically, if a stock has a beta is 1.2, in theory; the fluctuation of this stock will be 20% higher than the fluctuation of the market In the situation that we find a company with beta = -2.5, a What will the stock profitability ratios change if the market profitability ratio increases 5%? If the market profitability ratios decreases 5%? • If Δrm changes =5% from formula (1), we have: Δrx = β*Δrm = -2.5*(5%) = -12.5% Expected stock profitability ratios will reduce 12.5% • Similarly, if Δrm changes = -5% Expected stock profitability ratios Δrx = β*Δrm = -2.5*(-5) = 12.5% Expected profitability rate of the shares will increase 12.5% b One million dollars for investing in well diversified stock portfolio is available Now we receive additional USD 20,000 from the will, to choose Student: which action will bring safety for profitability ratios portfolio, we will analyze the following: From formula (1) we have: With β=0, profitability ratio of the stock r1= profitability ratio of short-term Treasury bonds With β=1, profitability ratio of stock r2 = profitability ratio in the market rm With β=-0.25, we have r3 =rf -0.25*(rm-rf) Perform r1, r2,r3 on the same graph we have the following diagram: Comments: The investment decision depends on market growth factors: If rm < rf we will invest in stock with r3 (β=-0.25) If rm = rf we will invest in any stock If rm > rf we will invest in stock with β =1 Question 2: If you can either keep cash or invest in stock with an interest rate of 8% You can not sell stock when you need money, so, you have to make up for the cash deficit by using a bank credit quota with 10% of interest rate Should you invest more or less in stock in each situation below? a Sometimes you are not sure about future cash flows Student: b Bank interest rate rises to 11% c Interest rates of stock and bank loan interest rates increase at the same rate d You adjust the forecast of future cash needs lower Answer : a In the case we are uncertain about the cash flow in the future; we should invest less in stocks When we are unsure about the future cash flow, which means that we are not sure about the demand for the capital in the future Then we should reduce investment in stocks for the occurrence of lack of money, the cost of interest on bank loans will be higher than rates of investment stocks leading to the financial cost incurred in this case b If the interest rate rises to 11%, we should also invest less in stocks Because when interest rates increase, this means borrowing costs will increase while the interest rate of stock investment is unchanged This causes the increase in financial costs, so, we should less invest in stock c If the bank interest rate and stock interest rate increase at the same ratio, as the first Because once the bank interest rate and stock investment rate increase respectively, this means that the difference between bank interest and interest rate stock investment is unchanged This leads the financial costs not change, so we remain the same rate as the original investment d If we adjust the demand of forecasts for future cash lower, we should be invest more in stocks When the future cash needs decreasing, this means the amount of idle money increasing In this case, we should invest more in stock in order to increase the effectiveness of financial investment Question VDEC company is concerning about the cost of using capital for the company According to the current investigations, we have the following data Suppose the corporate income tax rate is 40% Student: Debit: The Company can increase unlimited debt by selling the coupon bonds with interest rate of 10% annually; the bonds have denominations of USD 1,000 The cost of commissions paid to the underwriter is USD 30 / stock, issuance cost is USD 20 / stock, the term is 10 years Preferred stock: The Company may sell preferred stock unlimitedly in number with price of USD 100 / stock, the interest rate is 11% / year Issuance cost is USD 20 / stock Common stock: The Company's common stock is currently being sold at USD 80 / stock The company expects to pay dividends in cash USD / stock next year Company's dividend growth of 6% / year and does not change in the future Stock will be sold at the price less than USD / stock, the issuance cost is USD / stock Company can sell with unlimited quantities Retained profit: The Company expects to keep USD 225,000 of profit in the next year If there is not retained profit, the company will issue new common stock a Calculate the cost for each funding source b Calculate the average capital cost, assuming the target capital structure is: Source Ratio Long term debt 40% Preferred stock 15% Common stock 45% Total 100% (1) Determine breaking point of retained profit (2) Calculate the cost of using marginal capital and the cost of using average capital related to the entire new funding sources c Use information about the investment opportunities in the following table to draw the line of using of Weighted Marginal Cost of Capital – (WMCC) and Investment opportunity schedules (IOS) on the same graph Student: Project A Primary investment USD 100,000 IRR 17.4% B USD 200,000 16.0 C USD 100,000 14.2 D USD 200,000 13.7 E USD 100,000 10.0 e Do you have any advice about financial sources that the company should choose? Total optimal funding for the company? And explain your point of view Answer: a Cost of using capital for each funding source: Cost of selling a bond = Nominal value – Commission cost –Issuance cost = 1.000-30-20= USD 950 + Cost of using capital for Coupon bonds project: 950= 100[(1- (1+ rd )-10] / rd rd = 6,51% + Capital cost of preferred stock: rp = Dp / ( Pp – f ) = ( USD 100x 11% ) / ( USD 100 - USD 20 ) rp = 13.75% + Capital cost of common stock: re = ( DIV1 / Po ) + g = 6/80 + 6% re = 13.5% + Capital cost of new common stock: rne = ( DIV / Pne ) + g = [ 6/ ( 800- – ) ] + 6% rne = 14.33% b Part b.1 : Identify the breaking point of Retained profit BPe = Amount of Retained profit/ Ratio of common stock = Aj / Wj = USD 225,000/45% = USD 500,000 Student: Thus, there is a breaking point occurs when USD 225,000 of retained profit is used up Part b.2: Cost of using marginal capital and drawing the graph for choosing the options: Make a table of segment of BPe profit Range of capital source Ri – capital Wi capital WACC cost for cost ratio using average capital < I < USD 500,000 I > USD 500,000 re = 13.5% 45% rp = 13,.75% 15% rd = 6.51% re = 14.33% 40% 45% rp = 13.75% 15% rd = 6.51% 40% 10.74% 11.11% To select investment projects, we should draw the line of cost for using Weighted Marginal Cost of Capital – (WMCC) and Investment Opportunity Schedules (IOS) on the same graph as follows: Student: WACC (%) 17,4 A 16.0 B C 14,2 D 11,7 WMCC 11,0 10,74 10,0 E IOS I (1.000$) 100 200 300 500 600 700 Based on the graph: we see • A project with investment capital: USD 100,000 with profitability rate IRR = 17.4% higher than the cost of using Weighted Marginal Cost of Capital – (WMCC) (10, 74%) • Project B with investment capital: USD 200,000 profitability rate IRR = 16.0% higher than the cost of using Weighted Marginal Cost of Capital (10, 74%) • C project with investment capital: USD 300,000 has the highest profitability rate IRR = 14.2% higher than the cost of using Weighted Marginal Cost of Capital (10, 74%) • D project with investment capital: USD 600,000 profitability rate IRR = 11.7% higher than the cost of using Weighted Marginal Cost of Capital (10, 74%) • E project with investment capital: USD 700,000 profitability rate IRR = 10.0%, lower than the cost of using Weighted Marginal Cost of Capital (10, 74%) 10 Student: Thus, the lines of investment opportunities of the four projects A, B, C, D are located higher than WMCC line (the cost of using Weighted Marginal Cost of Capital) so, the profit from each project is expected to be higher than the cost of using Weighted Marginal Cost of Capital and in accordance with the objective of maximizing the value of assets of the company Therefore, VDEC Company should invest in four projects A, B, C, D with optimum total funding for the company is USD 1,200,000 The company should not invest in the project E as it is inefficient project financially because the project's profitability rate is lower than the cost of using Weighted Marginal Cost of Capital 11