Assignment – BMMF January Semester 2013 BMMF5103 – Managemen

ASSIGNMENT – BMMF JANUARY SEMESTER 2013 BMMF5103 – MANAGERIAL FINANCE ASSIGNMENT

This assignment contains 6 questions worth 120 marks. Please answer ALL questions.

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Discuss two key limitations of the proprietorship form of business. Why is it important for a financial manager to be able to forecast and plan, as well as to coordinate and control the activities within the firm? Why is shareholder wealth maximization better than simple profit maximization as a goal for the firm? When do companies incur the agency costs? Support your answer by giving an example.

Briefly explain the term "security market line". Where would underpriced and overpriced securities plot on the SML (security market line)? Briefly explain the "capital asset pricing model". How does the model explain the relationship between risk and return? Briefly explain how diversification reduces risk. Discuss the importance of "beta" as a measure of risk. List the three forms of market efficiency and explain the basis for it.

Ms. Sally has an income of RM40,000 this year and RM60,000 next year. She can invest in a project that costs RM30,000 this year, which generates an income of RM36,000 next year. The market interest rate is 10%. What will be her consumption next year if Ms. Sally invests in the project and consumes RM50,000 this year? After retirement, you expect to live for 25 years. You would like to have RM75,000 income each year. How much should you save in retirement to receive this income, if the interest is 9% per year? Mr. Walid expects to retire in 30 years and would like to accumulate RM1 million in his pension fund. If the annual interest rate is 12%, how much should he deposit monthly? For RM10,000, you can buy a 5-year annuity paying RM2358.65 annually at the beginning of each year. Calculate the implied interest rate. What is the nominal rate for an investment at 10.47% effective compounded monthly?

Wynners Bhd. is expected to pay a dividend of RM2 per share, growing at 4% forever. With current stock price RM20, estimate the cost of equity. Rainbow Technology has just paid RM0.50 dividend; with growth at 24% for 2 years and then 8%, at a required 16%, value the stock. Universal Stars, a no-growth firm, earns RM20 million annually on assets; with all earnings paid as dividends and a cost of capital of 10%, what is the current stock price? For a bond with 8.0% semi-annual coupons, face value RM1000, YTM 10%, what is the price? For a four-year bond with 8% coupons and current price RM878.31, what is the YTM?

Discuss the limitations of financial ratios. Given a debt ratio of 0.5, what is the debt-equity ratio? For a ratio of 1.65, what proportion of assets is equity? Using provided data, prepare the income statement and balance sheet for Merck (values in millions).

The Mayor Company has two divisions with estimated returns under different economic states and subjective probabilities. Calculate the market return, variance, standard deviation, coefficient of variation, division returns, variances, covariances, betas, and required market returns. Determine which division to keep or spin off and find the beta of the entire company.

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Managerial finance plays a pivotal role in guiding firms toward maximizing value for shareholders while maintaining operational efficiency and strategic agility. This multifaceted subject encompasses various principles, models, and analytical tools that aid management in making informed decisions. This paper explores crucial concepts relevant to managerial finance, including business structures, investment appraisal, risk management, market efficiency, financial ratios, and strategic division analysis, supported by current scholarly insights.

Limitations of Proprietorship Business

The proprietorship business structure is popular due to its simplicity and ease of formation, but it suffers from significant limitations. Firstly, unlimited liability is a major concern; the owner’s personal assets are at risk if the business incurs debts or legal liabilities. A second limitation is limited capital availability. Because proprietors rely on personal funds or bank loans, raising substantial capital becomes difficult, restricting the growth potential of such businesses (Brealey, Myers & Allen, 2019). These limitations reduce the ability of sole proprietorships to scale and compete effectively in larger markets.

Importance of Forecasting and Planning for Financial Managers

Financial managers require forecasting and planning skills to anticipate future financial needs, allocate resources efficiently, and craft strategies aligned with corporate goals. Effective forecasting reduces uncertainties, aiding in cash flow management, investment decision-making, and risk mitigation (Ross, Westerfield & Jordan, 2020). Coordination and control are equally vital, ensuring departmental activities conform to strategic plans, thereby optimizing performance, reducing costs, and enhancing profitability. A lack of planning can lead to financial shortfalls, missed opportunities, or misallocation of resources, underscoring its importance.

Shareholder Wealth Maximization vs. Profit Maximization

The goal of maximizing shareholder wealth aligns management’s decisions with returns that enhance stock prices, reflecting the long-term interests of shareholders (Brealey, Myers & Allen, 2019). Unlike profit maximization, which may focus on short-term gains at the expense of future stability and shareholder value, wealth maximization considers the timing, risk, and sustainability of profits. This approach encourages investments and policies that increase the overall value of the firm, accommodating risk-adjusted returns (Damodaran, 2012).

Agency Costs and Their Examples

Agency costs arise when there is a conflict of interest between managers (agents) and shareholders (principals). These costs include monitoring expenses and the reduction in firm value due to managers pursuing personal goals rather than shareholder interests. An example occurs when managers continue with a project that benefits their status or compensation but does not maximize shareholders' wealth, such as overinvestment in lavish office spaces (Jensen & Meckling, 1976).

Security Market Line and Asset Pricing

The Security Market Line (SML) represents the expected return of assets as a function of systematic risk, measured by beta. Assets plotting above the line are undervalued (underpriced), providing higher returns for their risk, whereas those below are overvalued (overpriced), offering lower returns (Sharpe, 1964). The SML thus serves as a benchmark for evaluating investment opportunities.

Capital Asset Pricing Model (CAPM)

The CAPM explains the relationship between expected return and systematic risk, proposing that the expected return on an asset equals the risk-free rate plus a risk premium proportional to beta. It rationalizes that higher beta signifies higher expected return due to greater exposure to market risks, aligning investor incentives with risk management (Fama & French, 2004).

Diversification and Beta

Diversification minimizes unsystematic risk by spreading investments across various assets, thereby reducing the portfolio's overall volatility. Beta, as a measure of systematic risk, indicates an asset's sensitivity to market movements. A beta greater than 1 suggests higher volatility relative to the market, while less than 1 indicates lower risk (Markowitz, 1952; Chen et al., 1986).

Market Efficiency Forms

The Efficient Market Hypothesis (EMH) posits three forms: weak, semi-strong, and strong. The weak form asserts that past prices cannot predict future prices; semi-strong suggests all public information is reflected in stock prices; and strong form claims that all information, public and private, is already incorporated (Fama, 1970). This framework influences investment strategies and regulatory policies.

Investment Decision-Making and Time Value of Money

Ms. Sally's investment scenario demonstrates the importance of the time value of money. Investing RM30,000 to generate future income affects consumption plans, highlighting the need to consider interest rates and opportunity costs. Similarly, calculating retirement savings involves discounted cash flows to ensure desired income streams. Annuities and compound interest calculations enable individuals to plan for long-term financial security, emphasizing prudent asset allocation and risk management (Bodie, 2013).

Valuation of Bonds and Rate Calculations

Bond pricing involves discounting future cash flows (coupons and face value) at the yield to maturity. Calculating the present value of semi-annual coupons and the face value provides the bond’s current price. When the bond's price is known, solving for YTM via iterative methods or approximation formulas reveals the market return expectations (Jarrow & Turnbull, 1995). Accurate bond valuation aids in investment decisions and risk assessment.

Stock Valuation Models

The Gordon Growth Model (GGM) estimates stock values based on dividends growing at a constant rate, involving the dividend forecast and cost of equity. Variations in dividend growth rates necessitate multi-stage valuation models, incorporating different growth phases and the required rate of return (Pike & Neale, 2009). These models underpin fundamental analysis in equity valuation.

Financial Ratios and Analysis

Financial ratios serve as tools for assessing a company's operational efficiency, liquidity, leverage, and profitability. However, they are limited by differences in accounting practices, industry standards, and temporal factors. Ratios may also oversimplify complex financial realities or be distorted by seasonal or one-time events, requiring cautious interpretation (Penman, 2013).

Leverage Ratios and Financial Statements

The debt-equity ratio derived from the debt ratio indicates the company's financial leverage. Calculations based on provided data for Merck include constructing an income statement and balance sheet, providing insights into financial health, asset utilization, and profitability, which are essential for strategic planning and investor relations.

Risk and Return Analysis of Divisions

The analysis of divisions' returns across different economic states, along with their covariances and betas, illuminates assessment of risk profiles and diversification benefits. Calculations show which divisions offer optimal risk-adjusted returns, guiding strategic decisions to maximize corporate value.

Conclusion

Overall, managerial finance integrates theoretical models and practical tools to enable effective decision-making, risk management, and strategic planning. Understanding the limitations of models, the significance of market efficiency, and the importance of accurate valuation are fundamental to fostering corporate growth and shareholder wealth maximization in today's dynamic economic environment.

References

• Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance (12th ed.). McGraw-Hill Education.
• Bodie, Z. (2013). Financial Accounting and Reporting. McGraw-Hill Education.
• Damodaran, A. (2012). Investment Valuation: Tools and Techniques (2nd ed.). Wiley.
• Fama, E. F. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance, 25(2), 383–417.
• Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25–46.
• Jensen, M. C., & Meckling, W. H. (1976). Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics, 3(4), 305–360.
• Jarrow, R. A., & Turnbull, S. M. (1995). Pricing Derivatives on Financial Securities Subject to Credit Risk. Journal of Finance, 50(1), 53–85.
• Markowitz, H. (1952). Portfolio Selection. Journal of Finance, 7(1), 77–91.
• Pike, R., & Neale, B. (2009). Corporate Valuation: A Guide for Managers and Investors. Wiley.
• Penman, S. H. (2013). Financial Statement Analysis and Security Valuation (5th ed.). McGraw-Hill Education.
• Ross, S. A., Westerfield, R., & Jordan, B. D. (2020). Fundamentals of Corporate Finance (12th ed.). McGraw-Hill Education.