Coverfin 139: Financial Policy And Strategy Professor Manuch

Coverfin 139 Financial Policy And Strategyprofessor Manuchehr Shahro

Calculate Watkin’s value operations

Calculate the company’s total value

Calculate the value of common equity

Estimate the beta for IBM as a company and discuss whether this beta would be equal to the beta estimated by regressing past returns on IBM stock against a market index, explaining why or why not.

Estimate the cost of equity for IBM and each division using the treasury bond rate and other provided data, and identify which division’s cost of equity should be used to value the printer division.

Estimate the beta for IBM after divesting the mainframe business and paying out the cash as a dividend, considering the company's debt.

Develop a financial strategy analysis for a client with $250,000 savings planning to work for 10 more years, including calculations for retirement needs, savings rate, and effect of changing interest rates on withdrawals and stock valuation.

Calculate the value of stock for a company paying dividends with specified growth rates before and after 3 years, including the impact of different growth periods.

Evaluate the impact of leveraging for Savemart under various tax assumptions, determining beta, firm value, and the gain from leverage under MM and Miller’s models.

Determine whether to invest in franchises L or S based on NPV, IRR, and MIRR, and plot NPV profiles to compare crossing points.

Estimate HDI’s cost of capital using bond prices, preferred stock prices, dividend growth, CAPM, and other given data, including effects of flotation costs and variable growth assumptions for a potential new division involved in internet projects.

Sample Paper For Above instruction

Introduction

Financial strategy and policy analysis play a crucial role in guiding corporate investment, valuation, and capital structure decisions. This paper synthesizes comprehensive financial analysis encompassing company valuation, beta estimation, cost of capital, and investment decision frameworks, applying foundational finance principles to real-world scenarios. The discussed topics include valuation of Watkins Inc., beta estimation for IBM, dividend discount models, levered beta calculations, and strategic investment assessments for franchises and internet sectors. Recognizing the interdependence of financial metrics and strategic decisions, this analysis aims to elucidate methods to optimize corporate financial policies aligned with shareholder value maximization.

Watkins Inc. Valuation and Capital Structure

Watkins Inc., which has never paid dividends and whose future dividend policy remains uncertain, currently generates a free cash flow (FCF) of $100,000, expected to grow perpetually at 7%. With a WACC of 11%, the enterprise valuation focuses on the operations excluding non-operating securities. The value of operations (VU) can be estimated using the perpetuity growth model: VU = FCF / (WACC - g) = $100,000 / (0.11 - 0.07) = $100,000 / 0.04 = $2,500,000. This valuation reflects the core operational value, assuming constant growth and risk levels.

To determine the company's total value (VL), include non-operating marketable securities valued at $325,000 and debt of $1,000,000. Assuming no preferred stock issuance, the total value becomes VL = VU + non-operating securities = $2,500,000 + $325,000 = $2,825,000. To derive the equity value, subtract debt: Equity Value = VL - Debt = $2,825,000 - $1,000,000 = $1,825,000. This calculation illustrates the company's total valuation by integrating core operations, marketable securities, and leverage effects.

Beta Estimation for IBM

The beta for IBM, segmented into four business groups, can be estimated using the weighted average beta method: Beta_IBMs = (Market Value Group 1 Beta 1 + Market Value Group 2 Beta 2 + ... ) / Total Market Value. Calculations yield: (2 + 2 + 1 + 3) billion / 8 billion total (1.10 + 1.50 + 2.00 + 1.00) / (1 + 1 + 1 + 1) = 8 / 8 (1.10 + 1.50 + 2.00 + 1.00) / 4 = 1.55. This shows the company’s aggregate beta based on the business segments. This beta would differ from regressions on historical stock returns because it reflects projected business risks rather than past market behavior.

Cost of Equity and Beta Adjustments

Utilizing the capital asset pricing model (CAPM), the cost of equity for IBM is calculated: Ke = Risk-Free Rate + Beta Market Risk Premium = 7.5% + 1.55 5% = 7.5% + 7.75% = 15.25%. For individual divisions, the beta—and consequently the cost of equity—would vary; for example, the printer division with a beta of 1.00, yields a cost of equity: 7.5% + 1.00 * 5% = 12.5%. The appropriate division-specific cost of equity should be used for valuation.

If IBM divests the mainframe business, the beta is adjusted downward based on the removal of the segment’s risk profile. Assuming the mainframe contributed significantly to risk, the post-divestiture beta might decline; calculations should consider the debt and remaining operational risks. The remaining beta could be approximated using unlevered beta formulas to reassess the company’s risk profile.

Retirement Planning and Investment Growth

A client with $250,000 at age 55 plans to work for 10 more years earning 5% annually before retiring. To determine the amount needed at retirement to withdrawal $80,000 annually for 25 years, the present value of an annuity calculator at 5% rate applies: PV = $80,000 [(1 - (1 + r)^-n) / r] = $80,000 [1 - (1 + 0.05)^-25] / 0.05 ≈ $1,297,000. This sum must be accumulated by retirement, requiring annual savings and investment growth considerations.

To determine the annual savings needed, the future value of current savings plus annual contributions must match this goal, considering the 5% return. Additionally, if interest rates decline to 4% at retirement, the present value of the withdrawals increases, requiring a reduction in immediate withdrawal amounts or increased savings now to hedge against lower yields.

Stock Valuation with Variable Growth

The valuation of stock paying an initial dividend of $1.00, with subsequent growth rates—15%, 6%—over specified periods utilizes the Dividend Discount Model (DDM). The first five years’ dividends are projected as D1 = D0 * (1 + g1), and so forth, then applying the Gordon Growth Model thereafter: P0 = D1 / (Ke - g), where Ke is derived from CAPM. This comprehensive approach combines forecasted growth rates to estimate present stock value accurately.

Leverage and Tax Implications

Assessing leverage impacts involves calculating firm values, equity beta, and the incremental gains from leverage using the Modigliani-Miller models under different tax regimes. With current data, the unlevered beta equals 1.2 (since no debt), while post-leverage beta is adjusted for debt levels and tax shields, impacting firm valuation and investor risk perceptions. The analysis highlights tax shields’ effects on leverage benefits and differences under MM and Miller’s models.

Investment Decisions in Franchises and NPV Analysis

Value assessments for franchises entail calculating NPV, IRR, and modified internal rate of return (MIRR). Using projected cash flows, initial investments, and discount rates of 10%, the calculations determine acceptability. NPV profiles plotted for both franchises reveal the discount rates at which investments break even or are most attractive, enabling strategic decision-making based on risk-return tradeoffs.

Estimating Cost of Capital for HDI

HDI’s cost of capital involves integrating bond yields, preferred stock costs, and equity estimates via CAPM and DCF methods. For example, bond yields are adjusted for tax to derive after-tax cost of debt. The cost of preferred stock accounts for dividend yields, and the equity cost integrates beta, risk-free rates, and market premiums. Flotation costs are incorporated into new stock issuance calculations, ensuring comprehensive WACC estimation.

Using the provided data, calculations demonstrate how to approach the WACC determination, considering the firm’s target capital structure and the variability of growth and risk assumptions, especially for new internet projects with different financial characteristics.

Conclusion

This detailed analysis underscores the importance of integrating valuation techniques, risk assessments, and financial theory to inform strategic decisions. From company valuation to capital budgeting, the principles illustrated serve as a foundation for effective financial management aligned with shareholder value maximization.

References

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