Abstract 2
Introduction . 3
Lessons from Capital Market History . 3
Return, Risk and the SML .. 5
Cost of Capital 7
Financial Leverage and Capital Structure Policy 9
Conclusion 11
Abstract
This paper entails a critical analysis and discussion of the components of the corporate finance and its subsequent application in the contemporary business environment. The discussion and analyses contained in this paper are centered on the book by Ross, Westerfield and Jordan (2012) which is titled: “Fundamentals of Corporate Finance.” In this book, different aspects and components of this subject of corporate finance have been discussed in great depth and this paper essentially entails a summarization of some of these concepts.
The first concept which has been discussed in this paper is chapter 12 of the book which is titled: “Lessons from Capital Market History” (Ross, Westerfield and Jordan, 2012). The main assertions and propositions of this chapter have been analyzed subsequently in the paper.
The second chapter which has been discussed in this paper is Chapter 13, which is titled: “Return, Risk and the Security Market Line” (Ross, Westerfield and Jordan, 2012). This chapter contains a discussion of various elements that are related to risk and return evaluation within a practical investment scenario according to the authors.
The third chapter which was evaluated in this paper is Chapter 13 which is titled: “Cost of Capital” (Ross, Westerfield and Jordan, 2012). According to the authors, this chapter entails an in depth discussion on the various elements and factors that go into the determination of the total cost of capital at which a firm acquires the required financial resources.
Finally, the last chapter which was analyzed in this paper is Chapter 16 which is titled: “Financial Leverage and Capital Structure Policy” (Ross, Westerfield and Jordan, 2012). According to the authors, this chapter has discussed in great depth the effect of financial leverage on the total cost of capital and financial structure of a firm.
Introduction
This paper entails a critical discussion of the various components of corporate finance that have previously been discussed by Ross, Westerfield and Jordan (2012) in their book which was specifically dedicated to this subject. The contents and components of corporate finance that have been discussed in this paper are critical in the formulation and creation of ideal financing structures that are required in supporting the day to day running of various corporate organizations.
The discussions contained in this paper mainly relate to the concept of risk and return within a financial framework and the corresponding factors and subtopics that are derived directly from these two key concepts. Through this detailed discussion and understanding, the paper will bring out the main points related to these two topics as well as those emanating from them within the context of a practical corporate entity.
Chapter 12: Lessons from Capital Market History
Background
The fundamental discussion contained in this chapter entails an evaluation of the elements of the required rate of return on an investment within the context of a corporate organization. Accordingly, Ross, Westerfield and Jordan (365) assert that the required rate of return on an investment is primarily dependent on the risk which is inherent to that investment and subsequently, the higher the risk the higher the return and vice versa. The objective in this regard according to Ross, Westerfield and Jordan (365) is to determine the perspective of risk and return based on the historical assertions that have been made on the same within the context of capital markets.
Recent Developments
According to Ross, Westerfield and Jordan (364), the determination of the return on an investment is undertaken based on three critical measures. The first measure is the total dollar return which is computed as the summation of the total dividend return and the total capital gain associated with a particular investment according to Ross, Westerfield and Jordan (367). The second measure of the return on an investment is it percentage return which is the difference between its price at the beginning of the investment and at the end of the investment duration multiplied by 100 (Mehra 572). Finally, the average return is the third measure of the return on an investment according to Ross, Westerfield and Jordan (367).
Current Issues
Based on the previously identified measures of the return on an investment, Ross, Westerfield and Jordan (374) assert that certain securities that comprise of a higher risk profile such as stocks correspondingly record higher average returns than less risk securities such as Treasury Issues. Other factors that impact the return of an investment according to Ross, Westerfield and Jordan (374) are the size of the underlying investee company (whether it is a growth stock or a mature stock); the tenor of the security (which is the duration in which it is held); and lastly, the cost of capital associated with the investment (Ross, Westerfield and Jordan, 374).
Implications
The implications of the above issues related to the return on a security are that the investor who holds growth securities will enjoy higher returns on their investments although these securities are relatively more risky compared to larger stocks of companies are deemed to be mature (Ross, Westerfield and Jordan 374). Secondly, as the risk on an underlying investment increases, the variability associated with it subsequently increases as well according to Ross, Westerfield and Jordan (378) as measured by the Variance. Variability in this regard is described as the volatility of the returns on a given stock held over a one year duration compared to a government security held by an investor over a similar time frame (Ross, Westerfield and Jordan 378).
Suggestions
As a strategy of managing the risk associated with the securities held by an investor, Ross, Westerfield and Jordan (381) propose that an investor should hold to different types of securities that have correspondingly different risk profiles so as to reduce the overall variability associated with their investment. Ross, Westerfield and Jordan (381) add that variability in this context can be used as a basis of determining the overall risk associated with the portfolio and the expected returns at the end of the investment period.
Chapter 13: Return, Risk and the Security Market Line
Background
Having previously discussed the measures of the return on an investment and the fundamental factors that influence this return, this chapter discussed the concept of risk in an investment and the relationship between the risk and the total return (Ross, Westerfield and Jordan 400). This chapter subsequently entails a discussion on the definition of the inherent risk which is associated with an investment, how it is measured and how it can be quantified within the context of a specific investment. The relationship between this risk and the return is also discussed in this chapter according to Ross, Westerfield and Jordan (401).
Recent Developments
In terms of the relationship between risk and return, recent development in corporate finance have led to the establishment of the Security Market Line which demonstrate the reward that an investor expects to receive as a result of holding a given quantity of risk according to Ross, Westerfield and Jordan (403). This security market line can subsequently be used in predicting the future returns on an investment based on the underlying recorded variance of the same investment and the presently available information relating to the investment given the probability of its occurrence according to Ross, Westerfield and Jordan (401).
Current Issues
Although the security market line is an ideal tool which can be used to develop the relationship between the risk of an investment and the corresponding return, Ross, Westerfield and Jordan (409) note that the return on investment is not an absolute figure but rather is comprised of two distinct elements. These elements are the expected return on the investment and the unexpected return on the same investment. The unexpected return on the investments arises from unforeseen events which directly impact the investment leading to situation where it becomes difficult to precisely predict the actual Total return on the said investment by an investor over a given duration of time according to Ross, Westerfield and Jordan (409).
Implications
As a result of the unpredictable components which comprise the unexpected return on an investment, Ross, Westerfield and Jordan (409) note that the arrival of unexpected information may result in the increase or in the decrease of the total return on the investment depending on the extent to which this information affects it. Consequently, the actual return on the same investment will vary either mildly or significantly from the expected return on the investment leading to a situation of unpredictable returns by an investor as these differences could either have positive or negative implications according to Ross, Westerfield and Jordan (410).
Suggestions
As a result of the significant impact of the unexpected return component of an investment, Ross, Westerfield and Jordan (410) propose that an investor must diversify some of the risk which is specifically inherent with the investment by including other securities or investments that do not react in a similar manner to the same information. In this regard, this diversification entails the inclusion of securities which belong to different industries that are unrelated to one another and which imply a zero sum effect (Knetcht 63). A zero sum effect in this context refers to a scenario where by the unexpected information may result in adverse consequences on the value of one investment while at the same time lead to the increase in the value of another investment which is also held by the same investor according to Ross, Westerfield and Jordan (411).
Chapter 14: Cost of Capital
Background
According to Ross, Westerfield and Jordan (412), this chapter entails a critical discussion on how the cost of capital of a corporate firm is determined at a given point in time. This cost of capital entails a determination of the actual cost of equity capital as well as the actual cost of debt which is associated with a given firm. Consequently, the total cost of capital is determined as summation of the cost of debt and of equity associated with the firm according to Ross, Westerfield and Jordan (412).
Recent Developments
According to Ross, Westerfield and Jordan (438), recent developments in the field of corporate finance have led to the assertion that the required return on an investment is equal to the total cost of capital of the underlying firm. In this regard, for the Net Present Value on a firm`s project to be positive, the project must generate cash flows whose average return exceed the cost at which the funds that were acquired to finance the project were subsequently borrowed at. In this regard, Ross, Westerfield and Jordan (439) add that the cost of capital which is associated with a given firm or project primarily depends on the usage of the underlying funds as opposed to their corresponding sources.
Current Issues
According to Ross, Westerfield and Jordan (439), the capital structure of a firm comprises of the specific ratio in which debt and equity capital has been consumed in financing the firm`s operations. However, for this capital structure to exist, it is important that the cost of equity and debt are determined individually first before they are combined together. Consequently, the cost of equity can be determined through the use of either the Dividend Discount Model or the Security Market Line approaches. However, the use of the Dividend Discount Model in the determination of the cost of equity can only apply in a situation whereby a company pays dividends every year (Ross, Westerfield and Jordan 440).
3.4 Implications
As a result of the use of the Dividend Discount model in the determination of the cost of equity, Ross, Westerfield and Jordan (439) note that the biggest drawback to this approach is that the use of this model is useless since a number of firms do not pay dividends at the end of their respective financial periods constantly. Furthermore, the model is deemed to be too sensitive to growth rate associated with the firm due to inverse relationship which exists between the growth rate and the company`s cost of equity. Ross, Westerfield and Jordan (439) also add that the model fails to consider the inherent risk which is associated with a given project or firm in computing its total cost of equity.
Suggestions
Chapter 16: Financial Leverage and Capital Structure Policy
Background
According to Ross, Westerfield and Jordan (510), this chapter entails a critical discussion on the use of financial leverage by a firm to fund its various operations and current or proposed projects. In this regard, financial leverage can be described as the practice in which a firm uses debt financing to fund its operations. The implication of the use of this debt can have far reaching consequences both positive and negative on the overall capital structure of the firm as well as in the determination of its overall health and financial sophistication according to Ross, Westerfield and Jordan (510).
Recent Developments
According to Ross, Westerfield and Jordan (511), the capital structure of a business entity is a significant consideration in the determination of the extent to which external leverage will affect its overall performance and riskiness at a given point in time. Ross, Westerfield and Jordan (511) further add that the use of financial leverage can generally increases the variability of either or both the Earnings Per Share as well as the Return On Equity ratios of a firm. The corresponding effects of such increases in the firm`s variability is the subsequent magnification of either gains or losses that are attributable to the shareholders as a result of the use of the external leverage.
Current Issues
Many corporate firms find themselves in a dilemma as to whether they should use external leverage to finance their projects or undertakings, or whether they should instead opt for the available equity capital or any existing internally retained funds. This dilemma is primarily influenced by the failure by these firms to understand leverage in terms of when it is beneficial to a firm as well as when it is detrimental according to Ross, Westerfield and Jordan (511). According to Ross, Westerfield and Jordan (514), the effect of externally borrowed fund in a firm in the form of leverage primarily depends on its Earnings Before Interest and Taxes (EBIT). In a scenario where this EBIT Is high, leverage is seen as being beneficial to the firm and vice versa (Ross, Westerfield and Jordan 514).
Implications
As a result of the use of leverage by a firm, the returns to the shareholders are significantly increased based on the respective valuations of the before and after Return on Equity and the Earnings Per Share according to Ross, Westerfield and Jordan (514). However, these increases in the returns that are attributable to shareholders also imply a higher risk to their portfolios as result of the fact that the Earnings Per Share and the Return on Equity are much more sensitive to any underlying changes in the Earnings Before Interest and Taxes measures and the Financial leverage (Ross, Westerfield and Jordan 514).
Suggestions
Ross, Westerfield and Jordan note that the tax benefits that are associated with leverage are only beneficial to firm that currently operates in tax paying position. Consequently, firms that are likely to face financial distress should acquire less financial leverage than firms that have a lower risk of financial distress (Ghosh 29). On the other hand, Ross, Westerfield and Jordan (532) add that firm that are highly profitable should utilize more external debt sources because their likelihood of bankruptcy is very low and the corresponding value of their tax shield is significantly high compared to less financially profitable firms (Ross, Westerfield and Jordan 532).
Conclusion
This paper has discussed in great depth the various components relating to corporate finance that were highlighted by Ross, Westerfield and Jordan (20120 in their previously published book. The paper has discussed these concepts based on a framework that sought to understand their background first before delving into what they entailed. Secondly, the paper also sought to understand the recent developments that may have taken place in relation to these concepts of corporate finance.
Thirdly, the paper also sought to identify and evaluate any current issues that may exist and which relate directly to these concepts as well as the subsequent implications of these issues. Finally, the paper has discussed possible suggestions that can be adopted by corporate organizations going forward. In closing, it is expected that the discussions contained in this analytical paper will contribute positively to the field of corporate finance both in the short and long runs.
Works Cited
Ghosh, Arvin. Capital Structure and Firm Performance. NJ: Transaction Publishers, 2012.
Jordan, Bradford., Westerfield, Randolph and Ross, Stephen. Fundamentals of Corporate
Finance. New York: McGraw Hill, 2012. Print
Knetcht, Mathias. Diversification, Industry Dynamism, and Economic Performance. London:
Springer, 2013. Print
Mehra, Raj. Handbook of the Equity Risk Premium. NJ: Elsevier, 2011. Print
Pratt, Shannon. Cost of Capital. New York: John Willey, 2010. Print
