Part One
Risk
There is no standard way to define risks. However, one of the definitions of risk is the probability that the return on an investment will be lower than the expected return (Business Dictionary, n.d.). Examples of risk include business risk, transactional risks and exchange rate risk.
Beta
Beta is a measure of systematic risk of a stock. The value measures the volatility of the stock compared to the volatility of the market (Forbes, n.d.). The value of Beta can be either positive or negative while the beta value of the market is always one. As such, in interpreting the value of the portfolio or the stock beta, a portfolio or a stock that has negative beta value implies that such a stock moves in the opposite direction compared to the market while a stock that has a positive beta moves in the same direction as the market movement. Nonetheless, experts observe that although a negative Beta can exist, it is highly unlikely (Investopedia, 2003). Furthermore, considering the value of the beta and comparing it to 1, value of the market beta value, if a beta value is greater than one, it means that the stock is more volatile compared to the market meaning the degree of that stock or portfolio price fluctuation is greater than the general market price fluctuations. For example, on 7th April, the value of Apple’s Beta was 1.01 meaning that the volatility of apple stock price was 1% more volatile than the market (Investopedia, 2003). A beta value of 1 means that such a stock or portfolio matches the volatility of the market while a beta value that is below 1 but greater than 0 means that the volatility of the stock is lesser than the volatility of the market. It is also possible to have a beta value of 0 for some assets. Cash has a zero beta -assuming that there will be no inflation - since the value of cash will remain the same regardless of the market movement.
The required rate of return refers to the minimum rate an investor will demand to invest in a given portfolio. The value is computed through the application of the capital asset price model. First, one needs to compute the Beta of the portfolio by carrying a regression analysis of the stock over the market with the market being the independent variable. The higher the beta of a given stock or portfolio, the higher the volatility of the stock or portfolio which will, in turn, translate to higher risks. Conventionally, higher risk assets will have a higher return since the investor will need a higher risk premium for assuming higher risks (Daily Finance, n.d.). For example, consider two firms A and B that have betas 0.3 and 1.3 respectively. The risk-free rate is 3% and the market free rate is 8%. It is expected that firm B should have a higher required rate of return as shown below
Capital Structure
A firm capital structure refers to the combination of sources of funds that an organization uses to funds its operations and growth (Lexicon, n.d.). Ideally, a firm has three sources of funds to fund its activities. Equity is the one of the sources of finances. Equity comes from paid cash from the shareholders through the purchase of ordinary share capital. The second source of financing is the debt which the firm obtains from long-term loans and/or debentures. The third source is the preferred shares which are obtained from investors that purchase the preferred stocks. There are entities that only use equity financing - it is not possible to have a firm that only uses preferred shares and debt alone - while others use the three sources of capital in a given structure. For example, considering a firm that uses three element of finance, equity will account for {market value of equity/ (market value of (Preferred shares + equity+ debt)} while debt will account for {market value of preferred shares (market value of (Preferred shares + equity+ debt)} and debt will account for {market value of Debt/ (market value of (Preferred shares + equity+ debt)}. As such, considering a firm that uses 1 million of debt, 2 million in equity and 0.5, million in preferred shares, the capital structure will be (1/3.5) as the debt proportion, (2/3.5) as the equity proportion and (0.5/3.5) as the preferred share proportion thus consisting the firm’s capital structure.
Dividend
Dividend refers to the distribution of the firm earnings that is distributed to a given class of shareholders namely ordinary shareholders and preferred shareholders. The dividend can be paid in terms of stock, cash or other properties. In relation to preferred shareholders, the firm is obligated to pay these dividends. Furthermore, the preferred share dividends can be claimed in arrears meaning that the dividend will be carried forward if the firm fails to honor its obligation in a given year. However, for the ordinary share, the firm only pays a dividend after the board finds it prudent to pay and the value of dividend paid is at the discretion of the board, for most firms. In addition, shareholder dividend cannot be claimed in arrears. In addition, there are firms that pay dividends only after year end while others pay an interim dividend and year-end dividends. Finally, the value of the dividend is subject to the firm firms’ policy relating to payout ratio. Some firms maintain a constant percentage while others prefer having a constant value say 1 dollar per share in any year while other prefer to determine yearly payout ratio. Nonetheless, except for the firms that pay its dividend using a policy that dictates a specific value, the other two sets of companies will use the payout ratio to pay the dividend. For example, for a company that maintains a fixed payout ratio, say 45%, and another firm that has determined to have a 45% payout ratio for that year, the two firms will pay 45% of earnings per share every year. Assume earning of $4 per share, the dividend paid will be 0.9.
Repurchase
Stock repurchase refers to the firm repurchasing some of its shares from the shareholders (Business Dictionary, n.d.). The organization may buy the shares from the capital markets or offer the shareholders an opportunity to tender their shares directly to the organization at predetermined price. Often, when companies opt for the share repurchase, the firm thinks that its shares are undervalued by the market (Business Dictionary, n.d.). As such, by conducting the repurchase, the firm aims at reducing the number of shares in the market thus improving the firm share value in the market since it lowers the supply of its shares. For example, assume a company that has 5 million shares. If the firm opts to repurchase one million of its shares, the firm will leave only 4 million shares being traded thus cutting the share supply by one million but leaving the demand intact. The effect will be to improve the value of the shares.
Market Risk Premium
Market risk premium refers to the difference between the risk-free rate and the expected rate on a given portfolio. The market risk premium is also equal to the gradient, also known as the slope, of the security market line (Investopedia, 2003). For example, if the expected rate is 6% and the risk free rate is 3%, it means that the market risk premium 3% (6%-3%) meaning also the gradient of the SML is 0.03.
Dividend Yield
The dividend yield is a measure of the amount of cash that an investor is earning from every dollar invested in equity. As such, the dividend yield is a financial ratio that captures the manner in which an organization pays its dividends relative to its market price. Mathematically, the relationship is captured by the formulae
Dividend yield = Annual Dividend per share / Price per share (The Motley Fool, n.d.)
For example, consider a firm that paid an annual dividend 1.5 while its market price is 30. The annual dividend yield is 5% {(1.5/30) *100%}.
Flotation Cost
Floatation costs are the costs that a public limited company will incur to raise capital (Financial-dictionary, n.d.). Examples of the floatation costs include legal fees, registration fees, and underwriting expenses.
Free Cash Flow
Free cash flow represents the cash available to the firm having factored the cash needs for maintaining the current asset and acquiring additional assets (Drake, n.d.). The value is computed as
FCF= EBIT (1-Tax Rate) - Capital Expenditure - Change in Net Working Capital + Depreciation + Amortization (Drake, n.d.)
For example, consider a firm whose EBIT is 200 million, capital expenditure is 30 million, change in net working capital is -20 million, amortization is 2 million and depreciation is 5 million. Take the tax rate to be 35%. The FCF will be
Free Cash Flow = 200 (1.65) – 30 + 20 + 2 + 5 = 127
The positive value implies that the firm can free utilize 127 million. Suppose the value was negative, it means that the firm does not have any amount that it can utilize freely since the money is tied up.
Part Two
Question Two
Weighted average cost of capital refers to the average rate the company rewards is providers of capital. In others words, it refers to the costs that the firm will incur in utilizing capital availed (Hollberg, n.d.). The following procedure is used to derive the WACC equation
Where
E is the market value of equity
MVp is the market value of preferred shares
MVd is the market value of debt
I is the interest in debt
D is the dividend per share
G is the growth rate
P is the price of one share
F is the floatation cost
P is the share price at the date of computation
Ke is the cost of equity
Kd is the cost of debt
Kp is the cost of preferred shares
Therefore,
WACC = {(E/V)*Ke} + {(P/V)*Kp)} + {(D/V)*Kd}
Using Apple financial statement for the previous year, the following computation refers to the computation Apple’s WACC.
Capital budgeting refers to the techniques that are used to appraise the economic viability of investment projects. Broadly, there are two sets of capital budgeting techniques namely discounted methods an undiscounted method. The discounted methods factor the time value for money while the non-discounted methods ignore it. Examples of the non-discounted method include payback period and accounting rate of return while the discounting include net present value, Internal rate of return and profitability index (Irfanullah, n.d.).
Target Capital structure
Target capital structure refers to the optimal combination of capital namely equity, debt and preferred shares that will have the effect of improving the firm market value (Investopedia, 2008).
Derivation of Net Present Value
The net present value of a project is the summation of the discounted future cash flows less the initial cash outlay (Net Present Value, n.d.). Therefore, the NPV is derived as follows
NPV = 1nCash Flows 1+WACCn – Initial Cash Outlay
In this case, WACC is used as the discounting factor. It is assumed that the firm will use a combination of resources from all the financing alternatives. Therefore, since it is not specific which funds will be used in the project, the firm will use the average cost of its capital to discount the cash flow.
Part Three
Question One
Standalone risks refer to a form of risk that is attributable to a given project or activity. As such, if the said operation or project would cease, the risk would cease as well (Investopedia, 2007). In relation to a stock, this is the risk associated with investing in a given stock.
Using the example of a stock, in order to measure the stand-alone risk, the firm uses the standard deviation of the daily returns of the stock. For example, consider a stock whose prices from April 1st 2004 to 11th April 2016 are shown in the table below.
Variance = 1n(Xi-u)^2n
Where u is the average
Xi is the observation on each day
N is the number of days
Standard Deviation = variance ^0.5
The market risk is also called the systematic risk. Therefore, this form of risk cannot be eliminated through diversification since it affects are all sectors uniformly. Systematic risk is associated to return. Conventional wisdom dictates that a high-risk rate requires a high rate of return. To understand the riskiness of a stock, one will consider the beta value which measures the volatility of the stock relative to the volatility in the market. As such, when a firm has a beta beyond 1, say 1.3, it means that such a stock is more volatile than the market thus, it is riskier since a change of 1 percent of the market will mean that the price will fluctuate at least 30% more than the market. As such, the market risk influences the riskiness of a stock.
Market risk is measured using the Beta of a stock. Therefore, in order to get the beta, one will use the following formulae
Beta= 1n(Xi-u1)(Yi-u2)1n(Xi-u1)^2
Where Xi are the market observations
U1 is the average of the market values in a given period
Yi are the stock price observations
U2 is the stock price average in a defined period
Question Three
The target capital structure refers to the most optimal combination of various financing option namely equity, preferred shares and debt.
There is a relationship between the target capital structure and WACC. WACC is computed from the three components that are optimized in order to attain the optimal capital structure. As such, when the three capital structures have been optimized, it means that the firm is operating at the lowest WACC possible. The reason is that optimizing when costs are involved reducing the costs incurred to utilize a given source of fund to the lowest rate possible. As such, the processes of optimism, in turn, translate to a reduction in the value of WACC since it is based on the three element of capital and the costs involved.
Operating leverage
Operating leverage measures the rate at which the firm incurs a combination of variable and fixed costs. Gross margin is a major factor in this element. If a business makes few sales that have a high gross margin, such as business will have a high operational leverage while a business that makes many sales that have a low gross margin will have a low operational leverage (Investopedia, 2003).
Organization that tends to have high fixed costs will tend to have a higher operating leverage compared to entities that have higher variable costs and lower fixed costs. As such, as sales increases, the new sales will be contributing more to profitability than to meeting the fixed costs. However, higher operating risks expose the firm to a higher degree of demand forecasting risks since the firm tries to maximize on operational leverage and profitability (Investopedia, 2003).
However, this formula may be expressed as follows
Q(P-VC)QP-VC-FC
Where Q is the number of units sold
P is the price per unit of sale
VC is the variable cost
FC is the fixed costs
As earlier noted, high operation leverage will expose the business to business risk through demand forecast sensitivity. As such, a slight error in demand forecast will be amplified thus leading to exaggerated cash flows projections. Therefore, the firm may think that they will have adequate funds thus ignore seeking a debt and bank on internal financing since free cash flows are expected to be high or the firm may see high levels of free cash flow and embark on investment that may stall in the middle leading to the firm seeking debt that may be expensive. Simply, operating leverage affect capital decision since it affects the statements that are the foundation in making the capital decision.
References
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Daily Finance. (n.d.). What Is Risk and Return? - DailyFinance. Retrieved April 11, 2016, from http://www.dailyfinance.com/2013/04/24/what-is-risk-and-return/
Drake, P. (n.d.). What is free cash flow and how do calculate it. Retrieved April, 2016, from http://educ.jmu.edu/~drakepp/general/FCF.pdf
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