Business Finance

Business Finance

QUESTION 1   

Strategic option 1: Whether to purchase a new machine

The Net Present Value of the project $147,003, the machine should be purchase. A positive NPV demonstrates that the machine will provide more cash flows than the initial cost. Please see the appendix for the work. From working it can be observed that the purchase of the machine will increase the company profitability. The project should, therefore, be accepted.

Strategic option 2: Mergers and Acquisitions opportunities

To get the present value of the share of Fiona plc in its present form we use the dividend discount model. Below is the formula for stock value.

Present value of stock = (dividend per share) / (discount rate – growth rate)

For the purpose of this calculation I have assumed that the cost of capital/ discounting rate is 11%.

Present value of stock =3/(11-7)

Share price value = 0.75

Based on the current form the value of Fiona plc is £0.75.

What value would be added if XP plc were successful?

First, the Maximum exchange ratio for the merger is equal to 1:6

Maximum exchange ratio =1/6 =0.167.

Non-dilutive offer price =(5.42 x14)/31 =2.45

Maximum exchange ratio = 2.45/5.42 =0.45

Premium =2.45-0.75 =1.7

If XP plc were successful the value of the share would increase by £1.7 per share.

What value would be added if Angela plc was successful?

Ratio of share exchange =1/4 =0.25

Non-dilutive offer price = (4.44 x14)/38 =1.64

Maximum exchange ratio = 1.64/4.44 =0.369

Premium =1.64-0.75 =0.89

The value of the share would increase by 0.89

If Angela plc was successful what would be the change in wealth for the two sets of shareholders?

Maximum exchange ratio = Maximum offer price/ Pre-merger MPS of predator

If XP plc was successful what would be the change in wealth for the two sets of shareholders

If XP plc acquisition was successful the wealth of both the target and predator shareholders would be affected.  If the deal is successful Fiona PLC would exchange six shares for one share.

The exchange ratio = 1/6= 0.45

The maximum exchange ratio = 0.369

This indicates that the exchange ratio is higher than the maximum exchange ratio. The value of the share in the predator firm will be diluted. On the other hand the value of the share in the target company will go up. This means that the Fiona plc will create more wealth from the takeover deal.

If Angela plc was successful the wealth of Angela plc and Fiona plc shareholders will be affected.

Maximum exchange ratio =1/6 =0.167.

Non-dilutive offer price =(5.42 x14)/31 =2.45

Post merger shares = ( ¼*1000) +1.8m = 2.05m

Equity value =250 *4.4 =£1.1m

This means that the shareholder value of Fiona will go up. On the other hand the share value of Agile will be diluted. The exchange ratio is higher compare to the maximum exchange ratio. The wealth of the predator will be diluted.

Strategic option 3

Required:

1. Calculate and graphically display the Security Market Line (SML).

The security market line (SML) is a graphical representation of the Capital Asset Pricing Model (CAPM). It shows the required rate of return of a portfolio as a function of systematic risk. The capital asset pricing model is used to compute the expected return.

Required Return = Risk-Free Rate of Return + Beta (Market Return – Risk-Free Rate of Return).

E(R_i) = R_f + β_i [E(R_M) – R_f]

The Tate & Lyle is correctly valued as it falls within the security market line.

For each of the four investment opportunities listed above calculate and display graphically whether they are under- or over-priced

The figures in the security market line represent the correctly priced securities. The assets above the security market line (SML) are undervalued. This means that for any amount of risk (beta), the security yield a higher return. On the other hand the securities below the security market line are overvalued since for any given amount of risk (beta), the security will yield a lower return. In this case Smith Group is considered to be undervalued meaning that its risk will produce higher returns. The other three assets are overvalued. For investment purposes the undervalued asset should be accepted while the overvalued asset should be rejected. This is because the main aim of an investor is to maximize return and hence the investor should choose the stock with the highest returns.

Question 2                                         

Discuss the reasons why the NPV method of investment appraisal might be considered superior over other investment appraisal techniques.

(maximum word counts 300 words)

Investors use different methods to appraise projects such as payback period, internal rate of return, and profitability index. All these methods are appropriate in the capital budget, however, the net present value is considered to be the best method of appraising investment. Investors use net present value to calculate the cash flow present value-based discounting factor and recommend whether the project should be undertaken based on the value-added to the shareholder wealth (Bierman Jr and Smidt, 2012). To reach the conclusion that net present value is the best investment appraisal method we must compare NPV with other methods.

Net Present Value V.S. Payback Period

The payback period refers to the period required by the project to recover the initial investment. Though this method is simple to calculate it does not consider the time value of money. Further, the method ignores the cash flow after the payback period.

Net Present Value vs. Internal Rate of Return

The internal rate of return computes the rate of return in which the project NPV is zero. The project will not make a profit either loss. The method ignores the economy of scale. It is hard for an investor to differentiate two investments with similar IRR. The NPV is assumed in absolute terms. The method that cash flows will be reinvested at the same discounting rate. In most cases, this is not practical in real business (Chen, 2012). NPV assumes both borrowing rates which are near the market rate and hence make it more practical. The project may have multiple IRR which not the case in NPV.

In relation to the profitability index, NPV is considered to be more superior.  In some cases projects will have the same profitability index with vast different absolute dollar returns.

In conclusion, the net present value is considered to be the best method for investment appraisal as it considers the time value of money. Further, the methods have selection criteria. The net present cash flow method uses all cash flow to evaluate the project method.

QUESTION 3                                                                                                (30 MARKS)

Mergers and Acquisitions

Merger and acquisition refer to the consolidation of more than one company. Mergers and acquisition one of the major company restructuring activities performed by corporate in order to enhance operational efficiency and returns of the business (Nelson, 2018).  Mergers and acquisition are associated with enormous benefits which increase their attractiveness.

Below are the main motivations behind mergers and acquisitions.

SYNERGIES

Synergy is the main motivation for mergers and acquisitions. It is expected that when two companies merge the value of the new business will be more compared to when the two companies operate separately. Synergy describes the positive net gain that results as a result of combing more than one company through mergers and acquisitions (Green, M.B., 2016.). Many investors believe that companies are able to combine forces through mergers and acquisitions. Merger and acquisition enhance the ability to generate revenue. For example research and development activities, production diversification and market expansion help the company create revenue synergies.

Financial Strength

Mergers and acquisitions help in liquidity improvement as well as have direct to cash. The company enters into mergers so as to strengthen its asset value. Mergers and acquisitions help the company to dispose of outdated and surplus assets for cash out of the combined business (Masulis and Simsir, 2018). Lack of adequate financial capacity results in the merger with the company which has high financial capacity. Higher financial capacity as a result of mergers and acquisitions helps in the implementation of business operations.

Market expansion and strategy

Companies enter into mergers and acquisitions with the aim of neutralizing competition and protecting themselves from the existing markets. The company also uses the acquired resources to acquire new markets.  According to market power, motive companies enter into mergers and acquisitions so as to achieve market more. Merger and acquisition help the company in obtaining a monopoly position hence increasing the company profitability.

In addition, companies merge with foreign companies to enter the foreign market. Merging and acquisition is also a good strategy used by foreign companies to reduce the risk associated with expansion. By entering the market in foreign nations, companies can reduce the risk associated with foreign exchange and lower the risk associated with local recessions.

Speculative motive

According to Gort 2010, some mergers and acquisitions are motivated speculative motives. The company takes over underperforming companies with the hope that the company value will rise in the future.

There might be significant differences in present value expectations between current shareholders and potential shareholders that are interested to purchase the company. Particularly, periods with large economic fluctuations may produce these differences.

Diversification and risk reduction

Diversification and risk reduction is another reason why the company enters into mergers and acquisition deal. When organizations decide to diversify their investment and products, they may opt to enter a merger to satisfy these needs. Diversification plays an important role in minimizing risk for an organization that has much business in only one sector. Acquiring and merging business for the sake of diversification play an important role in the risk reduction strategy.

The reason why merger and acquisition fail

Inadequate due diligence is one of the main reasons behind the failure of mergers and acquisitions. Once a merger deal is commenced, the expectation of high return is high. Most of the key player fails to carry out the required oversight during the merger process. This results in the management not having the required information about the target company and return this may result in losses.

Secondly, mergers and acquisitions fail because of poor strategic fit. It is good to note that the target and predator company have their strategies and objective which are different and may conflict with each other. When there is a conflict of strategy the merger may end up failing. Further mergers and acquisitions fail as a result of poorly managed integration. Lack of good design and plan results in failure in the implementation of mergers and acquisitions.

The further over-optimistic result in failure of merger and acquisition. In case the acquiring firm is too optimistic in its forecast of the target firm then the management would end up making unrealistic decisions. This may result in the management pay a too high premium for the company being acquired. This may result in the loss of the shareholders’ capital.

Lack of adequate capacity is another reason for merger and acquisition failure. After the merger some of the key partners may leave the company due to succession or retirement, or where the merging companies have planned staff attrition, the company should replace the professionals soon after the merger and acquisition. Lack of adequate human resource capacity to implement the merger there is a likelihood of a merger failing.  In addition to inadequate capacity, the merger and acquisition may fail due to a lack of adequate innovation and technology (Frankel and Forman, 2017). For a merger to be effective it is important to purchase the required technology. This helps to increase efficiency in how operations are executed. Failure to invest in resources in technology upgrade and training of technical employees can result in poor implementation of technology hence resulting in the high cost of operation.

Finally, mergers and acquisitions fail due to a lack of effective communication. Failure of the management team to fully communicate on the rationale of the transition plan, what is expected, and how to solve disputes may result in failure in the merger. The management should communicate effectively to the employees and other stakeholders on the intention of the company to implement a merger and acquisition with another company.

QUESTION 4

Difference between the Capital Asset Pricing Model, Arbitrage Theory, and Fama & French’s Three-Factor

Capital Asset Pricing Model (CAPM) was developed in the 1960s by Jack Treynor, William F. Sharpe, John Lintner, and Jan Mossin to determine the appropriate theoretical rate of return produced by an asset at a given level of risk. Later in the arbitrage pricing theory (APT) was developed by economist Stephen Ross in 1976 as an alternative for the capital pricing model. Arbitrage pricing theory provided a framework for explaining the expected theoretical rate of return on a portfolio or asset, as a linear function of the asset/portfolio risk in relation to different facture explaining the systematic risk (Kisman and Restiyanita, 2015). The Fama-French Three-Factor-Model (TFM) I based on APT. the Fama-French Three-Factor-Model (TFM) is considered to be an improvement of the capital pricing model.

All three models are used to determine the theoretical rate of return of a portfolio or asset however the difference between Capital Asset Pricing Model, Arbitrage Theory and Fama & French’s Three-Factor lies on the assumption used to determine the theoretical of return. The Capital Asset Pricing Model applies the risk-free rate of return,  investment risk, expected market return, and the beta of the portfolio in relation to the entire market so as to quantify the forecasted return of the portfolio (Iqbal and Haider, 2005). The beta of a portfolio is used to measure the volatility of stock return in relation to the market return.

Arbitrage pricing theory in comparison to the capital asset pricing model uses fewer assumptions and can be difficult to apply. The theory assumes that security prices are affected by different factors that can be sorted into company-specific and macroeconomic factors.

One major difference between the Capital Asset Pricing Model and Arbitrage pricing theory is that APT does not define specific risk factors associated with the investment. On the other hand capital, asset pricing model applies the return and risk premium to represent the market and business risk.

APT is considered to be inaccurate to be short-term however in the medium and long-term is considered to be an informative method of investment return forecast. On other hard CAPM is a snapshot and is considered to be more accurate in the short-term as compared to the long-term.

The CAPM assumes a linear relationship between the investment portfolios while on the other hand, APT assumes a linear relationship between the risk factors. APT argues that linear relationship does not exist; the theory is not able to adequately predict the outcomes. Both CAPM and APT are not realistic and some improvement was needed (Chung, Y.P., Johnson, H. and Schill, 2006). In addition, the capital pricing model considers a single factor while arbitrage considers multi-factors. The model assumes that the return of the portfolio can be forecasted using the expected return and macroeconomic factors that capture systematic risk. CAPM depends on historical data while the APT relies on future data to predict the expected return.

Contrary to capital asset price model which assume that markets are perfectly efficient, arbitrage pricing theory assumes that market is likely to misprice stocks from time to time and later correct its self when stocks or portfolio return back to fair value (Eraslan, 2013). Arbitrage’s aim is to take advantage of any investment deviation from the expected market return based on the arbitrage pricing theory.

Unlike the capital asset pricing model which is a single factor model for measuring the correlation between stock returns, market risk, the Fama-French model depends on stock return and ait relationship to other risk factors which include market, size of stock, and book value to the market-based risk factor. The model assumes the return of the stock will be affected by the risk associated with the market in which the stock is traded. Large companies are also assumed to be exposed to higher risk however they are projected to have high returns.

Reference

Bierman Jr, H., and Smidt, S., 2012. The capital budgeting decision: an economic analysis of investment projects. Routledge.

Chen, J.H., 2012, July. Adding flexibility for the NPV method in capital budgeting. In the Global Conference on Business & Finance Proceedings (Vol. 7, No. 2, p. 49). Institute for Business & Finance Research.

Chung, Y.P., Johnson, H., and Schill, M.J., 2006. Asset pricing when returns are nonnormal: Fama‐french factors versus higher‐order systematic comments. The Journal of Business, 79(2), pp.923-940.

Eraslan, V., 2013. Fama and French three-factor model: Evidence from Istanbul stock exchange. Business and Economics Research Journal, 4(2), p.11.

Frankel, M.E., and Forman, L.H., 2017. Mergers and acquisitions basics: the key steps of acquisitions, divestitures, and investments. John Wiley & Sons.

Green, M.B., 2016. Mergers and acquisitions. International Encyclopedia of Geography: People, the Earth, Environment and Technology, pp.1-9.

Kisman, Z., and Restiyanita, S., 2015. M. The Validity of Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) in Predicting the Return of Stocks in Indonesia Stock Exchange. American Journal of Economics, Finance, and Management, 1(3), pp.184-189.

Masulis, R.W., and Simsir, S.A., 2018. Deal initiation in mergers and acquisitions. Journal of Financial and Quantitative Analysis, 53(6), pp.2389-2430.

Nelson, T., 2018. Mergers and Acquisitions from A to Z. Amazon.

Appendix

Question 1

Deprecation