Corporate Finance calculation

Corporate Finance calculation

Corporate Finance

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Section A

Question 1

1. Calculation of Yield to Maturity on Issuance of a Liquid Option Notes (LYONS) by CapsLock Sdn. Bhd. at the end of 2006 for 15 years.

Price of the bond * (1+YTM) ⁿ =Face value of the bond

As such, Yield to Maturity = (Face value of the bond / current price of the bond)^{n (}1/ Years to Maturity) – 1

= RM (1,000 / 532.15) ^1/15 – 1

= 1.0431715 -1

=0.0431715

=4.32%

1. Calculation of the value of the option paid by the investors, for the convertible bond, with the conversion option.

Bond Floor = ∑ⁿ _t=1 C/ (1+r) ^t + P/ (1+r) ⁿ

Where;

C = the convertible bond’s Yield to Maturity

P = the convertible bond par value

r    = straight bond Yield to Maturity

n = number of years till maturity

Therefore,

The Present Value factor = 1 – (1/ (1+r)ⁿ)

= 1-(1/1.1¹⁵

= 0.7606

Present value of the Yield = (0.043 *RM 1,000) /0.1) * Present Value factor

= RM 430*0.7606

= RM 327.06

Present value par value = RM 1,000/ 1.1¹⁵

=RM 239.39

Value to investors (Bond floor) = Present value of Yield +Present value of par value

= RM (327.06 +239.39)

=RM 566.45

1. Conversion value and conversion price of the bond at the end of the year 2006

Conversion value = Number of shares that can be converted * Market price per share

= Conversion ratio * market price per share

= RM 50.5 *8.76

= RM 442.38

Conversion price = Par value of Bond / Conversion ratio

= RM 1,000 /8.76

= RM 114.16

2016. Conversion price at the end of the year 2016. At the end of the year 2016, the par value of the bond stands at RM 603.71

Therefore, Conversion price = Par value of Bond / Conversion ratio

= RM 603.71 / 8.76

= RM 68.92

Based on the calculation above, the bond par value at the end of the year 2016, ranks lower than the face value at maturity of the bond. As such, the conversion price decreased in comparison to that at the end of 2006 when the bond issuance took place. The reduction in the face value of the bond is attributable to changes in market conditions such as inflation that directly affect the movement of interest rates. For instance, the interest rates might have gone up thus reducing the value of the bond hence the reduction in the conversion price.

The conversion price has an inverse correlation to Yield to Maturity.  Bond prices have a similar relationship with the Yield to Maturity, such that with increased rates due to inflation, bond prices go up. The increase in bond prices is attributable to increased demand for bonds that carry fixed interest rates. On the other hand, increased bond prices lead to a decrease in Yield to Maturity. Therefore decrease in conversion price indicates increased Yield to Maturity. The issuing company would, therefore, call on the investor for the conversion of the bond so as not to pay a higher yield to the investor.

1. Explanation of why the market price for a convertible bond differs from the value of a straight bond.

The convertible bond is a hybrid security, offers a higher yield than the common stock but lesser than that of the straight corporate bonds. Issuing companies normally offer lower coupon rates to convertible bond owners compared to those owning straight bonds. However, due to the ability of convertible bonds for conversion to common stock, its value remains higher than that of a straight bond. Owners of convertible bonds usually convert the bonds to common stock when the expected sale proceeds from stock exceed the face value of the bond including the remaining coupon payments, for the coupon earning convertible bonds.

The higher value could be explained by the earnings that investors gain from the issuing company’s stock when prices appreciate and the investor chooses to trade in the bond for the company stock. Additionally, the high value of convertible bond originates from the dividends paid to the shares owned by the investor after conversion. Therefore, the convertible bonds have higher prices than that of straight bonds due to the feature that allows an investor to mitigate risk on the bonds by exchanging the bonds for several shares of the issuing company’s stock as stated in the conversion ratio.

The conversion feature potentially offers high returns to the convertible bond investors thus the issuance of the convertible bonds at higher prices. In conclusion, the face value of a non-convertible bond appears more attractive in comparison to the convertible bond. The value of the convertible bond only supersedes that of the non-convertible bond once the conversion to shares of the issuing company comes into play. Despite the yield from a straight bond being locked and assured, investors would prefer convertible bonds that have a potentially lower yield in comparison to the non-convertible ones due to their hybrid feature. The explanation is as per the diagram below.

 Bond price for convertible bond versus the non-convertible bond

Bond price

Section B

Question 4

1. Value at Risk (VaR) of Bond X and the VaR of Bond Y

Total investment                                 =         RM 20 million

Investment in Bond X                                    =         70%* RM 20 million

=         RM 14 million

Investment in Bond Y                                    =         30% *RM 20 million

=         RM 6 million

Standard deviation of Bond X                       =         1%

Standard deviation of Bond Y                       =         1.5%

Correlation coefficient                        =         -0.60

Period                                                  =          10-day period

Confidence interval                            =          99%

At a confidence level of 99%, here’s a 1% chance of loss of value VaR on the bonds.

Therefore VaR for Bond X    =          √10 – day period * Standard deviation *Amount invested

=          3.16*1%*RM 14 million

=          RM 442,400

VaR for Bond Y         =          √10 – day period * Standard deviation *Amount invested

=          3.16*1.5%*RM 6 million

=          RM 284,400

1. VaR of a portfolio which invests 70% of funds in Bond X and Y.

VaR     = √VaR₁ ² + VaR₂ ² +2 * Corr_1,2 * VaR₁  * VaR₂

                = √0.4424² +0.2844² + 2*-0.60 * 0.4424 *0.2844

= √0.1958 +0.0809 +-1.2 * 0.4424 *0.2844

= √0.1958 + 0.0809 – 0.1510

= √0.1257

=0.3545

= RM 354,542.00

1. Determination of whether there is any benefit in diversification using answers in question a, and b.

Based on the answers in question a, and b, there’s a clear benefit on diversification of the investor’s portfolio by investing in bonds X and Y. diversification reduces risk through the allocation of investments among different securities, in this case, bond X and Y. therefore, it’s clear based on the two bonds that they react differently to the same environment, hence the maximization of returns by the investor as=t the same time reducing risk. Individually, the investor would have a combined risk of RM 736,800. However, due to diversification, the risk for the portfolio appears lower at RM 354,542.00. Therefore, the investor benefited more by diversifying the portfolio.

1. Five factors determine whether a bond will have a low credit risk.

A bond could be defined as a fixed income investment through which a corporation or the government raises funds. The investor receives periodic payments on the investment while at the expiry of the maturity period; they receive the face value. There’s the consideration of investment in bonds being low risk as compared to other investments, mainly due to various factors as outlined below.

1. Term to maturity of the bond

Term to maturity of the bond outlines the life of the bond from the issuance date to its maturity date when the issue redeems the bond and pays the face value to the bondholder. Short term bonds have low risk as well as low yields. They are more preferable to risk-averse investors whose top priority is the safety of their investments. Long term bonds have high risk as compared to short term bonds. Investors who are risk-takers lock their funds for longer periods during which, fluctuation in interest rates and inflation rates affect the bond price. However, the high risk associated with long term bonds generates higher returns for the investor.

1. Fixed interest payments

Bond issuers pay a fixed rate of interest to the bondholders known as coupon rates as agreed in the trust indenture. Some payments could be semiannual, while others could be semiannual. The rate of interest does not change over the life of the bond. As such the investors have the assurance of their periodic interest payments for the duration of the bond thus guaranteeing low risk for the investment. Unlike stocks whose price determination is by the forces of the law of demand and supply which could lead to either a gain or a loss, fixed interest payments carry a low risk.

• The credit rating of the issuing company

Credit rating is by third parties, keeping the evaluation of the bonds independent and objective. The main credit rating agencies include the Moody’s, Standard and Poor, and Fitch. The credit rating is on the financial strength of the issuing company. A rating of AAA indicates strong financial ability while B indicates adverse conditions with the impaired capability of payment. Therefore, the investment-grade ratings such as AAA, AA, and A of bonds indicate a low risk to the investors while speculative or junk bonds rated CCC carries high risk.

1. Bond features

Some of the bonds are either callable or non-callable. Others have the feature of being convertible while others are non-convertible. Callable bonds bear a high risk as compared to non-callable bonds. Companies recall their bonds when the interest rate goes lower to borrow at a better rate. As such, the high risk associated with the bond gets compensated by offering investors higher returns. On the other hand, a bond that has a convertibility feature carries more risk than the non-convertible bonds. The high risk is attributable to the bond prices being more volatile and relying on the stock price movements.

1. Legal protection

The government issued bonds carry less risk compared to corporate bonds due to low default risk associated with the government. Additionally, bondholders enjoy a certain degree of legal protection. In most countries, in case a company becomes bankrupt, bondholders would receive a recovery amount whereas the company’s equity stock ends being valueless. As such the legal protection offered on bondholders makes holding of bonds have low risk as compared to stockholders. Besides, the indenture and the covenants specify the terms of the bond, the rights of the bondholders, and the duties of the issuer serving as a formal contract.

Question 5

1. Critically discuss the implications of cash conversion cycle management on the survival of a firm.

The cash conversion cycle indicates the time taken by a firm for the conversion of its investments in the form of inventory and other resources from sales into cash flows. The quantitative measure aids the company in determining the efficiency of its operations and management of its cash cycles. The cycle is illustrated below. The diagram indicates the process flow in a business set up. A firm has an available inventory that its sales to its customers on credit. The business collects the sales proceeds within the agreed credit period. Part of the cash gets utilized in paying suppliers for goods supplied while the balance gets plowed into the business.

Therefore, the cash conversion cycle could be summarized as the summation of the day’s sales outstanding and days inventory outstanding less day’s payable outstanding. The day’s inventory outstanding indicates the number of days taken to convert the inventory into sales. Days sales outstanding on the other hand demonstrates the number of days taken in collecting cash from the sales, while days payable outstanding shows how long the business takes to pay its suppliers. Therefore, the cash conversion cycle is an indicator of the efficient management of working capital by a business.

Working capital management through the cash conversion cycle forms an integral part of a firm’s survival. For instance, a positive cash conversion cycle indicates a shorter time in paying creditors as compared to the time taken in converting inventory into sales and collecting cash from the sales. As such the business would be constrained in meeting its financial obligations as they fall due hence threatening the survival of the firm. However, the impact the slow conversion of inventory has on the survival of the firm could be mitigated in various ways.

The slow movement of the inventory could be an indicator of changes in the tastes and preferences of the firm’s customers. On the other hand, the goods could be at a high price. Therefore, the business ought to reduce the price probably to its original cost, in a bid to dispose of the existing stock and create room for more inventories in tandem with customer’s tastes and preferences. The business would then be in a position to retain its valuable customers hence the continuity of the business.

Payment of suppliers before the firm collects its cash from sales leads to constrained cash flow. Once a firm meets its accounts payables, then the cash gets unavailable for purchase of inventory and other investments in the business.  Firms require regular amounts of cash to meet routine payments, cover miscellaneous costs, and buy inputs to produce or stock more goods.  As such, the business should negotiate for favorable credit terms to ensure continuity of the business through freeing up part of its available cash for use in business operations.

Consequently, the firm could ensure its survival by maintaining a certain amount of cash to meet day to day expenses as well as meeting regular expenditures. Some of the businesses that encounter a positive cash conversion cycle include most service providers.  Some businesses enjoying a negative cash conversion cycle include online stores such as Amazon where it takes shorter to convert inventory into sales and collect cash as it’s on a cash basis. The online store’s suppliers only get paid once the goods get sold.  As a result, such businesses experience a high degree of survival, all other factors held constant.

Optimization of the cash conversion cycle affects the business cash flows which has a direct impact on the number of external funds required to finance its operations. In most cases, lending institutions rely on the cash flows of business in extending a credit facility. Therefore, poor management of the cash conversion cycle as evidenced in the financial statements could deny business access to credit facilities. As such, the operations of the business get constrained for lack of financing leading to the closure of such firms.

The cash conversion cycle has both a positive and negative effect on the profitability of any firm. Firms exist for various reasons, the major ones being maximizing shareholders’ wealth and profit maximization. Therefore, a long cash conversion cycle could lead to high sales due to the longer credit terms which could translate to increased profitability of the business, assuming financial stability of the business to finance its day to day operations before the expiry of the extended credit period.

On the other hand, the long conversion cycle could lead to constrained working capital hence limiting the operations of the business. The effect that has on the business includes defaulted credit facilities attracting interest penalties which may eat into the earnings of the business hence reducing its profitability. Firms with declining profitability are undesirable for investors thus encountering challenges in attracting equity funding hence threatening the survival of the business.

The survival of the business gets threatened when the business indulges in more debt in a bid to finances its operations due to poor management of working capital.  In case of constrained business operations hence the inability to meet its obligations as they fall due, creditors to collect the amount owed to them could exercise their legal right of liquidating the business hence leading to its closure. Therefore any firm should work towards having high profitability with shorter cash conversion cycles.

In conclusion, the management of the cash conversion cycle determines the ability of any business to survive in any industry. Companies require adequate funds for Research and Development, proper rewarding of its employees to attract talent and retain and continuous innovation of its products for relevancy in the industry. All those functions could only be achieved with adequate working capital through proper management of its cash conversion cycle.

1. Roles of the investment bank and underwriting syndicate in initial public offerings (IPOs)

Investment banks are a sector of the banking operation that deals with assisting individuals or firms with financial consultancy services and raising capital. Investment banks serve as an intermediary between investors and the issuing company. As such, the investment bank provides underwriting services for the stock being issued to the market by a company that decides to go public for the sole purpose of seeking equity financing. Additionally, the investment bank offers a financial and advisory function to a firm engaging in Initial Public Offering.

The underwriting process involves the investment bank purchasing several shares of the stock being issued. The investment bank then resells through the stock exchange and arranges for the distribution of issuance. Other roles by the investment bank include organizing for roadshows in a bid to establish demand for the shares. The roadshows aim at generating interest in the Initial Public Offering. Besides, the bank sells the shares to public investors to increase market value for the company. Additionally, they enforce a lock-up period during which an investor cannot dispose of the shares.

The move aims at generating demand for the shares thus increasing the market value. Investment banks determine the timing of the new issue as well as the offer price for each share of the stock being issued under Initial Public Offering, and the total amount targeted. Pricing of the share gets critical in that too high prices may lead to investors shunning the opportunity. On the other hand, low pricing could lead to the firm incurring losses out of the issuance. As such investment banks assist in setting a fair price for the new issue. Proper timing impacts the firm’s profitability and affects the movement of the shares.

In cases where the issue becomes too large for one investment bank to handle, a group of investment banks comes together to sell the new offering. The underwriter syndicate pulls their resources together intending to rewrite the issuance of the shares and spread out the risk. Members of the syndicate buy shares from the issuing company to sell to investors. Therefore, the underwriting syndicate takes away the risk from the issuing company as the syndicate as the issuing company upfront. In case the share performs poorly in the market, the underwriting syndicate keeps it in its inventories thus absorbing the risk of price decline.

Underwriting syndicates reduces the chances of share underpricing. As earlier indicated, the investment bank determines the price of the new share. Therefore underwriting syndicate ensures a thorough analysis of the market thereby leading to a frequent revision of the set price to eliminate any chance of underpricing. Additional investment banks add to additional market making. The analyst coverage role of the underwriting syndicate ensures each investment bank selects a security analyst to carry out research on the issuing company and issue recommendations.

The lead underwriter in the underwriting syndicate forms the dominant market maker in the stock exchange. Additionally, the co-managers in the syndicate also make the market once trading of the newly issued share begins. Association of reputable investment banks offers a form of certification on the quality of the issue. The probability of underpricing ranks low. As such, investors would have trust in investing in such a share as a result of the guarantee of analyst coverage. Underwriting syndicate gets involved in information production, useful in decision making by the potential investors.

Besides, underwriting syndicate help eliminates any arbitrage by including both active and passive investment banks’ information of the syndicate. Therefore the syndicate remains the only Centre for information dissemination concerning the share.