FINC5001_Capital Markets & Corporate Finance_2009 Semester 1

FINC 5001 Capital Markets and Corporate Finance

Tutorial Questions and Solutions

Week 2

–

Preliminary concepts

DQ 1

The

text

refers

to

three

types

of

financial

decision

–

the

investment

decision,

the

financing decision, and the dividend decision. Describe each in detail, and explain

how

these

decisions

relate

to

the

corporate

objective.

Categorise

each

of

the

following

decisions

in

terms

of

whether

it

is

an

investment,

financing

or

dividend

decision and explain why it is in that category.

?

Corporate managers face three important decisions in their attempt to maximise

shareholder wealth. These decisions are the investment decision, the financing

decision and the dividend decision. Fisher argued that the firm’s investment

decision is independent of the

preference of the owner and the firm’s financing

decision. The investment rule is to invest until the return on the marginal dollar

invested equals the cost of funds, that is, maximise net present value.

?

Financial decisions

focus on three factors:

investment decision

,

financing

decision

and

dividend decision

. The investment decision relates to the manner in

which funds raised in capital markets are employed in productive activities. The

objective of such investments is to generate future cash flows, thus providing a

‘return’ to investors. The capital budgeting or project evaluation function is the

process by which the investment decision is undertaken.

?

The financing decision relates to the mix of funding obtained from capital markets,

that is the mix of debt and equity issued by the firm to fund its operations.

?

The dividend decision relates to the form in which the returns generated by the

firm are passed on to equity holders.

a)

Javelin Pharmaceutical Ltd purchases all of the shares in O’Hara Ltd.

Investment Decision

b)

Tabcorp Holdings Ltd buys new poker machines for its business.

Investment decision

c)

Brushwood Ltd hopes to raise $$53 million in an equity issue of ordinary

shares and will use the funds to repay its long-term debt.

Financing decision.

d)

Devastation Games Ltd purchases the copyright for a new video game.

Investment Decision

e)

News Corporation declares a dividend of 20c per share.

Dividend Decision

f)

Brushwood Ltd pays $$5 million to repurchase 1% of the shares held by its

current shareholders

Financing Decision or Dividend Decision

g)

Creek Ltd announces the raising of $$50 million in bonds in the United States.

Financing Decision

h)

Charles Grogin sells shares to finance his new online wine cellar.

Financing Decision

DQ 9

Discuss some of the institutional mechanisms that exist in Australia for ensuring that

financial managers act in the best interests of the company owners.

Regulators such as the Australian Securities and Investments Commission (ASIC)

are among these mechanisms. Two important roles of ASIC are to prevent corporate

crime

and

to

protect

investors.

Both

of

these

roles

are

consistent

with

the

maximisation of owners’ wealth. It is unlikely, however, that the existence of ASIC

will provide an airtight guarantee that directors of a company will pursue the interests

of shareholders.

Remuneration

packages

are

another

way

in

which

the

owners

of

a

company

can

promote decision-

making by a corporation that maximises owner wealth. Directors’

salaries can be packaged such that every time the value of a company goes up, so does

the wealth of the directors. For example tying directors and managers remuneration to

the market capitalisation of a corporation.

Directors often hold shares in the companies that they run. This practice increases

the

likelihood

that

a

director

will

attempt

to

maximise

the

wealth

of

shareholders,

because the director’s wealth will increase simultaneously.

The market for corporate control (i.e. the takeover market) may also promote the

maximisation

of

shareholder

wealth.

The

idea

is

that

if

management

is

running

a

company inefficiently, the company’s share price will be depressed. Corporate raiders

aim to take over such corporations by purchasing a majority shareholding, then using

their acquired voting power to partly or completely replace the existing management

team. In theory, the new (or upgraded) management team operates the business more

efficiently (and therefore profitably), thereby resulting in gains. The threat of job loss

associated

with

corporate

raids

therefore

provides

an

incentive

to

management

to

pursue the objective of maximisation of share value, that is, shareholder wealth. This

mechanism is sometimes referred to as the ‘discipline of the capital market’.

Another

mechanism

that

encourages

management

of

a

corporation

to

increase

owner wealth is owner voting power. For example, a group of shareholders who are

dissatisfied

with

the

manner

in

which

a

corporation

is

run

may

decide

to

sack

the

management.

Such

a

‘group’

of

shareholders

typically

does

not

refer

to

individual

investors.

Despite

the

fact

that

these

mechanisms

are

in

place,

there

is

always

the

presence of an agency problem. Since the managers of a corporation (the agents) have

control over the funds of shareholders (the principals), there is always a danger that

they

may

not

act

in

the

best

interests

of

shareholders.

This

is

because

they

might

prefer to take actions that enhance their own personal position, even if such actions

are

against

shareholders’

best

interests.

Acco

rdingly,

the

mechanisms

that

we

have

discussed here may not always be adequate to guarantee that the interests of owners of

the firm will be pursued.

DQ 10

It has been said that the objective of a firm is to look after the interest of the owners of

the firm

–

the ordinary shareholders. However, firms are run by managers (directors)

who are often not owners (shareholders). Surely then managers would be more

interested in looking after their own interests rather than those of some face-less

crowd. True or false? Explain. Are the interests of the two groups necessarily

incompatible?

It

may

be

that

the

managers

would

maximise

their

own

benefits

&

wealth

to

the

detriment of the s/h, but there are mechanisms that act to minimise their diversions.

a)

Management incentive packages:

-

compensation based on performance / profits

-

stock options whose value increase with value of firm (better).

b)

Poor managers will not survive in long term:

-

ousted by shareholder revolt (eg. AGM)

-

removed in takeover (poor management creates t/o targets)

-

not likely to be promoted to larger companies

-

may find difficult to get another job (reputation effects)

Generally the problem is known as Agency cost of equity.

PQ 3

What is the rate of return on an asset that will pay $$104,000 in one year, if it is priced

at $$97,000 today?

Return = (FV/PV)

–

1

= (104,000/97,000)

–

1

= 0.07216 or 7.22%