FINANCIAL MANAGEMENT
Contents
FINANCIAL MANAGEMENT. 1
1. What are the implications of market efficiency for corporate finance?. 2
2. State the key assumptions underlying the *Modigliani and Miller theory* of capital structure. Discuss the two key propositions of their theory. 3
3. How does the presence of taxes, financial distress costs, and agency costs, modify the MM results? 4
4. Discuss the *guidelines* to be borne in mind while hammering out the *capital structure policy* of a firm? 5
5. Describe the key ingredients of the *Reliance Industries* financing strategy. 7
6. What is the traditional position on the effect of *dividend policy* on firm value? Evaluate the empirical evidence on it. 7
7. What is the essence of Miller and Modigliani (MM) 'dividend irrelevance' theorem? What are the criticisms of MM position?. 8
8. Discuss the plausible reasons and dubious reasons for paying dividends. 9
9. Discuss the considerations relevant for determining the dividend payout ratio. 10
10. Describe Lintner's model of corporate dividend behaviour. 10
11. Discuss the rationale for share buybacks. What are the common objections to share buybacks?. 11
12. Describe the major innovations in debt securities. Show how innovative debt instruments add value. 11
13. Discuss the nature of bond covenants. 13
14. What are the plausible reasons as well as dubious reasons for lease finance?. 14
15. Describe and evaluate the following approaches to corporate valuation: adjusted book value approach, stock and debt approach, and direct comparison approach. 14
16. Discuss the important guidelines to be borne in mind while valuing a company. 15
17. Discuss the economic approach to valuation of intangibles. 16
18. Discuss the key steps in the Markon approach to value based management. 17
19. Discuss the key steps in the McKinsey approach to value based management. 18
20. Discuss the key elements of the EVA bonus plan. 18
21. Define the following measures used in the BCG approach to shareholder value management: (a) total shareholder return (TSR) (b) cash flow return on investment (CFROI), (c) cash value added (CVA), and (d) total business return (TBR). 18
22. What are the key premises of value based management (VBM)? What lessons can be gleaned from VBM adopters?. 19
23. Discuss the key business principles followed by Berkshire Hathaway. 20
24. What are the plausible reasons and dubious reasons for mergers?. 20
25. What are the major ingredients of debt restructuring in India?. 20
26. Discuss the key steps involved in managing an acquisitions programme. 21
27. What are the distinctive features of a balanced scorecard? What are the advantages and pitfalls of a balanced scorecard?. 21
28. Discuss the guidelines for total cost management. 21
29. Discuss the key features of corporate governance in the Anglo-American world and the German-Japanese world. 22
30. Suggest ways and means of reforming corporate governance in practice. 22
31. Why do executive compensation plans often fail to promote value creation? Discuss the guidelines relevant for designing an incentive compensation plan. 23
32. What are the key SEBI guidelines on Employee Stock Option Scheme? How does an indexed option work? 23
33. What are the common ingredients of a revival plan?. 24
34. Discuss the key guidelines for corporate risk management. 25
35. What are the characteristics or features of intangible assets or intangible-intensive firms and what are their implications for financial management?
. 2536. What are financial innovations? What factors have motivated financial innovations?. 26
1. What are the implications of market efficiency for corporate finance?
ANSWER:
No. | Market Efficiency | Implications on Corporate Finance |
1 | Market prices are best proxies | Firms aim to maximize this |
2 | Return earned by shareholders | Judge a corporate policy or event in terms of its impact on security |
3 | Short term forecasts | Do not try to take advantage of timing the market |
4 | Financial Illusions | Financial manipulation discouraged |
5 | Bad stock performance (in spite of good fundamentals | Defer raising equity capital |
6 | Interest rates low | Debt financing (and vice vesra) |
7 | Security prices carry lot of information about the future | Make use of it to predict financial distress in future |
8 | Securities are bought for their prospective cash flows | Company should be able to sell large blocks of additional securities without depressing prices, provided it can convince investors that it does not have private information. |
9 | New securities issues at market prices | No concern for existing shareholders |
10 | Investors will not pay for what they can accomplish on their own | Securities should be capable of generating higher return |
2. State the key assumptions underlying the *Modigliani and Miller theory* of capital structure. Discuss the two key propositions of their theory.
ANSWER:
There are two principal sources of fiannce for a business firm - equity and debt. The proportions that benefit the firm and share holders has been a debate for long. There have been several theories proposed on whether capital structure matters or not.
One such theory is M&M Theory that we will discuss now.
First, as any other theory, there are few assumptions.
Assumptions
1) Perfect Capital Market
2) Rational Investors and Managers
3) Homogeneous Expectations
4) Equivalent Risk classes
5) Absence of Taxes
Proposition I The value of a firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of capital structure.
Proposition I is identical to the Net Operating Income approach. In equilibrium, identical assets should sell for the same price, irrespective of how they are financed. MM involved arbitrage argument to prove the point.
Example of Firm A and B. A is pure equity. B is with equal proportion of Equity and Debt. An investor has a choice to replace the corporate leverage with personal leverage, by borrowing money in personal capacity. In the process he will make money that is differential arising due to average cost of capital between firms.
When investors sell their equity in firm B and buy equity in A with personal leverage, the market value of the firm B tends to decline and the market value of the firm A tends to rise. This process over period will ensure equilibrium.
Proposition II
The expected return on equity is equal to the expected rate of return on assets, plus a premium. The premium is equal to the debt-equity ratio times the difference between the expected return on assets and the expected return on debt.
3. How does the presence of taxes, financial distress costs, and agency costs, modify the MM results?
ANSWER:
Corporate Taxes:
When taxes are applicable to corporate income, debt financing is advantages. While dividends and retained earnings are not tax deductible for tax purposes, interest on debt is a tax deductible expense. As a result, the total income available for both shareholders and debt holders is greater when debt capital is used.
[Impact on MM Results]
Financial Distress:
Costs of Financial distress originate from
1) Arguments between shareholders and creditors delay liquidation of assets
2) Assets sold under distress fetch less value
3) Legal and admin costs associated with bankruptcy proceedings are quite high
4) Managers become myopic
5) All stakeholders (suppliers, distributors, shareholders) dilute their commitment
Agency Costs:
The loss in efficiency on account of restrictions on operational freedom plus the cost of monitoring represent agency costs associated with debt.
4. Discuss the *guidelines* to be borne in mind while hammering out the *capital structure policy* of a firm?
ANSWER:
KEYWORDS
1) Debt
2) Flexibility
3) Risk Exposure
4) Control
5) Corporate Strategy
6) Agency Costs
7) Timing
8) Proactively
9) Credit rating
10) Innovation
11) Widen sources
12) Signal value
13) Communicate
1) Avail Tax Advantage of Debt.
2) Preserve Flexibility
Do not over commit to debt. Be flexible to take advantage of changing market conditions and financing options available in future.
3) Ensure that Total Risk Exposure is reasonable
Business risk refers to the variability of earnings before interest and taxes. It is influenced by demand, price, input prices variability and proportion of fixed costs.
Financial risk represents risk emanating from financial leverage.
Both the above risks should not be unduly high. If the firm has a low business risk profile, it can assume a high degree of financial risk otherwise not.
4) Examine the control implementations of alternative financing plans
Each of the financing options such as Rights Issues, Debt and Public issues have their on implications on dilution of control and cost. These two parameters along with risk needs to be assessed.
5) Subordinate financial policy to corporate strategy
Financial policy originates in capital market and corporate strategy originates in product market. Financial policies should get integrated to corporate strategy.
6) Mitigate Potential Agency Costs
Agency costs are involved in monitoring the financing strategy and performance of the management. This monitoring can be expensive if handed over to third party entity. Commercial banks do the job of lending money as well as monitor as watchdogs at low cost.
7) Resort to Timing Judiciously
Market is efficient most of the times, but not always. It makes sense to time the financing option, such as debt or equity accordingly. A company resolution to have equal percentage of debt and equity in capital structure need not maintain this ratio at all points of time.
8) Finance proactively not reactively
Financing and investment decisions should be decoupled. The opportunities need to be exploited by active proactively.
9) Know the norms of lenders and credit rating agencies
Financial institutions consider tangible assets like plant, machinery, etc rather than outlays on R&D or market development. Have a sound portfolio of the assets before approaching a bank.
Similarly, credit raters consider the parameters such as:
(i) earning power
(ii) business and financial risks
(iii) asset protection
(iv) cash flow adequacy
(v) financial flexibility
(vi) quality of accounting.
10)Issue innovative securities
SEBI guidelines introduced in 1992 lets issuers have considerable
freedom in designing their financial instruments.
11)Widen the range of financing sources
12)Understand the signal value of financing choices
A firm confident about future cash flows goes for debt
financing. On the other hand, if the future is highly uncertain,
they may be inclined to issue equity capital. Hence debt conveys
positive signal and equity negative.
Managers need to be aware of this signal that investors receive
when the decision reaches the market.
13)Communicate intelligently with investors
1) De-emphasise creative accounting
2) Avoid financial hype
3) Cut lead steers into planning process
5. Describe the key ingredients of the *Reliance Industries* financing strategy.
ANSWER: [PAGE 564][FULL ANSWER]
1) Think BIG
2) Dedicate a team to treasury management
3) Develop a steady relationship with the merchant bankers
4) Be in a state of readiness
5) Be the first
6) Delink financing and investment decisions
7) Think international
8) Ensure that primary market investor is adequately rewarded
9) Cultivate the institutional investors
10) Deepen the market for its debt (pg: 565)
6. What is the traditional position on the effect of *dividend policy* on firm value? Evaluate the empirical evidence on it.
ANSWER:
According to the traditional position proposed by Graham and
Dodd, the stock market places considerably more weight on
dividends than on retained earnings.
P = m(D + E/3)
In numerical terms, weight attached to dividends is four times
the weight attached to retained earnings. The weights provided
by profounder was on subjective judgments and not derived from
objective, empirical analysis.
Empirical Evidence:
PRICE = a + b {DIVIDEND} + c {RETAINED EARNINGS}
+ Limitation 1:
Limitation in empirical evidence, that risk is totally not considered in above equation. Dividend and risk are inversely proportional, hence higher risk means lower dividend. The omission of risk will lead to upward bias of b, the coefficient of dividend.
A better regression equation is :
PRICE = a + b {DIVIDEND} + c {RETAINED EARNINGS} + d /RISK/
+ Limitation 2 ::
Secondly, measurement error distorts results. It is well known that the measurement of earnings is almost invariably subject to error. The dividend figure, however, is given precisely. So, the measurement error in earnings is fully transmitted to retained earnings which are simply earnings minus dividends. In regression analysis, when a variable (retained earnings) is subject to measurement error, its coefficient is biased downward.
Considering both limitations, when b > c will mean a higher dividend payout ratio increases stock value.
7. What is the essence of Miller and Modigliani (MM) 'dividend irrelevance' theorem? What are the criticisms of MM position?
ANSWER:
*MM argument:* If a company retains earnings instead of giving it out as dividends, shareholders enjoy capital appreciation equal to the amount of earnings retained. If it distributes earnings by way of dividends instead of retaining it, the shareholders enjoy dividends equal in value to the amount by which his capital would have appreciated had the company chosen to retain its earnings. Hence, the division of earnings between dividends and retained earnings is irrelevant from the point of view of the shareholders.
Assumptions:
1. There is no tax advantage or disadvantage associated with dividends
2. The investment and dividend decisions of the firm are independent
3. Firms can issue stock without incurring any floatation or transaction costs to raise money for investment projects
CRITISIM of MM Position:
1. Information about prospects: Dividend payout gives information about prospects of the company. A higher dividend may indicate a promising future. A lower may indicate uncertain future. Dividends reduce uncertainty perceived by investors. Hence investors prefer dividends to capital gains.
2. Uncertainty and wide fluctuations: of share prices may tend investors not to sell their shares and expect a high payout ratio. Some investors who wish to get less current income may be hesitant to buy shares in fluctuating market. Such investors would prefer, and value more, a lower payout ratio.
3. Offering of Additional equity at lower prices: MM assume that additional equity can be sold at the same market price. In practice, firms following the advice and suggestions of merchant bankers offer additional equity at a price lower than teh current market price.
4. Issue cost: MM irrelevance proposition is based on the premise that the rupee of dividends can be replaced by a rupee of external financing. This is possible when there is no issue cost. Due to this, other things being equal, it is advantageous to retain earnings rather than pay dividends and resort to external finance.
5. Transaction costs :: Due to transaction costs, shareholders who have preference for current income, would prefer a higher payout ratio and shareholders who have preference for deferred income would prefer a lower payout ratio.
6. Differential rates of taxes: tax on capital gains is different that tax on dividends
7. Rationing: self-imposed and market-imposed. In real world, the general policy followed is to have investment policy linked with dividend policy. A firm which has many highly profitable investment opportunities and which is unwilling or unable to obtain finances from outside, would promote the interest of its shareholders by lowering the payout ratio.
8. Discuss the plausible reasons and dubious reasons for paying dividends.
ANSWER:
A. Plausible reasons:
1. Investor preference for dividends:
a. Self-control and dividends
b. Aversion to regret and dividends
2. Information signaling:
3. Clientele effect: The concentration of investors in companies with dividend policies that are matched to their preferences is called the clientele effect. The existence of this effect implies that:
a. a firm gets the investors they deserve.
b. it will be difficult for the firm to change an established dividend policy.
B. Dubious reasons:
a. Bird-in-hand fallacy
b. Existence of excess cash
9. Discuss the considerations relevant for determining the dividend payout ratio.
ANSWER:
1. Funds requirement in foreseeable future is a key factor considered in payout ratio.
2. Liquidity position has a bearing on the dividend decision. Firm may not be able to distribute more than a small portion of its earnings, despite its desire to do so, because of insufficient liquidity.
3. Access to external sources of financing. A firm with easy access to financing is less constrained in its dividend decision.
4. Shareholder preference on dividend payout
5. Difference in the cost of external equity and retained earnings
6. Dilution of control. External financing, unless it is through rights issue, involves dilution of control. If shareholders and management of the firm are averse to dilution of control, may pay less in dividends.
7. There is an indirect tax on firm in paying dividends. In the hands of investors, the dividends are tax-free (at the moment). There is taxation on long-term and short-term capital gains on investors. These factors affect the dividend payout ratio.
10. Describe Lintner's model of corporate dividend behaviour.
ANSWER:
Linter’s survey of corporate dividend behaviour showed that:
1. Firms set long-run target payout ratios
2. Managers are concerned more about the change in the dividend than the absolute level
3. Dividends tend to follow earnings, but dividends follow more smoother path than earnings
4. Dividends are sticky in nature because managers have reluctance to effect dividend changes that may have to be reversed.
Linter expressed corporate dividend behavior in the form:
D_t = cr EPSt + (1 - c) D t-1
D_t = dividend per share for year t
c = adjustment rate
r = target payout rate
EPS_t = earnings per share for year t
D_{t-1} = dividend per share for year t-1
11. Discuss the rationale for share buybacks. What are the common objections to share buybacks?
ANSWER:
1. Better use of surplus cash: Some senior managers enter into mergers and acquisitions to make use of excess cash. Managers sitting on pile of cash may lead to incorrect decisions to diversify or grow. Some companies take the right call to buy back shares that increases the investor confidence.
2. Price stability - if a company buys back its shares when the price looks depressed to the management (which presumably is better equipped to assess its value), the repurchase action of the management tends to have a buoying effect in an otherwise bearish market
3. Tax advantage - A share buyback produces long-term capital gains and is tax-advantageous compared to a dividend payment.
4. Control - share buybacks can be used as an instrument to increase the insider control in firms.
5. Voluntary character - When a firm distributes dividends, investors do not have any option. However when a firm announces a share buyback programme, investors have an option to sell or not to sell.
6. No implied commitment - Unlike dividend payments, share buybacks are one time exercises (not periodic).
Objections to share buybacks:
1. Unfair advantage - zero sum game between selling and non-selling group of investors. In fact, this is not the case. Due to different goals and investment horizons, it is NOT a zero-sum game. The exercise benefits all, depending on individual investment goals.
2. Manipulation - by management to get attractive offers. Defocus from main business to stock market games in creating attractive offers of share buyback.
12. Describe the major innovations in debt securities. Show how innovative debt instruments add value.
ANSWER:
A wide range of innovative debt securities have been created, particularly from the middle 1970s. Various factors like increased volatility of interest rates and frequent changes in tax and regulatory framework. Deregulation in financial markets and competition played a significant role in innovation.
1. Deep discount bonds or zero coupon bonds. Attractive for investors who want to be immune to reinvestment rate risk. For issuer the advantage of conserving cash flows during the life of bonds.
Example: In 1996, IDBI bonds at Rs.5300 maturity period of 25 years with face value of Rs.2 lakhs.
A major drawback of this bond is the balloon payment at the end of the term by issuer. Arranging for funds at the end could be a challenge and hence investor is subject to higher risk.
2. Floating rate bonds – Conventional bonds have a fixed rate of interest. Floating rate bonds interest rate (coupon rate) is variable and is linked with a benchmark rate such as Treasury bill interest rate. These bonds are to counter the inflation risk.
Example: In 1993, SBI issued 5 million unsecured redeemable, subordinated floating interest rate bonds in the nature of promissory notes carrying interest at 3 percent per annum over the bank’s maximum term deposit rate.
3. Commodity linked bonds
Payoff from a commodity linked bond depends to some extent on the price of a certain commodity. These bonds are having been a response to volatility in commodity prices. Such bonds enable the producer of the commodity to cope with price fluctuations. The purchaser is typically the consumer of the commodity. This gives the purchaser an effective way to counter the expenditure on the commodity.
For example: Issuer: In June 1986, Standard Oil Corporation issued zero coupon notes which would mature in 1992. The payoff from each note was defined as: $1000 + 200 [price per barrel of oil in dollars - $25].
Buyer: Power plant that uses oil as fuel.
4. Bonds with embedded options
Convertible bonds – give the bond holder the right (option) to convert them into equity shares on certain term.
Callable bonds give issuer the right (option) to redeem them prematurely on certain terms
Puttable bonds give the investor the right to prematurely sell them back to the issuer on certain terms.
5. Extendable Notes
Short-term debt instruments (1 – 5 years), gives investors an option to redeem on maturity at prevailing interest rates or extend maturity.
6. Structured Notes
A debt obligation derived from another debt obligation is called structured notes. First structured notes were created by backing zero-coupon bonds with Non-cancellable Treasury bonds. Another type of structured notes is securitized debt instruments.
7. Inverse floaters
Floating rate note (or bond) is tied with a reference/benchmark rate such as LIBOR. The movement is in tandem with the Floating rate note. When the LIBOR increase, the Floating rate note increases proportionately. For example FRN = LIBOR + 1%
The interest rate of an inverse floater moves counter to a benchmark rate. For example: IF = 14% - LIBOR.
8. Junk Bonds
Bonds that have a credit rating of BB or lower by S&P and ‘Ba’ or lower by Moody’s are referred to as junk bonds. Since the name “junk” is used in negative connotation, the industry word for such bonds is “high yield bonds” as they pay above average returns.
Sources of value:
Innovative Debt security devices are essentially Positive NPV devices. They add value in one or more of the following ways:
1. Risk reallocation / Yield Reduction
2. Lower Issuance Cost
3. Tax Arbitrage
4. Reduced Agency Costs
5. Enhanced Liquidity
13. Discuss the nature of bond covenants.
ANSWER:
Bond covenant is a legally binding promise by Bond issuer to the bond holder. A covenant is meant to protect bondholders. Suppliers of bond capital are fully aware that shareholders and their agent – Managers can hurt their interest.
The following actions by the firm increase the default risk:
1. Dividend payment: Not considering the cash flow needs to honour claims of bond holders.
2. Claim dilution: Issuing another debt with same or higher priority than existing
3. Asset substitution: Low risk projects to high-risk projects
4. Underinvestment - Firm with large outstanding debt, it may reject positive NPV proposals as the same may benefit the bondholders primarily.
Positive Covenants
1. Periodically furnish financial reports to lenders
2. Maintain certain working capital
3. Setup a sinking fund for redemption of debt
4. Maintain certain net worth
5. Mortgage its assets
Negative Covenants
1. Firm cannot raise additional long term debt
2. Cannot undertake a diversification project or acquire another firm or merge with another firm
3. May not dispose or lease its major assets
4. May not pay dividends in excess of certain percentage
14. What are the plausible reasons as well as dubious reasons for lease finance?
ANSWER:
Plausible Reasons:
1. Convenience, compared to buy and sell for short period.
2. Benefits of standardization through regular format of contracts and economies of scale. This reduces the overhead costs in contract administration and transaction costs.
3. Better utilization of Tax Shields - a firm that cannot on its own avail of tax benefits of owning an asset may share a part of that benefit in the form of lower lease rentals by taking the assets on lease from a firm that enjoys tax benefits in full.
4. Fewer Restrictive Covenants - compared to term loans which need the firm to disclose financial position and maintain healthy liquidity ratios.
5. Lower cost of obsolescence risk
6. Expeditious Implementation compared to debt financing from lending institutions (such as project appraisal, supporting documents, processing time, etc). Debt financing could take 3 months or more. But lease finance takes only few days.
7. Matching of lease rentals to cash flow capabilities in contrast to rigid debt repayment. Tailor made lease rentals are possible. Seasonal lease rental may appeal to firms which have pronounced seasonality in their operations. Stepped-up lease rentals are suitable for firms which are likely to experience a gradual increase in revenues over a period of time. Deferred lease rental makes sense when there is a long gestation period before revenues are generated.
Dubious Reasons:
1. Hundred percent financing. Whether firm goes for the leasing option or the borrowing-cum-buying option, it incurs a similar liability, while preserving cash. So there is nothing special about leasing.
2. Circumvention of certain controls - certain organizations consider leasing decision as operational, rather than capital budgeting decision. Hence line and middle managers could opt for leasing, to circumvent the tedious approval process.
3. Favorable Financial Ratios - Traditionally, leases (both operating and financial) have been regarded as off-balance sheet sources of finance in India. This have favorable impact on debt/equity ratios.
15. Describe and evaluate the following approaches to corporate valuation: adjusted book value approach, stock and debt approach, and direct comparison approach.
ANSWER:
A. ADJUSTED BOOK VALUE APPROACH
1. Relies on information found in balance sheet.
2. Two ways of using balance sheet information
a. Book values of investor claims
b. Total assets minus total non-investor claims (like accounts payable and provisions)
Limitations of book value approach
1. Does not consider inflation
2. Due to technological changes, assets become obsolete
3. Organizational capital is not accounted, like human resources, knowledge, etc.
Adjusting Book Value to reflect Replacement Cost:
Various assets, such as Cash, Debtors, Inventories, Other current assets, Fixed Tangible Assets, Non-operating Assets are valued differently.
In this approach, the net book values are replaced with Replacement costs.
a. Cash has no issue in valuation. Simplest form of valuation.
b. Debtors – Generally debtors are valued at face value. If the quality of debtors is doubtful, prudent calls need to be taken for allowance of bad debts.
c. Inventories – can be classified into three categories – raw materials, work-in-process and finished goods. Raw materials may be valued at their most recent cost of acquisition. Work-in-progress may be approached from cost point of view or selling price point of view. Cost point = cost of raw materials + cost of processing; selling point = selling price – cost of sales). Finished goods inventory is generally appraised by determining the sale price realizable in the ordinary course of business less expenses to be incurred in packaging, holding, transporting, selling and collection of receivables.
d. Other current assets – like deposits, prepaid expenses and accruals are valued at their book value.
e. Fixed Tangible assets – land, buildings and civil works, and plant and machinery fall into this category. Land is valued as if it is vacant and available for sale. Buildings and civil works may be valued at replacement cost less physical depreciation and deterioration. The value of plant and machinery may be appraised at market price of similar (used) asset plus the cost of transportation and installation.
f. Non-Operating assets – Assets not required for meeting the operating requirements of the business are referred to as non-operating assets. These are valued at fair market value.
Adjusting Book Value to Reflect Liquidation Value:
Estimate the value of each asset in the secondary market, assuming the firm is immediately liquidated. In the lack of such market for each asset, the estimation is hypothetical. This approach is a serious drawback of not estimating for Organizational capital. This approach works better when the firm is already dead.
Book Value Approach has limited applicability in real life.
B. STOCK AND DEBT APPROACH (Market Approach)
1. When securities of the firm are traded publicly, the value can be obtained by adding the market value of all outstanding shares.
2. The problem of stock volatility. Averaging? If stock market is believed to be efficient, then there is no justification for averaging.
C. DIRECT COMPARISION APPROACH
1. Simple logic that similar items sell at same price.
2. The principle heavily rests on identifying a similar asset.
3. Steps in applying direct comparison approach
1. Analyze the economy
2. Analyze the industry
3. Analyze the subject company
4. Select comparable companies
5. Analyze financial aspects of subject and comparable companies
6. Choose observable financial variable
7. Value the subject company
16. Discuss the important guidelines to be borne in mind while valuing a company.
ANSWER:
1. Understand pros and cons of valuation approaches (adjusted book value, stock and debt approach, direct comparison approach, discounted cash flow approach)
2. Use at least two different approaches. Final amount can be valuated based on the weighted average of the valuation figures.
3. Work with a Value Range considering 2 to 3 scenarios
4. Go behind numbers such as return on invested capital, growth rate, and cost of capital. Also evaluate entry barriers like economies of scale, product differentiation, technological edge, patent protection, etc.
5. Value Flexibility: Consider flexibility in selecting future options. This is especially required when using Discounted Cash Flows. DCF takes into account the future expected cash flows based on current conditions.
6. Blend theory with judgment - quantitative analysis to qualitative judgment
7. Avoid reverse financial engineering
8. Beware of possible pitfalls
a. Use of shortcuts
b. Belief in hockey stick
c. Short forecast horizons
9. Adjust for control premia and non-marketability factor – when valuating a partial business, instead of whole. Add 20 to 60 percent, to the prorate value of the firm.
10. Debunk the myths surrounding valuation
a. Valuation is objective exercise
b. Well done valuation is timeless
c. The end product is important, and not the process
17. Discuss the economic approach to valuation of intangibles.
ANSWER: [more reading required: pg1074, 1075, 1076]
The most important types of intangible assets are:
1. Brands
2. Publishing rights
3. Intellectual Property
4. Licenses
There are three different approaches to valuing intangible assets:
1. Cost approach – aggregating the costs such as historical costs and replacement costs incurred in developing the intangible asset. This approach is not relevant for intangible assets. A highly expensive research program may generate less value compared to less expensive research application that has major benefit to consumers.
2. Market approach – comparable to similar asset. This approach is difficult because of the uniqueness of each intangible asset. The activity in the market has limited transactions.
3. Economic approach – (detailed below)
The value of an intangible asset is determined by estimating the cash flows or earnings expected to be generated by the intangible asset and then capitalizing it by using an appropriate discount rate or earnings multiple.
Steps involved in valuation of intangibles using Economic Approach:
1. Estimate the cash flow/earnings
a. Direct identification method – If the only significant asset of the business is the intangible asset, it is possible to readily identify the cash flows / earnings associated with the intangible asset.
b. Brand contribution method
i. utility cost method
ii. return on capital method
iii. premium profits method
iv. retail premium method
c. Royalty method
2. Capitalize the cash flow/earnings
a. Discounted Cash Flow method
b. Earnings multiple method
18. Discuss the key steps in the Markon approach to value based management.
ANSWER:
The key steps in the Marakon approach are:
1. Specify the financial determinants of value
2. Understand the strategic drivers of value
3. Formulate higher value strategies
4. Develop superior organizational capabilities
1. Specify the financial determinants of value
Marakon approach is based on a market-to-book ratio model. The book value, B, measures approximately the capital contributed by shareholders, where as the market value of equity, M, reflects how productively the firm has employed capital contributed by the shareholders, as assessed by stock market.
Hence, the management creates value for shareholders if M exceeds B, decreases value if M is less than B, and maintains value if M is equal to B.
M = Market value of equity
B = Book value of equity
r = return on equity
g = growth rate in dividends
k = cost of equity
2. Understand the strategic determinants of value
The key financial determinants of value are the spread and growth rate of dividends. Spread is the difference between return on equity and the cost of equity. The two primary strategic determinants of spread and growth and hence value creation are:
a. Market economies
b. Competitive position
a. Market Economics: refers to structural factors which determine the average equity spread as well as growth rate applicable to all competitors in a particular market segment. Market economics consists of: Intensity of direct competition, Intensity of indirect competition, Threat of entry, Supplier pressures, Regulatory pressures, Customer pressures.
b. Competitive Position: is shaped by product differentiation and economic cost position.
3. Formulate higher value strategies
Value is created by participating in attractive markets and/or building competitive advantage. Thus, the key elements of a firm’s strategy are its participation strategy and competitive strategy.
4. Develop superior organizational capabilities to overcome internal barriers to value creation.
1. A competent and energetic chief executive who is fully committed to the goal of value maximization
2. Corporate governance mechanism that promotes highest degree of accountability
3. Top management compensation
4. Resource allocation system based on
i. Zero-based allocation
ii. Principle of funding strategies
iii. Principle of no capital rationing
iv. Principle of zero tolerance for bad growth
5. A performance management process
19. Discuss the key steps in the McKinsey approach to value based management.
ANSWER:
The key steps in the McKinsey Approach to VBM are:
1. Ensure the supremacy of value maximization - preach top-down
2. Find the value drivers - business unit level and group level
3. Establish appropriate managerial processes - strategy development, target setting, action plan/budget, performance management.
4. Implement value-based management properly - assess if the company performance oriented, decisions value based, low-cost value based management
20. Discuss the key elements of the EVA bonus plan.
ANSWER:
The key elements of EVA bonus plan are:
1. Bonus is linked to increases in EVA - this makes managers think and act like managers. They will enhance operating efficiency, make profitable investments, withdraw unproductive capital, and select financing strategies to reduce cost of capital.
2. There is no floor or ceiling on the bonus - the ceiling is lowered below zero and no limit on bonus amount.
3. The target bonus is generous - than traditional, as the bonus plan is risky than before.
4. Performance targets are set by formula, not negotiation
5. A bonus bank is established
21. Define the following measures used in the BCG approach to shareholder value management:
(a) Total Shareholder Return (TSR)
(b) Cash Flow Return on investment (CFROI),
(c) Cash Value Added (CVA), and
(d) Total Business Return (TBR).
ANSWER:
A. Total Shareholder Return (TSR)
B. Cash Flow Return on Investment (CFROI)
A sustainable cash flow a business generates in a given year as a percentage of the cash invested in the firm’s assets.
C. Cash Value Added (CVA)
D. Total Business Return (TBR)
22. What are the key premises of value based management (VBM)? What lessons can be gleaned from VBM adopters?
ANSWER:
A. Key Premises
1. Value of a company is equal to the present value of future cash flows
2. Conventional accounting earnings is not a sufficient indicator of value creation because they are not the same as cash flow, do not reflect risk, do not include opportunity cost of capital, do not consider time value of money.
3. For managing shareholder value, firms should use metrics that are linked to value creation and employ them consistently in all facets of financial management
4. A well design performance measurement and compensation system is essential to motivate employees to focus their attention on creating shareholder value
B. Lessons learnt
1. Top Management support and involvement is essential
2. A good incentive plan is necessary
3. Employees should be properly educated
4. The choice of value metric per se is not critical
5. VBM works well in certain cases
6. One size doesn’t fit all
23. Discuss the key business principles followed by Berkshire Hathaway.
ANSWER:
1. Regard shareholders as partners (HR)
2. Attract and retain high quality owners (HR)
3. Centralize financial decisions and decentralize operating decisions (FIN)
4. Allocate capital flexibly (FIN)
5. Stay within your circle of competence (STRATEGY)
6. Apply stiff criteria for acquisitions (STRATEGY)
7. Make long-term commitments (STRATEGY)
8. Minimize the use of debt (FIN)
9. Finance proactively, not reactively (FIN)
10. Retain earnings only when you can create value (FIN)
11. Hire well, manage little and be a cheerleader (HR)
24. What are the plausible reasons and dubious reasons for mergers?
ANSWER:
A merger refers to a combination of two or more companies into one company. It may involve absorption or consolidation. In absorption, one company acquires another company. Example: Google buying YouTube; Tata acquiring Corus, Tata acquiring Jaguar+Land Rover. In a consolidation, two or more companies combine to form a new company. Example: Time-Warner; Mahindra and Satyam
Mergers may be classified into several types:
a. Horizontal - same line of business
b. vertical - different stages of producting in same industry
c. conglomerate - unrelated line of business
A. PLAUSIBLE REASONS
a. Strategic benefit
b. Economies of Scale
d. Economies of Scope
e. Economies of Vertical Integration
f. Complementary Resources
g. Tax Shields
h. Utilization of Surplus funds
i. Managerial effectiveness
B. DUBIOUS REASONS
a. Diversification
b. Lower financing costs
c. Earnings growth
25. What are the major ingredients of debt restructuring in India?
ANSWER: [supplement - pg: 43, 44, 45]
Debt restructuring is a part of the reconstruction of a balance sheet that relates to the borrowing obligations of a company.
1. To reduce cost of borrowing - by retiring high cost existing debt with fine rates.
2. To improve liquidity and working capital position
3. To rehabilitate a company that is insolvent
26. Discuss the key steps involved in managing an acquisitions programme.
ANSWER:
5. Manage the pre-acquisition phase
6. Screen candidates
7. Evaluate the remaining candidates
2. Determine the mode of acquisition (Three major modes of acquisition - merger, purchase of assets, takeover)
3. Negotiate and consummate the deal
4. Manage the post-acquisition integration
27. What are the distinctive features of a balanced scorecard? What are the advantages and pitfalls of a balanced scorecard?
ANSWER:
The Balanced Scorecard Approach pioneered by Robert Kaplan, David Norton, and others seek to develop an integrated performance management system.
Distinctive Features: [REVISE FIGURES on pg 1001]
1. Balanced scorecard is strategy driven comprehensive
2. performance management system
3. Covers four important perspectives of business:
a. Financial – attractive to shareholders?
b. Customer – does the company provide value to customer?
c. Internal business – what is the company good at?
d. Learning and growth – does company improve and innovate continually?
4. Balanced scorecard represents a linked series of objectives and measures.
Pros and Cons
1. Focuses managerial attention on a handful of measures that are critical to the company’s success
2. It summarizes the competitive agenda of the company
3. Guards company from sub-optimization, as managers are forced to look at all the measures together.
4. Establishing reliable cause-effect relationships is very difficult
5. Managers are likely to be fixated on financial results
6. Measurement overall possible
7. BSC does not assign weights to different measures. This leads to difficulty in specifying trade-offs between financial and non-financial measures.
8. The supplier perspective has been ignored.
28. Discuss the guidelines for total cost management.
ANSWER:
1. Understand your cost drivers
2. Focus on the entire value chain
3. Combine Total Cost Management to Business process Reengineering
4. Do it right the first time as total quality management demands
5. Exercise rigorous cost control at the design and product development stage
6. Team up with your vendors
7. Benchmark against the best
8. Resort to flexible manufacturing systems
9. Switch to just-in-time systems
10. Rely on activity based costing
11. Stretch your brands
12. Watch your Ad spend
13. Rationalize your distribution and servicing structure
14. Use information technology to cut costs
15. Manage Human Resources (HR) costs effectively
16. Trim Non-manufacturing overheads
29. Discuss the key features of corporate governance in the Anglo-American world and the German-Japanese world.
ANSWER:
Anglo-American
1. Ownership of companies is more or less equally divided between individual and institutional investors
2. Companies are typically run by professional managers
3. Directors are rarely independent of management
4. Institutional investors do not actively participate or hold commitment
5. Institutional investors neither have inclination nor ability to monitor effectively
6. Legal system is well developed. The disclosure norms are comprehensive, rules against insider training, etc are strict.
7. Fairly active market to take over under performing firms.
German-Japanese
1. Banks and financial institutions have substantial stakes in the equity capital of companies.
2. Institutional investors view themselves as long-term investors.
3. Disclosure norms, checks on insider trading, emphasis on liquidity not effective. Hence the efficiency of the capital market may be impaired
4. There is hardly any market for corporate control. Takeovers, hostile or otherwise are very rare.
30. Suggest ways and means of reforming corporate governance in practice.
ANSWER:
1. Strengthen the hands of Institutional investors
2. Separate management from control - The function of management must vest with the chief executive officer and his team and the function of control with Board of Directors.
3. Expand the role of non-executive directors
4. Limit the size of the board
5. Ensure that the board is informationally well equipped
6. Link Managerial compensation to performance
7. Enhance contestability - if the management consistently under-performs, there should be real possibility to dislodge it through market for corporate control. Takeovers are treated as positive actions in realizing this.
8. Introduce to the cumulative voting system (pg984)
9. Improve corporate accounting and reporting practices
31. Why do executive compensation plans often fail to promote value creation? Discuss the guidelines relevant for designing an incentive compensation plan.
ANSWER:
1. Linkage between size and pay
2. Emphasis on short-term performance
3. Reliance on accounting measures
Designing the Incentive Compensation Plan
1. Integrate the incentive plan into the total compensation architecture
2. Choose the appropriate level of risk posture and time focus
3. Use objective criteria
4. Select the right set of performance measurement
5. Reward relative performance
6. Discourage narrowly restrictive behavior
7. Abandon attempts to measure what executives control
8. Strengthen the decision making horizon of the executives
9. Employ stock options judiciously
10. Ensure tax-efficiency (simple measure = post-tax benefit to manager/post-tax cost to company)
32. What are the key SEBI guidelines on Employee Stock Option Scheme? How does an indexed option work?
ANSWER:
1. Eligibility - an employee should not be a promoter and not a director who holds more than 10 percent of the outstanding equity shares.
2. Compensation committee – company should contains a compensation committee which shall be a committee of the board of directors consisting of majority independent directors.
3. Shareholder approval for ESOS
4. Pricing - company has freedom to decide the exercise price of the options to employees
5. Lock-in period and rights of the option holder - minimum of one year period between grant and vesting of options.
6. Accounting treatment - Accounting treatment of options may be determined using Black scholes model or as the difference between market price (when options are granted) and exercise price.
The Case of Indexed options:
33. What are the common ingredients of a revival plan?
ANSWER:
1. Settlement with creditors :: FINANCE (1)
2. Provision of additional capital :: FINANCE (2)
3. Divestment and disposal :: FINANCE (3)
4. Reformation of product-market strategy :: MARKETING (1)
5. Modernization of plant and machinery :: OPERATIONS (1)
6. Reduction in manpower :: HR (1)
7. Strict control over costs :: FINANCE (4)
8. Streamlining of operations :: OPERATIONS (2)
9. Improvement in managerial systems :: HR (2)
10. Workers' participation :: HR (3)
11. Change of management :: HR (4)
34. Discuss the key guidelines for corporate risk management.
ANSWER:
1. Align risk management with corporate strategy
2. Proactively manage uncertainties
3. Employ a mix of real and financial methods
4. Know the limits of risk management tools
5. Don’t put undue pressure on corporate treasuries to generate profits
6. Learn when it is worth reducing risk
35. What are the characteristics or features of intangible assets or intangible-intensive firms and what are their implications for financial management?
ANSWER:
1. Intangibles involve a large fixed (sunk) costs and negligible variable cost
2. Hazy property rights (and spillovers)
3. Investment in intangibles is comparatively riskier
4. Do not have organized and competitive markets
5. A very large portion of the value of an intangible-intensive firm is accounted for by the future growth value.
6. Find the real worth of an intangible asset
Implications for Financial Management:
1. High-risk and high return proposition
2. Hazy property rights give considerable challenge in financial management
3. Managers in an intangible-intensive business have to cope with a rapidly changing environment. Managers must constantly strive to convert potential value into actual value.
4. Rely primarily on equity financing
a. Business risk of such a firm is high, debt financing adds financial risk.
b. Lenders are typically averse to grant loans against intangible assets
c. Intangible-intensive firms have valuable growth options. Such firms need greater financial flexibility
5. Meaningful investor communication is important
36. What are financial innovations? What factors have motivated financial innovations?
