ASSIGNMENT No. 2
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Q.1 Could a security’s intrinsic value to an investor ever differ from the security’s market value? If so, under what circumstances?
Intrinsic value is an approximation of a company’s actual true value. It does not depend on market value. Intrinsic value is one of the core metrics used to evaluate a company’s worth. The basic ideology is to make investments in companies that have a higher intrinsic or true value instead of those whose value is dictated by the market. Intrinsic value can be considered to be a part of fundamental analysis. While estimating the intrinsic value, both tangible and intangible parameters are considered. This includes market analysis, financial statements, and the business plan of the company. It is fairly a complicated procedure that one will have to go through when estimating the intrinsic value of a company. As there exist various variables such as the intangible assets of the company, the approximation of the true value of a given company may vary vastly across analysts. A few analysts will make use of the discounted cash flow analysis to cover future earnings in their calculation while some consider only the current liquid value or the book value which is reflected in the company’s latest balance sheet. Furthermore, challenges arise from the balance sheets themselves. The task of risk adjusting the cash flows is very subjective and a combination of both art and science. There are two main methods:
- Discount rate – Using a discount rate that includes a risk premium in it to adequately discount the cash flows
- Certainty factor – Using a factor on a scale of 0-100% certainty of the cash flows in the forecast materializing (This approach is believed to be used by Warren Buffett. Learn more by reading Buffett’s annual letters to shareholders)
- In the discount rate approach, a financial analyst will typically use a company’s weighted average cost of capital (WACC). The formula for WACC includes the risk-free rate (usually a government bond yield) plus a premium based on the volatility of the stock multiplied by an equity risk premium. Learn all about the WACC formula here.
- The rationale behind this approach is that if a stock is more volatile, it’s a riskier investment. Therefore, a higher discount rate is used, which has the effect of reducing the value of cash flow that would be received further in the future (because of the greater uncertainty).
- A certainty factor, or probability, can be assigned to each individual cash flow or multiplied against the entire net present value (NPV)of the business as a means of discounting the investment. In this approach, only the risk-free rate is used as the discount rate since the cash flows are already risk-adjusted.
- For example, the cash flow from a US Treasury note comes with a 100% certainty attached to it, so the discount rate is equal to yield, say 2.5% in this example. Compare that to the cash flow from a very high-growth and high-risk technology company. A 50% probability factor is assigned to the cash flow from the tech company and the same 2.5% discount rate is used.
This is due to the fact that the balance sheets are prepared internally by the company and may not always accurately represent the assets and liabilities. The market value of a company is its value as represented by the share price of the company. Hence, market value can be considerably lower or higher than the company’s intrinsic value.
The market value is often used to represent the market capitalization of a listed company and is calculated by obtaining the product of the current share price and the number of outstanding shares of the company. One should always know that the market value of a company is obtained from its present share price, and it does not always reflect the accurate worth of the company. Therefore, the market value of a company can be considered just as an estimate of public sentiment towards the company. This is because of the fact that the market value represents the demand and supply in the market, and how interested the investors are when it comes to investing in the company.
Another major difficulty in estimating the market value of the company comes when one has to account illiquid assets such as its real estate and other business operations. The market value of a company is higher than its intrinsic value when there exists a strong demand for investments which will lead to overvaluation. The vice versa will hold true if there is not much demand for investments, and this may lead to the company being undervalued.
There is a significant difference between intrinsic value and market value, though both are ways of valuing a company. Intrinsic value is an estimate of the actual true value of a company, regardless of market value.
Market value is the current value of a company as reflected by the company’s stock price. Therefore, market value may be significantly higher or lower than the intrinsic value. Market value is also commonly used to refer to the market capitalization of a publicly-traded company and is obtained by multiplying the number of its outstanding shares by the current share price. The P/B ratio is just one measure of equity valuation. Analysts commonly examine a company and its stock price from several angles in an effort to get the most accurate assessment of its genuine value. A good complementary evaluation measure to a P/B comparison is the return on equity (ROE) ratio. This is an indication of how efficiently a company is using its shareholders’ equity to generate additional profits.
If a stock has a significantly lower intrinsic value than its current market price, it looks like a red flag that the stock is overvalued. But that’s not necessarily the case.
The disparity between intrinsic value and market price is known in the investment world as the price to book ratio (P/B):
- Price is the current value of the stock as set by the market.
- Book value is the stock’s intrinsic value. It is the amount a shareholder would be entitled to receive, in theory, if the company was liquidated.
Q.2 Suppose that firm finances its seasonal (temporary) current assets with long-term funds. What is the impact of this decision on the profitability and risk of this firm?
The benefits of long-term and short-term financing can be best determined by how they align with different needs. Companies typically utilize short-term, asset-based financing when they’re first getting off the ground, and in general, this type of financing is used more for working capital. After a company grows beyond short-term, asset-based loans, they will typically progress to short-term, cash-flow based bank loans. At the point when a company starts to gain scale and establish a track record, they may access either cash-flow or asset-based, long-term financing, which has several strategic. The benefits offered by long-term financing compared to short term, mostly relate to their difference in maturities. Long-term financing offers longer maturities, at a natural fixed rate over the course of the loan, without the need for a ‘swap.’ The key benefits of long-term vs. short term financing are as follows:
Coincides with Long-Term Strategy – Long-term financing enables a company to align its capital structure with its long-term strategic goals, affording the business more time to realize a return on an investment.
Matches Duration of Asset Base with Duration of Liabilities – The maturity associated with long-term financing better coordinates with the typical lifespan of assets purchased.
Long-Term Support from Investor – A company can benefit from having a long-term relationship with the same investor throughout the life of the financing. With the right investor, companies stand to gain from a long-term relationship and partnership, in addition to ongoing support. Being that the financing is long term, a company will not have to repeatedly bring in new financing partners who may not understand the business as well, which can often happen with short-term financing.
Limits Company’s Exposure to Interest Rate Risk – Long-term, fixed-rate financing minimizes the refinancing risk that comes with shorter-term debt maturities, due to its fixed interest rate, thus decreasing a company’s interest rate and balance sheet risk.
Diversifies Capital Portfolio – Long-term financing provides greater flexibility and resources to fund various capital needs, and reduces dependence on any one capital source. It also enables companies to spread out their debt maturities.
Many companies consider long-term financing to be ‘patient’ financing, given its longer maturities (5-25+ years). Long-term financing is ideal for businesses seeking to extend or layer out their refinancing obligations beyond the typical bank tenor. Longer maturities often allow for delayed, limited or no amortization, which can be attractive to companies with objectives such as buying out a shareholder, investing in capital assets, projects or acquisitions that have a longer investment return runway. It is common for long-term financing to also have a fixed-interest rate. A long-term, largely fixed-rate balance sheet can enable companies to better manage financial risk should interest rates rise. As previously mentioned, a business would also have more time to pay back the financing, while having certainty of financing cost over the life of an investment. Long-term financing providers are typically institutional investors, such as large insurance companies, that given their capital base, have consistent capacity to lend on a long-term basis.
Long-term capital is congruent with a company’s long-term, strategic plans. Thus, it is most commonly used to support long-term initiatives, such as making acquisitions, opening a new production facility, financing internal events (like share repurchases) as well as preparing for rising interest rates; some companies choose to operate with a minimum level of debt on their balance sheet to maximize their balance sheet efficiency – managing interest rate risk for this is important and makes it a great fit for long-term capital.
It is comparatively easy to repay short-term loans than long-term ones when the need for funds decreases. Long-term funds, e.g., debenture or preference share capital cannot be redeemed before time. Therefore, when the need for finance is of seasonal/ fluctuating nature, short-term sources (for financing current assets) will be more advantageous than long-term ones from the standpoint of flexibility.
long-term finance shifts risk to the providers because they have to bear the fluctuations in the probability of default and the loss in the event of default, along with other changing conditions in financial markets, such as interest rate risk. In contrast, short-term finance shifts risk to users because it forces them to roll over financing constantly. Therefore, long-term finance may not always be optimal. Providers and users will decide how they share the risk involved in financing at different maturities, depending on their needs.
Long-term finance will be “supplied” when users want to finance long-term projects and want to avoid rollover risks and when providers/intermediaries have long-term liabilities and want to match the maturity of their assets and liabilities. However, providers of financing may at times prefer short-term contracts to guard against moral hazard and agency problems in lending. Financing contracts with a short maturity improve the lender’s ability to monitor borrowers through the implicit threat of restricted access to credit in the future in case of default. At the same time, users might also prefer short-term finance in some instances in order to match the maturity of their assets and liabilities. In this situation, long-term finance is “not preferred” (see Figure 1).
Moreover, even in situations when users and providers of finance would ideally prefer long-term finance contracts, market failures such as information asymmetries and coordination problems may cause the amount contracted in equilibrium to be lower than desired by both parties. In this situation long-term finance is “scarce” or Information asymmetries could prevent the creditor from knowing the true repayment capacity and willingness to pay of the borrower, thus making the creditor reluctant to agree to the amount of long-term finance requested. Coordination problems between lenders and borrowers may trigger a “maturity rat race” in which lenders shorten the maturity of contracts to protect their claims and shorten the average maturity of debt contracts available in equilibrium.
Governments have a role to play in promoting long-term finance when it is undersupplied or scarce because of market failures and policy distortions. The government can promote long-term finance without introducing distortions by pursuing policies that foster macroeconomic stability, low inflation, and viable investment opportunities; promoting a contestable banking system with healthy entry and exit and supported with strong regulation and supervision; putting in place a legal and contractual environment that adequately protects the rights of creditors and borrowers; fostering financial infrastructure that limits information asymmetries; and promoting the development of capital markets and institutional investors. In contrast, efforts to promote long-term finance through directed-credit, subsidies, and government-owned banks have not been successful in general due to political capture and poor corporate governance practices, and have proven costly for taxpayers.
Q.3 The probability distribution of possible net present values for project X has an expected value of Rs. 20,000 and a standard deviation of Rs. 10,000. Assuming a normal distribution, calculated the that net present value will be zero or less, that it will be greater than Rs. 30,000, and that it will be less than Rs. 5,000.
Expected Value = 20000
SD = 10000
P = 5000 < x < 30000
Q.4 DFL and graphically display of financing plans Wells and Associates has EBIT of Rs. 67,500. Interest costs are Rs. 22,500 and the firm has 15,000 shares of common stock outstanding. Assume a 40% tax rate.
- Use the degree of financial leverage (DFL) formula to calculate the DFL for the firm.
Base Level EBIT = 67,500 / {67,500 – 22,500 [0 X (1 / (1 – 0.4)]} = 67,500 / 45,000 = 1.50
- Using a set of EBIT-EPS axes, plot Wells and Associate’s financing plan.
- If the firm also has 1,000 shares of preferred stock paying a Rs. 6.00 annual dividend per share, what is the DFL?
DFL at Base Level EBIT = 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇−𝐼−(𝑃𝐷 𝑋 1 1−𝑇 ) DFL at Base Level EBIT = 67,500 / {67,500 – 22,500 [6,000 X (1 / (1 – 0.4)]} DFL at Base Level EBIT = 67,500 / (45,000 -10,000) DFL at Base Level EBIT = 67,500 / 35,000 = 1.93
- Plot the financing plan b.
- Briefly discuss the graph of the two financing plans
Q.5 Accounts receivable as collateral. Cost of borrowing Maximum Bank has analyzed the accounts receivable of Scientific Software, Inc. The bank has chosen eight accounting totaling Rs. 134,000 that it it will accept as collateral. The bank’s term includes a lending rate at prim 3% and a 2% commission charge. The prime rate currently is 8.5%. The bank will adjust the accounts by 10% for returns and allowances. It then will lend up to 85% of the adjusted acceptable collateral. What is the maximum amount that the bank will lend to Scientific Software?
First, converting R percent to r a decimal
r = R/100 = 85%/100 = 0.85 per year.
Putting time into years for simplicity,
12 months / 12 months/year = 1 years.
Solving our equation:
A = 134000(1 + (0.85 × 1)) = 247900
A = $247,900.00
The total amount accrued, principal plus interest, from simple interest on a principal of $134,000.00 at a rate of 85% per year for 1 years (12 months) is $247,900.00.
What is Scientific Software’s effective annual of interest if it borrows Rs. 100,000 for 12 months? For 6 months? For 3 months? (Assume that the prime rate remains at 8.5% during the life of the loan).
For 12 Month
First, converting R percent to r a decimal
r = R/100 = 8.5%/100 = 0.085 per year.
Putting time into years for simplicity,
12 months / 12 months/year = 1 years.
Solving our equation:
A = 100000(1 + (0.085 × 1)) = 108500
A = $108,500.00
The total amount accrued, principal plus interest, from simple interest on a principal of $100,000.00 at a rate of 8.5% per year for 1 years (12 months) is $108,500.00.
For 6 Month
First, converting R percent to r a decimal
r = R/100 = 8.5%/100 = 0.085 per year.
Putting time into years for simplicity,
6 months / 12 months/year = 0.5 years.
Solving our equation:
A = 100000(1 + (0.085 × 0.5)) = 104250
A = $104,250.00
The total amount accrued, principal plus interest, from simple interest on a principal of $100,000.00 at a rate of 8.5% per year for 0.5 years (6 months) is $104,250.00.
For 3 Month
First, converting R percent to r a decimal
r = R/100 = 8.5%/100 = 0.085 per year.
Putting time into years for simplicity,
3 months / 12 months/year = 0.25 years.
Solving our equation:
A = 100000(1 + (0.085 × 0.25)) = 102125
A = $102,125.00
The total amount accrued, principal plus interest, from simple interest on a principal of $100,000.00 at a rate of 8.5% per year for 0.25 years (3 months) is $102,125.00.
