The objective of the given report is to answer the financial questions with regards to different aspects of NPV coupled with risk and return related discussion. In this regards, reference has been given to the portfolio theory and theoretical underpinnings related to capital budgeting. Additionally, the client investments have also been critically analysed in order to provide advice to the client with regards to the appropriate choice so as to maximise returns on the investments at hand. A key limitation is that the analysis has been based on standard assumptions related to NPV and other valuation models such as dividend discount model which may not be true.
1) The central tenet of portfolio theory is that the risk and return tend to be correlated. It is based on the assumption that investors are risk averse and therefore to invest in a risky asset class, compensation is required in the form of higher returns. The stock market investments need to be viewed in the backdrop of portfolio theory. The average returns of the stock market tend to exceed the average returns of lower risk class assets such as bonds. This indicates towards higher risk being present which need to be properly managed to reduce exposure (Damodaran, 2015).
With regards to stocks, there are two types of risks namely systematic risk and unsystematic risk. Systematic risk is also called as non-diversifiable risk as it is a general risk associated with market investment and cannot be mitigated using portfolio or diversification. On the other hand, unsystematic risk is the diversifiable risk and therefore can be managed by diversification of the portfolio. In this regards, it is noticeable that the risk associated with the stock is captured by the standard deviation of the stock returns. Through diversification, there tends to some natural hedge and hence the deviations from mean is lowered which enables lowering of risk (Northington, 2015).
In order to maximise the benefits of diversification, it is essential that the portfolio must contain of stocks that are negative correlated since this tends to reduce the diversifiable risk component to almost zero. For example, comprising the portfolio of a company which exports goods and one which imports goods would make the portfolio stable in time of volatile currency. However, through perfect diversification also, risk cannot be made zero since systematic risk would still be present which would be captured using beta. This term represents the underlying risk associated with the portfolio or stock and is used to deriving expected returns (Petty et. al., 2015).
2) There are two main conditions which ought to be fulfilled in order to ensure that WACC of the firm is used for assessing new projects. One key requirement is that the new project should have similar risk profile in comparison to the firm as a whole. If the project has higher or lower risk in comparison to the average risk of the firm, then the WACC also needs to be revised upwards or downwards respectively. This is because the underlying returns expected on funding would be dependent on the perceived risk of the project (Parrino and Kidwell, 2014).
Another key aspect is that the capital structure related to funding the project should match the existing capital structure of the firm. IF there is any significant difference in this regards, then the firm WACC cannot be used for the project (Brealey, Myers and Allen, 2014).
3) a) The decision rule for NPV is that the project which has a positive NPV must be selected. However, in case of mutually exclusive projects, even if a project has positive NPV, it may not be selected as the alternative project may have a higher positive NPV. Thus, for a project with positive NPV to be selected, it is imperative that the company should have enough resources particularly finance for implementing the project. In case of shortage of finance, projects having the highest positive NPV are selected and those at the lower end are ignored (Arnold, 2015).
1) The first step is to compute the required return on equity for the Lloyd stock which would require the use of CAPM Model (Arnold, 2015).
Required return on equity = Risk free rate + Beta*Market Risk Premium
Considering the given data, the following computation can be made.
Required return on Lloyd share = 4 + 1.4*(10-4) = 12.4 %
In order to estimate the fair price of the stock in 2017, it is imperative to use the Gordon Dividend approach highlighted below (Brealey, Myers and Allen, 2014).
Intrinsic share price = Next year dividend/( Required return – Perpetual growth of dividend)
Thus, based on the dividend history, the next year dividend and also the dividend growth rate till perpetuity ought to be determined.
It is apparent from the dividend history of the company that the dividend in 2010 was $ 0.3 while the corresponding value in 2016 stands at $ 0.5.
Hence, dividend growth rate = [(0.5-0.3)/0.3]*100 = 66.67%
However, the above growth has been achieved over a period of 6 years, hence annual growth rate = 66.67/6 = 11.11%
Expected dividend in 2018 = 0.5*1.1111 = $ 0.5556
Expected stock price at the end of 2017 = 0.5556/(0.124 -0.111) = $ 43.06
Expected stock price at the end of 2016 = 43.06/1.124 = $ 38.3
It is apparent that at the existing price the stock is strongly undervalued and hence it makes sense to invest in the given stock (Northington, 2015).
2) a) The various assumptions related to dividend growth model are indicated as follows (Petty et. al., 2015).
Total preference shares = 100,000
Hence, market value of preference shares = 8.65*100000 = $ 865,000
Current price of common share = $ 2.95
Total common shares = 500,000
Hence, market value of common shares = 2.95*500000 = $1,475,000
The market debt of debt can be computed as indicated below.
Total capital = Sum of market value of debt, preference shares and common shares = $ 5,456,689.54
Weight of preferences shares = 865000/5,456,689.54 = 0.1585
Weight of ordinary shares = 1475000/5,456,689.54 = 0.2703
Weight of debt = 3116689.54/5,456,689.54 = $ 5712
Hence, after tax debt cost = 9% (1-0.3) = 6.3%
Cost of preference shares = (Dividend/Market Price) = (1.20/8.65) = 13.87%
Cost of equity can be computed using the Gordon dividend approach.
Cost of equity = (0.25*1.04/2.95) + 0.04 = 12.81%
WACC = 12.81% * 0.2703 + 13.87% * 0.1585 + 6.3%* 0.5712 = 9.26%
3) In the given case, since the life of the two projects is different, hence the NPV of the projects would be used to compute the equivalent annual annuity using the formula indicated as follows (Damodaran, 2015).
Project 1 Equivalent Annual Cash Flow
Initial outlay = $ 13 million
Annual cash flows = $ 3.5 million
System life = 8 years
It is assumed that the annual cash flows tend to take place at the end of the year.
The present value of annuity can be found using the following formula (Parrino and Kidwell, 2014).
For the given case, P = $ 3.5 million, r=14%, n= 8 years
NPV = [3.5 *(1-1.14-8)/0.14] – 13 = $ 3.24 million
Equivalent annual cash flow = 0.14*3.24/(1-1.14-8) = $ 0.697 million
Project 2 Equivalent Annual Cash Flow
Initial outlay = $ 18 million
Annual cash flows = $ 6 million
System life = 5 years
It is assumed that the annual cash flows tend to take place at the end of the year.
The present value of annuity can be found using the following formula.
For the given case, P = $ 6 million, r=14%, n= 5 years
NPV = [6 *(1-1.14-5)/0.14] – 18 = $ 2.60 million
Equivalent annual cash flow = 0.14*2.60/(1-1.14-5) = $ 0.700 million
Based on the above analysis, it is apparent that the preferred project would be Project 2 as it has a higher equivalent annual cash flow. Hence, the company must invest in this project.
Conclusion & Recommendation
From the above discussion, it can be concluded that diversification tends to reduce the stock risk by eliminating the unsystematic risk. The client is recommended to invest in Lloyds Ltd stock as currently the stock is highly undervalued. Also, with regards to RunRig Ltd, the WACC has been computed as 9.26% by considering the individuals weights and costs of individual sources of financing. In relation to the telecommunication sector start-up company, it would be preferable to invest in Project 2 as the equivalent annual cash flows would be greater in this case.
References
Arnold, G. (2015) Corporate Financial Management. 3rd ed. Sydney: Financial Times Management.
Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 6th ed. New York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
Northington, S. (2015) Finance, 4th ed. New York: Ferguson
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publication
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. and Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French Forest Australia
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