Financial Strategies For ACME Iron

CAPM

Being a part of special analyst group of ACME iron, few issues have been faced and it has been raised in front of the chief financial officer of the company. The several prospective and financial strategies have been used to evaluate the financial performance of the company. The report briefs about the various issues of the company and their suggestions for the betterment of the company. In the report, various financial strategies such as CAPM, WACC, capital investment analysis, dividend policy, bankruptcy risk analysis, decision tree creation, real option analysis etc has been done so that a better report could be prepared about the performance of the company and the position of the company.

Evaluating the financial issues of an organization and resolving them on time is crucial part of a business. It aids the business to manage and run the operations in a better and efficient way. The report briefs that the financial position of the company is average and few changes are required to be done by the chief financial officer of the company to enhance the performance and the position of the company.

CAPM stands for capital assets pricing method. This model is used by the companies to segregate the market risk and individual stock risk. CAPM measures the required rate of return of the company. For evaluating and measuring the data from CAPM model, beta, market risk and risk free return is required to be evaluated. Beta is a measurement of changes in the stock price at a particular time (Cook & Tang, 2010). It briefs about the total risk of the company. On the other hand, risk free return of a country evaluates about the total interest rate of risk free securities and the inflationary rate. Lastly, the market return stands for the total return from the industry.

In case of ACME iron, it has been found that the risk free rate of the treasury bond of 10 years is 2.79% (Bloomberg, 2018). On the other hand, the expected market return is 6% and the beta of the industry is 1.82 (Betas by Sector, 2018). Through the data, the required rate of return of the company has been calculated. The required rate of return of the company is 8.63% which briefs that the investors expect 8.63% dividend from the company (Hise & Strawser, 2013).

a) Calculation of cost of equity (CAPM) Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper
Risk free rate	2.79%
Expected market return	6.00%
Beta	1.820
Required rate of return = risk free rate + Beta * (Market rate of return – risk free rate of return)	8.63%

It briefs that if the company raise funds through equity then the business is required to pay 8.63% as dividend amount to the stockholders. The cost of equity of the company is 8.63% which is quite higher and thus the organization should enhance the funds through equity after evaluating all the other resources and the business should accept the source which is less risky and less costly (Baker & English, 2011). 

WACC

Further, for evaluating the financial performance of the company and aids the managers of the company to prepare better financial strategies, capita structure of the company has been analyzed and the WACC of the company has been measured so that a better decision could be prepared (Khamees, Al-Fayoumi & Al-Thuneibat, 2010). Capital stricture depicts about the total capital of the company which has been raised by the company through internal and external sources to rise the long term founds of the company. WACC stands for weighted average cost of capital. This process is used by the financial analyst and the professionals to evaluate the total cost of capital which would be paid by the company to the sources from where the capital has been raised (Baker, Dutta & Saadi, 2010).

In the case, capital structure and WACC of ACME iron has been calculated. On the basis of annual report of the company, it has been found that the debt of the company is $ 13,00,00,000 and the total equity of the company is 17,04,23,000. Company has rise the long term funds only through debt and equity. On the basis of evaluation, it has been found that the weight of debt of the company is 43.27% and the equity weight of the company is 56.73%.

Capital structure
	Price	Weight
Debt	13,00,00,000	43.27%
Equity	17,04,23,000	56.73%
	30,04,23,000

Further, the WACC of the company has been evaluated and it has been found that the total cost of debt of the company is 4.80% as the interest rate of the company is 8% and the tax rate of the company is 40%. Thus cost of equity of the company is 4.8% (8*(100%-40%)). In addition, the cost of equity of the company is 8.63% (Moyer et al, 2011)

Calculation of cost of debt
Outstanding debt	13,00,00,000
interest rate	8.00%
Tax rate	40.0%
Kd	4.80%
Calculation of cost of equity (CAPM)
RF	2.79%
RM	6.00%
Beta	1.82
Required rate of return	8.63%

Thus, the WACC of the company is 6.97%. The calculations of WACC brief that the cost of equity is quite higher. And at the same time, the weight of equity is also higher due to which the cost of capital of the company is also higher.

Capital structure
	Price	Cost	Weight	WACC
Debt	13,00,00,000	4.80%	43.27%	0.020771
Equity	17,04,23,000	8.63%	56.73%	0.048968
	30,04,23,000	Kd	6.97%

The WACC calculations have been done to evaluate the current cost of capital of the company and to brief the financial officer of the company about the ways through which the cost of capital of the company could be reduced.

Further, for evaluating the financial performance of the company and aids the managers of the company to evaluate the new investment opportunities, new weight average cost of capital has been calculated. WACC process is used by the financial analyst and the professionals to evaluate the total cost of capital which would be paid by the company to the sources from where the capital has been raised (Higgins, 2012).

In the case, company is planning to invest into the new project. The total initial investment of the project is $ 1 million and the cost of debt and cost of equity of the company is 8% and 12%.  The calculations of new project briefs that if the 50% funds would be raised by the company through debt and rest would be raised through equity than the total cost of capital of the company would be 10% (Brigham & Houston, 2012).

Capital Structure
Capital component	Proportion	Cost	Product
Equity	50%	12%	6%
Debt	50%	8%	4%
WACC	10%

Dividend Policy

Further, it has been evaluate that the net cash flows from the new project would be $ 73,333.33.

Cost or project	10,00,000
Cost of savings of project		1,00,000.00
Less: Depreciation		33,333.33
	EBIT	66,666.67
Less: Tax		26,666.67
Add Back: Depreciation		33,333.33
Annual cash flows after tax		73,333.33

On the basis of the cash outflows of the new project and cash inflow of the new project, the project breakeven on simple cash basis (Payback period) would be 13.64 years. And the project breakeven on the discounted cash basis would be Undefined as the total time period of cash recovery is over the useful life of the new ramp (Chandra, 2011).  

The net present value of the new project has also been evaluated to identify that whether the project would be profitable for the company or not. The net present value calculations brief that the net present value of the project is $ -3,08,693 which explains that if the organization would invest into the project then huge losses would be faced by the company (madhura, 2011).

The case briefs that AMCE Iron should not accept the proposal as the cost of capital of the company would be 10% and on the other hand, huge losses would be faced by the company.

Scenario analysis study has been done further to evaluate the different scenarios of the company and make a conclusion about the better scenario. The first scenario of the company briefs about the $ 15 million cash inflow per year for 10 years. The calculations of both the scenario are as follows:

	Occurrence	Cost of capital	Inflow	P.V.
Scenario 1	0.50%	10%	$ 1,50,00,000	$  4,21,68,507	Best project
Investment
Scenario 2	0.50%	10%	$    20,00,000	$ -3,77,10,866

Economic value added and market value added are the measurement of an organization to evaluate the financial performance o the company which is based on the residual wealth. In the case, EV, MVA, PE of industry, ACME iron and a competitor has been calculated to analyze that whether the performance of the company is good in context with the market and the industry.

The economic value added calculations of the industry, ACME iron and a competitor briefs that the EVA of all the three companies are not good. Though, the position of ACME iron is better than the industry average (Brigham & Ehrhardt, 2013). It expresses to the public about the lesser economic profits of the company. The internal positions are briefed about the EVA ratio and it explains that the performance of the company is required to be better.

Economic Value Added
		Industry Average	Competitor 1	ACME Iron
EBIT		1,79,75,000	1,82,55,000	1,07,42,000
Less: Tax		71,90,000	73,02,000	42,96,800
NOPAT		1,07,85,000	1,09,53,000	64,45,200
Capital invested	67,50,00,000	69,54,55,000	30,04,23,000
WACC		13.0%	15.0%	12.0%
Annual EVA	(7,69,65,000)	(9,33,65,250)	(2,96,05,560)

Further, market value of the companies and the industry has been evaluated and it has been found that the market value of the ACME iron is far better than the industry and the competitors. It expresses to the public about the better market position of the company. The external positions are briefed about the MVA and it explains that the performance of the company is quite better. The company is just required to maintain the same level.

Market Value Added
		Industry Average	Competitor 1	ACME Iron
Market capitalization	69,37,50,000	70,00,00,000	41,25,00,000
Capital invested	67,50,00,000	69,54,55,000	30,04,23,000
Annual MVA	1,87,50,000	45,45,000	11,20,77,000

Further, the price earnings ratio has been calculated and it has been found that the P/E position of ACEM iron is better (Baker & Wurgler, 2015). It expresses to the public about the better investment position of the company. The external positions are briefed about the PE ratio and it explains that the performance of the company is quite better. The company is just required to maintain the same level.

Calculation of price earnings ratio
		Industry Average	Competitor 1	ACME Iron
Share price	27.75	35.00	27.75
Net earnings	15000000	15000000	7045000
Shares outstanding	25000000	20000000	15000000
Earnings per share	0.6	0.75	0.469666667
P/E ratio		46.25	46.67	59.08

Leasing is a contract in which one party agrees to pay the lessor for the use of property, building or any assets. In the given case, ACME iron is thinking to take a computer on lease. The after taxes cash flow of the leasing from year 1 to year 9 are as follows:

a) After tax cash flow
Year	Lease (after tax)	Depreciation tax benefit	Total
1	-7000	-2355	-9355
2	-7000	-2355	-9355
3	-7000	-2355	-9355
4	-7000	-2355	-9355
5	-7000	-2355	-9355
6	-7000	-2355	-9355
7	-7000	-2355	-9355
8	-7000	-2355	-9355
9	-7000	-2355	-9355

It briefs that the after tax cash flow of the computer would be $ 9,355 every year till 9 years. Further, the after tax cash flow of the 0 year has been calculated and it has been found that the total computer cost is $ 70650 out of which $ 7000 has been paid by the company as lease amount and thus the total flow would be $ 63,650. The after tax cash flow of o year is as follows:

After tax cash flow
Year	Computer cost	Lease (after tax)	Depreciation tax benefit	Total
0	70650	-7000		63650

Further, the NPV of the computer has been calculated to identify the loss or the profit of the company due to lease. It has been measured that the net present value of the computer is -$ 9,774.33. It expresses that the lease contract would offer loss to the company.

Net present value
Year	Computer cost	Lease (after tax)	0	Total	P.V. Factor	P.V.
0	70650	-7000		63650	1.00	-63650
1		-7000	-2355	-9355	0.91	8504.545
2		-7000	-2355	-9355	0.83	7731.405
3		-7000	-2355	-9355	0.75	7028.55
4		-7000	-2355	-9355	0.68	6389.591
5		-7000	-2355	-9355	0.62	5808.719
6		-7000	-2355	-9355	0.56	5280.654
7		-7000	-2355	-9355	0.51	4800.594
8		-7000	-2355	-9355	0.47	4364.177
9		-7000	-2355	-9355	0.42	3967.433
Total	70650	-70000	-21195	-20545		-9774.33

And, in case, the computer has residual value worth $ 500 than the present value would be -$ 20,395.

a) After tax cash flow
Year	Computer cost	Lease (after tax)	0	Total
0	70650	-7000		63650
1		-7000	-2338.33	-9338.33
2		-7000	-2338.33	-9338.33
3		-7000	-2338.33	-9338.33
4		-7000	-2338.33	-9338.33
5		-7000	-2338.33	-9338.33
6		-7000	-2338.33	-9338.33
7		-7000	-2338.33	-9338.33
8		-7000	-2338.33	-9338.33
9		-7000	-2338.33	-9338.33
Total	70650	-70000	-21045	-20395

On the basis of both the cases (Residual value and non residual value), it has been found that huge losses would be faced by the company. Thus, it is recommended to the company to buy the computer rather than taking it on lease.

Ratios of the company have been calculated further to identify the performance and the position of the company.

Compute Internal Growth Rate:

ROA x plowback ratio/ 1-ROA x plowback ratio

ROA = Net Income/Avg. Total Assets

ROA = 7,045,000/[(435,750,000 + 459,225,000)/2}

ROA=  7,045,000/447,487,500 = 1.5743%

IGR = .015743 X 0.6667/1- (.015743x 0.6667]

IGR = .0105/.9897 = 1.061%

ROA = Net Income/ Total Average Assets

ROE = Net Income/ Total Average Equity

Compute Sustainable Growth Rate:

ROE x plowback ratio/ 1-ROE x plowback ratio

ROE = 7,045,000/[(165,726,000 + 170,423,000)/2]

ROE = 7,045,000/168,074,500

ROE = 4.192%

ROE x plowback ratio/ 1-ROE x plowback ratio

SGR = (.015743 * .6667)/[1 – (.015743 * .6667)

SGR = .0236/.9895 = 2.385

With $3 million Dividend payment

<>2015 Net Income:       7,045,000

2015 Dividends:         3,000,000

Payout Ratio:              3,000,000/7,045,000 = .4258

Plowback ratio:          Addition to retained earnings divided by net earnings

Plowback:                   4,045,000/7,045,000 = 0.5742

IG = ROA x plowback ratio/ 1-ROA x plowback ratio

IG = .015743%  x 0.5742/[(1-.015743) x 0.5742]

On the basis of the above calculations and the analysis on the income statement and the balance sheet, it has been found that the relevant dividend policy should be followed by the company (Gibson, 2011). This dividend policy briefs that the net profit must be distributed by the company amount the stockholders of the company so that they could feel motivated towards the company and invest more amount in the company.

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