Topic: Advance Corporate Finance and Question One Critically evaluate the strengths and weaknesses of the CAPM Investors are said to be rational and undertaking investment is a risky activity. Investors expect adequate compensation for the risks they take in investment activities. CAPM is a tool used by investors in assessing and evaluating the risks involved in investing in a given security. Systematic and market risks affect returns on investment (Wajeeh & Trainor, 2008, p. 243). Financial instruments require critical analysis and assessment of the risks involved in order to make the right choice.
CAPM has been criticized and termed ineffective but it has a number of strengths. Acknowledges the rationality of investors CAPM treats investors as rational decision making units. Acknowledging this fact makes it easier for evaluations and assessments to be conducted, given that an investor will expect maximum benefit from investing in a given instrument. The higher the risks involved, the higher the expected returns. Time The model does not ignore the fact that the value of money changes with time. The value of a given amount of money today will not be the same at a later date for the same amount.
It therefore provides a basis for this adjustment and further provides a coherent and a systematic procedure for the incorporating money value over time in investment plans. Risks CAPM does not treat the financial markets as perfect markets. Although it assumes that capital markets are perfectly efficient, it does not rule out occurrences of risks. Depending on the affinity to take risks, investors vary from risk neutral, risk averse to risk takers. The model outlines an evaluation criterion for each of them in computing the expected return of a financial instrument given the risks involved.
On the other hand, the CAPM has a number of identified weaknesses which include: The assumption of normally distributed asset returns is not realistic. This is because; equity returns fail to actualize this assumption among other market in the financial markets. As a result, the market experiences significant swings that are far beyond being considered a normal distribution. Stock returns vary and the model fails to explain such variations. The return on a given investment may be higher or lower than that predicted by the model.
This failure to provide firm grounds for risk and return assessments and evaluations show that the model has its shortcomings. The model shows that the variance of returns is an adequate measurement of risk (Wajeeh & Trainor, 2008, p. 441). This is true only when the assumption of normal distribution is considered. However, the normal distribution of returns has been disputed due to swings observed in the markets from time to time. This fails to acknowledge that investors have preferences and the variance of returns may not be an effective measure in this case. Investment activities require that costs be incurred before returns are reaped.
Taxes are also charged by the relevant authorities in the economies that financial markets operate. This model ignores these facts. The assumption of no taxes and no transaction costs is not realistic in a real world scenario. Critically evaluate one alternative model Weighted Average Cost of Capital (WACC) Capital is not obtained without incurring a cost. WACC is the calculation of the cost of capital to a firm, where each capital category is proportionately weighted (Wajeeh & Trainor, 2008, p.
456). This model recognizes the various sources of capital available to a firm. Equity returns and risk valuations are employed in this model. An increase in return on equity will increase the WACC of the firm. The same effect is generated when risks are high and valuations are decreasing. Debt and equity are the main sources of finance to a firm’s assets. A firm’s required return given its operation and performance is given by WACC. Question Two The trade-off theory is a critical assessment of the benefits and costs of financing a firm through debt.
The trade-off between the two factors provides an optimal capital structure for the firm according to this theory (Wajeeh & Trainor, 2008, p. 504). Financing decisions are central to the operation and performance of a firm. Cost and capital and taxes are key influence in financial decision making processes. Debt is a major source of finance for many firms. Employing this theory depends on the firm’s ability to integrate the variables it considers in its actual operations. High profit making firms are characterized by a low debt ratio.
This theory may hold in financial decision making since for such firms, savings on tax interest is possible if such firms raise their debt ratios. Different firms have different preferences when it comes to financing its operations. Almost every firm prefers internal financial sources to external sources. On the same note, borrowing is considered better than the issuance of securities that carry high risks. Whatever the case, there lacks perfect information. As a result, discrepancies arise between managers, shareholders and lenders as to the best decision to make and what actions to take.
Such are the arguments of Pecking Order theory in capital structure context. This among other theories are evaluated and assessed in the light of the performance of a firm, and the most suitable holds in the capital structure-financial decisions in a firm. Question Three Investors expect adequate compensation for the risks they take or rather face in investment activities. One the ways that investors are compensated is by payment of dividends by a firm to the firm’s investors. There are numerous arguments as to when and how dividends should be paid.
Some argue that dividends maximize investor wealth, while othersdispute the argument. In some instances, dividends have been considered irrelevant, but it all depends on the dividend policy adopted by the firm. Empirical testing of dividend policies is necessary because investors have different preferences about dividends and so are the paying firms. High, low or dividend irrelevance pay-out has been found to be valid in the context of the different identified clientele in investment activities (Brigham and Houston, 2004, p. 113). The main idea is to maintain dividend stability that further makes it possible to maintain a favourable stock price.
Investors who require steady cash flows from their investments may not find a firm that does not pay dividends favourable. However, all other factors that affect the stock price other than the straight pay-out should be considered in determining when and how to make dividend pay-outs. Question Four It is important that firms consider the welfare the shareholders. Shareholders form a fundamental component of the firm. The operation and performance of a firm is bound to the demands and interests of the shareholders.
Shareholder wealth maximization in the light of aligning performance measures is not an easy task. This is due to the existence of a number of hindering factors, one of them is the agency problem. The ideas and interests of the shareholders may differ from those of the management. The goals pursued at such an instance are likely to conflict, distorting measures tailored towards achieving some specified desired goals like shareholder wealth maximization. An investment is held for a specific period of time. Within this time, capital gains and dividends are earned by that investment.
The accumulated returns over the holding period are referred to as the total shareholder return. It can also be defined in terms of internal rate of return (IRR) considering the total cash flows within the investment period. Both EP and EVA are used to indicate the generation of an economic value. Increased EP and EVA depict an increased economic value, a situation that shows a positive value for the shareholders. An opposite scenario shows that the capital of the firm is eroding and shareholder wealth maximization is hard to achieve on such a trend.
Balancing shareholder wealth maximization in the context of improved performance measures is challenging. Another concept integral to performance measures and shareholder wealth maximization is the Market Value Added (MVA). Bond and shareholders make capital claims to a company. Summed claims and the market value of debt and equity constitute the MVA (Wajeeh & Trainor, 2008, p. 611). Shareholder wealth maximization isthe light of residual wealth and the performance of the firmposes a challenge to the alignment of performance measures for the firm. Question Five Management buy-outs – Shareholders have controlling rights in the various firms that they are attached to.
Existing shareholders of a given firm can sell their controlling interest to the management or the executive of the firm. The purchase of the shareholders’ controlling interest by the executive or the management is referred to as management buy-out. Divestments – This is the process through which assets are sold. It is simply opposite to investment. Acquisitions – These are actions taken by corporates where a company buys a significant amount or all stakes of ownership of the target firm, such that the stake selling firm is now controlled by the buying firm.
Acquisitions mostly occur as firms pursue growth, expansion and development. Corporate restructuring plays a central role in determining the value of a firm over time. However, difficulties in measuring the firm value are evident given the restructuring mechanism that a firm adopts. Divestments and acquisitions can be used to determine the value created by the corporate restructuring process. A number of factors influence corporate restructuring in the context of divestment and acquisition.
They include: future expectations of business performance of the firm, long term financing sources, trends of firm portfolio over time, competition and competition strategies adopted by the firm. Difficulties involved in the process of measuring firm value are based on the ability to balance debt and equity of the firm. References Brigham & Houston. (2004). Fundamentals of Financial Management (Concise 4 e). Mason, Ohio: South-Western Division of Thomson Learning. Wajeeh, E., & Trainor, T. (2008). Advanced Corporate Finance: A Practical Approach. First Edition. California: Pearson Education.