Corporate Finance Issues - Assignment Example

CORPORATE FINANCE Name: University: Date: Answer Sheet Part A) 30 Multiple Choice Questions Write the letter that corresponds to your selected answer, on this answer sheet. 1. B 26. B 2. C 27. D 3. D 28. C 4. A 29. C 5. B 30. D 6. A 31. A 7. A 32. D 8. B 33. B 9. A 34. D 10. D 35. B 11. C 36. C 12. D 37. C 23. C 38. A 24. C 39. B 25. A 40. C Question 2: International Finance a) I. USD 0.6164 = 1 C$ USD 1.0821 = (1.0821/0.6164) = 1.75552 C$ Therefore, the exchange rate will be given as 1.75552 C$/euro or 0.56963 Euro/ C$ ii. (US $0.6164/C$) / (US $ 1.0821/euro) = 0.5696C$/euro It follows that the triangular arbitrage will be demonstrated as follows given the following exchange rate; U.S.$0.6164 / C$, €0.6064 / C$ and U.S.$1.0821 / €. Exchange US $ 1000000 into 1622323C$ (using exchange rate U.S.$0.6164 / C$) Trade 1622323C$ for 983777 Euros (using exchange rate €0.6064 / C$) Convert 98377 Euros into US $ 1064545 (using exchange rate U.S.$1.0821 / €). In the above process, the bank makes a riskless profit of US $ 64545 b) I. (1 + r¥)/ (1+r$) = (¥/$f)/ (¥/$s) the condition should hold where the interest parity is not violated. To confirm such consistencies, it will be given as; (1 + 0.05)/ (1 + 0.04) = (131.6136/131.4924) 1.05/1.04 = 1.001 1.001 = 1.001 Therefore, the interest rate parity holds in this case. ii. The interest rate parity enables the investors to access currency in an affordable rate of interest, convert the available cash by use of the spot rates in hand and also be able to enter into the forward contract in an attempt to realize cash plus the high expected interest. In addition, the investments will be done at a higher rate of interest, conversion of cash back via forward contract and repayment of the interest plus the principle amount in which the interest paid will obviously be lower than the interest received. c) When a company involves in the foreign exchange transactions, various risks are imminent to hinder its overall smooth flow of operations. Among them include the economic risk, transaction risk and translation risks. Transaction risk involves the risk associated with exchange rate where there is a delay in time when entering into a specified financial contract and when settling it. For instance, where the time difference between settlement period and the date of entering the contract is large then the company will face a greater transaction risk. This is due to the availability of more time for fluctuation of the exchange rate. Economic risk involves the risks associated with the frequent changes in the economy. The companies involved in international trade are not able to predict effectively the changes that the economy can experience in the long run. For instance, the economic recession in which the world faced in the early 2008 affected the financial exchange market and the exchange rate declined tremendously. Such effect made the investors to shy away from investing in the stock markets especially the ones outside their domestic country. Currently, the financial analysts predict future economic implications that will be experienced in the financial sector. For instance, the ‘exit strategies’ deployed by governments and central banks of industrialized countries may impede economic development it the near future. In this case, the Central Banks will foster the reduction in the currency supply in order to impede drying up of markets. Such practices will have an effect in the exchange rate and cross-border investors will be adversely affected. Translation risk is the risks associated with the changes imminent on the financial statements of the companies which indulge themselves with foreign transactions. As such, where the balance sheet is dominated with foreign assets, equity and liability then the company is facing highest translation risk. This is due to the effect of frequent changes in the exchange rate. In the economy, the exchange rate usually changes quarterly and therefore will be inconsistent with the reported figures in the balance sheet. Despite these risks that the financial company faces when indulging in foreign exchange transactions, hedging need to be put into consideration in order to ensure that these risks are mitigated. This include: forward contract, future contracts, call option, currency swap among others. In future contract, the company enters into a transaction with the buyer on the sell of the stock and they agree upon the date in which the payment will be made and also the exchange rate that will be applicable at that time. The future contract is usually entered into by the seller when the current exchange rate is unfavourable. Forward contract, on the other hand, involves the buyer and seller fixing a date in which they can indulge in the transaction. They also agree on the exchange rate in which they will use during that specified period. Such contract can be advantageous to both sides as during the period set, the exchange rate can be either lower than the fixed one (benefiting the seller) or higher than the fixed rate (benefiting the buyer). Currency swap involves dealing with another company in a different geographical region. The borrowing company agrees to pay the amount plus the interest therein in the domestic currency in which the amount is equivalent to the Net Present Value of the borrowed amount in the foreign currency. No cross border transactions take place. Question 3: NPV and WACC a) NPV for project A = - 250000 + 25000/1.1 + 125000/1.12 + 175000/1.13 = $116174 The project shows a positive NPV indicating that investing on the project will add value to the company. NPV for project B = -250000 + 150000/1.1 + 100000/1.21 + 75000/1.331 = $25358 The project shows a positive NPV showing that the project will imminently add value to the Company. b) According to the NPV criterion, the company needs to invest in a project where NPV is greater than or equal to zero. It, therefore, implies that both the projects add value to the company but project A is more beneficial to project B as it yields high positive NPV. As such, under independent projects, the two projects will be selected as it provides a positive NPV c) In the case of mutually exclusive projects, only the one with the highest positive value is selected. This implies that project A will be preferred to project B as it yields high positive NPV. d) As the cash flows are discounted annually, the difference in the reported cash inflows for the two projects will not yield the same NPV. Indeed, for the project to realize high positive NPV it should be able to record high cash inflow at the final periods of operations. e) Increase in the cost of capital to 15% will change the management decisions. As such, project B will yield a positive NPV and project A will have a negative NPV. This shows that the company will select project B. f) The change in the cost of capital will either decrease the present value of cash inflows by lower magnitude or higher magnitude. The impact will be felt on the overall yield of the cash inflows and as such increase or decrease the NPV of the projects. g) NPV uses discount rate to come up with appropriate investment decision. The discount rate in which the management selects is based on the weighted average cost of capital (WACC). Question 4: Efficient Market Hypothesis a) Stock market overreaction and under reaction involves the changes in the stock prices will face in the volatile economy. The basis of these changes is the information supplied to the economy. The research findings showed that when new information is highly preferred by investors compared to old ones. Therefore, where there is new information circulating in the market, the rational investor will otherwise make a judgment basing it on that new information. The advocates of market efficiency argue that such manifestation will have an adverse effect to the overall performance of the stock market in the economy. As such, investors are not willing to analyze the new information available critical before making an informed decision. This may lead to poor decision making hence financial loss by the investor. b) In the stock market, anomalies are experienced during the stock trade. Some of the anomalies which are imminent include: post earnings announcement drift anomaly, accruals anomaly, share repurchases, insider trading among others. For effectiveness in the stock market, the management needs to identify and eliminate these anomalies with ease. These anomalies are brought about by the new information being circulated in the economy. This is in consistent with the semi strong market efficiency as it is also brought about by the effect of new information in the economy. c) In a semi-strong economy, neither technical analysis nor fundamental analysis will increase the return yield for the stock available in the economy. Therefore, it implies that the company can only trade on the existing prices in order to yield the return that other investors are earning. This will only be applicable when the information on the stock distribution by the company is made public. d) The random walk concept followed by stock prices shows the stock prices in the stock market are not consistent and changes rapidly and frequently with changes in the information available in the economy; either publicly or privately. However, the stock prices are consistent with efficient market hypothesis. e) The stock investment follows the sophisticated filter rules as it incorporates any slight changes in the stock market perceptions. For instance, new information available to the investors in the economy will inherently change the stock market trading. f) The financial market efficiency shown by the returns of the two stocks is that of weak-form efficiency as the future prices cannot be predicted with ease. This is evident by the inconsistent changes in the stock returns. Investors are not able to acquire the full information on the available stocks in the stock market. g) The market efficiency is strong-form as both the public and private information available is utilized by the investors in the economy. Therefore, no single investors can possess advantage over the other in the prediction of the stock prices. References Berk, J. D. 2007. Corporate finance. London: Pearson Addison Wesley.pp 45-69 Ross, S. W. 2006. Corporate Finance. New York: McGraw-Hill/Irwin.pp 102-152 Read More