Assignment Code: MMPF-002 / TMA / JULY / 2022-23

Course Code: MMPF-002

Assignment Name: Capital Investment and Financing Decisions

Year: 2022 - 2023

Verification Status: Verified by Professor

Note: Attempt all the questions.

Q 1. What do you understand by capital structure? Explain the various theories of capital structure and discuss the similarities and dissimilarities between Net Income Theory and Modigilian – Miller (MM) Theory.

Ans) Capital structure refers to the mix of debt and equity that a company uses to finance its operations and investments. It is the way in which a firm chooses to raise funds to finance its operations, growth, and investment opportunities. The capital structure decision is important because it affects the cost of capital, the risk profile of the firm, and the value of the firm.

There are various theories of capital structure, including:

1. Net Income Theory: Net Income Theory suggests that the value of a firm is independent of its capital structure. This means that the firm's value is determined by its earning power, which is measured by its net operating income (NOI). The cost of capital remains constant, regardless of the debt-equity mix. According to this theory, the value of the firm is maximized when the cost of debt and equity is equal, which is known as the "optimal capital structure." This theory assumes that there are no taxes, transaction costs, or bankruptcy costs.

2. Modigliani-Miller (MM) Theory: This theory suggests that the value of a firm is determined by its cash flows and is independent of its capital structure. According to this theory, the value of the firm is determined by its expected cash flows discounted at the cost of capital. The cost of capital is a function of the riskiness of the firm's cash flows, not its capital structure. This theory assumes that there are no taxes or transaction costs, but bankruptcy costs exist.

Similarities between Net Income Theory and MM Theory

1. Both theories suggest that the value of a firm is independent of its capital structure.

2. Both theories assume that there are no taxes or transaction costs.

Dissimilarities between Net Income Theory and MM Theory:

1. The Net Income Theory assumes that bankruptcy costs do not exist, while MM Theory assumes that they do exist.

2. The Net Income Theory assumes that the cost of capital remains constant, regardless of the debt-equity mix, while MM Theory assumes that the cost of capital is a function of the riskiness of the firm's cash flows, not its capital structure.

3. The Net Income Theory is based on the assumption of a perfect capital market, while MM Theory is based on the assumption of an imperfect capital market.

One of the main assumptions of the Net Income Theory is that there are no taxes. In reality, most companies are subject to taxes, which can affect the cost of capital and the optimal capital structure. In addition, the theory assumes that there are no transaction costs, such as the costs of issuing new securities or paying dividends, which can also affect the firm's value. Another assumption of the Net Income Theory is that there are no bankruptcy costs. However, bankruptcy costs can be significant, and they can increase as the firm becomes more highly leveraged.

One of the key assumptions of the MM Theory is that there are no taxes. However, in the real world, taxes are an important consideration in the capital structure decision. Specifically, the tax deductibility of interest payments makes debt financing more attractive than equity financing. Another assumption of the MM Theory is that there are no transaction costs. In reality, transaction costs such as underwriting fees and legal expenses can be significant, particularly for small firms. Finally, the MM Theory assumes that bankruptcy costs exist. This is an important consideration when determining the optimal capital structure, as the costs of bankruptcy increase as the firm becomes more highly leveraged.

In summary, while both Net Income Theory and MM Theory suggest that the value of a firm is independent of its capital structure, they differ in their assumptions about taxes, transaction costs, and bankruptcy costs. The Net Income Theory assumes that these costs do not exist, while MM Theory assumes that taxes and bankruptcy costs exist, but transaction costs do not. It's important to keep these assumptions in mind when considering the capital structure decision for a real-world firm.

Q 2. How is cash flow for capital budgeting estimated? Describe and distinguish the Net Present Value (NPV) method and Internal Rate of Return (IRR) methods of Capital Budgeting.

Ans) Cash flow estimation is a critical component of capital budgeting, as it helps firms determine the expected cash inflows and outflows associated with a particular investment opportunity. There are several steps involved in estimating cash flows for capital budgeting:

Determine the initial investment required for the project

1. Estimate the cash inflows that are expected to be generated by the project over its life.

2. Estimate the cash outflows associated with the project, including operating costs, maintenance costs, and taxes.

3. Estimate the salvage value of the project at the end of its life.

Once the cash flows have been estimated, firms can use various capital budgeting techniques to evaluate the investment opportunity. Estimating cash flows is a crucial aspect of capital budgeting. The goal is to determine the expected cash inflows and outflows associated with a particular investment opportunity. The estimation of cash flows involves several steps, including the determination of the initial investment required for the project, estimation of the expected cash inflows that the project will generate over its life, estimation of the cash outflows associated with the project, and estimation of the salvage value of the project at the end of its life. Two commonly used methods are the Net Present Value (NPV) method and Internal Rate of Return (IRR) method.

Net Present Value (NPV) method

The NPV method involves discounting the estimated future cash flows of an investment back to their present value using a discount rate that reflects the time value of money and the risk associated with the investment. The NPV is calculated by subtracting the initial investment from the present value of the expected cash inflows, taking into account the expected cash outflows. If the NPV is positive, the investment is expected to generate a positive return and is considered acceptable. If the NPV is negative, the investment is not expected to generate a positive return and should be rejected. The NPV method helps firms make informed investment decisions that take into account the opportunity cost of the investment. The NPV method also allows firms to compare investment opportunities with differing cash flows, allowing them to choose the most profitable opportunity.

Internal Rate of Return (IRR) method

The IRR method calculates the internal rate of return that makes the present value of the expected cash inflows equal to the initial investment. The IRR is the rate at which the NPV of an investment is zero. The IRR is a measure of the investment's profitability, and it is compared to the required rate of return or cost of capital to determine whether the investment should be accepted or rejected. If the IRR is greater than the required rate of return or cost of capital, the investment is expected to generate a positive return and is considered acceptable. If the IRR is less than the required rate of return or cost of capital, the investment is not expected to generate a positive return and should be rejected. The IRR method is useful because it provides a simple measure of the investment's profitability. It is easy to communicate and understand, and it provides a clear measure of the return on the investment. The IRR method also takes into account the time value of money, as it discounts the future cash flows back to their present value.

Differences between NPV and IRR

While both the NPV and IRR methods are commonly used in capital budgeting, they have some key differences. The key difference between the NPV and IRR methods is that the NPV method focuses on the absolute dollar value of the investment, while the IRR method focuses on the rate of return generated by the investment. The NPV method is generally considered to be more dependable, as it takes into account the time value of money and the risk associated with the investment. The IRR method, however, is easier to understand and communicate, as it provides a simple measure of the investment's profitability. Both methods can be used in conjunction with one another to evaluate investment opportunities and help firms make informed capital budgeting decisions.

Q 3. What do you understand by Business and Financial risks? Explain the process of determining Asset Betas.

Ans) Business risk and financial risk are two important concepts in finance that are used to evaluate the risk associated with an investment or a business.

Business Risk

Business risk refers to the risk inherent in the operations of a business, such as the risk of competition, changes in consumer preferences, technological changes, and other external factors that may impact the business's ability to generate profits. Business risk is specific to the industry in which the business operates and is often measured by analysing the business's revenue and earnings volatility. Businesses with high levels of business risk are more vulnerable to external factors and are generally considered riskier investments.

Financial Risk

Financial risk, on the other hand, refers to the risk associated with the use of debt or other financial leverage to finance a business or investment. When a business takes on debt, it is obligated to pay interest and principal payments to its creditors. The use of debt can increase the potential reward for shareholders, but it also increases the risk. If the business is unable to generate enough cash flow to meet its debt obligations, it may default on its debt and face bankruptcy. Financial risk is often measured by analysing a business's debt-to-equity ratio, interest coverage ratio, and other financial metrics that assess the company's ability to meet its debt obligations.

It is important for investors and analysts to evaluate both business risk and financial risk when making investment decisions. A business with high business risk and low financial risk may be a good investment if it has a sustainable competitive advantage, while a business with low business risk and high financial risk may be riskier if it has a high debt load that could lead to bankruptcy. The appropriate level of business risk and financial risk varies depending on the investor's risk tolerance, investment objectives, and other factors. Determining asset betas is an important step in estimating the cost of equity capital using the Capital Asset Pricing Model (CAPM). Asset betas represent the risk of a particular asset relative to the overall market, and they are used to estimate the expected return of the asset based on the expected return of the market.

The process of determining asset betas involves several steps:

1. Identify the asset: The first step is to identify the asset for which you want to determine the beta. This could be a stock, bond, or any other asset that is publicly traded.

2. Determine the period for the analysis: The next step is to determine the period for which you want to analyze the asset's returns. Typically, a period of three to five years is used to capture long-term trends in the asset's returns.

3. Collect the asset's historical returns: The next step is to collect the historical returns of the asset over the chosen period. This can be done using financial databases or other sources of financial information.

4. Calculate the asset's average return: Once the historical returns have been collected, the next step is to calculate the average return of the asset over the chosen period. This can be done by taking the sum of the returns and dividing by the number of periods.

5. Calculate the market's average return: The next step is to calculate the average return of the market over the same period. This can be done by taking the average returns of a market index, such as the S&P 500.

6. Calculate the asset's excess returns: To calculate the asset beta, the excess returns of the asset over the market must be calculated. This can be done by subtracting the market's average return from the asset's average return for each period.

7. Calculate the asset beta: Once the excess returns have been calculated, the asset beta can be calculated by dividing the asset's average excess return by the market's average excess return. The resulting number is the asset's beta, which represents the risk of the asset relative to the overall market.

It is important to note that determining asset betas is not an exact science and requires some judgment. The choice of the period for the analysis, the choice of the market index, and other factors can affect the accuracy of the beta calculation. Additionally, asset betas are subject to change over time as the risk of the asset and the overall market changes. As a result, it is important to regularly review and update the asset betas used in the CAPM to ensure that they reflect the current market conditions.

Q 4. Explain the various non-traditional sources of long-term financing and bring out their relative advantages and disadvantages.

Ans) Non-traditional sources of long-term financing refer to sources of funding for businesses that are outside the traditional banking system. These sources of financing have become increasingly popular in recent years, especially among small and medium-sized enterprises (SMEs), as they provide access to capital when traditional financing options are not available or are insufficient.

Non-traditional sources of long-term financing include:

1. Crowdfunding: Crowdfunding is a method of raising capital from a large number of people, typically through online platforms. This can include equity crowdfunding, where investors receive a share of the company in exchange for their investment, or reward-based crowdfunding, where backers receive a product or service in return for their contribution. Crowdfunding is the practice of raising funds from a large number of individuals via an online platform. Crowdfunding platforms can be divided into four categories: donation-based, reward-based, equity-based, and debt-based crowdfunding.

2. Peer-to-peer lending: Peer-to-peer lending (P2P lending) involves individuals lending money to other individuals or businesses through online platforms, bypassing traditional financial institutions. This can be an attractive option for borrowers who may not qualify for traditional bank loans, and for investors seeking higher returns than those offered by savings accounts or other low-risk investments.

3. Angel investors: Angel investors are high net worth individuals who invest their own money in startups or early-stage companies in exchange for equity. They often provide not only funding but also mentorship and guidance to the companies they invest in.

4. Family offices: Family offices are private wealth management firms that manage the assets and investments of high-net-worth families. Some family offices also invest in startups and private companies, providing long-term financing for these companies.

5. Corporate venture capital: Corporate venture capital (CVC) is the practice of established companies investing in startups and early-stage companies in their industry. This can provide startups with access to the resources and expertise of the larger company, while also providing the larger company with potential investment opportunities and insights into emerging technologies and markets.

6. Initial Coin Offerings (ICOs): ICOs involve the creation and sale of a new cryptocurrency or token to investors, typically through blockchain-based platforms. While ICOs have come under scrutiny for their lack of regulation and potential for fraud, they have also provided a new source of funding for startups and blockchain projects.

Advantages of non-traditional sources of financing:

1. More accessible: Non-traditional sources of financing can be more accessible to small businesses, startups, and individuals who may not have access to traditional financing options, such as bank loans or venture capital.

2. Greater flexibility: Non-traditional sources of financing can offer greater flexibility in terms of the amount and terms of the financing. For example, crowdfunding platforms can allow businesses to raise smaller amounts of funding from a large number of backers, while P2P lending platforms can offer more flexible repayment terms than traditional bank loans.

3. Potential for higher returns: Non-traditional sources of financing, such as angel investing or ICOs, can offer the potential for higher returns on investment than traditional financing options.

4. Access to expertise and resources: Some non-traditional financing options, such as corporate venture capital or family offices, can provide startups with access to valuable resources, expertise, and networks.

Disadvantages of non-traditional sources of financing

1. Riskier: Non-traditional sources of financing can be riskier than traditional financing options, as they may lack regulatory oversight and be subject to greater volatility.

2. Lack of established track record: Many non-traditional financing options, such as ICOs or equity crowdfunding, are relatively new and lack an established track record of success.

3. Potentially higher costs: Some non-traditional financing options, such as P2P lending, may have higher interest rates or fees than traditional bank loans.

4. Potential for conflicts of interest: Non-traditional financing options that involve investment from individuals or entities with other business interests, such as family offices or corporate venture capital, may create conflicts of interest or put pressure on the company to prioritize the interests of the investor over the business.

Overall, non-traditional sources of financing can offer unique advantages and disadvantages compared to traditional financing options. Companies should carefully consider their options and seek advice from experienced professionals before pursuing any particular financing strategy.

Q 5. Who are the stakeholders of a company? The different types of stakeholder’s demand what types of information.

Ans) Stakeholders of a company are a diverse group of individuals and organizations with various interests and expectations, and the company's success depends on balancing and satisfying the needs and expectations of all stakeholders.

They can be divided into two categories: internal and external stakeholders:

Internal Stakeholders

Internal stakeholders are individuals or groups that are directly involved in the operations and management of the company, such as:

1. Shareholders or owners of the company who have invested capital in the business and own a portion of the company.

2. Board of Directors who are responsible for overseeing the management of the company and ensuring it operates in the best interests of the shareholders.

3. Employees who work for the company and are directly impacted by its decisions, policies, and practices.

4. Management team who are responsible for running the day-to-day operations of the company and making strategic decisions.

External Stakeholders

External stakeholders are individuals, groups, or entities that are indirectly affected by the

operations of the company, such as:

1. Customers who purchase the products or services of the company.

2. Suppliers who provide goods or services to the company.

3. Creditors who lend money to the company, such as banks or bondholders.

4. Government agencies that regulate the operations of the company or provide support in the form of grants, tax breaks, or loans.

5. Community and society at large who are affected by the company's activities, such as environmental impact, social responsibility, and economic development.

6. Stakeholders play an important role in the success of a company, and it is important for companies to identify and engage with their stakeholders to ensure that they are meeting the needs and expectations of these groups.

Different types of stakeholders demand different types of information depending on their specific interests and concerns. Some examples are:

Shareholders: Shareholders are interested in the financial performance of the company, including revenue, profits, dividends, and stock price. They also want to know about the company's future plans and strategies, risks, and potential returns on investment.

Board of Directors: The Board of Directors is responsible for overseeing the management of the company and ensuring that it operates in the best interests of the shareholders. They want to know about the company's financial and operational performance, risks, and strategic plans. They also require information about compliance with legal and regulatory requirements.

Employees: Employees are interested in job security, compensation, benefits, and opportunities for advancement. They want to know about the company's financial performance, including revenue, profits, and bonuses, as well as plans for expansion, layoffs, or restructuring.

Management Team: The management team is responsible for running the day-to-day operations of the company and making strategic decisions. They need information about the company's financial and operational performance, risks, opportunities, and competitive environment. They also require information about the availability of resources, such as capital and human resources.

Customers: Customers are interested in the quality, price, and availability of the company's products or services. They also want to know about the company's reputation, social responsibility, and environmental impact.

Suppliers: Suppliers are interested in the company's financial stability, ability to pay bills on time, and long-term prospects. They want to know about the company's order volume, payment terms, and product quality requirements.

Creditors: Creditors are interested in the company's ability to pay back loans or bonds on time and in full. They want to know about the company's financial performance, credit rating, collateral, and cash flow projections.

Government Agencies: Government agencies are interested in the company's compliance with laws and regulations, environmental impact, social responsibility, and economic impact. They want to know about the company's financial performance, taxes paid, and employment statistics.

Understanding the specific information needs of different stakeholders is crucial for companies to maintain good relationships with these groups and to achieve their overall business objectives.