1. WAAC why should managers and/or analysts add a premium to the wighted average
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Question
1. WAAC why should managers and/or analysts add a premium to the wighted average cost of capital (WACC) when determining discount or hurdle rates or minimum desired rates of return? 2. Un-levered Beta what does it mean to calculate an un-levered beta?what useful purpose does it serve to calculate an un-levered Beta? 3. Dividends & dividend policy: what are the major reasons given for companies avoiding reductions or cuts to regular dividends? 4. bankruptcy proceeding: what are the thought processes for company deciding between a chapter 7 (liquidation) and a chapter 11 (reorganization)? 5. MIRR & IRR: what are the advantages of MIRR over IRR? what are the major differences between MIRR and IRR? 6. Agency Conflicts: briefly describe what is meant by the term agency conflicts when it comes to managing large public corporations? 7. Corporate Governance: what steps can the company board of directors take to minimize or reduce the agency conflicts you described in part 6 above?
Explanation / Answer
1. Why should managers and/or analysts add a premium to the wighted average cost of capital (WACC) when determining discount or hurdle rates or minimum desired rates of return?
A- The capital funding of a company is made of 2 components- debt and equity. The company has to pay some money annually to the lenders as interest payments as well as to the shareholders as dividend. WACC is weighted average cost of capital of the company by which a company measure the amount that have to be paid to both the shareholders and lenders. But every company is in the market to make profit. So A company add premium with the hurdle rate or MARR so that the projects undertaken can generate some profit.
Let, For example, a company with a hurdle rate of 12% for acceptable projects, would most likely accept a project if it has an internal rate of return of 18% and does not have a significantly higher degree of risk. Alternately, discounting the future cash flows of this project by the hurdle rate of 12% would lead to a large and positive net present value, which would also lead to the project's acceptance. But If the IRR is 10%, the the project will not be accepted as it cannot recover the WACC and so it will make loss.
2. What does it mean to calculate an un-levered beta?what useful purpose does it serve to calculate an un-levered Beta?
A- Beta is a measure of volatility of the price of a financial asset in comparison to the market as a whole. The unlevered beta is the beta of a company without taking its debt into account. Unlevering a beta removes the financial effects of leverage.
Beta is a measure of systematic risk of a company, not financial risk. As company’s pile on more debt, they take on financial risk, not necessarily systematic risk. Thus, for an investor, it is necessary to eliminate the effects of debt from the calculation of beta to capture the true information beta is trying to tell the investor. It is better to use an unlevered beta over a levered beta when a company or investor wishes to measure the performance of a publicly traded security in relation to market movements without the effects of that company's debt factor.
3. What are the major reasons given for companies avoiding reductions or cuts to regular dividends?
A- Dividends, the cash distributions that many companies pay out regularly at the end of the year ( generally) to shareholders from earnings, send a clear, powerful message about future prospects and performance. A company's willingness and ability to pay steady dividends over time and its power to increase them provide good reputation about its fundamentals.
Dividend is the steady income for many persons especially in the developing countries who does not have a sound knowledge about stock market. A cut or reduction in the amount of dividend may cause many investors to leave the company and that will cause the share price to drop eventually.
4. What are the thought processes for company deciding between liquidation and reorganization?
A- In the liquidation process, the trustee sells the assets of the debtor and then uses the money to pay back the creditors as much as possible. Once this is done, the debtor is given a discharge, which cancels the rest of the debt permanently. The whole process takes around 6 months if everything goes according to the plan.
In the reorganization process, Reorganization is an attempt to extend the life of a company facing bankruptcy through special arrangements and restructuring in order to minimize the possibility of past situations reoccurring. This includes, restatements of assets and liabilties , reorganiza finances, rescheduling the payments etc.
Forcing a company for liquidation sometimes harm the economy but that does not mean all companies bounce bank if they are given some time. In many cases , a forced liquidation would end up causing even worse problems than bankruptcy not only for the creditors and employees of that company , but also for the shareholders and customers and suppliers. Rather big companies take help from the govt or merchant bankers to revive their situation.
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