Summary results of financial tasks

Review the scenarios through 9. Assemble a report responding to the tasks you have been given by the Controller. Structure your report so it is clear which task you are addressing. Summarize the results of each task in the body of your report and refer to the detailed supporting calculations contained in your excel work sheet. This is a “lessons learned” report as well as your showcase for your individual thoughts and recommendations on all items completed during the semester.

Task 1 – Assessment

As it relates to task 1, the task leverages the capital asset pricing model to determine an adequate rate of return for an investment. From the task, the betas obtained from Yahoo finance are often below meaning that the covariance between the stock and the overall market is not high. Within task 1, there was a beta of .59. This indicates for every 1 percentage point increase in the market, the stock only goes up roughly .59. This may indicate a very stable and mature company that doesn’t have much price volatility as compared to the market. One area of concern related to task 1 is the equity risk premium. Here, the risk premium seems rather low considering the low interest rates prevailing in the market. I believe the expected return should be somewhat higher considering the robust GDP growth America has experienced recently, low interest rates, and accommodative monetary and fiscal policy. As a result, the expected market return should be somewhere near 9% and is calculated as 2-3% GDP growth, 2-3% inflation, and a 2-3% dividend yield. When combined, the expected market return should be somewhere between 6% and 9%. As the country is expected to experience rapid growth after COVID-19 due to pent up demand the return should probably be closer to 9%.

I disagree with the task statement noting that the industry is less risk because the industry beta is .88. Beta does not measure risk. It measures volatility which is not synonymous with risk. For most real-world investors, risk is defined as the propensity for permanent capital loss. Beta only shows how a particular stock price moves in relation to the market which again, does not measure riskiness. Likewise, during a market decline a stock with a beta of 2 will presumable decline twice as fast of the market. If the stock price is lower, then the stock is actually less risky for the investor as they are receiving more value when they purchase the stock. For example, if an investor believes the stock is worth $50 and the stock falls to $25 during a market decline, the security is much less risky as the investor has a much larger margin of safety when purchasing during a market decline. As a result, I disagree that with the task 1 statement that industry is less risky.

A lesson learned from Task 1 is that market return expectations can vary quickly as market conditions change. In addition, analyst should use other measurement techniques in conjunction with Beta to measure the overall riskiness of a particular stock.

Task 2 – Assessment

WACC is a very important concept as it relates to the ACME company and its ability to finance projects. In task two we learned that the WACC of the ACME company is relatively as compared to the required return base on CAPM in task 1. The WACC in task two was low due in part to the high leverage being employed in the business. In Task 2, ACME is using roughly 63% debt financing which significantly lowers its WACC due to how inexpensive debt financing is. This is also what is occurring in the real world as companies are raising record levels of debt financing at very low interest rates. The low interest rate environment has enabled companies to borrower a very low rates, therefore allowing them to serve the debt much more easily. Companies are also refinancing their debt to lower their overall WACC. With a higher proportion of cheaper debt within their capital structure companies can lower their overall WACC while also increasing their overall market value added. By also having a lower WACC, the hurdle rate for projects to be accepted is also much more likely. In the case of Task 2, the overall WACC was 3.8%. As a result, a project with return higher than this WACC will add value to the organization. Projects that return less than the 3.8% should be rejected based on their inability to add value to the organization. These projects due to their low return actually destroy value in the organization and should therefore be avoided. WACC therefore helps in capital budgeting decisions that will have implications for the company for many years into the future.

Lessons learned from Task 3 is that WACC is used heavily within the capital budgeting process to better ascertain if a project should be accepted or rejected. With a low interest rate environment, it is to the companies benefit to have a larger proportion of their capital structure in debt securities as to lower the overall WACC of the company. Management should be conservative with the total quantity of debt as to avoid financial constraints during an economic recession.

Task 3 – Assessment

Task 3 provided an example of NPV calculations and how they are related to the acceptance of a project. NPV provides management with a simple tool to assess the validity of a capital project. As ACME is in a heavily capital-intensive industry, NPV is needed to provide guidance as to what projects should accepted and what projects should be rejected. NPV operates under the principles associated with the time value of money. Cash flows that are further out into the future are worth less to the company than cash flows that occur within the first few years. This is due to the fact that cash flow further out is much riskier as they are less certain. In addition, the company loses the ability to invest near-term cash flows and earn interest. As a result, the company must discount these future cash flows into their equivalent value today. This is essentially the premise of NPV calculations and are often the foundation for capital budgeting decisions. High returning projects generate the highest NPV and therefore add value to the organization. Likewise, negative projects actually destroy value within the organization and should therefore be rejected. With many of the assets that ACME will be investing in, a large proportion of them will have very long useful lives. As a result, it is important to forecast future cash flows resulting from these investments and discount them at an appropriate interest rate. The interest rate that is typically used is the WACC along with an adjustment for inflation. Projects with a positive NPV are typically accepted while those with a negative NPV are rejected as they destroy value for the organization. The same project noted in Task 3 had a negative NPV of -$308,692.97 which resulting in the project being rejected.

Task 3 also details the payback period which is essentially the length of time needed to pay back the initial investment. This is very similar to break even analysis and is critical to the capital budgeting decisions making process. Higher payback period indicates higher profitability and therefore a high return project. Using both the NPV and the payback period, the capital project in Task 3 should be rejected

Lesson learned during this task is that NPV calculation are crucial within the capital budgeting process. In addition, a variety of tools such as NPV, payback period, discounted payback period and much should be used when evaluating a particular project

Task 4 – Assessment

Although NPV, in its basic form, allows managers to make capital budgeting decisions, they often don’t take into account options. From a real-world perspective, projects often come with many options that account for the uncertainty related to their future cash flows. In addition, financial resources are limited thus requiring managers to select various capital project with various options that can maximize shareholder wealth. As it relates to ACME, as a capital-intensive company these options can have both positive or negative ramifications for the business. For ACME’s business, management often utilizes decision trees that provide management with an “invest” or “don’t invest” thought process. The investment decision is then segmented into various outcome depending on various circumstances prevailing at a given moment. These options range from an outcome with a positive NPV to outcomes with significantly negative NPV calculations.

The lesson learned here is that business environments are often unpredictable and often involve a litany of differing scenarios and variable. Through a proper decision tree, management can look to account, and prepare for the most likely scenarios. This ultimately allows management to better account for both adverse and positive outcomes and format a plan of action. This is critical from a business perspective as the overall economic environment can be unpredictable as the world has realized with COVID-19. As a result, management needs a mechanism to help mitigate losses in the case of an adverse outcome while also investing to help generate shareholder wealth.

Task 5 – Assessment

Economic value add and market value add are critical elements in the evaluation of a business. As task 5 indicates, EVA is a tool used extensively to properly measure the true value a business is creating over its cost of capital. This is an important measure because it can help determine if the funds invested in the organization are resulting in a positive output for the company. If the formula is positive the funds are producing profits, but if the result is negative the company is not receiving a benefit of the invested capital. EVA analysis is important as it helps manager avoid many of the common pitfalls and traps associated with business valuation. One such technique is the use of EBITDA as a means to measure profitability and value creation. Many companies use this term as a means of indicating cash flow but in many instances this figure is very misleading. For, interest, taxes, and depreciation are all real business expenses that should be accounted for in the evaluation process. Depreciation in particular is the worst kind of expense as companies must pay for the property, plant and equipment upfront and then depreciate the asset later on over many years. ACME in particular is a capital-intensive business that will require large investments in property, plant and equipment. To provide figures that exclude depreciation in this respect is misleading to both management and to potential investors. The same goes for both interest and taxes. Both of the expenses are very real and should therefore be accounted for in the evaluation of the business.

With EVA Analysis the company uses the Net Operating Profit after tax (NOPAT), which is a much more effective measurement of business performance when compared to either EBIT or EBITDA. When reviewing ACME, the company unfortunately has a negative EVA due primarily to the large amount of capital needed to be invested into the business. The industry overall has a negative EVA as competitors also require large amounts of invested capital in order to properly operate. This is combined with a relative low amount of NOPAT resulting from the heavily capital expenditures, resulting in no value added.

As it relates to Market Value Added or MVA, the company performs much better. MVA is calculated as the market value of ACME’s shares subtracted by the book value of company’s shareholders’ equity. Here both the industry and ACME have positive MVA with ACME being well above the industry average.

Task 5 next discusses the P/E ration and market capitalization. The price to earnings ratio indicates the amount of money an individual investor is paying for each dollar of earnings. P/E ratios are heavily used be investors in order to evaluate how cheap a particular is relative to peers in the industry. It also allows investors to determine the overall value they are receiving with each share they purchase. A low or high P/E by itself does not indicate if a stock is “cheap” or “expensive.” For example, a low P/E stock may have a low multiple because its future growth prospects are limited. Likewise, a high P/E stock may be due to the fact that the business was temporarily depressed and therefore earnings were low relative to historic levels. Finally, interest rates and market sentiments can impact the P/E ratio. Currently, many investors are very optimistic about the future prospects of American business. As a result, stocks are trading a very high multiples relative to historical standards. Low interest rates and accommodative monetary and fiscal policy has also created asset price inflation as it relates to stocks. Finally, overoptimism from retail investors as it relates to stocks like GameStop and AMC has also created vary dramatic changes in P/E ratios.

As it relates to ACME, the company has the highest P/E in relation to its peer competitor and the industry overall at 58.55. Investors are willing to pay premium prices for the earnings of the business. This may indicate an optimistic outlook on the company and the industry overall. It may also indicate that the industry and the company may be overpriced. Market capitalization is the market price of the shares multiplied by the overall shares outstanding. This figure essentially shows what the business is worth.

The lessons learned during task 5 is that investors should not rely on a single metric such as P/E to evaluate a stock or a business. It is also important for investors to recognize the value added to the company above its WACC.

Task 6 – Assessment

Task 6 is another example of NPV calculation and how they are applied to equipment being leased by ACME. Much like the prior tasks, NPV indicates the overall value creation from a project or capital budgeting decisions. Decisions with a positive NPV should be accepted while those with negative NPV outcomes should be rejected. This particularly NPV calculation adds a few addition variables such as after-tax cash flows and a corporate tax rate. Understanding which cash flows are relevant is key to determining the best financing methods or project acceptance. It also helps to detail all assumptions within the model since questions may arise years after the initial construction of the model. As it relates to leasing a new computer, the NPV was negative and should therefore be rejected.

The primary lesson learned in this task is associated with the appropriate discount rate to use when discounting future cash flows. A small change in the discount rate can have a disproportionate impact on the overall outcome of the NPV calculation.

Task 7 – Assessment

Distribution to shareholders in the form of dividends and share buyback are important decision for CFO’s. Distributions ultimately reward investors with a return while also retaining earnings for future dividend growth in the upcoming years. Share buybacks help to improve the share of earnings attributable to the investor. As it relates to the decision to distribute earnings, the CFO must be confident that earnings in the future will be able to cover dividends. Shareholders and market participants react negatively to dividend cuts as it is a signal the company may not be performing well and therefore can not pay them. As a result, the CFO should have an adequate dividend coverage ratio that takes into account any potential decline in business activity. In the case of ACME, the company is retaining roughly 36% of its earnings within the business and paying out roughly 64%. Here, the company should continue to maintain the dividend as coverage appears adequate. As noted in the Task 5, the stock is trading a very high P/E multiple with may indicate the stock if fully valued. Therefore, the company should not return capital to shareholders in the form of a buyback simply due to the potentially overvaluation of the stock price. Here continuing to pay the dividend would be the best course of action for the CFO, being mindful of small dividend raises in conjunction with overall business performance.

Task 8 – Assessment

Task 8 was related to share repurchases with the same lessons learned as noted in task 7. Share buybacks are advantageous when shares can be purchased for less that what the company is worth. By doing so the existing ownership of the shareholders that remains is improved without them having to purchase any additional shares. Share buybacks also have tax advantages as investors are often taxed on dividend distributions. Share buybacks often do not come with the same tax consequences as those of dividends. A repurchase notice may be viewed as a real signal that the administration considered the shares are underestimated/undervalued. Shareholders have a preference if they want money, they can offer their shares, receive the money, and give the taxes, or they can hold their shares and evade taxes. If the corporation boosts the dividend to dispose of excess funds, this greater dividend must be sustained to avoid unfriendly share price reactions. A stock repurchase, on the other hand, does not obligate administration to planned repurchases. It restructures the corporation capital structure without expanding the corporation's debt load.