Corporate Finance Assignment Sample

Here’s the sample of corporate finance assignment.

Introduction

Financial management is a significant process that is associated with managing the fund. The term financial management can be defined as the planning, organising, directing and controlling. In the financial management, an organisation takes the different kind of the decision including investment decision, financial decision and dividend decision. Basically, the financial management includes two terms such debt financial and equality finance. In this, cost of the equity is a significant where a company has to take decisions (Bali and Engle, 2010). Cost of equity can affect the various decision of the company. In order to calculated the cost of the equity different methods are used by the firm. This report enhances knowledge cost of equity finance using the dividend growth model and cost of equity by using the capital asset pricing model (CAPM) in the context of Hiscox plc.  

Cost of equity finance using the Dividend Growth Model

In the term of the financial management, the cost of equity is paid against the fund of the shareholders. It is a kind of the return that is expected by the investor in the market to receive from an investment in a business. The cost of the equity is also known as the compensation that is provided by the shareholder to the company to achieve the financial and operation goals and objectives. In the order words, cost of equity is cost of the company that is paid as return to the equity investors of the company (Bekaert and Engstrom, 2010).

Dividend growth model is one of method that is used in the calculation of the cost of the equity. It is subject of the great depth and complexity to valuate equity. The evaluation of the equity provides the depth understanding the business. It also provides an effective forecasting of the performance of the company. It is because it is essential to select an appropriate method helps the company to minimise the cost of the equity. This method is also known as the dividend discount model. Cost of equity can be used with the help of Gordon’s Dividend model. The model focuses on the dividends growth model is on the provided dividend to the equity shareholder of the company. As per this model, the cost of the equity is calculated on the basis of the current market price and the future expected dividends of the company. In this method, cost of the equity is found when these two things are identified equal (Cai, 2010).     

The cost the equity is well known concept as well it is more important what company is earning from the raised equity. Under the process of calculating the cost of equity by the dividend growth model, the earning from the cost of the equity is linked with future value of the stock of the company. By the help of the comparing dividend growth rate, investor can find the actual rate of return. Mainly, it is based on the current situation of the company in the context of the profit earning. In another words, the cost equity is rate of return that is provided to equity shareholders.    

From the annual report of the company, it is found that Hiscox is using the both kinds of the finance such as debt and finance and equity fiancé in the business operation (Dempsey, 2013).  But, the main purpose to calculate the cost of equity. According to the annual report 2016 of the company, it is found that the total equity of the company is 1,818,403 (£000) (Hiscox Plc, 2016).     

Cost of equity = Ke = (D1 / P0) + g

P0 = current market value of equity, ex-dividend = 1, 818,403

D1 = expected dividend = 466270345.4

Ke = cost of the equity = 26%

g = Constant Maturity Rate = 2.39

= 26 + 2.39

= 28.39%

From the above calculation, it can be interpreted that cost of the equity by the dividend growth model is 28.39%.  

Cost of equity by using the Capital Asset Pricing Model (CAPM)

Capital asset pricing model is also a significant method of calculating the cost of the equity finance of the company in the capital management. The capital assets pricing model is a kind of model that determines the relationship between systematic risks and expected return for assets particularly stock of the company (He, Lepone, and Leung, 2013)  Mainly this model is used in the case of the risky securities in the market. CAPM is used by different financial analyst in the accounting, in order to provide the relationship between risk and expected return. The risk related with the financial investment can be secured for the investors by the use of this method. In the security market, many securities contain high risks and some have low risk in the investment return. CAPM measures the investment risk in the form of beta that shows the investment risk in the measurable format (Dhaliwal et al., 2014). This method is very useful for the investors to obtain risk free rate of return and develop the understanding in which security an investor should invest. This method is highly used by financial professionals to calculate the required returns on the provided risk size.

CAPM = Risk free rate of return + beta of assets * market premium

Risk free rate of return = 2.39%

Beta of assets = 0.59

Market premium = 6%

Cost of equity = 0.0239 +   0.59 *0.06

= 5.9%

From the above calculation by using the CAPM, it is found that the cost of the equity for Hiscox plc is 5.9%. It means that company pays 5.9% dividend to its equity shareholder. In the calculation of cost of the equity by CAPM, the formula that is used is Risk-Free Rate of Return + Beta of Asset * market premium rate. In this, it is found that the risk free rate of return as the risk free rate is used as the 10 year treasury constant maturity rate that is found 2.39%. At the same time, the beta of the company is found 0.59 and market premium rate is identified 6%. Hence, it is calculated that the cost of the equity finance for Hiscox is 5.9% for the financial year 2016. It means that company is paying £5.9 against £100 investment. As concerning of total equity of the company and percentage of the cost of the equity, it is found that the total cost of the equity is £107285800 (£1, 818,403000 * 5.9%).           

Dividend Growth Model v/s Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a financial theory that calculates the relationship among risk and expected return on the investment. While, the Dividend Growth Model assumes that the future dividend per share grow with the constant rate. According to the research study of Barberis, et al. (2015), the CAPM includes the systematic risks only that provides the real cost of values to the investors. In this method, al the unsystematic risks are eliminated during the analysis of the assets price. At the same time, CAPM is a simple method as comparison of dividend growth model and easily use. It provides the possible outcomes for the required rate of return and the investor can grow their money to authentic estimation (Kung and Schmid, 2015). The CAPM model helps the investor to provide the risk of the market or company and generalise the issued stock of the company. But in concern to Dividend Growth Model, it is only applicable to provide the current paying of the dividend on share.

The CAPM model develops the theoretical relationship among the return and risk to provide accuracy in the expected returns by testing and research. The rate of return on the dividends are grow in constant and reasonable rate but Dividend Growth Model not increase with the growing rate and there is not relationship among the risk and return (Kogan and Papanikolaou, 2014). Furthermore, Dividend Growth Model also provides the net present value of the future dividend based on the stock value. This model is commonly used for calculating the share price of the company but CAP model only presents the future dividend price of the share. The CAPM is the good technique to calculate the growth of the investment that protects with the different investment and market risk to the investor. It provides the diversification option to change the investment organisation in case one fails. The CAPM is also helpful to provide overall portfolio protection from the different market risk.

The rate in dividend per share has constant growth that is the main limitation of this model (Ai, et al., 2012). This model cannot be used in the estimation of the cost of equity because it needs the value of stock and estimated growth rate of investors. So, most of the invest managers uses CAPM for defining the dividend rate of the investment. Decision related with the finance can be taken with traditional techniques but financial decisions are taken with the use of CAPM for the sound judgement. It is because it presents realistic and useful estimations of the cost of equity capital to take the accurate decisions. But in order to use CAPM, there is a need of the different values for the risk free rate of returns, market return, and equity risk premium (Dempsey, 2013). Whereas, the dividend growth model does not openly believes on thinks which is related with risk. At the same time, CAPM provides batter dividend rates then dividend growth model to the investors which are helpful to attract more investors for the company.

Need to calculate the cost of equity finance accurately

An organization needs to accurately calculate the cost of equity finance for satisfying the investors. The accuracy in the calculation of cost of equity finance is very necessary to maximize the value of firm (Dhaliwal, et al., 2014). If the average cost of capital is reduced then it can help to improve the value of firm. The capital structure is the combination of both debt and equity that saves the business from the different financial risks. On the other hand, the calculation of the cost of equity finance is also helpful to take the business decision related with the capital budgeting. The accuracy in the estimation of the cost of capital is very necessary to evaluate the attractiveness of the investment. If rate of return is more than cost of capital of the firm then the project is accepted during the internal rate of return method.

The cost of equity finance is also helpful to evaluate the financial performance of the company’s top management. The actual profitability of the organisation can also be compared by the use of cost of equity in the investment project (Farre-Mensa, and Ljungqvist, 2016). It provides the rate of return on the investment to the investors which is helpful to provide the idea that which investment is batter. The cost of equity also defines the required rate of return on the investment project to invest. According to the current business scenario, the value of the firm can also be increased by the use of accurate cost of equity calculation by the organisation. At the same time the cost of capital provides the effective debt and equity to the organisation in the capital structure that help the company to analyse the financial risk of the business and increase the investment (He, et al., 2013). The accuracy in the calculation of the cost of equity also helps the investors to invest in the right company. It is because it provides the analysis of the different organisation accurately and provides the equity cost for comparison.

In order to manage the working capital, the cost of capital plays a significant role by calculating the cost of carrying investment. It also helps to evaluates the different strategies concerning with the receivables. In addition to this, the cost of equity capital also plays an important role to take the decisions regarding the dividends. For this, the firm decides the dividend policy on the basis of the nature of the firm such as growth firm has different policy then decline firm. At the same time, the capital structure of the company is also determined by the use of the cost of equity finance in the company (Hwang, et al., 2013). In order to design the optimum capital structure, the debt and equity of the company is accurately provided. The overall cost of capital should fulfil the objectives of the company.

Calculation and discussion the return expected by shareholders to compensate

Financial risk

In the business environment, investors use the some ratios in order to calculate the financial risk at the time of making the investment decision. For this, the ratio that mainly used is debt to capital ratio, debt to equity ratio. In the context of Hiscox that ratios are calculated below.

Corporate Finance Assignment

Debt to capital ratio – this ratio is calculated to measure the leverage that provides a basic knowledge of the financial structure in terms capital (Duffie, 2010) . In order to calculate this ratio, the formula is used that is Debt / (shareholder’s equity + debt)

Debt of the company = 4,823,375

Shareholder’s equity and + debt = 6,641,778 

= 4,823,375 / 6,641,778 

= 0.72

 

Debt to equity ratio – It is also a significant ratio that is used by the investors to compare the equity finance and debt finance. It is calculated in the below manner:

= Total debt / Total equity    

Total debt = 4,823,375

Total equity = 1,818,403

= 4,823,375 / 1,818,403

= 2.65

From above calculation, it is found that Hiscox believes in the debt finance instead of the equity finance. Due to this, investors of the company are secure. Hence, there is minimum financial risk to invest in company.      

Business risk

In the share market, when an investor goes for investment decision then it evaluated the business risk of the company (Engsted and Pedersen, 2010). For this, it calculated profitability situation of the company. For this, gross profit margin and net profit margin can be calculated. In the context of Hiscox, net profit margin and gross profit margin is below

Net profit margin – It shows the ability of the management to generate the profit that can be calculated in the below manner: 

NPM = Net profit / net sales * 100

= 336,986 / 2,402,579 * 100

= 14%

Gross profit margin – it depicts the ability of the company to maintain the cost sold that is calculated in the below manner.

= Gross profit / net sales *100

= 1,787,943 / 2,402,579 * 100

= 74%

Hence, it can be said that profit margin of the company is relevant and appropriate the business risk. Due to this, investment decision in Hiscox will be good.            

The minimum risk present in the financial system

In the calculation of the cost of equity by using the CAPM, beta value is considered that determine the risk presented in the financial system. The beta value above than1.0 shows that the financial system of the company can be more risky (Farre-Mensa and Ljungqvist, 2016). On the other hand, beta value less than 1.0 indicates the less risky financial system. In the CAPM, beta value is identified 0.59 that is below than 1.0. It means financial system of Hiscox contain the minimum risk for the investors. Hence, the decision of the investment will be beneficial.         

References

Ai, H., Croce, M.M. and Li, K., (2012) Toward a quantitative general equilibrium asset pricing model with intangible capital. The Review of Financial Studies, 26(2), pp.491-530.

Bali, T.G. and Engle, R.F. (2010) The intertemporal capital asset pricing model with dynamic conditional correlations. Journal of Monetary Economics, 57(4), pp.377-390.

Barberis, N., Greenwood, R., Jin, L. and Shleifer, A. (2015) X-CAPM: An extrapolative capital asset pricing model. Journal of Financial Economics, 115(1), pp.1-24.

Bekaert, G. and Engstrom, E., (2010) Inflation and the stock market: Understanding the “Fed Model”. Journal of Monetary Economics, 57(3), pp.278-294.

Cai, F. (2010) Demographic transition, demographic dividend, and Lewis turning point in China. China Economic Journal3(2), pp.107-119.

Dempsey, M., (2013) The capital asset pricing model (CAPM): the history of a failed revolutionary idea in finance?. Abacus, 49(S1), pp.7-23.

Dhaliwal, D., Li, O.Z., Tsang, A. and Yang, Y.G., (2014) Corporate social responsibility disclosure and the cost of equity capital: The roles of stakeholder orientation and financial transparency. Journal of Accounting and Public Policy, 33(4), pp.328-355.

Duffie, D. (2010) Dynamic asset pricing theory. UK: Princeton University Press.

Engsted, T. and Pedersen, T.Q. (2010) The dividend–price ratio does predict dividend growth: International evidence. Journal of Empirical Finance, 17(4), pp.585-605.

Farre-Mensa, J. and Ljungqvist, A., (2016) Do measures of financial constraints measure financial constraints?. The Review of Financial Studies, 29(2), pp.271-308.

He, W.P., Lepone, A. and Leung, H., (2013) Information asymmetry and the cost of equity capital. International Review of Economics & Finance, 27, pp.611-620.

Hwang, L.S., Lee, W.J., Lim, S.Y. and Park, K.H., (2013) Does information risk affect the implied cost of equity capital? An analysis of PIN and adjusted PIN. Journal of Accounting and Economics, 55(2), pp.148-167.

Kogan, L. and Papanikolaou, D., (2014) Growth opportunities, technology shocks, and asset prices. The Journal of Finance, 69(2), pp.675-718.

Kung, H. and Schmid, L., (2015) Innovation, growth, and asset prices. The Journal of Finance, 70(3), pp.1001-1037.

Lewellen, J., Nagel, S. and Shanken, J. (2010) A skeptical appraisal of asset pricing tests. Journal of Financial economics96(2), pp.175-194.

Ross, S.A. (2013) The arbitrage theory of capital asset pricing. In HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING: Part I (pp. 11-30).

Hiscox Plc (2016) Annual report [Online] Available at http://www.hiscoxgroup.com/investors/report-and-accounts/latest-report.aspx

 

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