Question

Answer three parts of the following question. Your answer for each part should be no longer than two pages long (a) The Gordon Growth Model (GGM) says that all else equal, share prices are an increasing function of return 1. on equity (ROE). Outline how a manager could potentially boost their company's share price by increasing return on equity. Explain your answer (b) Outline graphically the difference between the minimum variance frontier when investors can invest only in risky assets and the capital allocation line where risky and riskless assets are available to the investor? (c) The relationship between the present value of growth opportunities (PVGO) and share valuation. (d) In their 2010 survey of the capital budgeting practices of Irish firms, Kester and Robbins (2010, pg. 81) conclude: "the respondents in our survey indicated that the DCF technique NPV was the most important measure for decision making, followed closely by payback". Based on your knowledge of capital budgeting/investment appraisal techniques, compare and contrast the NPV and payback techniques. (e) Compare and contrast the capital and security market lines. Explain your answer (f) Outline with the aid of an example, the relationship between bond prices and interest rates.

Answer 1

The three parts that I have answered are “a”, “d” and “f”.

(a): Return on Equity (RoE) is a popular measure of profitability and is computed using the formula: RoE = equity earning/average net worth. The numerator of this ratio is profit after tax less preference dividends. The denominator includes all contributions made by equity shareholders (paid up capital+reserves and surplus). RoE can also be called as return on net worth.

An increasing RoE indicates that profitability of equity funds that are invested in a firm are rising. In other words it indicates an increase in the productivity of the ownership capital in the firm. Now managers can boost their company’s share price by increasing RoE. This is because increasing RoE indicates increasing productivity of the ownership capital in the firm and as such more people will want to invest their money in the firm. This will increase the demand for the shares of the company resulting in an increase in their prices. Increasing RoE will indicate increasing profitability and so the shares of the company will start commanding a premium over and above their intrinsic value, resulting to increase in share prices.

(d): NPV technique of capital budgeting is the technique in which the sum of the present value of all cash flows – positive as well as negative – is considered. These cash flows are expected to occur over the life of the project.

Formula: NPV = sum of all (till n) Ct/(1+r)^t – Initial investment

In the above formula Ct = cash flow at the end of year t, n = life of the project, r = discount rate.

Payback period, on the other hand, is the length of time that is required to recover the initial cash outlay. For example if the investment in a project is $600,000 and the cash inflows are $100,000, $150,000, $150,000 and $200,000 in years one to four then the payback period is 4 years. This is because at the end of the 4^th year cash outflow of $600,000 = cash inflow of $600,000.

NPV is an attractive capital budgeting tool as NPVs are additive, the intermediate cash flows are invested at cost of capital, NPV allows for time varying discount rates. On the other hand the payback period is not as attractive as an investment tool as it ignores the time value of money. Secondly all cash flows beyond the payback period are not considered. This leads to a tendency of having a bias against long term projects in the payback method.

(f): An inverse relationship exists between bond prices and interest rates. When bonds are issued the coupon rates are usually very close to the prevailing market interest rates. The reason for the inverse relationship between bond prices and interest rates is due to the concept of opportunity cost. When interest rate rises it will create a situation in which the coupon payments of the bonds are lower than the market interest rate. As such the bonds become less attractive to investors and hence their prices decline. When interest rate falls the coupon rate of the bonds (which are fixed at all times) will become higher than the market interest rates and this will make the bond more attractive for investors. This will cause the price of the bond to rise.

To explain with the help of an example consider that company XYZ is issuing bonds at 7% coupon rates. A bond holder will receive $70 as coupon payments each year (assuming a face value of $1000). Now suppose that the interest rate goes up and the market interest rate is 8%. Thus people will not be willing to pay $1000 for the bond that is still paying 7%. This will force company XYZ to sell its bonds at a lower price. In the opposite situation when interest rate falls to 6% the bonds will be paying a higher rate and hence it will be priced at a premium.