Question

1. Cash Flows and Present Value:

a) Briefly describe the consistency principle in Discounted Cash Flows Model. Discuss its application in evaluating a firm’s different sources of capital (debt, equity and firm). [8 Marks]

b) Discuss the specialty of FCF and WACC in terms of the consistency principle.

2. Capital Structure Question

a) Briefly define the term of Business Operational Risk and discuss its major risk elements or components (what activities are related to the operational risk) [6 Marks]

b) Briefly define the Financial risk and describe the basic financial risk under the perfect market condition (no tax, no transaction costs, no information effects and no bankruptcy costs) [5 Marks]

c) List and explain three types of financial risks additional to the basic form mentioned in the question b) above

Answer 1

1. Cash flow and present value:

a) Consistancy principal in discounting cash flow:

Consistency Principle is one of the four major principles that are used for estimating the project cash flows. According to this principle, consistency in the cash flows is very necessary. At the same time, consistency in the applicable discount rates on the cash flows should also be maintained. The most important is the consistency of the discount rate that is to be applied on the project cash flow. There are two types of discount rate known as the weighted average cost of capital and cost of equity.

Consistency in discounting modle:

Since the consistancy is very important for evaluate the accurate measures, one must ensure this into specially in discounting models. It should be notted that the discouting rates shall be even over the period of time.For accurate result one must ensure the aplication of the principle in numeraters, denominations and discounting factor in this model.

b)Consistency principle in FCF:

Cash flows and the discount rates applied to these cash flows must be consistent with respect to the investor group and inflation.

Investor group:

The cash flow of a project from the point of view of all investors is the cash flow available to all investors after paying taxes and meeting investing needs of the project, if any.

Cash flows to all investors = PBIT (1-T)

   + Depreciation

   - Capital Expenditure

   - Change in NWC

Inflation:

Either incorporate expected inflation in the estimates of future cash flows and apply a nominal discount rate to the same.Or estimate future cash flows in real terms and apply a real discount rate to the same

Principle of consistancy in computing cost of capital:

The most important principle underlying successful implementation of the cost of capital is consistency between the components of WACC and free cash flow. To assure consistency,

•It must include the opportunity costs from all sources of capital — debt, equity, and so on—since free cash flow is available to all investors.

•It must weight each security’s required return by its market-based target weight, not by its historical book value.

•It must be computed after corporate taxes (since free cash flow is calculated in after-tax terms). Any financing-related tax shields not included in free cash flow must be incorporated into the cost of capital or valued separately.

•It must be denominated in the same currency as free cash flow

•It must be denominated in nominal terms when cash flows are stated in nominal terms

2)

a)

Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events (including legal risk), differ from the expected losses". Following are the types of opertaiona risk

1. Internal Fraud – misappropriation of assets, tax evasion, intentional mismarking of positions, bribery
2. External Fraud – theft of information, hacking damage, third-party theft and forgery
3. Employment Practices and Workplace Safety – discrimination, workers compensation, employee health and safety
4. Clients, Products, and Business Practice – market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning
5. Damage to Physical Assets – natural disasters, terrorism, vandalism
6. Business Disruption and Systems Failures – utility disruptions, software failures, hardware failures
7. Execution, Delivery, and Process Management – data entry errors, accounting errors

b) Financial risk is the possibility that shareholders or other financial stakeholders will lose money when they invest in a company that has debt if the company's cash flow proves inadequate to meet its financial obligation.

The basic financial risk nder perfect competition will be maintaing the affordable cost of capital and the adequate level of profit to fulfill the obligations.

c) Types of financial risk:

• market risk: it involves the risk of changing conditions in the specific marketplace in which a company competes for business.
• operational risk: it refer to the various risks that can arise from a company's ordinary business activities.
• liquidity risk: includes asset liquidity and operational funding liquidity risk. Asset liquidity refers to the relative ease with which a company can convert its assets into cash should there be a sudden, substantial need for additional cash flow.
• credit risk: This is the risk businesses incur by extending credit to customers. It can also refer to the company's own credit risk with suppliers.