Question

In: Finance

Adams Video is considering whether to make an investment in a new type of technology.

1. Project Evaluation --Cash Flows question:

Adams Video is considering whether to make an investment in a new type of technology. The following factors are considered in the initial discussion:i). The company has already spent $3 million researching the technology; ii). The new technology will affect the cash flows produced by the other operations of the company; iii). If the investment is not made, then the company will be able to sell one of its laboratories for $2 million.

a) Which of the above factors should the company consider when it decides whether to undertake the investment? [4 Marks]

b) Explain why for each of the factors. [6 Marks]

c) Explain why we must use incremental cash flows in project evaluation.

2. Firm Value with FCF and WACC:

a) Describe the FCF definition (in terms of its underlying object or asset) and its practical application; [8 Marks]

b) Discuss the special function of WACC.

3. Corporate Governance question:

a) Provide a simple definition of Corporate Governance (in traditional Corporate Finance terms) in your own words; [8 Marks]

b) Discuss the possible relation between CEO compensation and company performance in terms of corporate risk and average equity return.

4. Capital Structure Question:

a) Briefly define the terms: Business Risk and Financial risk; [8 Marks]

b) Describe how the business risk and financial risk could be included in the value of WACC, which is calculated with the formula:

WACC = Wd * Rd * (1-Tc)+We * Re

Solutions

Expert Solution

1)

a) Factors to be consider-

  • The company has already spend 3 millions in researching the tevnolog
  • The technology will effect the cash flows of operation.
  • If the technology is not accepted, compny can sell the lab for 2 million

b) Why:

  • The company has alredy faced a cash outflow of 3 million for the technology- Net cash outflow has to be taken in consideration while taking every investment decision
  • The net returns of the company will be increased by the technology- The impact of investment, whether the company will be able to recover the cash outflow or not
  • Option 3 can also be valid since it tells if the technology is not being accepted, then they will suffer loss os 1 million. hence for accepting the technology, it must generate atlest a return of 2 million or more.

c) Why we must take incremental cash flow:

The incremental cash flows tell how exactly the project han effected the performance of the business. By studying the incremental cash flow on can estimate how much returns the project is able to generate or loss. This is a very important consideration in taking investment decisions.

2)

a) Free cash flow (FCF) is a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. This cash can be used for expansion, dividends, reducing debt, or other purposes.

Practical application:

The formula for free cash flow is:

FCF = Operating Cash Flow - Capital Expenditures

The data needed to calculate a company's free cash flow is usually on its cash flow statement. For example, if Company is having a cash flow statement reported $10 million of cash from operations and $2 million of capital expenditures for the year, then Company XYZ's free cash flow was $10 million - $2 million = $8 million.

b) Special function of WACC-

The WACC is used by a company for various reasons like to evaluate the capital stucture, to understand and analyse the current finanacial possition, to take future financing decision, valuation of a company etc. It can be calculated as below:

it is a composition of the individual cost of equity and debt capital source of a company.The cost of each source is multiply by their total proportion the the companies capital structure.

3)

a) Corporate Governance refers to the way a corporation is governed. It is the technique by which companies are directed and managed. It means carrying the business as per the stakeholders’ desires. It is actually conducted by the board of Directors and the concerned committees for the company’s stakeholder’s benefit. It is all about balancing individual and societal goals, as well as, economic and social goals.

b) In many studies, this is found that generaly the ceo pay does not effects the companies performance but where we look to the practical situations, the ceo pay does effect the investment decisions of various stakeholder specially when the financial performance of the company is not good. shareolders may object to this term where the company is not generating ROE in sufficient manner. Hence there is a threat of corporate risk as well. Hence the comapny shall always consider these factors while compensating CEO.

4)

a)

Business risk refers to the basic viability of a business, the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit.

Financial Risk is the uncertainty arising due to the use of debt finance in the capital structure of the company. The capital structure of the company can be made up of equity capital or preference capital or debt capital or the combination of any.

b) WACC = Wd * Rd * (1-Tc)+We * Re

The business risk lies with the companies obligation to generate the sufficient profits and the fiancial risk lies with the companies obligation to pay off its fixed interest. Both of these term are included in the concept of WACC.

Wd * Rd * (1-Tc) mmay be defined as the value of financial risk in practical ways as this implicates the overall debt obligation the company. furthe business risk is a much more bigger term with which can be said that ability of company to pay off its fixed cost. unless and untill a firm does have that it will not be able to cope with their cosst of financing.


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