Corporate Finance Assignment: Questions And Essay

Question 1

1. The relevant formula to be used is as follows.

 FV_n = PV ( 1 + i )ⁿ 

In the given case, PV = $ 3996, i = 5%, n= 25-18 = 7 years 

Hence, amount at my 25^th birthday if left untouched = 3996 *(1.05)⁷ = $ 5,622.77 

1. Again the same formula would be used as indicated above. 

In the given case, PV = $ 3996, i = 5%, n= 65-18 = 47 years 

Hence, amount at my 65^th birthday if left untouched = 3996 *(1.05)⁴⁷ = $ 39.584.26 

1. Let the amount put by my grandfather originally be X

FV_n = PV ( 1 + i )ⁿ

In the given case, FV = $ 3996, i = 5%, n= 18-0= 18 years

Hence, 3996 = X*1.05¹⁸ 

Solving the above, X = $ 1,660.42 

Thus, the original amount is $ 1,660.42. 

Question 2

The ranking of the three alternatives provided would be done based on their present value which can be found using the following formula.

PV = FV_n/ ( 1 + i )ⁿ 

1. $ 100 received in one year 

PV = 100/1.1 =  $ 90.91 

$ 200 received in five years 

PV = 200/1.1⁵ = $124.18 

$ 300 received in 10 years 

PV = 300/1.1¹⁰ = $ 115.66 

Hence, the ranking is as shown below. 

• $ 200 received in five years (Most Valuable)
• $ 300 received in 10 years
• $ 100 received in one year (Least Valuable) 

1. $ 100 received in one year 

PV = 100/1.05 = $ 95.24 

$ 200 received in five years 

PV = 200/1.05⁵ = $156.71 

$ 300 received in 10 years 

PV = 300/1.05¹⁰ = $ 184.17 

Hence, the ranking is as shown below.

• $ 300 received in 10 years (Most Valuable)
• $ 200 received in five years
• $ 100 received in one year (Least Valuable) 

1. $ 100 received in one year 

PV = 100/1.20 = $ 83.33 

$ 200 received in five years 

PV = 200/1.20⁵ = $80.38 

$ 300 received in 10 years 

PV = 300/1.20¹⁰ = $ 48.45 

Hence, the ranking is as shown below. 

• $ 100 received in one year (Most Valuable)
• $ 200 received in five years
• $ 300 received in 10 years (Least Valuable) 

Question 3

1. Portfolio Return = W_A*E(R_A) + W_B*E(R_B) = 5*7 + 0.5*10 = 8.5% p.a. 

1. The standard deviation of portfolio is computed below.

σ_p = √(0.5²*0.16² + 0.5²*0.20² + 2*0.5*0.5*0.16*0.20*0.22) = 0.1411 or 14.11% 

1. Expected portfolio return = W_A*E(R_A) + W_B*E(R_B) = 6*7 + 0.4*10 = 8.2% p.a.

Expected portfolio beta = W_A*β_A + W_B* β_B = 0.6*1.2 + 0.4*0.5 = 0.92 

Question 4 

1. IRR is that rate of interest or discount rate for which the NPV of the project becomes zero.

The formula for NPV is given below. 

Let the assumed value of IRR for project A be x%. IRR computation for Project A is indicated below. 

0 = 25/(1+(x/100))  +  20/(1+(x/100))²   + 20/(1+(x/100))³   + 15/(1+(x/100))⁴   – 50 

Solving the above, we get x= 24% 

Let the assumed value of IRR for project B be y%. IRR computation for Project B is indicated below. 

0 = 20/(1+(y/100))  +  40/(1+(y/100))²   + 50/(1+(y/100))³   + 60/(1+(y/100))⁴   – 100 

Solving the above, we get y= 21% 

Hence, from the above computations, the IRR for project A and project B are 24% and 21% respectively. 

1. Again the formula for NPV would be used. 

NPV (Project A) = -50 + (25/1.05) + (20/1.05²) + (20/1.05³) + (15/1.05⁴) = $ 21.57 million 

NPV (Project B) = 100 + (20/1.05) + (40/1.05²) + (50/1.05³) + (60/1.05⁴) = $ 47.88 million 

1. The projects are ranked differently by NPV and IRR owing to the assumption that the project cash flows would be invested at the same rate as the IRR which is significantly higher than the discount rate used for NPV computation.

1. Payback period is the time required to cover initial investment. 

Question 2

For project A, initial investment = $ 50 million 

Hence, payback period = 2 + (5/20) = 2.25 years 

For project B, initial investment = $ 100 million 

Hence, payback period = 2 + (40/50) = 2.8 years 

Both are acceptable since the payback period for both is less than the desired 3 years but if only one has to be chosen on basis of payback period, than it would be project A which has the lower payback period.

One limitation of this method is that this method does not take into consideration the time value of money which is inferior in comparison to the other capital budgeting techniques such as NPV, IRR.

ESSAY SECTION

The issue of off-balance sheet liabilities in indeed a concerning one. The Enron episode is a good example of how the companies can use off balance sheet liabilities in order to conceal the true financial position and thereby impair the decision making ability of the investors and other stakeholders.  Usually, the investor community relies on the audit and assurance personnel to bring out these concerns, but when the management on purpose is concealing these debts, they normally form a quid-pro quo relation with the external auditor. This comes intuitively as the debt concealed through various creative accounting typically runs into billions of dollars and hence paying some millions as incremental audit fee sounds a fair bargain to both concerned parties (Arens et. al., 2013). In the wake of this background, it is essential to highlight the importance of business ethics in modern business environment coupled with its impact on corporate governance. 

Business ethics essentially refers to the analysis of the ethical dimensions related to the economic activities of the organisation in a systematic manner on different levels. In the wake of various corporate scandals, it is apparent that investors have realised that there are limitations with regards to the audit and assurance services even though they might continue to remain independent also. As a result, it is critical that the underlying organisation driven by the management must promote business ethics (Thomas & Lamm, 2012). This is imperative as the underlying agency costs are on the rise due to trust deficit between the management and the owners or the shareholders. Also, in accordance to the ethical principles, it is evident that the board or the top management are essentially agents of the owners who act as the principal. One of the key fiduciary duties that the agent has is to safeguard the interest of the principal and this is done by taking decisions that tend to promote the interest of the principal. In order to take these decisions, the presence of business ethics is imperative (Sparks & Pan, 2010).

Question 3

A common observation across various bankruptcy cases in the last two decades is that the management has typically acted in a manner which maximises the short term gain for the executives at the cost of the long term investors. This is typically because the management takes risky or imprudent decisions so that they can deliver returns that can exceed their performance targets and thereby yield fat bonuses. However, in the process they fail to consider the long term implications of their actions on the shareholders along with other stakeholders (Shivani & Manjula, 2016).

 In case of any potential issue that crops up in terms of losses or any liability, this is then hidden through creative accounting as highlighted in case of Enron or concealed from the shareholders through a mutually benefitting alliance with the auditors as seen in not only Enron (in US) but also other such corporate scandals such as HIH Insurance and One Tel in Australia.  On the other hand, it is required that the management must be sensitive to the interest of the shareholders since they are accountable to them and hence should take decisions for long term value creation (Arens, et. al., 2013).. Further, applying the deontological ethical perspective, if every management behaves in such manner, then owners would have no choice but to run their companies which in no way is a superior option considering the lack of critical skills by many shareholders (Sparks & Pan, 2010). 

In order to avoid the above situation from arising, the shareholders tend to rely on key concept namely corporate governance. This essentially refers to the internal processes and the working of the firm. In the wake of these corporate scandals, a lot of emphasis has been placed on enhancing the corporate governance levels through sound practices which can provide suitable checks and balances (Shivani & Manjula, 2016). In Australian context, modifications in the Corporations Act 2001 have been introduced through the Corporate Law Economic Reform Program (Audit Reform & Corporate Disclosure) Act 2004 in order to strengthen the internal processes. These involve appointment of majority of non-executive directors to the board of directors which theoretically implies that interest of the minority shareholders would be safeguarded owing to non-executive directors not having any financial stake in taking undue risk to enhance the profitability of the business or misreport the actual financial performance. Further, sound corporate governance policies also recommend formation of various internal committees related to audit, remuneration which tend to enhance the internal controls and thereby reduce the risk of financial frauds (Arens et. al., 2013). 

Question 4

However, it is noteworthy that similar to audit and assurance, corporate governance is a control mechanism which ought to raise a red flag in case of any discrepancy. As a result, akin to audit and assurance which provide reasonable assurance only, corporate governance provides reasonable defence only. If there is collusion amongst the top management personnel, then the risk of financial fraud could be potentially significant. Hence, it is pivotal that the business ethics should be given due importance as if the underlying ethics of the management and the organisation are in place, then despite the lapses in internal controls and practices, no financial fraud would occur. Further, it is imperative to note that corporate governance mechanisms are essentially meant to detect an irregularities but rectification can only be done if the top management wants to take some action on the potential discrepancy (Thomas & Lamm, 2012). 

A glaring example of this is presented in case of Enron where the main issue behind the failure was that of lack of business ethics.  This is apparent from the fact that the top management at all time was not only aware of the wrongdoing but were actually the prime perpetuators since an active role was played by the management in building up this corporate scandal. This is evident from the role played by the CFO Andrew Fastow in enabling the complex restructuring so as to hide the debts of Enron through special purpose vehicles and off balance sheet liabilities. In this process, able support was received by the banker, auditors and accountants (Lemus, 2014). 

The Enron scandal has brought to light the importance of management ethics to the forefront and post this scandal it is being given a high importance. This is apparent from empirical studies which have indicated a valuation premium for those companies which tend to have high corporate governance standards and management with high integrity. Thus, in wake of these concerns by the investors, it becomes pivotal that companies need to focus on ethical leadership which plays a key role in lowering of the agency costs and also improving the corporate governance framework (Lemus, 2014).

This can be done by having a code of ethics in place and ensure that business ethics are imbibed in the corporate culture so that ethical dimensions of various decisions are always considered.  Additionally, various studies have also indicated that employees at various levels tend to face ethical dilemmas and hence ethics training must be given. Also, to the extent ethical assistance must be offered for which some organisations tend to avoid an ethics officer who tends to provide guidance in case of situations where an ethical dilemma is faced. These initiatives tend to integrate ethics with the organisational DNA and enhance the ethical conduct witnessed in the organisation (Jackling et. al., 2007). 

From the above discussion, it is apparent that the Enron scandal was a watershed event in the history of corporate bankruptcy. Owing to the unprecedented scale of this financial scandal coupled with active involvement of the management in framing this scandal, there has been unprecedented focus on business ethics. The shareholders along with stakeholders have understood that besides strengthening the corporate governance mechanism to safeguard the interest of the shareholders, it is also essential that business ethics must be given its due importance and this should ideally be represented in the form of an ethical leadership at the helm of affairs.  In order to ensure the same, various measures can be undertaken such as having an organisation wide ethical code besides ethics training for the employees and the management coupled with ethics guidance in case of ethical dilemma. The strengthening of ethics tends to complement the corporate governance practices as well or else these practices may be only namesake. However, in an organisation with ethical leadership, the corporate governance framework is likely to be stronger and more effective. 

References 

Jackling, B., Cooper, B. J., Leung, P., & Dellaportas, S. (2007). Professional accounting bodies’ perceptions of ethical issues, causes of ethical failure and ethics education. Managerial Auditing Journal, 22(9), 928-944

Lemus, E. (June, 2014). The Financial Collapse of the Enron Corporation and its Impact in the United States Capital Market. Global Journal of Management and Business Research, 14(5), 328-339 

Shivani, T. & Manjula, S. (2016) Corporate Governance & Business Ethics: Challenges & Responsibilities, International Journal of Research in Finance and Marketing, 6(3), 137-153 

Sparks, J. R., & Pan, Y. (2010). Ethical judgments in business ethics research: Definition, and research agenda. Journal of Business Ethics, 91(3), 405-418 

Thomas, T. E., & Lamm, E. (2012). Legitimacy and organizational sustainability. Journal of Business Ethics, 110(2), 191–203