Assignment Question

Answer the following questions: Q1. What are the different ways available for the corporations to distribute income among the shareholders? Suppose a firm promises to pay dividends of $200,000 every year in perpetuity with 200,000 shares outstanding. Assume a discount rate of 11.1%. What is the present value of one of the firm’s shares?(2 marks) Q2. What is Stock repurchase? Explain the four ways to implement stock repurchase. (3 marks) Q3. Calculate the rate at which a firm can grow without changing its leverage if its payout ratio is 30%; equity outstanding at the beginning of the year is $9,500,000; and its net income for the year is $2,000,000.(2 marks) Q4. What do you mean by Long term financial planning? Take an example and explain the sales percentage model of financial planning. (3 marks) Answers:

Answer

Different Ways of Income Distribution and Present Value Calculation

Corporations utilize various methods to distribute income among shareholders, including dividend payments, stock repurchases, and issuing bonus shares (Ross, Westerfield, & Jordan, 2020). Dividend payments are a common way for companies to share their profits with shareholders, providing them with a regular income stream and reinforcing investor confidence in the company’s financial stability (Berk & DeMarzo, 2020). Stock repurchases, on the other hand, allow companies to buy back their own shares from the market, which can be advantageous in signaling undervaluation to the market and boosting earnings per share (Brealey et al., 2021). Issuing bonus shares is another method of income distribution that enables companies to reward existing shareholders without affecting the company’s cash position or financial obligations.

In the context of present value calculation, understanding the concept of discount rate significance is crucial. The discount rate represents the opportunity cost of capital and reflects the investors’ required rate of return, considering the risk associated with the investment (Higgins, 2018). When computing the present value of perpetual dividends, the discount rate plays a critical role in determining the value of the dividends over an infinite time horizon. Additionally, the present value of a share is a fundamental metric that investors use to assess the attractiveness of an investment opportunity. By comparing the calculated present value with the market price of the share, investors can make informed decisions regarding the potential profitability and valuation of the company’s shares.

 Explanation of Stock Repurchase Strategies

Stock repurchases are a strategic financial tool used by companies to manage their capital structure and enhance shareholder value (Ross et al., 2020). Open market repurchase is a popular method among companies, allowing them to repurchase shares gradually from the open market over an extended period. This approach provides flexibility to the company, enabling it to adjust the repurchase volume based on market conditions and available capital. A tender offer, on the other hand, is a more direct and time-bound approach where the company offers to buy a specific number of shares at a predetermined price, typically at a premium to the market price. This approach can be used to efficiently return excess cash to shareholders or thwart potential hostile takeovers by reducing the number of shares available in the market (Berk & DeMarzo, 2020).

Accelerated share repurchase (ASR) programs involve the company repurchasing a large block of its shares from an investment bank upfront. This approach provides immediate benefits by swiftly reducing the number of outstanding shares, consequently boosting earnings per share and signaling confidence in the company’s financial position. Targeted repurchases are more strategic and selective, allowing the company to repurchase shares from specific shareholders, such as employees or executives, as part of employee compensation or incentive programs. This approach can align the interests of the management with those of the shareholders, fostering a sense of ownership and accountability among key personnel (Higgins, 2018).

Calculation of Sustainable Growth Rate and Leverage

The sustainable growth rate (SGR) is a vital financial metric that indicates the rate at which a company can grow its sales without changing its leverage or financial structure. By maintaining a consistent leverage ratio, the company can sustain its growth without overextending its financial resources or risking financial instability (Brealey et al., 2021). However, it is essential to note that sustainable growth is influenced by various internal and external factors, including market conditions, industry dynamics, and the company’s competitive position.

In the context of the given example, a 30% payout ratio signifies that the company retains 70% of its earnings, which can be reinvested to fuel future growth and expansion. By leveraging the retained earnings, the company can achieve a sustainable growth rate determined by the product of the retention ratio and the return on equity (ROE). This strategic use of retained earnings to fund internal growth initiatives allows the company to capitalize on new opportunities and sustain its competitive edge in the market (Ross et al., 2020). By effectively managing its payout ratio and leveraging retained earnings, the company can strike a balance between rewarding shareholders and ensuring sustainable long-term growth and profitability.

 Understanding Long-Term Financial Planning and Sales Percentage Model

Long-term financial planning is a comprehensive process that involves setting and achieving strategic financial goals over an extended time horizon, typically spanning three to five years or more (Higgins, 2018). It encompasses various key elements, including investment planning, capital budgeting, financial forecasting, and risk management. By developing a robust long-term financial plan, companies can effectively allocate their financial resources, manage their capital structure, and navigate market uncertainties to achieve sustainable growth and profitability. Furthermore, a well-defined long-term financial plan enables companies to anticipate and address potential financial challenges and capitalize on emerging opportunities, fostering financial stability and resilience in an ever-evolving business landscape.

The sales percentage model is a widely used approach in financial planning that facilitates the estimation of various financial components based on a percentage of forecasted sales (Brealey et al., 2021). This model provides a systematic framework for forecasting key financial elements, such as accounts receivable, inventory levels, and working capital requirements, based on the projected sales volume. By establishing a proportional relationship between sales and key financial indicators, companies can develop a more accurate and reliable financial plan that aligns with their strategic objectives and operational needs. Additionally, the sales percentage model enables companies to identify potential financial bottlenecks and optimize their resource allocation to support sustainable growth and operational efficiency (Ross et al., 2020). By integrating the sales percentage model into their long-term financial planning process, companies can enhance their financial forecasting capabilities and make informed decisions to achieve their long-term growth and profitability goals.

References

Berk, J., & DeMarzo, P. (2020). Corporate Finance (5th ed.). Pearson.

Brealey, R. A., Myers, S. C., & Allen, F. (2021). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.

Higgins, R. C. (2018). Analysis for Financial Management (12th ed.). McGraw-Hill Education.

Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2020). Fundamentals of Corporate Finance (12th ed.). McGraw-Hill Education.

FAQs

Q1. What are the different ways available for corporations to distribute income among the shareholders?

• Corporations can distribute income among shareholders through dividend payments, stock repurchases, and issuing bonus shares.

Q2. What is stock repurchase, and how can it be implemented?

• Stock repurchase refers to a company buying back its own shares from the market. It can be implemented through open market repurchase, tender offer, accelerated share repurchase (ASR), and targeted repurchase.

Q3. How is the sustainable growth rate (SGR) calculated, and what does it indicate?

• The SGR is calculated using the formula SGR = Retention Ratio * Return on Equity (ROE). It signifies the rate at which a company can grow without changing its leverage.

Q4. What is long-term financial planning, and how does the sales percentage model contribute to it?

• Long-term financial planning involves setting and achieving strategic financial goals over an extended period. The sales percentage model helps in estimating various financial components based on a percentage of forecasted sales.

Q5. How does the discount rate affect the present value of shares, and why is it essential in valuation?

• The discount rate impacts the present value of shares, representing the required rate of return by investors. It is crucial in assessing the attractiveness of investment opportunities and comparing present values with market prices.