COPORATE FINANCE

UNIT – IV

Simulation Analysis

Definition: The Simulation Analysis is a method, wherein the infinite calculations are made to obtain the
possible outcomes and probabilities for any choice of action.

The concept of simulation analysis can be further comprehended through the following steps:

1. The first step is to model the project. A model shows how the net present value is related to the
parameters and the exogenous variables. The parameters are the variables specified by the
decision maker and are held constant throughout the simulation, whereas the exogenous variables
are randomly determined and are beyond the control of the decision maker.
2. The next step is to specify the values of the parameters and assign probabilities to the random
variables that arise from the external factors.
3. Randomly, select any value from the probability distribution of each of the exogenous variables.
4. Compute the NPV for both the randomly generated values of exogenous variables and the
parameter values, as specified by the decision maker.
5. Repeat the step 3 and 4 again and again, to get a large number of simulated values of NPV.

This whole process of simulation analysis compels the decision maker to consider all the
interdependencies and uncertainties characterizing the project. Thus, the viability of the project is
determined on the basis of number of outcomes and the probabilities realized through a series of actions
performed during the simulation analysis.

CASH INADEQUACY

Definition: Inadequacy refers to the lack of production capacity or insufficient production capacity of a
company’s current assets to meet its current or future production demands. In other words, growing
manufacturers reach a point where their current equipment can’t produce enough to meet the growing
demand of their productions. These manufacturers need to continue to invest in more machinery in order to
increase production. Their current equipment is said to be inadequate because it can’t produce enough.

Example

Inadequacy is usually used to help determine the useful life of a plant asset or fixed asset. Remember, the
useful life isn’t always how long the asset will be able to produce products. The useful life is also called the
service life because it takes into consideration factors like inadequacy and obsolescence. Both of these factors
may cut the useful life of an asset shorter than the actual physical life.

Most of the time inadequacy is difficult to predict because of unpredictable future demand and production
innovations. For instance, a piece of machinery might be able to produce products just fine, but a newer
technology is invented and renders the old machine obsolete. Companies can usually estimate the inadequacy
of a piece of equipment better when they have experience in that industry.

CASH INSOLVENCY

Insolvency Definition – In simple terms, a firm is called insolvent when it isn’t able to meet its financial
obligations. In other words, when a firm’s total liabilities exceed its total assets, we call the firm as an
insolvent entity.

The basic reason for which a firm becomes insolvent is that it takes on too much of debts. A firm takes debt for
two reasons. First, the firm wants to invest in a new project or expand the business (e.g. enter a new market).
Second, the firm wants to increase its financial leverage.

Too much of anything doesn’t yield good results. That’s why, when a firm takes on too much debt, it can’t
meet its financial obligation and is called insolvent.

But they don’t give up so easily. They try to raise capital from other sources, sell off some of the assets, and try
to remain afloat for some time. However, if a load of debt is too much that nothing changes the equation; the
firm gets compelled to file for bankruptcy.

In business, there are two kinds of factors that dictate the future prospect.

The first kind of factors are controllable factors where you can improve your bottom line, you can understand
the risk of taking too much debt, and you can produce more to increase your sales.

The second kind of factors is uncontrollable factors where you don’t have any control. The global economic
crash, political issues, industrial outrage etc. are factors which you can do nothing about.

Companies don’t become insolvent just because they go out of money. Companies become insolvent because
they don’t pay attention to the following things –

 The cash inflows of the company

 The future cash flows
 The total assets
 The liabilities piling up
 Increased expenses
 Decreased production
 Poor revenue
 Contingency plans
CASH INSOLVENCY ANALYSIS - FINANCIAL MANAGEMENT

The times interest earned and fixed -charge coverage ratios were introduced. These ratios provide an indicator
of the ability of a firm to meet its interest and other fixed charge obligations (including lease payments, sinking
fund payments, and preferred dividends) out of current operating income. Also, in that chapter, liquidity
ratios, such as the current ratio and the quick ratio, were introduced.

Liquidity ratios provide a simple measure of a firm’s ability to meet its obligations, especially in the near term.
In that chapter, we also indicated that the best measure of a firm’s cash adequacy can be obtained by
preparing a detailed cash budget.

Coverage ratios and liquidity ratios do not provide an adequate picture of a firm’s solvency position. A firm is
said to be technically insolvent if it is unable to meet its current obligations. We need a more comprehensive
measure of the ability of a firm to meet its obligations if this information is to be used to assist in capital
structure planning.

This measure must consider both the cash on hand and the cash expected to be generated in the future.
Donaldson has suggested that a firm’s level of fixed financial charges (including interest, preferred dividends,
sinking fund obligations, and lease payments), and thus its debt -carrying capacity, should depend on the cash
balances and net cash flows that can be expected to be available in a worst -case (recessionary environment)
scenario. This analysis requires the preparation of a detailed cash budget under assumed recessionary
conditions.

Donaldson defines a firm’s net cash balance in a recession, CBR, to be

CBR = CB0 + FCFR

where CB0 is the cash (and marketable securities) balance at the beginning of the recession, and FCFR is the
free cash flows expected to be generated during the recession. Free cash flow represents the portion of a
firm’s total cash flow available to service additional debt, to make dividend payments to common
stockholders, and to invest in other projects. For example, suppose MINECO, a natural resource company,
reported a cash (and marketable securities) balance of approximately $154 million. Suppose also that
management anticipates free cash flows of $210 million during a projected 1-year recession.

These free cash flows reflect both operating cash flows during the recession and current required fixed
financial charges. Under the current capital structure, consisting of approximately 32 percent debt, the cash
balance at the end of the recession would be $364 million ($154 million plus $210 million). Assume that the
management of MINECO is considering a change in its capital structure that would add an additional $280
million of annual after-tax interest and sinking fund payments (i.e., fixed financial charges). The effect would
be a cash balance at the end of the recession of

CBR = $154 million + $210 million – $280 million = $84 million

The managers of MINECO must decide if this projected cash balance of $84 million leaves them enough of a
cushion in a recession.
This analysis can be enhanced if it is possible to specify the probability distribution of expected free cash flows
during a recession. For example, if the MINECO managers believe, based upon past experience, that free cash
flows are approximately normally distributed with an expected value during a 1-year recession (FCFR) of $210
million and a standard deviation of $140 million, they can compute the probability of running out of cash if the
new debt is added.

The probability of running out of cash is equal to the probability of ending the recession with a cash balance of
less than $0. The probability distribution of MINECO’s cash balance [panel of will have the same shape (i.e.,
approximately normal with a standard deviation, s, of $140 million) as the probability distribution of free cash
flows , except that it will be shifted to the left from a mean (FCFR) of $210 million to a mean (CBR) of $84
million [i.e., by the beginning cash balance ($154 million) plus expected free cash flows ($210 million) less
additional fixed financial charges ($280 million)].

Employing an expression similar to Equation , where cash balance (CBR) is the variable of interest rather than
EBIT, a cash balance of $0 is equivalent on the standard normal curve to the following:

Z = ($0 - $84 million)/$140 million = -0.60

From Table, the probability of a z value of –0.60 or less is 27.43 percent. Thus, with an additional $280 million
in fixed financial charges, the probability of MINECO running out of cash during a 1-year recession is about 27
percent

The MINECO managers may feel that this is too much risk to assume. If they only want to assume a 5 percent
risk of running out of cash during a 1-year recession, they can determine the amount of additional interest and
sinking fund payments (i.e., fixed financial charges) that can be safely added. First, find the number of
standard deviations (z) to the left of the mean that gives a 5 percent probability of occurrence in the lower tail
of the distribution. From Table , this value of z is found to be approximately –1.65.Next, we calculate the
expected cash balance (CBR) needed at the end of a 1-year recession if the risk of running out of cash is to be
held to 5 percent:

Z = -1.65 = ($0 - CBR)/$140,000,000

CBR = $231,000,000

Finally, since MINECO expects to enter the recession with $154 million in cash and to generate $210 million in
free cash flow during a 1-year recession, it can take on just $133 million (i.e., $154 million + $210 million –
$231 million) in additional fixed financial charges.

The willingness of management to assume the risk associated with running out of cash depends on several
factors, including funds available from outstanding lines of credit with banks and the sale of new long-term
debt, preferred stock, and common stock, and the potential funds realized by cutting back on expenses during
a business downturn, reducing dividends, and selling assets.
OPTION PRICING MODELS

Option Pricing Models are mathematical models that use certain variables to calculate the theoretical value of
an option. The theoretical value of an option is an estimate of what an option should worth using all known
inputs. In other words, option pricing models provide us a fair value of an option. Knowing the estimate of the
fair value of an option, finance professionals could adjust their trading strategies and portfolios. Therefore,
option pricing models are powerful tools for finance professionals involved in options trading.

A formal definition of an option states that it is a type of contract between two parties that provides one party
the right but not the obligation to buy or sell the underlying asset at a predetermined price before or at
expiration day. There are two major types of options: calls and puts.

 Call is an option contract that gives you the right but not the obligation to buy the underlying asset at a
predetermined price before or at expiration day.
 Put is an option contract that gives you the right but not the obligation to sell the underlying asset at a
predetermined price before at expiration day.

Risk-neutral Probability

Before we start discussing different option pricing models, we should understand the concept of risk-neutral
probabilities, which are widely used in option pricing and may be encountered in different option pricing
models.

The risk-neutral probability is a theoretical probability of future outcomes adjusted for risk. There are two
main assumptions behind this concept:

The current value of asset equals to its expected payoff discounted at the risk-free rate.

There are no arbitrage opportunities in the market.

The risk-neutral probability is the probability that the stock price would rise in a risk-neutral world. However,
we neither assume that all the investors in the market are risk-neutral nor the fact that risky assets will earn
the risk-free rate of return. This theoretical value measures the probability of buying and selling the assets as if
there was a single probability for everything in the market.

Binomial Option Pricing Model

The simplest method to price the options is to use a binomial option pricing model. This model uses the
assumption of perfectly efficient markets. Under this assumption, the model can price the option at each point
of a specified timeframe.

Under the binomial model, we consider that the price of the underlying asset will either go up or down in the
period. Given the possible prices of the underlying asset and the strike price of an option, we can calculate the
payoff of the option under these scenarios, then discount these payoffs and find the value of that option as of
today.

Black-Scholes Model

The Black-Scholes model is another commonly used option pricing model. This model was discovered in 1973
by the economists Fischer Black and Myron Scholes. Both Black and Scholes received the Nobel Memorial Prize
in the economics for their discovery.

The Black-Scholes model was developed mainly for the pricing European options on stocks. The model
operates under the certain assumptions regarding the distribution of the stock price and the economic
environment. The assumptions about the stock price distribution include:

 Continuously compounded returns on the stock are normally distributed and independent over time.
 The volatility of continuously compounded returns is known and constant.
 Future dividends are known (as a dollar amount or as a fixed dividend yield).

The assumptions about the economic environment are:

 The risk-free rate is known and constant.

 There are no transaction costs or taxes.
 It is possible to short-sell with no cost and to borrow at the risk-free rate.

Nevertheless, these assumptions can be relaxed and adjusted for special circumstances if it is necessary. In
addition, we could easily use this model to price options on assets other than stocks (currencies, futures).

The main variables used in the Black-Scholes model include:

 Price of underlying asset (S) is a current market price of the asset

 Strike price (K) is a price at which an option can be exercised
 Volatility (σ) is a measure of how much the security prices will move in the subsequent periods.
Volatility is the trickiest input in the option pricing model as the historical volatility is not the most
reliable input for this model
 Time until expiration (T) is a time between calculation and option’s exercise date
  Interest rate (r) is a risk-free interest rate
 Dividend yield (δ) was not originally the main input into the model. The original Black-Scholes model
was developed for pricing options on non-paying dividends stocks.

INTERDEPENDENCE OF INVESTMENT FINANCING AND DIVIDEND DECISIONS

The term Business finance consists of a wide range of activities and disciplines that basically revolves around
the management of finance and other valuable assets within an organization or in other words it can be
defined as a process of acquisition and distribution of funds within an organization.

As the finance is very important for an organization, it is important to manage it effectively. It basically
involves proper planning as well controlling of the firm’s financial resources. The main goals of financial
management include:

 Profit Maximization by increasing revenue, controlling costs and minimizing risk.

 Wealth Maximization as it not only serves shareholder’s interest but provide security to creditors.

FINANCE FUNCTIONS:

The basic function of finance basically includes the three financial decisions such as:

INVESTMENT DECISION:

It is the first and foremost important financial decision. The business generally has limited finance but the
opportunities to invest are much wider. Hence the finance manager is required to access the profitability or
return of various investment decisions and decide a policy which ensures high liquidity, profitably and sound
health of an organization.

It includes short term investment decisions known as working capital management decisions and long term
investment decisions known as capital budgeting decisions.

FINANCING DECISION:

Once the requirement of funds has been estimated, the next important step is to determine the sources of
finance. The manager should try to maintain a balance between debt and equity so as to ensure minimized
risk and maximum profitability to business.

DIVIDEND DECISION:

The third and last function of finance includes dividend decisions. Dividend is that part of profit, which is
distributed to shareholders as a reward to high risk investment in business. It is basically concerned with
deciding as to how much part of profit will be retained for the future investments and how much part of profit
will be distributed among shareholders. High rate of dividend ensures higher wealth of shareholders and also
increase market price of shares.

INVESTING, FINANCIAL AND DIVIDEND DECISIONS ARE ALL INTERLINKED:

Although the basic decisions of finance includes three types of decisions i.e. investing, finance and dividend
decisions but they are interlinked with each other somehow. It can be evident from the following points:

 The main objective of all the above decisions is same which is profit maximization of business and
wealth maximization of shareholders.
 In order to make investment decisions such as investing in some major projects, the first thing we need
to consider is the finance available and required to make investment.
 Finance decision is also influenced by dividend decision. If more of the dividend is distributed, there is
a need to raise more finance from external sources.
 If more of the profits are retained for long term investment, there is less need of outside financing.

Hence, there is a need to take into account the joint impact of all the three decisions and effect of each of the
decision on the market value of the company and its shares to achieve the overall objective of the business.