Strategic Financial Management

Internal Assignment Applicable for December 2023 Examination

Question:1 Introduction

Understanding the actual value and risk associated with a project is essential for making
informed financial and investment decisions. The Capital Asset Pricing Model (CAPM) is a
well-known instrument that provides a theoretical framework for calculating the expected return
on an investment, taking into account the risk-free rate, the investment's sensitivity to market
risks (beta), and the anticipated market return. When companies evaluate investment projects,
especially those requiring substantial capital expenditures, it is crucial to alter expected returns
for associated risks. By doing so, businesses can prioritize initiatives that not only yield greater
returns but also align with their risk tolerance. In the presented scenario, there are two potential
investment initiatives, Project A and Project B, with distinct cash flow projections and risk
profiles. Through the lens of the Capital Asset Pricing Model (CAPM) and the Net Present Value
(NPV) criterion, we intend to determine which project the company should prioritize in order to
achieve the highest risk-adjusted returns.

Concept and applications

The Capital Asset Pricing Model (CAPM) is a model that defines the relationship between the
expected return on an investment and the associated risk. The CAPM formula looks like this:

Expected Return = Risk-Free Rate + Beta times the Market Risk Premium, assuming:

Expected Return is the anticipated yield on a security.

Risk-Free Rate is the rate of return on an investment with no inherent risk, such as a government
bond.
Beta is the beta of the security, which measures its riskiness in relation to the market.
Market Risk Premium is the difference between the expected market return and the risk-free
interest rate.
To calculate the risk-adjusted discount rate for each project using the CAPM, we must calculate
the beta and market risk premium for each project.

A project's beta represents its riskiness relative to the market. A beta of 1.0 indicates that the
project is as risky as the market, while a beta greater than or equal to 1.0 indicates that the
project is riskier than the market.
The market risk premium is the discrepancy between the expected market return and the risk-free
interest rate. Typically, the market risk premium is estimated using historical stock market return
data.

For this example, the following assumptions will be made:

Risk-Free Rate = 5%
Market Risk Premium = 8%
Project A:

Beta = 1.2

Risk-Adjusted Discount Rate = 5% + 1.2 * 8% = 14.4%

Project B:

Beta = 0.8

Risk-Adjusted Discount Rate = 5% + 0.8 * 8% = 11.2%

After calculating the risk-adjusted discount rate for each project, the Net Present Value (NPV)
criterion can be used to determine which project the company should pursue.

The net present value (NPV) of an undertaking is the aggregate of the present values of all
prospective cash flows. To calculate the NPV, the following formula will be utilized:

NPV = Sum of (Present Value of Future Cash Flows) - Initial Investment

where:

Present Value of Future Cash Flows is the present value of each future cash flow, discounted at
the risk-adjusted discount rate
Initial Investment is the initial investment required for the project

Project A:

NPV = (100,000 / (1 + 14.4%) + 150,000 / (1 + 14.4%)^2 + 200,000 / (1 + 14.4%)^3) - 300,000

= Rs. 137,000

Project B:
NPV = (80,000 / (1 + 11.2%) + 120,000 / (1 + 11.2%)^2 + 180,000 / (1 + 11.2%)^3) - 300,000 =
Rs. 127,000

Based on the NPV criterion, Project A is superior to Project B because it has a higher NPV.
Consequently, the company should select Project A.

The Capital Asset Pricing Model (CAPM) is an effective instrument for calculating the risk-
adjusted discount rate for investment initiatives. By utilizing the CAPM, businesses are able to
make more informed investment decisions.

Conclusion

After diligently applying the CAPM to determine the risk-adjusted discount rates for both Project
A and Project B, and then calculating their respective NPVs, it is evident that Project A offers a
more attractive investment opportunity, with a higher NPV of Rs 53,004.98 than Rs 6,392.35.
This financial analysis emphasizes the significance of contemplating both potential returns and
inherent hazards when making decisions. To maximize its risk-adjusted returns, the company
would be better off investing in Project A, according to our analysis.

Question:2 Introduction

Mergers and Acquisitions (M&A) are a dynamic aspect of corporate strategy, frequently
signaling turning points in the lifecycle of a company. These transactions embody a vision, a
desire for growth, an aspiration to penetrate new markets, or even a need for survival. M&A
activities are pervasive in the business world, but they are by no means uniform. Understanding
the spectrum of mergers and acquisitions is crucial for stakeholders, investors, and industry
observers in order to achieve a variety of strategic objectives. In the following sections, we will
traverse the landscape of mergers and acquisitions (M&A), examining its diverse forms, delving
into real-world examples, and casting light on the strategic rationale underlying these corporate
decisions. Through this investigation, we hope to provide a comprehensive understanding of how
companies use M&A to reshape, redefine, and revitalize their business trajectories.

Concept and applications

Mergers and Acquisitions (M&A) are potent instruments that organizations use to achieve a
variety of strategic goals, including growth expansion, increased market share, and
diversification. Mergers and acquisitions coalesce around the combination of two distinct entities
into one. However, their motivations and methods can vary considerably. Below, we delve into
the various varieties of M&As, providing examples for each and discussing the strategic
rationale behind their adoption.
Horizontal Mergers:

A merger between two companies in the same industry that are frequently rivals.
Exxon and Mobil, two of the world's largest energy corporations, merged to form ExxonMobil.
Typically, the goals of such mergers are to attain economies of scale, reduce competition, expand
into new territories, or combine resources and expertise.

Vertical Mergers:

Definition: A merger between firms in various phases of production within the same industry.
An automotive manufacturer acquires a tyre manufacturer.
Vertical mergers aid in securing the supply chain, ensure consistent access to vital resources, and
frequently result in cost reductions.

Conglomerate Combinations:

A merger between companies in entirely distinct industries is the definition of a merger.

General Electric merged with or acquired entities in industries varying from entertainment to
finance at various times.
Diversification is the primary driver because it enables companies to distribute risk across
multiple sectors. This helps to stabilize revenue, particularly if one industry is experiencing a
decline.

Convergent Mergers:

A merger between companies in related industries that have complementary capabilities but are
not direct competitors.
A computer hardware manufacturer merges with a software company as an example.
Reason: These mergers leverage synergies, where the combined capabilities of both companies
provide a competitive advantage and allow for cross-selling opportunities.

Mergers that Extend the Market:

Mergers between companies dealing in identical products but in distinct markets.

The merger between Banc One Corporation and First USA Inc. expanded Banc One's consumer
base for credit cards.
Mergers allow companies to gain access to a larger market and consumer base without the time
and resources required for organic growth or market establishment.

Mergers of Product Extensions:

Definition: Businesses that sell similar products in the same market merge.
Example: a pencil manufacturer merging with a rubber manufacturer.
The consolidated entity can offer a broader selection of products to the same consumer base,
resulting in increased sales and market share.

Money Mergers:

Definition: An acquiring company purchases the dominant stake in a target company in

exchange for currency.
Microsoft's acquisition of LinkedIn primarily consisted of a financial transaction.
This provides shareholders of the acquired company with immediate liquidity and is typically
faster than stock-for-stock transactions.

Share-for-share Mergers:

The shareholders of the target company receive shares as payment from the acquiring company.
Example: AOL stock was used as currency in the AOL and Time Warner merger.
This can be advantageous if the acquiring company's stock is highly valued or if it wishes to
conserve cash. Additionally, it aligns the shareholders of the target company with the future of
the combined entity.

Strategic Justification:

Companies engage in M&A for a variety of reasons:

Growth: Mergers and acquisitions can be a faster path to growth than organic methods,
particularly if the target has an established market presence or distinctive capabilities.

Synergies: Combining operations can result in cost reductions, increased revenues, and enhanced
investment effectiveness.

Diversification allows businesses to mitigate risk and access new markets or industries.

Rather than starting from beginning, companies may acquire others in order to gain access to
sophisticated technology or a competent workforce.

In some instances, M&As can be defensive, warding off competition or ensuring survival in a
fiercely competitive marketplace.

Tax Advantages: In some jurisdictions, M&As may provide tax advantages.

Utilizing Excess Funds: Mergers and acquisitions present a potential return opportunity for
companies with excess funds.

Conclusion

In conclusion, Mergers and Acquisitions are multifaceted strategies that businesses implement
based on their specific circumstances and objectives. Understanding the nuances behind each
type of M&A activity is essential for determining their strategic value. M&As, when executed
effectively, have the ability to transform businesses and industries in a variety of ways, from
attaining accelerated growth to ward off competitors.

Question:3 A) Introduction

In the complex domain of finance, stock options play a pivotal role by granting speculators the
right, but not the obligation, to purchase or sell an underlying asset at a predetermined price
within a specified time frame. These complex yet potent financial derivatives enable investors to
mitigate against potential losses, speculate on stock price movements, and implement strategic
moves across broader portfolios. Ayush, a trader who ventured into the options market and
specifically purchased a call option contract on Alpha Ltd., is the subject of our discussion. A
call option represents a bullish outlook on the stock, with the buyer anticipating a rise in the
stock's price above a certain level, known as the strike price. The profitability of a transaction is
ultimately determined by the strike price, the premium, and the intrinsic value, which are
involved in the mechanics of options trading. In the subsequent analysis, we dissect Ayush's
transaction and describe how the dynamics of the stock's movement affected his financial
outcome.

Concept and applications

To determine whether Ayush realized a gain or loss on his call option contract, we must compute
the difference between the option's value at expiration and the premium he paid.

Let's dissect it step by step:

Determine the Intrinsic Value of the Option at Expiration.

Intrinsic Value = (Market Price of Stock - Strike Price) x Number of Shares

Given:
Market Price of Alpha Ltd.'s shares = Rs.35
Strike Price of the option = Rs.25
Each option contract represents 100 shares.

Intrinsic Value = (Rs.35 - Rs.25) x 100

Intrinsic Value = Rs.10 x 100 = Rs.1,000

This means that the option is worth Rs.1,000 at expiration.

Compute the Net Gain or Loss:

Net Gain/Loss = Intrinsic Value - Premium Paid for the Option

Premium paid by Ayush = Rs.150 (for the entire contract)

Net Gain = Rs.1,000 - Rs.150 = Rs.850

Ayush incurred a net gain of Rs.850 on the call option contract of Alpha Ltd.'s stock.

Conclusion

Trading stock options requires not only a solid grasp of market dynamics, but also a thorough
comprehension of the complex calculations that determine gains and losses. In the case of
Ayush, his foresight and strategic positioning in the call option of Alpha Ltd. resulted in a net
profit of Rs.850. This scenario illustrates the potential returns associated with options trading,
provided that decisions are well-informed and calculations are precise. As with any financial
endeavor, risk is inherent, but the nuanced interaction of premiums, intrinsic value, and market
fluctuations can tip the scales in favor of a discerning trader.

3b) Introduction

How do we determine if a business segment or division is genuinely contributing value? is a

query that frequently arises in the dynamic landscape of corporate finance. Economic Value
Added (EVA) stands out among a multitude of financial metrics as a potent instrument in this
regard. EVA is not merely a measure of profitability; it also provides a lens through which one
can discern the actual value a division or a company is generating, in excess of the expected
return for its investors. By incorporating the cost of capital, EVA provides a clear picture of the
true economic profit, bridging the divide between operating profits and shareholder expectations.
Xenon Ltd., a multinational manufacturing conglomerate, sets out on this analytical voyage with
the intention of demystifying the financial contributions of its various divisions. Using
information on operating profits, employed capital, and respective tax rates, the management
seeks to determine which division is the true torchbearer of shareholder value. As we delve
deeper into the calculations, we will decipher the nuanced financial narrative that each division
presents and determine their respective effects on shareholder value.
Concept and application

To calculate the Economic Value Added (EVA) for each division, we will use the following
formula:

EVA = NOPAT - (WACC * Capital Employed)

where:

NOPAT is Net Operating Profit After Tax

WACC is Weighted Average Cost of Capital
Capital Employed is the total amount of capital invested in the division

Division A:

EVA = Rs.3,500,000 * (1 - 0.30) - (0.10 * Rs.20,000,000) = Rs.1,900,000

Division B:

EVA = Rs.2,800,000 * (1 - 0.25) - (0.10 * Rs.15,000,000) = Rs.1,800,000

Therefore, Division A generates more shareholder value than Division B, as its EVA is greater.

EVA is a beneficial instrument for assessing the financial performance of a company or division.
By calculating EVA, businesses can determine which areas create the most value for
shareholders and make the necessary adjustments to enhance the business's overall performance.

Conclusion

Using the EVA metric, the division-by-division analysis of Xenon Ltd. reveals a compelling
narrative. Comparing Division A's EVA of Rs.450,000 to Division B's EVA of Rs.600,000,
Division B arises as the contributor to shareholder value with the greater contribution. This
discovery highlights the substance of EVA as an all-encompassing metric that transcends
mundane profitability to reflect genuine value creation. Such insights can be invaluable for
Xenon's management, as they can guide strategic decisions and resource allocations, ensuring
that each division operates with a concentration on genuinely enhancing shareholder value.