COACHING CLASSES FOR ICMAP STUDENTS

Modigliani–Miller theorem

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani–Miller theorem is also often called the capital structure irrelevance principle.

Historical background

Miller and Modigliani derived the theorem and wrote their groundbreaking article when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. The story goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corporate finance. When they read the material that existed they found it inconsistent so they sat down together to try to figure it out. The result of this was the article in the American Economic Review and what has later been known as the M&M theorem.

Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed byequity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani–Miller theorem states that the value of the two firms is the same.

Without taxes

Proposition I:  where  is the value of an unlevered firm = price of buying a firm composed only of equity, and  is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. Another word for levered is geared, which has the same meaning.

To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information, in the absence of efficient markets, or if the investor has a different risk profile to the firm.

Proposition II:.

 is the required rate of return on equity, or cost of equity.

•  is the company unlevered cost of capital (ie assume no leverage).
•  is the required rate of return on borrowings, or cost of debt.
•  is the debt-to-equity ratio.

A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC).

These propositions are true assuming the following assumptions:

• no transaction costs exist, and
• individuals and corporations borrow at the same rates.

These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

With taxes

Proposition I:

where

•  is the value of a levered firm.
•  is the value of an unlevered firm.
•  is the tax rate () x the value of debt (D)
• the term  assumes debt is perpetual

This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible.

Proposition II:

where

•  is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium.
•  is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0).
•  is the required rate of return on borrowings, or cost of debt.
•  is the debt-to-equity ratio.
•  is the tax rate.

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula however has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100%

The following assumptions are made in the propositions with taxes:

• corporations are taxed at the rate  on earnings after interest,
• no transaction costs exist, and
• individuals and corporations borrow at the same rate

Miller and Modigliani published a number of follow-up papers discussing some of these issues.

The theorem was first proposed by F. Modigliani and M. Miller in 1958.

SWITCH OVER PLAN FOR THE STUDENTS OF CMA 2005 AND CAM 2010 SYLLABUSES UNDER NEW SYLLABUS 2012

SWITCH OVER PLAN FOR THE STUDENTS OF CMA 2005 AND CAM 2010 SYLLABUSES UNDER NEW SYLLABUS 2012

Business SWOT Analysis - Threats is an Opportunity

SWOT Analysis is an abbreviation for Strengths; Weaknesses; Opportunities and Threats. In the application of four factors of SWOT, proper understanding of the differences between them would bring about maximum benefits.

The Four SWOT Factors are also known as the Internal and External Factors. The Internal factors consist of Strengths and Weaknesses, whereas the External Factors consist of Opportunities and Threats.

In normal practice, the four SWOT factors can be clearly categorised based on the findings. Below are some examples:-

Strengths:

Strong financials
vast customer base
positive cash flow

Weaknesses:

long delivery lead time
high inventory
inconsistent quality

Opportunities

export incentives
acceptance of middle east countries
Good relations with trade ministry

Threats

escalating of cost
product substitition
computer virus attack by year 2000

As case study: Every Threats is an Opportunity ?
Every Threats is indeed an opportunity! Take for example: Before Y2K millennium, there was a global threat that the computer system may go burst on the 1st day of year 2000. This Threat was clearly beyond anyones' control, and it was inevitable. During that time, all organizations had 2 choices ie. Do something to overcome the computer threats or do nothing and wait for the worst to happen.

Most big and medium size organizations in Malaysia I contacted chosen to pay a high cost to work on an "enhanced" computer system that supposedly can overcome the computer threats. How did this Y2K threats taken as an opportunity? In fact, those organizations who did something to the computer system took the opportunity to upgrade or enhance their computer system to improve their inventory system while overcome the possible computer threats.

With this example of Threats, you can actually flip the Threats the other way round and turn it into an Opportunity.

What is a going concern qualification?

The going concern principle is that you assume a business will continue in the future, unless there is evidence to the contrary. When an auditor conducts an examination of the accounting records of a company, he has an obligation to review its ability to continue as a going concern; if his assessment is that there is a substantial doubt regarding the company's ability to continue in the future (defined as the following year), then he must include a going concern qualification in his opinion of the company's financial statements. This statement is typically presented in a separate explanatory paragraph that follows the auditor's opinion paragraph. There are no specific procedures that an auditor must follow to arrive at a going concern opinion. Instead, he derives this information from the sum total of all other audit procedures performed. Indicators of a potential going concern problem are: Negative trends. Can include declining sales, increasing costs, recurring losses, adverse financial ratios, and so forth. Employees. Loss of key managers or skilled employees, as well as labor difficulties of various types. Systems. Inadequate accounting record keeping. Legal. Legal proceedings against the company, which may include pending liabilities and penalties related to environmental or other laws. Intellectual property. The loss of a key license or patent. Business structure. The company has lost a major customer or key supplier. Financing. The company has defaulted on a loan or is unable to locate new financing. The auditor's going concern qualification can be mitigated by management if it has a plan to counteract the problem. If such a plan exists, the auditor must assess its likelihood of implementation and obtain evidential matter about the most significant elements of the plan. For example, if the CEO has declared that he will extend a loan to the company to cover a projected cash shortfall, evidential matter might be considered a promissory note in which the CEO is obligated to provide a stated amount of funds to the company. The going concern qualification is of great concern to lenders, since it is a major indicator of the inability of a company to pay back its debts. Some lenders specify in their loan documents that a going concern qualification will trigger the acceleration of all remaining loan payments. An auditor who is considering issuing a going concern qualification will discuss the issue with management in advance, so that management can create a recovery plan that may be sufficient to keep the auditor from issuing the qualification. Thus, the going concern qualification is a major issue, but you will have a chance to find a way around the problem and potentially keep the auditor from issuing it.

Laws of Indemnity and Guarantee

Laws of Indemnity and Guarantee Definition: A Contract by which one party promises to save the other from loss caused to him - by the conduct of the promisor himself - by the conduct of any other person is called a contract of Indemnity. The loss must be cause by some human agency. • Contingent Contract • Express or Implied Contract • Objective : To same the indemnified from loss • Liability of Indemnifier: Primary, Absolute, Total • Indemnifier cannot sue third person. Parties: 1) Indemnifier: The person who makes the promise of indemnity is called indemnifier. 2) Indemnified (Indemnity Holder): The person with whom the promise of indemnity is made is called Indemnified or Indemnity holder. Rights of Indemnified (When sued): The indemnified in a contract of indemnity is entitled to recover from his indemnifier: 1) Damages: All damages which he may be compelled to pay in any suit in respect of any matter to which indemnity applies. 2) Cost: All cost which he may be compelled to pay in any such suit: - if (in bringing or defending it) he did not contravene the orders of the indemnifier. - if he acted as if would have been prudent for him to act in the absence of any contract of indemnity. 3) Sums: All sums which he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the indemnifier. Contract of Guarantee / Suretyship: A contract: - to perform the promise, or - to discharge the liability of a third person in case of his default is called a contract of guarantee. • Guarantee: An Express contract Parties: 1) Surety (Guarantor): The person who gives the guarantee is called the surety. 2) Creditor: The person to whom the guarantee is given is called creditor. 3) Principal Debtor: The person in respect of who’s default the guarantee is given is called Principal Debtor. Guarantee: A Package of Contracts: An implied contract of Indemnity. Consideration for Guarantee: • Any thing done • Any promise made for the benefit of the Principal Debtor is the sufficient consideration to the surety for giving the guarantee. Nature and Extent of Surety’s Liability: • At the time of making of contract of guarantee, the surety is at liberty to state the limit of his liability • In such a case, the surety is liable only to the extent of his stated limit on the default of the principal debtor. • In the absence of any such contract, the liability of the surety is co-extensive with that of the principal debtor. • Whatever the case may be, the liability of the surety is secondary and conditional that is it arises on the default of the principal debtor. Kinds of Guarantee: 1) Specific Guarantee: A guarantee given for a single particular transaction, undertaking or debt is the specific guarantee. Once if has been upon by the creditor, the surety cannot revoke it. 2) Continuing Guarantee: A Guarantee which extends to a series of transaction is called Continuing guarantee. Revocation of Continuing Guarantee: 1) By Notice: A continuing guarantee may be revoked at any time by the surety by giving notice to the creditor but only for future transaction. 2) By Death (of surety): In the absence of any special contract, a continuing guarantee is revoked by the death of surety but only for future transaction. Invalid Guarantee: 1) Guarantee obtained by Misrepresentation: Any guarantee which has been obtained by means of misrepresentation made by the creditor, or with his knowledge and assent, concerning a material part of the transaction, is invalid. 2) Guarantee obtained by Concealment: Any guarantee which the creditor has obtained by means of keeping silence as to material circumstances is invalid. 3) Failure of Co-surety to join: Where a person gives a guarantee upon a contract that the creditor shall not act upon it until another person has joined in it as co-surety, the guarantee is invalid if that person does not join. Rights of Surety: Against Creditor: 1) Right to securities: A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time of making a contract of guarantee. This is immaterial whether the surety is or is not aware of the existence of such security. Securities: Jewellry, Expensive Items 2) Right of Set-off: The surety is entitled (in a suit filed by the creditor against the surety) to the benefit of any set-off for counter claim which the principal debtor might possess against the creditor. 3) Right to Quia-Timet (because he fears or apprehends) action: The surety has a right at any time after the guarantee debt has became due and before he called upon to pay to require the creditor to sue the principal debtor for the performance of promise. However the surety must undertake to indemnify the creditor for the risk of delay and expenses which he may incur by so doing. Against Principal Debtor: 1) Right of Subrogation: The terms subrogation may be defined as the substitution of one person with another with same right and liabilities. After discharging his liability on the default of principal debtor, the surety is vested with all the rights which the creditor has against the principal debtor, for e.g. a) Right to securities (if any) held by creditor. b) Right to initiate proceedings against the principal debtor in his own name. 2) Right to Indemnify: The surety is entitled: - to an indemnity from the principal debtor - to recover any sum he has paid rightfully under the Guarantee. Against Co-Sureties: 1) Right of Contribution: - Where a debt is guaranteed by two or more persons * and one of them pays more than his share of that debt, he is entitled to compel contribution from the other(s). - Co-sureties need not to be bound under the same contract, * the right to contribution being independent of any agreement for that purpose. - If the co-sureties are bound indifferent sums, * they are liable to pay equally as far as their agreed obligation permits. Discharge of Surety: When the liability of a surety comes to an end, the surety is said to be discharged. Modes: 1) By Performance: Where the guaranteed obligation is properly discharged by performance of principal debtor, the obligation of surety with respect to that undertaking is thereby discharge. Performance which releases the principal debtor also discharges the surety. 2) By Variance: If the creditor and principal debtor vary the terms and conditions of their contract without the consent of surety, the surety is discharged in respect of transaction made after the variation. 3) By Revocation: a) By Notice: A continuing guarantee may at any time be revoked by the surety, as to future transactions, by notice to the creditor. b) By Death: The death of the surety operates, in the absence of any contract to the contrary, as a revocation of a continuing guarantee, so far as regards future transactions. 4) By Release of Principal Debtor: The surety is discharged by any contract between the creditor and principal debtor, by which the principal debtor is released. 5) By Act or Omission of Creditor: The surety is discharged by any act or omission of creditor, the legal consequence of which is the discharge of principal debtor. 6) By Composition: A contract by which the creditor makes the composition with principal debtor, discharges the surety unless the surety assents to such contract. 7) By Extension of time: Where a creditor without the consent of surety promises to give time to principal debtor, the surety is discharged. 8) By Promise not to sue: A contract (without the consent of surety) by which the creditor promises not to sue the principal debtor, discharges the surety. 9) By Impairing surety’s remedy: If the creditor - does not act which is in consistent with the rights of the surety, - omits to do any act which his duty to the surety requires him to do and the eventual remedy of the surety himself against the principal debtor is thereby impaired the surety is discharged. 10) By Loss of security: If the creditor: - loses - (without the consent of surety) returns, the security which he has against the principal debtor at the time of making of contract of Guarantee, The surety is discharged to the extent of the value of the security. This is immaterial whether the surety is or is not aware of the existence of such security. Discharges of Surety by acts of Creditor: 1. By Variance 2. Be Release 3. By Act or Omission 4. By Composition 5. By Extension of time 6. By Promise not to sue 7. By Impairing surety’s remedy 8. By Loss of security When surety not discharged due to acts of creditor: 1) Agreement with third person: When a contract to give time to the Principal debtor is made by the creditor with third person and not with the principal debtor, the surety is not discharged. 2) Forbearance to Sue: Mere forbearance on the part of the creditor to sue the principal debtor discharge the surety unless and until the limitation period for recovery of debt expires. 3) Release of Co-Surety: When there are co-sureties a release by the creditor of one of them does not discharge the other, neither does it free the surety so released from his responsibility to the other securities. Difference between Indemnity and Guarantee: Indemnity Guarantee 1) Number of Parties In indemnity there are two parties i.e. indemnifier and indemnified. In guarantee, there are three parties i.e. surety, creditor and principal debtor. 2) Number of Contracts In indemnity there is only one contract between indemnifier and indemnified. In guarantee, there are three contracts i.e. - between surety and creditor - between surety and principal debtor - an implied contract of indemnity between the principal debtor and surety. 3) Formation A contract of indemnity may be expressed or Implied. A contract of guarantee is always be an express contract. 4) Nature of Undertaking A contract of indemnity is of contingent nature A contract of guarantee is a collateral contract 5) Nature of Liability The liability of indemnifier is Primary, Absolute, Total Here the primary liability is that of principal debtor. The liability of surety is secondary and conditional. 6) Commencement of Liability The liability of indemnifier commences when the indemnified suffer loss The liability of surety commences when the principal debtor makes default 7) Objective To save the indemnified from a loss which may occur to him in the future To provide security to the creditor in respect of existing debs and liabilities 8) Right to sue Indemnifier cannot sue the third person in his own name but he may initiate the proceedings on behalf of indemnified On the default of principal debtor, the surety (after discharging his liability) may sue him in his own name. Guarantee is not a contract of uberrimae fidei: A contract of guarantee is not a contract of uberrimae fidei, i.e., one requiring full disclosure of all material facts by the principal debtor or creditor to the surety before the contract is entered into. Fraud on the part of the principal debtor is not enough to set aside the contract, unless the surety can show that the creditor or his agent knew of the fraud and was a party to it. When a guarantee is given to a banker, there is no obligation on the banker to inform the intending surety of matters affecting the credit of the debtor or any circumstance connected with the transaction which render the position of the surety more hazardous. If the guarantee is in the nature of insurance, as in a fidelity guarantee, all material facts must be disclosed, otherwise the surety can avoid the contract.

HOW TO DISTRIBUTE QUALITY COST

HOW TO DISTRIBUTE QUALITY COST