BA7024 CORPORATE FINANCE

Unit IV

-Simulation and financing decision

-Cash inadequacy and cash insolvency
-Probability of cash insolvency
-Pricing model
-Agency costs
-Financing and dividend decisions.
 Significance of Simulation
Simulation is sophisticated statistical bases to
deal with uncertainty.
Simulation is useful in solving business
problems which is not known in advance.
Based on the cash flows and a mathematical
model.
It reproduces the essence of the real
operations.
 Significance of Simulation
An understanding of the probability of specific
outcomes
Ability to pinpoint and test the driving
variables within a model
A far more flexible financial model
A clear summary of the results presented by
custom charts and reports.
 Monte carlo simulation
To calculate the value of an option with
multiple sources of uncertainty.
Technique in which statistical distribution
functions are created by using random
numbers.
Adequately represented by mathematical
models.
Yielded solution is optimal.
Steps in Monte Carlo Simulation
Step 1: Define the Problem
Identify clearly the objectives
Identify factors which have greatest effect
Step 2: Construct the model
Specify variables and parameters
Formulate appropriate decision rules
Identify the type of distribution
Specify the manner in which time will change
Define relationship between variables
Steps in Monte Carlo Simulation
Step 3: Preparation of Model for Experimentation
Define starting conditions for simulation
Specify the number of runs for simulation
Step 4: Execute steps 1 to 3 and experiment with
the model
Define a coding system and select a random number
generator
Create the random numbers to be used in simulation
Associate the generated random number with the
factors identified already.
 Choosing the right distribution in Monte
Carlo Model

Uniform distribution
Normal distribution
Triangular distribution
Lognormal distribution
 Symptoms of cash inadequacy
The business is short on cashflows
Contractual obligations require that the firm
retain a minimal balance.
Company is required to hold cash balances.
Weak collection policies leave the firm
showing a net income but lacking liquid funds.
Organizations credit rating is detoriating
Fixed interest costs are high.
Remedial Measures of Cash Inadequacy

Obtain immediate finance by incurring debt

Sell assets to generate cash
Enter into sales leaseback arrangements
Postpone cash payments wherever possible
Rent rather than buy
Make only those cash payments necessary
Reduce selling prices on products.
 Cash insolvency
Cash inadequacy leads to excessive borrowing
which leads to cash insolvency.
Insolvency means the inability to pay ones
debt as they fall due.
A company is deemed unable to pay its debts.
Value of the companys assets is less than the
amount of its liabilities.
 Types of cash insolvency
Cash flow insolvency
When the net income of the company is reduced
by certain factors
Those factors are loss of regular clients, income
reduction of contracts etc
When regular donations begin to drop due to any
of economic circumstances.
Inability to meet debt obligations.
 Types of cash insolvency
Balance sheet insolvency
Current assets of the organization are outweighed by
their liabilities.
There is not enough monthly income to pay debt
obligations.
Forced to borrow money and pay monthly expenses.
Using the working capital, bank line of credit, business
credit cards is also some forms
If this continues month after month balance sheet
insolvency is the result.
 Determining the probability of cash
insolvency / bankruptcy
For a publicly traded firm, there are three basic
information to determine the cash insolvency.
Financial Statements
Market price of the firms debt and equity
Subjective appraisals of the firms prospects
and risk.
Models for determining the probability of
cash insolvency

Black scholes Merton model

Z Score model
Vasicek kealhofer model
 Black Scholes Merton Model
Equity can be viewed as a call option
Pay offs to equity mimic the pay offs for call
option
Equity holders will let their call option expire
when the value of the assets is not sufficient.
The probability of bankruptcy is simply the
probability that the market value of assets is
less than the face value of liabilities.
 Z Score Model
To predict the probability that a firm will
undergo bankruptcy within two years.
Z score uses multiple corporate income and
balance sheet values to measure financial
health.
Model is based on financial ratios and their
relation to bankruptcy.
It combines four of five common business
ratios with high likelihood of bankruptcy.
Let's have a look at some of the world's
largest corporate bankruptcies starting with
Lehman Brothers.

Lehman Brothers Bankruptcy.

Washington Mutual Bankruptcy.
WorldCom Bankruptcy.
General Motors Bankruptcy.
CIT Bankruptcy.
Enron Bankruptcy.
Conseco Bankruptcy.
Chrysler LLC Bankruptcy.
 Vasicek Kealhofer Model
Firms equity is a perpetual option with the
default point acting as a absorbing barrier for
the firms asset value.
The convertible securities are assumed to
convert and dilute the existing equity.
Estimate asset value and volatility
Calculate the distance to default.
Calculate the default probability.
 Financial option pricing model
OPMs are normally applied to corporate
investment problems.
There are over a variety of developments in
option pricing models.
Two models which are important are
Binomial option pricing model
Black scholes model
 Binomial Option Pricing Model
This model provides a generalizable numerical
method for the valuation of options.
Important technique of pricing a stock option
by a binomial option.
The final possible stock prices are equal to the
intrinsic values.
It uses the discrete time model of the varying
price over time.
Forms of Binomial option pricing
Single period binomial model
Two period binomial model
Multi period binomial model
 Assumptions of black scoles model

Stock pays no dividend during the options life

European exercise terms are used
Markets are efficient
No commissions are charged
Interest rates remain constant and known
Returns are log normally distributed.
 Factors affecting option pricing
Volatility
Expiration date
Striking prices
Dividends
Interest rates
 Agency costs
A type of internal cost that arises from or must
be paid to an agent acting on behalf of a
principal.
Professional managers acting as agents for
shareholders.
Board of directors
Debt holders
Share holders/ residual risk bearers.
 Types of agency costs
Indirect agency cost
Indirect agency cost is a lost opportunity.
Direct agency cost
First type is corporate expenditure that
benefits management but costs stockholders.
Second type is an expense that arises from
the need to monitor management actions.
 Resolving the agency problem
Market forces
Behavior of security market participants
Hostile takeovers
Agency costs
monitoring expenditure
Bonding expenditures
Opportunity costs
Structuring expenditure
Incentive plans
Performance plans
 Types of dividend
On the basis of types of shares
Equity dividend paid on equity shares
Preference dividend paid to preference shareholders
On the basis of modes of payment
Cash dividend in the form of cash
Bonus share by the issue of stock dividend
Scrip dividend when the cash position is temporarily
weak
Bond dividends in the form of debentures and bonds
Property dividend payable in the form of assets
Composite dividend partly in cash and partly other form
 Types of dividend decisions
On the basis of time of payment
Interim dividend
Pays dividend before it declares in its annual general
body meeting
Regular dividend
Declared in AGM
Special dividend
Rate of dividend should not be changed year on year.
 Classification of dividend policy
Regular dividend policy
Investors get dividend at a usual rate
Stable dividend policy
Payment of certain sum of money is regularly paid to
all shareholders.
Irregular dividend policy
Company does not pay regular dividend to the
shareholders.
No dividend policy
Due to requirements of funds for the growth.
 Determinants of dividend policy
Legal restrictions
To protect the interest of creditors and outsiders
Size of the earnings
Both the amount and earnings to be taken into account year on
year.
Investment opportunities
Support and look for dividends and financing investment
opportunities.
Liquidity position
Payment of dividends involves outflow of cash from the business.
Managements attitude
Some companies expand only to the extent of their internal
earnings.
 Determinants of dividend policy
State of capital market
Capital market funds position is comfortable but the firm
has to access to it.
Contractual restrictions
Firms ability to pay cash dividends is restricted by certain
specific condition.
Profit rate and stability of earnings
Firm with large rate of return on its investment will have
larger profits.
Inflation
Management should reduce the rate of dividend during a
period of inflation to maintain.
Interdependence of investment, financing
and dividend decision
Major functions or decisions like investment
financing dividend are interrelated and
interconnected.
Such decision making process is known as
interdependence of investment, financing and
dividend decisions
Financing decisions
Investment decision
Dividend decision.