The aim of the calculations is to show how to compute a division’s market value from its net operating income and expected return and to illustrate how an entity creates value from its investments. They are also designed to show how the impact of the changes in the average return rate on the market value of a division. The results show that a division's net operating income and its market value have a direct positive relationship. In this case, when the division's net operating income increases, its market value will also increase if the expected return rate remains constant (Vernimmen et al., 2014) . When there is a positive change in the expected return, the division’s market value will be negatively affected. The results also show that an increase in the investment in a division leads to an increase in the division’s operating income. In turn, the division’s market value will also increase.
The results and computations from the exercise highlight the importance of investing in a division and, as a result, the entity's financial strategy can be enhanced by making such investments. The increase in the investment in a company's divisions is likely to lead to an increase in the operating income from the divisions. Such an increase in operating income may be due to the increase in operational efficiency (Abrahams, 2020) . In addition, increased investments in a division lead to the acquisition of addition cash-generating assets, and, in effect, the entity realizes increases in productivity. Such productivity gains are shown in the form of net operating income increments. The valuation of the entity's division can assist the entity to make key decisions when faced with cash flow problems. If the entity has many divisions, it can sell the division with the lowest value and, as a result, obtain cash for its operations.
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Exercise 1 Chapter 29
The aim of the calculations is to show how to compute the cost of equity using the stock’s current market price and its future dividend payments. These computations show how to compute the metric when the growth rate is not constant. The results show that the entity's cost of equity is 18% when the share's current trading price is 30.2, and the dividends paid are 5 and 6 for the first five years and next five years, respectively. These results provide relevant information regarding what is the cost of purchasing the entity's equity.
The determination of the entity's cost of equity is vital in enabling an entity to devise an effective financial strategy in terms of maintaining a suitable dividend payout ratio. The cost of equity allows the entity to determine how investors perceive the entity’s stock (Vernimmen et al., 2014) . If investors plan to invest in the entity, they will be keen to determine how much it costs to invest in the entity's stock. Investors expect a high rate of return on their investments, and, in such a case, an entity can use this information to determine how much returns it will provide to investors in the form of dividends. An increase in the dividends may provide a high rate of return to the investors, but it may deny the entity crucial cash resources for reinvestments. In this case, the cost of equity calculation can assist the entity to determine the ideal dividend payout ratio. In this case, the entity can increase its investments to ensure it meets the minimum rate of return required by the investors. Such a decision has an effect on the entity's capital structure, given that the entity may need to reduce its debt obligations significantly to rely on investor financing.
Exercise 2 Chapter 29
The aim of the calculations is to show how to determine the cost of debt using the debt's nominal value, its trading price, and its time to maturity. The calculations depict the impact of discounting cash flows on the cost of the entity's debt. The aim of the results is to show that the debt attracts interest which is paid yearly until the debt matures. Based on the results, the interest cost is paid for five years, given that it takes five years to reach maturity. The coupon rate of the debt is computed yearly to determine how much amount debt holders will receive. The results also show the nature of a debt obligation. The debt is a form of a loan that attracts interest with the principal amount repaid at the end of the maturity period (Anderson, 2013) . Based on the results, only the coupon rate of 110 is paid from year 1 to year 4, with the principal and coupon rate being paid in year 5.
The computations are vital in guiding the entity to provide a suitable rate of return to the debtholders and creditors. The entity may need to borrow money if its investor financing is inadequate. The debt obligations do not dilute the equity position of investors and are easily available (Anderson, 2013) . For these reasons, an entity is likely to take up debt in its books. Before acquiring debt from lenders, the entity needs to determine the minimum return rate required by debtholders and creditors. The minimum rate determines the amount of interest payments the firm will need to pay to the lenders and debtholders. If the entity can meet this rate, then it can go ahead and acquire debt. However, it should not take up too much debt to avoid collapsing in the long run.
Exercise 3 Chapter 29
The aim of the computations is to illustrate the determination of the cost of capital using the cost of equity, cost of debt, the current value of equity, and the current value of debt. Based on the computations, the current value of equity can be determined by multiplying the number of shares by the current trading price. The aim of the results is to show how a high cost of debt and a high cost of equity can lead to a high cost of capital. The results show how the weights of the debt and equity have an impact on the overall cost of capital.
The computations and results allow the entity to decide on its mix of debt and equity. In this case, the firm's financial strategy can focus on obtaining an optimum mix of debt and capital and, in this case, take advantage of the benefits of the two capital types. A high level of debt increases the financial risk of the entity, given the increase in the probability of collapse (Anderson, 2013) . On the contrary, a high level of equity leads to dilution of the stakes of the current investors. For this reason, the entity should ensure that it has the right mix of debt and equity to ensure neither capital source is too high. The entity needs to ensure that its overall cost of capital is low to ensure that it pays low amounts to service its debt and cater for the capital it is raising. In this case, it can preserve a high valuation due to the low cost of capital. Additionally, it should be able to meet the minimum return rate required by the investors and debt-holders. Such a return rate will ensure that the entity’s financial strategy is effective and feasible.
References
Abrahams, S. (2020). Competitive advantage in investing: Building winning professional portfolios . Hoboken: Wiley.
Anderson, T. J. (2013). The value of debt: How to manage both sides of a balance sheet to maximize wealth . Hoboken, New Jersey: Wiley.
Vernimmen, P., Quiry, P., Dallocchio, M., Le Fur, Y., & Salvi, A. (2014). Corporate finance: theory and practice . John Wiley & Sons.
