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F3 > B. Sources of long-term funds > Flashcards

B. Sources of long-term funds Flashcards

1
Q

what are some sources of external finance?

A
  1. the capital markets: new share issues, rights issues or bonds
  2. bank borrowings
  3. venture capital funds: high risk
  4. government and similar sources
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2
Q

what is the main issue with venture capital funds?

A

providers tend to demand significant equity participation in a company and will also want to influence the policy of the company

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3
Q

what is the criteria for selecting sources of finance?

A
  • cost of the different sources of finance
  • duration: how long is finance required?
  • lending restrictions
  • gearing level
  • liquidity implications
  • the currency of the cash flows associated with the new project
  • impact of different financing options on the financial statements, tax position and financial stakeholders of the entity
  • availability of finance
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4
Q

what are the liquidity implications of financing?

A

ability of the business to service the new debt, allocating sufficient cash resources to meet interest and capital repayment obligations

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5
Q

why is debt finance cheaper than equity?

A

cost of interest is allowable expense for tax purposes, so cost of debt is interest cost less the tax relief on the interest

lower risk taken with debt finance

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6
Q

how does the duration of debt finance compare to equity finance?

A

debt: fixed term, can be short or long

equity capital:long term ‘permanent’ capital

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7
Q

how should a company decide the duration of financing?

A

matching concept

long term assets financed by long term funds

short term assets such as inventories and receivables should be financed by a mixture of short-term and long-term funds

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8
Q

what is a debt covenant?

A

clauses written into existing debt agreements which protect the lender’s interest by requiring the borrower to satisfy certain criteria

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9
Q

what is debt finance?

A

loan of funds to a business without conferring ownership rights

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10
Q

what are the key features of debt finance?

A
  • interest is paid out of pre-tax profits as an expense of the business
  • paying interest reduces the taxable profits of the business and hence the tax payable
  • debt finance carries a risk of default if interest and principal payments are not met
  • to reduce the risk to the lender, security and/or covenants are used
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11
Q

how does currency affect debt financing?

A

cash flows of new project should be denominated in a foreign currency, the entity may decide to raise finance denominated in the same foreign currency, to reduce the risk of exchange rate movements by matching the receipts from the project with the servicing costs of the finance

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12
Q

how do different financing options affect the financial statements?

A

investors use ratio analysis which they calculate from financial statement e.g. ROE or gearing and interest cover

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13
Q

how do different financing options affect the tax position?

A

debt finance gives rise to interest payments which are tax deductible, so impacting the tax position of the business

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14
Q

how do different financing options affect the financial stakeholders?

A

closely monitor the business’ performance

management must clearly explain the rationale for any new financing method which impacts the financial statements or the tax position

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15
Q

what is a share?

A

a fixed identifiable unit of capital in an entity which normally has a fixed nominal value, which may be quite different from its market value

shareholders receive returns in the form of dividends and also capital growth in the share price

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16
Q

what are ordinary shares?

A

dividend paid at directors’ discretion

owners of the company, attend meetings and have voting rights

paid last to other finance providers on winding up

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17
Q

what are preference shares?

A

pays fixed dividend

get paid before ordinary but after other debtors

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18
Q

why are preference shares considered to behave in the same way as debt finance?

A

paid fixed portion annually, similar to interest paid

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19
Q

how are preference shares different to debt finance?

A

dividends are paid out of post-tax profits unlike debt finance where interest is paid out of pre-tax profits

preference share dividends can be skipped but debt finance interest can’t be

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20
Q

what are the 4 types of preference shares?

A

cumulative preference shares
non-cumulative preference shares
participating preference shares
convertible preference shares

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21
Q

what are cumulative and non cumulative shares?

A

cumulative:must be paid including skipped shared

non-cumulative:skipped dividends do not have to be paid

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22
Q

what are participating shares?

A

give the holder fixed dividends plus extra earnings based on certain conditions

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23
Q

what are convertible preference shares?

A

can be exchanged for a specified number of ordinary shares on some given future date

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24
Q

what is the primary function of the stock market?

A

enable companies to raise new finance

  • access to large pool of potential investors
  • in UK, must be plc before accessing stock market
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25
Q

what is the secondary function of the stock market?

A

enable investors to sell their investments to other investors

  • more marketable than unlisted companies
  • tend to be more attractive to investors
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26
Q

what does it mean when a company is ‘limited by shares”?

A

has shareholders and liability of the shareholders to creditors is limited to original capital invested i.e. nominal value of the shares and and premium paid in return

personal assets protected in the event of insolvency

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27
Q

what is a stock exchange listing?

A

when an entity obtains a listing for its shares on a stock exchange i.e. flotation or IPO

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28
Q

what are the advantages of a listing?

A
  • once listed, the market will provide a more accurate valuation of the entity than had been previously possible
  • realisation of paper profits, and mechanism for buying and selling shares int he future at will
  • raise profile of entity, which may have an impact on revenues, credibility with suppliers and long-term providers of finance
  • raise capital for future investment
  • makes employee share schemes more accessible
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29
Q

what are the disadvantages of a listing?

A
  • costly for a small entity (flotation, underwriting costs, etc)
  • making enough shares available to allow a market, a and hence loss of at least some control of the original owners
  • reporting requirements are more onerous
  • stock exchange rules for obtaining a quotation can be stringent
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30
Q

how do key stakeholders benefit from a stock market listing?

A 
more marketable
appreciation in value
better reputation and profile
better credit rating
more access to finance
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31
Q

what are the 2 important capital markets in the UK?

A

Stock Exchange for larger companies, more stringent criteria

AIM for smaller companies, more straightforward admission

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32
Q

what determines prices on the stock exchange?

A

forces of supply and demand

demand drives up prices of shares

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33
Q

what are the 3 most commonly used methods of issuing shares?

A

IPO
Placing
Rights issue

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34
Q

what is an IPO/flotation?

A

shares are offered for sale to investors through an issuing house
can be fixed price or in tender offer investors are invited to at suggested price
all shares are sold at best price which they would be taken up

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35
Q

what is placing?

A

shares are placed directly with certain investors (normally institutions) on a pre-arranged basis

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36
Q

what is Stagging?

A

selling IPO shares immediately

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37
Q

what is an IPO lockup period?

A

contractual restriction that prevents insiders who are holding a company’s shares before it goes public, from selling the shares for a period usually lasting 90-180 days after the company goes public

insiders include company founders, owners, managers, employees and venture capitalists

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38
Q

what is the purpose of an IPO lockup?

A

prevent the market from being flooded with a large number of shares which would depress the share price

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39
Q

why does an insider’s selling activity have a strong impact on a company’s share price?

A

they typically own a large percentage of shares

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40
Q

what are tender offers?

A

alternative to fixed price offer

  • subscribers tender for the shares at, or above, a minimum fixed price
  • once all prices received, a strike price is set and bidders who offered above are given shares
  • strike price set to make sure that the company raises the required amount of finance from the share issue
  • all pay strike price
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41
Q

what is an alternative name for placing?

A

placement or private placement

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42
Q

what is placing?

A

sale of securities to a relatively small number of select investors as a way of raising capital

investors are usually large banks, mutual funds, insurance companies and pension funds

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43
Q

why is placing a popular method?

A

cheaper and quicker to arrange than most other methods but does not normally lead to a very active market for the shares after flotation

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44
Q

what is private equity?

A

equity capital that is not quoted on a public exchange

consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity

try to improve financial results and prospects of a company in the hope of reselling the company to another firm or cashing out via an IPO

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45
Q

what is a leveraged buyout?

A

large amounts of debt are issues to fund a large purchase

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46
Q

who usually takes the lead role in an IPO?

A

investment banks

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47
Q

what do investment banks advise on in IPOs?

A
  • the appointment of other specialists eg lawyers
  • stock exchange requirements
  • forms of any new capital to be made available
  • the number of shares to be issued and the issue price
  • arrangements for underwriting
  • publishing the offer
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48
Q

what do stockbrokers do during IPOs?

A

provide advice on the various methods of obtaining a listing

work with IB to identify institutional investors, but usually they are involved with smaller issues and placings

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49
Q

how are institutional investors involved in IPOs?

A

little direct involvement other than as investors and agreeing to buy shares

provide indication of take-up of shares

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50
Q

what is a rights issue?

A

new shares are issued to existing shareholders in proportion to their existing shareholding

relatively simple to arrange and do not dilute control

not always suitable way of raining large amounts of finance

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51
Q

what is pre emption rights?

A

the right to buy new shares ahead of outside investors

prevent dilution by new issues

protected by law and can only be waived with the consent of shareholders

cheaper than public issue but more expensive than placing

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52
Q

how is the issue price of rights issue set?

A

low enough to secure acceptance

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53
Q

what is underwriting?

A

avoids the possibility that the entity will not sell all of the shares it is issuing and so receive less funds than it expects

usually financial institutions such as merchant banks

agree to buy unsubscribed shares for a fee

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54
Q

how can underwriting costs be avoided?

A

through a deep-discounted rights issue

reduces possibility of shareholder not taking up their rights

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55
Q

what happens to the market price after rights issue?

A
  • tendency for price to fall after announcement
  • temporary fall due to:consequences of issue, future profits, future dividends

after actual issue, price will normally fall again because:

  • -more shares in issue
  • -new shares were issues at market price discount
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56
Q

what are cum rights?

A

when rights issue announced, all existing shareholders have the right to subscribe for new shares and so there are rights attached to the shares and the shares are traded cum rights

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57
Q

what are the ex rights?

A

on first day of dealings, the rights no longer exist and the old shares are now traded ex rights i.e. no rights attached

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58
Q

what is TERP?

A

theoretical ex rights price is price the shares will trade on the first day of trading after issue

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59
Q

what are the courses of action open to a shareholder?

A
  • do nothing:shares diluted
  • renounce the rights and sell them on the market
  • exercise the rights
  • renounce part of the rights and take up reaminder
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60
Q

what are the implications of rights issue to the shareholder?

A
  • option of buying shares at a preferential price
  • have the option of withdrawing cash by selling their rights
  • able to maintain their existing relative voting position
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61
Q

what are the implications of a rights issue from the viewpoint of the company?

A
  • simple and cheap to implement
  • usually successful
  • provides favourable publicity
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62
Q

how does the wealth of a shareholder increase during a project?

A

increases by their share of the project NPV as long as they either take up the rights or sells them

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63
Q

what is the ranking for the following:

  • ex rights
  • cum rights
  • issue price
A

Issue price < Ex rights price < Cum rights price

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64
Q

what is debt secuirty?

A

in the event of a default, the lender will be able to take assets in exchange for the amounts owing

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65
Q

what is fixed charge security?

A

the debt is secured against a specific asset, normally land or buildings

preferred as puts lender at front of queue

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66
Q

what is floating charge?

A

secured against general assets e.g inventory

not as strong as fixed charge security in list of creditors

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67
Q

what is a covenant?

A

specific requirements or limitations laid down as a condition of taking on debt financing

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68
Q

what are some examples of covenants?

A

dividend restrictions: amount they can pay
financial ratios:specific levels and certain ratios
financial reports:regular
issue of further debt:restrictions

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69
Q

why are dividend restrictions placed?

A

prevent excessive dividend payments which may seriously weaken the company’s future cash flows and thereby place the lender at greater risk

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70
Q

how do debt covenants protect both the lender and the borrower?

A

lender: requiring and prohibiting activities
borrower: reduce the cost of borrowing

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71
Q

what are negative debt covenants?

A

state what the borrower cannot do

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72
Q

what are some examples of negative debt covenants?

A
  • additional long-term debt
  • pay cash dividends exceeding certain threshold
  • sell certain assets
  • enter into leases
  • combine in any way with another firm
  • compensate or increase salaries of certain employees
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73
Q

what are positive debt covenants?

A

state what the borrower must do

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74
Q

what are some examples of positive debt covenants?

A
  • maintain certain minimum financial ratios
  • maintain accounting record in accordance with generally accepted accounting principles
  • provide audited financial statements
  • perform regular maintenance of assets used as security
  • maintain life insurance policies on certain key employees
  • pay taxes and other liabilities when due
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75
Q

which covenants most commonly lead to technical default?

A

net worth and current ratio

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76
Q

what are some alternative responses to breaching a covenant?

A
  • waive the breach and continue the loan
  • waive the breach and impose additional constraints
  • require penalty payment
  • increase interest rate
  • demand immediate repayment of the loan
  • increase security needed
  • terminate debt agreement
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77
Q

why is better for the borrower to approach the lender if they suspect a breach?

A

the earlier the better
can negotiate a smaller penalty
give details of recovery plan, additional security or parent company guarantees

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78
Q

what are the 2 types of sources for debt finance?

A

banks or capital markets

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79
Q

what is the criteria for selecting debt instruments?

A
  • liquidity
  • timescale
  • cost
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80
Q

what is a key feature that differentiates the bond market from bank borrowings?

A

accessibility

latter open to all - preferred by SMEs

former is costly and cumbersome for aspiring companies, need to build reputation to get higher interest rates

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81
Q

what are the differences in cost between capital markets and bank finance?

A

bank:submission to terms set out by the bank as well as dealing with sometimes uncertain conditions
capital markets:difficult and expensive but reduced cost once in

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82
Q

what are money market borrowings?

A

money market used by a participant as a means of borrowing and lending in the short term i.e. <12m

interbank lending

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83
Q

what are RCFs?

A

revolving credit facilities

-can withdraw up to a pre-approved credit limit
amount fo available credit decreases and increases as -funds are borrowed and then repaid
-make repayments based on amount used or withdrawn plus interest

flexible debt financing option

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84
Q

what is a bond?

A

debt security in which the issuer owes the holders a debt and depending on the terms of the bond, is obliged to pay interest and repay the principal at a later date

like a loan
-coupon is interest

85
Q

what is the major difference between bonds and shares?

A

shareholders have an equity stake in the company and bondholders have a creditor stake

-another difference is bonds usually have defined terms (maturity) but shares may be outstanding indefinitely

86
Q

what is a commercial paper?

A

large, well-established listed companies with good credit ratings may issue short-term unsecured money market security referred to as commercial paper

  • generally mature within 9 months
  • risky if used for longer term finance as may be insufficient investor interest at one of the 3 month issue dates so need backups
  • can trade at any time before the maturity date
87
Q

what are the 3 main groups of the bond market?

A

issues
underwriters
purchasers

88
Q

who are the issuers in the bond market?

A

sell bonds

usually governments(biggest one), banks and corporations

89
Q

who are the underwriters in the bond market?

A

investment banks and other financial institutions

help sell the bonds

more risk involved with this type of debt

90
Q

what is a MTN?

A

medium term note programme

issuer via the underwriter can issue debt securities on a regular and/or continuous basis

91
Q

who are the purchases in the bond market?

A

buy the bonds

governments, banks

92
Q

what are the 2 stages of the admission process into the London stock exchange?

A

listing

admission to trading

93
Q

what is the listing stage of the admission process to the London stock exchange?

A

if not already listed, must apply

  • listing dependent on the securities gaining admission to trading on the Main Market through satisfying the Exchange’s admission and disclosure standards
  • can take 3 days
  • appointing advisers with extensive experience of listing and agreeing the timetable well in advance should help shorten the process
94
Q

who controls admission of companies to the Official List?

A

UKLA (UK Listing Authority). a division of the Financial Conduct Authority

FCA responsible for approval

95
Q

what is the OrB?

A

Order book for retail Bonds

  • launches by London Stock exchange
  • electronic order-driven trading service for UK government, corporate and supranational bonds
96
Q

what is the aim of ORBs?

A

offer retail investor’s efficient access to an on-screen secondary market in retail denominated London listed debt instruments

97
Q

why was the ORB introduced?

A

in response to demand from private investors in the UK for a cost effective and transparent mechanism fo gaining access to fixed income securities and to develop the market for retail denominated bonds in the UK

98
Q

How early must documentation be submitted or admission to the ORB?

A

11 days prior to the admission date

99
Q

what should documentation to the ORB include?

A

an electronic copy of the base prospectus and the relevant pricing supplement/final terms document, a cope of the relevant board minutes relating to the issue, confirmation of the market maker who will be supporting the security and an indicative opening price for the security

100
Q

why should all bonds admitted to the ORB have at least on registered market maker?

A

to ensure that all instruments available on the ORB are tradeable and have prices available throughout the day

101
Q

who can act as the market maker of a security?

A

the issue or a third party broker but must be a member firm of London Stock Exchange and be authorised to deal

102
Q

what prices must the market maker quote?

A

two-way prices (buy and sell) in the security throughout the continuous trading period

103
Q

what is the range for prices of secuirities?

A

must be within maximum spread requirement determined by the trading segment and trading sector of the security

also a minimum volume (equivalent to nominal value) of securities which must be quoted on either side

104
Q

how do market makers register in a security?

A

complete and submit a registration information form

market maker has no obligation to quote in more than on security and there is no fee payable to register in ORB securities

105
Q

what is the main reason that companies want to borrow in foreign currency?

A

fund a foreign investment project or foreign subsidiary

106
Q

what does foreign currency borrowing provide?

A

a hedge of the value of the project or subsidiary to protect against changes in value due to currency movements

-borrowing can be serviced from cash flows arising from the foreign currency investment

107
Q

what choice of currency do firms have when it comes to debt financing?

A

developed country:whichever currency they prefer

developing country:in international currency e.g. USD

108
Q

what are Eurobonds?

A

issues on the international capital markets

  • any major currency
  • listed on domestic stock exchange but cannot be traded through that exchange
  • bearer instruments and pay interest annually, gross of tax
109
Q

how are Eurobonds different to domestic bonds?

A

domestic bonds are both listed and traded on the local stock exchange and are usually registered bonds, that is, registered to a named holder

110
Q

what is the Eurobond market?

A

self-regulated off-shore market

self-regulation is promoted by the International Capital Market Association (ICMA) who set rules for members to follow in areas such as processing transactions and payment of comission

111
Q

what issues need to be considered as an entity aims to achieve its target debt profile?

A
  • should the entity borrow at a fixed or floating rate?
  • should the debt have a short-term or a long-term repayment date?
  • should domestic currency or foreign currency borrowings be used?
112
Q

what is interest rate risk?

A

risk of gains or losses on assets and liabilities due to changes in interest rates

-will occur for any organisation which has assets or liabilities on which interest is payable or receivable

113
Q

what does the exposure to interest rate risk depend on?

A

the amount of interest bearing assets or liabilities that na entity holds and the type that these are (floating or fixed rate)

114
Q

what is refinancing risk?

A

associated with interest rate risk because it looks at the risk that borrowings will not be refinanced or will not be refinanced at the same rate

115
Q

what are some of the reasons that borrowings will not be financed at the same rate?

A
  • lenders are unwilling to lend or only prepared to lend at higher rates
  • the credit rating of the company has reduced making it a more attractive lending option
  • the company may need to refinance quickly and therefore have difficulty in obtaining the best rates
116
Q

why is the refinancing risk higher for shot-term debt finance?

A

has to be regularly repaid and then renegotiated if additional finance is needed

117
Q

what is currency risk?

A

risk that arises from possible future movements in an exchange rate

2 way risk:adverse or favourable

118
Q

which organisations foes currency risk affect?

A
  • assets and/or liabilities in a foreign currency
  • regular income and/or expenditures in a foreign currency
  • no assets
119
Q

what are some other sources of finance?

A 
retained earnings
existing cash balances
sale and leaseback
grants
debt with warrants attached
convertible debt
venture capital
business angels
government assistance
leasing
120
Q

why is using retained earnings not cheap?

A

assets= equity + liability

all assets are funded by equity and liabilities

cost of that cash should be based on the cost of the debt and/or equity that was used to fund it

this would be WACC

121
Q

what is sale and leaseback?

A

selling good quality fixed assets such as high street buildings and leasing them back over many years (25+)

funds are released without any loss of use of assets

any potential capital gain on assets is forgone

popular for retail organisations e.g. tesco, M&S

122
Q

what are grants?

A

often related to tech, job creation or regional policy

particular important to SMEs

key advantage:do not need to be paid back

usually provided by government

123
Q

what is a warrant?

A

option to buy shares at a specified point in the future for a specified (exercise) price

often issued with a bond as a sweetener to encourage investors to purchase the bonds

  • potential for capital gain
  • can sell warrant before exercise date
  • can buy share on exercise date
124
Q

what is venture capital?

A

finance provided to young, unquoted profit-making entities to help them expand

-equity finance

  • accept low levels or dividends
  • receive most of their returns as capital gains on exit e.g IPO or flotation
125
Q

what is a business angel?

A

similar to venture capitalists

for smaller companies

126
Q

what is government assistant?

A

schemes to assist SMEs, relocating businesses, innovators, new job creation

127
Q

what is a lease?

A

commercial agreement where an equipment owner conveys the right to use the equipment in return for payment by the equipment user of a specified rental over a pre-agreed period of time

128
Q

whats are the reasons for leasing?

A
  • readily available form of finance so convenient
  • removes the need for significant capital outlay at the beginning of a project’s life i.e. avoids the need to find the capital at the outset
  • cheaper in financial terms than conventional debt financing:asset backed finance so less risky for lender, lower rate than standard borrowing
129
Q

when is the lease or buy decision made?

A

only once the decision to invest in the asset has been taken

130
Q

what rate should lease vs buy decisions be discounted?

A

BOTH at the post tax cost of debt-both have similar risk

131
Q

are Eurobonds held in a register of bondholders?

A

no as they are bearer instruments

132
Q

what is the main advantage of issuing a CULS?

A

lower return that it demands due to the attraction of the option of conversion to equity i.e. it is cheaper to service than ordinary debt

133
Q

what are the 2 things that happen to cost of capital (WACC) when an entity increases gearing?

A

WACC falls as debt is a cheaper source of finance than equity
WACC rises as the equity holders perceive more risk caused by the increase in debt so the cost of equity rises

134
Q

why is cost of debt cheaper than cost of equity?

A

interest is an obligation so less risk for lender

interest is tax deductible reducing cost

135
Q

why does the risk perception increase as gearing increases?

A

extra interest payments may make dividend payments less likely

136
Q

why might low/no gearing not be in the equity investor’s best interests?

A

because the entity might then be failing to exploit the benefits which borrowing can bring

137
Q

what happens to the ordinary share price of highly geared entities in times of rising interest rates?

A

tend to be depressing

138
Q

in the traditional view, what happens to the WACC as debt is introduced?

A

will fall as debt finance is cheaper and outweighs any increases in the cost of equity required to compensate equity holders for higher financial risk

139
Q

what happens at extreme levels of gearing?

A

cost of debt will also rise as loaners will become worried about the security of their loans

140
Q

what happens at the optimal capital structure in the traditional view of gearing?

A

the overall return required by investors is minimised

141
Q

what are the conclusions of the traditional view?

A

shareholder wealth is affected by changing the level of gearing

there is an optimal gearing ratio at which WACC is minimised and the total value of the company is maximised

financial managers have a duty to achieve and maintain this ratio

while we accept that the WACC is probably U shaped for entities generally, we cannot precisely calculate a best gearing level

the optimum level will differ from one entity to another and can only be found by trial and error

142
Q

what are M&M’s key assumptions?

A

perfect capital market:no information costs and transaction costs
debt is risk free and cost of debt remains constant at all levels of gearing
investors are indifferent between personal and corporate gearing
investors and companies can borrow at the same rate of interest

143
Q

why is the WACC and business value constant at all levels of gearing under M&M no tax theory?

A

the two opposing forces cancel out exactly

144
Q

what do M&M believe that a value of a company solely depends on?

A

future post tax (pre financing) operating income generated by its assets

145
Q

what was M&M’s 1958 proposition about companies of the same type?

A

operate in the same type of business and face similar operating risks so must have the same total value

146
Q

why is the WACC constant at all levels of gearing?

A

any benefit from the increased proportion of cheaper debt finance (downward force on the WACC) must be exactly offset by the increase in the cost of equity (upward force on the WACC)

147
Q

what is the essential point that M&M make that goes against the traditionalist view?

A

ignoring tax, a company should be indifferent between all possible capital structures

148
Q

how does M&M support their theory?

A

show that market pressures will ensure that 2 companies identical in every aspect apart from

149
Q

what is the logic behind M&M’s model?

A

mathematical analysis of a world in which a number of major assumptions have been imposed

  • many assumptions unrealistic
  • inspired further work that examines the impact of relaxing those assumptions in order to tell how gearing might affect the behaviour of capital markets
150
Q

why does M&M conclude that geared companies have an advantage over ungeared companies?

A

corporation tax system carries a distortion under which returns to debt holders (interest) are tax deductible for the company, whereas returns to debt holders equity holders are not

  • pay less tax
  • will have greater market value and lower weighted average cost of capital
151
Q

what is the optimum gearing level?

A

99.9% debt

152
Q

what is the value of a company without tax?

A

Vu=Vg

153
Q

what is the WACC of a company without tax?

A

Kadj=Keu

154
Q

what is the value of a company with tax?

A

Vg=Vu + TB

155
Q

What is M&M’s key belief?

A

that the market would not reward companies for something that could be achieved at zero cost and zero risk

156
Q

what is the most unrealistic M&M key assumptino?

A

that debt is risk free

-higher levels of debt mean higher risk for lenders and shareholders

157
Q

what are the main practical considerations companies deal with when determining their capital structures?

A
  • company’s ability to borrow money
  • existing debt covenants
  • increasing costs of debt finance as gearing rises
  • views of other stakeholders and rating agencies
  • tax exhaustion
  • directors’ interest
158
Q

what is the debt capacity?

A

maximum level of borrowing that a company can comfortably support
-function of creditworthiness and credit scoring

159
Q

why are the views of stakeholders important to consider too?

A

affect credit score or creditworthiness

  • reduction may be evidenced by a credit rating downgrade
  • reputational damage (suppliers, customers)
160
Q

what is tax exhaustion?

A

at some point interest payable will be so high that taxable profit will be reduced to zero

beyond this point, there will be no further benefit of raising debt finance

for tax exhaustion to apply, the company must be making a loss and will have breached any interest cover covenants
-will have bigger issues than loss of tax relief

161
Q

how does the director’s interest affect gearing?

A

may be reluctant to rely too heavily on debt because their careers may be affected if they borrow responsible but company is unable to service the debt

may prefer to raise equity rather than debt, even when the company has some remaining borrowing capacity

162
Q

what are additional considerations for groups of companies?

A 
tax issues
country risk
type of finance provided by the parent
transfer pricing
thin capitalisation rules
163
Q

in terms of country risk, where will there be less exposure risk?

A

borrowing funds in the country where it generates its net income
-any servicing costs for the finance can then be paid out of the income generated without worrying about exchange rate movements

164
Q

why does the choice between debt/equity provided by a parent company make no difference to cash?

A

they are both financed by cash by the parent and therefore can be funded by the parent by either debt or equity

the choice of capital structure for a subsidiary is therefore independent of the decision regarding the appropriate group capital structure

165
Q

what adjustments does transfer pricing require when once company lends to another in the group?

A

an adjustment if it is deemed that the interest rate charged is not set at a market rate

166
Q

what are the debt:equity ratios and interest cover numbers that indicate thin capitalisation?

A

ratio greater than 50:50

interest cover < 3

167
Q

what is thin capitalisation?

A

aims to stop companies from getting excessive tax relief on interest if the have entered into a borrowing with a related party that exceed the amount a third party lender would be prepared to lend

168
Q

what do the thin capitalisation rules include?

A
  • interest on the part of the borrowing that an independent third party would be prepared to lend the company is allowable
  • the excess is disallowed
  • the borrowing capacity of the individual company and its subsidiaries is considered (but not the rest of the group)
169
Q

what factors determine thin capitalisation?

A

gearing: high debt causes thin cap issues

interest cover

170
Q

what are the key factors to consider in relation to the payment of dividends?

A
  • M&M’s dividend irrelevancy argument
  • the interests of shareholders (the clientele and the bird-in-the-hand argument
  • the signalling effect or information content of dividends
  • the cash needs of the entity
171
Q

what is M&M’s dividend irrelevancy theory?

A

says that the pattern of dividend payout should be irrelevant

as long as companies continue to invest in positive NPV projects, the wealth of the SH should increase whether or not the company makes a dividend payment this year

172
Q

what is the argument M&M uses for the Dividend Irrelevancy Theory?

A
  1. the return on a share is determined by the share’s risk
  2. the return itself is delivered to shareholders in 2 parts:one part is the dividend paid and the other is the capital gain/loss in the share price
  3. the dividend decision is how the return is delivered:how much of the earnings are paid as dividends vs reinvested
  4. as the dividend decision does not affect the risk of the shares, it does not affect their return. All the dividend decision therefore does is to determine how the return is to be split up between dividends and capital gains
  5. do shareholders ming how the returns are split? answer according to M&M is no they dont is we asusme i) there are no taxes
    11) shares can be bought and sold free of any transaction costs
173
Q

how does M&M argue that shareholders can ‘manufacture’ a dividend policy irrespective of company policy?

A

if a person is holding shares but the company withholds a dividend, the SH can sell some of the shares to replace the lost income

174
Q

id dividends were taxes and capital gains were tax free, what would the shareholder prefer?

A

dividends delivered in the form of capital gains rather than dividends

175
Q

when would investors prefer if the returns were delivered as dividends rather than capital gains?

A

if they had to incur transaction costs when realising their capital gains

176
Q

what does M&M suggest that entities should focus on between investment policy and dividend policy?

A

investment policy as investors could manufacture dividends if they need to

177
Q

what are the 2 important considerations of the interests of shareholders?

A

clientele effect

bird-in-the-hand argument

178
Q

what is the clientele effect?

A

companies should follow a consistent dividend policy to ensure they gather clientele who like their particular policy

irl, investors will have a preference for dividends or capital gains

179
Q

what is the bird-in-the-hand argument?

A

a dividend is certain and some investors prefer that over the promise of future dividends

even if capital gains would be more tax efficient

180
Q

what is the signalling effect?

A

investors look at dividend decision as signal on company’s financial performance and future

firms will choose to keep steady, predictable dividend annually regardless of situation

181
Q

what are 2 strong dividend signals?

A
  1. reduction in the dividend per share signals that the company is in financial difficulties
  2. a failure to pay out any dividend at all signals that the company is very close to receivership
182
Q

what did Litner discover about dividend growth?

A

dividend growth lagged two to three years behind earnings growth
-managers reluctant to increase dividend per share until they are confident they can maintan new level

183
Q

what are some exceptions to Litner’s discover?

A

Apple Computers: paid no dividends for years, preferring to reinvest and reduce need for financing.Market responded positively to Apple throughout and share price rose strongly

184
Q

how would the cash needs affect a small company’s dividend decision?

A

poorer credit rating, struggle to raise finance from external sources so its cash needs might have to be met by restricting the amount of dividends it pays out

185
Q

how would the cash needs affect a growing company’s dividend decision?

A

will have many potential investment opportunities. the cash needs for these new investments will have to be met by balancing dividend policy alongside external finance sources

186
Q

how would the cash needs affect a well-established company’s dividend decision?

A

might be cash rich which allows them to afford large dividends without compromising it internal cash needs

187
Q

how do managers reconcile these differing views of dividend policy in the real world?

A

make a judgement on dividend policy after taking many varying factors into acocunt

188
Q

what are the key considerations of dividend policy in the real world?

A
  • the clientele effect
  • the cash needs of the company
  • signalling
  • legal factors
  • debt covenants
  • tax implications
  • link to investment and financing
  • inflation:dividend increase needed to maintain purchasing power of last year’s dividends?
189
Q

what are the 4 commonly adopted dividend policies?

A

stable dividend policy
constant payout ratio
zero dividend policy
residual approach to dividends

190
Q

what is the stable dividend policy?

A

paying out a constant or constantly growing dividend each year:

  • offers investors a predictable cash flow
  • reduces management opportunities to divert funds to non-profitable activities
  • works well for mature firms with stable cash flows
191
Q

what is the risk with stable dividend policy?

A

reduced earnings would force a dividend cut with all the associated difficulties

192
Q

what is the constant payout ratio?

A

paying out a constant proportion of equity earnings:

  • maintains a link between earnings, reinvestment rate and dividend flow but
  • cash flow is unpredictable for the investor
  • gives no indication of management intention or expectation
193
Q

what is the zero dividend policy?

A

all surplus earnings are invested back into the business. Such a policy:

  • is common during the growth phase
  • should be reflected in increased share price

when growth opportunities are exhausted (no further positive NPV projects are available):

  • cash will start to accumulate
  • a new distribution policy will be required
194
Q

what is the residual dividend policy?

A

a dividend is paid only if no further positive NPV projects available. This may be popular for firms:

  • in the growth phase
  • without easy access to alternative sources of funds
195
Q

what are the risks of residual dividend policy?

A

cash flow is unpredictable for the investor

gives constantly changing signals regarding management expectations

196
Q

what are ratchet patterns?

A

a variant on the stable dividend policy

paying out a stable, but rising dividend per share:

  • dividends lag behind earnings, but can then be maintained even when earnings fall below the dividend level
  • avoids ‘bad news’ signals
  • does not disturb the tax position of investors
197
Q

what are scrip dividends?

A

bonus shares free of charge as an alternative to a cash dividend

198
Q

what are the reasons for a scrip dividend?

A
  • if the company wishes to retain cash in the business
  • if shareholders wish to reinvest dividends in the company but avoid brokerage costs of buying shares
  • if there are tax advantages of receiving shares rather than cash
199
Q

what is impact of a scrip dividend?

A
  • if all shareholders opt for bonus shares, the scrip issues has the effect of capitalising reserves. Reserves reduce and share capital increases
  • both share price and earnings per share will fall due to the greater number of shares in issue-overall value of each shareholders’ shares and share in future earning theoretically remain unchanged
200
Q

what is the disadvantage to shareholders in holding share capital instead of reserves?

A

share capital is non-distributable in the future

201
Q

Santander examples of scrip dividend

A
  • Feb 2011
  • rights issued without charge

Shareholders given rights to receive additional shares and 3 options for their allotment of rights:

1) sell the rights off market to Santander and receive a fixed cash amount
2) sell the rights on market and receive cash
3) hold the rights and receive new Santander shares, 1 share for every 65 rights held

202
Q

what is share repurchase?

A

alternative to paying a dividend

used when the company has no positive NPV projects to invest in, so it returns the cash to shareholders

alternatively, a company may decide to use a one-off large dividend to return surplus cash to shareholders

203
Q

how ca share repurchase be used to privatise a company?

A

buy back all their shares

this is rare

204
Q

what are the advantages of share repurchase?

A
  • choice for investors
  • lower future total dividends
  • can change control
  • no change in the share price:paying dividend would lower the share price
  • removes the dividend policy precedent:failing to repeat a large one-off dividend can send the market a negative signal
205
Q

what are the disadvantages of share repurchase?

A
  • approval needed in general meeting: more time consuming
  • difficult to set a fair price for the repurchase:company will hope for a lower price whereas shareholders will hope for a higher price
206
Q

what happens if all shareholders agree to the repurchase?

A

both a share repurchase and a one-off large dividend have the same impact on the cash, and the gearing of the company (they reduce the value of equity, so increase the gearing and hence financial risk and cost of equity)

207
Q

what is the effect on EPS and share price for scrip dividends or share repurchase?

A

scrip dividend:EPS falls, share price falls

share repurchase: EPS rises, share price stays constant

208
Q

how does scrip dividend affect total shareholder’s equity and capital structure?

A

total equity in SFP remains the same

capital structure and gearing ratio is the same

F3 (4 decks)

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