CF final exam study Flashcards
Sustainability - lecture 5 Define: Corporate social responsibility? Negative screening? Stranded assets? TBL? Universal owner?
CSR = approach to business which factors in economic, social, environmental and ethical impacts to mitigate risk, decrease costs, improve brand image
Negative screening = investment approach which excludes some companies based on their policies, actions, or products.
Stranded assets = assets that may be written down in value as a result of future changes
TBL = economic, social, environmental
Universal owner = tied to market as a whole because of broad investments
Sustainability - lecture 5
Contrast the four core investment approaches
- Negative screening = provides transparency + restricts investment where legislation is likely to come in later and lessen returns, yet restricts investment pool
- Positive screening = allows investment in positive future
- Best in class = Good for passive investment, however bad because allows dirty companies in too, also restricts investment pool
- Thematic approach = allows investor to clearly invest in personal convictions, however limits investment pool
Sustainability - lecture 5
Outline two broad investment approaches?
Active shareholder engagement = invest wherever you choose, and aim to make positive change through shareholder engagement = fail to do so results in divestment
ESG ratings = invest on the basis of ESG ratings
Ethics - lecture 6 Define: Ethics Values Consequentialism Catergorical moral reasoning
Ethics = set of moral principles or values Values = core beliefs about what is important and how one should behave across a wide variety of situations
Consequentialism = Ethical view that whats right or wrong depends on the consequences of ones actions
Categorical moral reasoning = Ethical view that whats right or wrong depends on the intrinsic quality of the act
Ethics - lecture 6
outline the three areas of normative ethics?
Consequentialism = Consequences guide actions
Deontology = duties, obligations, principles guide actions
Virtue ethics = integrity guides actions = depends on each persons personality
Ethics - lecture 6
Name the three areas of particular interest concerning ethics in finance and approaches for managing these issues
What are the whistleblowers obligations to employer
- Conflict of interest = utilise independent monitoring + commit to being objective + use rules/policies to prohibit gifts
- Insider trading = manage information asymmetry through the timely and well monitored release of information
- Whistleblowing = implement a whistleblowing policy = trained staff for dealing with issues, procedure for reporting issues, commitment to taking appropriate action (contractual obligation founded by company in first place), a guarantee against retaliation
Whistleblowing = Whistle-blowing is the voluntary release of non-public information, as a moral protest, by a member or former member of an organisation to an appropriate audience outside the normal channels of communication regarding illegal and/or immoral conduct in the organisation that is opposed to the public interest.
Obligation s = duty of loyalty to protect confidential information and to act in their best interest + no obligation to do anything outside their job.
Ethics - lecture 6
Discuss why the Law cannot be used as a standard for ethics
Who is responsible for enforcing the law concerning corporations in Australia?
Which law is most important for corporations?
The law cannot be used as a standard for ethics because it takes time to adjust + it is different in each country
ASIC
Corporations act 2001 = duties of directors, officers, employees. Shareholder rights. Financial reports and audits
Payout policy and valuation - lecture 7
Which two payout policy options are available?
Are dividends paid out only as cash?
How can a firm use a DRP to payout higher dividends without using more cash?
Three issues associated with a DRP?
Payout policy = dividends or share repurchases
Dividends = no, they can be paid out in terms of shares as part of a DRP (discount to market price + no transaction costs)
higher dividend payout = depending on the DRP rate = cash is reinvested in the bussiness by those who choose to use the DRP = this reinvested cash can be paid out as extra to those who didnt use the DRP (1/1-0.2) = 1.25
Issues of DRP:
1) retain too much cash
2) price discount adds up to more than savings on issue costs
3) Non-participants suffer whenever a price discount is offered
Payout policy and valuation - lecture 7
What are three advantages of share buybacks?
What are the findings of Brav, graham, Harvey, Michaely?
Advantages:
1) payoff particular investors
2) Shrink the firm and equity
3) good for distributing surplus cash
BGHM = managers concern lies with dividend changes and not with the set dividend level itself. hence to avoid reducing dividends, managers will smooth them using the formula Div1 - Div0 = adjustment rate x ((target ratio x EPS) - Div 0)
- Dividend changes follow shifts in long-run sustainable earnings
Payout policy and valuation - lecture 7
Contrast the inherent information in share repurchases vs Dividends up/down?
Share repurchases = may signal firm is running out of uses for cash or may signal firm confidence shares are underpriced (= why they are buying them back)
Dividends up = signals firm confidence in long-term earnings
Dividends down = signal cash or earnings shortfall
Payout policy and valuation - lecture 7
Summarise the irrelevancy of payout policy in a perfect capital market?
If the company uses surplus cash to pay dividends then the ex-dividend share price will drop by the dividend amount. However shareholder wealth will remain the same as the price drop will be offset by the dividend they just received
If the company uses surplus cash to repurchase shares then share price will remain the same as the total number of outstanding shares drops in proportion to the drop in company Assets ( = Assets current value - surplus cash used for buybacks) = shareholder wealth remains the same….
Payout policy and valuation - lecture 7
Outline the first approach for calculating share price
Approach 1:
Here we calculate the present value of cash flows and divide this by the number of outstanding shares. The result is the PV of the company cash flows per person i.e. the price of a share
Alternatively if there is dividend growth we can simply use the dividend perpetuity growth formula to value shares
Payout policy and valuation - lecture 7
outline the second approach for calculating share price (where total shares are changing due to share repurchases)
Lets assume dividends are paid and also some share repurchases are made AND FCF is a set amount continuing for the foreseeable future ….
First: Calculate ex dividend price
Second: Calculate how many shares are left outstanding after share repurchases are made at the ex-dividend price. (Dividends come first)
Third: calculate the FCF per share using the new amount of outstanding shares.
Fourth: subtract the original FCF per share from the new FCF per share and divide by the old FCF per share to find the growth rate
Fifth: use the dividend perpetuity with growth to calculate the new share price
Payout policy and valuation - lecture 7
When is cash considered surplus and payout necessary?
Outline the payout policy of a firm in regards to its lifecycle.
Why are high-payout stocks valued?
1: Positive NPV projects exhausted and FCF likely to continue
2: Debt levels are prudent and manageable
3: sufficient rainy day funds
At first no payout policy as surplus cash is used for positive NPV projects. Once these projects start to run out the surplus cash will be used for share repurchases. The preference for repurchases before dividends stems from the flexibility of repurchases (if the company experiences financial stress they will have to lower their dividends, and as BGHM have shown, managers dont want to do this) Then comes an announcement of regular dividends and then finally the announcement of growth for dividends and/or larger repurchases
High-payout stocks = less surplus cash = less agency problems.
Payout policy and valuation - lecture 7
State the three conclusions on Share repurchases and DCF models of share prices
1: Today’s market capitalisation and share price are not affected by how payout is split between dividends and repurchases
2: Shifting payout to repurchases reduces current dividends but produces an offsetting increase in future earnings and dividends per share
3: When valuing cash flow per share, it is double counting to include both the dividends per share and cash received from repurchases (you don’t get any subsequent dividends after repurchases)
Does debt policy matter - lecture 8
When a firms splits its capital structure, who receives payment first?
What is MM propositions 1?
First payment = when a company splits its capital structure, using debt and equity, debt-holders will be paid first through an established cash stream which is relatively safe.
MM proposition 1 = “the market value of a firm is independent of its capital structure” = firm value is determined by its real assets and not the securities it issues
Does debt policy matter - lecture 8
How could we show that the Value of a levered firm must equal to the value of an unlevered firm?
Vl = Vu: For this we must first consider the very important fact that two investments with the same payoff must have the same cost in order to avoid arbitrage.
Now, consider buying 10% of a levered firms shares. The return on this investment will be 10% of the levered firms profits - the interest they pay due to their use of debt (levered). As you own 10% of the company and are hence entitled to 10% of their after interest profits
Next consider an equivalent investment where you take a loan equivalent to 10% and use this loan to buy 10% of an unlevered firms shares. Your return will be the same since you will receive your 10% of profits (10% ownership) - the interest you pay due to your use of debt. Now consider the first notion concerning arbitrage… As these investments both have the same cost they must also have the same return, hence the value of a levered firm must equal that of an unlevered firm.
When investors can borrow personally just as easily and cheaply, company borrowin will not increase value and shareholders wealth
Does debt policy matter - lecture 8
Recall the graph of EPS vs operating income for a n unlevered firm and a levered firm. There is a break even point of operating income where a levered firm begins to generate higher EPS then an all equity firm. Why is this so?
Why then, if the EPS goes up does the share price remain unchanged?? How would we use Beta to support this fact?
This is because the levered firms issuance of debt will be used to repurchase shares and as such EPS will go up once the operating income exceeds the interest the company owes.
The share price remains unchanged because the company now has higher risk and as such the extra EPS serves as the reward premium for investors holding this extra risk (because the levered company will generate an eps of 0 if operating income is < interest). therefore the discount rate to be applied for future earnings (in order to determine share price) will also rise.
To support this fact we could use the weighted beta formula to show that an a 50/50 levered firm has 2 x the beta of an unlevered firm.
Does debt policy matter - lecture 8
What does MM proposition 2 state?
how do we calculate rA?
Contrast the variability of return on shares for a levered and an unlevered firm?
Proposition 2 states that the expected rate of return on equity increases in proportion to the debt-equity ratio
rA = expected operating income / market value of all securities
Variability of returns = For a levered firm the variability of returns stems from both business risk and financial risk. For an unlevered firm the variability of returns stems solely from the business risk
Does debt policy matter - lecture 8
Contrast the traditional position with the MM view concerning rE, WACC and rA
What is the problem with the traditionalist view?
MM believe rE rises just enough with leveraging to keep rA and WACC constant no matter the capital structure.
Traditionalists believe that rE does rise, however it does so to a different degree. At first it will rise slower than MM predict (thus rA will decline at first) and then it will shoot up really fast (with excessive borrowing) (thus rA and WACC will begin to rise) *(not stay constant as MM predict)
Problem with traditionalist view = if this were in fact the case, then there would be a point in which rA is minimised. However demand for these “premium” shares would push rA back to equilibrium
Does debt policy matter - lecture 8
When we begin to consider tax within our capital structure, we are able to utilise the tax shield. What is the overall effect of utilising this tax shield?
What is the equation for the interest tax shield?
What does the tax shield depend on?
Debt repayments are not taxed, however equity payments are taxed. So by using more debt we reduce our total tax paid. Henceforth the tax savings increase the total income to shareholders + debtholders.
The tax shield will provide extra income in the amount of tax rate x interest (as this is the amount saved by lowering our total tax)
The tax shield depends on two things:
- the marginal corporate tax rate
- The ability of a firm to earn enough income to cover interest payments
Does debt policy matter - lecture 8
MMs proposition 1 as corrected to reflect corporate income tax becomes:
After-tax value of firm = value if all equity financed + PV (tax shield)
How does this change if the debt is permanent?
If the debt is permanent then the PV(tax shield) can be simplified to Tc x D
Optimal financing policy - lecture 9
outline the RAF
How do we calculate Tpe (considering tax rate on dividends as well as tax on realised capital gain)
RAF = (1-Tp)/ ((1-Tpe)(1-Tc))
Raf > 1 debt is better
RAF < 1 equity is better
RAF = 1 debt policy irrelevant
if Tp = Tpe then RAF simplifies to 1/(t-Tc) and will hence be greater then 1 and so debt is better
RAF = The RAF formula allows us to determine if the taxpayer (given their specific tax rates on different income sources and the company tax rate) is better off lending to the company or buying shares in the company only in terms of the tax they will pay
Tpe = (dividend payout ratio x dividend tax rate) + (retention ratio x capital gain tax rate)
Optimal financing policy - lecture 9
Consider financial distress, where is the optimal debt ratio determined?
The optimal debt ratio is determined at where the marginal benefit of tax shield due to additional borrowing is just offset by the marginal increase in PV(costs of financial distress)
