CH3 International Operations and Intl Inv Appraisal

Question 1

the theory of comparative advantage

Answer 1

two countries can gain from trade when each focuses on the indsutries for which it has lowest opportunity cost

Question 2

Transfer pricing

Answer 2

the price charged by one part of a company when supplying goods or services to another part of the company, overseas subsidiary. With TP possible to report lower profits in countries with high taxes and higher profit in country with low tax rate
But Coutnries require prices to set on arms length basis = market price

Question 3

Remittance restriction

Answer 3

occurs when foreign country places a limit on foreign profits that can be repatriated back to the parent company. This may change extra tax payable by the parent company

Question 4

working capital req-t

Answer 4

it is assumed that WC req-t for the foreign project will increase by the annual rate of inflation in that country

Question 5

CH 4: The financing decision. Fin systems

Answer 5

1. fin markets (capital markets - stock markets for shares and bond markets (>1 year) and money markets (<1 year),
2. fin institutions - banks, building societies, insurance companies and pension funds
3. fin assets and liabilities (mortgages, bonds, bills and equity shares)
   Fin systems collectively:
4. channels funds from lenders to borrowers
5. provides mechnaism for payments - e.g. direct debits, cheque clearing system
6. creates liquidity and money - e.g. banks create money through increasing their lending
7. provides fin services as insurance and pensions
8. offers facilities to manage investment portfolios - hedge risk

Question 6

money markets

Answer 6

provides short term debt financing and investment (<1 year)

Question 7

derivatives markets

Answer 7

provide instruments for the management of financial risk, such as options and futures contract

Question 8

Insurance markets

Answer 8

facilitate redistribution of various risks

Question 9

forex markets

Answer 9

facilitate trading of foreign exchange

Question 10

raising finance considerations

Answer 10

ongoing servicing cost, issue cost, gearing, optimal capital structure, availability, tax, flexibility, cash flow profile, risk profile, covenants

Question 11

raising finance, criteria for future finance raised

Answer 11

1. Achieve or maintain target gearing ratio
2. Focus on certain sources only
3. Review key ratios before selecting suitable source

Question 12

tax position

Answer 12

tax benefits of debt only remain available whilst the firm is in a tax paying position

Question 13

flexibility

Answer 13

some firms operating in high-risk industries use mainly equity finance to gain the flexibility not to have to pay dividends should returns fall

Question 14

cash flow profile

Answer 14

CF forecasts are central to financing decisions - e.g ensuring that two sources of finance do not mature at the same time

Question 15

risk profile

Answer 15

business profile can have a far greater impact on directors than on a well-diversified investor. It may be argued that directors have a natural tendency to be cautious about borrowing

Question 16

theoretical considerations

Answer 16

the main capital structure theories assess the way in which a change in gearing/capital structure impacts on the firm’s WACC
lower WACC is the goal! bc projects will have higher NPV and hence wealth of the firm will be increased
consider relative sizes of the following:
1. debt is cheaper than equity (lower risk and tax relief on interest), so we might expect that increasing proportion of debt finance would reduce WACC, but increasing levels of debt make equity more risky bc fixed commitment is paid before equity - finance risk
so increasing gearing (proportion of finance in the form of debt) increases the cost of equity and that would increase WACC

Question 17

which has the greater effect on the WACC

Answer 17

1. the reduction in the WACC caused by cheaper debt
2. the increase in WACC caused by the increase in fin risk and Keg
   firm should have optimal level of gearing, where WACC is minimised -

Question 18

traditional view on

Answer 18

at low levels of gearing
equity holders see risk increases as marginal as gearing rises, so the cheapness of debt dominates resulting in lower WACC

Question 19

higher levels of gearing

Answer 19

equity holders become increasingly concerned with the increased volatility of their returns (debt interest is paid first). this dominates the cheapness of the extra debt so the WACC stars to rise as gearing increases

Question 20

at very high levels of gearing

Answer 20

serious bankrupcy risk worries equity and debt holders alike so both Ke and Kd rise with increased gearing, resulting in the WACC rising further
only trial and error to locate optimal level of gearing

Question 21

gearing

Answer 21

debt and preference shares give rise to fixed payments that must be made before ordinary shareholder dividends are paid. These methods of finance thus increase shareholder risk

Question 22

Modigliani and Miller theory (with tax)

Answer 22

bc of the tax advantages of issuing debt finance firms should increase their gearing as much as possible
1. Ke increases as gearing increases bc risks for equity holders is now higher. But this is adjusted to reflect that:
- debt interest is tax deductible
- lower debt costs imply less volatility in returns for the same level of gearing, giving smaller increases in Ke
- the increase in Ke does not offset the benefit of the cheaper debt finance and therefore the WACC falls as gearing increased

Question 23

Why MM is not optimal

Answer 23

1. bankruptcy risk (as gearing increase -> concern to shareholders -> reduction in share price -> increase WACC), 2. agency costs (lenders/debenture holders may impose restrictions in the loan agreements that limits mng freedom of action)
2. tax exhaustion (after a certain level of gearing companies will discover that they have no tax liability left against which to offset interest charges kd(1-t) simply becomes Kd
   the impact of 4. borrowing/debt capacity (companies with assets, which have an active second-hand market, and low levels of depreciation such as property companies, have high borrowing capacity
   differences in risk tolerance levels bn shareholders and directors, restrictions in Articles of Association, increases in cost of borrowing as gearing increases

Question 24

real world - static trade-off theory

Answer 24

firms will achieve optimum gearing level by trade-off/ Firms in stable (static) position will adjust their current level of gearing to achieve target
1. benefits of debt: tax shield -> increase firm value
2. cost of debt: reduction in value caused by the PV of the cost of fin distress and bankruptcy and increased agency costs