Chapter 2 - measuring returns to shareholders

Question 1

how can a profit seeking company find financial performance

Answer 1

short term financial performance can be found using ratio analysis

Question 2

how to measure long term performance

Answer 2

profit shouldn’t be the sole indicator, doesn’t consider long term finance that has been invested in the firm

Question 3

how can you measure capital employed

Answer 3

• long term debt finance eg long term loan
• preference shares = shares paying a fixed dividend
• ordinary shares (equity finance) = ordinary shareholders are owners of the company, these shares don’t pay a fixed dividend so can vary year on year

Question 4

what is capital

Answer 4

capital is total amount of long term finance committed by investors

Question 5

what is ROCE

Answer 5

return on capital employed

measures a company’s current success by relating amount of profit to value of resources employed in generating it

(efficiency)

Question 6

two ROCE formulas

Answer 6

profit before interest and tax / long term debt plus equity
AS A %

profit before interest and tax / total assets - current liabilities
AS A %

Question 7

what is operating profit

Answer 7

profit before interest and tax

Question 8

how else can capital be measured

Answer 8

can be measured in terms of how the long term finance has been invested

ie. assets that have been purchased (short term liabilities)
can include non current assets (long term) like land/buildings
or current assets eg inventory or trade receivables

Question 9

how does the figure for capital change

Answer 9

is usually averaged out between beginning and end of the year

ROCE can also be based solely on value of capital employed at end of year

Question 10

what is earnings per share

Answer 10

shows maximum dividend that could be paid to the owners of the business out of that years profit after all payments have been made to other providers of finance

Question 11

EPS formula

Answer 11

EPS = profit after interest, tax and preference dividend / number of issued equity shares

Question 12

difference between EPS and ROCE

Answer 12

EPS shows return earned by ordinary shareholders only

unlike ROCE which considers the return generated to all the investors including those who have just lent money to the company

Question 13

what do ROCE or EPS not show

Answer 13

don’t show whether the level of returns being achieved are acceptable to the owners of the business

Question 14

what is risk free rates

Answer 14

rate of return that is available on risk free investments will be low = risk free rates

Question 15

how can the risks associated with investments be classified

Answer 15

SYSTEMATIC RISK = risk associated with market sector eg car industry if there is a recession it may be affected most because a new car isn’t a necessity

UNSYSTEMATIC RISK = associated with a specific company because of unique factors. eg a product recall by specific car manufacturer. shareholders can reduce exposure by investing in number of companies

Question 16

what is another way of saying return expected by shareholders

Answer 16

return expected by shareholders = cost of equity

can be used to assess whether the level of return that has been achieved is acceptable to shareholders

Question 17

how does value of shares change

Answer 17

value of shares depends on a company’s future cash flow potential not just current profitability

Question 18

what is discounting future cash flows

Answer 18

when valuing a share on basis of future cash flows we need to recognise that money expected to be received in future is worth less than money received today

adjusted to reflect time value of money

Question 19

what is free cash flows to equity

Answer 19

the cash flows generated by a business in a particular year after interest and tax and investment spending

Question 20

in what ways are cash flows to equity available

Answer 20

available either to pay as a dividend or to keep within a business - either way this cash is a benefit to ordinary shareholders

Question 21

what are free cash flows to the firm

Answer 21

cash flows generated by a business in a particular year after tax and investment spending but BEFORE interest

available to pay to all investors whether shareholders or providers of debt finance

Question 22

what is a perpetuity

Answer 22

the present value of a constant cash flow that is expected for the foreseeable future

Question 23

present value to perpetuity formula

Answer 23

= cash flow / cost of capital (cost of equity)

Question 24

what is the impact of the value of company’s shares

Answer 24

value of company’s shares directly influences shareholder wealth

future cash flows depend on state of economy but also management have influence over cash flows so can increase share price

Question 25

who has power to influence share prices

Answer 25

management can increase share prices over long run and that will be the most important to shareholders

Question 26

how can shareholder wealth be measured

Answer 26

monitored by measuring dividends paid to ordinary shareholders plus any changes in value of shares

measure is sometimes called total shareholder return

Question 27

total shareholder return (%) formula

Answer 27

dividend yield (%) + capital gain or loss (%)

Question 28

what can cause a share price to decrease

Answer 28

• interest rates have risen since the announcement
• outlook for the economy has worsened
• new investments are regarded as particularly risky.