Chapter 5&6&7

Question 1

What are the 2 ways of estimating the cost of equity

Answer 1

Dividend valuation model

CAPM

Question 2

What is the formula for ex div

Answer 2

Ex div = cum div - next dividend

Question 3

What is 1 pro of DVM

What are 4 cons of DVM

Answer 3

Pro:
Calculate ke based off market data

Cons:
Constant div growth assumed and this is unrealistic and based on historic data

Model falls down if g > ke

Identifying ex div share price difficult for listed companies and very difficult for unlisted companies

Assumes that worth for shareholders is only represented by dividends

Question 4

What is the formula for the earnings retention model

What do the variables represent

Answer 4

g = r b

G = growth in future dividends

r = return on shareholder capital = PAT / opening equity

b = proportion of profits retained

Question 5

What are 4 problems with the earnings retention model

Answer 5

Reliance on accounting profits

Assumption r and b will be constant

Inflation can distort ARR if assets valued on historical cost basis

Model assumes new finance comes from equity

Question 6

What is the equation to find the price of preference shares

Answer 6

Po = D / kp

Question 7

What is the equation for the cost of irredeemable debt

Answer 7

Kd = Interest (1-t) / Po

Question 8

What is the spreadsheet function to find the cost of redeemable debt

What must we do with this answer

Answer 8

=RATE(number of periods, coupon payment, current ex div market value of bond, redemption value)

Then multiply by (1-t) to reflect the post tax cost of debt

Question 9

How does calculating the cost of convertible debt differ to the calculating the cost of redeemable debt

Answer 9

Since it is convertible, the redemption value will be the higher of the expected share price and the redemption amount on the bond

Expected share price in n years time estimated by
Price n years time = price now * (1+g)^n

Question 10

We can use the WACC to appraise a project so long as what 4 things are true

Answer 10

New project has the same business risk as existing operations

No change in long term capital structure of the company

We are not using project specific finance

Project is relatively small

Question 11

What is the equation for operating gearing

What does it mean for businesses

Answer 11

Operating gearing = contribution / PBIT

If higher it means more fixed operating costs and means a company’s profits are very sensitive to changes in sales volumes which contributes to business risk

Question 12

What is the equation for interest cover

Answer 12

Interest cover = EBIT / interest

Question 13

What are the 5 assumptions of MM 1958

Answer 13

Capital markets are perfect

Investors are rational and risk averse

There are no transaction costs

Debt is always risk free

There is no taxation

Question 14

What is the relationship that MM 1963 showed

Answer 14

Vg = Vu + Dt

Value of geared firm = value of ungeared firm + tax shield

Question 15

What are 3 problems associated with high gearing

Answer 15

Bankruptcy costs - eg redundancy repayments - investors demand higher return to compensate them for the risk of the company being unable to pay them back

Agency costs - loan covenants will often restrict the actions of directors in high gearing situations

Tax exhaustion - once taxable profits have been reduced to zero there is no tax benefit from any additional interest payments

Question 16

What are 5 practical aspects which apply to the traditional and MM theories

Answer 16

Business risk - gearing adds financial risk to existing business risk, so high business risk companies tend to have lower gearing

Quality of assets - firms with tangible assets find it easier to borrow

Availability of finance - small firms less attractive to lenders so often rely on equity finance

Cost of raising finance - issue costs are 0 for retained earnings and high for new share issue

Tax rate - higher tax rate, more desirable debt becomes

Question 17

What do you call the beta of a geared company

What do you call the beta of an ungeared company

Answer 17

Equity beta (Be)

Asset beta (Ba)

Question 18

What are the 7 steps to take if business risk changes and you want to calculate WACC

Answer 18

1) Locate proxy company

2) determine equity beta, tax rate and gearing of proxy company

3) ungear the proxy beta (using proxy gearing)

4) re gear the new asset beta (using our gearing)

5) use CAPM to determine Ke

6) use ke to determine new project specific WACC

7) use new WACC to evaluate new project

Question 19

What method can you use if the capital structure of a company changes to find the WACC

Which model does it use

Answer 19

Adjusted present value

MM 1963(with tax)

Question 20

What are the 3 steps to APV

Answer 20

Calculate the base case value of the project using Keu

Add present value of the tax shield (PV of the tax saving on interest, discounted at the pre-tax cost of debt)

Deduct costs if issuing the finance to arrive at the APV

Question 21

What is the main problem with the APV approach

Answer 21

Uses the MM 1963 assumptions so agency costs, bankruptcy costs, tax exhaustion not reflected

Question 22

What is the pecking order when it comes to raising equity finance

Answer 22

Due to issue costs:
1) retained earnings (cheapest)
2) rights issues and placing
3) new issues to the public

Question 23

What are the 6 arguments for dividend relevance policy

And explain them

Answer 23

Clientele effect - s/h invest in company for dividend policy, if it changes they may divest —> leads to fall in share price

Uncertainty - cash is more certain for s/h than possible future returns

Signaling - markets see reduction in divs as bad news, can lead to share price fall

Agency problem - s/h may prefer cash payout now to limit impact of directors acting in own interest

Taxation - dividend and cap gains are taxed differently

Cash availability - dividends can only be paid if a company has sufficient cash

Question 24

What is the main purpose of a share repurchase

What other option has a similar effect

Answer 24

Returning cash to shareholders without disrupting pattern of dividends

Special dividend

Question 25

What is a scrip dividend

Answer 25

Allows shareholders to swap cash now for a capital gain helping to avoid liquidity problems

Question 26

What is the method in which you use for project appraisal if the capital structure changes

Answer 26

Adjusted present value method

Question 27

What is the excel formula for calculating the growth rate

Answer 27

= POWER(most recent value/oldest value, 1/number of periods of growth)