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Financial Management > Course notes > Flashcards

Course notes Flashcards

1
Q

Define strategy

A

Strategic planning is concerned with the long-term direction of the business and how the business will achieve its objectives

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2
Q

What is financial strategy?

A

Concerned with the financial aspects of the strategic planning process.

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3
Q

What are the four key decisions to consider in financial strategy?

A

Financing
Investment
Dividend
Risk Management

All of the decisions are interrelated

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4
Q

What is a stakeholder?

A

A stakeholder is an individual or group of individuals with an interest in the organisation

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5
Q

What are the 8 categories of stakeholders?

A

Shareholder
Lenders
Directors/Senior managers
Employees
Customers
Suppliers
Government
Community

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6
Q

Who are the shareholder agents?

A

Directors

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7
Q

What is agency theory?

A

Says the directors will always put the shareholders’ objectives first.
They do need to consider the other stakeholders as they need to be happy to ensure that shareholder wealth is maximised

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8
Q

What is the agency problem?

A

Refers to the situation where the directors may be tempted to act in their own interests rather than the shareholders

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9
Q

Define sustainability

A

Meeting the needs of the current generations without compromising the needs of the future generations.

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10
Q

Define sustainable development

A

Recognises the interdependence between business, society and the environment.
Initiatives by governments business and organisations to promote sustainable development.

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11
Q

What are the two fundamental aspects to sustainability?

A

Impacts and dependencies

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12
Q

What is double materiality?

A

Incorporated in the Corporate Sustainability Reporting Directive (CSRD)

Means companies must report on how sustainability issues might create financial risks for the company
AND
The company’s own impacts on people and the environment

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13
Q

What makes up the ESG?

A

Environmental
Social
Governance

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14
Q

What is the purpose of IFRS Sustainability Disclosure Standards?

A

Provide high-quality, transparent and comparable information which covers a range of ESG topics about which investors want information

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15
Q

What is the general rule for sustainability report?

A

Environmental factors
Social factors
Governance factors
Policies, practice and performance
Targets

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16
Q

Examples of measuring environmental impact for ESG

A

Pollutants and effluents released
Percentage of waste recycled

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17
Q

Examples of measuring social impact for ESG

A

Employee turnover
Number of notifiable accidents
Supply chain sustainability

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18
Q

Examples of measuring governance impact for ESG

A

Diversity of the board
Bribery and corruption training for employees
Board member expertise

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19
Q

What are the challenges of ESG data?

A

Lack of comparability - can choose what they want to report
Insufficient measurable outcomes - often non-financial
Lack of assurance - data is not subject to normal assurance
Greenwashing - Companies provide the public with misleading or false information about the environmental impact of their products/operations

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20
Q

What are ESG ratings?

A

Rating agencies use ESG metrics to grade a company’s ESG performance.

A good rating boost brands image and helps get cheaper finance

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21
Q

What is the pay back period?

A

How many years of project cash flows are needed to recover the initial investment

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22
Q

How do you calculate payback period?

A

Cumulative total of cash flows until you hit 0
Assume that cashflows are generated evenly throughout the year.

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23
Q

What does ARR stand for?

A

Accounting Rate of Return

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24
Q

What does the annual rate of return show?

A

% annual return on the project

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25
Q

How do you calculate ARR?

A

Average annual profit /average investment

Average investment
(Initial outlay + scrap value)/2

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26
Q

Net present value is what process

A

Summing the present value of all future cash flows at the cost of capital

Gives the profit of project in today’s money

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27
Q

How do you make judgements on NPV?

A

If negative = DON’T DO IT
If positive = DO IT as it increase shareholder wealth

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28
Q

How do you calculate NPV?

A

Each cashflow and divide by (1+r)^n when r is the rate and n is the number of years

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29
Q

What is an annuity?

A

Constant annual cashflow with a set end date

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30
Q

How do you calculate an annuity?

A

PV = A/R *(1- (1/(1+r)^n))

r is rate
n is the number of years
a is the cash flow

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31
Q

What is a perpetuity?

A

A never-ending constant annual cash flow

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32
Q

How do you calculate a perpetuity?

A

PV = A/R

A is the cash flow
R is the rate

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33
Q

What is the IRR?

A

Internal Rate of Return

Represents the actual annual % return on the project

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34
Q

How do you calculate the IRR?

A

Using IRR on Excel and highlight the cashflows

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35
Q

Pros of payback period

A

Simple to calculate and understand
Can use initial screening tool
Recognises importance of liquidity
Focuses on nearest (most certain) future cashflows

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36
Q

Cons of payback period

A

Ignores the time value of money
Only considers the cashflows up to the date of payback
Encourages short-termism
No clear decision rule (e.g. set years)

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37
Q

Pros of Accounting Rate of Return or ROCE

A

Simple to calculate and understand
Looks at the entire life of the project
Reflects the way that external investors judge the organisation (% return)

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38
Q

Cons of Accounting Rate of Return

A

Ignores the time value of money
Based on profits, not relevant cashflows
Doesn’t consider the length of the project (and therefore liquidity)
No clear decision rule

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39
Q

Pros of net present value

A

Takes into account the time value of money
Shows the shareholders wealth created by the project
Can allow for risk (by adjusting cost of capital)
Clear decision
Looks at entire project

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40
Q

Cons of net present value

A

Requires the cost of capital to be estimated several years into the future
Calculations can be time consuming and easily misunderstood
Doesn’t factor in liquidity/time taken to generate return
Assumes you can reinvest proceeds at cost of capital

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41
Q

Pros of internal rate of return

A

Allows for the time value of money
Does not require an exact cost of funds to be estimated
Easy to interpret
Looks at entire project

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42
Q

Cons of internal rate of return

A

Ignores the size of the investment required and total cash inflows
Can give a conflicting answer to NPV when evaluating mutually exclusive projects (if projects of different length/size)
Assumes you can reinvest proceeds at the IRR.

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43
Q

Sensitivity calc formula for cost of capital

A

IRR-Cost of Capital
Over
Cost of capital

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44
Q

Sensitivity calc for cashflow inputs

A

NPV of project
Over
PV of cashflow input

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45
Q

Equivalent annual cost calc

A

NPV of project
Over
Annuity factor for project life

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46
Q

Profitability index calc

A

NPV
Over
Initial Investment

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47
Q

When do you take into consideration the inflation in NPV

A

When the cashflows include inflation you use
(1+m)=(1+real)*(1+inflation)

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47
Q

What non-financial factors should be considered when appraising new projects?

A

– Compliance of the project with current / future legislation
– Impact of the project on staff morale
– Impact on suppliers and customers
– Impact on the organisation’s reputation
– Sustainability of resources used in the project

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48
Q

How do you calculate the working capital in NPV

A

T0 is the full amount
Take the incremental part of the cashflow each of the following years
Then recover everything in the final year

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49
Q

What do you have to remember with tax in NPV?

A

The timing of the tax to make sure it falls in the correct T

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50
Q

What are the three factors for being a relevant cashflow?

A

Incremental - impacted by the decision
Future - Only future costs (anything past is sunk)
Cashflows - Ignore non-cash items e.g. depreciation

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51
Q

What is risk?

A

Number of known outcomes with known likelihoods

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52
Q

What is uncertainty?

A

Unknown range of possible outcomes

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53
Q

Expected values is when

A

You use probabilities of each outcome to get the most likely (expected) outcome

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54
Q

Problems with expected outcomes

A

Not an actual option
Only as reliable as the probabilities
Helpful over longer periods but not really over 1 period decisions

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55
Q

Sensitivity is used for risk or uncertainty?

A

Uncertainty

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56
Q

What does sensitivity analysis show?

A

The level of change that can happen before the wring decision is made

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57
Q

When is simulation useful?

A

Where many of the inputs to the NPV calculation can have several different outcomes

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58
Q

Negative of simulation

A

It does not determine how likely such a change is and cannot cope with multiple inputs changing at the same time

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59
Q

How can simulation be used?

A

Analysing the spread of results can help to better understand the project

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60
Q

How does adjusting the discount rate work?

A

Can be used on uncertainty or risk

Increasing cost of capital can give a more conservative outcome

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61
Q

How do you calculate correlation coefficient?

A

Use spreadsheet
=Correl(Data range 1, data range 2)

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62
Q

What are data outliers?

A

Observations that are abnormal and can therefore slightly distort the results

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63
Q

How do you calculate mean?

A

Use =average(data set) on excel

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64
Q

How do you calculate standard deviation?

A

=STDEV(cell range)

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65
Q

What is helpful about the standard deviation?

A

It tells you on average how far each results lies from the mean

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66
Q

What is con of standard deviation?

A

Can be higher just because data in the set is higher

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67
Q

What is better than standard deviation?

A

Co-efficient of variation

Gives the standard deviation as a percentage of the mean

Higher the percentage
Wider the spread

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68
Q

What are the 7 factors that determine the value of a business?

A

Sales growth rate
Operating profit margin
Corp tax rate
Investment in non-current assets
Investment in working capital
Cost of capital
Life of projected cashflows

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69
Q

How can the 7 factors of business value be used?

A

Forecast future cashflows

Split into period of competitive advantage (less than 10 years)
AND
Residual period (valued as a perpetuity or lump sum using P/E)
Discount WACC to find the value of business
Deduct market value of debt to find value in equity

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70
Q

What are the 5 real options that should be considered alongside NPV?

A

Follow-on options
Abandonment options
Timing options
Growth options
Flexibility options

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71
Q

What are follow on options?

A

Ability to launch future products off the back of this one, or extend life of the project e.g games console to see games

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72
Q

What are abandonment options?

A

The ability to exit a project early and sell the assets

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73
Q

What are timing options?

A

The ability to delay the start of the project to wait for favourable market conditions

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74
Q

What are growth options?

A

The ability to ‘dip your toe in the water’ with a small initial investment and then grow

E.g launch in different locations are different times

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75
Q

What are flexibility options?

A

The ability to change suppliers/ materials/ locations if a cheaper option becomes available

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76
Q

What are the risks when investing overseas?

A

Political risks
-Quotas (import limits)
-Tariffs (charges to imports)
-Non-trade barriers (legal/safety standards)
-Restrictions (on buying foreign companies)
-Nationalisation (of your assets)
-Minimum shareholding (by residents)

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77
Q

How can you mitigate the risk from quotas when expanding?

A

Negotiations with the government

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78
Q

How can you mitigate the risk from tarrifs when expanding?

A

Insurance against nationalism

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79
Q

How can you mitigate the risk from non-trade barriers when expanding?

A

Product strategies e.g. locate somewhere abroad to prevent the need to trade over barriers

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80
Q

How can you mitigate the risk from restrictions when expanding?

A

Management structure e.g. joint ventures

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81
Q

What are the three types of long-term finance?

A

Debt
Preference shares
Ordinary shares

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82
Q

What order do the sources of finance get paid back in?

A

Debt then pref shares then ordinary shares

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83
Q

What are the returns for the types of sources of finance?

A

Debt - Fixed interest
Pref shares - fixed dividend, paid before ordinary
Ordinary shares- discretionary dividend from accumulated profits

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84
Q

What is the capital return/liquidation for each source of finance?

A

Debt - if redeemable then do so at par or premium

Pref shares - Assume irredeemable unless told otherwise

Ordinary shares - No obligation to redeem

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85
Q

What is the tax impact of the sources of finance?

A

Debt - interest is deductible - leads to corp tax saving

All shares have no tax saving as dividends are not deductible

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86
Q

What is the control given by the sources of finance?

A

Debt - No voting rights

Pref shares - Only have voting rights if dividends are in arrears

Ordinary shares - Have voting rights

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87
Q

Levels of risk and reward with sources of finance

A

Debt
Low risk = low reward
Preference shares
Higher risk = Higher reward
Ordinary shares
Highest risk = Highest reward

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88
Q

What are the two sources of equity finance?

A

Rights issue
Public offer

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89
Q

How does the rights issue generate equity finance?

A

A company offers further shares, at a fixed price, to existing shareholders, in proportion to their existing holding

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90
Q

How do you calculate the theoretical share price after issuance and when would you use it?

A

Used when issuing rights share

TERP = (Total share value before + proceeds - issue costs + project NPV)
Over
Total shares before + new shares issued

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91
Q

How do you calculate the issue of one right in rights issue?

A

TERP - Subscription price

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92
Q

Pros and cons of rights issue

A

Pros
Lower costs than public offer
No impact on control (if everyone exercises their right)

Cons
Need to consider if the shareholders want to put more money in

Need to make the price attractive but high enough top generate income

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93
Q

Pros and cons of public offer

A

Pros
Large potential investment

Cons
Expensive - fees paid to banks and advisors. Need to underwrite the issuance also

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94
Q

What is it called when a company obtains a stock exchange listing at the same points as public offer?

A

It’s called an Initial Public Offering (IPO)

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95
Q

If there is a public offer what are the two options?

A

Shares are sold to an issuing house - who offer shares to the public
Or
Shares are offered directly to the public

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96
Q

What are the two internal sources of finance?

A

Retained earnings
Improving working capital management efficiency

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97
Q

When you are doing EAC for replacement cycles how do you lay it out?

A

Do separate NPVs for each cycle
Divide NPV by relevant annuity factor
Then compare the results of each
Conclude

When doing the NPVs for each cycle only include the number of years in that cycle

Do not include the costs of replacement at the end
ONLY include the costs in that cycle

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98
Q

In dividend growth do you include or exclude special dividends?

A

Exclude

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99
Q

In regearing the Ba to give Be make sure you use the what values of equity and debt

A

Market values not the nominal values

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100
Q

What is the ‘pecking order’ to minimise issuance costs?

A

Retained earnings (no issuance costs)
Rights issues (low issue costs)
New issues (high issue costs)

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101
Q

What are the 4 types of debt?

A

Irredeemable
Redeemable
Convertible
Loan stock with warrants

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102
Q

Describe irredeemable debt

A

Pay fixed interest annually

Never redeem

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103
Q

Describe redeemable debt

A

Pay interest annually

Redeem at par or premium in n years

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104
Q

Describe convertible debt

A

Pay fixed interest annually and holder can choose to redeem or convert to ordinary shares at maturity

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105
Q

Describe loan stock with warrants

A

Pay fixed interest annually plus holder gets separate call options on ordinary shares

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106
Q

What has lower interest convertible or redeemable debt?

A

Convertible due to the sweetener of the conversion

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107
Q

What are representations and warranties in loan documentation?

A

Checks before the loan is made

Categories are
Legality of borrowing
Financial condition

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108
Q

What are guarantees in loan documentation?

A

The lender seeks a guarantee from a guarantor

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109
Q

What are covenants in loan documentation?

A

The borrow commits to do/refrain from doing certain things to protect the lender

Categories are
Providing information
Negative pledges
Financial covenants
Restrictions

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110
Q

What 5 issues should you consider when looking at the type of finances?

A

1) Impact on financial performance
2) Impact on financial position
3) Cost of the finance/impact on the WACC
4) Impact on the shareholders
5) Matching to term/risk

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111
Q

Green finance means?

A

Many different definitions
but
thought as financing of investments that provide environmental benefits.

Whole organisation approach

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112
Q

5 methods of green financing

A

Green loans
Sustainability linked loans
Green bonds
Green funds
Social bonds

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113
Q

What are green loans?

A

Loans specifically to help finance green projects

Demand growing

Often lenders offer better terms to borrowers that show they are reducing environmental impact

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114
Q

What are sustainability linked loans?

A

Differ from green loans in that they are loans for any purpose

The pricing mechanism means that loans are cheaper if the borrower achieve certain sustainability

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115
Q

What are green bonds?

A

Fixed interest bond used to raise money for climate and environmental projects.

Typically secured and have the same credit rating as a company’s other debt obligations

Come with tax incentives

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116
Q

What are green funds?

A

To help investors target investment in companies with higher standards of social responsibility many stock markets product an index of firms that satisfy social and environmental criteria

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117
Q

What are social bonds?

A

Used to raise funds for projects that address or mitigate specific social issues and/or seek to achieve positive social outcomes

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118
Q

What are the four key components of Green Loan Principles?

A

Use of proceeds
Process for project evaluation and selection
Management of proceeds
Reporting

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119
Q

What are the two theoretical considerations in dividend policy?

A

Residual theory

Irrelevancy theory

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120
Q

What is residual theory?

A

Dividends only paid out after all projects with a positive NPV have been financed

Left over is dividends

Maximises shareholder wealth

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121
Q

What is the irrelevancy theory?

A

Companies can always invest in positive NPV projects

If cannot fund out of retained earnings then raise further funds

Shareholders will get a smaller share of returns from the new project, compensated with dividend received

If dividend too low, manufacture a dividend by selling shares

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122
Q

What are the 6 practical considerations in dividend policy?

A

Clientele effect - if dividend policy changes, shareholders may divest

Uncertainty - cash now is more certain for shareholders

Signalling - markets see dividend reductions negatively, reduces price

Agency - SH nervous Directors act in own interest

Tax - Shareholder may prefer dividends over capital gains

Liquidity - dividends should only be paid when there is enough cash to remain solvent

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123
Q

What are the alternatives to paying a cash dividend?

A

Share repurchase
Scrip dividend

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124
Q

What is formula for CAPM?

A

Ke = rf + B(rm-rf)

rf = risk free rate
rm = return on market portfolio
B = exposure to systematic risk

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125
Q

Pros of CAPM

A

Directly links risks and returns

Can be used when share price unknown

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126
Q

Cons of CAPM

A

Assumes:
Shareholders are diversified
All inputs will remain constant and at historic values
Investors can borrow and deposit at rf
Exposure to all systematic risks can be groups into one measure

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127
Q

What is the formula for dividend valuation model?

A

Ke = Do(1+g)
+g
Po

Do = dividend just paid
g = Dividend growth
Po = current ex-div share price

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128
Q

Pros of dividend valuation model

A

Calculates Ke based on market data

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129
Q

Cons of dividend valuation model

A

Assumes constant dividend growth which is unrealistic

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

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130
Q

What are the two methods to measure growth?

A

Historical dividend
Earnings retention method

131
Q

What is the historical dividend method to calculate growth?

A

Old div x (1+g)^n = Div now

=Power(New/Old,1/growth periods)

132
Q

What is earnings retention method to calculate growth?

A

g= br

b = % earnings retained
r = PAT/ opening shareholders funds

133
Q

Who do you calc Kd for preference shares?

A

Kd = Do/Po

134
Q

Who do you calc Kd for irredeemable debt?

A

Interest *(1-t)
/
Po

135
Q

Who do you calc Kd for bank debt?

A

Interest rate x (1-t)

136
Q

Who do you calc Kd for redeemable debt?

A

Find IRR of debt cashflows
to= MV
t1-tn=interest
tn = Redemption value

Multiply by (1-t)

137
Q

Who do you calc Kd for convertible debt?

A

Use IRR as for redeemable debt

tn = higher of redemption and future MV of shares

Multiply by (1-t)

OR

Rate formula

138
Q

When hedging make sure you convert from points by…

A

Multiply by 10

139
Q

FRA is

A

Forward Rate Agreements

140
Q

If FRA is 3-9 what does it mean?

A

Starts in 3 months and ends in 9 months

Therefore last 6 months

141
Q

Who buys FRAs?

A

Borrowers

142
Q

Who sells FRAs?

A

Lenders

143
Q

How does the rates work on interest rate futures?

A

100-r

98 is 2% rate

144
Q

In interest rate futures, do borrowers buy or sell?

A

Sell now

Opposite of FRA

145
Q

In interest rate futures, do lenders buy or sell?

A

Buy now

Opposite of FRA

146
Q

In interest rate futures, what is the standard size and length?

A

£500k

3 months

147
Q

How do you calculate the number of contracts in interest rate futures?

A

=Loan size / 500k
*
Loan period / 3

148
Q

How do you calculate the cash flow on futures in interest rate futures?

A

(Futures start - futures end) *3/12 *500 *no. contracts

149
Q

In traded interest options, borrowers buy put or calls?

A

Put

Same as futures

150
Q

In traded interest options, lenders buy put or calls?

A

Calls

Same as futures

151
Q

In traded interest options, how do you calculate the number of contracts?

A

=Loan size / 500k
*
Loan period / 3

152
Q

How do you calculate the premium in traded interest options?

A

No. contracts * 500k * 3/12 * % premium

153
Q

What type of hedging can lapse and therefore you get an upside potential?

A

Options

154
Q

How do you calc gain on option in traded interest options

A

No. contracts * 500k * 3/12 * (strike-spot)/100

155
Q

What does in the money mean?

A

Gain if option used

Spot > strike

156
Q

What does out of the money mean?

A

Loss if option used

Spot < strike

157
Q

What does intrinsic value mean?

A

Value of option if exercised today

Never negative as you wouldn’t do option so

158
Q

What affects time value?

A

Volatility
Time till expiry
Interest rates

159
Q

How does volatility affect time value?

A

Increased volatility

Increased time value

160
Q

How does time to expiry affect time value?

A

Later expiry

Increased time value

161
Q

How do interest rates affect time value?

A

Calls
Increase in interest value
PV exercise price down
Value of call up
Time value up as more desirable

162
Q

Are put options buy or sell?

A

Sell

163
Q

Are call options buy or sell?

A

Buy

164
Q

How to you remember if put and calls are buy or sell?

A

Make sure there is a 3 and a 4 letter

So
put is sell (3 + 4)
call is buy (4 + 3)

165
Q

Types of risk for foreign exchange rates

A

Economic (Long term risk from trading in foreign country)

Transaction - Gain/loss on short term foreign currency transactions
This is the one you hedge

Translation - accounting gains/losses from consolidation of a foreign sub

166
Q

In forwards for foreign exchange rates, do you add or deduct a discount to the spot rate?

A

Add a discount

167
Q

In forwards for foreign exchange rates, do you add or deduct a premium to the spot rate?

A

Deduct a premium

168
Q

What is a forward in foreign exchange?

A

Binding agreement

You agree a rate now for a future transaction

169
Q

How do you set up currency future transactions?

A

FX Receipt in future
= Buy £ later
So Buy now and sell later

FX Payment in future
= Sell £ later
So Sell now and buy later

170
Q

How do you calculate the number of contracts for currency futures?

A

FX Amount / Futures price
Over
contract size (62500)

171
Q

How do you calc gain or loss on futures in FX?

A

Contract size (62,500) * gain/loss on 1 contract * no. of contracts

172
Q

What are the steps for currency options (OTC)?

A

What is the option ‘on’? (Will state)

Then

What do I want to do with that currency in the future?
Gives put or call

Then

Pay premium

Then

Convert at
the strike price of option if beneficial
or
the spot rate if option is not beneficial

173
Q

For traded currency options, how do you know if you want to buy or sell?

A

What you want to do in future do now

So FX receipt in future
Want to buy £ with it
So buy call options now

174
Q

For traded currency options, how do you calculate number of contracts?

A

FX amount / strike price
Over
Contract size (31,250)

175
Q

For traded currency options, how do you calculate the premium?

A

No. of contracts * Premium/100 * 31,250

Convert at spot rate
It is paid upfront

176
Q

For traded currency options, how do you calculate the gain on option?

A

No. of contracts * 31,250 * (spot - strike)

Convert at spot rate outcome date

177
Q

What is the set up for Money Market Hedge?

A

Home and Away columns

Now and future rows

178
Q

In money market hedge, if you are making a payment in future in US what do you do in UK now?

A

Borrow because you deposit in US now to pay US in future.

179
Q

In money market hedge, if you are receiving a payment in future in US what do you do in UK now?

A

Deposit because you borrow in US to make payment in future in US.

180
Q

What are the steps to money market hedge?

A

Set up grid

Work out what happens in future abroad

What do you need to do abroad to be able to do that

Do opposite in UK

Do interest in UK

Effective interest is abroad/ uk

181
Q

What is the formula for WACC?

A

(VeKe) + (VdKd) + (Vp*Kp)

Over

Ve+Vd+Vp

182
Q

What is the traditional theory?

A

Introducing debt starts as a good thing
The WACC falls because the increase in Ke is small.

As level of debt increases, Ke rises faster, Kd starts to rise and therefore WACC rises.

There is an optimum balance

183
Q

What is Miller and Modigliani - no tax (1958)?

A

Assume no tax
Total payments to investors are the same for equiv companies

Means the same total market value and same WACC

Means no optimum
WACC is the same at all gearing

184
Q

What is Miller and Modigliani - with tax (1963)?

A

Tax benefit of interest
Payments to investors are higher of equiv company with debt

Means that company with debt have higher total market value, lower WACC

Optimum is to gear up - more debt

185
Q

What are the 5 drawbacks of the three theories for capital structure?

A

Bankruptcy risk and costs - high gearing, high chance of insolvency

Tax exhaustion - the benefit of tax saving is eliminated with no profits

Agency costs - impact on board and company restrictive debt covenants

Availability of finance - not possible to gear up due to lack of assets or high business risk

Issue costs - with debt but none with retained earnings

186
Q

Types of risk for a business in relation to WACC

A

Business risk
SPLIT INTO

Specific (unsystematic) business risk
AND
Systematic business risk

Financial risk

187
Q

What is Specific (unsystematic) business risk?

A

Variability in PBIT due to factors specific to a company

Eg equip failure, labour strikes

Investors may be able to diversify this away

188
Q

What is business risk?

A

Variability in PBIT

Comprises both specific and systematic risk

189
Q

What is systematic business risk?

A

Variability in PBIT due to macro-economic factors

Eg FX moves, inflation

Impacted by business sector

Cannot be diversified against

Ba measures exposure

190
Q

What is financial risk?

A

Additional exposure to systematic risk due to gearing and associated interest payments

Interest rates are additional fixed payments - Profit to loss if sales volume drops

191
Q

If business risk changes

The steps in calculating this project specific discount rate using CAPM are as follows:

A

1) Locate suitable proxy company in new industry

2) Get equity beta, tax rates and gearing of proxy

3) Ungear proxy to get asset beta
Ba = Be
over (1+ D(1-t)/E)

4) Regear with our gearing
Be = Ba(1+D(1-t)/E)

5) Use CAPM to get Ke

6) Use Ke to get WACC

7) Use WACC to evaluate the project

192
Q

If gearing changes how do you get the adjusted present value (APV)?

A

1) Find asset beta
Ba = Be
over (1+ D(1-t)/E)

2) Use asset beta and CAPM to get ungeared Ke

3) Find NPV using new Ke

4) Add PV of tax savings on interest of new debt

5) Deduct any debt issuance costs

6) Result is APV

193
Q

What are the three levels of marketing efficiency according to efficient marketing hypothesis?

A

Weak form - reflects past info that is now fact

Semi-strong - past and public available info

Strong - all info public and private

194
Q

What are the 9 factors of behavioural finance?

A

Overconfidence - bad investments, lack of knowledge

Representativeness - Over-reaction to news

Narrow framing - Concentrating too heavily on one piece of info

Miscalc of probabilities

Ambiguity aversion - avoiding new business areas

Positive feedback - rising continues, falling continues

Cognitive dissonance - holding on to long held beliefs

Availability of bias - diregard big picture focus on latest news

Convertism - underreaction due to resistance to changing opinion

195
Q

When calculating the TERP for rights issue, do you add or minus issue costs?

A

Minus

196
Q

When calculating the TERP for rights issue, do you add or minus NPV?

A

Add

197
Q

How do you calc TERP?

A

Total value / Total shares

198
Q

What are the two types of asset based valuations?

A

Net realisable value

Replacement cost

199
Q

What is net realisable value asset based valuation?

A

NRV of assets less liabilities

Use when owner of business is forced to sell

200
Q

What are the pros of net realisable value asset based valuation?

A

Useful to get minimal acceptable value

Assets more certain than income

201
Q

What are the cons of net realisable value asset based valuation?

A

NRV of assets may be hard to estimate if specialised

Ignores goodwill

Need to estimate redundancy/ liquidation costs

202
Q

What is replacement cost in asset based valuation?

A

Cost of setting up business from scratch

Use when buyer is looking to set an upper limit for bidding for the company

203
Q

Pros of replacement costs asset based valuations

A

Useful to determine maximum price

Assets more certain than income

204
Q

Cons of replacement costs asset based valuations

A

Estimating replacement costs can be difficult

Estimating goodwill would be difficult

Setting up a business may not always be possible

205
Q

What are the 3 types of income based valuations?

A

Price-Earnings Ratio (P/E)
Earnings Yield (E/P)

Enterprise Value Multiple (EVM)

206
Q

What is gross redemption yield?

A

Pre-tax cost of debt

207
Q

What is the formula for P/E?

A

Share price/ EPS

EPS is earnings per share

208
Q

What is the formula for E/P?

A

EPS/ Share price

209
Q

How do you use P/E to get valuation?

A

P/E * Earnings

210
Q

What is earnings?

A

Profit after tax and after pref dividends

211
Q

What does High P/E means?

A

High investor confidence in future of co.

212
Q

What can you sell a right to a share for?

A

TERP - Rights costs

2.38 - 2 = 0.38

213
Q

How do you calculate the gross redemption yield?

A

Rate formula
(Periods, Payment, -PV, FV)

214
Q

How do you calculate the issue price per debenture?

A

PV formula
(Rate, periods, payment, FV)

215
Q

What are the 7 factors that drive business value ?

A

Sales growth
Operating profit margin
Corp tax rate
Investment in Non current assets
Working capital investment
Cost of capital
Life of cash flows

216
Q

When do you use P/E or E/P ratio in income based valuations?

A

When seeking to convert current sustainable earnings (typically unlisted) into a share valuation

217
Q

What is the formula for perpetuity with no growth?

A

Cash flow / rate

218
Q

What is the formula for perpetuity with growth?

A

Cash flow0 * (1+g)
/
r -g

219
Q

What are the pros of P/E and E/P?

A

Values the company
based on current
market valuations of
similar companies (i.e.
it is a market measure).

220
Q

How many decimal places if FX rates?

A

4

221
Q

How many decimal places are discount factors?

A

3

222
Q

What are the cons of P/E and E/P?

A

Need comparable company
Based on historic EPS
Earnings used need to be sustainable
Based on accounting profits
Need to adjust downwards for non-marketability of unquoted companies.

223
Q

How do you calculate the valuation of business using EVM?

A

EBITDA x EVM

224
Q

What is EBITDA?

A

Earnings before Interest, Tax, Depreciation and Amortisation

225
Q

What is the formula for annuity factor?

A

1/r * (1- (1/(1+r)^n)

226
Q

What are real options?

A

Additional strategic options associated with a project

227
Q

When do you use EVM for valuations?

A

When seeking to convert EBITDA into a company valuation

228
Q

Pros of EVM in income based valuations?

A

Similar P/E but ignores financing + accounting decisions and tax

Enables the comparison of two companies which may differ in these areas

229
Q

Cons of EVM in income based valuations

A

It is simplistic and reflects a point in time

Comparing the capital spend and tax management of two companies may be important

230
Q

3 tips for income-based valuations

A

If PAT has been volatile over recent years, consider using average PAT

Consider whether you need to adjust the profits to make them sustainable

If you have a choice of P/E ratios to use, use the one of the company most similar to the one you’re valuing

231
Q

What are 4 types of cash flow based valuations?

A

PV of future cashflows
Dividend yield
Dividend valuation model
Shareholder value analysis

232
Q

What is PV of future cashflows in cash flow based valuations?

A

The value of an asset is the PV of the cashflows it generate

Maximum price the bidder should pay is
PV of combined business cashflow - PV of bidders business cashflow

Discount cashflows after interest and tax at cost of equity

or

Discount cashflows before interest but after tax at the WACC = Ve + Vd, then deduct Vd

233
Q

When do you use PV of future cashflows

A

When you have detailed projections of the future cashflows of a company

When you expect synergies from the combination of business

234
Q

Pros of PV of future cashflows as a cash flow based valuation

A

Theoretically superior to asset based techniques

Not distorted by accounting policies

Factors in risk of investment + required return of bidder in the discount rate

Can factor in risk reduction/ synergies due to the combination

235
Q

Cons of PV of future cashflows as a cash flow based valuation

A

Difficult to accurately estimate future cashflows

Difficult to estimate the appropriate discount rate

Need a time horizon to estimate over

236
Q

What is the dividend yield and how is it used for cash flow based valuations?

A

Value = Dividend /Dividend yield

Dividend yield = Divi per share / share price

Used to convert current sustainable dividends (unlisted) into a share valuation

237
Q

Pro of dividend yield as a cash flow based valuation

A

Values the company based on current market valuations of similar companies

238
Q

Con of dividend yield as a cash flow based valuation

A

Have to find a comparable company whose dividend yield we can use

Based on historic dividends

Dividends used need to be sustainable

Will need to adjust downwards for non-marketability of unquoted companies

239
Q

How is dividend valuation model used in cash flow based valuations?

A

Po = Do(1+g) / ke - g

Used to value non-controlling interest

240
Q

Pros of dividend valuation model fro cash flow based valuations

A

Bases valuation on future dividend stream

Useful for valuing shares in non-marketable companies (with downward adjustment)

241
Q

Cons of dividend valuation model for cash flow based valuations

A

Assume constant dividend growth (unlikely)

Have to estimate Ke (difficult)

Assumes constant Ke

Hard to use if deliberately low dividend policy

Growth based on historic data

Formula breaks down if g bigger or equal to Ke

Estimated growth can be distorted by inflation

Not useful for valuing controlling interests

242
Q

How is shareholder value analysis used in cash flow based valuations?

A

Value is driven by 7 factors

  • Sales growth
  • Op. profit margin
  • Corp tax rate
  • Investment in NCA
  • Life of cash flows
  • Cost of capital
  • WC investment

Use to forecast future cashflows

Split into competitive advantage (less than 10 years)

Residual period (valued as perpetuity or lump sum)

Discount at the WACC and deduct the MV of debt

243
Q

Pros of shareholder value analysis in cash flow based valuation

A

Values the free cash flows of a company

Not distorted by accounting policies which can affect other methods

244
Q

Cons of shareholder value analysis in cash flow based valuation

A

Valuation is dominated by the terminal value (for residual period)

Methodology heavily dependent on the inputs to the model

245
Q

What are the 4 other factors in valuation?

A

Maximum price - a buyer would pay

Synergies - make sure to include cost savings where businesses merge

Value property at market value, then deduct an annual charge for rent

Value surplus assets and investments at current market value

246
Q

3 steps to comment/advise on a range of valuations

A

Set out in a table

Comment on each valuation e.g pros and cons and relate to scenario

Conclude by suggesting suitable range of values

247
Q

How do you value technology companies?

A

Asset - Could estimate amount to make assets from scratch
Doesn’t consider future growth

Earnings - Discredits method as may not be earnings in younger years

Dividend - Unlikely to pay dividend in early years

Market multiples - Possible to use ratios of similar companies
Can be difficult to identify

DCF - Likely to be best approach is likely to be most valid
Takes in future growth

248
Q

When valuing debt you have to?

A

Ensure you adjust for tax

249
Q

Pros of organic growth

A

Costs are spread over time
Less disruption

250
Q

Cons of organic growth

A

More risky

May be too slow

May be barriers to entry in new markets

251
Q

Pros of growth by acquisition

A

Synergy

Reduction of specific risk - diversification

Horizontal intergration - reduce
competition

Vertical intergration - safeguard bus. position

252
Q

Cons of growth by acquisition

A

Over-payment

Poor fit

Agency problem

253
Q

3 methods of payment for shares

A

Cash
Shares
Loan stock

254
Q

Pro of cash consideration for buyer of shares

A

More attractive to seller - get a better price

255
Q

Cons of cash consideration for buyer of shares

A

Causes liquidity problems for buyer

256
Q

Pro of cash consideration for seller of shares

A

Certain amount received

257
Q

Cons of cash consideration for seller of shares

A

Immediate tax issues
No ongoing stake in the business

258
Q

Pro of share consideration for seller of shares

A

No immediate tax issue

259
Q

Con of share consideration for seller of shares

A

Uncertain value received
Transaction costs

260
Q

Pro of share consideration for buyer of shares

A

Preserves liquidity
Ensures cooperation of seller in ongoing business

261
Q

Con of share consideration for buyer of shares

A

Dilution of control of existing shareholders

262
Q

Pro of loan stock consideration for buyer of shares

A

Avoids dillution of control of existing shareholders
Preserves immediate liquidity

263
Q

Con of loan stock consideration for buyer of shares

A

Increases gearing

264
Q

Pro of loan stock consideration for seller of shares

A

Lower risk than shares

265
Q

Con of loan stock consideration for seller of shares

A

May prefer higher return of equity

266
Q

Methods of divestment

A

Management buy-out (MBO)

Management buy-in

Spin-off (demerger)

Trade sale

Liquidation

267
Q

What is management buy-in?

A

As for an MBO, but external managers buy the business

267
Q

What is management buy-out?

A

Existing management of the business buy out the owners in order to greater control and financial reward

268
Q

What is a spin off (demerger)?

A

Holding company gives the shares in sub to its shareholders

269
Q

What is a trade sale?

A

The trade and assets are sold to a third party

270
Q

What is liquidation?

A

Company is wound up, assets sold, creditors paid, amounts returned to shareholders

271
Q

5 reasons to divest

A

To avoid the conglomerate discount (big groups undervalued)

Bad fit with other operations

Business to time intensive

Poor results

Need for liquidity

272
Q

4 areas where directors and shareholders may come into conflict

A

Takeovers
Time horizon
Risk
Debt

273
Q

How is the agency problem mitigated?

A

Appropriate management reward schemes

Corporate governance

Internal and external audits

274
Q

Tips for income statement and balance sheet

A

Forecast income first

Calc retained profits for the year

Calc balance sheet lines

Leave cash as balancing figure

Make sure to split share premium and share cap

275
Q

What to do if you have a forecasted cash deficit in cashflow?

A

Issue shares

Borrow

Sell surplus assets/liquid investments

Lag on supplier payments, incentives for customers to pay faster

276
Q

What to do if you have a forecasted cash surplus in cashflow?

A

Use to increase sales via better credit terms

Reduce short term borrowing

Put on deposit on the money markets

277
Q

5 ethical principles

A

Confidentiality
Objectivity
Integrity
Professional behaviour
Professional competence and due care

278
Q

5 ethical threats

A

Intimidation
Familiarity
Advocacy
Self interest
Self review

279
Q

4 actions to take when there is a conflict of interest

A

Notify both clients

Notify other relevant parties

Declare you do not act in the interest of one client alone

If it cannot be reduced the n resign from one

280
Q

5 controls to mitigate threat of conflict of interest

A

Use separate engagement teams

Restricted access to client info

Clear guidelines for engagement team members on confidentiality & security

Use of agreements signed by employees & partners

Regular review of application of safeguards by senior partner/ compliance team

281
Q

Ethical situations specific to FM

A

 Ensure that written consent needed for anyone to share documents prepared for client use
 Take into account the interests of all shareholders, unless acting for a specific group of them
 Avoiding advising assurance clients on takeovers
 Avoiding sponsoring / marketing / underwriting securities issuances for assurance clients
 Avoid undertaking management responsibilities of an assurance client
 Beware of self-interest threats / familiarity threats to objectivity during corporate finance assignments

282
Q

What are the Environmental Cost Classifications?

A

Prevention - Stop impact - Staff training
Appraisal - Monitoring - Onsite inspections
Internal failure - internal waste - Waste disposal
External failure - external waste - fines

283
Q

What is predictive analytics?

A

Use historic or current data to predict the future

284
Q

What is prescriptive analytics?

A

AI/ Algorithms - Calculates best business decision

285
Q

Advantage and disadvantages of prescriptive analytics

A

+ Gives a decision in a complex situation

  • Advanced data science skills are needed
  • Only as reliable as input data/programming
286
Q

What is the Monte Carlo Simulation?

A

Hundreds of NPVs for one scenario
Alternative variables each time

Results in most common NPV
Range of possible outcomes

287
Q

Advantage and disadvantage of Monte Carlo Simulation?

A

+ Shows spread of NPV’s
+ Useful for problem solving

  • No decision
  • Computer based
  • Expensive
  • Probability assumptions needed
288
Q

How do you do mean on excel?

A

=Average(data range)

289
Q

How do you do standard deviation on excel? What is it?

A

=STDEV(Data range)

Show variability/ spread of dataset

290
Q

How do you do coefficient of variation? What is it?

A

= Standard deviation / mean * 100%

Variability compared to mean
Better for comparing datasets of different scales

291
Q

What percentage is covered by 1 standard deviations either side of mean in normal distribution?

A

68.2% of values

292
Q

What percentage is covered by 2 standard deviations either side of mean in normal distribution?

A

95.4%

293
Q

What percentage is covered by 3 standard deviations either side of mean in normal distribution?

A

99.6%

294
Q

Outline three risks of interest rate swaps.

A

Counterparty risk: the risk that the other company will default before the completion of the agreement.

Position/market risk: the risk of unfavourable market movements of interest rates after the
company enters a swap.

Transparency risk: the risk that the financial statements may be misleading as a result of the swap.

295
Q

What is loan stock with a warrant?

A

A loan that comes with separate call options

296
Q

What is the advantage of loan stock with a warrant?

A

Lower interest rates

297
Q

What is crowdfunding?

A

Equity

Pitching online to investors

Need to have attractive business plan
E.g. quality product, service or team

298
Q

Advantages and disadvantages of crowd funding

A

+ Available to start ups
+ Increase awareness
+ Fast

  • High admin
  • Fee
  • Legal/ advisory costs for due dilligence
299
Q

What is peer to peer funding?

A

Debt

Can be secured or unsecured

Connects established business with investors

Need to have credit checks - track record

300
Q

Advantages of peer to peer funding

A

+ Lower rates
+ Quick
+ More accessible for poor credit ratings
+ Tax savings

301
Q

What is beat the market?

A

Selling and buying shares to make a profit

302
Q

How do you beat the market in weak form?

A

Analysis of forecasts

303
Q

How do you beat the market in semi strong form?

A

Insider trading (illegal)

304
Q

How do you beat the market in strong form?

A

Pure luck

305
Q

When does a positive NPV project affect the share price?

A

Weak - when evidenced
Semi - when announced
Strong - when board agrees

306
Q
A
307
Q

What does capital rationing mean?

A

The situation where a company doesn’t have sufficient funds to invest in all positive NPV projects

308
Q

What does capital rationing mean?

A

The situation where a company doesn’t have sufficient funds to invest in all positive NPV projects

309
Q

What does hard capital rationing mean?

A

Where an organisation would like to raise more funds but no stakeholder is prepared to invest.

This May results from potential returns not being high enough to compensate for the perceived risks involved.

External capital markets limit supply of funds.

310
Q

What does hard capital rationing mean?

A

Where an organisation would like to raise more funds but no stakeholder is prepared to invest.

This May results from potential returns not being high enough to compensate for the perceived risks involved.

311
Q

What does soft capital rationing mean?

A

An organisation could raise more funds but has decided not to. This may result from a concern that the available finance is too expensive or may result in a loss of control.

Internally limited

312
Q

What do you do if projects are divisible in capital rationing?

A

Rank them but profitability index (NPV/Investment)
Choose highest
Work down
Divisible means can do half a project

313
Q

What do you do if projects are divisible in capital rationing?

A

Rank them by profitability index (NPV/Investment)
Choose highest
Work down
Divisible means can do half a project

314
Q

How do you deal with indivisible projects in capital rationing?

A

Can’t have half a project so just trial and error to make the most of the investment available.

Assumption that any fund not invested in a project will be deposited at the cost of capital

315
Q

How do you deal with indivisible projects in capital rationing?

A

Can’t have half a project so just trial and error to make the most of the investment available.

Assumption that any fund not invested in a project will be deposited at the cost of capital

316
Q

What is shareholder value analysis?

A

The process of analysis the activities of a business to identify how they will result in increasing shareholder wealth

317
Q

What is interest rate parity?

A

The idea of how forward rates are set.

Uses normal interest rates in two countries and the spot rate to
Determine a fair forward exchange rate
Predict the future expected spot rate

The idea is the investor should be in the same position whether they invest here or exchange, invest and exchange back

No wins from foreign currency

318
Q

What is interest rate parity?

A

The idea of how forward rates are set.

Uses normal interest rates in two countries and the spot rate to
Determine a fair forward exchange rate
Predict the future expected spot rate

The idea is the investor should be in the same position whether they invest here or exchange, invest and exchange back

No wins from foreign currency

319
Q

What is purchasing power parity?

A

The law of one price

After translation an item should cost the same in any currency

Stops the idea of buying abroad because it’s cheaper

320
Q

What is purchasing power parity?

A

The law of one price

After translation an item should cost the same in any currency

Stops the idea of buying abroad because it’s cheaper

321
Q

What is the formula for interest rate parity?

A

Spot rate x

(1+overseas interest rate) / (1+uk interest rate)

322
Q

What is the purchasing parity formula?

A

Spot rate x

(1+overseas interest rate) / (1+Uk interest rate)

323
Q

What must you remember when doing the P/E ratio?

A

To get the average profit before interest and tax, so add up all of the ones that you’ve got, and divide by how many there are to get the average don’t just use the most recent one

This is to get the earnings figure, so you do that, and then you take off the interest on the tax to give you the actual earnings for like average

Financial Management (2 decks)

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