Debt Finance Flashcards
Outline what you understand by credit risk/ default risk of a bond and state how investors are compensated for this risk
Meaning of credit risk:
• A company with financial difficulties may be unable to fully repay the loan.
• The risk of default is known as the credit risk of the bond, meaning that the bond’s cash-flows are not know with certainty.
Compensation of credit risk:
• To compensate for the risk of default, investors will demand a higher interest rate.
Compare and contrast the terms Debt and Equity
Debt is less risky than equity, so lower return required:
Debt offers Statutory right to interest payments.
Debt holders are paid off before shareholders in corporate liquidation.
Interest payments are tax-deductible.
What are the differences between book value per share and share price?
Book Value uses historic figures to value assets.
And current value of assets may differ from historic figures.
However, share price reflects expectations of future growth or failure
Discuss the weaknesses of the Internal Rate of Return (IRR).
The standard IRR suffers from certain weakness that one should be mindful of when using it:
- Unconventional cash flows will generate multiple IRRs.
- IRR makes an assumption that cash flows attributable to a project will be re-invested at a rate of return equal to IRR.
Note that prevailing interest rates may be different – therefore leading to unrealistic figures
Explain how hard capital rationing can occur
May be imposed externally
• A covenant attached to an existing loan may not allow additional funds to be raised.
• Investors consider the company to be too risky.
• General situation of the economy
Weak form efficiency
According to the weak form of market efficiency, prices reflect the information contained from historic prices. If markets are weak form efficient it should be impossible to consistently make superior profits from studying past returns.
Semi-Strong efficiency
Semi-strong form requires that prices reflect not just past prices but all other published information such as information from reading the financial press. If markets are efficient in this sense prices will adjust immediately to public information such as the announcement of the last quarter’s earnings, a new issue of stock, a merger announcement.
Strong form efficiency
Strong form efficiency is such that prices reflect all information including private information, public and historic information. This form of information could take the form of painstaking analysis of the company and the economy. If the market is strong form efficient, no one investor could make abnormal returns from share dealing, not even from ‘insider information’.
The primary objective of a company is assumed to be the maximization of shareholders wealth. There are other secondary objectives commonly referred to as surrogate (alternatives) of a company. Briefly define five of such surrogate objectives of a company.
Surrogate objectives Profit maximisation Market share maximisation Earnings per share (EPS) growth Social responsibility Sales maximisation Survival Dividend growth
Explain the effects of inflation on capital investment decisions, and the ways investment appraisal can take account of inflation.
Inflation can have a serious effect on capital investment decisions by both reducing the value of future cash flows
and/or increasing the uncertainty about these cash flows.
• Investment appraisal can take account of inflation in two ways :
- By discounting nominal (money) cash flow with a nominal cost of capital;
- By discounting real cash flow with real cost of capital.
Outline three assumptions of perfect capital markets and briefly explain the limitations of these assumptions.
No taxes or transaction costs
All participants have the same expectations regarding asset prices, interest rates and other economic factors. (similar to homogenous expectations)
Free entry to and exit from the market.
A large number of buyers and sellers with none that dominates the market.
Many buyers and sellers
Information is costless and freely available.
Provide a summary of the weaknesses of the Payback method which have led to it not being the recommended investment appraisal method.
Payback ignores the time value of money
Payback ignores the timing of cash flows within the payback period
Payback ignores post-payback cash flows.
The choice of payback period is arbitrary
Payback does not measure profitability
allocational efficiency
Allocational efficiency: the capital market, through the medium of pricing efficiency, allocates funds to where they can best be used
pricing efficiency
Pricing efficiency: the prices of capital market securities fully and fairly reflect all information concerning past events and all events that the market expects to occur in the future. The prices of securities are therefore fair prices.
operational efficiency
Operational efficiency: transaction costs in the market should be as low as possible and required trading should be quickly effected
Explain the limitations of the Dividend Growth Model as a method to calculate the share prices
- What if the company pays no dividend? – The shares of Dell and Apple did not have zero value even though they only recently started paying dividends.
- The DGM implies an ongoing supply of attractive projects to match the earnings available for retention.
- The model works if the discount rate exceeds the growth rate.
Explain the advantages to a company of stock market listing
- Access to a wider pool of finance.
- Improved marketability of shares.
- Enhanced public image.
- Original owners selling holding to obtain funds for other projects.
- Easier to seek growth by acquisition.
Explain why convertible bonds are attractive to companies as a way of raising finance for funding new projects
Self-liquidating, so avoids redemption Share prices do not fall on conversion In the long term, gearing is lowered Conversion increases debt capacity Lower coupon than straight debt Interest is tax deductible
Explain five reasons why leasing continues to be a popular method by which companies finance their activities.
Short of cash: Leasing is helpful for small companies in the case where they cannot borrow to finance the acquisition of an asset because of a lack of good-quality assets to offer as security.
There are tax advantages if companies have different tax positions: This is when the lessor and lessee have different tax positions. A tax paying lessor could buy an asset, use the capital allowance and then lease the asset to a non-tax-paying lessee.
Tax benefits could arise due to year-end effects as different accounting year-ends may allow a lessor to capture tax benefits more quickly than a lessee. This benefit is more pronounced when the lessors have several subsidiaries with different year-ends.
Obsolescence of assets: some assets may become obsolete in a short period of time due to the fast pace of technological change.
Operating leases can appear on off balance sheet and therefore do not interfere with a company’s borrowing capacity.
The flexibility of lease contracts with respect to the choice of equipment and the
scheduling of lease payments has promoted leasing.
Discuss five limitations for ROCE
ROCE is not based on cash, but uses accounting profit, which is open to manipulation and is not linked directly to the fundamental objective of maximising shareholder wealth.
The method uses average profits and therefore ignores the timing of profits.
ROCE does not consider the time value of money
It fails to account for the length of the project life.
Given that the ROCE is expressed in percentage terms, it ignores the size of the investment made
Present the main reasons why an agency relationship exists in companies.
• An agency relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests. The agency problem occurs when managers make decisions that are not consistent with the objective of shareholders’ wealth maximization (SHWM). The agency problem is considered as an internal constraint – will interfere with SHWM.
Explain three ways that agency problems can be reduced?
o Shareholders should monitor the actions of managers such as:-
▪ Using independently audited financial statements and additional reporting requirements;
▪ Shadowing senior managers and using external analysts
o To monitor managers, shareholders could incorporate clauses into managerial contracts.
o Monitoring:
▪ To monitor managers, shareholders could incorporate clauses into managerial contracts. to minimize the sum of the following agency costs:
▪ financial contracting costs, such as transaction and legal costs;
▪ The opportunity cost of any contractual constraints;
▪ The cost of managers’ incentives and bonus fees;
▪ monitoring costs, such as the cost of reports and audits;
▪ The loss of wealth owing to suboptimal behaviour of the agent
Keeping in mind the Efficient Market Hypothesis, evaluate the following statement: “A small number of investors with common characteristics can beat the market over long time periods.”
Even in an efficient market, one would expect to see stocks to be mispriced randomly.
• Probabilistically speaking, almost half of the investors can beat the market at any point of time.
• Some investors may be able to do so over long term by pure chance or luck.
• However, if some investors share common characteristics such as they work together, they use same approach, they learned from someone else, then there is the possibility of market inefficiencies.
• If the market is efficient, these small investors cannot beat the market over long time periods.
Strenghts of Payback
- Simple concept to understand
- Easy to calculate (provided future cash flows have been calculated)
- Uses cash, not accounting profit
- Takes risk into account (in the sense that earlier cash flows are more certain).
What are convertible bonds?
Convertible bonds can be converted to ordinary shares at the option of the holder on a specific date.
book value
Book Value is defined as Total Assets (plant, machinery, inventory, deposits …) less Total Liabilities (debt, accounts payable, tax…)
Liquidation Value
Liquidation Value is the amount of cash a company could raise if it sold all its assets. Note that creditors will have to be paid
Outline three features of preference shares
- Preferential right to receive dividend
- Although permanent capital, do not normally carry voting rights
- Less risky than ordinary shares, riskier than debt
- Cumulative and non-cumulative preference shares.
- Participating preference shares: both fixed and variable dividend income.
- Variable rate preference shares – the dividend rate is linked to a variable market rate such as LIBOR.
- Convertible preference shares – convert to ordinary shares in the future.
Advantages of Preference shares
- No need to pay dividend if profits are poor
- Do not dilute ownership and control
- Unsecured, so preserve debt capacity
- No right to appoint a receiver.
What is capital rationing?
• Capital rationing occurs when a firm does not have enough capital to undertake all projects with a positive NPV.
Discuss types of capital rationing with relevant examples.
- May be imposed externally – external factors preventing a company from raising additional funds e.g.
- A covenant attached to an existing loan may not allow additional funds to be raised.
- Investors consider the company to be too risky.
- General situation of the economy
- Soft capital rationing may be imposed internally by management e.g.
- Not to issue more equity in order to avoid dilution of control or earnings per share;
- Not to raise debt finance in order to avoid fixed interest payment obligations / effect on gearing.
- Limited management skills available for a few projects
Explain the meaning of the term “agency problem” within the context of a public listed company
The agency problem arises because of the divorce of ownership and control
There are two agents: the shareholders (principal) and managers (agent).
The agency problem occurs because of the divergent goals
And an asymmetry of information between the agents
Managers act to maximise their own wealth rather than that of the shareholders
Discuss some of the problems that may result from companies making profit their main objective.
- Companies may be making a profit and yet not have the cash to pay for the urgent needs.
• Profit must be measured accurately as two different accountants may calculate it differently.
• Profit is usually measured over a one-year period and therefore looks at the short-term at the expense of the long-term survival of the company. Shareholders are more interested in the long run gain.
• Profit ignores risk that the firm will have to take.
• The time value of money is not considered when calculating profit.
