Economics II Flashcards
Debt
Lending from banks or bond buyers
Equity
Selling shares/stake
Publicly / Privately
Retained Profit
Previous years profit not distributed to share holders as dividends
Trade Credit
Pay suppliers later than they get paid
Invoice Discounting
Selling trade debt for a fee
Free Cash Flow
Operating Cash Flow - Capital Expenditure
Cash gener from revenues - acquir/maintain fixed assets
Operating Expenditure
Ongoing cost to running a business
Simulation
Estimation of probabilities of different possible outcomes
Break-Even Analysis
Analysis of level of sales at which the project breaks even
Exogenous
Endogenous
Internal Cause
External Cause
Option Pricing
A contract giving purchaser right to buy asset in future at specified strike price.
Protect material price changes
Option seller must have asset to hand
Intrinsic Value
Difference between strike price and underlying asset
Iron Triangle of PM
Time, Cost, Scope and Quality
Sensitivity Analysis
Analysis of effect of changes in one variable
Scenario Analysis
Project Analysis given particular combination of assumptions
CAPM Model
Cost of Equity Ke = Rf + B(Rm - Rf) Rf - Risk Free B - Risk Estimate Rm - Risk Market CAPM > 1 - Firms move more than marker more risk
ROSF
(Net Profit after interest payment) / (Shareholder Funds)
Single Year rate of return on each unit of share capital
Narrow assessment of profitability
Capital Employed
Total Assets - Current Liabilities (Debt + Equity)
ROTA
2 Part Du Pont
PBIT / TA = (PBIT / T) x (T / TA)
Relationship of OP margin + its asset turnover ratio
ROCE
3 Part Du Pont
PBIT / TA = (PBIT / T) x (T / TA) x (TA / K)
Efficiency of which its capital is employed
Higher % the better
ROE
5 Part Du Pont
PAIT / E =
(PBIT / T) x (T / TA) x (TA / K) x (PAIT / PBIT) x (K / E)
Capital Worth
Total Assets - Total Liabilties
Developers into 2 types
Speculative - Develop and Sell/Rent
Owner-user - Develop and use as part of the business
Net Present Value
Comparing cost of project with future value of revenue discount rate applied so it can be compared with alternative investments
Developer J-Curve
Initial High Risk -ve cost costs (trough high risk period)
Trade Credit / off plan sales reduce risk and cash inflow
Cash revenues increase as costs get smaller
End of a project
Divestment in Fixed Costs - Plant/equipment moved/sold
Divestment in Working Capital - inventory sold accounts receivable collected
3 Components of Cash Flow
-ve cashflow from investment in fixed assets
-ve cashflow from investment in working capital
+ve cashflow from operations (revenue)
Payback Definition
Time taken to recover initial investment
Packback period < specified cut off period
Delay Causes in PFI Projects
42% - PM issue / subcontractor under finance/resourcing
15% Jarvis PLc (railway) financial difficulties
6% - Planning permission issue / dispute between parties
Uncertainty vs Risk
Uncertainty cannot be quantified, unknown risk
Risk is measurable and can be quantified
Actuaries collect data
Exchange Rate Risk Mitigation
Forward Contracts - Lock agreed exchange rate Option
Price Variance Clauses - Client agrees to take some exposure, as full hedge is expensive
Hedging - Buy asset that will do opposite if euro crashes
Asymmetric Information
Where one party has more info than another
Securitisation / NINJA
Allowed mortgage obligations to be pooled together to create financial products that could be resold via capital markets
No Income No Jobs or Assets
Dutch Books
A set of odds and bets which guarantees a profit regardless of the outcome of the gamble
Moral Hazard
One party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the costs
PFI
Type of Public Private Partnership
Private firms paid more to complete gov contracts FIXED
Integrated Public Procurement
700 projects signed 2013 Mar 9.6bn ann gov liabiliti 13/14
PF2
Increased equity 15% from 10%
No soft facilities management
Only really used for schools and road project investments
Profit Margin
PBIT / Turnover
Interest Tax Burden
PAIT / PBIT
ROCE
PBIT / Capital Employed
Gearing
Total Assets / Capital Employed
Ratio of companies debt to value of ordinary shares
Asset Turnover
Turnover / Total Assets
Ponzi Scheme
Operator generates funds for old investors w/ new ones
High risk FCF < INterest + principle payment
Constant Short run refinancing, increasing pot insolvency
ADCSR
Ratio determining how many times your turnover is over your debt repayment
Hedge
A risk management technique to reduce losses/gain/risk
Least risky FCF > principle + interest payment
FCF < Annual Debt Cover Service Ratio
Liquid asset kicker - margin of safety superfluous to ops
Speculative
Medium Risk
FCF > Interest payments
Trading in an asset, risk losing everything or substantial gain
Risk insolvency if variable interest rates incre above limit
Pay interest on loan/refinance in future to pay principal
Flows of Funds into a company
Sales Revenue Gross Trading Profit - Current CoProdu/Interest Payment Taxable Profit - Taxation Net Profit - Dividends Retained Earnings
Internal Cash Flow
New Equity, New Creditors, New LT debt Finance
New Investment expenditure, Repayment of loans, increase financial assets
Capital Intensity
Requiring of large amounts of resources in order operate
Residual Claimant
After all costs of production have been paid the money left is to the residual claimants
Securitisation Advantages
Can be low risk ideal for pension funds Regular and consistent cash flow AAA credit ratings Assets removed from the business onto SPV Pass on the risk
Special Purpose Vehicle
A subsidiary company with asset/liability structure and legal status to fulfil narrow.specific/temporary objectives. Isolate from firm to reduce risk..
CDO
Collaterised Debt Obligation
Debt, range of returns some more/less risky
Banking Crisis
More people invest in CDO’s and demand increases
Banks try to increase supply by offering more mortgages
People who can afford them already have them
Banks offer to people that cannot afford them NINJA
Defaulting turns CDO’s into houses and they put them on the market
High supply reduces price and housing price collapses
Securitisation Disadvantages
More complicated way of funding than bank loans
People default and have asset rather than income
Can cause global financial crisis
Market Risk
Risk affecting whole market
Cannot be diversified
Systematic Risk
Idiosyncratic Risk
Risk specific to a firm or industry
Can be diversified
Advantages of Equity
Less risk, no monthly loan repayments
Dont take funds out of business
Credit problems only option
Disadvantages of Equity
Investors return could be higher than interest payments
Loss of control
Potential conflict
Advantages of Debt
Control, once debt is repaid tie is severed
Loan interest is tax deductible, dividends not
Predictability of cash flow, agreed in advance
Disadvantages of Debt
Qualification, need to have high credit rating
Fixed payments bad for unpredictable cash flow
Collateral risk
Land Banking
Large areas of land waiting to be developed on
Government Bonds
Debt security issued by government to fund spending
Backed by the credit of government so risk free
Predictable income, greater guarantee and risk free
NPV
Overall value of inward cash flows in excess of outward cash flows in present value terms
Accept investment if NPV is positive
Adv/Disadv of NPV
Recognises time Value of money
Takes into account entire inflows and returns
Projects may have unequal lives, returns or costs
Finance
Pays at the beginning
Funding
Pays at the end
Gov funding: tax payer funds eventually (education/health)
User funding/private revenues: individual user via charging (toll, road, utilities)
Private Finance
Banks and equity investors wanting a return
Financed by the gov borrowing money from private investors to pay for specific projects.
Public Government Finance
Lend against future tax revenues.
Public infrastructure, can be financed by the government earning future revenue from tax, which then is used to pay for specific projects.
Why is debt desirable
- Interest on debt is cheap thus reduces liability so shareholders get more for their return.
- Replaces the need to issue new shares & dilute ownership (debt still enables ownership of company)
Prioritisation on liquidation of assets
- Administrator’s fees
- Fixed charge holders (senior debt)
- Preferential creditors (e.g. employees)
- Floating charge holders.
- Unsecured creditors (e.g. trade creditors and unsecured debt)
- Subordinated debt holders
- Preference shareholders
- Ordinary shareholders
Time Value for Money
100 now, Greater purchasing power, future cash is less certain borrower may default
Borrowers need more profit cos of delay receipt
Myers 1984
Pecking order - used retained earnings first
Shareholder Returns
Share price appreciation - increase in market value
Dividends - share in net profit
Forward / Backward Looking
Based on previous historical transactions
Expected future profitability
What do Projects Face
Inflation: impact real future values
Demand: impact on revenues
Design: can specification be achieved.
Construction risk: on time & budget.
Availability: contractual levels of output.
Legislative: legal changes affect operations.
Policy: will general policy change(refinancing gain share)
Maintenance risk: can we predict OPEX.
Planning risk: can projects meet planning.
Technology: can we rely on innovation (reducing costs)
Developer
Contractor
May not receive payment until project is finished & sold.
Receive staged/interim progress payments from client.
IRR
Discount rate that makes NPV = 0
At what discount rate will you break even
Liquid Asset Kicker
Uncommitted capital used to cover deficits between debt service & net FCF
Cash flow margin
Capital value margin
Assumed certainty of net cash flows.
Assumed appreciation of asset
What is more risky
Bigger is more risky, greater variance in the mean
Smaller but higher less risky as less variance
CAPEX
Money spent acquiring/maintaining fixed assets
More expensive than future OPEX
Not subject to discountin expensive present value terms
Whole Life Cost
Total cost of ownership over a lifetime
Cost of build + operations
CAPEX + OPEX
Higher CAPEX today for lower OPEX tomorrow
Performance Bond
Provide surity/insurance against construction risk
Assess contractor risk failure and price on: Job complexity, schedule, contractor expertise, past performance etc
Relevance of Du Pont
Separate influences of profitability
Companies overall financial health/stability
Clues on business strategy
Gilts
Lending against future tax revenues
RRR
Required Reserve Ratio
Amount of money they need to to prevent insolvency
Expansionary Monetary Policy
Increase aggregate demand / increase growth
Cutting interest rates or increasing money supply
More borrowing - more spending - AD1 incr AD2 LRAS
Lower unemployment
Why EMP Doesn’t Works
Consumer confidence low, dont want to spend
Credit crunch banks may not have funds to loan
Global - fall in expo negates effects of incr comsumption
Low Interest Rates
Reduce cost of spending so more likely to
Reduce incentive to save so spend money instead
Lower repayments more disposable income
Reduce value of pound - SPICED
Interest Rate and Pound
Lower incentive for foreign investments
Less hot money flows
Lower demand so pound falls
Contractors Gearing
Lower Gearing 0-20%
Higher equity vs debt
Pay more tax, less interest, equity is not tax deductible
Return attributed to shareholders is high
ROSF is low and Earnings per share is low
Developers Gearing
Higher Gearing 60-80% Higher debt vs equity Pay more interest, less tax Return to shareholders is lower Less equity so return per share/ROSF is higher
Why are Government Bonds risk free
Can easily increase taxes and generate revenue to pay off their debt, more easily than a firm
How to determine the correct discount rate
Need to use WACC, weighted debt and equity
Compares proportion is funded by debt / equity
ROCE vs ROSF
ROCE measures profitabili/effici of capital employed
(Higher ROCE means greater returns)
ROSF is a profitability measurement of the firm
(Higher greater return in dividends for shareholders)
Debt investor more risk adverse?
They’re guaranteed to get something in return
Interest payment or asset
Equity, ordinary shareholder lowest repayment
Debt Seniority
Equity won’t make you bankrupt
Accounting Cost vs Opportunity Cost
Rev - Explicit costs (raw mat/utilities/cost of production)
Value of next best alternative forgone when decision is made includes implicit costs
High vs Low Capital Intensity
Costs come from investment in machines, equipment
Contractors with lots of plant
Software developers with few machines
Similar ROCE to ROSF
When gearing is 0
There is no tax
Assumptions about future project cash flows can be relied upon?
No certainty for cash flow, needs to be adjusted for risk
Discount rate an estimation
Actually uses a discount rate to get present value
Easy to compare/contrast projects
Two types of firms
- Risk profiles in terms of attracting equity investors,
- Key indicators equity investors use to assess investment potential
Talk about systematic risk
If all plots on capm line then all unique risk
Spotify has high systematic risk
Thames water low systematic risk
Firms more debt than ROCE
-K=TA-CL=D+E
-Incr debt incr liabilities not have enough assets to pay debt, insolvency
-Increase risk of administration and finally bankruptcy
-Debt can finance growths likely to increase total assets
-Incr TA incre K which also has the effect of incre ROCE
Benefits of Investing in each firm
Stock Y riskier, great area around 0% high risk 0/- return
Stock Y great area over X higher chance of high return
Stock Y greater variance more risky
Stock X return less but mean is higher
CAPM Diagram
Y - Expected return X - Standard deviation (risk)
CAPM > 1 - Firms move more than marker more risk
Rf intersects diversification curve B
Increasing expected returns without increasing stnd dev
Scatter Graphs Firm A / B
Positive Beta above 1 like 1.6 Lower Beta between 0-1 like 0.5 Beta 1 - S&P 500 Beta > 1 - NASDAQ Beta < 1 - Utilities
Benefits Today Costs Tomorrow
Discount rate used to give accurate measurement
If discount rate is wrong makes it useless
