Exam Practice Flashcards
NPV Questions (Q1 Every Year)
Create table with years on top
Put all of the costs for each year from the question
Sum all income and costs per year and discount to PV using the DF and cost of capital/WACC from question e.g. 8%
IGNORE SUNK COSTS LIKE MARKET RESEARCH COSTS
Sum all years to get NPV. If positive accept deal
Sensitivity Analysis
Might get asked to find the sensitivity of sales value etc.
Find sales value for each year, discount back to present value and add together.
Sensitivity = NPV/PV
e.g. NPV is £60m and PV of sales is £680m, sensitivity is 8%. (sales must fall by 8% for NPV to reach Zero)
Calculating impact of the project on share price
If a company adopts a positive NPV project and communicates this news to the capital market, the value of the company should rise by the NPV.
May have to calculate the market value of the firm. i.e.
- Issued £1 ordinary shares with a total nominal value of £50 million.
- Ex-div share price at 1 April 2019 is £12 per share.
Therefore current market value is 50m x 12 = £600m
If the project gives £60m NPV, the market value should increase to £660m, 10%
FreeCashFlow Valuations (Every year, usually q2/3)
Create table with years on top and Terminal Point as last year. Terminal Point growth will be in question (sales growth after period etc.). If it is 0, take the final year’s numbers and repeat, without investment in assets value.
Fill with sales, margin, tax and all other costs to get FCF, then discount to PV using the WACC.
For TP column, the FCF figure should be divided by the WACC to get Terminal Value, which is then discounted at the final year’s discount factor e.g. 4th year’s
Sum together all years (bar first year) and subtract total value of debt to get Equity Value.
Valuation questions: Non-Current Assets to Turnover Ratio
Non-current asset turnover ratio (sales/non-current assets)
e.g. lets say historic ratio is 4, and the question states assets must be replaced each year in line with sales growth at historical averages (2019 Q3)
Sales grew from 30,000 -> 32,700
2,700/4 = 675 ,’, 675 Investment in assets required that year (cost). Repeat for each year.
Part b of valuation questions:
recommend whether they should do the deal and highlight limitations of your advice
Find current profit (FCF less interest for year of the transaction)
e.g.
Profit for year is 4,800, they pay tax at 20% and have debt at £5m paying 5% each year
Interest payable = 5% of £5m = £250k, subtract 20% tax = £200,000
therefore profit for year = £4.8m - 200k = £4.6m
Industry PE ratio in question. Multiply the profit for Year (Earnings) by the industry PE ratio to get Value based on PE.
Compare to the FCF worked out in part A
If the value is too high, either PE ratio is wrong or FCF valuation is too low. Perhaps the whole market is inflated and sales growth/margins are too optimistic
Acquisitions - Evaluating the benefit of the takeover for both shareholders
Write values of the two firms out, shares, share price, total value (shares x price), and Premium for the company to be acquired
Divide cost savings generated by the WACC e.g. £18m cost savings each year, WACC 12%, 18m/0.12 = £150m total cost savings
NPV of takeover for Acquirer shareholders:
Value of acquired firm + cost savings of 150m, less cost of acquisition
Gain for acquired firm shareholders:
premium x total shares e.g. 40% premium on 50m £4 shares = £1.60 per share x 50m = £80m
Calculate how much shares of each firm should rise
4 Reasons for acquisitions and 4 reasons they may go wrong
Pros:
Reduce competition
Improve supply chain
Cut costs through synergies
Share knowledge
Issues:
Lack of fit
Best people may leave
Lack of integration
Paid too much
Acquisitions: Calculating how many shares must be issued for the cost savings to be shared equally between the firms
Cost savings is the amount each firms value has to rise.
Find new values of firms if this was the case (old value + cost saving) and calculate price per share at this new value.
Divide the two new share prices (Acquired/Acquirer)
Multiply this value by total current shares to find how many NEW SHARES must be issued.
Price per share = acquirer pre takeover + acquired pre takeover + cost savings / New total shares (including new ones issued
Discuss the effects on managers and investors of
potential investment projects that have positive net present values but negative
accounting profits
3
If markets are efficient, share price should go up with any positive NPV project. Accounting losses shouldn’t effect the share price if the NPV is positive.
There are agency conflicts between managers and owners - managers may prefer lower NPV projects that have higher accounting profits. Especially if bonuses are based on profits
Behavioural aspects can’t be ignored so there must be good communication and trust between managers and investors
Explain and show how a money market hedge (MMH) can be used to fix the …
payment.
Buy the current value of the transaction at the spot rate
Place the foreign currency purchased in a money market and receive interest until payment is made
Use the deposit to make the foreign currency payment
IN EXAM:
Value of foreign currency required/1+foreign interest rate
Called ‘amount to lend in ‘…currency’
Divide this number by current spot rate. Call it (exchange sterling to ‘… currency’ at current spot rate)
Say Sterling borrowing interest rate = 1.5%
then
Multiply previous value (exchange sterling to ‘… currency’ at current spot rate)
by 1.015 (1+sterling interest rate)
This number gives us the guaranteed cash payment regardless of currency movements
Would you advise your directors to hedge the payment via a MMH or to do nothing? Assume that spot rates at further date are either … or …
Firm doesn’t hedge:
Potential spot rate 1: Foreign currency required/spot rate 1
Potential spot rate 2: Currency required/spot rate 2
Firm hedges:
Potential spot rate 1: Previously calculated figure (from hedging calculations on previous slide) - unhedged figure spot rate 1
Potential spot rate 2: Previously calculated figure - unhedged figure spot rate 2 (above)
Should a firm hedge?
5
Depends on directors attitude to risk - they may want certainty
If there’s a large difference in interest rates that implies high inflation expectations in country w high interest, so maybe best not to hedge, let Foreign currency fall and then the liability has been reduced
Hedging is time consuming
Hedging removes potential upside
Cost of capital should fall if cash flows are less volatile due to hedging
If the directors have investments in that foreign currency they are already hedged so dont required the firm to do it for them
Calculating sterling receipt of transaction if the firm uses a forward
{Value of transaction / [current spot rate (highest if selling, lowest if buying) + forward contract discount or - Premium]} - Cost of forward (arrangement fee)
e.g. receiving $20m to £
current spot rate is 1.30-1.32
Forward contract discount: 0.0057 - 0.0077 (as we’re buying £s, we use highest figure)
If it said FC Premium instead of discount, we subtract it
Arrangement fee: $0.35 per $100
$20m / 1.32 + 0.0077
less Cost of Forward ($20m/100 x 0.35)
= 14,993,644 (guaranteed cash receipt regardless of movement in Exchange Rates)
Then compare this figure with non-hedged figures
Spot rate 1: Forward receipt - non hedged figure at SP1
SP2: repeat but SP2
Calculating sterling receipt of transaction if the firm uses an option
value of transaction e.g. $20m/put or call option rate
Then subtract cost of option
Which =
Value of transaction*cost of option/100
Results are either:
Option is exercised at SP1 as cash reciept is better than if we do not hedge
OR
Option not exercised, but we do incur transaction cost
i.e. Unhedged cash reiept at SP2 - option cost
Valuations -
Valuing equity using FCF from NOPAT
(Not given WACC in question)
1) Calculate WACC. Write total value of equity and debt, along with the % of capital it is. e.g. Firm has £4bn equity, £2bn debt ,’, 67% equity 33% debt
Find cost for both equity and debt. Cost of Equity = Risk free rate + (Geared Equity Beta * Market Premium)
Cost of debt = Interest rate * (1-Tax Rate) e.g. 4% * (1-19%)
Multiply the cost of equity by its percentage (67%^) to get Weighted cost. Repeat for debt and add together to get WACC
2) Create table, Years on top and rows as: NOPAT, Investment in assets (often retained earnings reinvested if stated as so in Q). Subtract investment in assets from NOPAT to get FCF for each year.
Have TP as a column at end. Figure for FCF at TP = final year’s FCF x 1+terminal growth rate
TP FCF/(Calculated WACC - Terminal growth rate) = Terminal Value e.g. 308/0.09-0.025
Discount all years using the calculated WACC from earlier, discounting the TV at final years DF
Sum all together to get Enterprise Value, then subtract total Debt e.g. £2bn to get Equity Value
Valuations:
Value equity using the adjusted present value method
1) Calculate cost of ungeared equity
Risk free fate + (ungeared equity beta*Market premium)
2) Create table with years and TP, taking FCF from above and discounting at the Cost of ungeared equity just calculated
For TP, TP FCF/(Calculated Cost of ungeared equity - Terminal growth rate).
Essentially exact same as before but use Unlevered cost of equity instead of levered
3) Multiply total debt * tax rate to get total Value of Tax Shield
e.g. £2000 * 0.19 = 380
4) Value of firm = (Value of unlevered firm from first table + Total Tax Shield)
Subtract total debt
= Equity Value
Compare WACC to APV methods of valuing equity
WACC is less than unlevered cost because the firm has debt
Identification of tax shield in APV is useful so that debt can change
WACC fixes the capital structure, so using APV instead of market value would lower WACC
Based on your equity valuations (WACC and APV), should the firm be bought? What other considerations to make?
If both values are lower than market value then we should BUY
Other factors include:
Synergies
Cost savings
Other alternatives
Divestments -
Assess the benefit of the divestment for shareholders of both firms
1) Value of OG firm post divestment:
New cash flows/WACC or Discount Rate = PV
Sale of divested firm: Price per share x shares sold
New value of OG if proceeds from sale reinvested:
Gain to OG shareholders = New Value - Value pre divestment
2) New firm Value:
New firms cash flows in perpetuity/WACC or Discount Rate
Less Price Paid
= Gian to new firm shareholders
What would divested firm have to be sold for to split benefits evenly between shareholders?
Calculate new cash flows by adding cash flows of both firms
Present value of both = new cash flows/WACC or DR
Find difference between current value of firm pre-split and the combined value
Divide this gain by 2 to get the equal split
Add current market cap and the equal split
Difference between this number and Firm post-divestment value is the amount the divested firm has to sell for to split evenly
Calculating ROE & Proving it using ROA+Spread*FLEV
ROE: Profit after tax (including interest expense)/Opening Equity
ROA+SpreadFLEV:
ROA: NOPAT/Operating Assets
Spread: ROA - NIE (Debt Rate after Tax, Debt Interest Rate(1-Tax Rate)
FLEV: Debt/Equity
Does the firm’s shareholders benefit from the debt financing?
If ROA is lower than ROE then they do benefit
price to earnings ratio
price to sales ratio
market to book ratio
dividend yield
Using these multiples to value equity
Price to Earnings: Market Cap/Income after tax
Price to Sales: Market Cap/Sales
Market to Book: Market Cap/Equity
Dividend Yield: Annual dividend paid/Market Cap
-> Given two firms, need to use the ratios of one to value the other. Multiply the number from the unknown firm by the ratio to get value.
-> Sum all values together then find the mean. This is the estimated equity
current ratio
acid test ratio
inventories days
receivables days
payables days
Retention Ratio
Current Ratio: Inventories+Recievables+Cash/Payables
Acid test: Recievables+Cash/Payables
Inventories days: Inventories*365/Cost of Sales
Receivables days: Receivables*365/Sales
Payables Days: Payables*365/(CoS+R&D Expenses+S&D Expenses)
Retention Ratio: 1- Payout Ratio (Annual dividend paid/Profit after Tax)
Dividend Valuation Model Without Cost of Equity
2023 Q4
Paul directors want to buy Jones. Jones dividend growth is 5%, Paul believe they can make it 7% w synergies etc. Dividends currently £90m per year, share price £0.82, 550m shares
Calc value of Jones to Paul
Calc latest dividend per share
Calc next years dividend per share using growth rate given (5%)
Find required return:
(Next year’s dividend per share/Current share price) + Current dividend growth = 11.75%
Find New Next Year’s dividend using New Growth Rate (7%)
New value per share:
New next year’s dividend/(required return-new growth rate)
New value of Jones:
New value per share x total shares
How to calculate ungeared beta/ Cost of ungeared equity from geared beta
Debt/Equity
1-Tax Rate e.g. 1-25%=75%
D/E*1-Tc
Ungeared Beta =
Geared Beta (from Q usually)/1+D/E*1-Tc
,’,
Cost of unlevered equity = Risk free rate + (Ungeared Beta*Market Premium)
Should firm use debt or equity to fund takeover?
4
Debt gives tax benefit
Equity saves cash and does not increase debt, but means acquired firms shareholders are still involved
Debt means buying out all the shareholders of acquired firm, meaning the acquirer is left with all the risks and rewards of ownership
Debt may not be ideal if firm is already highly leveraged
Dividend Policy - M&M 1961
M&M 1961 (Modigliani&Miller) states that in a perfect world with perfect information, no tax etc. dividend policy doesnt matter. As there is no difference between buying a stock for £48 with £2 dividend and a £50 stock.
If investor wants a dividend they can ‘create their own’ by selling off a % of the stock each year.
In reality this isn’t the case
Main factors that affect dividend policy
2
Tax:
- Dividends and capital gains may be taxed at different rates, thus affecting how investors decide which stocks to buy. If dividends are taxed lower, may prefer high dividend stocks
Signalling:
- Dividend increases signal good performance. It is more credible than management stating ‘they had a good year’.
- Management are percieved to have better inside knowledge of firm than investors. INFORMATION ASSYMETRY. Thus an increase in dividends suggest management are positive about firms finances.
- Firms very rarely cut dividends, this often leads to strong negative reactions from investors
Risks with operating overseas
3
Economic risk: Changes in currencies, political issues e.g. Russia
Credit Risk: Firms may not pay, harder potentially to get payment
Physical Risk: Goods may go astray
Calculating IRR of project
Use random number as DF, say 30%. Discount FCF of the project (should already have done NPV at this point) with this random DF. See if the NPV is negative. If it isnt then retry with higher DF.
When NPV goes negative, subtract the DF used e.g. 30% by the Investors required return from Q e.g. 9% to get DIFFERENCE IN RATES
Initial NPV/(Initial NPV-negative NPV at random DF) = Proportion
IRR = IRR base rate (investors return from Q)+(Difference in rates*Proportion)
Alternative Dividend Valuation Model
Project total dividends each year. Include profit on disposal if company is to be sold at end year.
Discount using DF. Sum together to get PV and add any special dividend.
Final valuation = Sum PV + Special dividend
If asked to do DVM post a project. Take NPV of the project + Special dividend + Disposal PV
