Exam Revision Flashcards
Explain what is meant by the statement “The use of current liabilities as opposed to long-term debt subjects the firm to a greater risk of liquidity.”
The use of current liabilities, or short-term debt as opposed to long-term debt, subjects the firm to a greater risk of illiquidity. Short-term debt, by its very nature, must be repaid or “rolled over” more often than long-term debt. Thus, the possibility that the firm’s financial condition might deteriorate to a point where the needed funds might not be available is increased when short-term debt is used.
Corporations issue bonds for several reasons:
Raise capital
Interest rate
Longer term
Efficient
b. Explain why bond prices have an inverse relationship with interest rate movements?
Par bond
Premium bond
Discount bond
Since the coupon rate of a bond is fixed until maturity, the price of a bond will vary according to interest rate movements in the market. If the coupon rate is the same as the market interest rate, then the bond will sell for its par value (i.e. a ‘par bond’).
However, if the coupon rate is greater than the market interest rate, then there will be increased demand for the bond which causes an increase in the market price of the bond, resulting in the bond selling for a premium (i.e. a ‘premium bond’).
Conversely, if the coupon rate is less than the market interest rate, then there will be decreased demand for the bond which causes a decrease in the market price of the bond, resulting in the bond selling for a discount (i.e. a ‘discount bond’).
In this way, bond prices are said to have an inverse relationship with interest rate movements, with bonds prices increasing when market interest rates decline and bond prices decreasing when market interest rates rise.
What factors determine a bond’s rating?
Ratings involve a judgment about the future risk potential of the bond. Bond ratings are favourably affected by (1) a greater reliance on equity, and not debt, in financing the firm, (2) profitable operations, (3) a low variability in past earnings, (4) large firm size, and (5) little use of subordinated debt.
Assume that Woolworths recently acquired an alcohol beverage company that was in financial distress. Because of the acquisition, Mood’s downgraded this Bond from Baa2 to Ba2 to reflect an increase in risks of the Woolworths Group Ltd. What impact will this have on the bond value? Explain.
Bond ratings affect saleability and cost. There exists an inverse relationship between the quality of a bond and the rate of return that must be provided to bondholders. This reflects the lender’s risk-return trade-off. Therefore, the lower a bond’s rating, the higher the perceived default risk, the higher the interest rate required by investors, which lead potentially to a reduction in Woolworths’ bond value.
c. Use your findings in question (a) and (b) to evaluate and discuss the return and risk associated with each asset. Which asset appears to be preferable? Explain.
Because Asset A and asset B have different average annual returns (10.5% vs 8.6%),
. Since the coefficient of variation of returns of 0.14 for Asset B over the 2015-2018 period is well below Asset A’ s coefficient of variation of 0.53
Based on average return, Asset A appears to be preferable. However, since the coefficient of variation of returns of 0.14 for Asset B is well below Asset A’ s coefficient of variation of 0.53, Asset B appears to be less risky than Asset A and thus Asset B is the preferable investment. However, investor preference may change based on his/her attitude towards risk.
pros and cons of sd and cv
Although both standard deviation and coefficient of variation assess a firm’s total risk (firm-specific risk and diversifiable risk), they do not link risks and rewards.
CAPM pros
The CAPM approach may be a superior technique compared to the coefficient of variation and standard deviation approach, given that CAPM uses ‘beta’ to reflect a firm’s non-diversifiable risk, while the cv and sd approach focuses on a firm’s total risk. Despite the limitations of the CAPM approach, it provides a useful conceptual framework for evaluating and linking risk and return for many firms.
Why do investors and firms calculate their weighted average cost of capital?
i. Investors would want to know a firm’s cost of capital (before investing in any asset. For instance, if their expected return is higher than a firm’s WACC, they may opt to invest in the asset to increase their wealth, if other factors remain the same. If the expected return is less than a firm’s WACC, they should choose not to invest in the asset, assuming that other factors remain the same.
ii. The cost of capital is used as the minimum acceptable rate of return for capital investments. The value of the firm is maximized by accepting all projects where the net present value is positive when discounted at the firm’s cost of capital.
How does a firm’s tax rate affect its cost of capital?
The effect of taxes on the firm’s cost of capital is observed in computing the cost of debt. Because interest expense is tax-deductible, the use of debt decreases the firm’s overall cost of capital and taxes compared to the use of equity (ignoring the cost of bankruptcy). Therefore, we compute the cost of debt on an after-tax basis, to show that a firm does not have to pay the full cost of debt.
What is the effect of the flotation costs associated with a new security issue on a firm’s weighted average cost of capital?
In completing a security offering, investment bankers and others receive a commission for their services. This represents the expenses of issuing new security. As a result, the amount of capital raised, net of these flotation costs, is less than the total funds paid by investors who purchase the security. Consequently, the firm must earn more than the investors’ required rate of return to compensate for this leakage of capital. From the company’s perspective, this raises the cost of equity, which in turn increases the weighted average cost of capital of the company.
Forecasting the terminal value of equipment 20 years from now is difficult to do accurately, but errors in estimation probably have a small effect on the NPV. Explain
After a number of years, the present value factors for all discount rates become quite small, and the incremental effect of future cash flows is therefore small. According to the present value tables, after about 15 years, the incremental values at rates above 8 to 10% are small. If these cash flows are small, but include error, the size of error would also be small and likely have little effect on the overall analysis.
When projects have longer lives, it is more difficult to accurately estimate the cash flows and discount rates over the life of the project. Explain why this statement is true.
Estimating future cash flows becomes more difficult over longer periods of time because the uncertainties increase. Changes in economic, political, and consumer tastes that affect cash flows cannot be easily predicted. More information is usually available about near-term economic factors than long-term.
A community health clinic operates as a not-for-profit entity. Typical capital expenditure decisions involve acquiring equipment that will perform medical tests beyond those currently possible at the clinic (hence, adding revenues) and/or perform tests more efficiently than currently (hence, decreasing expenses). To evaluate such expenditures, the clinic uses a discount rate equal to the return on its investment trust portfolio. Explain, briefly, why it does this.
The return on the investment portfolio represents the clinic’s opportunity cost for funds. They can earn at least that return; therefore, any other investment must yield a higher return.
Capital budgeting process
Put the following six steps for capital budgeting in the most likely order, numbering the first activity as number 1, the second as 2, and so on.
The proper sequence is: 4, 1, 5, 2, 3 and 6.
Identify relevant cash flows.
Perform sensitivity analysis.
Apply the relevant quantitative analysis technique.
Identify decision alternatives.
Analyse qualitative factors
Consider quantitative and qualitative information to make a decision.
Abbots Limited allows divisional managers to make capital investment decisions up to $10 million. However, divisional managers are required to send to head office details of each decision taken, including their justifications. The manager of the hospitality and conference facilities division, Chloe Wang, has been trying to improve this process within her division. At present, department managers within the division are required to provide a detailed NPV analysis of their investment proposals. Because of the nature of her division, Chloe wonders whether the right long-term projects are treated fairly within this decision model. She feels that some of the investment opportunities proposed by department managers are more strategic and a lot of potential projects do not seem to be meeting the positive NPV requirement.
Required
Outline how Chloe might improve the investment decision-making model within the hospitality and conference facilities division to cater for strategic investments.
Steps that Chloe can take to improve the investment decision-making model within the hospitality and conference facilities division to cater for strategic investments include:
- A detailed assessment of how the project proposed delivers on Abbots Limited corporate and business strategies; the extent to which there is uncertainty in cash flow determination
- Incorporating the moving baseline concept — The cashflows used in the analysis should also incorporate the potential loss in cashflow that could arise if the project is not accepted. This will provide greater insight if using NPV as part of the appraisal methodology.
- Developing a scale measure to incorporate any qualitative factors — perhaps a scale of 1 to 10 to rate the importance to the organisation, for example
a. Effect on entity’s reputation
b. Quality requirements from customers/government
c. Effect on employee morale
d. The track record of the manager making the proposal.
e. Risk of the project
f. Costs of reversing the decision.
Your brother, Jack, was laid off from his job with a large and famous software company. He would like to sell his shares in the company and use the proceeds to start a restaurant. The stock is currently valued at $500 000. He received a job offer from a competitor that will pay $90 000 per year plus benefits. He asked you to help him decide the best course of action.
Required
(a) What are the alternatives that Jack faces?
(b) Choose the most appropriate analysis technique and explain your choice.
The choices are (1) hold the stock and work for $90 000 per year or (2) sell the stock, do not take the job, and start the restaurant. This is a long-term decision.
(b) Either IRR or NPV methods could be used for this analysis. The decision is a long-term decision and therefore needs to include the time value of money. Both of these methods do that. With the NPV method, inflation rates for different categories of costs could be used, so the results would be more precise. In addition, it may be easier to understand the differences in these two plans in today’s dollars, rather than in rates of returns.
List the steps you would take to develop a spreadsheet that your brother could manipulate to help with the quantitative aspects of this decision. Assume that you only have time to set up a template and that your brother will fill in the specific information. However, you need to tell him the general categories of information he will need to gather.
The following categories would be set into an input box: Investment amount, risk free rate, risk premium for the restaurant and for the stock, inflation rate, tax rates, all of the cash flows from the restaurant. Once these are in the input box, formulas for calculating the incremental cash flows over time need to be set up, and the real cash flows would need to be inflated and then discounted.
Explain why it is possible for your brother to make a good decision even though he cannot know for sure how well his alternatives would work out.
Jackson faces many uncertainties, no matter which alternative he chooses. If he performs sensitivity analyses around each alternative and formally incorporates qualitative factors, such as the amount of enjoyment he takes in his current position and his perceptions of this aspect of owning a restaurant, he will be able to make a high quality decision.
NPV Tax Calculation
Taxes = net savings less depreciation times tax rate
3 main categories of investments
Regulatory Investments
comply with regulatory, safety, health and environmental requirements; often mandatory expenditure for operations to continue
Operational capital investment decisions
made for operational purposes, for example replacement or upgrade of equipment discretionary expenditure to continue the status quo of operational activities
Strategic capital investment decisions
deviates from normal operations (i.e. new products; new acquisitions; new geographical locations) involves greater risk and often greater outlay of funds
Why do many financial analysts prefer to use the market value of debt and equity in calculating the weights for WACC?
If a company is a private company, the analyst would have to use the book value. However, if a firm’s debt and stocks are traded in the open market, analysts would prefer a Market Value WACC because investors demand today’s market-required rate of return on the market value of the capital. This also reflects the valid economic claim and risks of each type of financing outstanding whereas book values may not.
Current ratio is a
ratio
Debt ratio is a
percentage (measuring amount of assets that are funded by liabilities)
Explain and analyse
During 2014–2016, current ratio declined dramatically, and debt ratio increased substantially. The company experienced net profit; however, the owner’s equity also decreased in the mentioned years.
Assets also increased
The latest is most likely to pay out dividends. The company made investments in the long-term assets, this may partially explain the declining current ratio, but it is mostly due to the collection of receivables and dividend payouts. In 2016, there is a huge increase in debt ratio which is mostly due to increase in both current and long-term liabilities and the decreasing of cash. So, we can see that the financial situation was getting riskier during the years 2015–2016.
The last year’s tendency is better, there is an increase in current ratio, quite a drop-in debt ratio, and an increase in equity.
Why?
This is mostly due to better cash management as well as improved dividend policy.
Q2. A popular theory for managing risk to the firm that arises out of its management of working capital (that is, current assets and current liabilities) involves following the principle of self-liquidating debt. How would this principle be applied in each of the following situations? Explain your responses to each alternative.
a. Longleaf Homes owns a chain of senior housing complexes in the Seattle, Washington, area. The firm is presently debating whether it should borrow short or long term to raise $10 million in needed funds. The funds are to be used to expand the firm’s care facilities, which are expected to last 20 years.
b. Arrow Chemicals needs $5 million to purchase inventory to support its growing sales volume. Arrow does not expect the need for additional inventory to diminish in the future.
c. Blocker Building Materials, Inc. is reviewing its plans for the coming year and expects that during the months of November through January it will need an additional $5 million to finance the seasonal expansion in inventories and receivables.
The principle of self-liquidating debt (hedging principle) suggests that the long-term care facilities, which are expected to be productive for 20 years, should be financed with a source of financing that has a similar maturity. Thus, Longleaf should use long-term debt for its expansion.
This example is a “permanent” increase in the firm’s needs for inventory. Consequently, this financing would be best raised using a permanent source of financing such as intermediate-term loans, long-term debt, preferred stock, or common equity.
Seasonal expansions in working capital are followed by seasonal contractions. Therefore, this need for financing would best be provided by a short-term loan or temporary source of financing such as unsecured bank loans, commercial paper or loans secured by accounts receivable or inventory.
What can DPO also be written as
Accounts payable/ (cost of goods sold/365)
What is the main determinant of net working capital?
The main point of net working capital management is to make decisions regarding a company’s current assets and liabilities. The most important determinants are: hedging principle, which is the principle of self-liquidating debt, the notion of permanent and temporary current assets as well as sources of spontaneous finance.
Discuss the risk-return relationship involved in the firm’s asset-investment decisions as that relationship pertains to its working capital management?
The greater the firm’s investment in current assets the greater its liquidity. The firm may choose to invest additional funds in cash or marketable securities as a means of increasing its liquidity. However, by increasing its investment in cash and marketable securities, the firm reduces its risk of illiquidity. But, the firm has increased its investment in assets that earn little or no return. The firm can reduce its risk of illiquidity only by reducing its overall return on invested funds and vice versa.
Briefly explain how a company determines its target or optimal capital structure.
The target capital structure refers to the optimal mix of debt, preference shares and ordinary equity with which the company plans to use to finance its investment opportunities. The target capital structure for a company is determined by the capital structure that minimizes the overall cost of capital for the company, thereby maximizing the market value of the company, which in turn maximizes the overall wealth of its ordinary shareholders.
Business risk
Business risk is the risk or uncertainty associated with a company’s business operations, ignoring any fixed financing effects. Business risk refers to the relative variability of a company’s operating income that arise from changes to its cost structure and/or changes to its operating environment. Since changes in operating income affect a company’s profitability and/or financial viability, both preference shareholders and ordinary shareholders are affected by business risk.
Financial risk
The additional variability in earnings available to ordinary shareholders that arise from the company’s financing decisions and includes the additional risk of bankruptcy from the use of financial leverage. Since changes in the earnings available to ordinary shareholders affect a company’s ability to make dividend payments to ordinary shareholders, only ordinary shareholders are affected by financial risk.
three (3) general theories of capital structures
Trade-off Theory
Signalling Theory
Pecking Order Theory
Trade-off Theory
Trade-off Theory argues that, since interest payments are a tax-deductible expense, the government effectively subsidises part of the cost of debt capital, resulting in more operating income flowing through to shareholders. However, as the company uses greater amounts of debt, the risk of bankruptcy also increases, which results in the company having to pay higher interest rates.
Signalling Theory
Signalling Theory argues that management’s choice between debt financing versus equity financing is viewed by investors as a signal about the management’s perception of the future financial prospects for the company. Since external investors expect that companies with bright financial prospects will prefer debt financing over equity financing, the decision to use debt financing is viewed as a positive signal by market investors that company managers perceive the company’s future financial prospects to be bright. Conversely, since external investors expect that only companies with poor financial prospects will prefer equity financing, the decision to use equity financing is viewed as a negative signal by market investors that company managers perceive the company’s future financial prospects to be poor.
Pecking Order Theory
Since external investors know that company managers will attempt to issue new equity when they perceive the company’s shares as overpriced, market investors will necessarily discount the price that they are willing to pay for the company’s shares by underpricing the company’s shares. Pecking Order Theory argues that, to avoid this underpricing, company managers prefer to finance investment opportunities using retained earnings, followed by debt financing, and will only choose equity financing as last resort.
The relative advantages of debt financing compared to equity financing are as follows:
(1) Maintaining ownership and control:
(2) Tax deductions:
(3) Lower interest rates:
The relative disadvantages of debt financing compared to equity financing are as follows:
(1) Repayment obligations:
(2) Risk of bankruptcy:
(3) Need for collateral:
