Exam Revision Flashcards

Question

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

Answer 1

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.

Answer 2

This is mostly due to better cash management as well as improved dividend policy.

Answer 3

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.

Answer 4

Accounts payable/ (cost of goods sold/365)

Answer 5

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.

Answer 6

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.

Answer 7

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.

Answer 8

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.

Answer 9

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.

Answer 10

Trade-off Theory Signalling Theory Pecking Order Theory

Answer 11

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.

Answer 12

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.

Answer 13

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.

Answer 14

(1) Maintaining ownership and control: (2) Tax deductions: (3) Lower interest rates:

Answer 15

(1) Repayment obligations: (2) Risk of bankruptcy: (3) Need for collateral:

Answer 16

DOL = CM/Profit Is the ratio of a company’s fixed costs to its variable costs. A high degree of operating leverage indicates a high proportion of fixed costs. Firms operating at a high degree of operating leverage face higher risk of loss when sales decrease but enjoy profits that rise more quickly when sales increase

Answer 17

Operating Leverage refers to the presence of fixed operating costs (as opposed to variable operating costs) within a company’s cost structure. A company with relatively high fixed operating costs will experience greater variability in operating income if sales were to change.

Answer 18

A 10% increase in revenues should yield a 193.3% increase in operating income (10%*19.33)

Answer 19

Financial Leverage refers to the use of fixed-cost sources of finance (rather than variable-cost sources) to finance a portion of a company’s assets. Higher financial leverage (in the form of greater debt financing) leads to potentially greater returns to shareholders, but also results in higher financial risks due to the need to make periodic fixed repayments on a regular basis.

Answer 20

Therefore, the target (or optimal) capital structure for a company is 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.

Answer 21

NET OPERATING INCOME AKA EBIT AKA (CONTRIBUTION MARGIN - FIXED COSTS) DIVIDED BY TAXABLE INCOME AKA NET OPERATING INCOME - INTEREST EXPENSE

Answer 22

A unsecured long-term debt. Because these bonds are unsecured, the earning ability of the issuing corporation is of great concern to the bondholder. They are also viewed as being more risky than secured bonds and, as a result, must provide investors with a higher yield than secured bonds provide. Often the issuing firm attempts to provide some protection to the holder through the prohibition of any additional encumbrance of assets.

Answer 23

A bond secured by a loan on real property. Typically, the value of the real property is greater than that of the mortgage bonds issued. This provides the mortgage bondholders with a margin of safety in the event the market value of the secured property declines. In the case of foreclosure, the trustees have the power to sell the secured property and use the proceeds to pay the bondholders. In the event that the proceeds from this sale do not cover the bonds, the bondholders become general creditors, similar to debenture bondholders, for the unpaid portion of the debt.

Answer 24

Eurobonds are bonds issued in a country different from the one in which the currency of the bond is denominated. For example, a bond that is issued in Europe or in Asia by an American company that pays interest and principal to the lender in U.S. dollars would be considered a Eurobond. Thus, even if the bond is not issued in Europe, it merely needs to be sold in a country different from the one in whose currency it is denominated to be considered a Eurobond.

Answer 25

Zero coupon bonds are bonds that pay no coupon interest. They allow the issuing firm to issue bonds at a substantial discount from their $1,000 face value. The investor receives all of the return from the appreciation of the bond at maturity.

Answer 26

Junk bonds refer to any bond with a rating of BB or below. The major participants in this market are new firms that do not have an established record of performance. Many junk bonds have been issued to finance corporate buyouts.

Answer 27

In the case of insolvency, claims of debt in general, including bonds, are honored before those of both common stock and preferred stock. Bonds have a claim on income that comes ahead of common and preferred stock. If interest on bonds is not paid, the bond trustees can classify the firm insolvent and force it into bankruptcy. Thus, the bondholder's claim on income is more likely to be honored than that of common and preferred stockholders, whose dividends are paid at the discretion of the firm's management.

Answer 28

In five years, Filkins will have to repay $4.5 million when the bond matures. However, because the debt is a zero-coupon bond, there will no interest payments in the meantime. Thus, the annual debt service costs are $0.

Answer 29

The conversion price simply is the face (par) value of the bond divided by the conversion ratio; the conversion price for this issue is $1000/25 = $40. Therefore, it would be beneficial for investors to convert their bonds into ordinary shares when the share price is greater than $40 per share. The conversion feature would add some flexibility to the bonds as an investment. Investors might find it attractive to buy the bonds because they can later decide whether they prefer to remain bondholders or to convert and become stockholders.

Answer 30

The price of the bond will increase from $813.77 towards $1000, hitting $1000 (plus accrued interest) at the maturity date (assuming the firm does not default).

Answer 31

Preference shares are considered as a form of ‘hybrid security’ because preference shares possess some features that are similar to bonds and some features that are similar to ordinary shares. On the one hand, preference shares are similar to bonds in that fixed dividends must be paid to preference shareholders before dividends can be paid to ordinary shareholders. On the other hand, preference shares are similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders.

Answer 32

As ‘residual claimants’, ordinary shareholders have residual claims to any earnings that remain only after: (i) interest payments are made to debtholders; (ii) corporate tax is paid to the government; and (iii) dividends are paid to preference shareholders. Additionally, in the event a company becomes bankrupt, ordinary shareholders have residual claims to any assets that remain only after: (i) all claims by debtholders are settled; and (ii) all claims by preference shareholders are settled.

Answer 33

Declaration date is the date on which the company’s board of directors publicly announces the amount and the specifics (such as the payment date) of the next dividend payment.

Answer 34

Cum dividend refers to the situation where the legal right to the next dividend payment accompanies a share. When investors purchase shares that are cum dividend, they are entitled to receive the next dividend payment on the payment date. Conversely, when shareholders sell shares that are cum dividend, they will not be entitled to receive the next dividend payment on the payment date.

Answer 35

The date on which the legal right to the next dividend payment no longer accompanies a share. Shareholders that sell shares on or after the ex-dividend date will still be entitled to receive the next dividend payment on the payment date, although the new owner will not. Usually, shares that trade immediately after the ex-dividend date will be accompanied by a decline in the share price that is equivalent to the amount of the next dividend payment.

Answer 36

Record date is the date on which the company determines the list of shareholders that will receive the next dividend payment. In Australia, the record date occurs 4 business days after the ex-dividend date.

Answer 37

Payment date is the date on which the company actually makes the dividend payments to the shareholders on its record.

Answer 38

Dividend irrelevance theory and dividend relevance theory

Answer 39

Dividend Irrelevance Theory states that a company’s dividend policy is irrelevant and has no effect on the overall cost of capital nor the market value of the company. Specifically, Dividend Irrelevance Theory argues that the market value of a company is determined by the basic earning power and the business risk of the company. Therefore, the market value of a company depends only on the net income (or positive cashflows) produced by the company and not on how it splits its retained earnings between financing investments for future growth versus dividend payments to shareholders.

Answer 40

As a result, Dividend Irrelevance Theory contends that investors are only concerned with the total returns they receive, and not whether they receive those returns in the form of dividends, capital gains or both. Since Dividend Irrelevance Theory argues that shareholders are not concerned with a company’s dividend policy, this implies that company managers can set any dividend policy without affecting the company’s share price.

Answer 41

In contrast, Dividend Relevance Theory states that the market value of a company is affected by its dividend policy, with the optimal dividend policy being the one that maximizes the market value of the company. Specifically, Dividend Relevance Theory contends that a company’s dividend policy can affect its market value due to investor preferences for either dividends (as ‘bird-in-hand’ theory contends) or capital gains (as ‘tax preference’ theory contends):

Answer 42

The ‘Bird-in-Hand’ Theory argues that, since current dividend payments are more certain than future capital gains, investors would prefer to receive dividends today rather than receive capital gains in the future. This implies that company managers ought to set a high regular dividend payments policy so as to minimize the cost of equity and maximize the company’s share price.

Answer 43

The ‘Tax Preference’ Theory argues that, since dividends are taxed immediately whereas capital gains are not taxed until the share is sold, investors would prefer to defer tax by receiving capital gains in the future rather than receiving dividends today and being taxed immediately. This implies that company managers should set a low regular dividend payments policy so as to minimize the cost of equity and maximize the company’s share price.

Answer 44

The policy dictates that dividend payments to shareholders should only be paid out of leftover earnings. Although the policy minimises the cost of capital for the company, the policy will necessarily result in the variation of dividend payments to shareholders. This sends conflicting signals to investors that might, in turn, adversely affect the company’s share price.

Answer 45

The policy in which the company distributes a fixed proportion of its earnings to shareholders in the form of dividend payments. Although the dividend payout ratio remains constant over time, the dollar value of dividend payments will necessarily fluctuate as earnings change over time which sends conflicting signals to investors that might adversely affect the company’s share price.

Answer 46

Stable dollar dividend policy refers to the policy in which the company pays a fixed dollar amount of dividend payments to shareholders each year such that the annual dollar dividend is relatively predictable for investors. This sends a positive signal to investors that will, in turn, help to attract more investors, thereby maintaining or boosting the company’s share price.

Answer 47

Low regular dividend plus extras dividend policy refers to the policy in which the company pays a low regular dollar dividend to shareholders plus an extra year-end dividend in prosperous years when the company is performing well financially. The ‘low regular dividend plus extras’ dividend policy represents a compromise between the stable dollar dividend policy and the constant payout ratio dividend policy

Answer 48

Share repurchases (or share buy-backs) refers to the distribution of earnings by a company to its shareholders by purchasing its own shares from existing shareholders.

Answer 49

(1) To distribute excess cash to shareholders: (2) To adjust the company’s capital structure: (3) To adjust for employee share-based compensation: (4) Signal to investors:

Answer 50

(1) Company might overpay for shares: With share repurchases, the company might end up paying too much for the purchased shares. This is especially so when substantial amounts of shares are purchased on the market, which might in turn cause a marked increase in the company’s share price. (2) Irregular interval between share repurchases: Since the interval between share repurchases are generally irregular, participating investors cannot rely on the cash that they receive from share repurchases. As a result, some investors might prefer cash distribution through regular dividend payments rather than through share repurchases by the company.

Answer 51

repayment divided by interest rate

Answer 52

Premium: We can see that the bond’s value is greater when semi-annual interest is paid. This will always occur when the bond sells at a premium (i.e. investors required return is less than coupon rate) Par: We can see that the bond’s value is slightly less or equal when semi-annual interest is paid. This will always occur when the bond sells at par (i.e. investors required return is equal to coupon rate) Discount: We can see that the bond’s value is lower when semi-annual interest is paid. This will always occur when the bond sells at a discount (i.e. market return is greater than the coupon rate)

Answer 53

Usually, when an inflation rate increases by 1%, investors would require an additional 1% interest rate to cover their losses resulting in changes in the cost of living. That is, for a bond with a market rate of 8% before changes in inflation, the new required rate is 9%.

Answer 54

Provides corporations with a way to raise capital without diluting the current shareholders' equity.

Answer 55

With bonds, corporations can often borrow at a lower interest rate than the rate available in banks. By issuing bonds directly to the investors, corporations can eliminate the banks as "middlemen" in the transactions. Without the intermediaries, the borrowing process becomes more efficient and less expensive.

Answer 56

By issuing bonds, corporations can often borrow money for a fixed rate for a longer term than it could at a bank. Most banks will not make fixed rate loans for longer than five years because they fear losing money if their cost of funds (raised by selling CDs, savings accounts, and the like) rises to a higher rate than long-term loans. Most companies want to borrow money for long terms and so elect to issue bonds.

Answer 57

The bond market offers a very efficient way to borrow capital. By issuing bonds, the borrower is spared the task of undergoing numerous separate negotiations and transactions in order to raise the capital it needs.

Answer 58

For the financial manager, bond ratings are extremely important. They provide an indicator of default risk that in turn affects the rate of return that must be paid on borrowed funds.

Answer 59

The use of historical data such that beta may or may not reflect the future variability of returns. Therefore, the required rate of return specified by the CAPM may be viewed only as rough approximations. CAPM is based on the unrealistic assumption of the efficient market hypothesis such as (a) many small investors all having the same information and expectations for securities; (b) no restrictions on investment;

Answer 60

Unlike equity financing, debt financing does not involve selling claims to ownership of the business to market investors. As such, by using debt financing, the owner is able to maintain ownership and control over the business.

Answer 61

Unlike the dividend payments associated with equity financing, the interest payments associated with debt financing are tax deductible, with the government effectively subsidizing part of the cost of debt capital.

Answer 62

Since debtholders usually demand lower returns (in the form of lower interest rates) than ordinary shareholders, debt financing is typically cheaper than equity financing.

Answer 63

With debt financing, there is a need to make periodic fixed repayments to the debtholder on a regular basis. As such, the business must ensure that it can generate sufficient cash flows to meet the repayments when they fall due or face becoming bankrupt. There is, however, no such repayment obligation with equity financing.

Answer 64

Debt financing increases the risk of bankruptcy for the business. Furthermore, in the event the business becomes bankrupt, the debtholder has priority in claiming the assets of the business before ordinary shareholders. There is, however, no such risk of bankruptcy with equity financing.

Answer 65

With debt financing, the business is usually required to pledge some of its assets as collateral in order to protect the debtholder against possible default. There is, however, no such requirement for collateral with equity financing.

Answer 66

Therefore, from the Trade-off Theory’s perspective, the optimal capital structure for a company is the point at which the tax benefit from additional debt exactly offsets the increase in bankruptcy-related cost, thus resulting in the minimum overall cost of capital for the company.

Answer 67

Accordingly, the implication of Signalling Theory is that companies should always maintain a reserve borrowing capacity by using less debt than the ‘optimum debt level’ suggested by Trade-off Theory in order to ensure that further debt capital can be obtained later if required.

Answer 68

Unlike regular dividend payments, share repurchases provide flexibility by allowing companies to distribute excess cash to shareholders without changing the amount of regular dividend payments.

Answer 69

Unlike regular dividend payments, share repurchases are an effective method to immediately change the company’s capital structure when the proportion of equity is substantially higher than the target capital structure prescribes.

Answer 70

Unlike regular dividend payments, share repurchases reduce the dilution effect that occurs when employee options are exercised, thereby minimizing the effect on the company’s share price.

Answer 71

Unlike regular dividend payments, share repurchases allow company managers to signal to investors that they perceive the company’s share price to be under-valued, and thus represent a bargain for investors to purchase.

Answer 72

Contribution margin per unit * units sold

Answer 73

trade credit, unsecured bank loans, and commercial paper.