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:
Degree of operating leverage
DOL
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
Operating leverage
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.
Operating leverage of 19.33 can be interpreted as:
The ratio of MM Bikes fixed costs to variable costs
A 10% increase in revenues should yield a 193.3% increase in operating income (10%*19.33)
Financial leverage
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.
Therefore, the target (or optimal) capital structure
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.
Degree of total leverage =
DOL * DFL
DFL Calculation
NET OPERATING INCOME AKA EBIT AKA (CONTRIBUTION MARGIN - FIXED COSTS)
DIVIDED BY
TAXABLE INCOME AKA NET OPERATING INCOME - INTEREST EXPENSE
Debenture bond
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.
Mortgage bond
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.
Eurobonds
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.
Zero coupon bonds
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.
Junk bonds.
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.
Describe the bondholder’s claim on the firm’s assets and income.
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.
Filkins Farm Equipment needs to raise $4.5 million for expansion. It expects that five-year zero coupon bonds can be sold at a price of $567.44 for each $1000 bond.
What will be the burden of this bond issue on the future cash flows generated by Filkins? What will be the annual debt service costs?
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.
The Swift Company is planning to finance an expansion. The principal executives of the company agree that an industrial company such as theirs should finance growth by issuing ordinary shares rather than by taking on additional debt. Because they believe that the current price of Swift’s ordinary shares do not reflect the company’s true worth, they have decided to sell convertible bonds. Each convertible bond has a face value equal to $1000 and can be converted into 25 ordinary shares.
a. What would be the minimum share price that would make it beneficial for bondholders to convert their bonds? Ignore the effects of taxes or other costs.
b. What would be the benefits of including a call provision with these bonds?
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.
Suppose that five years ago CSL Limited sold a 15-year bond issue that had a $1000 par value and a 7 per cent coupon rate. Interest is paid semi-annually.
Present value of the bond is 813.07
Suppose that the interest rate remained at 10 per cent for the next 10 years. What would happen to the price of the CSL Limited bonds over time?
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).
Explain why preference shares are considered as a form of hybrid security.
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.
Explain why a company’s ordinary shareholders are often referred to as its residual claimants
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.
Declaration date
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.
Cum dividend
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.
Ex-dividend date
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.
Record date
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.
Payment date
Payment date is the date on which the company actually makes the dividend payments to the shareholders on its record.
Does dividend policy affect the share price of a company? Briefly discuss the various viewpoints of the three (3) general theories of dividend policy with respect to this question together with the practical implications for each theory.
Dividend irrelevance theory and dividend relevance theory
Dividend irrelevance theory
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.
Dividend irrelevance theory practical implication
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.
dividend relevance theory
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):
Bird-in-Hand’ Theory:
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.
Tax Preference’ Theory:
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.
Residual dividend policy
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.
Constant payout ratio dividend policy
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.
Stable dollar dividend policy
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.
Low regular dividend plus extras dividend policy
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
Share repurchases
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.
From the perspective of company managers, the relative advantages of share repurchases compared to regular dividend payments are as follows:
(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:
From the perspective of company managers, the relative disadvantages of share repurchases compared to regular dividend payments are as follows:
(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.
Perpetuity bond value calculation
repayment divided by interest rate
COMPARING BOND’S VALUE FOR VARIOUS REQUIRED RATES
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)
III. If Alice strongly believes that inflation will rise by 1% during the next six months, what is the most she should pay for the bond, assuming annual interest?
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%.
Corporations issue bonds for several reasons:
Raise capital
Provides corporations with a way to raise capital without diluting the current shareholders’ equity.
Corporations issue bonds for several reasons:
Interest rate
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.
Corporations issue bonds for several reasons:
Longer term
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.
Corporations issue bonds for several reasons:
Efficient
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.
Why are bond ratings important
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.
CAPM Cons
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;
(1) Maintaining ownership and control:
advantages of debt financing
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.
(2) Tax deductions:
advantages of debt financing
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.
(3) Lower interest rates:
advantages of debt financing
Since debtholders usually demand lower returns (in the form of lower interest rates) than ordinary shareholders, debt financing is typically cheaper than equity financing.
(1) Repayment obligations:
disadvantages of debt financing
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.
(2) Risk of bankruptcy:
disadvantages of debt financing
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.
(3) Need for collateral:
disadvantages of debt financing
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.
Trade off theory perspective optimal capital structure
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.
Practical implication of the signalling theory
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.
PROS SHARE REPURCHASES (1) To distribute excess cash to shareholders:
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.
PROS SHARE REPURCHASES (2) To adjust the company’s capital structure:
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.
PROS SHARE REPURCHASES (3) To adjust for employee share-based compensation:
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.
PROS SHARE REPURCHASES (4) Signal to investors:
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.
Profit =
Contribution margin per unit * units sold
The three major sources of unsecured short-term credit are
trade credit, unsecured bank loans, and commercial paper.
