F2 Flashcards
LONG-TERM FINANCE
What are the 4 equity sources of finance? Do not explain.
- Rights issue of shares
- New issue of shares
- Stock market
- Alternative Investment Market (AIM)
LONG-TERM FINANCE
What are the two types of shares and what are their differences?
- Ordinary Shares: also known as equity shares, allows you to claim dividends if offered. Shareholder will be a part owner of the company and therefore can vote/attend meetings. Paid last out of all investors (both for dividends and winding up).
- Preference Shares: paid dividend at a fixed rate based on the nominal value of the share. Can be accumulated dividends. Holders do not own any part of the company and cannot vote/attend meetings. Paid in preference to ordinary share holders.
LONG-TERM FINANCE
What are the 4 types of preference shares?
- Cumulative - dividends build up until paid.
- Non-Cumulative - dividends can be missed.
- Participating - fixed dividend and can get extra in good years
- Convertible - can be converted into ordinary shares based on certain conditions.
LONG-TERM FINANCE
What are some ‘other’ sources of long-term finance (i.e. not Debt/Equity)
- Using Retained Earnings
- Government Grants
- VCs/Angel Investors (although you would likely lose some control of the business)
LONG-TERM FINANCE
What are the primary and secondary functions of the stock market and what is a prerequisite for a company?
- Primary: allows companies to raise new finance by issuing shares or marketable debt.
- Secondary: enables subsequent trading of investments between investors
Companies MUST be a PLC (public limited company).
LONG-TERM FINANCE
What is a Rights Issue of Shares?
- New shares are issued to existing shareholders in proportion to their existing shareholdings. (Private companies can partake)
- Often at a discounted price - but if price is too low, too much earning per share dilution can happen.
- Rights issues are simple to arrange and do not alter control, but are not always suitable for raising large amounts of finance.
- Can be underwritten (underwriter buys any not sold shares).
LONG-TERM FINANCE
What does Cum rights price and TERP mean and what’s the formula?
- Cum rights price (CRP) = price of share immediately before rights issue
- Theoretical ex rights price (TERP) = theoretical price of share immediately after rights issue
TERP = (N x cum rights price) + issue price
- - - - - - - - - - - - - - - - - - - - - - - - - - -
(N + 1)
LONG-TERM FINANCE
What does AIM stand for and what does it mean?
Alternative Investment Market
- A stock exchange for smaller companies
- More straightforward admission requirements than the main stock exchange.
LONG-TERM FINANCE
What does it mean to issue shares on the stock market and what are the 5 advantages and disadvantages?
- A company may float on the stock market - this can make their shares more attractive.
- Shares offered to the general public. This is typically done using an IPO. The IPO price isnt necessarily the same as the nominal value
Advantages:
- Better company valuation
- Mechanism for trading shares in the future
- Company profile is raised
- Easier access for future capital finance
- Employee share scheme more accessible
Disadvantages
- Costly for a small entity
- Can lead to a loss of control for original owners
- Reporting reqs more onerous
- Stringent rules for obtaining a quotation
- Risk of failure (share price tanks)
LONG-TERM FINANCE
What is bank finance?
Bank Finance - for unlisted companies (and many listed ones too), a bank loan is the first option for debt finance.
LONG-TERM FINANCE
What is traded debt and what are the debt finance definitions?
Traded Debt (Debentures/Loan Stock/Bonds) - Listed companies can issue debt to investors, usually in $100 nominal value blocks (par value) - purchaser received interest (coupon rate).
Market value is the cash received from issuing the loan. Premium is the extra amount repayable at redemption date based on par value.
Can be redeemable/irredeemable.
Can have warrants i.e. investor can purchase shares in the company.
Can be convertible i.e. investor can swap debt for shares in the future.
LONG-TERM FINANCE
What is an RCF?
Revolving Credit Facility (RCF) - companies can borrow funds up to a pre-determined limit. Limit is changed based on how much is being used/been paid back.
LONG-TERM FINANCE
What are Commercial Papers?
Commercial Paper (unsecured loan) - no fixed (i.e. buildings) or floating (i.e. inventory) security.
Covenants can be in place which are rules/stipulations on how company is run/money managed.
COST OF CAPITAL
What is the WACC?
Weighted Average Cost of Capital is the average cost of the entity’s finance, weighted according to the proportion of each element in the overall pool of funds.
Market valued are used for the weightings.
The formula WILL be given during the exam.
COST OF CAPITAL
What does DVM stand for and what is the theory?
The Dividend Valuation Model theory is that the price of a share is the present value of the dividends, discounted at the shareholders’ required rate of return.
COST OF CAPITAL
What is the formula for the DVM - No Growth
Ke = d
- -
Po
Where:
Ke = Cost of Equity
d = Constant Dividend
Po = ex div market price of a share (ex div = after dividend is paid)
COST OF CAPITAL
What is the formula for the DVM - With Growth?
Ke = Do (1 + g)
- - - - - - - - - + g
Po
Where: Ke = Cost of Equity Do = Constant Dividend Po = ex div market price of a share (ex div = after dividend is paid) g = dividend growth.
COST OF CAPITAL
What are the two ways to calculate growth for the DVM?
Based on retention of profits: g = r x b = return on reinvested funds x proportion of funds retained
or
Based on averaging method: g = n√(Do/Dn) - 1
- Do = Current Div
- Dn = Dividend n years ago (oldest)
COST OF CAPITAL
What is Gordons Growth Model?
g = b * Re
Where:
b = earning retention rate (% of profits retained i.e. not given as a div)
Re = accounting rate of return (% returns on projects)
COST OF CAPITAL
What is cum div and ex div and how do you calculate the change?
Cum Div means that a div is just about to be paid, Ex Div means its just been paid.
To calculate a Cum Div –> Ex Div: Share Price - Divident payout
COST OF CAPITAL
What are the repayments equal to for the cost of equity and the cost of debt?
The cost of equity is equal to the required return to the ordinary shareholders.
The cost of debt is not equal to the required return of the debt holders, because the company gets tax relief on debt interest.
COST OF CAPITAL
What is the formula for Irredeemable debt?
Kd = I ( 1 - T )
- - - - - - -
Po
Where:
Po = ex interest market price of the debt
I = annual interest rate
T = tax rate
COST OF CAPITAL
What is the formula for a Bank Loan?
Kd = I ( 1 - T)
Where:
I = interest rate
T = tax rate
COST OF CAPITAL
What is the formula for the cost of preference shares?
Kp = annual dividend/ex-dividend share price
COST OF CAPITAL
Verbally summarise how you would calculate the cost of Redeemable Debt and Convertible Debt.
Redeemable Debt - Using the discounted cashflow method and the IRR formula in the formula sheet.
Convertible Debt - As above but must work out if redemption value is more than share value, use the highest value to work out IRR.
COST OF CAPITAL
What 3 things need to be in place for WACC to be suitable for use?
- Constant capital structure
- New investment carries the same business risk profile of the entity
- New investment is marginal to the entity
COST OF CAPITAL
What are the two calculations for Yield to Maturity and how do they differ to the cost of debt calculations?
- YTM - - - - - - - - - - - - - - - - - - - - - - -
. / \
. / \
. Irredeemable Debt Redeemable Debt
. | |
. Annual Interest Received IRR Calculation
. - - - - - - - - - - - - - - - - - - - - - x100
. Market Value
- YTM - - - - - - - - - - - - - - - - - - - - - - -
YTM is always GROSS of tax, whereas the cost of debt is always NET of tax (this is because of the tax deduction)
COST OF CAPITAL
What is the IRR Formaula?
IRR = ( NL )
L + (H - L)(—————)
( NL - Nh )
Where:
L & H = Lower and Higher discounted rate used
NL & NH = NPV at the lower and higher rate
FINANCIAL INSTRUMENTS
What is a financial instrument?
A contract that creates a financial asset for one party, and a financial liability for another.
FINANCIAL INSTRUMENTS
When looking at the type of transactions, an Asset is any of:
- Cash
- An equity instrument of another company
- The right to receive cash from another party
- Contractual rights to exchange financial instruments under favourable terms (IAS 32)
FINANCIAL INSTRUMENTS
When looking at the type of transactions, a Liability is any of:
- An obligation to pay cash or deliver another financial asset to another entity
- An exchange of financial instruments under unfavourable terms (IAS 32)
FINANCIAL INSTRUMENTS
When looking at the type of transactions, an Equity is:
- Any contract where there is residual interest in the assets of an entity after deducting all of its liabilities (ordinary shares)
FINANCIAL INSTRUMENTS
Classify the following financial Instruments
Instrument Classification
-> Ordinary Shares | ->
-> Loans | ->
-> Debentures/Loan Stock | ->
/Loan Notes/Bonds |
-> Preference Shares | ->
-> Convertible Loans | ->
Instrument Classification
-> Ordinary Shares -> Equity
- > Loans -> Liability
- > Debentures/Loan Stock/Loan Notes/Bonds -> Liability
- > Preference Shares -> Depends. If obligation to deliver cash = Liability BUT If no obligation = equity
- > Convertible Loans -> Both. A hybrid instrument.
FINANCIAL INSTRUMENTS
What is the split accounting required for the INITIAL RECOGNITION of Convertible Loan notes?
Step 1 - Dr Cash actually received
Step 2 - Cr Liability (PV of cash flows)
Step 3 - Cr Equity (bal fig)
FINANCIAL INSTRUMENTS
What is the classification for Financial Liabilities and what is their initial recognition and subsequent treatment?
- Depending on the type - if amortised:
Initial Recognition
- Cash received less costs incurred
Subsequent Treatment
Year || Bal B/F || Effective Interest Rate || (Coupon Rate) || Bal C/F
Year 1. ||
Year 2…||
- If classified as FVPL:
N.B - Liabilities held for trading (including derivatives) can be designated as FVPL
Initial Recognition
- Cash revived at FV
- Issue costs would be expensed
Subsequent Treatment
- Measured at FV each year with movement going to P&L
FINANCIAL INSTRUMENTS
When classifying an investment in shares, when would the equity be held as FVPL and what would its initial recognition/subsequent treatment be?
Held as Fair Value Through Profit & Loss when the equity is held for trading.
Initial Recognition
- At FV (cost)
- Issue costs expensed to P&L
Subsequent Treatment
- Revalue to FV
- Gain or Losses to P&L
FINANCIAL INSTRUMENTS
When classifying an investment in shares, when would the equity be held as FVOCI and what would its initial recognition/subsequent treatment be?
Held as Fair Value Through Through Other Comprehensive Income when the equity is not held for trading AND it is irrevocably designed.
Initial Recognition
- At FV (cost)
- Tx costs added
Subsequent Treatment
- Revalue to FV
- Gain or Losses to Other Comprehensive Income (and reserves on SFP)
N.b. the gain/loss in OCI is NEVER reclassified to P&L in the future.
FINANCIAL INSTRUMENTS
When classifying Debt financial assets, outline the Contractual Cashflow, Initial Recognition and Subsequent Treatment for holding until redemption?
FVPL
Contractual Cashflow
- Passed
Initial Recognition
- At FV (cost)
- Tx cost added
Subsequent Treatment
- At amortised cost
FINANCIAL INSTRUMENTS
When classifying Debt financial assets, outline the Contractual Cashflow, Initial Recognition and Subsequent Treatment for holding to redemption AND selling before redemption?
FVOCI
Contractual Cashflow
- Passed
Initial Recognition
- At FV (cost)
- Tx cost added
Subsequent Treatment
- Revalue to FV
- Gain or loss to OCI (and reserves on SFP)
N.b. The gain or loss in OCI IS reclassified to P&L in the future
FINANCIAL INSTRUMENTS
When classifying Debt financial assets, outline the Business Model, Contractual Cashflow, Initial Recognition and Subsequent Treatment when the model does not fit FVPL or FVOCI?
Contractual Cashflow
- Does not pass the tests for Amortised Cost/FVOCI
Initial Recognition
- At FV (cost)
- Tx cost expensed to P&L
Subsequent Treatment
- Revalue to FV
- Gain or losses to P&L
FINANCIAL INSTRUMENTS
What are the 3 characteristics of a Derivative and how are they classified?
- Little of no initial value
- Value changes in response to a change in underlying factor
- Settled in the future
Always classified as FVPL
EARNINGS PER SHARE
What are the formulas for Basic EPS and Diluted EPS?
- Basic EPS
Profits attributable to ordinary share holders - Weighted average number of ordinary shares
- Diluted EPS
Basic Earnings + Potential Extra Profits - Weighted avrg no. of shares + potential extra shares
EARNINGS PER SHARE
When calculating EPS, how do you calculate profits and the weighted avrg no. shares?
Profits
- > = Profits after tax - and NCI - (%*Non-Redeem Pref Shares)
- > Deduct cumulative preference div in the year they accrue, even if not paid
Weighted avrg. no. shares
Date || Actual No. of Shares || N/12 || Bonus Fraction || Weighted Avrg.
EARNINGS PER SHARE
What is a bonus issue of shares and how are they accounted for?
Bonus shares are those issued for free based on how many the holder has, i.e. 1 for 4.
Accounted for by increasing the issue in proportion. Use the regular weighted average table layout to calculate. Break out pre and post bonus issue in the table.
EARNINGS PER SHARE
How do you compare an earnings per share that has a bonus issue?
For the years prior EPS, multiply it by the inverse of the bonus fraction - will ALWAYS be lower.
i. e bonus issue of 1 to 9 = 10/9 bonus fraction, inverse is 9/10
14. 4 cents -> 13.0 cents
EARNINGS PER SHARE
What are some reasons to issue bonus shares?
Some argue its effectively paying a dividend when the co. doesnt want to pay cash.
The real reason is to lower the SP to make it more attractive.
