Finance Flashcards
Finance Financial awareness
Chapter 11 of the ICAEW Workbook covers financial awareness because the
examiner wants learners to understand the issues that have occurred in recent years,
so that socially responsible decisions can be made about finance.
The key features of this chapter include:
Financial strategy is defined as managing an organisation’s financial resources
so as to achieve its business objectives and maximise its value.
The finance function should be involved in the decision making of a company
and labelling the finance function as a business partner is one way of doing this.
Investors have a responsibility to incorporate ESG (environmental, social,
governance) factors into their investment portfolio. This should influence the
decisions of the companies they invest in.
In addition to this chapter, it is important to understand current issues and new
developments in finance.
A recap of markets and finance products can be found in Appendix 2 – Recap of
Financial Management.
Finance Choosing an appropriate financing option
The choice of which financing option to use in a particular case will depend upon the
specific circumstances of the project, the business making the decision, and the
general business environment.
The main considerations are:
Cost (as a general rule debt is cheaper than equity for both issue costs and
finance costs)
Current level of gearing – not only the mix of debt to equity a company currently
has, but also the mix of short to long term debt
The signalling effect (issuing equity may be seen as a last resort)
Availability (size of the company)
Security is often needed for debt finance
Duration – match the term of finance to the term of the proposed project
Control – equity issues may change the balance of control
Cash flow – equity is more flexible if cash flows are uncertain
Covenants in existing debt agreements
Currency
Green finance (finance available for environmentally beneficial companies)
Finance Bonds
If a company wants to issue a bond, it needs to know what return (yield) is required
by the lenders so that it can set the appropriate issue price/coupon rate/redemption
premium. Market / issue prices are covered in more detail in Chapter 4 – Business
and securities valuation.
Finance Bonds 3.1 Yield on a bond
Three key things that affect the yield required on a bond:
1 Base rates e.g. if base rates are low then the required yield will be low too
2 The credit worthiness of the company. For major listed companies, ratings
agencies will issue a credit rating – see detail below
3 The liquidity and marketability of the bonds. The smaller the number of bonds
that are issued the less liquid they are, and therefore riskier requiring a higher
yield
Finance Bonds 3.2 Calculation of yield
There are two ways of calculating the yield on a bond:
1 Flat yield
This is simply the coupon rate divided by current market value. Consequently, it
ignores the impact of any redemption payment, so the flat yield is of little use in
practice.
2 Gross redemption yield (yield to maturity)
This is the more commonly used definition of yield. It is calculated by finding the
IRR of:
the current market value
the gross interest payments
the redemption amount
It can be calculated using the spreadsheet function:
=IRR(cell range) or;
=RATE(number of periods, interest payment, current market value, redemption)
Finance Bonds 3.3 The yield curve for a bond
The yield curve plots gross redemption yields of bonds of equal credit risk and
different maturities. It can help to measure bond investors’ feelings about risk.
The upward slope shows that the yield on a bond is greater the longer there is to
maturity.
For example, this means that 5% Treasury bills with 3 years to maturity will have a
lower yield than 5% Treasury bills with 5 years to maturity.
The main reason for the shape of the yield curve is the Liquidity Preference Theory.
This states that investors will demand a higher return the longer they have to wait for
redemption. If the bond is long dated, then the yield will rise compared to a short
dated bond.
Finance Bonds 3.4 Credit ratings – credit risk and credit spread
The yield on a bond will be influenced by the likelihood of the company issuing the
bond to default (‘credit risk’).
Typical criteria to analyse for assessing credit risk
Loan suitability – length of loan/term structure etc.
Affordability
Security availability
Financial stability
Capital structure
Management
Credit rating companies (such as Standard and Poor’s, Moody’s and Fitch) assess
this risk, and bond yields are determined accordingly.
Yield on a corporate bond = risk free rate + credit spread
The ‘credit spread’ is determined by the assessed credit risk of the company.
Finance Bonds 3.5 Volatility of a bond’s value
There is an inverse relationship between interest rates and bond prices.
So if interest rates rise bond prices fall (and vice versa).
However, the prices of some bonds are more sensitive to changes in interest rates
than others (their prices are more volatile).
The price of a bond is more volatile if the bond has a:
Longer time until maturity
Lower coupon
Lower yield
In order to be able to compare the volatility of two different bonds we can use the
Macauley Duration.
This calculation gives a measure of the sensitivity of a bond’s price to changes in
interest rates (more sensitive/volatile bonds have longer durations).
It is the weighted average length of time to the receipt of a bond’s benefits.
The calculation itself is not examinable, but an awareness of the model can be useful
when assessing two different bond options.
Finance Overseas finance
If a company is investing overseas then it might be more suitable to take out a
foreign currency loan, rather than a UK loan. It can often provide a natural hedge
against foreign currency risk.
Finance Overseas finance 4.1 Factors affecting the financing decision Yield calculation
When calculating the yield on overseas finance, it is important to take account of the
exchange rate movement.
Step 1 – translate all currency cash flows into sterling at the predicted exchange
rates
Step 2 – apply the IRR / RATE function to the sterling cash flows
Finance Overseas finance 4.1 Factors affecting the financing decision Tax:
If interest isn’t tax deductible in the O/S country, then debt finance becomes
notably less attractive
High local taxes increase the benefit of tax deductibility
High withholding taxes or other remittance restrictions makes equity less
attractive
Finance Overseas finance 4.1 Factors affecting the financing decision Exchange rate risk:
Financing an O/S investment with a loan in another currency is risky, especially
if the exchange rate is volatile
Financing a foreign investment with a local currency loan would remove this risk
(but borrowing in local currency may be more expensive for a foreign company)
Finance Overseas finance 4.1 Factors affecting the financing decision Business risk:
International diversification may reduce the volatility of the firm’s operating
profits, enabling the firm to take on more borrowing
Finance Overseas finance 4.1 Factors affecting the financing decision Guarantees:
A parent company may guarantee the debts of a subsidiary enabling it to have a
more highly geared capital structure than normal
Finance Leasing
As an alternative to buying an asset outright with a loan, the company can lease the
asset. This will spread the cost over several years rather than a significant lump sum
up front.
We assume the asset and the project will remain the same regardless of the finance
option, therefore when comparing a loan to a lease agreement it becomes purely a
financing decision.
In order to compare the costs of finance, we calculate an NPV of the relevant cash
flows discounted at the post-tax cost of finance.
Finance Leasing Relevant cash flows for leasing:
The lease payments (often paid at the start of the year)
The tax relief on lease payments (watch out for timing – if the lease payment is
at the start of the year (Year 0) the tax saving will be at the end of the year
(Year 1)).
Finance Leasing Relevant cash flows for buying:
The purchase payment and scrap value of the asset
The tax savings from tax-allowable depreciation
Finance Leasing Discount rate to be used:
For both sets of calculations use the post-tax cost of borrowing:
Cost of borrowing (1 – tax rate)
Finance Dividend policy
Retained earnings are an important source of finance for a company, but a process
of reinvesting money back into the company can have an impact on the money being
paid out as dividends.
If investors are used to having a stable dividend policy, which is then changed, it can
impact on the value of the firm.
This impact can be assessed through a valuation model, such as the formula:
g = b (ROA + D (ROA – i(1 – t))) E
Where:
g is the growth rate
ROA is the return on the net assets of the company
b is the retention rate
D is the book value of debt
E is the book value of equity
i is the cost of debt
t is the corporate tax rate
Financial reconstruction
Financial reconstruction schemes are undertaken when companies have got into
difficulties or as part of a strategy to enhance the value of the firm for its owners.
Financial reconstruction Designing a reconstruction
Step 1: Estimate the position of each party if liquidation is to go ahead. This will
be the minimum acceptable.
1 Fixed charge holder
2 Liquidator’s fee
3 Preferential creditors (such as wages and salaries)
4 Floating charge holder
5 Unsecured creditors
Step 2: Assess additional sources of finance.
Step 3: Design the reconstruction according to the details of the question.
Step 4: Calculate and assess the new position and also how each group has
fared, compare to step 1.
Step 5: Check that the company is financially viable after the reconstruction.
Financial reconstruction Methods of reconstruction
Leveraged capitalisation – a firm replaces the majority of its equity with a
package of debt.
Debt-equity swap – A portion of the debt is exchanged for a predetermined
amount of equity, possibly done to reduce the gearing level.
Equity-debt swap – shareholders are given the right to exchange their shares
for a predetermined amount of debt.
Refinancing – a firm may replace current debt with a package of cheaper or
more flexible debt, but the benefits may be outweighed by penalty clauses or
transaction fees from paying off the original debt early.
Securitisation – is the process of using non-liquid assets, such as future season
ticket sales for football clubs, or trade receivables as collateral for a loan.
Financial distress Legal consequences of financial distress
Fraudulent trading – occurs where a company has traded with intent to defraud
creditors.
Wrongful trading – occurs when directors have continued to trade when the
company is no longer financially viable and should be in liquidation.
Financial distress Management of companies in financial distress
Administration – the powers of management are subjugated to the authority of
the administrator, who has the same powers as those of the directors and may
do anything necessary to try and save the company if possible.
Company voluntary arrangement – the directors retain control and manage the
company and they must put together a proposal to put to creditors as an
acceptable alternative to liquidation.
Directors need to act responsibly when a company is in financial
distress. Poor decisions, such as wrongful trading can result in
imprisonment (Rule of Law).
