Finance and capital structure Flashcards
1
Q
Limitations of the Gordon’s growth model
A
- g must be less than ke, otherwise the share price will be infinitely high
- this consistent level of growth is impossible
- in reality, companies experience varying levels of growth over time
- relies on accounting profits rather than CFs
- assumes b and r are constant
- ARR can be distorted by inflation
- assumes all new finance is from equity or gearing is constant
2
Q
Limitations/assumptions of dividend valuation model
A
- value of shares is derived solely from dividends, which is untrue
- dividends do not grow or grow at a constant rate
- share prices are constant - in reality fluctuate
- ignores future income growth
3
Q
Reservations for using WACC
A
- dividend growth rate might change in future
- all project have different business risks so each should have risk specific discount factors
- market values might change in the future
- tax rate might change in the future
- gearing ratio might change in future
- other sources of finance might emerge in future
4
Q
What is the WACC hurdle rate?
A
- cost of funds that a company raises and uses, and the return that investors expect to be paid for putting funds into the company and therefore is
- The minimum return that a company must make on its own investments, to earn the cash flows out of which investors can be paid their return
- if the hurdle rate is not achieved, then the company is investing in projects with negative NPV and the value of the company and wealth of shareholders will decline
5
Q
Key points regarding dividend growth
A
- it should be based on future growth - forecast, strategy, retentions etc
- often uses past - past dividend per share and GGM
- 0% growth means constant share price with no capital growth. Return is just dividend yield
6
Q
General details about keeping money in with banks
A
- you are lending them your money for loans
- they reward you with interest, but they also charge interest to loanees, therefore they are making a profit on this aspect
- the interest you get is not linked to the profit the bank makes
- banks are safe, interest rates are low. Risk and reward come hand-in-hand
- interest rates are in line with inflation, it is likely you are not worse off having your money in the bank against inflation
7
Q
General details on shares
A
- become a part owner of the business
- usually buying them off someone who no longer wants them - an individual or private investor
- sometimes companies issue more shares to raise finance for themselves
8
Q
General details on company profits / dividends
A
- most companies reinvest the majority of their profits to provide future gains for the shareholders
- they usually leave some left to as a dividend to pay the shareholders now
- companies do not have to pay dividends
- investors of large companies usually expect a dividend
9
Q
Details and assumptions of CAPM
A
- based on one factor affecting return on a portfolio - systematic risk - measured by beta
Assumptions
- linear relationship between return on companies and average of all securities in the market
- Individual securities will be more or less risky than the market average in a fairly predictable/measurable way over time.
10
Q
Alternatives to CAPM
A
- Arbitrage Pricing Theory APT
- Bond yield plus premium approach
- Dividend valuation model
11
Q
Explain APT
A
- similar to CAPM but adds a premium to risk free rate
- premium is divided into lots of bits
- difficulty in deciding the size of each bit
- different authors suggest different things, e.g. inflation, interest rates, company size etc
- should be used when there is a dramatic change in gearing
12
Q
Explain bond yield plus premium approach
A
- uses rate of interest a company can borrow at rather than risk free rate as starting point
- risk of company reflected in borrowing rate
- fixed premium added to reflect equity riskier than debt
13
Q
Explain dividend valuation model
A
- looks at predicted future dividend per share compared to share price
- measures actual return
- assuming market is perfectly efficient, then this is the return we should be getting
14
Q
Advantages of a rights issue
A
- no change in control of the company if the rights are fully taken up
- dividend payments are flexible and not obligatory
15
Q
Disadvantages of a rights issue
A
- unlisted company may be unattractive to shareholders
- is it what the shareholders want? can they afford it?
