Financial Management Flashcards
Share for share exchange adv and Disadv
Share for share exchange = where shareholders in target company are offered shares in the bidding company in exchange for the target company’s shares
Advantages
- no cash is required, preserves liquidity so surplus cash can be used elsewhere
- shareholders retain an interest in combined group
- additional shares will reduce hearing
Disadvantages
- issue costs on new shares
- dilute control for existing shareholders
Advantages and disadvantages of SVA
Advantages
- Theoretically better than earnings (which may be manipulated) and assets (which don’t focus on income generated)
- Predictions difficult as cash flows as in perpetuity
- Once a period of competitive advantage is over then its growth rate is much slower and a terminal residual value is calculated based on cash flows to perpetuity
- This terminal value is a major part of the overall value of a company
What is the Gordon growth / earning retention model
- dividend growth based on the rate of return on RE
- Thus g= rb
- GGM based on the premise that RE are the only source of funds
- Growth is achieved by re-investing earnings
- Then put in DWM to get Ke assuming value of share = PV of growing future dividends
Explain CAPM
Assume investors have diversified portfolio so just systemic risk
CAPM says the required return for an investment is the risk free rate + equity risk premium * (beta) which is the systemic risk of investment compared to the market and therefore the amount of the premium needed
Higher perceived risk, higher beta figure and higher equity return required by investors
Assumptions of WACC
- Historic proportions of debt and equity are not to be changed (if not then APV)
- Systemic business risk is not going to be changed (not going into new industry) (if not then CAPM)
- Finance is not project specific (eg cheap government loans)
When to use APV and how to calculate
If gearing changes, WACC may change
To find new WACC require new MV of company’s shares but this requires the NPV of the proposed investment to be known, which needs the new WACC:
(1) discount project with Ke (ungeared cost of equity) to find NPV
(2) calculate PV of tax shield on the new debt finance
(3) adjust for issue costs (using pre-tax cost of debt)
Total up 1,2,3 if APV positive proceed with investment
Interest rate parity
IRP shows that differences in interest rates cannot be exploited as forward rate will adjust to offset any gains
Average forward rate = average spot today * (1+ average FC interest raten/12)/(1+ average UK interest raten/12)
Shows that value of sterling against FC will fall if FC interest rates lower.
The FC gain in value is called a premium
M&M dividend irrelevance hypothesis
Pattern of dividends don’t affect shareholder wealth
As long as directors concentrate on investing in projects with positive NPV dividends in the future will compensate for cut today
Shareholders can manufacture dividends
Assumes
- perfect info
- shareholders indifferent between income and capital growth, therefore no transaction costs
- in order to pay dividend company must have enough cash and distributable profitd
What is political risk and how to limit
Risk of gov action affecting value
- import quotas/tarriffs = locally produced goods more competitive
- legal restrictions on products
- restriction of foreign ownership = stops company buying others
- enforced nationalisation = gov could nationalise foreign owned companies and their assets
Limit
- negotiations
- insurance
- management structure (JV local)
Issues with CAPM
Rm = based on historic rather than expected future returns
Rf = no such thing, not even gilts
Beta = calculated using statistical analysis of difference between market return and return of a particular share/ industry
- too simplistic, there is likely to be multiple different factors needed to calculate risk
Equity financing options
- Internally generated funds
- no change of control
- no pricing or issue costs
- easy and quick
- may not have cash/ may need to cut dividend - Rights issue
- quick + easy
- low issue cost
- no change of control
- pricing straightforward
- existing shareholders may not be willing to invest - New issue
- time consuming
- high issue cost
- existing shareholder control reduced
- important to set price at right level - Venture capital = VC buy 20-49% shares, give advice, position on board, get shares if company fails to hit VC targets
- Crowdfunding = company uses platform for wide range of investors and pays a fee to website
- ICO = investor gets token that may be used for share/entitlement for service and payment made in crypto
- securities so regulatory criteria
Debt financing options
- Overdraft
- flexible and easy
- useful for seasonal business
- risky (repayable on demand)
- interest cost can be high - Term loans = loan from single lender
- low arrangement fee
- safe: payment date fixed
- generally requires security
- interest rate can be fixed or floating - Loan stock / Debentures = small amounts from different lenders
- higher issue costs
- safe: payment date fixed (or irredeemable)
- can lower coupon by redeeming at premium, conversion rights or warrants attached - Convertible loan stock = can be converted into predetermined amount or into company’s shares
- lower interest rates - Loan stock with warrants = entitled holder to subscribe to ordinary share at predermined price at set dates
- Peer to peer lending
- lower interest rates
- quick to arrange
- companies with low credit ratings
Dividend valuation model assumptions
- Perfect market = perfect info, no transaction costs, rational investors
- All investors have same expectations
- Interim dividends ignored
- Personal tax issues ignored
M&M gearing (with and without tax)
Without
Assumptions
- capital markets efficient
- no transaction costs
- interest rates are the same for everyone
- no bankruptcy costs
If no tax then WACC unaffected by gearing changes
If tax then WACC decreases as gearing increases due to tax relief gained on interest (tax shield)
What are issues with WACC
- Doesn’t include short term sources of finance e.g overdraft which are used over long periods of time so affect cost of capital
- Hard to calculate WACC for small unquoted company as no market values to obtain accurate returns
- Future tax changes will affect cost of debt so will affect WACC
What’s a scrip dividend
Company lets shareholders choose if they want to take dividends in form of new shares rather than case
Allows them to increase shareholding without paying stamp or broker fees
Saves companies finding cash to pay dividends
Why is a merger a good idea
Elimination/ reduction of competition
Economies of scale
Synergies
Risk spreading through diversification
Access to some aspect of target that bidders consider under utilised
Ways to finance an acquisition
Cash
- may have issues raising cash
- bidder gets all to themself- no dilution of control
- target gets a certain sum they can spend straight away but no ongoing interest in the business
- target pays CGT
Shares
- issue costs
- dilution of control
- don’t have to raise cash
- target gets ongoing interest in business
Loan stock
- target has increased gearing and needs to pay interest
- no dilution of control
- seller gets fixed income but limited ongoing involvement
Why might firms divest (sell subsidiaries)
- To concentrate on core activities/ lack of fit
- To get rid of part of business causing problems/ discontinues of scale
- To raise cash
