Financial Management Flashcards
What is the relationship between inflation and rates
1+m = (1+i)(1+r) m = money rate (what should be used to discount) I = inflation r = real rate
What is Shareholder Value Analysis
process of analysing the activities of a business to identify how they will result in increasing shareholder wealth
What are the 7 key drivers of value in SVA
sales growth rate operating profit margin CT rate Investment in NCA's Investment in Working capital Cost of capital Life of projected cash flow
What are real options and give some examples
Intangible issues that could affect the investment but whose value is less easy to quantify
Follow on option
Abandonment option
Timing option
Growth option
What is the difference between risk and uncertainty
risk: several outcomes and probabilities known and quantified
Uncertainty: possible outcomes are known but probabilities are unknown
methods for handling uncertainty
- setting maximum payback periods
- increasing the discount rate for appraising the project
- assessing the best and worst possible situations
- using sensitivity analysis
strengths and weaknesses of sensitivity analysis [3/3]
strengths
- facilitates subjective judgement
- identifies the areas crucial to success
- no complicated theory needed to understand
weaknesses
- only one factor can be analysed at a time
- assumes changes to variables are independent
- provides information on changes, doesn’t indicate what changes should be made
What is unsystematic risk
risk that can be diversified away by a diversified portfolio
Give some weaknesses of the CAPM [4]
- shareholders may not be diversified, especially in smaller companies
- depends on perfect capital markets
- need to determine the risk-free rate and return on market. historical returns and expected returns have limitations
- errors in the statistical analysis used to calculate B values, which may also change over time
What are the three alternatives to the CAPM
Alpha value
Arbitrage pricing model
Fama-french three-factor model
What is the alpha value model
measures how wrong the CAPM is, will tend to zero over time for an individual share
If its > 0, investors would want to buy the share, thus increasing its price
What is the arbitrage pricing model
Assumes that the return on each security is based on a number of independent factors.
Assumes that investors are fully diversified so only systematic risk influences the returns
What is the fame-french three factor model
Three factors are
- return on market portfolio less the risk-free rate of interest
- size factor as the difference between a portfolio of the smallest stocks and a portfolio of the larger stocks
- value factor, a share with a high balance book value per share compared to market price should have a higher return that one with a low book value
What is the hedge efficiency
Refers to the extent of risk neutralisation that the hedge delivers
= gain on futures/loss on portfolio x 100%
Limitations of FRAs [3]
- usually only available on loans over £500k
- hard to obtain for periods of over one year
- remove any upside potential
What is
a) transaction risk
b) translation risk
c) Economic risk
a) risk of adverse exchange rate movements occurring in the course of normal international trading
b) risk of accounting losses when converting into home currency
c) effect of exchange rate of the international competitiveness of a company
Ways to reduce transaction risk
invoice in the company’s home currency
matching receipts and payments
Advantages/Disadvantages of currency futures [3/3]
Advantages
- transaction date flexibility
exchange regulated market so counterparty risk reduced
- highly liquid market so easy to do
Disadvantages
- contracts can’t be tailored
- limited number of currencies traded
- broker fees
What are the advantages of convertible loans [3]
- obtaining finance at a lower rate of interest than on ordinary debentures
- encouraging possible investors with the prospect of a future share in profits
- being able to issue equity cheaply (if converted)
Explain the efficient market hypothesis
Weak form efficiency: prices reflect information about past prices, follow a random walk, and future prices can’t be predicted from past prices
Semi-strong form efficiency: prices incorporate all publicly available information, market can’t be beaten by examining public info, can only be beaten by inside information
Strong form efficiency: reflect all information, public or not
Problems with underlying assumptions and data used in dividend valuation model [3/2]
- shares have value because of the dividends
- dividends either don’t grow, or grow at a constant date
- estimates future dividends based on historic data
- share price is used in the DVM but is subject to volatility
- growth in future dividends, not completely based on past dividends
What is operating and financial gearing
Operating gearing is the extent to which operating costs are fixed, as opposed to variable, measuring by establishing total contribution to EBIT
Financial gearing is how much debt is used in the capital structure
Discuss Modigliani and Miller 1958
value of debt + value of equity in gearing firm = value of equity in equivalent ungeared firm
- WACC is constant no matter what
- no optimal level of gearing
- benefits of cheap debt finance offset exactly by increased returns for shareholders for the extra risk
Discuss Modigliani and Miller 1963
value of debt + value of equity in geared firm = value of equity in equivalent ungeared firm + tax shield on debt
- the effect of interest allowable against tax means geared companies pay less tax
- WACC falls as gearing rises
- optimal level is nearly 100%
