Financial Strategy Formulation

Question 1

What is unsystematic/specific risk?

Answer 1

Considers the diversification of a portfolio.

A well-diversified portfolio carries significantly less unsystematic risk than an investment in only one or two instruments.

Question 2

What is systematic/market risk?

Answer 2

Caused by factors which affect all industries and business to one extent or another.

Interest rates, tax legislation, exchange rates and business cycles.

Question 3

How is portfolio risk defined?

Answer 3

Systematic Risk + Unsystematic Risk

Question 4

What is the Capital Asset Pricing Model used for?

Answer 4

To calculate the cost of equity (Ke)

Question 5

What type of investor is most likely to use the CAPM?

Answer 5

Investors with a broad range of investments who are worried about how a fall in the stock market as a whole would affect their investments.

Question 6

Describe the relationship between risk and return.

Answer 6

The greater the risk of the asset the higher the return is expected by the investor.

Risk = risk free rate + risk endured on investment.

Question 7

How is risk defined within the CAPM?

Answer 7

Risk is defined in the CAPM by using beta factors.

The higher the beta factor the higher the risk and so the higher return expected.

Question 8

What is the CAPM formula?

Answer 8

E(r) = Rf + B (Rm - Rf)

Question 9

What are the main limitations of the CAPM?

Answer 9

1. Estimating Market Return
   Achieved by comparing movements in the stock market as a whole. This will be volatile in reality and will overstate the return expected as it will not pick up the firms that have failed and consequently fallen out of the market.
2. Estimating Beta Factors
   Based on historical data and will not give an accurate indication of risk if the company has recently changed its gearing or strategy.
3. Other Risks
   CAPM ignores the size of a company and also the ratio of book value of equity to market value of equity. (Low assets vs. market value will warrant a higher return).

Question 10

List the 5 types of debt finance that may be presented in the exam.

Answer 10

1. Bank Loan (post tax value)
2. Preference shares (flexible, dividend can be deferred)
3. Leasing (more likely available, ownership remains with lessor)
4. Bond/Debenture/Loan Note
5. Convertible Bonds

Question 11

What are the characteristics of a bond/debenture/loan note?

Answer 11

A tradable IOU 
Nominal value $100 or $1000
Maturity 7-30 years
Pays fixed interest
Protected by covenants

Slower & more expensive to organise than normal bank loan.
Less flexible in event of default

Cheaper interest costs

Question 12

What are the characteristics of a convertible bond?

Answer 12

A hybrid of debt and equity
Cheaper interest costs
Fewer covenants
Attractive if shares are underpriced.

Question 13

What are the three ways to calculate the cost of a bond?

Answer 13

1. IRR of the cash flows
2. Risk free rate derived from yield curve
3. Credit risk premium from the bond’s credit rating.

Question 14

Explain the two yield curve theories.

Answer 14

1. Expectations theory
   Interest rates will rise in the future and so investors will expect a higher return on long term debt.
2. Liquidity preference theory
   The curve reflects the compensation that investors require higher returns for sacrificing liquidity on long-dated bonds.

Question 15

How do we calculate the value of debt and equity for the WACC if it is not provided to us?

Answer 15

Debt: use the pre-tax present value of future cash flows discounted at the required return.

Equity:

Question 16

What is the key assumption needed in order for the WACC to hold for project evaluation?

Answer 16

The company will maintain both its existing capital structure and the project has the same risk as the company.
In essence, both financial and business risk remain unchanged.