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Financial Management > Financing > Flashcards

Financing Flashcards

1
Q

Why is equity a more expensive source of finance than debt?

A

Investors have a high risk and therefore expect a higher return
It is low risk for the company as they do not have to repay investors
High issue costs (new shares, underwriting fees)

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2
Q

What is the CAPM formula?

A

rj = rf Bj (rm - rj)

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3
Q

What is the beta factor (Bj) and what is it based on?

A

The specific risk from investing in a particular company.
The nature of the business and the company’s financing structure (mixture and equity & debt)

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4
Q

Advantages of the CAPM model

A

Focusses on how required returns are linked to risk
Can be used for project appraisal:
higher risk = higher return required by investor

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5
Q

Disadvantages of the CAPM model

A

Hard to identify risk-free rate, average market return and beta factors
Assumes that all investors are diversified and therefore not exposed to unsystematic risk

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6
Q

How do you calculate the market value of equity (MVe)?

A

No. shares x Marker value of shares (ex-div)

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7
Q

What is the key principle of the Dividend Valuation Model (DVM)

A

Investors value shares based on future dividends and require a certain return

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8
Q

How do you calculate the dividend growth (g) using the POWER function?

A

=POWER(most recent dividend/oldest dividend, 1/no. periods) - 1

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9
Q

How do you calculate dividend growth (g) using the Gordon’s growth model?

A

Accounting rate of return (Profits/Equity Capital) x Profits retained %
Equity capital = retained earnings b/fwd + share capital
Profits retained % = Retained profit/profits
g = r x b

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10
Q

How do you account for special dividends when calculating g?

A

Ignore special dividends

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11
Q

Advantages of the Dividend Valuation Model (DVM)

A

Some investors buy shares purely for dividends
Inputs are readily available (e.g. historic dividends, share price)

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12
Q

Disadvantages of the Dividend Valuation Model (DVM)

A

Not all value comes from dividends
Estimating g is difficult
Historic inputs: not an indicator of future
Assumes perpetual dividend growth
Earnings retention: Uses historic accounting profits for g

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13
Q

How do you calculate the cost of preference shares (kp)?

A

kp = D/P0
Preference shares have a fixed dividend which doesn’t grow.
Same formula as equity but without the g

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14
Q

How do you calculate the market value of preference shares (MVp)?

A

No. preference shares x Marker value of preference shares (ex-div)

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15
Q

Why is debt less risky for investors compared to equity?

A

The company must pay the debtholders
Debtholders may have security over the company’s assets
Debtholders may insist on covenants

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16
Q

How do you calculate the cost of irredeemable debt (Kp)?

A

Kd = I x (1-T) / P

I = interest
P = Bond price
T = Tax rate

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17
Q

How do you calculate the market value of irredeemable debt (Kp)?

A

No. irredeemable debentures x Marker value of irredeemable debentures (ex-int)

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18
Q

How do you calculate the cost of Redeemable Debt (Kd)?

A

Us the rate function:
= RATE (years, interest paid per year, Bond purchased by investor, nominal amount)
Cost to the company is x(1-T)

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19
Q

How do you calculate the market value of Redeemable Debt (Kd)?

A

No. redeemable debentures x Marker value of redeemable debentures (ex-int)

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20
Q

How do you treat convertible bonds?

A

At redemption, the debtholder will have the option to take the cash or convert the debt to shares (equity).
Assume that investor will choose the option which gives them the highest value

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21
Q

Advantages of convertible bonds

A

Lower interest rate
Encourages potential investors
Cheap way to issue equity compared with new share issue

22
Q

Disadvantages of convertible bonds

A

Uncertainty if they will convert
Will dilute existing ownership

23
Q

What is Peer-to-Peer (P2P) lending?

A

Connects established businesses looking to borrow with investors wanting to lend, usually via an online platform

24
Q

Advantages of Peer-to-Peer (P2P) lending

A

Lower interest rates and fees due to competition
Quicker processing with streamlined procedures
More accessible for borrowers with low credit ratings

25
Q

What are the 5 types of green finance?

A

Green loans - for projects with specific green purpose
Sustainability linked loans - for any purpose, cheaper if ESG targets met
Green bonds - Fixed interest, often secured
Green funds - Stock market index which meets criteria
Social bonds - Raise funds for new projects for social issues

26
Q

Limitations of WACC

A

Ignores short term finance: overdrafts, trade payables
Bank loans don’t have a market value unlike shares and bonds
Some finance could be project-specific

27
Q

What is portfolio theory?

A

Portfolio theory shows that the only logical portfolio to hold is one, which is fully diversified to eliminate all unsystematic risk

28
Q

What does gearing measure?

A

The portion of a company’s financing which comes from debt

29
Q

How can debt increase the cost of equity?

A

Interest paid to debtholders is compulsory.
The more debt, the more interest, which means there is a greater chance that shareholders will have a lower earnings & dividends.

30
Q

How can debt lead to an increase cost of debt?

A

If gearing becomes too high, then there is a greater risk that the company’s profits will not be sufficient to make all the interest payments

31
Q

How do you calculate the interest cover and what does it show?

A

Profit before interest / Interest
It shows the company’s ability to meet its interest payments

32
Q

How does WACC impact the market value of a company?

A

A decrease in WACC will increase the market value of a company, creating shareholder wealth

33
Q

What is the traditional view of gearing?

A

Debt is cheaper than equity because debtholders take less risk so debt reduces WACC.
At high levels debt will increase equity and debt
Optimal level: the point at which new debt doesn’t increase cost of equity

34
Q

What is the M&M 1958 (ignoring tax) view of gearing?

A

Debt is cheaper than equity but debt creates a bankruptcy risk which causes Ke to increase by an equal offsetting amount.
Overall effect on cost of capital is neutral

35
Q

What is the M&M 1963 (including tax) view of gearing?

A

Debt is cheaper than equity because debtholders take less risk and there is a tax saving on interest payments
Optimal gearing is 100% debt

36
Q

What is the Modern view (including tax) view of gearing?

A

High levels of debt create a bankruptcy risk and causes cost of equity & debt to rise.
Optimal level where debt reduces cost of capital without being high enough to push up cost of equity.
Optimal amount varies by industry

37
Q

What would happen when introducing debt when gearing is low or nil?

A

This will reduce WACC and increase the share price

38
Q

What are some issues with using WACC?

A

WACC assumes that the proportions of debt and equity will not change (if they do use APV)
WACC assumes that systematic business risk does not change (if it does re-gear CAPM beta)

39
Q

How does APV solve the issues of WACC?

A

Discount the project using the cost of equity without gearing
Treat the tax savings on the interest payments as a cash inflow discounted using cost of debt
Include any costs incurred from issuing debt

40
Q

What are the limitations of APV?

A

Assumes company has taxable profits
The cost of equity may rise significantly

41
Q

What makes up the beta factor (Bj)?

A

The business risk (Ba) - the risk of operating in a certain industry
The financing risk (gearing structure)

42
Q

What does the asset beta measure (Ba)?

A

The systematic risk of the business

43
Q

What does the equity beta measure?

A

The systematic business risk and the firm’s level of gearing

44
Q

What is systematic risk? Give examples

A

The risk that all companies are exposed to no matter which market sector they operate in. It cannot be eliminated through diversification.
Examples include interest rates, recession, wars, COVID

45
Q

What is unsystematic risk? Give examples

A

The risk that affects a particular market sector or individual/company, most of this risk can be diversified away by investing in a portfolio.
Examples include; the chairman resigning; strikes by the employees of a company; changes in regulations that affects a particular market sector.

46
Q

How do you calculate the market value of the bond purchased by the investor?

A

Use the PV function:
=PV(Return required by investor, years, interest rate, redemptio)

47
Q

What is an equity rights issue?

A

New shares firstly offered to existing shareholders (usually at a discount)

48
Q

Why might TERP’s differ from actual ex-rights price?

A

Market reaction
Economic events eg interest rate change

49
Q

Why might investors want to be paid dividends even if there isn’t a positive NPV?

A

Investors may prefer to see stable and rising dividends as this signals the success of a company
Some invest for income not long-term share price growth as they need regular income
Some prefer income rather than capital growth for tax reasons

50
Q

What could be an alternative to paying an ordinary dividend?

A

A special one-off dividend
Or buy-back some of the company shares

Financial Management (6 decks)

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