Financing an organisation Flashcards
What is the risk-free rate?
It is the minimum rate of return for all investors. It compensates for time preference and includes and an element for expected inflation. Examples include Treasury Bills and Government Bonds (aka Gilts).
What is a yield curve?
A yield curve is a graphical representation of the term structure of interest rates on bond yields with different maturity dates, depending on investors’ expectations.
What are the different types of yield curve?
Yield curves can be flat, rising, humped or falling.
A rising curve is where investors expect rates to go up in future. Conversely, a falling curve is where they expect rates to go down. A flat curve is where investors expect rates to stay unchanged. A humped curve describes the scenario where there is a lack of demand for bonds with medium maturity. e.g. there may be demand from banks for short-term bonds and pension funds for long-term bonds.
What is the equity (or market) risk premium?
It is the difference between the return on a stock market and the risk-free rate.
What are the different ways to estimate the future equity risk premium?
- By Using historical data
- By asking experts
- By estimating the implied future equity risk premium from today’s stock market value using DVM.
Why is the equity risk premium higher for emerging markets?
It may be due to less developed corporate governance, stock market regulation, accounting disclosure and legal protection for minority investors in those markets.
What is the Weighted Average Cost of Capital (or WACC)?
The WACC represents the average of the cost of equity and debt weighted by the proportions each contributes to the total funding of the company.
What is the cost of equity?
It is the return that investors expect for investing in a share, given the risk.
What two ways can be used to calculate the cost of equity?
- Using the Capital Asset Pricing Model (CAPM)
2. Dividend Valuation Model (DVM)
What two ways can be used to calculate the cost of debt?
- By estimating the cost of an organisation’s debt relative to a risk-free benchmark; the credit risk premium.
- By looking at how much debt a company has and what its interest payments are.
List five reasons why organisations typically use a hurdle rate that is higher than the WACC?
- They don’t reflect true cash flow forecasts
- Positive projects are charged a higher hurdle rate to compensate for negative NPV projects that must be undertaken,
- To reflect the option value of delaying a project until later.
- To compensate for changes to the cost of debt or equity over time.
- To compensate for projects that are riskier than the current average for the organisation. Thus, by adding a premium to the WACC, organisations are adjusting for relative project risk.
What effect does tax have on a company’s value?
It provides an allowable deduction (aka Tax Shield) from taxable income that results in a reduction of taxes owed.
Tax shields differ between countries and are based on what deductions are eligible versus ineligible. Their value depends on the effective tax rate for the corporation.
What is the bird in the hand theory?
It is the idea that a dividend today is worth more than a potential capital gain in the future.
What are the advantages and disadvantages of CAPM?
<li>It is simple to use</li>
<li>It requires only the risk-free rate, the equity risk premium and share (or market) beta - all of which can be estimated. </li>
<li>It can be used to compare investments</li>
<li>It only covers a single time period</li>
What are the advantages and disadvantages of DVM?
<li>It is simple to use</li>
<li>It can be made more complex/accurate by using several growth forecast periods.</li>
<li>It does not require market level inputs</li>
<li>It is only as good as the forecasts for growth (g)</li>
