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CIMA F2 > Financing Capital Projects > Flashcards

Financing Capital Projects Flashcards

1
Q

When would a company be able to afford a large investment project without external sources of finance?

A

having a large cash surplus

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2
Q

What are the 3 sources of external finance?

A

capital markets
banks and finance houses
government and similar sources

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3
Q

what is equity?

A

shares or ownership rights in a business

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4
Q

What is a share?

A

fixed identifiable unit of capital in an entity which normally has a fixed nominal value which may be quite different from its market value

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5
Q

what do shareholders receive in return for their shares?

A

returns in the form of dividends

capital growth in the share price

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6
Q

what are ordinary shares?

A

voting rights as they are equity shares
paid at directors’ discretion
subordinate to other creditors i.e get money last

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7
Q

what are preference shares?

A

return is a fixed dividend
paid before ordinary hence the name
subordinate to other creditors but receive payout before ordinary

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8
Q

why are preference shares considered to behave in a similar way to debt finance?

A

as the return is a fixed % of the nominal value as which is similar to interest payments opposed to ordinary shares which are decided by director

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9
Q

how are preference shares different from debt finance?

A
  • paid out of post tax profits so no tax benefit

- does not have the obligation to pay annually (when insufficient profits) unlike debt interest

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10
Q

what is a cumulative preference share?

A

dividend must be rolled forward and paid following year if unpaid

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11
Q

what is a non-cumulative preference share?

A

can miss dividends

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12
Q

what is a participating preference share?

A

holder gets fixes dividends + extra earnings based on performance of business

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13
Q

what is a convertible preference share?

A

can be exchanged for a specified number of ordinary shares on some given future date
-might be more profitable if share price increased than to accept cash

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14
Q

what is a redeemable preference share?

A

holder will be repaid capital (usually at par) at a pre-determined future date

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15
Q

why are convertible preference shares attractive to investors?

A

participation in hot growth companies means price will be high at conversion
for a profit, share price at conversion must be higher than amount paid on original investment

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16
Q

what is the primary function of a stock market?

A

enable companies to raise new finance through equity or debt

-can communicate with a large pool of investors

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17
Q

what condition must a UK company be before raising public finance?

A

must be a plc

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18
Q

what is the secondary function of the stock market?

A

enable investors to sell their investment to other investors

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19
Q

why are listed companies more attractive to investors than unlisted?

A

they are more marketable as they can be sold amongst investors

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20
Q

why are private limited companies (ltd) not offered publicly?

A

lighter disclosure requirements

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21
Q

what does limited by shares mean?

A

the shareholders liability is limited to the initial investment

  • nominal value of shares and any premium paid in return for issue of shares
  • protection of personal assets in insolvency but money invested will be lost
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22
Q

is a plc listed or unlisted?

A

can be both

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23
Q

what is a stock exchange listing?

A

quotation for its shares on stock exchange

aka flotations or IPO

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24
Q

what are the advantages of a listing?

A
  • once listed, market will provide a more accurate valuation than before
  • creates a mechanism for buying and selling shares in the future at will
  • raises profile of entity
  • raises capital for future investment
  • employee share schemes more accessible, some are offered them as salary package
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25
Q

disadvantages of a listing

A
  • costly for small entity
  • making enough shares available may lead to loss of control
  • reporting requirements
  • stock exchange rules for obtaining quotation stringent
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26
Q

what are the 2 important capital markets in the UK?

A

LSE-for larger companies, high cost and scrutiny but extremely marketable
AIM-alternative investment market for smaller companies with lower costs and less stringent entry criteria

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27
Q

how are share prices determined?

A

supply and demand:perform well, shares more attractive, creates demand; perform badly, more on sale, increased supply driving prices down

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28
Q

what role do investment banks play in share issue?

A
  • appointing specialists enroute.g lawyers
  • stock exchange requirements
  • forms of any new capital to be made available
  • number of shares issues and price
  • underwriting arrangement
  • publishing the offer
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29
Q

what role do stockbrokers provide in a share issue?

A

provide advice on methods of obtaining a listing

-may work with IBs on identifying institutional investors who are involved with smaller issues and placings

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30
Q

what role do institutional investors play in share issue?

A

are investors from large organisations e.g pensions funds

  • have little direct involvement other than as investors
  • may be used to test how much to buy and at what price
  • after issue, have major influence on the evaluation and market for the shares
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31
Q

what do registrars to an issues do?

A

provide admin functions such as collecting potential investor info, monitoring payments and advise regarding share issue to stock exchange, investors and issuing entities

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32
Q

what do reporting accountants do?

A

provide advice regarding impact on the financial statements of any potential share issues
-must consider wider ramifications on economic decisions enroute.g implications on loan covenants

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33
Q

what role do underwriters play in share issue?

A

help raise finance by taking on the risk of new issue and attempting to promote the new share to 3rd party investors
-retain part of proceeds from raising the finance in return for bearing the risk

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34
Q

What are the most commonly used methods of issuing new shares?

A

IPO
placing
rights issue

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35
Q

What is an IPO?

A

when a company is listed on the stock exchange for the first time

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36
Q

Who are shares offered to investors through for IPOs?

A

issues houses

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37
Q

How are IPO shares offered?

A

fixed price set by company

tender offer

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38
Q

How does a tender offer work?

A

subscribers tender no/ shares and share price above a preset minimum
after offers received, ‘strike price’ determined
shares allocated to all bidders who offered above strike price
bidders pay strike price

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39
Q

What is a strike price?

A

the price at which the company will be able to raise required amount of finance
it is the price all successful bidders pay for the share

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40
Q

what is placing shares?

A

when shares are places directly with certain investors on a pre-arranged basis

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41
Q

what type of investors receive placing shares?

A

normally institutions

  • not offered to public
  • cheaper and quicker
  • not a very active market
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42
Q

What is right issue?

A

new shares are offered for sale to existing shareholders only, in proportion to the size of their shareholding
-cheaper to organise than public offering

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43
Q

What is pre-emption rights?

A

the right to buy new shares ahead of outsider investors

-prevents dilution of stake

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44
Q

How are pre-emption rights regulated?

A

protected by law

can only be waived with consent of shareholders

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45
Q

What is the criteria for issue price of a right issue?

A
  • low enough to secure acceptance of shareholder i.e not same as MPS (prevailing market price)
  • high enough to avoid excessive dilution of EPS
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46
Q

What is the usual discount on rights issue price?

A

20%

47
Q

How is issue quantity determined?

A

issue price set first then the quantity of shares issued

  • issue price affects EPS and dividend cover
  • then Q calculated
48
Q

Why does the MPS usually fall after the ANNOUNCEMENT of rights issue?

A

due to uncertainty about:

  • consequences of the issue
  • future profits
  • future dividends
49
Q

Why does the MPS usually fall after the actual rights issue?

A
  • more shares in issue (EPS)

- new shares issued at a discount (TERP)

50
Q

what is cum rights (CRP)?

A

during rights issue, allows an existing shareholder to subscribe to a rights offering declared by a company
this right is knows as cum rights

51
Q

what is ex rights?

A

on the first day of dealings in the newly issues shares, the rights no longer exist and the old shares are now traded ‘ex rights’ i.e without rights

52
Q

What is TERP?

A

theoretical ‘ex rights’ price

theoretical price that the rights issue shares will trade on the first day of issue

53
Q

How is TERP calculated?

A

[(new share x CRP) + old shares x MPS]/ total amount of shares

54
Q

What are the implications of rights issue on shareholders?

A
  • option to buy are preferential price
  • option to withdraw cash and sell rights
  • able to maintain their existing relative voting position by exercising the rights
55
Q

What are the implications of rights issue on the company?

A
  • simple and cheap to implement
  • usually successful i.e fully subscribed
  • if often provides favourable publicity
56
Q

What is debt finance?

A

loan of funds without conferring ownership rights

creates obligation to repay capital and interest repayment based on arrangement

57
Q

what are the key features of debt financing?

A
  • interest is paid out of pre-tax profits as an expense of the business
  • carries a risk of default if interest and principal payments are not met
58
Q

What are the 2 types of security/charges lenders require?

A

fixed charge

floating charge

59
Q

what is a fixed charge?

A

debt secured against a specific asset

  • usually land or building
  • preferred as front of queue at liquidation
  • mortgage is similar to fixed charge
60
Q

what is a floating charge?

A

debt secured against underlying assets that fluctuate in value

  • e.g inventory
  • not front of queue in the event of liquidation
  • still ahead of other creditors with no security
61
Q

What is a covenant?

A

specific limitations/requirements laid down as a condition on taking debt finance

62
Q

What are the different types of covenants?

A

dividend restrictions: limit of level of payout to prevent excessive payments that may weaken future cash flows and place lender at risk
financial ratios: specified levels set
financial reports:regular accounts and financial reports to be provided to the lender to monitor progress
issue of further debt:amount and type of debt that can be issued

63
Q

what is a bond?

A

debt security which the issuer owes the holders a debt and is obliged to pay interest and/or to repay the principal at a later date i.e formal contract to repay borrowed money with interest at fixed intervals

64
Q

What are the differences between bonds and shares

A
  • ownership rights of shares vs creditor stake

- bonds have defined maturity whereas shares are not redeemed at a certain date

65
Q

what are the 3 groups of a bond market?

A

issuers, underwriters and purchasers

66
Q

what are issuers in DCMs?

A

sell bonds in the capital markets to fund the operations of their organisations
mostly consists of governments, banks and corporations

67
Q

why do issuers issue bonds?

A

govt: help fund country’s operations

banks & corporations: to finance operations

68
Q

what are underwriters?

A

typically investment banks and other fin institutions that help the issuer to sell the bonds in the market

  • prepare for offering e.g create prospectus and other docs
  • need greatest for corporate debt market as there are more risks associated with this type of debt
69
Q

Who can underwriters place bonds with?

A
  • with specific investors (bond placement)
  • sell more widely on market
  • medium term note(MTN) programme where the issuer via the UW can issue debt securities on a regular or continuous basis
70
Q

who are purchasers in a bond market?

A

the final players who purchase the bonds

-investors such as individuals, banks etc

71
Q

how do governments play a large role in the market?

A
  • borrow and lend money to govts and banks
  • invest in foreign bonds if they have excessive reserves of that country’s money as a result of trade between countries e.g Japan is a major holder of US govt debt such as US gilts
72
Q

what are alternative sources of finance other than equity or debt?

A 
cash RE: use existing cash, profits might not be liquid 
sale and leaseback
grants
debt with warrants attached
convertible debt
venture capital
business angels
73
Q

what is a sale and leaseback?

A

selling good quality fixed assets such as high street buildings and leasing them back over many years (25+)

  • funds are released without any loss of the use of the assets
  • potential capital gain foregone
  • popular means of funding for retail orgs with substantial high street property e.g Tesco
74
Q

what are grants?

A

-tech, job creation or regional policy
of particular importance to small and medium-sized businesses i.e unlisted
-don’t need to be paid back
-provided by local governments, national governments and other larger bodies

75
Q

what are debt with warrants attached?

A

warrant

  • option to buy shares at a specified point in the future for a specified (exercise) price, often issues with bond to encourage investors to purchase bonds
  • offers a potential capital gain where the share price may rise above the exercise price
  • holder has option to buy the share on the exercise date but can also choose to sell the warrant before that date with no impact on the bond
  • bond and warrant are separate items once issued
76
Q

What is convertible debt?

A

similar to attaching warrant to a debt instrument but option to convert shares cannot be detached and traded separately

  • can convert into shares at a predetermined date
  • could result in capital gains if share value is greater than value of debt
  • otw investor should retain the debt until maturity
77
Q

what is venture capital?

A

finance provided to young, unquoted profit-making entities to help them expand

  • usually equity finance, but can be mix of debt and equity
  • accept low levels of dividends and expect to make most of their returns as capital gains on exit
  • exit=IPO or flotation where VC can sell stake on stock market
78
Q

what is a business angel?

A

similar to VC however they are wealthy investors who provide equity finance to small businesses
-VC are rarely interested in investing in small businesses as this is uneconomic

79
Q

What are the benefits of equity vs debt finance to businesses?

A

no default risk; high default risk for debt

dividends are discretionary; for debt, minimum servicing annually (interest)

80
Q

What are the benefits of debt vs equity from an investor point of view?

A

cheaper form of finance; equity can be expensive in periods of strong performance
easily accessible; for equity uptake depends on market conditions and shareholder appetite

81
Q

why is debt cheaper than equity?

A

lower risk so accept less ownership/returns

82
Q

what’s the difference between ordinary shares and preference shares?

A

ordinary: carry voting rights, discretionary dividends, returns are proportional
preference: no voting rights, guaranteed dividends, fixed proportion

83
Q

What is the WACC?

A

weighted average cost of capital

the average cost of an entity’s finance

84
Q

How is the WACC calculated?

A

sum of cost of capital x proportion of capital

85
Q

what is the cost of equity?

A

the rate of return that ordinary shareholders expect to receive on the investment

86
Q

what are the 2 methods of calculating cost of equity?

A

dividend valuation model (DVM) for constant dividends
-preference shares
DVM with growth
-ordinary shares

87
Q

what is the fundamental theory of share valuation?

A

assumption that the market price of a share is related to the future dividend income stream from that share, in such a way that the market price is assumed to be the present value of that future dividend

88
Q

what is the ex div value of a share?

A

the value just after a dividend has been paid

89
Q

what is the cum div price?

A

price just before payment

90
Q

how is the ex div price calculated from the cum div price?

A

cum div price - dividend=ex div (P0)

91
Q

what are the 2 methods of calculating growth?

A

the averaging method
-when time and diff share prices given
the growth model based on profit retention rate
-when proportion of funds given

92
Q

what are the assumptions of the growth model based on retention rate?

A
  • entity must be fully finance by equity
  • retained profits are the only source of additional investment
  • a constant proportion of each year’s earnings is retained for reinvestment
  • projects finances from retained earnings earn a constant rate of return
93
Q

what is the rationale behind the growth model retention rate?

A

an increase in the level of profits (due to profits not paid out as dividends) will give rise to increases (and therefore growth) in future dividends

94
Q

what formula is used to calculate cost of preference shares and why?

A

constant dividend: k=d/P0

  • constant level of dividend
  • quotes as a percentage of nominal value
95
Q

what is the cost of debt?

A

the rate of return that debt providers require on the funds that they provide

96
Q

what is the cost of debt assumed to be?

A

the present value of its future cash flows

97
Q

what are the benefits of debt?

A

interest is tax deductible so interest payments are always net of tax

98
Q

what is the coupon rate?

A

the interest paid on debt
-stated as a percentage of nominal value

E.g 7% convertible bonds

99
Q

how is the interest paid on debt calculated?

A

coupon rate x nominal value of debt

e.g 4% 100 par

4% x 100 is interest paid

100
Q

when can you use the same formula for irredeemable bonds as redeemable?

A

when the redemption value is equal to the current market price or as an approximation for long-dated debt

101
Q

what is IRR?

A

internal rate of return

-discount rate which gives a zero NPV

102
Q

What are the 3 steps to calculating the cost of debt (IRR)?

A
  1. cash flows
  2. discounting to calculate 2 NPVs
  3. calculate IRR
103
Q

what assumption is made to calculate the cost of convertible bonds?

A

that all investors will make the same decision

104
Q

how will investors choose whether to pick cash or shares on redemption date?

A

compare value of cash option (value at par) vs value of conversion option (nx(current price x growth^t)

105
Q

are bond values or market values used in WACC calculations?

A

market value

106
Q

what are the issues with WACC calculation?

A
  • doesn’t include short-term finance as it is a tool for long term investment appraisal but if short-term finance is used to fund long-term projects then it should be
  • loans do not have market value like bonds so their weightings are approximations
  • the cost of capital for small entities
  • -if unquoted, obtaining cost of finance is much more difficult
  • -lack of liquidity offered by the entity’s securities plus the smaller size of the entity tend to make finance more expensive
107
Q

what conditions have to be met for WACC to be used as a discount rate?

A
  1. constant capital structure otw weightings will change
  2. new investment does not carry different risk profile or change strategy significantly
  3. new investment is marginal to the entity
108
Q

how is yield to maturity (YTM) different to cost of debt?

A

YTM is calculated from the investor’s perspective

-doesn’t adjust for tax

109
Q

what is a yield?

A

return received on a debt instrument in the form of annual interest (coupon) and, if redeemable, the final redemption payment

110
Q

What does YTM help the investor decide?

A

an informed method of considering whether the method is worthwhile via % of return

111
Q

what is the YTM defined as?

A

effective average annual percentage return to the investor relative to the current market value of the bond

112
Q

is tax deducted from the YTM?

A

no as investors obtain no tax relief from the interest received

113
Q

how is YTM calculated for redeemable and irredeemable debt?

A

redeemable: (annual interest received/current market value of debt)x100%
irredeemable: IRR of bond price

CIMA F2 (5 decks)

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