Financing Options (blue)

Question 0

WHAT DO YOU CALCULATE g ON WHEN DEALING WITH:

(i) NEW SHARE/ RIGHTS ISSUE
(ii) BONUS ISSUE

Answer 0

NEW ISSUES AND RIGHTS ISSUES
Calculate g by looking at growth in dividend per share

BONUS ISSUE
Calculate g by looking at growth in total dividends

Question 1

CUM/ EX DIV

Answer 1

Cum div = before dividend payment
Ex div = after dividend payment

[Cum div share price - Dividend due = Ex div share price]

To calculate the ke or MVe we use the ex div share price for D0.

Question 2

WHAT ARE THE THREE THEORIES OF GEARING?

Answer 2

1) Traditional view
2) Modigliani & Miller, No tax theory
3) Modigliani & Miller, With-tax theory

Question 3

WHAT IS THE TRADITIONAL VIEW OF GEARING?

Answer 3

LOW LEVELS OF GEARING
Risk is unchanged. As cheaper debt is incorporated the WACC falls.

HIGHER LEVELS OF GEARING
Increased volatility in returns as debt interest paid first. Increased equity risk increases Ke and WACC starts to rise.

VERY HIGH LEVELS OF GEARING
Bankruptcy risk worries equity and debt holders. Both Ke and Kd rise and WACC rises further.

CONCLUSION
There is an optimal level of gearing.

Question 4

WHAT IS THE NO TAX THEORY OF GEARING, MODIGLIANI AND MILLER?

Answer 4

Based on premise of perfect capital market (no transaction costs, no individual dominates market, full information, investors are rational and risk averse, no taxes).

Movement in Ke is exactly offset by the movement in Kd, such that incorporation of cheap debt is exactly balanced by the rise in Ke.

CONCLUSION
So the WACC will remain constant regardless of the level of gearing.

Question 5

WHAT IS THE WITH TAX THEORY OF GEARING, MODIGLIANI AND MILLER?

Answer 5

Modified result to reflect the fact that corporate tax system gives relief on interest payments.

Debt interest is tax deductible so Kd is lower than before, the increase on Ke does not offset benefit of cheaper finance.

CONCLUSION
WACC falls as gearing increases. Optimal capital structure is 99.9% gearing.

Question 6

WHAT ARE THE PROBLEMS WITH HIGH LEVELS OF GEARING?

Answer 6

• increased bankruptcy risk
• tax exhaustion = tax shield may not be achieved if company
  profits are not high enough to cover interest costs
• agency costs = directors may be more risk averse than
  shareholders

Question 7

WHAT IS AN ASSET BETA?

Answer 7

A beta measuring systematic business risk only - i.e. The smaller beta that isn’t increased to reflect gearing

Question 8

WHAT IS A EQUITY BETA?

Answer 8

A beta reflecting systematic business risk and the firms level of gearing - i.e. The larger beta that has gearing in it.

Question 9

WHAT IS ORGANIC GROWTH AND WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF IT?

Answer 9

It is achieved through internally generated projects whether funded with retained earnings or new finance.

ADVANTAGES

• spreads costs
• no disruption

DISADVANTAGES

• risk
• slower
• barriers

Question 10

WHAT IS AN ACQUISITION AND WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF IT?

Answer 10

A bidder company acquires a target company either entirely or by buying enough shares to exercise control.

ADVANTAGES

• synergy
• risk reduction
• reduced competition
• vertical protection
• may increase shareholder wealth

DISADVANTAGES
- synergy is not automatic, it must be pursued
- restructuring costs may be significant
- busting company may end up paying more in terms if both price and fees than it
gains in synergistic benefits

Question 11

WHAT IS THE ASSET BASED APPROACH FOR COMPANY VALUATIONS?

Answer 11

Start with the balance sheet and adjust it to market value. This can be done in one of two ways:

1) Net realisable value - cash that could be generated from selling off the assets individually.
2) Replacement costs - the cost of setting up an equivalent business’s from scratch.

PROBLEMS
- the value of intangibles on the balance sheet will be missed

Question 12

WHAT IS THE INCOME BASED APPROACH FOR COMPANY VALUATIONS?

Answer 12

This approach estimates future income. There are three methods as follows:

1) Dividend based valuation
2) Earning based valuation
3) Cash flows based valuation

Question 13

WHAT IS THE DIVIDENDS BASED VALUATION METHOD?

Answer 13

• normally used for valuing a minority interest
• it is simply the present value of future expected dividend payments discounted
  at Ke
  (1 + g)
  Present value = d1 x ______
  Ke - g
• dividend yield can also be used as a more simplistic model

PROBLEMS
- estimating future dividends
- finding similar listed companies
- private company valuation will need to be adjusted downwards to reflect lack of
marketability if Ke is estimated by using the CAPM or by looking at other
quoted companies

Question 14

WHAT IS THE EARNINGS BASED VALUATION METHOD?

Answer 14

Commonly used to value controlling interests.

        Value = Earning x PE ratio

• earnings are taken as profit after tax and preference dividends but before ordinary
  dividends
• PE ratio is found by looking at PE ratios of other similar listed companies
• high PE ratio implies high level of investor confidence that earning will grow
  strongly

PROBLEMS
- latest earnings figures may be misleading
- accounting policies may be used to manipulate earnings figures
- finding appropriately similar listed companies
- private company listing may need to be adjusted down awards to reflect lack of
marketability

Question 15

WHAT IS THE CASH FLOW BASED VALUATION METHOD?

Answer 15

Used to value controlling interests.

Calculated by estimated the post tax operating cash flows or the target company to infinity an discounting at the investing companies WACC.

The market value of debt will need to be deducted to give the equity value.

 PV is cash flows, discounted at WACC               X
 Less MV of debt                                                  (X)
                                                                              \_\_
 Value of equity                                                     X

If the company holds any investments then the value of these needs to be added separately.

PROBLEMS
- theoretically the best approach, but may be difficult to estimate future cash flows and the
relevant discount rate

Question 16

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF OF A BIDDING COMPANY PAYING THE TARGET SHAREHOLDERS FOR THEIR SHARES IN CASH?

Answer 16

ADVANTAGES
- buyer gets full control of the target as well as full entitlement to
future profits
- seller may prefer this method as they receive a certain
unconditional amount

DISADVANTAGES
- buyer will have to find cash from somewhere
- sellers expertise may be lost from business as there is no
motivation for them to stay to ensure the success of the
business
- capital gains tax liabilities arise immediately

Question 17

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF OF A BIDDING COMPANY PAYING THE TARGET SHAREHOLDERS FOR THEIR SHARES IN BID COMPANY SHARES?

Answer 17

ADVANTAGES

• no need to fund a cash payment
• seller is motivated to stay to work for the success of the combination
• CGT effects are deferred

DISADVANTAGES
- control is diluted and future profits will be shared with the seller

Question 18

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF OF A BIDDING COMPANY PAYING THE TARGET SHAREHOLDERS FOR THEIR SHARES IN LOAN STOCK?

Answer 18

ADVANTAGES
- cash payment without the need to find immediate finance

DISADVANTAGES
- buyer will have to pay interest on the debt until it is redeemed

Question 19

WHAT ARE THE 3 MAIN METHODS OF EQUITY FINANCE?

Answer 19

1) retained profit
2) rights issue
3) new issue

Firms will generally choose the sources in the above order.

Question 20

WHAT ARE THE 3 MAIN METHODS OR DEBT FINANCE?

Answer 20

1) term loans
2) loan stocks (bonds or debentures)
3) convertible loan stock
4) loan stock with warrants