FM

Question 1

What is the formula for dividends based approach of valuation

Answer 1

Used for valuing a minority interest, as the investor cannot control dividend policy, therefore income will depend on the dividends that the company is likely to pay out

Formula:
Present value of future expected dividend payments discounted at Ke

Ke - (cost of equity)
D0 - (the latest dividend)
D1 - (upcoming dividend or latest dividend × projected growth)
G - (growth)

Present value = (d1 x 1/Ke - g)

Or

Yield = Dividend/Price

If we can estimate the yield by looking at similar companies we can estimate the price as

Price = Dividend/Yield

Pros and cons:
Mainly revolve around the estimates used

Question 2

What is Yield?

Answer 2

Yield is the debt holders’ required rate of return. (Referred to as ‘r’)

R = i/P 0

Where
i = annual interest starting in one year’s time

P 0 = original price

Excel formula yield on debt
=RATE(number of time periods, interest payment, market value, redemption value)

Question 3

General letter abbreviations

Answer 3

i = annual interest starting in one year’s time

r = debt holders’ required return (yield)

Kd = cost of debt

Ke = cost of equity

T = corporation tax rate

P = price

NPV = Net present value

Question 4

Excel formulas

Answer 4

Yield on debt
=RATE(number of time periods, interest payment, market value, redemption value)

NPV =NPV(discount rate %, NCFs from T1 onwards) + initial cash flow

Growth =Power(most recent fig./oldest fig, 1/number of years)

Question 5

Capital Asset Pricing Model (CAPM)

A way of estimating the rate of return that a FULLY DIVERSIFIED equity shareholder would require from a particular investment

Answer 5

Formula:
Rj = Rf + B (Rm - Rf)

Rj = required return from an investment

Rf = risk free rate -> assumed to be the rate on Treasury Bills

Rm = average return on the market

(Rm - Rf) = equity risk premium

B (BETA) = systematic risk of the investment compared to market and therefore amount of the premium needed

Question 6

Dividend yield method

Answer 6

Used to value minority interests

Question 7

Cum div
&
Ex div

Answer 7

Cum div = share price before the dividend payment

Ex div = share price after the dividend payment

Cum div share price - dividend due = Ex div share price

Question 8

Earnings based method

If a controlling share is held, the owner can access earnings generated - so earnings based method is used

Question 9

Problems with Earnings based method

Answer 9

Erratic or manipulated earnings - unusually high or low earnings in previous year could distort values
Could mitigate by
- excluding one-off items
- use and average of the last few years earnings

Accounting policies can be used to manipulate earnings like: a change in depreciation policy could suggest the company’s earnings are artificially growing

Difficult to find similar listed companies to compare to

Listed companies tend to be overvalued

It is worth 1 Mark in the exam to say that a limited company should be reduced in values because of lack of marketability

Question 10

PE multiple valuation

Answer 10

PE ratio = price per share/earnings per share

Or

PE ratio = total share value/total earnings

Rearranged

Price per share = PE ratio x Earnings per share

Or

Total share value = PE ratio x total earnings

Earnings = suitable earnings available to shareholders

One off values in questions must be excluded

PE ratios are only available for listed companies

For limited companies, an approximation must be used

Question 11

EBITDA multiple

Takes away from controversial accounting policies like depreciation and amortisation and gives an approximation for cash earned per year. Cash is more factual than profit so better for measuring

Answer 11

Enterprise (EBITDA) multiple = Enterprise value/EBITDA

Enterprise value = the market value of all types of finance.
Calculated as:
Equity + debt - cash - short term investments

Question 12

Cash flow based approach

Also used for majority ownership

Answer 12

Value of equity = PV of cash flow to infinity discounted at WACC - MV of debt

Question 13

Discounted cash flow approach

Most detailed approach to value controlling interests

Answer 13

Equity = PV of pre-interest cash flows discounted @ WACC + Value of investments - Value of debt

Question 14

Calculate perpetuity

Answer 14

Present value of perpetuity cashflow = Perpetuity cashflow* 1/discount rate

1÷discount factor %, * annuity discount factor for the previous year.

I.e. if calculating perpetuity for T4, use annuity decimal from T3

Or for a Growing Continuing Value:
(After tax cash flows for last known year * intended growth rate)/(discount factor - intended growth rate)

Or

1/(1+r)^n

r = discount rate %
n = number of periods

Question 15

What is WACC

Answer 15

Weighted average cost of capital

It is an average of Ke (cost of equity), Kp (cost of preference shares) and Kd (cost of debt) weighted according to the current market values of equity, preference and debt within a company’s capital structure

Question 16

Foward

Answer 16

A binding agreement to buy or sell something in the future at a price fixed today

Tailor made and difficult to cancel

Could turn out to be advantageous or disadvantageous

Question 17

Future

Answer 17

Standardised exchange traded contract to buy or sell something at an agreed price on a future date

Set sizes and for set dates

Easy to buy or sell on exchange like shares are bought

Usually closed out before due date

Question 18

An Option

Answer 18

Gives the right but not obligation to buy or sell a specific quantity of an item at a predetermined price

Over the counter options:
Attached to forward contracts, pric agreed upfront. Tailor made

Traded options:
As futures are traded on exchange and option on futures is a traded option.
Standardised

Question 19

Simulations

strengths and weaknesses

Answer 19

Strengths

Useful for problems that cannot be solved analytically

Can consider changes to multiple variables

Take into account probability of variables changing

Weaknesses
They do not suggest a correct decision

Expensive and time consuming ti create

Info on probabilities may be unreliable

Question 20

Trade risks

Answer 20

Physical risk (loss or damage require replacement costs)

Political risk (region based restrictions/taxes)

Liquidity risk (inability to finance credit or pay debts)

Credit risk (risk of customers defaulting)

Cultural risk (incompatibility with cultural preferences)

Human error

Question 21

Market efficiency

How stock market prices react to events

Answer 21

Weak form - share prices reflect info about past price mvmt, and future price mvmt cannot be predicted from past mvmts

Semi-strong form - Share prices incorporate all publicly available info rapidly and accurately. The market cannot be beaten by analysing publicly available info

Strong form - Share prices reflect all info whether published or not. Insider dealing has no value

London stock exchange is usually semi-strong efficient

Semi strong markets react to press releases

Strong markets do not react to press releases bc the info is already reflected in stock prices

Question 22

Bankruptcy

Answer 22

Very high gearing (I.e. very high reliance on debt) puts a business at risk of bankruptcy

Question 23

Gearing theory

Answer 23

Traditional view = low gearing (I.e. low reliance on debt = decrease in WACC = company value rises

High gearing (I.e. High reliance on debt) = cost of debt rises = WACC rises = company value drops

Modigliani and Miller 1963- company WACC and company value is not affected by level of gearing other than through effects of tax relief. Tax relief =fall in WACC = company value rises

Question 24

Pros and cons of loan finance

Answer 24

Traditional view
Loan finance is cheap because it is low risk to lenders and loan interest is tax deductible

This means gearing increases, so WACC decreases, so company value rises

Shareholders and lenders are relatively inconcerned about increased risk at low level of gearing

Higher gearing = Higher risk = Higher returns demanded by shareholders and lenders = Higher wacc = lower company value

Modigliani and Miller view
Shareholders are immediately concerned by any gearing

Gearing (loan finance) is only beneficial because of tax relief

Modern view
M&M probably right about gearing only being beneficial bc of tax

High gearing = Shareholders worry about bankruptcy = Higher returns demanded=wacc up= Business value down

Optimum gearing = WACC is minimised and company value is maximised

Question 25

Underwriting

Answer 25

Advantage
Form of insurance which ensure that all funds required are raised/sold

Disadvantage
Can signal lack of confidence in the product/service/projects ability to sell/succeed.
Market appetite may be less than expected.
Underwriting is expensive to procure (1 - 2% of funds raised)

Question 26

Shareholder Value analysis (SVA)

Answer 26

Alternative method of calculating company value based on future cash flows and 7 ‘value drivers’ which are manageable by the company:

Length of project
Sales growth rate
Profit margin
Fixed assets investment
Working capital investment
Tax rate
Discount rate

Question 27

Shareholder value analysis

Answer 27

Process of analysing business activities to identify how they will result in increasing sharhokder wealth:

Are these drivers being maximised:
Sales growth rate
Op profit margin
Investment in working capital
Cost of capital
Life of projected cash flows
Corporation tax rate

Question 28

Systemic vs unsystemic risk

Answer 28

Systemic- risk that all companies are exposed to no matter which market sectors, e.g. war, economic crash etc.
It cannot be eliminated through diversification

Unsystemic- rusks which are specific to a particular market sector
It can be reduced through diversification

Question 29

Inflation

Answer 29

When discount rate is given at ‘real cost’ it must be multiplied by inflation rate, then -1 to find the usable discount rate

The ‘money rate’ is the discount rate including inflation

Question 30

Adjusted present value (APV)

Answer 30

Useful when gearing changes and therefore financial risk changes

Apv used when financial risk changes regardless of chang in business risk.

Step 1 calculate base case cash flow:
Project cashflow*CAPM Ke(using industry asset beta).

This equals NPV as if the firm had no debt finance

Step 2 calculate pv of finance side effects:
Costs involved discounted for relevant number of periods.

APV = step 1 + step 2

Question 31

Data analytics

Answer 31

Predictive analytics:
Regression analytics- quantifies relationship between 2 variables. I.e. if weather improves, more people will pay for outdoor activities

Decision trees- used to consider multiple decisions and their impacts.

Prescriptive analytics:
Combining AI, statistical tools and Predictive analytics to calculate optimum outcomes for business decisions.

E.g. identifying optimal production levels considering factors like demand, supplier lead times and use of machinery

Question 32

Real options

Answer 32

Delay- postpone a project to wait for a favourable situation or see how another company succeeds with a similar project.

Abandon - reject the project before starting or part way through if sales are lower than expected, costs higher, competition steeper.

Follow on - expand the project if it performs well

Growth - implement the project incrementally over time, rather than the full scale of the plan from the start.

Flexibility - making strategic amendments to the project during its life cycle to maximise profits

Question 33

Sensitivity analysis

Answer 33

Exam tip(if something is effected by sales volume and price, it means contribution)

CF Sensitivity = NPV/PV of flow under consideration (after tax)

Discount rate sensitivity=difference between cost if capital and IRR
IRR= DF1+(NPV/(NPV@DF1+NPV@DF2))*(DF2-DF1)

Project life sensitivity= the time when the cumulative present value of cf goes from positive to negative (in reverse order)

Strengths:
Relatively straightforward

Identifies critical success area fpr the project e.g. sales volume, materials price

Facilitates subjective judgement

Weaknesses:
Ignores probability

Does not suggest a correct decision

Assumes changes in variables can be made independently

Question 34

Irr calculation (incomplete)

Answer 34

Formula

Df1[given in q] + (PV of df1/(pv of df1 - pv of df2))*(df2-df1)

Question 35

Interest rate parity

Answer 35

Interest rate parity claims that the difference between the spot and the future exchange rates is equal to the differential between interest rates available in the two currencies

Otherwise risk free gains could be made

Used by banks to calculate forward rate quoted for a currency

Forward rate= current spot rate*((1+if)/(1+iuk))

iF = foreign currency interest rate for period

iUK = UK interest rate for period

Question 36

DVM vs CAPM

Answer 36

DVM shareholders benefit from owning a share by receiving dividend into the future and capital gain on value of the shares.

The pv of this benefit creates the current price of the shares this share price is determined by expected future dividends discounted at investors required rate of return.

CAPM specific/unsystematic risk can be diversified away by investors so it is assumed investors are rational and have a diversified portfolio. Systematic risk cannot be diversified away - micro economic factors. A company’s beta is calculated from the performance of its share price against the market average and is taken as a measure of the market’s view of the risk attached to the security in question. The higher the perceived risk then the higher the beta figure and thus the higher the equity return required by investors

Question 37

Portfolio effect

Answer 37

Portfolio effect
A portfolio of investments helps spread risk.

Investors can usually spread risk themselves - they don’t need managers to do it for them. Limitations come if the area a company is diversifying into requires skills and knowledge that the business does not have as this would increase the risk of the investment failing

Question 38

Purchasing power parity (PPP)

Answer 38

PPP caims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries

The country with higher inflation is subject to a depreciation in its currency

In equilibrium, identical goods will cost the same in any currency

Future spot rate= current spot rate*((1+inflF)/(1+inflUK))

Question 39

Index options

Answer 39

Expiry date (closest date after transaction happens)

No. of contracts = value of portfolio/ (current index size*£10)

Calculate option premium= points associated to chosen call or put option£10number of contracts

When receiving
Gain if your chosen index is higher than the hypothetical

When paying
Gain When the hypothetical is higher than your index