FM Flashcards
NPV assumptions
- NPV is reflected in the increase of share price
- Finance used does not create significant gearing change
- Project is small relative to the company
- Project risk is the same as the company operating risk
NPV/APV Limitations
- Rely on restricted assumptions about the capital market
- Rm is based on historic and Rf is hard to calculate
- Business risk is assumed to be constant
- Neither value real options like follow-on or abandonment
- Assumes variables are independent
Data Bias
Selective - Bias in the small selection of data
Observer - Bias in the observation of the interpolation of data
Confirmation - The observer only sees the data that confirms their beliefs or views.
Behavioural factors
Conservative - risk averse and not open to change
Cognitive dissonance - Holding onto long term belief
Availability bias - Most recent data in mind
Extrapolative expectation - Based on past trends
Narrow framed - See a small portion and not the full picture
Overconfidence - over estimate upside
Miscalculation of probability - getting probabilities wrong
Dividend Alternatives
Share buy back - distribute surplus capital to investors, buy back and cancel so bring down issued share cap and change gearing
Special dividend - One off, does not affect Issued share cap
Scrip dividend - Option to have shares over dividends, increase share cap, no commision or stamp duty
Gearing views
Traditional
- Low level - Risk to equity holders remains unchanged
- High level - Risk increases, debt interest is paid first and worries holders. Increases Ke so WACC increases and decreases value of company
- Very high - Risk of bankruptcy worries holders and lenders, Ke rises and WACC goes up more, devaluing company even more
M&M(No tax)
- As cost of equity rises, so does cost of debt and therefore no change to WACC
- Perfect capital market
M&M (with tax)
- Tax deduction, reduces cost of debt, reduces gearing and therefore is good.
CAPM assumptions and limitations
CAPM - expected return of a capital asset and the risk it has relative to the market portfolio
Assumptions
- Main objective is to maximise shareholder wealth
- All shareholders are fully diversified
- Shareholders are the only participants in the firm
Limitations
- Estimating Rm is done with historical data
- Rf is tough to calculate since guilts are not risk free
- Beta are oversimplified
Alternatives
- Dividend valuation model
- Bond prices plus premium
- Arbitrage pricing theory
WACC assumptions and limitations
Assumptions
- Perfect market (immediate share response)
- Dividends paid once a year and grow at a constant rate
- hIstorical amount of Debt and Equity remain unchanged
- Business risk remains unchanged
- Finance raised is not project specific
- Project is small in relation to company size
Limitations
- Companies tend to use short loans and overdrafts instead
- Tough to use for small companies as no market value to get accurate returns from
Hedging
Forward
Adv - Tailored, Perfect hedge, Lots of currencies, Protects against downside
Disadv - no upside, tough to retract from, no secondary market
Future
Adv - Prevents downside, can use major currencies, traded on exchange
Disadv - Basis risk, rounding, imperfect hedge, no upside, requires cash collateral
Money market
Adv - Secondary market, prevents downside
Disadv - Utilises balance sheet, no upside
OTC Option
Adv - Tailored, perfect hedge, upside and downside covered, right but not obligated
Disadv -Expensive, pay prem up front
Traded currency option
Adv - Upside and downside, right but not oblig, option on underlying future
Disadv -Expensive, Imperfect hedge, pay premium up front
TERP
May not equal share price because:
- not fully taken
- Market reaction
- Negative signalling
- Money not invested in positive NPV projects
SEE
Social -
Economic -
Environmental -
Predictive/Prescriptive analysis
Predictive - based on historical information
Prescriptive - using computing and data to create a distribution analysis and the optimum solution of multiple variables
- Can be used for optimum pricing policy
Gordons growth model
Earnings retention model - Dividends grow based on proportion of dividends retained and the rate of return of those retained profits.
Growth is achieved by reinvesting earnings
Time value of options
Affected by
1. Time period to expiry
2. Volatility of the market price of shares
3. General level of interest rates
Replacements
Limitations
- Assume cost of asset is not subject to inflation or tax
- The operating efficiency is assumed unchanged
- Assumes assets will be replaced in perpetuity
