FM Flashcards
Financial Objectives (3)
- Shareholder wealth maximisation
- Profit maximisation
- Earnings per share growth
Total Shareholder Return
Divi + Change in Share Price / Price at the start of the year
Dividend Yield
Dividends per share / Share Price
If you purchased a share today, what % income
return would you expect on your investment?
EPS - Earnings per share
PAT / No of shares
The amount of earnings the company has generated
for the shareholders on each share they hold
P/E Ratio
Share Price / EPS
What is the market’s view of our future growth? A
high P/E ratio suggests high predicted growth
Agency Theory and Problem
Theory - Directors put shareholders worth first
Problem - May be tempted to act in their own interests
Macroeconomic policy targets (5)
Strengthening business to make the economy more competitive
Protecting the environment
Increasing employment opportunities
Ensuring fairness for families and communities
Delivering macroeconomic stability to encourage long term planning and investment
Fiscal Policy
How Governments raise and spend money
Taxation and government spending. E.g. inc tax or decrease public expenditure = decrease demand and output
Monetary Policy
Governments to regulate the supply of money
Aim = achieve price stability
E.g. reduce interest rates or quantitive easing = borrowing cheaper and therefore increase demand
Quantitive Easing
Central banks can increase the supply of money by repurchasing government debt from banks
Money + Capital Markets
Money = less than 12 months
Capital = 12+ months
Both have a primary and secondary market, issues and trading
Role of money markets (3)
Providing short-term liquidity to industry and the public sector
Providing short-term trade finance
Allowing an organisation to manage its exposure to foreign currency risk and interest rate risk
Functions of a stock market
To enable companies to raise new finance
To enable existing investors to sell their investments
To aid takeovers by issuing shares to finance the takeover
To enable private company shareholders to realise part/all of their investment by floating the
company
Functions of a corporate bond market (4)
To enable companies to disintermediate i.e. to deal directly with lenders
To enable companies to raise new debt finance
To enable existing debt investors to sell their debt
To aid takeovers by issuing debt to finance the takeover
Advantages of financial intermediaries
Security
Convenience
Aggregation. An intermediary can take small amounts from investors and lend on in larger
packages. This is a significant benefit as lenders and borrowers do not need to find people who
want to deal with exactly the same amounts as them.
Maturity transformation. The intermediary can provide investors and borrowers with
their desired timescales.
Source of funds. A borrower will normally be able to find an intermediary who is prepared to
provide them with some funds even if the general market conditions are not that favourable.
Advantages of ROCE (4)
It is simple to calculate
As a percentage the measure is familiar to non-accountants
It looks at the entire project
It reflects the way external investors judge the organisation
Disadvantages of ROCE (6)
No account is taken of the project life
No account is taken of the timing of the cashflows/it ignores the time value of money
The result may vary according to the accounting policy used
It may ignore working capital
It does not measure absolute gain
It does not give a definite decision
Advantages of payback (5)
It is simple to calculate
It is easy to understand, especially for non-accountants
It uses relevant cash flows
It can be used as an initial screening tool on projects before undertaking a more detailed review
It (rather crudely) allows for risk
Disadvantages of payback (4)
It ignores returns after the payback period
It ignores the timing of the cash flows
It does not give a definite decision
It ignores project profitability
Advantages of NPV (5)
It allows for the time value of money
It uses cash flows rather than profits
It shows the change in shareholders’ wealth/it gives an absolute measure of return
It can allow for risk via the cost of capital
It looks at the entire project
Disadvantages of NPV (3)
It can be difficult to understand or explain to managers
It requires knowledge of the cost of capital
It is relatively complex
Advantages of IRR (6)
It allows for the time value of money
It uses cash flows not profits
It does not require the exact cost of funds to be known
As a percentage, the measure is familiar to non-accountants
It looks at the entire project
It provides a relative measure of performance
Disadvantages of IRR (5)
It is not an absolute measure
Interpolation provides only and estimate and an accurate estimate requires the use of a
spreadsheet programme
It is fairly complex to calculate
Non conventional cash flows may give rise to multiple IRRs
It contains the inherent assumption that cash returned from the project will be re-invested at
the project’s IRR which may not be true
Advantages of sensitivity analysis (4)
Simple
Provides more information to allow management to make subjective judgements
Indicates which forecasts should be researched further
Indicates which variables require the closest control once the project starts
Disadvantages of sensitivity analysis (3)
Assumes variables change independently of each other
Does not assess the likelihood of change
Does not lead to a definite decision
Objectives of working capital management (2)
Liquidity, Profitability
Aggressive and Conservative Working Capital
A - Low level WC, higher profit, lower liquid, higher risk
C - high level WC, lower profit, higher liquidity, lower risk
Advantages of JIT
Reduced holding costs
Increased flexibility
Increased quality and efficiency
Closer relationships with suppliers and increased
price transparency
Disadvantages of JIT
Increased risk of stock-out
Less opportunity for bulk discounts
Low staff morale due to unpredictable production
schedule
Not appropriate for all organisations (e.g. NHS!)
Factoring, Invoice Discounting
Factoring doesn’t take administration
Invoice Discounting more for temporary cash shortage
Benefits of centralised treasury management and cash control
Allows the internal netting off of local surpluses and deficits which is cheaper
Lower bank charges due to increased volumes through a single point
Better interest rates on borrowing and lending due to increased volumes
Reduced external foreign exchange due to internal netting off
Allows the employment of experts due to the volume of work required
Real / Nominal Rate
Real rate (excludes inflation, compensates the lender for the time value of money)
Nominal rate (includes inflation, compensates the lender for TVM and inflation)
Hard / Soft Capital Rationing
Hard - Organisation would like to but no shareholder will invest. E.g. returns not being high enough for risk
Soft - Organisation could but chooses not to. E.g. finance too expensive
Venture Capital
Like dragons den
Investment in ordinary shares and unsecured debt for around 5 years, look for exit route by listing or selling.
Private placing
Shares sold privately to clients of an issuing house at a fixed price
Simple, cheap
Stock Exchange Listing criteria
Three year trading history
Worth at least 700k
At least 25% shares in the hands of the public
Matching of finances (3)
Duration
Currency
Pattern of cash flows
Riba
Interest / excess
Murabaha
Trade Credit
Bank buys an asset and sells to business for a marked up price.
Ijara
Lease finance
Lessor remains responsible of maintenance and insurance. Allowed as classed as ‘rental’ payments
Sukuk
Debt finance
Business asset with a life of 3-5 years is bought, used by business to earn profits, the profits and losses are shared with the third party.
Mudaraba
Equity Finance
Partner providing capital and partner providing time, skill and expertise.
The partners share in any profits made by the business and the capital provider suffers any losses.
Musharaka
Venture Capital
Two or more partners provide both the capital and the time,
skill and expertise required by the business.
These partners all share in the profits in a ratio agreed in their original contract. Losses are
always shared in proportion to the capital contributions.
Weaknesses of dividend growth model
It is too simplistic as most companies do not pay a constantly growing dividend
Identifying an ex-div share price is difficult for listed companies and very difficult for unlisted
companies and so the model is based on estimates
Advantages of CAPM
It directly links risk and return
It can be used to calculate the cost of equity when the dividends are not growing constantly
Disadvantages of CAPM
It can only be used when the investors are diversified
It assumes that all of the components will remain constant and the same as they have been
historically
It assumes that investors can invest and borrow at the risk free rate
It assumes that the capital markets are perfect i.e. no transaction costs, no tax and no dominant
investor
It assumes that the risk of all macroeconomic variables can be grouped into one measure
Creditor Heirarchy
(1) Secured Creditors e.g. fixed charge over a non-current asset
(2) Preferential Creditors e.g. pension schemes and employees
(3) Floating Charge Holders e.g. charge over the current assets
(4) Unsecured Creditors e.g. trade payables and the Crown
(5) Preference Shareholders
(6) Ordinary Shareholders
Pecking order theory
(1) Retained earnings: this is the easiest, quickest and cheapest (in terms of issue costs) way to
raise finance.
(2) Debt: this is relatively cheap to service and issue and can be interpreted as a sign of
management confidence.
(3) Convertible debt: this offers investors the potential to benefit, at the expense of the
shareholders, if the company does well.
(4) Preference shares; this offers an equity stake without the uncertainty of dividend levels.
(5) Ordinary shares: this is time consuming to arrange and expensive to service and if unsuccessful
leads to a general loss of confidence and accompanying fall in share price of the company.
Financing problems for small businesses
The funding gap - higher risk, limited track record and dependency on small no of employees
The maturity gap - only really able to raise short term finance which won’t match investments
The inadequate security - not very many non current assets as security
Residual theory - dividend
Dividends are paid out only after all projects with a positive NPV have been financed. Whatever cash is left (i.e. the residual amounts) is returned to shareholders as a dividend
Clientele Effect - Dividends
Shareholders are attracted by previous dividends, expect these to continue.
If the dividend policy changes then they might sell their shares
Signalling
If a company cuts its dividend, investors may interpret this as a sign of bad news and seek to sell their shares, leading to a reduction in share price
If a company increases its dividend, investors may interpret this as a sign of improved future
prospects and purchase shares in the company, increasing the share price.
Scrip dividend
A scrip dividend is a dividend paid by the issue of additional company shares, rather than by
cash. It is offered pro rata to existing shareholdings
Warrant
Share options attached to a debt issue in order to make the debt more attractive to potential investors
Receivables Management (7)
Credit control - Assess credit, Manage, Collection
Early Settlement Discount
Factoring/Invoice Discounting
Bills of Exchange - IOU
Export Factoring - same as factoring but foreign
Documentary Credits - Bank letter confirming
Export Credit Insurance - Insurance against international customers not paying
Sensitivity Calc
NPV of project / PV of cashflow input
Equivalent Annual Cost - e.g. van
NPV of project / Annuity factor for project life
Business Risk
Business operations. Related to PBIT or operating profit changes as revenue or turnover changes. Assessed by calculating operational gearing - 100 × contribution/PBIT)
Asset Beta
Financial Risk
Due to debt as finance. Related to capital structure. Variability in SH return due to paying interest. Calc - geating or interest cover
Specific / Systematic Risk
Both business risk
Systematic - Effects everyone
Specific - Specific
P/E Valuation
MV of all: P/E ratio x PAT
Individual share: P/E X EPS
Earnings Yield
Earnings Yield Ratio = PAT / MV of shares or EPS / SP
Value Company:
MV = PAT / Earnings yield
Share P = EPS / Earnings yield
Dividend Yield Valuation
MV of all shares = Div / Div yield
Translation Risk
Risk enterring short term transaction credit in diff currency
Economic Risk
Longer risk trading in foreign currency
Translation Risk
Accounting losses due to foreign currency
Interest Rate Parity Theory
Difference between current spot rate (S0) and current forward rate (F0) should equal the
difference between interest rates in each country
Investor should be indifferent between forward contract or borrowing
Purchasing Power Parity Theorem
Difference between current spot rate (S0) and expected future spot rate (S1) should equal
difference between inflation rates in each country
i.e. investor should be indifferent between buying goods in £ or converting money to $ and buying the same goods in $
Home currency invoicing
Invoicing in your home currency when selling
abroad eliminates transaction risk
Leading /lagging
Bringing forward a payment or delaying a payment
Asset & liability management
Borrow and fund in foreign and net off
Forward
exchange
contract
Binding agreement to buy/sell an amount of
currency on an agreed future date at an
exchange rate agreed today.
To get the FWD rate you add a discount to /
deduct a premium from the spot rate
Currency options
The right, but not the obligation, to buy (call), or sell (put) a set amount of currency at a set price (in another currency) at a future date
If exchange rate moves against you, use
the strike price on the option contract
If exchange rates move in your favour let
the option lapse and use the spot rate
Pay a premium upfront in $
Money market
hedging
Instead of using forwards and futures, you can
instead use borrowing / lending on money
markets + spot fx transactions to hedge your
exposure.
Simultation
Computer based evaluation on risk and probabilities of an investment. Picture of mean EPV is built up on the results. Risk can be assessed, with most likely outcome and probability of negative NPV.
Risk - adjusted discount rates
Risk associated with project can be incorporated into discount rate as a risk premium over risk free rate. Can be calculated using CAPM by ungearing Equity Beta or subjectively by choosing it is riskier.
Cum Div - Ex Div
Cum Div - last dividend
When can you use the same WACC?
Same business risk
No change in capital structure
Project quite small
Not using project specific finance e.g. gov grant
Miller and Modigliana - No Tax
WACC is same all levels of gearing
Miller and Modigliana - Tax
Gear as much as possible
Traditional capital structure theory
Trial and error for optimum capital structure.
Debt starts off good
Basis Risk
Basis risk is the possibility that movements in the currency futures price and spot price will be different. It is one of the reasons for an imperfect currency futures hedge.
