FM

Question 1

What are the three factors that affect the time value of options on shares?

Answer 1

Time period to the expiry of the option (longer=more valuable)

The volatility of the market price of the shares (more volatile= more valuable)

General level of interest rates

Question 2

What factors affect the intrinsic value of an exercise price of share options?

Answer 2

Call: lower the exercise price in relation to share price the higher the intrinsic value

Put: higher the exercise price in relation to the share price the higher the intrinsic value

Question 3

What factors affect the intrinsic value of a share price on share options?

Answer 3

For a call option the higher the share price the higher the intrinsic value

For a put option the lower the share price the higher the intrinsic value

Question 4

How do you calculate intrinsic value of of an option?

Answer 4

Call option: Intrinsic value = stock price - exercise price

Put option:
Intrinsic value = exercise price - stock price

Only options that are in the money have intrinsic value

Question 5

How do you calculate time value of share options?

Answer 5

Time value = option premium - intrinsic value

Question 6

What are the factors used in SVA?

Answer 6

Sales growth rate
Life of projected cash flow
Operating profit margin
Working capital investment
Cost of capital
Asset expenditure (non current)
Tax

Question 7

What are the limitations of sensitivity analysis?

Answer 7

Assumes variables change independently of one another

Does not assess likelihood of the variable changing

Does not give an actual decision (not an optimising technique)

Question 8

How does simulation address the weaknesses of sensitivity analysis?

Answer 8

It allows the effect of more than one variable changing. This gives more info on outcomes and their probabilities.

However it is not an optimising technique

Question 9

Name two real options and what they are

Answer 9

Abandonment option: abandon the project and sell the assets

Growth/follow on: continue the project for longer or launch a new project off the back of this one

Question 10

What are the limitations of expected values?

Answer 10

Discrete outcomes
Probabilities are subjective
Ignores risk
Less applicable to one off projects

Question 11

What are the three stages of simulation?

Answer 11

Specify major variables and their probabilities

Specify the relationships between the variables

Simulate the environment

Question 12

What are some practical ways to address risk?

Answer 12

Minimum payback period

Higher discount rates

Prudent estimates of cash flows

Assessment of best and worst outcomes

Question 13

What are the problems with CAPM?

Answer 13

Estimating Rm - in practice this is usually done using historic rather than future returns

Estimating Rf - gilts are not risk free

Calculation of beta - the way they’re calculated is too simplistic

Also assumes everyone is fully diversified

Question 14

What are some alternatives to CAPM?

Answer 14

Arbitrage pricing theory

Bond yield plus premium approach

Dividend valuation model

Question 15

What are the advantages and disadvantages of equity finance?

Answer 15

Advantages:
Readily available
Low cost
Immediate
No change in control

Disadvantages:
No cash may be available
May have an impact on dividends

Question 16

What are the advantages and disadvantages of rights issues?

Answer 16

Advantages:
Issue costs are lower than for a new issue
No change in control
Pricing is easier

Disadvantages:
Shareholders may be unwilling to invest

Question 17

What are the advantages and disadvantages of a new issue?

Answer 17

Advantages:
The finance is generally to be found somewhere

Disadvantages:
Expensive
Control can change
Pricing is difficult

Question 18

What’s the formula for a theoretical ex issue price?

Answer 18

(Current market value of shares in issue + cash raised by the issue + NPV of the project) / (current number of shares in issue + number of new shares issue)

Question 19

What is the theoretical value of a right?

Answer 19

Ex issue price - exercise right

Question 20

What are behaviours that cause inefficiency in a market?

Answer 20

Overconfidence and miscalculation of probability

Conservatism and cognitive dissonance

Availability bias and narrow framing

Representativeness and extrapolative expectation

Question 21

How do you calculate WACC?

Answer 21

MV x cost / MV

MV and cost of: equity, debt, and preference shares

Question 22

How do you calculate P0 (debt)

Answer 22

P0 =interest/yeild

Question 23

Disadvantages of WACC

Answer 23

Can’t use if gearing will change
DVM is not appropriate for a new industry
It assumes a perfect market
It assumes dividends are constant

Question 24

How do you work out earning per share?

Answer 24

Profit before interest and tax / number of ordinary shares

Question 25

How do you calculate the price earnings ratio?

Answer 25

Market value of shares/Earnings per share

Question 26

How do you calculate the gearing ratio?

Answer 26

Fixed return capital/ total long term capital

Question 27

Advantages/disadvantages of SVA

Answer 27

Based on future free cash flows that the company generates

Problems include estimating the inputs, estimating the growth, estimating the length of the planning horizon, the terminal value dominates the valuation