FM Flashcards
What are the three factors that affect the time value of options on shares?
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
What factors affect the intrinsic value of an exercise price of share options?
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
What factors affect the intrinsic value of a share price on share options?
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
How do you calculate intrinsic value of of an option?
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
How do you calculate time value of share options?
Time value = option premium - intrinsic value
What are the factors used in SVA?
Sales growth rate Life of projected cash flow Operating profit margin Working capital investment Cost of capital Asset expenditure (non current) Tax
What are the limitations of sensitivity analysis?
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)
How does simulation address the weaknesses of sensitivity analysis?
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
Name two real options and what they are
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
What are the limitations of expected values?
Discrete outcomes
Probabilities are subjective
Ignores risk
Less applicable to one off projects
What are the three stages of simulation?
Specify major variables and their probabilities
Specify the relationships between the variables
Simulate the environment
What are some practical ways to address risk?
Minimum payback period
Higher discount rates
Prudent estimates of cash flows
Assessment of best and worst outcomes
What are the problems with CAPM?
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
What are some alternatives to CAPM?
Arbitrage pricing theory
Bond yield plus premium approach
Dividend valuation model
What are the advantages and disadvantages of equity finance?
Advantages: Readily available Low cost Immediate No change in control
Disadvantages:
No cash may be available
May have an impact on dividends
What are the advantages and disadvantages of rights issues?
Advantages:
Issue costs are lower than for a new issue
No change in control
Pricing is easier
Disadvantages:
Shareholders may be unwilling to invest
What are the advantages and disadvantages of a new issue?
Advantages:
The finance is generally to be found somewhere
Disadvantages:
Expensive
Control can change
Pricing is difficult
What’s the formula for a theoretical ex issue price?
(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)
What is the theoretical value of a right?
Ex issue price - exercise right
What are behaviours that cause inefficiency in a market?
Overconfidence and miscalculation of probability
Conservatism and cognitive dissonance
Availability bias and narrow framing
Representativeness and extrapolative expectation
How do you calculate WACC?
MV x cost / MV
MV and cost of: equity, debt, and preference shares
How do you calculate P0 (debt)
P0 =interest/yeild
Disadvantages of WACC
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
How do you work out earning per share?
Profit before interest and tax / number of ordinary shares
How do you calculate the price earnings ratio?
Market value of shares/Earnings per share
How do you calculate the gearing ratio?
Fixed return capital/ total long term capital
Advantages/disadvantages of SVA
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
