FM

Question 1

What are practical techniques that could be used to deal with risk and uncertainty in forecasting the costs and revenues of a project?

Answer 1

For risk:

• Probability distributions and expected values relating to different possible outcomes
• Simulation
• Risk-adjusted discount rates

Techniques for dealing with uncertainty

• Setting a minimum payback period for projects
• Increasing the discount rate subjectively in order to submit the project to a higher ‘hurdle’ rate
• Making prudent estimates of outcomes to assess the worst possible scenario
• Assessing both the best and the worst possible scenarios to obtain a range of outcomes
• Using sensitivity analysis to measure the ‘margin of safety’ on input data

Question 2

What is the difference between risk and uncertainty?

Answer 2

Risk is when when the probabilities of certain outcomes are known.

Uncertainty is when possible outcomes are known, but probabilities of them are UNknown.

Question 3

What are real options to consider?

Answer 3

FATGF

Follow on (further projects/contracts as a result of undertaking this one ie. expansion)

Abandonment - can the project be abandoned at any time? Can we sell the machinary if we want to abandon it?

Timing - can we delay the project until competitors leave the market?

Growth - is there an opportunity to expand by undertaking this project?

Flexibility - what further options does this project give?

Question 4

When could we use the existing WACC?

Answer 4

The gearing ratios remain unchanged

The new project is similar to the firm’s existing activities so that the business risk (operating risk) remains unchanged

The finance is not project specific

The project is small in size

(also, need the market values of the loans)

Question 5

Why would we use CAPM over GGM when calculating the cost of equity?

Answer 5

When the gearing is likely to change as a result of the project (GGM doesn’t factor in gearing).

CAPM considers the systematic risk - if risk is greater, the cost of capital will be greater.

Question 6

What do we need to consider when adjusting for inflation?

Answer 6

Longer term estimates may be prone to error

Question 7

What is a SVA?

Answer 7

SVA is an income measure (not asset based) which concentrates on a company’s ability to generate value and thereby increase shareholder wealth. SVA is based on the fact that the value of a business is equal to the sum of the present values of the cash flows generated
by all of its activities, rather than just its earnings or dividends.

Seven value drivers are key to the SVA approach to valuing a company

(SOCICIL)

• how we can increase sales growth rate
• how can we increase operating profit margin by decreasing costs e.g. lease the machinary
• cost of capital - is it at its optimum level?
• Investment in NCA - can we get rid of some to increase liquidity?
• Corporation tax rate - don’t have much impact on this but are we being tax efficient?
• Investment in working capital - is it minimised? e.g. use JIT
• Life of projected cash flows - is the project life cycle correct, and are there any cash flows beyond the projection?

SVA links a business’ value to its strategy via the value drivers. The value of the business is calculated from the cash flows generated by drivers 1–6 above, which
are then discounted at the company’s cost of capital (driver 7).

Once you work out the cash flows, DEDUCT the MARKET VALUE of DEBT from it to get the value of equity. ADD any short-term investments.

Question 8

What is the formula for undertaking a sensitivity analysis?

Answer 8

NPV of project / PV of cash flows subject to uncertainty x 100%

Question 9

What are the advantages and disadvantages of sensitivity analysis?

Answer 9

Advantages:

• warns management of factors that are critical to the success of a project
• straightforward to calculate

Disadvantages:

• only looks at one factor at a time
• identifies how far a variable needs to change, not how likely
• provides info on the basis of which, decisions can be made but does not tell us directly the correct decision

Question 10

What are the advantages and disadvantages of a simulation?

Answer 10

Gives more info on the possible outcomes and their probabilities
Useful for problems that cannot be solved analytically

Doesn’t give a decision, just gives info on the basis to make the decision
Can be expensive to design and run
Requires assumptions to be made about the probability distributions which may be inaccurate

Question 11

What are the advantages and disadvantages of expected values?

Answer 11

A:

• information is simple - reduced to a single value for each choice
• easy to understand

D:

• probabilities of each outcome can be difficult to estimate (would need past experience of similar projects or results of market research)
• unless the same decision has to be made several times, the average will not be achieved
• the average gives no inidcation of the spread of possible results (ignores risk)

Question 12

What does it mean if a security has a beta greater than 1.00?

Answer 12

This investment is more affected by changes in macro-economic variables than the average market investment - will react quickly. These are called aggressive shares.

Lower than 1 = defensive.

Question 13

What is meant by intrinsic value?

Answer 13

Computeed assumin the expiry date is today. Out of the money options would have intrinsic value of 0.
In the money options = exercise price - current share price

Question 14

What is the time value of an option?

Answer 14

Difference between cost of the option and its intrinsic value.

Question 15

What are limitations of a FRA?

Answer 15

• lose out on upside potential
• difficult to obtain for periods of over 1 year
• usually only available on loans of atleast 500,00 GBP

Question 16

What are the dis/advantages of interest rate swaps?

Answer 16

• Arrangement costs are significantly less than terminating an existing loan and taking out a new one
• available for longer periods than short-term hedging such as options, FRAs and options allow.
• they are flexible as they can be arranged for tailor made amounts
• risk that the counterparty will default
• risk of unfavourable market movements of inerest/exchange rates after entering into a swap
• risk that the financial statements of the parties involved are misleading

Question 17

What is the value of a right?

Answer 17

Theoretical ex-rights price - subscription price

Question 18

What are the issues with a public issue of equity?

Answer 18

• expensive - issue costs are usually around 10% of of the value raised
• setting the issue price is difficult - too high means that not all shares might be taken up and underwriting is v expensive
• dilution of control for existing shareholders

Question 19

What are the dis/advantages of convertible loan stock issue?

Answer 19

A:

• encourages possible investors
• cheaper way of issuing equity
• saves the company from having to raise the cash to pay off the loan

D:

• probably need to provide securities for the loan
• possibility of loan covenants that impose borrrowing restrictionsor restricting dividends

Question 20

What are the benefits of choosing to borrow on the euromarkets by larger companies?

Answer 20

• easier to raise very large amounts of money very quickly than in the home market
• costs of borrowing is slightly cheaper than the for the same currency in home market
• issue costs are relatively low
• generally require no security
• attractive to investors as interest is paid gross

Question 21

When would be appropriate to use APV as opposed to WACC? How is APV calculated?

Answer 21

If the capital structure changes significantly.

It assumes that the project is only financed by equity, and uses that to arrive at a base case NPV. It then adjusts these cash flows for the present value of the costs and benefits of the actual type of finance used, including the present value of the tax shield on interest paid.

Question 22

Benefits/Limitations of net asset valuation?

Answer 22

A:

• straightforward to get values
• assets are more certain than income

D:

• book values likely to be out of date
• ignores future earnings and undervalues intangibles

Question 23

(Dis)advantages of future cash cash flow valuation

Answer 23

• incorporates all relevant cash flows and time value of money
• can be difficult to come up with projected cash flows
• calculating a suitable discount rate will be problematic

Question 24

(Dis)advantages of price/earnings valuation

Answer 24

• reflects stock market’s view of the potential of a company
• considers earnings potential of company
• using industry average may not reflect the company being valued
• earnings can be manipulated using accounting policies
• past earnings may not dictate future earnings

Question 25

What is the enterprise value/EBITDA multiple method of valuation?

Advantages/disadvantages?

Answer 25

Equity value = enterprise value - MV debt + cash/cash equivalents

A:

• takes debt into account
• unaffected by capital structure/depn policies

D:
= past earnings may not reflect future potential
- industry average may not be applicable
- ignores capex and efficient tax management

Question 26

How would you work out the cost of preference shares?

Answer 26

Dividend per pref share / price of pref share

Question 27

How would you work out the cost of irredeemable debt?

Answer 27

Interest / Price * (1-T)

Question 28

What is the efficient market hypothesis?

Answer 28

In efficient markets, all share prices are fair. If the market is very efficient, the share prices will reflect all of the information available. There are no patterns in share price movements and markets have no memory. In efficient markets, investors cannot consistently make above average returns other than by chance.

Weak form efficiency -
prices only change when new info is available and the info arrives in a random manner. Past prices cannot be used to earn consistently abnormal profits.

Semi-strong -
share prices are reflective of all publicly available info. The market can anticipate changes before new information if formally announced.

Strong form efficiency -
This cannot be used to earn consistently abnormal profits because all information, public and private is already reflected in the share price.

Question 29

What is an alternative view to the efficient market hypothesis?

Answer 29

Behavioural finance
Due to the irrational behaviour of investors such as overconfidence, miscalculation of probabilities and positive feedback, it leads to the weakening of market efficiency.

Question 30

What are the types of currency risk?

Answer 30

Transaction risk -
movements in exchange rates between the date the price is agreed and when the actual payment is made

Translation risk-
risk of making exchange losses when the transaction is translated into home currency

Economic risk -
impact of exchange rate movements on the competitiveness of the company

Question 31

How can we manage economic risk?

Answer 31

Reflect exchange rate movements in the pricing

Choose carefully which markets to operate in

Economic exposure may impact supply and location of production

Diversify operations worldwide for both buying and selling