FM general Flashcards
Hard capital rationing
External capital markets limit the supply of funds
Soft capital rationing
Firm imposes it’s own internal constraints on the amount of funds to be raised and investment in projects. Budgetary constraints. Can also arise where it is impractical for the firm to go to markets and raise a small amount of finance
Arbitrage Pricing Theory
Similar to CAPM. It adds a premium to the risk free rate but rather than just a single premium… the model divides the premium down into lots of bits.
Different authors have suggested different things such as inflation, level of industrial output, interest rates, size of the company .
Capital Asset Pricing Model (CAPM)
Way of estimating the rate of return that a fully diversified equity shareholder would require from a particular investment.
Rj = Rf + beta (rm-rf)
Problems with CAPM
RM = usually done with historic rate rather than future returns Rf = gilts are not risk free Beta = calculated using stat analysis of the difference between market return and the return of a particular share or industry. - way too simplistic.
Dividend policy - traditional
A consistent dividend stream was important
It was believed that it was better to have the certainty of a known dividend now than the uncertainty of having to wait.
Dividend policy - Modigliani and Miller
pattern of dividends does not affect shareholder wealth
As long as directors focus on investing into positive NPV projects, an increased dividend in the future will compensate for the cut today
M&M - DIY dividends
If money is needed today then shareholders can “manufacture dividends” by selling shares
Dividend Signalling
M&M assumed investors had perfect information about the company. In practice, although this is true for small owner managed businesses, with listed companies, a reduction in dividend can convey “bad news” to shareholders,
Clientele effect
M&M assumed investors were indifferent between dividends and capital growth. & if an investor required cash then he could manufacture dividends by selling shares. (investors have a preferred habitat).
Pecking Order Theory
A firm would generally choose in the following order if possible
(1) Retained profit - immediate no issue costs
(2) rights issue - some issue costs but no control or value given away
(3) as a last resort a new issue - expensive and difficult to price
Interest Cover equation
operating profit / interest
Financing Questions (FAT PRICE)
Financial risk Analysis and discussion Theory Practical gearing Ratios - Interest cover & hearing Industry Averages Conclusion Easy marks - financing checklist
No tax theory of Modigliani and miller 1958
Based on the premise of a perfect capital market
- no transaction costs
- no individual dominates the market
- full information efficiency
- all investors are rational and risk averse
- no taxes
With tax theory of Modigliani and miller
1963 m&m modified their model to reflect corporate tax system
Debt interest is tax deductible so kd is lower
Increase in ke does not offset the benefit of cheaper debt finance
WACC falls as gearing increases.
Summary
Gearing up reduced the WACC
Optimal capital structure is 99% gearing
Problems with high levels of gearing
Increased bankruptcy
Tax exhaustion - company profits are not high enough to cover the interest costs
Agency costs _ directors more risk averse
Asset beta
Beta measuring systematic business risk only
Equity beta
A beta reflecting systematic business risk and the firms level of gearing
Scrip dividend
Where a company allows shareholdersthe choice of taking dividends in the form of new shares rather than cash
Advantage of scrip dividend
Shareholders = painlessly increase their shareholding in the company without paying shareholder commission or stamp duty on a share purchase Company = does not have to find cash to pay dividend and can save tax
Advantages of growth by acquisition
Synergy
Risk reduction
Reduced competition
Vertical protection
Disadvantages of growth by acquisition
Synergy is not automatic
Restructuring costs following the acquisition may be significant
May end up paying more in terms of both price and fees than it gains in synergic benefits
Dividend yield
Yield = dividend / price Price = dividend / yield
Dividend valuation model
Value is simply the present value of the future expected dividend payments discounted at Ke
Dividends are expected to grow by a constant rate in perpetuity then:
PV = d1 x 1/ke - g
Problems with dividend based valuation
Estimating future dividends
Finding similar listed companies
If ke is estimated by CAPM or by looking at other quoted companies then a private co valuation will need to be reflected downwards to reflect lack of marketability (-25%)
PE multiple valuation
Equity value = earnings x PE ratio
Earnings are PAT and preference dividends
EBITDA multiple
Enterprise value = EBITDA x EBITDA multiple
Enterprise value
Market value of equity + preference shares + minority interest + debt - cash and cash equivalents
Cash flow based approach
PV cash flows to infinity discounted at WACC x
Less MV of debt (x)
Spin off
Shares in subsidiary company are given to the shareholders of the parent in proportion to their shareholdings
crowdfunding
allows a company to access finance from a large number of investors using a specific platform.
crowdfunding - advantages
useful for start-up companies with no trading history
provides a business awareness to attract customers
can be a quick process
crowdfunding - disadvantages
fee payable to the CF website
legal / advisory costs
admin cost of dealing with investor requests for more info
Peer-to-peer lending
connects established businesses looking to borrow with investors who want to lend, usually via an online platform
p2p - advantages
- usually lower interest rates
- quicker to arrange
- more accessible esp for those with low credit ratings
p2p - disadvantages
- require a high track record and credit checks will be performed
- can require an arrangement fee
Predictive analytics
use historical and current data to create predictions about the future.
e.g. linear regression models, decision trees, simulations.
Linear Regression Models
statistical tool used to identify the relationship between two variables
ADV: simple to use, easily explained and can be used to predict the impact from changes in estimates
DISADV: less meaningful if data is inaccurate, not always be a linear relationship, or spurious
Decision trees
used to identify the impact of different decisions on the outcome of an investment
ADV: simple, logical, used to consider multiple decisions
DISADV: many decisions can be difficult to interpret
simulation
looks at the impact of many variables changing at the same time
adv: provides more info about possible outcomes and sensitivities, & used for problems that cannot be solved analytically
disadv: does not identify a correct decision, time-consuming and complex, expensive & requires assumptions to be made
Prescriptive analytics
combining predictive with AI and algorithms, prescriptive can be used to calculate the optimum outcome from a variety of business decisions
ADV: multiple decisions and variables to identify the optimum investment
DISADV: complex and requires specialist data science skills
depends on reliability of data
Strong form efficiency
share price at all times incorporates all information that exists about the company.
SP moves instantly, insider trading is not possible
Semi Strong form efficiency
incorporates all information that has been made public about a company.
Insider trading is possible if moved before public
Weak form efficiency
when a new event happens, the share price does not react instantly. It takes time for the new information to be reflected in the price.
PE Valuation
PAT - preference dividend = x
EPS = x / ordinary shares = y
y x PE ratio = x
less non marketability (25%)
Valuation x
problems with PE valuation
profits may be erratic and so valuation will be unreliable
accounting policies may be used to manipulate earnings figures
finding appropriate listed companies
is the non-marketability reasonable?
rights issue
Issue costs
underwriting costs if company decides to protect its position
control - no dilution of control for those who take up their rights
need to discount offer price so that issue is fully subscribed
leaves credit lines open to finance further expansion
floating rate loan
avoiding being tied into higher fixed rates is market interest rates fall
risk of interest rates rising - cash budgeting problems
issue costs less than rights issue
early repayment - possibility
Shareholder Value Analysis SVA
Concentrates on a company’s ability to generate value and thereby increase shareholder wealth.
SVA - 7 drivers
- life of projected cash flows
- sales growth rate
- operating profit margin
- corporate tax rate
- investment in non current assets
- investment in working capital
- cost of capital
Valuation of tech companies
Asset method - difficult to apply because the value of tangible assets may not be high
Earnings method - low earnings in the early years
Dividend method - no dividend will be paid likely
Market multiples - possible to use ratios based on similar companies
Discounted cash flow - most likely valid approach. Different scenarios and cash flows could be modelled based on companies with similar business model
Single cash flow
cash flow x 1 / (1+r)^n
Perpetuity cash flow
A constant annual cash flow occurring forever
PV = annual CF x PF
With growth:
(PF * g / (r - g) ) * 1/1+r^n
Annuity Cash flow
A constant annual cash flow occurring for a SET number of years
(formula given)
SVA adv
values the free cash flows of the company and is not distorted by accounting policies which can affect other methods.
SVA disadv
dominated by the terminal value.
heavily dependent upon the inputs to the model such as estimating cash flows and growth.
Paying for ordinary shares - cash
ADVANTAGES
- buyer gets full control & entitlement to profits
- seller receives a certain unconditional amount
Paying for ordinary shares - cash
DISADVANTAGES
- find cash somewhere
- capital gains tax liabilities arise immediately
- sellers expertise may be lost as no motivation for them to stay
share for share exchange - ADVANTAGES
- no need to fund a cash payment
- seller is motivated to stay for work
- CGT deferred
share for share exchange - DISADVANTAGES
- control is diluted
- future profits shared with seller
Loan stock in exchange for shares - advantages
- advantages of cash payment with no need to find immediate finance
Loan stock in exchange for shares - disadvantages
buyer will have to pay interest on the debt until it is redeemed
Traditional View of gearing
low levels
- equity holders see risk being relatively unchanged.
- cheaper debt is incorporated - WACC falls
high levels
- equity holders see increased volatility of returns as debt interest is paid first
- increased equity risk increases ke and WACC starts to rise
very high levels
- bankruptcy risk
- kd + ke rise, WACC rises further
Unpublished information
remain confidential
not be disclosed
not to be used for a personal advantage
Market Capitalisation < Net Assets
- worth more if liquidated
- assumes that the NBV matches the MV.
- Market may see no future in the company and already valuing it on break up basis.
- dividend low payout (10%) - no plans to re-invest gives a high cash balance
- all equity funded, market may think is inadvisable and does not allow brennan to exploit the advantage of debt being cheaper than equity due to tax shield
Forward
binding agreement to buy or sell something in the future at a price agreed today
Future
forward contract that has been standardised (in terms of delivery date and quantity)
What effects the time value of an option?
- time period to expiry of the option
- volatility of the underlying security price
- general level of interest rates
Risks to trading abroad
Currency risk Government Stability Political and business ethics Economic Stability Import Restrictions Remittance Restrictions Special taxes, regulations for foreign companies Trading risks - physical risk, credit risk, liquidity risk
Time Value
intrinsic value - option premium
Intrinsic Value
Options that are in the money will have this.
What effects the intrinsic value?
- Exercise price
2. Share price
PE valuation
MV of ordinary share / EPS
Interest rate parity theory
difference between the spot rate and the future exchange rates is equal to the differential between interest rates available in the two currencies.
FR = spot rate x (1+foreign currency IR / 1 + UK interest rate)
Offer for sale
Shares would be sold to an issuing house, which then offers shares for sale to public
Offer for subscription / Direct offer
shares would be directly offered to the public - not an issuing house
Underwriting
For a fixed fee, a financing institution agree to purchase any shares not sold by the company.
ICO
Raises finance from investors
- investor receives a token, - share or entitlement for product or service
- payment is made in cryptocurrency.
Confidentiality
- different partners and teams
- necessary action to prevent leakage of any information
- regularly review the situation
Convertible debentures
can be converted into ordinary shares
adv:
- obtaining lower rate of interest
- encouraging possible investors with prospect of future share in profits
- element of short-term gearing
- avoiding the problem of redemption if th e conversion rights are taken up
- being able to issue equity cheaply
disadv:
- dilution of control if conversion rights are taken
- uncertainty as to whether they will be taken up
Economic risk
Longer term exchange rate movements might reduce the international competitiveness
