FM Sources Of Finance&Gearing&Dividend Policy

Question 1

Features or equity shares

Answer 1

Dividends related to profits and generally grow over time
Full voting rights therefore control the company
Paid last in a wind up but entitled to all profits after debt and pref are repaid
Suffer the most risk as the owners so have the highest return

Question 2

Features of pref shares.(5)

Answer 2

Fixed percentage dividend (in priority to ordinary shares)
Dividend is usually cumulative
Limited right to vote at GM
Repaid before equity in wind up
Treat like debt for gearing HOWEVER unlike interest the dividends are not tax deductible and aren’t guaranteed hence higher risk

Question 3

Debt features.(4)

Answer 3

Interest must be paid irrespective of profits and can force company into bankruptcy if can’t pay back
No voting rights
Repaid first in winding up of a company
Debt holders suffer least risk so commands lower return

Question 4

Pros and cons of internally generated funds. (4,2)

Answer 4

Pros:
Readily available
Low cost
Immediate
No change in control

Cons:
Cash may not be available
May impact of dividend policy

Question 5

Pros and cons of rights issues. (3,1)

Answer 5

Pros:
Issue costs are lower than a new issue
No change in control (unless shareholders don’t exercise their rights)
Pricing is easier than a new issue as no wealth shared w new investors

Cons:
Shareholders may not invest

Question 6

Pros and cons of new issues. (1,3)

Answer 6

Pros:
Finance is generally found somewhere

Cons:
Can have very high issue costs
Will reduce the control of the existing shareholders
Pricing is difficult (too high and will fail too low and existing shareholders will suffer)

Question 7

Pros and cons of venture capital.(1,3)

Answer 7

Pros:
Good way for start ups to attain finance
Gains are in CGT which could attract investment due to tax

Cons:
Usually high % of equity demanded
Usually investors want a board position
Can equity ratchet if targets aren’t met with no additional cost to investor

Question 8

Crowdfunding pros and cons.(3,3)

Answer 8

Pros:
Useful for start ups with no trading history
Provides business awareness to attract customers
Can be a quick process

Cons:
Fee is payable to crowdfunding website
Legal and advisory costs
Admin cost to dealing with investors requests for info

Question 9

Term loans pros and cons. (3,1)

Answer 9

Pros:
Arrangement fees are small compared with issue costs of loan stocks
May have either fixed or floating rates of interest
Interest payments attract tax relief

Cons:
Usually secured on company assets so might not be available if doesn’t have a balance sheet

Question 10

Pros and cons of loan stock (debentures). (4,2)

Answer 10

Pros:
May be unsecured
Loan stock can be sold by the original investor (flexible exit route)
Flexibility (redeemable or irredeemable and at a discount or premium redemption)
Debentures can be offered with conversion rights or warrants

Cons:
High issue costs
Often higher interest rates than a term loan (due to lower assets quality provided as security)

Question 11

What loan documentation will investors ask to be in place?(3)

Answer 11

Representations on legality and affordability of the loan
Guarantees such as parent company guaranteeing the loan of a subsidiary
covenants such as restrictions on taking out further debt finance or key ratios being maintained

Question 12

Peer to peer lending advantages over traditional bank lending.(3)

Answer 12

Usually come with the lower interest rates due to greater competition between lenders
Usually quicker to arrange
Can be more accessible especially if the company has a low credit rating

Question 13

4 types of behavioural finance.(4)

Answer 13

Overconfidence and miscalc of probability
Conservatism and cognitive dissonance (resistant to change their minds)
Availability bias and narrow framing (focus in one detail that stands out to them leading to over reliance rather than a holistic view)
Representativeness and extrapolative expectation-tend to assume history will repeat itsekf and tend to buy shareabkf price has risen and selk afger they habe falkrn

Question 14

What happens to WACC as we increase gearing?(2)

Answer 14

Debt is cheaper than equity as is less risky and interest is tax deductible increasing Kd pushes WACC down
Increasing debt makes the return to shareholders more variable and more risky causing Ke to rise which pushes WACC up

Question 15

Traditional theory of gearing.(4)

Answer 15

At low levels equity holders see little change in risk and as cheaper debt is incorporated WACC falls, at higher the increased volitility in returns comes from debt interest being paid first causes a increase in Ke and WACC starts to rise , at very high levels both Kd and Ke rise as bankruptcy worries both investors causing a further increase in WACC

conclusion:
Optimal gearing but no method other than trial and error to locate

Question 16

What is the no tax theory of M&M .(2)

Answer 16

Argues investors are rational and as gearing increases so does Ke in direct proportion with the Ke increase offset by the benefit of cheaper debt finance
This results in an unchanged WACC
CONCLUSION:
gearing is irrelevant

But assumes no tax! Plus other things

Question 17

With tax M&M gearing theory

Answer 17

Debt interest is tax deductible so Kd is lower however the increase in Ke does not offset the benefit of the cheaper debt finance therefore WACC falls as gearing increases
Conclusion:
Increased gearing reduces the WACC

Question 18

Practical problems and practises on gearing.(4)

Answer 18

Increased bankruptcy-increased gearing makes more likely
Tax exhaustion-the tax shield may not be achieved if profits are not high enough to cover interest costs
Agency costs-directors may be more risk averse than shareholders as it’s their job which relies on the company remaining solvency

Therefore gearing tends to be based on more practical concerns eg:
Costs of raising finance
Asset quality
Loan covenants
Availability of other sources of finance
Level of other risks

Question 19

Traditional view on dividend policy (1)

Answer 19

Consistent dividend stream is important as better certainty now “bird in the hand”

Question 20

M&M dividend theory.(2)

Answer 20

-Consistency is irrelevant -As long as funding positive NPV projects then would compensate for lower dividend today
-DIY dividends-investors require income then they can sell a few shares to manufacture their own dividend

Question 21

Dividends in the real work.(3)

Answer 21

Dividend signalling
Clientele effect:
income vs CGT
DIY dividends not as feasible eg transaction costs

Question 22

What is pecking order theory.(2)

Answer 22

Retained profit, rights issue, new issue
In practise most firms adopt a constant increase dividend
Prudential to ensure dividends lag behind earnings so they can be maintained even if a dip is seen

Question 23

Dividend alternatives.(2)

Answer 23

Share buyback
Scrip/stock dividend-allows shareholders the choice of taking dividend in form or shares ie stock over cash-NOT A SCRIP ISSUE (WHICH IS A BONUS ISSUE)

Benefit of scrip div:
Shareholders increase holding without brokers fees or stamp duty on purchase
Companies does not have to pay cash and can sometimes save cash