Foundations of Financial Management Flashcards
What are two methods of valuing a project?
NPV and IRR
What does the NPV method do?
The NPV discounts all the future cash flows and subtracts the initial investment.
What does the IRR method do?
It estimates the rate of return of a project compared to the hurdle rate
What is Capital Budgeting?
Capital Budgeting is when you make a decision on the choice of the project.
What is an annuity?
An annuity is an equal stream of net cash flows
How do you calculate the present value of an annuity, theoretically?
Calculate the annuity factor and then multiply it by the cash flows.
What is a perpetuity?
A Perpetuity is an infinite stream if equal future cash flows.
What is the IRR?
the IRR is the value of the discount rate that makes the NPV = 0, to accept the project the IRR>hurdle rate
What are the benefits of an IPO
- Ability to raise new capital
- Stock price provides performance measures
- Information more available
- Diversified source of finance
- Reduced borrowing costs
What are sources of internal funds:?
- Operating profits
- Proceeds from equity issue
- Proceeds from debt issue
What is a Rights Issue?
A Rights Issue is when a firm is public they issue more equity.
How do Rights Issues Work?
Firms offer existing shareholders the opportunity to buy more shares, proportional to the shares they already own.
How do we determine the discount rate?
Using CAPM
What does beta measure?
Beta measures systematic risk
What is systematic risk?
Risk that cannot be diversified away
What are the pros of IRR
- IRR is more intuitive than NPV
- Usually gives the signal as NPV
What are the cons of IRR
- There can be multiple IRR’s, so its unclear which one it is
- Doesn’t demonstrate if projects have different horizons
What is the WACC?
Weighted Average Cost of Capital
Why is the after-tax WACC higher than pre-tax?
Its higher because interest payments are tax deductible
What is capital structure?
Capital structure refers to the long-term financing decisions firms make
Is capital structure relevant to a firm in a perfect world?
According to MM 1958, capital structure is not relevant under perfect capital structure. This is demonstrated by at the pre-tax WACC formulae
What is riskier and why, debt or equity?
Equity is riskier, this is demonstrated by MM’s 2nd Proposition (the after-tax WACC formulae) this is because interest payments are tax deductible. But too much debt increases the riskiness as it increases the risk of obtaining bankruptcy costs.
When does a change in capital structure benefit shareholders? How should managers factor this in?
Changes in capital structure only benefit the shareholders when it adds value to the shareholders, thus managers should choose the capital structure that adds the most value to the company in order to create maximum benefit to the shareholders.
What are 3 agency costs of debt?
- Debt Overhang (firms threatened with default may not take on positive NPV projects because bondholders capture part of the value added)
- Asset Substitution (incentive to take larger risks)
- Milking the Company (e.g. pay out extra dividends or other distributions in time of financial crisis, leaving less behind for bondholders)
When is the optimal capital structure?
This is where the marginal benefit of the tax shield is equal to the marginal cost of bankruptcy (or financial distress).
State and explain each Payment Procedure of a dividend in order.
- Declaration date- the board passes a resolution to pass dividends.
- Cum-Dividend date- the last day the buyer is entitled to the dividend.
- Ex-Dividend date- shares start to trade without the dividend.
- Record date- shareholders registered on this date will receive a dividend.
What did MM say about payout policy and also the assumptions they make?
In a perfect world, the value of a firm with a fixed investment policy is independent of its dividend policy. So in theory there is no difference between receiving a dividend or not.
- Investment policy is fixed
- No market frictions (transaction cost, no taxes)
- Efficient markets, all prices are fair
- No asymmetric information
Why are home dividends not a perfect substitute for real cash dividends?
In the real world there are transaction costs:
-If shareholders pay higher taxes on capital gains than dividends then there is an incentive to payout cash dividends
What do efficient markets say about prices and risk?
Efficient markets say prices should reflect available information and returns should reflect risk.
What are seasonal effects, give an example and what are seasonal effects an example of?
Seasonal effects are an example of market inefficiency, they repeat in regular intervals and are therefore predictable. An example is the ‘January Effect’. This economically significant as its after the tax period. It mainly relates to small companies and involves special risks.
Another is the ‘Day of the Week Effect’
What are the 3 forms of efficient market hypothesis and explain them ?
- Weak form efficiency (prices reflect all information about past price behaviour)
- Semi-strong form efficiency (prices reflect all information on past prices and other relevant public information)
- Strong form efficiency (prices reflect all information on past prices, relevant public information and private information)
What is Behavioural finance?
Prices may deviate from there fundamental values because investors may not be fully rational
What is arbitrage?
An investment strategy that targets market inefficiency and and returns if and when prices return to there fundamental values
What are the limits of arbitrage?
- short selling fees are costly
- risk that the prices will diverge even further before they converge, very risky
How can we price stocks using fundamental values?
- Dividend Discount Model (DDM)
- Discounted Cash Flow Model (DCF)
- Market Multiples Valuation
What is the Dividend Discount Model?
The DDM is when you discount future dividend payments by return on equity
What is the Discounted Cash Flow Model
The DCF is when you discount free cash flows by the WACC, this gives you the enterprise Value. Then obtain the value of the equity proportion and divide by the number of shares.
What is the Market Multiples Valuation?
This is when you use price comparable’s. Look at the firms in similar industries and back-out prices from relevant ratios, such as the P/E ratio.
What is the spot exchange rate?
This is when you exchange currencies, the exchange rate is fixed.
What is a forward contract?
This is when you can exchange currency in the future, fixing the exchange rate of today. The forward rate should reflect exchange rate differentials.
What does the forward rate hypothesis assume?
It assumes that the forward rate is a good predictor of the future spot exchange rate
E[S$/£] = F$/£
What is market multiple valuation
This is when you value a firm based on the value of other comparable firms and adjust for scale between firms by expressing their value in terms of a valuation multiple
What are some price multiples
Price/Earnings
Price/Book
Price/Market
Price/Cash Flow
Price/Sales
What does it mean if a firm had low P/E ratios relative to their peers?
The firm with a low P/E is undervalued
How do you calculate the price of a firm using EPS and P/E (of a comparable firm)
EPS x P/E (comparable firm)
How is the stock pice determined?
The stock price is equal to all the future cash flows
Give a disadvantage for the forward exchange rate
It only works best with actively traded currencies
What is the international fisher effect
- Expected real interest rate r is the same in all countries
- Governments cannot directly control interest rates in international currency markets
- They can control domestic interest rates in the short run however
- Differences in domestic and real interest rates would only be different in the short run
