general study

Question 1

what is the purpose of profitability ratios

Answer 1

They determine the company’s overall financial condition

Question 2

what is the purpose of efficiency ratios

Answer 2

They show how effective the company is at using assets to generate income

Question 3

what is the purpose of liquidity ratios

Answer 3

It shows the company’s ability to pay its short term debt obligation

Question 4

what is the purpose of financial gearing ratios

Answer 4

they determine how likely the company is to becoming insolvent

Question 5

what is the purpose of investment ratios

Answer 5

They analyse what company is better to invest in

Question 6

What is operating leverage

Answer 6

This is how a company’s increase or decrease in revenue will effect its operating income (earnings before interest and tax)

Question 7

How to interpret the degree of operating leverage

Answer 7

Per percentage of increase (or decrease) in revenue growth will result in x% percentage of growth in operating income - DOL > 1 HIGH RISK / DOL < 1 LOW RISK

Question 8

What is financial risk?

Answer 8

this shows how volatile the company’s net earnings are as a result of fixed financial charges - the higher the financial charges the more volatile the earnings are

Question 9

how to interpret degree of financial leverage

Answer 9

the shows how sensitive the company’s capital is (Earnings per share) in relation to its operating income - DFL > 1 HIGH RISK / DFL < 1 LOW RISK

Question 10

How do we measure a company’s total risk

Answer 10

DTL = DOL * DFL - the higher the total risk a more sensitive a company’s NET PROFITS are to change in sales revenue

Question 11

what is systematic risk

Answer 11

it is an area of risk that can note be reduced or eliminated through a diverse portfolio

Question 12

how to interpret Beta

Answer 12

how does the value of the risk tie in with the overall market performance (systematic risk). Beta > 1 high risk and volatile returns / Beta < 1 low risk and stable returns

Question 13

what is a preference shareholder

Answer 13

they typically receive a set amount of dividends per year and are higher ranked than ordinary shareholders if the company was to become liquidated. They do not have any voting powers

Question 14

what is Weighted Average Cost of Capital (WACC)

Answer 14

this is the minimum rate of return that a company must earn in order to finance its assets - it is usually compared to return on capital employed in order to determine if there has been any additional value created for its shareholders - this is not determined by management but rather the market itself

Question 15

how to reduce the WACC and the optimal capital structure

Answer 15

debt is usually lower in cost than equity and is suitable if the financial leverage is low. however, the more this is done the higher the company’s finical leverage will become and the more riskier the business will become

Question 16

what are the limitations of the dividend growth model?

Answer 16

it lacks consistency and can also only be used on company’s that pay dividends at a rising rate. It is also deemed to conservative as it doesn’t take into account stock buybacks

Question 17

what is the capital asset pricing model

Answer 17

this is used to calculate the return that investors expect to receive given the level of risk that they are bearing.

Question 18

how to calculate the capital asset pricing model

Answer 18

Ri (expected rate of return) = Rf (market risk free rate) + beta (the relation between the value and systematic risk) * The market risk premium (expected return on the market - the risk free rate)

Question 19

how to Calculate the the weighted average cost of capital

Answer 19

WACC = the proportions of equity to debt * the cost of equity + the proportion of debt to equity * the cost of debt * 1 - tax rate

Question 20

what is the rapport shareholder value model

Answer 20

this model is a way for valuing a business on a discounting cash flow basis

Question 21

how is the rappaport model calculated

Answer 21

present value of operating cash flows within planning horizon + present value of operating cash flows after planning horizon + the current market value of securities and other non-operating investments

Question 22

what are the seven assumption drivers of the rappaport model

Answer 22

1) sales growth rate 2) operating profit margin 3) tax rate 4) fixed capital investment 5) working capital investment 6) planning period 7) the required rate of return

Question 23

what would be considered quantitative valuations methods

Answer 23

those that have measurable figures - income record, balance sheet data, cash generation, capital expenditure

Question 24

what would be considered qualitative valuation methods

Answer 24

measurements that are not tangible - quality of management, future growth potential, business maturity.

Question 25

what are the two assumptions of the dividend growth model

Answer 25

1. the current market value of the share are equal to sum of the future dividends which in and of itself are infinite 2. that they are consistently growing

Question 26

when would you use the Net Asset Value method (NAV)

Answer 26

when valuing a company that is in Finacial distress/liquidation or when the company is heavily reliant on assets to generate income

Question 27

Big Exam question time! How would you answer a question that is asking you what options shareholders should do in regards to selling all or one of their holdings in a company

Answer 27

1. first you would need to understand how the ownership structure of the Business work. this is simply done by Calculate their holding over the total current holding. this can then be followed up by providing the implications of their holdings in terms of control of the business.
2. Now you would analyse each option

(sell one-minority) if the purchasing of shares would mean that the 3rd party who intends on buying them would only have a minority holding in the company this would mean that they would not have control over the earnings or assets of the business and therefore the appropriate model would be the dividend-based valuation. this is done by calculating the dividend yield = latest annual dividend/share price

once you have this percentage AND THE COMPANY IS PRIVATELY LISTED you will need to add 20% of the yield each to the yield due to the lack of marketability and transferability.
Finally to calculate the value per share = Dividend per share / dividends yield to get a value per share.

(Sell one-majority) if this sale would result in the 3rd party becoming a majority shareholder then it would make sense to use the asset-based valuation model due to their control over the business.
this is simply done by Calculating the net assets (assets - liabilities) / number of shares.

(Sell combined-minority) as this would mean that the 3rd party would be a minority stake holder we would need to use the earrings based model and subtracted lack of marketability and transferability as well as lack of control from the P/E ratio (20% of the P/E ratio each)

once we have calculated our P/E ration we would need to calculate the future maintainable earnings. this is done by (profit before tax + exceptional items) * (1-tax rate) finally you multiple the FME by the P/E ratio to get the value of the business which can then be divided per share.

(Sell the whole company) if we were to calculate the value of the whole company we would do the same for the steps before however now you would just not include the lack of control in the calculation.

3. finally you would recommend a solution

Question 28

what are the limitations in the Price-to-earings ratio

Answer 28

it tells the company very little about the company’s future growth prospects and fails to consider any exceptional losses.

Question 29

what is the limitations of the dividend yield model

Answer 29

It does not take into account the reasons behind the dividends being paid out. under this method it would suggest that the higher the dividend pay out the more valuable the company is. however this could be reckless management decisions leading to these high dividends. on the other hand if the company is not releasing dividends in order to grow the company this would make the company less valuable but it doesn’t consider that this could be for future investments in the company.

Question 30

what are the limitations in the net asset value model

Answer 30

this model does not take into account external factors that largely influence business value. take apple and Tesla. both of these companies gain a large market value due to the management that run them and there over market perception. not just the amount of assets the company hold.

Question 31

How would you use the dividend growth model

Answer 31

the current share value = cost of equity * (1 + dividends growth rate) / (cost of equity - dividend growth rate)

Question 32

what is relevant cash flows

Answer 32

these are cash flows that can fluctuate over their life due to external factors like interest rates and inflation

Question 33

what is difference between special and general inflation

Answer 33

special relates to the changing in prices for individual goods and services. where general reduces the overall purchasing power of money

Question 34

Exam question - how would you evaluate an investment in a project using the net present value method

Answer 34

first you would need to include the initial investment as a negative into the project at year 0, then you would deduct the initial cost of capital. this will give you the net cash flow line. next you need to calculate the discounting factor which will give you the discounted cash flow.

Then from year 1 to year x you can include the operating cash flow multiplying it by the discounting factor.

at the end of the project you need to add back the scrap value and add back the working capital that was subtracted at the start.

the sum of the discounted cash flow values will give you the NPV.

Question 35

Exam question - How would you incorporate tax written down allowances with net present value.

Answer 35

the first year would start with the initial investment, and then you would deduct the written down allowance and this deduction is multiplied by the tax saving rate. this is done over the following years until you get a scarp value at the end of the life cycle.