general study Flashcards
what is the purpose of profitability ratios
They determine the company’s overall financial condition
what is the purpose of efficiency ratios
They show how effective the company is at using assets to generate income
what is the purpose of liquidity ratios
It shows the company’s ability to pay its short term debt obligation
what is the purpose of financial gearing ratios
they determine how likely the company is to becoming insolvent
what is the purpose of investment ratios
They analyse what company is better to invest in
What is operating leverage
This is how a company’s increase or decrease in revenue will effect its operating income (earnings before interest and tax)
How to interpret the degree of operating leverage
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
What is financial risk?
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
how to interpret degree of financial leverage
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
How do we measure a company’s total risk
DTL = DOL * DFL - the higher the total risk a more sensitive a company’s NET PROFITS are to change in sales revenue
what is systematic risk
it is an area of risk that can note be reduced or eliminated through a diverse portfolio
how to interpret Beta
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
what is a preference shareholder
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
what is Weighted Average Cost of Capital (WACC)
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
how to reduce the WACC and the optimal capital structure
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
what are the limitations of the dividend growth model?
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
what is the capital asset pricing model
this is used to calculate the return that investors expect to receive given the level of risk that they are bearing.
how to calculate the capital asset pricing model
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)
how to Calculate the the weighted average cost of capital
WACC = the proportions of equity to debt * the cost of equity + the proportion of debt to equity * the cost of debt * 1 - tax rate
what is the rapport shareholder value model
this model is a way for valuing a business on a discounting cash flow basis
how is the rappaport model calculated
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
what are the seven assumption drivers of the rappaport model
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
what would be considered quantitative valuations methods
those that have measurable figures - income record, balance sheet data, cash generation, capital expenditure
what would be considered qualitative valuation methods
measurements that are not tangible - quality of management, future growth potential, business maturity.
what are the two assumptions of the dividend growth model
- 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
when would you use the Net Asset Value method (NAV)
when valuing a company that is in Finacial distress/liquidation or when the company is heavily reliant on assets to generate income
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
- 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.
- 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.
- finally you would recommend a solution
what are the limitations in the Price-to-earings ratio
it tells the company very little about the company’s future growth prospects and fails to consider any exceptional losses.
what is the limitations of the dividend yield model
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.
what are the limitations in the net asset value model
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.
How would you use the dividend growth model
the current share value = cost of equity * (1 + dividends growth rate) / (cost of equity - dividend growth rate)
what is relevant cash flows
these are cash flows that can fluctuate over their life due to external factors like interest rates and inflation
what is difference between special and general inflation
special relates to the changing in prices for individual goods and services. where general reduces the overall purchasing power of money
Exam question - how would you evaluate an investment in a project using the net present value method
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.
Exam question - How would you incorporate tax written down allowances with net present value.
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.
