Initiate data input function Flashcards
Investment timing:
When should you delay an investment?
Delay = If the NPV will go up and other circumstances will remain
Long vs short lived equipment:
EAC?
Steps to making a decision?
EAC = equivalent annual cash flow Steps = 1: calculate NPV on options, 2: calculate EAC on options, 3: calculate PV perpetuity on options
When to replace an old machine?
Steps to making a decision?
Steps = 1: Calculate the EAC of the new machine. 2: formulate timelines for the relevant circumstances including salvage value. 3: calculate the NPV for the available options.
3 critical assumptions of annuity/perpetuity?
We have an annuity payment that started at the end of year x for n years. What do we need to consider in finding the PV?
- The first annuity payment is at the end of the first period
2: There are n payments in the annuity series or infinite number of payments in the perpetuity
3: PV is calculated at year 0
Consider = We need to first find our PV of the annuity at the start of year x and the bring this back a further x-1 years to calculate the pv as at year 0 i.e. (1+i)^-(x-1)
… in the case of a perpetuity x-1 becomes -infinity
Cost of capital?
Opportunity cost of capital?
When should the firm use a higher cost of capital?
Company cost of capital?
Cost of capital = the return investors (equity, debt) require in order to invest (provide capital) i.e. capital (which we need to run our firm) has a cost (the return we must give to our investors) = primarily dependant upon the use of funds, not the source (no dependant upon who gave me the capital, rather how i used it in risky projects)
opportunity cost of capital = the expected return that is forgone by investing in a project rather than in financial securities with the same risk
Use higher cost of capital = when the project is high-risk
Company cost of capital = the opportunity cost of capital for investment in the firm as a whole = defined as the expected return on a portfolio of the firms existing debt and equity securities = percentage of debt multiplied by percentage cost of debt + percentage of equity multiplied by percentage cost of equity
When there is no debt oustanding, what is the company cost of capital?
Why do we incorporate (1-T) into our WACC?
Under CAPM what does Beta tell us?
What does R^2 tell us?
How do we find the range of possible error in the estimated beta?
What determines a stocks total risk?
No debt = cost of capital is just the cost of equity
(1-T) = because interest from paying off debt is infact a tax-deductible expense
Beta tells us = how much on average the stock price changed when the market return was 1% higher or lower
R^2 = measures the proportion of the total variance in the stocks returns that can be explained by market movements i.e. measures market risk
Range of possible error in beta = We need the Beta as well as the standard error and then we simply produce a confidence intervale ( beta - 2 x standard error, beta + 2 x standard error)
Total risk = a small portion is due to movements in the market, the rest is firm-specific, diversifiable unique risk ( 1 - R^2 produces the diversifiable risk)
What determines asset betas?
What does not affect asset betas?
Affect Asset betas = 1: Cyclicality = Cyclical firms, whose revenues and earnings are strongly dependent on the state of the business cycle, tend to be high-beta firms, so high returns will be required. 2: Operating leverage = other things being equal, the alternative with the higher ratio of fixed costs to project value is said to have higher operating leverage and thus higher asset beta. 3: Other sources of risk = A long-term project is more exposed to shifts in the discount rate caused by changes in the risk free rate or the market risk premium and therefore will have a high beta.
Do not affect asset betas = diversifiable risks do not affect asset betas and discount rates
If a firm issues more debt to repay its outstanding equity, what happens to our Betas?
Betas = Our Asset beta remains the same, however the debt beta and equity beta go up. debt beta rise is due to default risk to debtholders increasing (more debt = harder to pay) and the equity beta rise is due to financial risk to shareholders (shareholders may loose money if companies cash flows do not meet expectations of debt)
Allowing for possible bad outcomes:
When allowing for possible bad outcomes what are we doing?
Once we have determined our PV, factoring in bad outcomes, how would we determine the correct discount rate?
What we are doing = we weight each of the possible cash flows by their probability to produce our probability-weighted cash flows. We then add all of these probability weighted cash flows together to produce our PMT. hence using the relevant annuity factor we will be able to find the correct PV which concerns the possibility of bad outcomes too.
Correct discount rate = we would simply equate our calculated PMV to our expected outcome (not our bad outcome, or good outcome, or weighted PMT) divided by (1+r) and then solve for r
Note: we can calculate the fudge factor by subtracting our given discount rate from the correct discount rate.
What is a sensitivity analysis?
What are the benefits (2) ?
What are the drawbacks (2) ?
Sensitivity analysis = recalculating the NPV of a project as each underlying variable is set one at a time at its optimistic or pessimistic value and all other variables are as expected (calculate NPV under expected outcomes, then calculate NPV by only changing one factor at a time)
Benefits = forces the manager to identify the underlying variables and calculate the consequences of misestimating the variables + indicates where additional information would be most useful, and helps to expose inappropriate forecasts
Drawbacks = what exactly optimistic or pessimistic means + underlying variables are likely to be interrelated not independent
What would we use scenario analysis for?
Under break-even analysis, what are the two main considerations that vary between accountancy based break-even and finance based break-even?
Scenario analysis = if we identify that variables are interrelated, we may use scenario analysis to look at different but consistent combinations of variables (whereas sensitivity analysis looks at one variable at a time)
Break-even = Accountancy based break-even analysis fails to consider the opportunity cost of capital or the time value of money
Operating leverage:
Contrast the operating leverage and business risk of a company with high fixed costs vs one with high variable costs?
When calculating DOL, how do we interpret our result?
Contrast = The company with high fixed costs will have higher business risk and higher operating leverage as they will HAVE to produce x amount in order to overcome their large fixed costs.
Note: operating leverage is usually defined in terms of accounting profits rather than cash flows
DOL = The result of our DOL equation, lets say 2.5, would be interpreted as a percentage (2.5%) which indicates what a 1% shortfall in project revenue would do to profits (a 2.5% shortfall in profits)
Monte Carlo simulation
What is it used for?
What are the steps (4)?
Use = a tool for considering all possible combinations of variables and showing the entire distribution of project outcomes
Steps:
1: Give computer equations to specify interdependence between different variables and different periods
2: Specify probabilities of possible forecast errors for each of the variables that determine cash flow
3: Select at random a value from the
distribution of each variable and calculate the net
cash flow for each period, repeat the process
thousand times to get probability distributions of
the project cash flows in each period (which reflect
project risk)
4: Calculate the expected cash flows from the distributions of project cash flows to find their present values
What are real options?
What are our four real options?
What are decision trees useful for?
Real options = companies act upon positive or negative outcomes, if a project is going great then they may expand, etc. Options to modify projects are known as real options
1: Option to expand
2: option to abandon (cut losses)
3: Timing options (to postpone investments)
4: production options (to provide flexibility in production)
Decision trees = help companies determine their
options by showing the timing of sequential
decisions and possible cash flow outcomes
Magna Charter: (decision tree)
What do Squares mark?
What do circles mark?
How do we show probabilities?
How do we show potential cash flows?
Procedure for determening the best option?
When we incorporate multiple real options throughout our decision tree, how do we value of option?
If one of our options produces a negative NPV what do we do?
Squares = decisions/actions
Circles = represent an outcome revealed by the economy/market at the time
probabilities = in parenthesis next to each outcome
cash flows = as an amount directly under each outcome
Procedure = we start with the right most square (decision/action) and figure out the NPV of that decision/actions outcome. We then keep doing this for all squares moving from right to left and factoring in NPV for squares we may have calculated prior
Valuing an option = determine the NPV with and without the real option and subtract the two to produce the value of the real option.
Negative NPV = if an option produces a negative NPV we equate it to zero as we would not consider an option with negative NPV
When an asset has an active market why do we not need to forecast future prices?
What does this mean for NPV calculations?
Dont forecast future prices = because in an active market an asset will be priced equal to the present value of the future price.
NPV calculations = when you have the market price of an asset USE IT! and remember market price is already the PV of the asset and as such does not require discount calculations. However annual costs still require discounting.
What are Economic rents?
Where do positive NPVs stem from?
What does corporate strategy aim to do?
What is the key to investing?
Economic rents = Profits that more than cover the cost of capital i.e. NPV = PV (rents)
Positive NPV = stem from a comparative advantage which may arise from a willingness to pay due to scarcity
Corporate strategy = aims to find and exploit sources of competitive advantage (in the long run, competition eliminates economic rents and no competitors can expand and earn more than the cost of capital on the investment)
Key to investing = determining the competitive advantage of any given company and, above all, the durability of that advantage
Michael porters five aspects of industry structure that determine which industries are able to provide sustained economic rents?
- Rivalry among existing competitors
- likelihood of new competition
- Threat of substitutes
- Bargaining power of suppliers
- Bargaining power of customers
3 ways a firm can secure competitive advantage within its industry?
1: Focus on better products (e.g. iphone)
2: Lower costs (e.g. IKEA)
3: particular market niche (Rolex)
As per our Starbucks case study:
What are seven factors which lead to failure
Failure:
- Failure to adapt product to different market
- Overconfidence in the products point of difference (what makes starbucks unique in america, does not necessarily make it unique in a good way here)
- Rapid expansion without consideration of service quality benchmark levels
- perception of the brand forcing itself onto an unwilling public due to its rapid expansion (grew so fast it felt forced, didnt grow in-line with needs of customers)
- Failure to advertise, as Australian culture is already dominated by coffee houses
- Didnt use franchising and as such the company owned all stores and so had little knowledge of local preference
- Used an unsustainable business model where people could buy 1 coffee and sit for hours
As per our starbucks case study
What are five valueable lessons?
- Crossing international borders is risky, so in-depth research is absolutely vital. Starbucks did not do their homework.
- Think global, but act local. Even well known and well-liked brands must adapt their products for local tastes.
- Establish a differential advantage then strive to sustain it, ensuring your product is unique enough to stand out amongst its competitors, and that it always will.
- Keep sight of what first generated the business’s success. At Starbucks, sales targets destroyed the idea of high-quality service that the brand had been built upon and which was the only competitive advantage it had.
- Consider the viability of the business model. If your model relies on charging a premium price, for instance, ensure the product on offer will be recognised as premium.
How do we calculate competitive prices (equilibrium prices)?
Competitive price = We must equate the NPV to zero to solve for unit price.
Calculating NPV:
Q1: What is the first thing we do (quickly get out of the way)?
Q2: What are the remaining factors we must look at (simply list them)
Q3: How do taxes effect our NPV
Q4: What are the discount rates we use for each component of our NPV model.
Q5: What do we use as n for our annuities:
Q1A: Firstly we subtract the initial investment at T=0
Q2A: Depreciation, revenue and costs
Q3A: 1:Taxes will subtract from the value of our revenue (as we pay some of our revenue to the government). 2: Taxes will decrease our costs at (1-T) (because costs are tax refundable). 3: Taxes will decrease the cost of our initial investment (as we define the cost of our initial investment through depreciation. In essence we break up the investment over x amount of years as depreciation and receive money back just as we would with operating costs (as per above)).
Q4A:
1: Initial investment = no discounting
2: Revenues = at cost of capital rate (unless revenue is determined by a market price)
3: Costs = at cost of capital rate
4: Depreciation = at the after-tax interest rate which is calculated as (1 - T) x nominal interest rate. Note: We also dont need to add depreciation back in if we simply multiply depreciation by T in the first place and not 1-T
Q5A: for our annuity factors n will be economic life, except for depreciation which will be at whatever the applicable straight line life is.
What are the five reasons why top management cannot always bypass middle managers and employees to make investment decisions? (five incentive bypass problems)
How do top managers overcome these problems?
1: Top management must rely on analysis done at lower levels as they themselves analyse many projects every year
2: The details of a capital investment project are beyond the view of executives and top manager cannot afford the time to investigate every alternative
3: Many investments are not in the capital budget, including R&D, worker training, marketing outlays designed to expand a market
4: Operating managers make small decisions every day such as inventory levels; these small decisions add up to large capital outlay
5: Executives are subject to the same kinds of temptations that afflict lower layers of management
Overcome = by ensuring that middle managers and employees have the right incentives to find and invest in positive-NPV projects
List 4 temptations managers on a fixed salary will face (Agency problems in capital budgeting)
Managers on a fixed salary will face various temptatiosn all of the time
- reduced effort - slacking off
- Perks - non-pecuniary rewards
- empire building - reluctant to disinvest
- Entrenching investment - projects that require or reward the skills of existing managers
In regards to Agency problems and risk taking managers are often risk averse, however their are exceptions, list 4?
- Managers must take some risks along the way to reach the top ranks
- Managers compensated with stock options have an incentive to take risk
- Managers sometimes have nothing to lose by taking on risks; gambling for redemption
- Organisations hesitate to curtail risky activities that are delivering, at least temporarily, rich profits
Monitoring of managers efforts is important to reduce agency costs. Who actually does the monitoring (5)?
- Board of directors - ASX requirement of a majority of independent directors
- Auditors - ensure consistency with accepted accounting principles
- Lenders – bank tracks company’s assets and cash flow to protect its loan
- Shareholders – can seek board nomination or sell out
- Rival companies – can take over poorly run businesses
What are management compensation plans used for? (4)
- attracting and retaining competent managers
- Giving managers the right incentives (motivation)
- reducing the need for monitoring
- Encouraging managers to maximise shareholder wealth
Upon analysing the argument that CEO compensation is too generous what are three major concerns? What are two alternative views on high conmpensation
What is the ideal sollution?
- Excessive pay, especially for mediocre performance
- Poor governance
- compensation to bankers who brought the GFC
- Talent is lacking so incentives are required
- arms-length contracting for managerial talent
Ideal solution = incentive contracts to maximise shareholder wealth
Compensation based on:
1. input (managers efforts) (although this is hard to observe)
2. output (income or value added as a result of the managers decisions) (however this can be effected by factors outside the managers control
What are four forms of incentive compensation?
- Bonuses - depend on accounting measures of profitability
- stock options
- restricted stock - stock that must be retained for several years
- performance shares - shares awarded only if the company meets an earnings or other target
What are four issues with tying compensation to stock prices?
- Stock prices depend on market and industry developments, thus exposing managers to market risks that are outside their control
- If today’s stock price already anticipates superior future performance, the improved performance will not be rewarded with a superior stock-market return
- Tempts managers to withhold bad news or manipulate reported earnings to pump up share prices
- Stock options can encourage excessive risk-taking; gamble for redemption when options are “underwater”
What are two things an ideal compensation system ensures?
In regards to an ideal compensation system what are the ASX corporate governance principles?
Is executive compensation regulated heavily?
Can shareholders do much about runaway CEO pay?
- that pay is reasonable
- that pay is linked to performance
Principles = Remunerate fairly and responsibly
heavy regulation = no
Shareholders = Companies must vote every three years on executive compensation, however the vote is non-binding unless a company decides otherwise
What are two advantages and three disadvantages of using accounting measures of performance?
A1: not based on performance relative to investors expectations
A2: Make it possible to measure the performance of junior managers who are responsible for only one division or plant
D1: Can increase current income by cutting back on investment outlays that should pay off in later years
D2: Accounting earnings are biased measures of true profitability
D3: Earnings can grow but still destroy value by not covering the cost of capital
In regards to compensation, how do companies recognise the cost of capital?
Many companies tie compensation to net return on investment (net ROI) or economic value added (EVA)
Net ROI = Book ROI - cost of capital
Book ROI = (after tax operating income) / (net depreciation book value of assets
EVA = residual income = income earned - income required = income earned - (cost of capital x investment)
What are the pros (4) and cons (4) of EVA?
- Makes the cost of capital visible to managers
- Managers are motivated to invest in projects that earn more than the cost of capital
- Leads to reduction in assets employed as unneeded assets are disposed of
- Can be used as an incentive compensation system to substitute for explicit monitoring
- A low EVA may be a consequence of factors outside the manager’s control
- Is still an accounting measure of performance, it depends on accurate measures of earnings and capital employed
- Unless adjustments are made to accounting data, the measure is biased and rewards quick payback projects
- Does not measure present value, so may underestimate the true profitability of new assets and overestimate that of old assets
When discussing bias in accounting measures of ROI and EVA what are the issues at hand?
- Book ROI and EVA are underestimated at first and overestimated thereafter. This is because book incomes does not measure true economic income and accounting income is too low when a project is young
- The greater the pressure for immediate book profit and EVA to reflect better performance, the more the manager is tempted to favour quick-payback projects
Contrast economic income and accounting income
Economic income factors in the PV of cash flows
Economic income = Cash flow - economic depreciation = C1 + (PV1 - PV0)
Accounting income = Cash flow - accounting depreciation
Economic rate of return = economic income / PV at start of the year
Accounting rate of return = Accounting income / BV at start of year
Many CEOs and CFOs pay too much attention to earnings, at least in the short run, to maintian smooth growth and to meet earnings targets. What are two issues with this?
When a firms earnings fall short by a few cents what can happen to stock prices? Resultantly what do we often see happen?
- Adjustment of firm operations and investments are made to manage earnings = reductions to spending in R&D, advertising, or maintenance if necessary to meet earnings targets
- Rejecting/deferring of positive NPV projects
Short earnings = stock prices can sometimes fall sharply as the market might assume that not delivering the target reveals potentially serious problems
Resultantly: With remarkable regularity, EPS either met or beat security analysts’ forecasts, but only by a few cents. AND. CFOs appeared to report conservatively in good times, building a stockpile of earnings that could be reported later for a rainy day
Under sustainable investment what are three perspectives to consider?
Environmental, social, governance (encompasses the rules, relationships, policies, systems and processes whereby authority within organisations is exercised and maintained)
What are the 6 principles under The United Nations-supported principles for responsible investment (PRI)
- We will incorporate ESG issues into investment analysis and decision-making processes.
- We will be active owners and incorporate ESG issues into our ownership policies and practices.
- We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- We will promote acceptance and implementation of the Principles within the investment industry.
- We will work together to enhance our effectiveness in implementing the Principles.
- We will each report on our activities and progress towards implementing the Principles.
Define the following terms: Active Ownership Community investment Corporate governance Corporate social responsibility Divestment Ethical investing Negative screening Positive screening Responsible investment statement restricted list Shareholder activism Short-termism Stranded assets Sustainability report Triple bottom line Universal owner
Active ownership = Voting and or engaged dialogue concerning ESG issues as well as business strategy issues
Community investment = capital from investors that is directed to communities underserved by traditional financial services (providing credit, equity, capital and basic banking products otherwise unaccesable)
Corporate governance = the procedures and processes according to which an organisation is directed and controlled
CSR = the approach to business which takes into account economic, social, environmental and ethical impacts for a variety of reasons, including mitigating risk, decreasing costs, and improving brand image and competitiveness
Divestment = selling or disposing of shares or other assets = for example stanford university pledged in 2014 to not directly invest in the mining of coal for use in energy generation
Ethical investing = the investment philosophy guided by moral values, ethical codes or religious beliefs
Negative screening = an investment approach that excludes some companies or sectors from the investment universe based on criteria relating to their policies, actions, products or services
Positive screening = opposite of negative i.e. using non-traditional criteria to determine whether or not to invest
Responsible investment statement = a general statement on responsible investment adopted by boards of trustees or directors that direct investment staff practices and decisions
restricted list = a list of securities that are not to be included in a portfolio by an investment manager
Shareholder activism = a public or confrontational approach to shareholder engagement
short-termism = bias that some investors demonstrate for near-or immediate-term investment performance share share price appreciation instead of long-term investment performance
stranded assets = assets that may have already or may in the future be written down in value e.g. coal mines if in the future we no longer require coal
sustainability report = a report produced by an organisation to inform stakeholders about its policies, programmes and performance regarding environmental, social and economic issues
Triple Bottom Line = a holistic approach to measuring a company’s performance on environmental, social and economic issues. The triple bottom line focuses companies not just on the economic value that they add, but also on the environmental and social value that they add or destroy
Universal owner = a large investor who holds a broad selection of investments in different public companies as well as other assets and who therefore is tied to the performance of markets or economies as a whole.
List the pros and cons of negative screening
Under positive screening what are 6 categories to look at?
Pro: Allows for a transparent process in particular for fund managers
Con: restricts the range of possible investments = possible negative effect on risk return profile
Con: Makes it difficult to match a benchmark index
Positive screening = Look at corporate governance of company, customers and suppliers, local engagement, human rights, human resources policies, environmental relationship.
List the four core investment strategies concerning sustainable investment
Negative screening
Positive screening
Best-inclass Approach = composition of a portfolio from the list of names that survive both ESG and financial screening i.e. the active selection of only those companies that meet a defined ranking hurdle established by ESG criteria. = may restrict investment universe but also open to ‘dirty’ companies gaining entry
Thematic approach = focus on specific theme and/or sector which may have economic potential while maintaining the pursuit of an environmental or social goal. Allows the investor to clearly invest in personal convictions but again limited universe
What are two broad investment strategies concerning sustainable investment?
Active shareholder engagement = shareholder engagement via voting, letters, petitions, public appeals.
ESG ratings = companies who provide an ESG rating (using this to guide investment decisions, however most companies tend to use this + their own analysis.
Define ethics Define business ethics Who decides what is "right"? Define values Who do we owe loyalty to?
Ethics = a set of moral principles or values
Business ethics = the principles, norms and standards of conduct that operate within business
Who decides = the society in which the business operates
Values = ones core beliefs about what is important, what is valued and how one should behave across a wide variety of situations
loyalty = owed to stakeholders
What are two forms of moral reasoning?
Consequentialist morel reasoning = locates morality in the consequences of an act, in the state of the world after acting
Categorical moral reasoning = reasoning depends on intrinsic quality of act, some actions appear categorically wrong
What are the three main branches of normative ethics
Consequentialism = What matters is the net balance of good consequences over bad = “will the actions serve the greater good of society” “Will the benefits outweigh the costs”
Deontology = focus on duties, obligations and principles = “do unto others as you would have them do unto you”
Virtue ethics = focus on integrity = considers the motivations, intentions and character of the individual
Accross which three levels can ethical dilemmas take place?
Country (nigerian mining deal with australia), company (ENRON) , individual (Ponzi scheme)
Three special topics in finance ethics:
Conflict of interest:
What?
How to manage?
Insider trading:
What?
Whistleblowing:
What?
Outline an effective whistle-blowing policy
What = when there is a conflict between personal and business interests = can occur due to bribes, misuse of positions or a violation of confidentiality
Avoidance = avoid acquring any interests that might bias your judgement
Objectivity = a commitment to being objective
Disclosure = allows clients to carefully look for any bias
Competition = ensures best rate or similar is taken
Rules and policies = prohibiting kind gifts or similar
Independent judgement = utilize a third party
structural changes = compartmentalise services
What = the illegal practice of trading on the stock exchange to one’s own advantage through having access to confidential information
What = the voluntary release of non-public information, as a moral protest, by a member or former member of an organisation to an appropriate audience outside the normal channels of communication regarding illegal and/or immoral conduct in the organisation that is opposed to the public interest.
Effective whistle blowing policy =
1) An effectively communicated statement of responsibility
2) A clearly defined procedure for reporting
3) Trained personnel to receive and investigate reports
4) A commitment to take appropriate action
5) A guarantee against retaliation
In australia who is responsible for the enforcement of corporations law and regulation?
What are some of their requirements?
What is generally the most important law for corporations in Australia?
What does this law cover?
Responsible = ASIC = The Australian Securities and Investment Commission
Requirements = maintain, facilitate and improve the performance of the financial system and entities in it
Important = the Corporations Act 2001 Covers = The duties of Directors, officers and employees, shareholder rights, financial reports and audit, related party transactions, continuous disclosure.
Modigliani and Miller proposition 1: (No taxes)
What did they show?
What was their famous proposition?
What did this proposition imply?
Outline the law of conservation of value?
Showed that = any combination of securities is as good as another in a perfect market
Famous proposition = “the market value of any firm is independent of its capital structure”
Imply = the firms value is determined by its real assets, not by the securities it issues
Law of conservation of value = we can slice a cash flow into as many parts as we like, the values of the parts will always sum back to the value of the unsliced stream
Modigliani and Miller proposition 2:
What did they show?
Showed that = the expected rate of return on equity increases in proportion to the debt-equity ratio = the more debt the firm has, the greater the return on equity
Financial risk and required return:
What is the risk associated with equity?
What is the risk associated with debt?
equity = business risk debt = financial risk
Interest tax shield:
What is the effect of the interest tax shield in regards to capital structure?
What does the tax shield depend on?
Effect = the total income that a levered firm can pay out to its debtholders and shareholders increases by the amount of the interest tax shield
tax shield depends on = the marginal corporate tax rate and on the ability of a firm to earn enough income to cover interest payments
Modigliani and Miller and taxes:
What do MandM say about tax?
They state that = although the pretax firm value is not affected by debt-equity mix, anything the firm can do to reduce its tax bill, such as borrow money will make shareholders better of
Two means of payout?
When can a company pay a dividend?
When are shares traded ex dividend (without dividend)?
Two means = dividends or repurchasing shares
Pay dividend = when assets exceed liabilities, if not then not allowed to pay dividend
ex dividend = shares are bought and sold cum dividend until 2 business days before the record date, and then shares trade ex dividend
What are stock dividends/stock splits?
What are the effects of a stock dividend?
What is a DRP? What is the main advantage for the company? what are 3 disadvantages?
Stock dividend = additional stocks awarded as per a specified percent of currently held stocks, as opposed to a cash payout i.e. stock dividend of 5% gives each shareholder an extra 5 shares for every 100 they own
Effects = number of shares on issue increase. Profits, assets and total value are unaffected. Value per share decreases
DRP = Dividend reinvestment plan = allows shareholders to have dividends on some or all of their shares automatically reinvested in the company, without transaction costs and usually at a small discount to the market price.
Main advantage = allows firm to retain part of their dividends as internal cash flow
Disadvantages = (1) Non-participating shareholders suffer whenever a price discount is offered (2) The price discount may be more expensive than the issue costs incurred in a regular share issue. (3) DRP may result in more cash being retained than companies can invest.
The introduction of a DRP allows firms to meet shareholders demand for higher dividend payouts without using more cash:
How would we calculate the new dividend payout value per share post-DRP?
Simply take the initial dividend payout amount per share, lets say $1, and then divide by 1- the percentage of people who undertook the DRP. Hence, if the introduction of a DRP attracts a 20% reinvestment rate…
1/(1-0.2) = 1.25 = post-DRP dividend payout per share
Share repurchases:
on-market vs off-market, what is the difference?
What must happen with repurchased shares?
What are share repurchases primarily used for?
on-market = shares repurchased through the market as a normal market transaction off-market = buy-back at a fixed price offered to all or some shareholders
cancellation of shares = shares must be cancelled in Australia when bought back (or sometimes used for DRP purposes)
primary use = as a device for distributing surplus cash to investors
According to Lintner (1956) what are three key observations concerning managers and dividend payouts?
- Managers are reluctant to make dividend changes that may have to be reversed i.e. changing dividend payout from $1.5 to $2 and then having to change it back to $1.5 because times are hard.
- To avoid the aforementioned risk of reduction in payout, managers “smooth” dividends i.e. managers use target ratios to move partway towards a target in each year
- Managers focus more on dividend changes than on absolute levels i.e. focus more on potential payout changes than on no changes
What information do investors draw from:
A dividend increase?
A dividend cut?
Dividend increase = managers do not increase dividends until they are confident that the new level of dividends is sustainable by future earnings = therefore announcement of a dividend increase signals managers confidence of higher future earnings (leading to a rise in the stock price)
Dividend cut = taken as a signal of a cash or earnings shortfall, managers usually put off cuts until enough bad news accumulate to force them to act.
What information do investors draw from:
Where stock repurchases are used to return unwanted cash?
Where stock repurchases are used in general?
How does the market typically react to share repurchases?
return unwanted cash = signals that the firm is running out of positive NPV projects to invest in
stock repurchase = may signal managements confidence in the future that the share is undervalued
Market reaction = on average the share price appears to rise, even more so if a premium is offered when buying back shares
In regards to share repurchases and dividend payouts, what was MandMs key finding?
What happens to share price after dividend payout?
What happens to share price after stock repurchase?
What happens to shareholder wealth with dividend payout vs share repurchase?
Considering the above questions, outline the difference between dividends and repurchases?
Any change in dividend payout must be offset by the sale or repurchase of shares
After dividend payout = equity decreases by payout amount, however outstanding stock remains the same = share price drops = New share price equals to prior share price - pay out i.e. share price of $130 and then a dividend of $1 results in new share price of $129 (ex-dividend) (or still $130 cum-dividend)
After stock repurchase = outstanding shares and company equity will fall in equal ratio = stock price remains the same
Shareholder wealth = remains the same under either circumstance ( as long as each pertains to the same magnitude i.e. $100 total payout vs $100 total share repurchase)
Difference 1 = repurchase avoids the fall in stock price that would occur on the ex-dividend day if the amount spent on repurchases were paid out as cash dividends
Difference 2 = Repurchases reduce the number of shares outstanding, so future earnings per share are higher than if the same amount were paid out as dividends
Their exists two approaches for calculating stock price through present value calculations when the number of shares is changing due to share repurchases. can you outline both?
Approach 1: Calculate the total value of all shares (market capitalisation) by discounting the free cash flow expected to be paid out to shareholders. Then calculate price per share by dividing total value of shares (market capitalisation) by the no. of shares currently outstanding.
PV = Future cash flows / r (r=cost of capital)
Price per share = PV / No. shares
Approach 2: calculate the PV of dividends per share, taking account of the increased growth rate of dividends per share caused by declining no. of shares as shares are repurchased:
PV = DIV/(r-g)
Ultimately what do dividends depend on when companies are deciding each year’s dividend?
Why are managers and investors more concerned with dividend changes than with dividend levels?
Do managers increase dividends temporarily, why or why not?
When share repurchases are being made, will the company finance these repurchases with a dividend cut?
Dividends depend on = The dividend depends on past dividends, and current and forecasted earnings.
concern for dividend changes = This is because dividend changes convey information to investors about future earnings
Temporary dividend increase = No they do not. managers attempt to “smooth” dividends so as to not communicate certain types of information. However, they may pay a “special dividend”
Share repurchase and dividend cut = No they will not. Again, the company will be concerned about changing dividends.
Outline the different taxation structures for operating income paid out as interest vs operating income paid out as equity income? Use an operating income of $1 to help clarify
Paid out as interest = Here we recognise that since we are paying our operating income out as interest on debt there are no initial corporate taxes taken out. However, there are personal taxes taken out for the debtholder (one receiving the interest). Hence income after all taxes = 1-Tp (where Tp = personal tax to debtholder
Paid out as equity income = Here we recognise the operating income as that of the firms and as such an inital corporate tax must be taken out i.e. 1-Tc. Furthermore there are personal taxes to be taken out for the equity-holder who is receiving an income. That is the personal tax = Tpe(1-Tc). Henceforth the income after all taxes will be (1-Tc)-Tpe(1-Tc) = (1-Tpe)(1-Tc)
Outline the Relative advantage formula:
Outline the Tpe formula:
RAF = (1-Tp)/((1-Tpe)(1-Tc)) = simply divide the income after all taxes for a debt-holder by the income after all taxes for a stockholder.
RAF > 1, debt is better
RAF < 1, equity is better
RAF = 1, debt policy is irrelevant
Tpe = (dividend payout ratio x dividend tax rate) + (retention ratio x capital gain tax rate)
- essentially it is a weighted average of dividend tax rate and capital gain tax rate
Under what condition is there little net tax advantage to borrowing?
What do we mean by Costs of financial distress?
What are the two types of costs we refer to here?
At what point is the optimal debt ratio achieved?
Little net tax advantage = for firms that are unlikely to earn sufficient profits to cover interest payments and benefit from the corporate tax shield.
Costs of financial distress = Additional costs incurred in times when it is challenging to keep up with debt payments.
1) Bankruptcy costs = direct and indirect costs of using the legal mechanism allowing creditors (people whom money is owed) to take over when a firm defaults.
2) Costs of financial distress short of bankruptcy =
- 1) supplier and employees may not want to stay with firm = costly
- 2) conflicts of interest between debtholders and shareholders of firms in financial distress may lead to distorted investment decisions = costly
- 3) shareholders acting in their narrow self-interest can gain at the expense of creditors by playing “games” that reduce the overall value of the firm = costly
Optimal debt ratio = is determined at where the marginal benefit of tax shield due to additional borrowing is just offset by the marginal increase in PV (costs of financial distress)
Financial distress without bankruptcy (distorted investment decisions):
Outline the idea of risk shifting
Outline the idea of refusing to contribute equity capital
Risk shifting = a firm may accept a high risk negative NPV project in times of distress. In doing so firm value / debt value will fall by the negative NPV amount = shareholders are essentially betting with debtholders money
- shareholders of levered firms gain when business risk increases as a result of negative-NPV projects
- the temptations to take risk and go for broke is strongest when the odds of default are high.
Refusing to contribute equity capital = Here we are considering a positive NPV project which would result in higher debt value and as such the payoff to debt holders if default were to occur would be higher = the greater the probability of default the more debtholders have to gain from investments that increase firm value.
Agency costs of debt:
What do we mean by the agency costs of debt?
How do lenders protect themselves?
Agency costs of debt = we are referring to the two games we have learned about which concern debt and financial distress. Where the firm managers will ignore potential resolutions on the debt end of things if it will interfere with the equity (shareholder) side of things.
Protection = to protect themselves, lenders put up fine print (or covenants) in the debt contracts stating what the borrower has to do and not do under specified circumstances (such as those relevant to the two games)
Costs of financial distress vary with type of asset: Discuss this statement?
Certain types of assets have their value effected by financial distress more than others. This loss of value is greatest for the intangible assets, such as R&D, that are linked to the health of the firm as a going concern.
The trade-off theory of capital structure:
Outline the theory?
Outline the implications for various types of companies?
To what do we attribute the delays experienced by firms in re balancing their capital structure to maintain an optimal level/range of leverage?
What does the theory successfully explain, what does it not?
Theory outline = The theory posits that firms have a target debt ratio that balances the costs of financial distress against the benefits of the interest tax shields
High target debt ratios = good for companies with safe, tangible assets and plenty of taxable income.
Low target debt ratios = good for unprofitable companies with risky, intangible assets
delays in re-balancing = due to the costs incurred in making the adjustments
Successfully explains = many industry differences in capital structure
Do not successfully explain = why the most profitable companies commonly borrow the least = under the theory, high profits should mean more debt-servicing capacity and a stronger tax incentive to use that capacity
The pecking-order theory of corporate finance:
Outline the theory?
Theory = states that firms prefer to use internally generated cash flow to finance investments, if external funds are required, the firm will prefer new issues of debt, followed by hybrid securities and new equity issues as a last resort.
= this explains why the most profitable firms within an industry borrow less - because they don’t need outside money = less profitable firms borrow more because debt is next on the pecking order when internal funds are exhausted.
i.e. internal financing first, external financing through debt second, and external financing through equity last.
Outline how Asymmetric information pushes firms to raise external funds by borrowing rather than by issuing common stock?
How can a firm avoid information problems and issue costs?
Pushes firms to raise external funds through borrowing = due to the pecking order theory, investors will perceive an issue of stock as the result of a firm not having enough internal cash flow and also not having the profitability to repay debts. As such investors will perceive securities as overpriced. Rather than providing underpriced securities, the firm will choose to finance through debt. By financing through debt the firm also signals to the market that managers are confident about the firm’s prospects and the firms future profits are sufficient to repay its debts. Henceforth asymmetric information pushes the company to raise external funds through borrowing rather than issuance of common stock.
Avoidance = if the firm has ample internally generated cash and does not have to sell any kind of security
Rajan and Zingales’ study:
Outline the four factors upon which they found debt ratios to depend (as well as the type of relation, positive or negative)
Size = positive relation
Tangible assets = positive relation
Profitability = negative relation (pecking order theory = if profitable then generating internal cash flow and doesn’t require debt)
Market to book ratio = negative relation
Financial slack:
What is financial slack?
What is required in order to have a large degree of financial slack?
outline the effects of having no financial slack vs too much
Financial slack = a measure of readily available cash, marketable securities, readily saleable real assets and ready access to the debt markets or to bank financing.
Large degree of financial slack = requires conservative financing so that potential lenders see the firms debt as a safe investment = financial slack is most valuable to growth companies that need financing to be quickly available for good investments.
no financial slack = firms work down the pecking order until they have to issue undervalued shares or borrow and risk financial distress
too much financial slack = tempts managers to over-invest, expand their perks, or empire build = makes agency problems between shareholders and managers worse.
WACC:
When the projects NPV is exactly 0, what will the WACC be?
Outline the 3 steps to adjust WACC when debt ratios differ?
NPV of 0 = indicates that the firms WACC is exactly equal to the expected return on the investment
Three step process when debt ratios will change due to acceptance of a project:
1) : Calculate the opportunity cost of capital. The formule used here is the WACC formula without the tax part.
2) : Estimate the cost of debt, rD, at the new debt ratio and calculate the new cost of equity, rE. (Use MM prop 2 formula)
3) : Recalculate the WACC at the new financing weights (with the same assets) using the new rE
Valuing businesses:
How do we calculate free cash flow?
How do we go about valuing a business?
Upon completing the prior valuation of a business, how could we further calculate the Value per share?
FCF = profit after tax + depreciation - investment in fixed assets - investment in working capital (do not deduct interest from the FCF)
Valuing a business = we use the formula PV(cash flows) + PV(terminal value). To do so we must:
1) : Forecast each years FCF out to an arbitrary medium-term valuation horizon. e.g. the FCF for the next 6 years.
2) : Calculate the PV horizon value by using the formula PVh = Future cash flows at the time of 1 year after year 6 (as year 6 is our horizon value) divided by (WACC - g). In essence a growth perpetuity. g = sales growth at time H+1
Calculate value per share = simply divide the PV of the company calculated - Debt by the no. of shares. = (PV(company) - Debt) / no. of shares
Estimating a firm’s WACC in practice:
How do we go about organising the sources of financing?
Step 1) (calculate the MV of outstanding securities)
How do we determine market value for our sources of financing?
Step 2) (calculate the after-tax cost for each source of financing)
How do we do this for debt and how do we do this for equity?
Step 3) (calculate the WACC)
How do we go about using our prior calculations to at last calculate the WACC?
Organise sources of financing = separate into debt and equity. Exclude accounts payable, other current liabilities, deferred taxes, accrued interest and provisions because they are not interest-bearing debt. Also exclude share capital, reserves and retained earnings as they are already collectively reflected in the market value of outstanding shares.
Determine market value =
1) : for short-term or floating interest loans, the face value is the market value.
2) : for bank mortgage loan calculate the PMT using the existing loan interest rate. And then calculate the PV using the current going interest rate i.e. took a loan at 10% 5 years ago, however if i want a new loan the going rate is now 11%. ( to correct for market value i will have to factor in the going 11% rate.)
3) : for bonds simply calculate the PV MV by discounting the coupon payments and the face value.
4) : for preference and ordinary shares the MV = no of shares * price per share. (as shares are sold at MV)
Calculate after-tax cost for sources of financing
1) : For debt simply use the formula rD(1-Tc) where rD is the CURRENT rate of interest
2) : for preference shares use the formula rP = annual dividend per share / market price
3) : for ordinary shares use CAPM to calculate rE (rF here is equal to the 10-year government bond rate)
Finally calculate WACC = find the weight of each financing source by calculating total market value (sum all MV) and finding the ratio of each financing source to total MV. Next simply multiply the weight of each financing source by the previously calculated After tax cost of each financing source. Then simply sum all of these products to produce WACC
