KAPLAN 1-5 Flashcards
key decisions of fin manager
Inv - what projects should be undertaken by the company?
Finance - how should necessary funds raised?
Div - how much should be allocated to be paid as return to shareholders? How much should be retained to meet the cash needs of the business
free cash flow
Rev-Costs-Investments
cash that is not retained and reinvested in the business. it is available to
1. all providers of capital of a company
2. to pay dividends or finance additional capital projects
used as a basis for evaluating potential inv project
as an indicator of company performance
to calc value of a firm and thus potential share price
Free CF to equity = Free CF-debt interest (for disctrib to shareholders)
relevant CF (Rev and costs)
relevant Rev and costs
- future
- incremental
Ignore the following
- sunk costs
- committed costs
- non-cash items
- apportioned OH
inflation
increase in prices leading to a general decline in the real value of money
fund providers require
real retrun for the money and
additional return to compensate inflation
real rate of return (cost of capital)
(1+i)=(1+r)(1+h)
(1+r)=(1+i)/(1+h)
r- real rate
i - money/nominal rate
h = general inflation rate
specific inflation rate
impact all the individual CF items - each CF is affected by specific rate (different rate of infl?)
general rate of inflation
impacts investors’ overall required rate of return
Investors need compensation for their lost purchasing power, which relates to their ability to buy a basket of all goods, rather than any specific one
real method of reflecting inflation
- do not inflate CF - leave them in real terms, i,e in today’s prices - To
- Discount using the real rate
Only used when general inflation rate - all cash flows are inflating at general rate
money/nominal method
- Inflate each CF by its specific inf rate, i.e convert into money flow
- Discount using the money rate
It is ok in q-s involving specific inflation rates, taxation or working capital
PV factor
cost of capital = (1+r)(1+h)
tax impact
charged on operating CF
tax allowable depreciation (capital allowances or writing down allowances) can be claimed, = generate tax relief
company is earning net taxable profits
IRR
- discount rate at which NPV of an investment is Zero
- standard projects (outflows followed by inflows) should be accepted if IRR is greater than the firm’s cost of capital
- can be found by linear interpolation
Linear interpolation
- Calculate 2 NPVs at 2 different costs of capital
- Find IRR
IRR = L (lower rate of interest) + (NL /(NL-NH))*(H-L)
NL - NPV at lower rate of interest
H - higher rate of interest
3. Compare IRR with company’s cost of borrowing
problems with IRR
Assumption. it is not project specific - not return from the project. It is so only if the funds can be reinvested at the IRR for the duration of the project
Decision rule is not always clear cut espe when many projects with all greater than cost of capital
choosing bn projects. Since projects can have multiple IRRs (or none at all) it is difficult to usefully compare projects using IRR.
for unconven-l projects w/o structured inflow, no IRR, more than 1 IRR, so greater than CC doesn’t work
IRR is unrealiable bc project with high IRR may not necessarily be the one with highest return in NPV terms it is unreliable for choosing bn ME projects
MIRR
MIRR=Project’s return
MIRR or PR > company’s cost of finance - accept the project
MIRR interp
yield of the investment under the assumption that any surplus will be reinvested at the firm’s current cost of capital
It does not give a measure of the max cost of finance that the firm could sustain and allow the project to be worhtwhile
it gives margin of error or room for negotiation
MIRR formula
(PVR/PVI)^1/n*(1+re)-1
PVR - PV of ‘return phase’ of the project
PVI - PV of ‘investment phase’ of the project
Re - firm’s cost of capital
duration (macaulay)
average time to recover the present value of the project if discounted at cost of capital
If CF discounted at project’s IRR - can be used to measure the time to recover the initial investment
3 techniques to measure the return to liquidity offered by capital project
payback, discounted payback, and duration
in practice firm that has ready access to capital markets should not worry about it
cons of discounted payback period
does not take into account beyond project date CFs - projects with highly negative terminal cash flows can appear attractive bc of their initial favourable cf or project with high cf after payback date can be discarded too
Cons of payback
does not take into account beyond project date CFs
fails to take time value of money into account (discounted payback addresses it)
Profitability Indexes (PI)
identify shortage of funds (limiting factor) -> PI = NPV/PV of capital invested
MIRR
- cash inflows - find terminal value - if invested at reinvestment rate - TV at year 1 is 4000*1.06^4 (5 year project); at year 5 TV = 10000^1
- cash outflows - find PV of outflows - discounted at cost of finance
- MIRR = nth root of (TV inflows/PV outflows)-1 - n=project length
ifi MIRR - return on project< cost of finance -> reject
calculate Macaulay duration
Sum of (PV*year)/sum of return phase PVs only
modified duration
name given to price sensitivity: % change in price per unit change in yield
Modified duration = Macalay duration/(1+cost of capital)
MNC
generates at least 25% of revenue from activities in ocuntriws other than own
value of shares
is heavily dependent on future expected dividends.
important to consider the dividend policy of the copmany and the effect this may have on shareholders’ expectation
MM
profits, not dividend policy is important
large dividend -> little future growth
smaller dividend (and therefore more retention) will result in more growth in the future. company shoudl worry about profits
Ch4: Agency costs
restrictive conditions on
1. levels of dividend
2. on the level of additional debt that can be raised
3.on mng from disposing major FA w/o debenture holders agreement
static trade-off
companies will trade off bn
1. tax shield benefits and
2. reduction in value caused by PV of the cost of fin distress and bankruptsy and increased agency cost
if fin distress and agency costs exceed the benefits of debt (tax shield) - less debt
Pecking order
- internal generated CF 2. Debt 3. equity
order bc of issue costs
Assymetry of informaton -> issuance of shares mb regarded as bad news for company - no internal zcf
while no issuance signals that new share prices could be undervalued (bc manager are only motivated to issue when shares are overpriced!) as mng has infromation that its value is higher and projcct is awesome
announc of new share issues are greeted with decline in stock prices
High CF -> gearing ratio decreases
Low CF -> gearing ration increases
gearing drift
roce
indication of retrun before financing charges! PBIT/Capital+Loan
ROE - geared option achieves a higher return bc debt at 10% is costing less than the return on capital (25%). the excess return passes to shareholder enhancing their return. the only differenc bn ROCE and ROE will be due to gearing and taxation
effects of agency costs
restrictions may
- encourage use of RE
- restrict further borrowing
- make new issues less attractive to investors
more on agency
shareholders more willing to gamble on risky projects bc if it doesn’t work out they will share losses with debenture holders. there are other ways managers (appointed by shareholders) act in the shareholders’ interest rather than debt holders
large shareholder dividends will secure part of company’s value for shareholders at the expense of creditors
changing risk
firm may spend loan to more riskier projects, therefore covenants are there to restrict
- issuing new debt - with superior claim on assets
- dividends - no div if no earnings increase
- merger activitty - post merger assets backing
- investments’ policy
equity finance
is most expensive source of finance but flexible; interest is high bc dividends are issued at discretion of managers, hence volatile and uncertain
overdraft
ST, arranged quickly, but bank can withdraw the facility at any time
specific financing options
- shares to existing holders -less dilluting
- public issues - increases marketability of the company’s shares, threat of takeover increases when company becomes listed
- private placing - private equity finance - investors organised through mediation of a venture capital company or private equity business - less scrutiny for company and regulation, hence investors require higher rate of return
listing req-s
minimum share prices, certain fin ratios, minimum sales levels,
IPO
private company issues new shares and offers them to public for the first time
investment banks are employed to market the new shares, gauge demand and set the IPO price and date
also
- direct listing (cons: no guarantee or support for share price and no promotion of it) + company must still comply with exchange reg req-s
- dutch auctions (descending price auction) last successful bidder - $80 - Pros: more transparancy - instir and small investors can get involved; Cos: less control on issue price, smal investor =less rigorous analysis = price may not reflect company’s prospects
- special purpose acquisition companies (SPACs)
- reverse takeovers
Special Purpose Acquisition Company (SPAC)
formed to raise capital through IPO for the purpose of acquiring or merging with existing company
Pro: quick IPO for company + premium for fast closur eof deal max 2 yrs cons: investors have to trust the SPAC promoters to find and acquire suitable target company, risk of overhyped investment or fraudulent
reverse takeover
used by private companies that want to become public. Private companies purchases majority shareholding in public company
2. private company’s shareholders exchange their shares for shares in public company.
Pros: no need to raise capital for private to become public, saves time and money vs IPO, After takeover shareholders should benefit from all the advantages of a stock market listing (shares are more marketable, company profile increased)
dark pool trading systems
trading volume in listed stocks created by institutional investors that are unavailable to the public. Block trades facilitated away from central exchanges
private equity
asset class consisting of equity securities and debt in operating companies that are not listed companies
Common investment strategies in PE:
- mezzanine
- leveraged buyouts (PE buys majority control in existing or mature firm to try to improve its results before selling it)
- venture capital
- growth capital
- distressed investments
debt financing options
leasing is considered debt as fixed payments are there, but compan can’t claim TAD bc no ownership
- bond issue - low cost, but if not underwritten not fully usbscribed
- convertible bond issue - the right of conversion to equity at some point
- mezannine finance - most risky; paid last in liquidation, and DEBT IS UNSECURED; High coupon rate has to be paid
- syndicated loan - for large amounts, whn 1 bank isn’t ready to take all risks; rates higher thna bond markets, but transaction costs low as loans are faster to arrange than bond issuance. Governed by single loan agreement
ICO (initial coin offering)
STO (Security token offering)
STO are subj to gov regulation vs ICO
STO tockens are asset backed, have monetary value in the real world
STO - comliance work before issuance; can divide significant assets into smaller units
international company finance
parent can take loan for foreign subs, but if subs is taken from it due to political risks, liability will still be intact. Or failure of the subs will leave the parent with liab
finance raised by subs if it can raise such funds
- denominated in subs currency
- result in reduction in forex risk, since parent’s exposure to the net worth of subsid will be reduced by the amount of foreign currency borrowing, but complete elimination os risk though matching won’t be possible due to thin capitalisation rules in foreign country , which may restrict debt/capital allowed
- maybe fav-ly accepted by that country as not all earnings leave the country
short-term funding options
- eurocurrency loans. loan to company with currency denominate not in local currency. borrowers must have first class credit rating and wish to deal with large sums of money
reference rates
LIBOR - london interbank offerred rate was pahsed out in 2021!!!
SOFR - the secured overnight financing rate
ESTER - euro short term rate
SONIA - the Sterling Overnight Index Average Rate
syndicated loan
has arranger and each syndicate contributes percentage of the loan and same % in repayment is received.
is made for intl lenders
Eurobonds
LT loans, usually 3-20 years duration issued and sold internationally and denominated in single currency, often not that of a borrower’s country
mb fixed or floating interest rates
suitable to fund large capital projects
syndicated credit
allow boorwer to take money when needed, but can choose not to take full amount/ These are expensive funds usually used to
- to fund takeovers
-to refinance debt incurred during takeover
dividend policy consider-n - factors limiting dividend capacity
- legal position (gov restriction on div to earnings)
- levels of profitability and CF (more stable better capacity), 3. expectations of shareholders, optimal gearing position - paying large dividend reduces value of equity, so can help to move towards optimal gearing
- inflation (paying out during the inflation based on historical cost profits -> erosion of operating capacity of the business)
control - tax - based on personla tax position, investors may prefer dividend income or capital gains through increasing share prices. Company should be aware of preferences.
liquidity/cash mngt in ST and LT
other sources of finances and necessary servicing cost
In practice div capacity = Free CF to Equity
Dividend policies
- stable dividend policy (ratchet pattern of payment - paying out stable but rising dividend per share)
- predictable CF to investors
- no opportunity to divert to non-profitable projects
-works well for mature companies - constant pay-out ratio - paying out constant proportion of equity earnings
- maintains a link bn earning, reinvestment rate and dividend flow, but CF is unpredictable for investor
- gives no indication of mng expectation or intention - zero dividend policy - all surplus earnings invested back into the business.
- growth phase of company
- should be reflected in increased share price
when growth phase is over (no further positive NPV projects available)
- cash will start to accumulate
- a new distribution policy will be required - residual approach to dividend
dividend is paid if no further positive NPV projects -> growth pahse companies w/o easy access to other funds
gives constantly changing signals on mng expectations; unpredictable CF
scrip dividends
dividends maybe taken in the form of shares
pro: no pain in increase shares by paying brokers or stamp duty
for company: no need to look for $ and mb tax savings
usually make so that if take by cash investor’ss wealth decreases - ‘enhanced scrip’. Script dividend turns RE to permanent share capital
- more shares reduce company’s gearing and increase its borrowing capacity
- sharehol tax adv if div isn’t cash
Cons:
investors doesn’t receive cash with which to pay tax for dividends
TYU 1 Divid case
- theoretical position
pattern of dividend payments is not relevant to an investor, provided the company invests in positive NPV projects.
Dividends are residual decision. Company should fund all positive NPV projects and any remaining funds be distributed as dividends
In Practice, investors treat level of dividends as signal about fin wellbeing of the company, and believe that high dividends signal confidence in future. it is in contrast iwth theory that confident company would retain dividends to invest in +NPV projects
Clientele effect - plan of cash for inv is important
Liquidity; cost of finance;
suitable policy
- has fairlu constant dividend pattern
- leaves sufficient funds for investment and avoids the need to incur transaction costs for raising funds in the future
Director Y is correct - value of share is in part dependent on the dividend stream. in theory as mentioned above it should not matter if dividend is missed, but in practice if shareholders are unhappy about the cut, and sell their shares -> price will fall
share buy-back
occurs when company
- no positive NPV project
- wants to increase share price (cosmetic exercise)
-wants to reduce cost of capital by increasing its gearing
- give + signal to market - buying shares by directors = + signal
increase EPS
effective use of surplus funds where growth is poor
constraints
deciding price
perception by investors of price being low
might been seen as failure of current mng to make better use of the fundsthrough reinvesting
dividend policy in MNC (dividends vs transfer pricing)
div to external shareholders
div bn group companies, facilitating the movement of profit and funds within group
Most common is stable dividend policy (rashcet )
Policy of constant pay-out ratio is seldom used bc of fluctuations in dividend per share
residual approach to dividends = common sense
if +NPV, must fund them and no transaction back and forth with giving dividends and asking money
Major problem with residual - large fluctuation = bad signal
blocked remittances need to circumvent
- loan interest - lending equiv of dividend to the parent company
- transfer prices - increase
- royalties
- patent fees
- management charges of fees
- parallel loans (currency swaps) -
FCFE MNC = potential dividend capacity
gross FCFE = operating CF + dividend from subsidiaries - net interest paid - tax
to determine potential dividend capacity of business, any capital re-investment must be taken into acc
NET FCFE = gross FCFE - capital expenditure +/- disposals/acquisitions + new capital issued
FCFE stategy
must show that reinvestment strategy will provide return to shareholders more than immediate pay-out in the form of dividends or share repurchase
capital restructure
- new debt issue - reduces future FCF by interest and debt repayment
- new equity issue
- new other type of capital
- share repurchase - reduces immediate FCF; increases FCF as dividends will be paid on fewer shares, but company may decide to keep abs dividend payout ratio the same
Transfer pricing basic principles
objectives of good domestic TP
1. maintain divisional autonomy
2. maintain motivation for managers
3. assess divisional performance objectively
4. ensure goal congruence
transfer profit from high tax to low tax countries.
repatriate $
build and maintain better intl competitive position
min import duties
set lower price to parent products as an alternative to dividend repayment
improve appearance of fin performance
TP options
market price; full cost; VC unacceptable for supplying country jusrisdiction as all profits allocated to receiving country; negotiated
tax havens
- cayman islands
- luxembourg
- liechtenstein
- bahamas
- jersey
profits taken in havens, costs incurred in tax hells
anti dumping legislation
dumping - selling goods at lower than market price; gov have anti-damping to protect local producers
appropriate TP
balance between
being compettive and commercial
minimising taxes and tariffs
AND
Being ethical
maintaining good relationship wiht host country
