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LUBS > LUBS2206 - Corporate Financial Management > Flashcards

LUBS2206 - Corporate Financial Management Flashcards

1
Q

What is agency theory?

A

Agency theory provides a description of the relationship between management and shareholders

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2
Q

Asymmetric information

A

Different groups knowing varying amount of detail about a business. For example, managers tend to know more about a business compared to shareholders

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3
Q

Type I agency relationships

A

When a principal hires an agent to represent their interests

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4
Q

Type II agency relationship

A

This is the relationship between majority and minority shareholders

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5
Q

Who are agency issues between in a widely held firm?

A

In widely held firms, there is a separation between ownership and control with agency issues between managers and shareholders

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6
Q

Who are agency issues between in a closely held firm?

A

In closely held firms, the manager and shareholder incentives are aligned and the agency issues are between controlling and non-controlling shareholders

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7
Q

What happens in a bank based system? Give 2 examples of where this system is implemented

A

In bank based systems, banks are central to the process of moving funds between demanders and suppliers of capital which means that there is more active monitoring.

Examples include Germany and Japan

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8
Q

What happens in a market based system? Give 2 examples of where this system is implemented

A

In market based systems, securities markets are as important and can be significantly more important. This requires external discipline.

Examples include the US and UK

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9
Q

Corporate governance

A

Corporate governance is the system by which companies are directed and controlled

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10
Q

What is the impact of effective corporate governance?

A

Effective corporate governance leads to good risk management and internal control, accountability to stakeholders and it means that the business is behaving in an ethical and effective way

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11
Q

6 OCED principles of good governance

A

1) Ensuring the basis for an effective corporate governance framework
2) The rights of shareholders and key ownership functions
3) The equitable treatment of shareholders
4) The role of stakeholders in corporate governance
5) Disclosure and transparency
6) The responsibilities of the board

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12
Q

In addition to implementing corporate governance using OCED principles, what are the two committees a business should have?

A

Remuneration committee
Audit committee

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13
Q

Capital structure

A

Capital structure refers to the mix of equity and debt making up a company’s long-term capital

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14
Q

Suppose 100 shares of equity have a par value of £2 each and are sold to shareholders for £10 per share. What is the total additional paid-in capital?

A

(10 - 2) x 100 = £800

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15
Q

Suppose 100 shares of equity have a par value of £2 each and are sold to shareholders for £10 per share. What is the total called up share capital?

A

2 x 100 = £200

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16
Q

Treasury shares

A

Shares the company has bought back from the market

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17
Q

What are treasury shares a form of?

A

Share repurchase

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18
Q

If the number of treasury shares increase, what happens to leverage and EPS?

A

Leverage increases and the number of shares outstanding is reduced so earnings per share (EPS) increases

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19
Q

What does the basic MM theorem state?

A

The basic theorem states that the value of a firm is unaffected by how that firm is financed.

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20
Q

MM Proposition I (no taxes)

A

The value of the levered firm is the same as the value of the unlevered firm because individuals can undo the effects of leverage through homeamade leverage

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21
Q

MM Propositions (no taxes) assumptions

A

1) No taxes
2) No transaction costs
3) Individuals and firms can borrow at the same rate

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22
Q

MM Proposition I (no taxes) formula

A

V(Levered) = V(Unlevered)

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23
Q

Homemade leverage

A

An investor can recreate the effects of corporate leverage by borrowing or lending personally

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24
Q

Describe the relationship between leveraged equity, risk and expected return

A

Leveraged equity has greater risk, therefore should have a greated return as compensation. This means that expected return on equity is positively related to leverage because the risk to equity holders increases with leverage

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25
Q

MM Proposition II (no taxes) idea

A

The cost of equity rises with leverage because the risk to equity rises with leverage

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26
Q

MM Proposition II (no taxes) formula

A

R(S) = R(0) + (B/S) (R(0) - R(B))
where R(S) is the cost of equity capital, R(0) is the cost of unlevered equity capital, (B/S) is the debt-equity ratio and (R(0) - R(B)) is the cost of debt capital

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27
Q

Weighted average cost of capital formula

A

WACC = (S/(S+B)) x R(S) + (B/(S+B))
x R(B) x (1-t)

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28
Q

Explain the impact of corporate taxes and the ‘tax shield’

A

Corporate leverage lowers tax payments. The interest tax shield means that leverage reduces cash outflows and thus adds to corporate value.

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29
Q

MM Propositions (with corporate taxes) assumptions

A
  • Corporations are taxed at the rate t on earnings after interest
  • No transaction costs
  • Individuals and companies borrow at the same rate
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30
Q

MM Proposition I (with corporate taxes) formula

A

V(L) = V(U) + tB
Where tB is the present value of the tax shield

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31
Q

MM Proposition II (with corporate taxes) formula

A

R(S) = R(0) + (B/S) * (1 - t) * (R(0) - R(B))

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32
Q

3 types of financial distress costs

A

Indirect, direct and agency costs

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33
Q

Give 3 examples of indirect costs

A
  • Impaired ability to conduct business
  • Suppliers demand cash
  • Loss of staff/trust
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34
Q

Give 3 examples of direct costs

A
  • Lawyers and other advisors
  • Admin and accounting fees
  • Expert witnesses
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35
Q

Give 3 examples of agency costs

A
  • Excessive risk taking
  • Under-investment
  • ‘Milking’ the property
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36
Q

Describe how agency costs occur

A

When bankruptcy threatens, there is often conflict between shareholders and bondholders which creates agency costs

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37
Q

Describe ‘milking’ the property

A

‘Milking’ the property occurs when the business pay out extra dividends in times of financial distress which leaves less in the firm for the bondholders and causes conflict between the shareholders and bondholders

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38
Q

What is a protective (restrictive) covenant?

A

An agreement that requires the borrower to either take or abstain from specific actions

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39
Q

Give 2 advantages of protective covenants

A
  • Maintain working capital at a minimum level
  • Furnish periodic financial statements to the lender
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40
Q

Disadvantages of protective covenants

A
  • Limitations on the amount of dividends a company may pay
  • Cannot pledge any of its assets to other lenders
  • Cannot merge with another firm
  • Cannot sell or lease major assets without approval of the lender
  • Cannot issue additional long-term debt
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41
Q

What is the consolidation of debt?

A

The act of combining several loans or liabilities into one loan to reduce conflicts

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42
Q

Value of the unlevered firm formula

A

V(U) = [EBIT(1-t)] / R(0)

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43
Q

What do the articles of incoporation set out?

A

They set forth the number of shares that can be issued

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44
Q

Give 3 examples of things that convince managers to work in the best interest of the shareholders

A
  • Compensation based on the value of equity
  • Share option plans
  • Threat of a proxy plan
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45
Q

The proposition that the cost of equity is a positive linear function of capital structure is called…

A

MM Proposition II

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46
Q

The optimal capital structure will tend to include more debt for firms with…

A

…lower probability of financial distress

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47
Q

When is WACC at its minimal point?

A

When a firm is operating with the optimal capital structure the WACC is at its minimal point

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48
Q

What is signalling theory?

A

Investors may be able to treat changing debt levels as a signal of firm value because rational firms are likely to raise debt levels when profits are expected to increase

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49
Q

What is the order of preference for sources of finance in the pecking order theory?

A

1) Retained earnings
2) Debt
3) Preference shares
4) Equity shares

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50
Q

Give 3 implications of the pecking order theory

A
  • There is no target amount of leverage
  • Profitable firms use less debt
  • Companies like financial slack
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51
Q

Principles of market timing theory

A
  • Firms will have more equity if they need funds when their market to book values are high
  • Firms will have more debt if they need funds in low market to book periods
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52
Q

When does financial distress occur?

A

Financial distress occurs when a firm’s operating cash flows are not sufficient to satisfy current obligations

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53
Q

Symptoms of financial distress

A
  • Dividend reductions
  • Plant/ store closures
  • Losses
  • Layoffs/ redundancies
  • CEO resignations
  • Plummeting share prices
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54
Q

Give 3 possible reasons for financial distress

A
  • High leverage ratio
  • Poor operating performance
  • Recession
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55
Q

Insolvency

A

The inability to pay debts

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56
Q

When does value-based insolvency occur?

A

Value-based insolvency occurs when a firm has a negative net worth

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57
Q

When does flow-based insolvency occur?

A

Flow-based insolvency occurs when operating cash flow is insufficient to meet current obligations

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58
Q

Firms that cannot emerge out of financial distress have two options, what are they?

A

Liquidation and reorganisation

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59
Q

What is liquidation?

A

Liquidation is the option of terminating the firm as a going concern. It involves a ‘fire sale’ of the assets and transfer of the proceeds to the creditors in order of an established priority of claims

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60
Q

What does liquidation require?

A

Court approval

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61
Q

What is reorganisation?

A

Reorganisation is the option of keeping the firm a going concern. It sometimes involves issuing new securities to replace old ones

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62
Q

What is the order of priority of claims according to the absolute priority rule (APR)? Hint: there are 9 items in the list

A

1) Admin expenses associated with liquidating the bankrupt’s assets
2) Unsecured claims arising after the filing of an involuntary bankruptcy petition
3) Wages, salaries and commission
4) Contributions to employee benefit plans arising within a set period before the filing date
5) Consumer claims
6) Tax claims
7) Secured and unsecured creditors’ claims
8) Preference shareholder claims
9) Ordinary shareholder claims

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63
Q

What happens in administration?

A

In an administration, the administrator will attempt to restructure the liabilities, look for a buyer for the whole business or break up into viable parts

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64
Q

What is pre-packaged administration?

A

The combination of private workout and legal bankruptcy and is the process of selling the assets of a company immediately after it has entered administration

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65
Q

Give 3 advantages of pre-packed administrations

A
  • The firm emerges from administration quickly with less cost
  • It enables the administrator to realise a greater amount for the assets due to business continuity and the goodwill of the company being preserved
  • Employees of the company are usually transferred to the new company preserving jobs
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66
Q

Z-score models??

A
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67
Q

What are the 3 valuation techniques for the levered firm?

A

1) Adjusted present value (APV)
2) Flow-to-equity (FTE)
3) Weighted average cost of capital (WACC)

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68
Q

R(0)

A

Unlevered cost of equity for an all equity firm (unlevered cost of capital)

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69
Q

R(S)

A

Levered cost of equity for a firm with debt in its capital structure

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70
Q

R(B)

A

Pre-tax cost of debt (interest on debt)

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71
Q

B

A

Amount of debt

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72
Q

t

A

corporate tax

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73
Q

B/S

A

Debt-equity ratio

74
Q

R(B) * (1-t)

A

Post-tax cost of debt

75
Q

R(F)

A

Risk-free rate

76
Q

R(M)

A

Market rate of return

77
Q

Describe how to use the APV valuation technique

A

Discount unlevered cash flows (UCF) by unlevered cost of equity R(0) to calculate the NPV.
Add financing cash flows discounted by the cost of debt R(B) to calculate the APV.
APV = NPV + NPVF

78
Q

Describe the Flow to Equity (FTE) method to find the NPV

A

Discount the levered cash flows (LCF) by the levered cost of equity R(S) to calculate the NPV

79
Q

When is it appropriate the use the FTE method?

A

Use when the firm’s target debt-to-value ratio applies to the project over its life

80
Q

Describe the WACC method to find the NPV

A

Discount unlevered cash flows (UCF) by the weighted average cost of capital to calculate the NPV

81
Q

What is asset risk? When is it the same? What value is it reflected in?

A

Asset risk only reflects the operating risk of a company. It is the same for all companies which have similar business operations. Asset risk is reflected in R(0) (unlevered cost of equity) and in R(S) (levered cost of equity)

82
Q

What is leverage risk? What value is it reflected in?

A

Leverage risk is the risk due to debt since leverage ‘magnifies’ the underlying risk of the business. It is reflected in R(S) (levered cost of equity)

83
Q

Market risk premium formula

A

R(m) - R(f)

84
Q

CAPM equation

A

R(i) = R(f) + Beta(i) * (R(m) - R(f))
where R(i) is the expected return on a security, R(f) is the risk-free rate, Beta(i) is the beta coefficient and R(m) - R(f) is the market risk premium

85
Q

What are the 2 types of risk?

A

Systematic and unsystematic

86
Q

What does CAPM represent/show? What is the most important variable?

A

CAPM summarises the relationship between the risk and return. The beta coefficient is the most important variable here since the beta value for a levered company’s equity will be higher than the beta of a similar but unlevered company’s equity

87
Q

The connection between MM proposition II and the CAPM means that it is possible to establish a mathematical relationship between…?

A

Asset beta and equity beta

88
Q

What is asset beta?

A

Asset beta is the beta of an unlevered company

89
Q

What is equity beta?

A

Equity beta is the beta of an levered company

90
Q

What are cash dividends?

A

A payment by a company to its shareholders. It is paid out of operating profits and usually paid twice a year

91
Q

What are stock dividends? Explain what a 2% stock dividend means.

A

When a company issues new stock. For example, a 2% stock dividend means giving one new share to every 50 shares owned

92
Q

What are stock splits? Explain what happens in a 3:1 stock split

A

A bit like a stock dividend but is much larger. For example, a 3:1 stock split means that one share becomes 3 new shares

93
Q

4 stages in the standard method of a cash dividend payment

A

Declaration date
Record date
Ex-dividend date
Payment date

94
Q

What happens on the declaration date of a cash dividend payment?

A

The board declare a dividend

95
Q

What is the significance of the record date of a cash dividend payment?

A

Declared dividends are distributable to shareholders on record on a specific date

96
Q

What happens on the ex-dividend date of a cash dividend payment?

A

A share of equity becomes ex-dividend on the date the seller is entitled to keep the dividend

97
Q

State the dividend irrelevancy theorem

A

The firm cannot increase or decrease its value based on the dividend policy it chooses because of homemade dividends

98
Q

What is share repurchase? What does it effectively do?

A

A process by which a company buys back its own shares from the capital market, thereby reducing the number of outstanding shares. Since the shares on the market are owned by shareholders, it is effectively a payment by a company to its shareholders

99
Q

Give the 3 approaches to share repurchase

A

Open-market purchase
Tender offer
Targeted repurchase

100
Q

Give 4 reasons for favouring a high dividend policy

A
  • Desire for current income
  • Agency costs
  • Behavioural finance
  • Dividend signalling
101
Q

What are the preferences of a high-tax individual regarding shares and dividends?

A

Don’t like dividends and desire zero to low-payout shares

102
Q

What are the preferences of a low-tax individual regarding shares and dividends?

A

Like some dividends and desire low to medium-payout shares

103
Q

What are the preferences of a tax-free institution regarding shares and dividends?

A

Like dividends and desire medium to high-payout shares

104
Q

Describe the catering theory of dividends when there are too few or too many dividend paying shares

A

Too few leads to excess demand which pushes attractiveness of dividends

Too many leads to excess supply which reduces attractiveness of dividends

105
Q

Give 3 advantages of paying dividends

A
  • Dividends appeal to investors who desire stable cash flow
  • Managers may increase dividends in order to signal their optimism concerning future cash flow
  • The board can use dividends to reduce the cash available to spend thrift managers
106
Q

Give 3 disadvantages of paying dividends

A
  • Dividends are taxed as ordinary income
  • They can reduce internal sources of financing and they may force the firm to forgo positive NPV projects or to rely on external equity financing
  • Once established, dividends cuts are hard to make without adversely affecting a firm’s share price
107
Q

The dividend-irrelevance proposition depends on what relationship between investment policy and dividend policy?

A

The investment policy is set before the dividend decision and not changed by the dividend policy

108
Q

What are the 2 types of public offering equity?

A

Initial public offering (IPO)
Seasoned equity offering (SEO)

109
Q

What is an initial public offering?

A

IPO is the sale of a company’s shares to the public for the first time

110
Q

What is a seasoned equity offering?

A

SEO is a new share issue when the company’s shares are already publicly traded to raise additional equity

111
Q

Give 5 advantages of a stock market listing

A
  • Access to wider pool of finance
  • Easier to seek growth by acquisition
  • Original owners selling shares
  • Enhances public image
  • Improved marketability of shares
112
Q

What is the general role of an underwriter?

A

Underwriters agree to buy at the issue price any shares which are not taken up by the investing public. They reduce the risk for the company for a fee

113
Q

What guarantee does an underwriter have to commit to? Where does the risk lie?

A

Underwriters must guarantee that it will sell all of the stock for the company at the offer price so the risk of not being able to sell them is on the underwriter, not the firm.

114
Q

How is the price set for an auction IPO?

A

Rather than setting a price itself and then allocating shares to buyers, the underwriter takes bids from investors and then sets the price

115
Q

How is underpricing of IPOs beneficial? And for the same reason, who is does it not benefit?

A

Underpricing helps the new shareholders since it provides immediate profit but it is an indirect cost of issuing new shares for the existing shareholders and the company

116
Q

Give an example of a passive portfolio strategy

A

When IPOs are systematically underpriced so there is always a significant first-day return

117
Q

Winner’s curse

A

When an offer is oversubscribed, investors cannot get all the shares they want because the issuer allocates the available shares pro-rata

118
Q

Give 4 disadvantages of a stock market listing

A
  • Greater public regulation, accountability and scrutiny
  • Wider circle of investors often with more demanding requirements
  • Greater legal requirements, and stock exchange regulation
  • Additional costs including brokerage commission and underwriting fees
119
Q

What is a cash offer?

A

A type of SEO in which a firm offers new shares to investors at large

120
Q

What is a rights offer or rights issue?

A

A type of SEO in which a firm offers the new shares only to existing shareholders and this prevents dilution

121
Q

Explain what the subscription price is and what a rational shareholder would do when there are rights offered?

A

The subscription price is the price that existing shareholders are allowed to pay for a share of equity. A rational shareholder will subscribe to the rights offering only if the subscription price is below the market price of the equity on the offers expiration date

122
Q

Ex-rights date

A

The date after which an investor will not receive the new issue rights and so is the date that the share price will fall

123
Q

In comparison to debt issuance expenses the total direct costs of equity issues are…?

A

Considerably greater

124
Q

Bonds

A

Bonds are long term debt capital raised by a company on which interest is paid, usually semi-annually and at a fixed rate

125
Q

Give 4 forms of bond

A

Deep discount bond
Zero-coupon bond
Convertible bond
Callable bond

126
Q

Deep discount bond

A

Loan notes issued at a price whihc is at a large discount to their par value but which are redeemable at par when they mature

127
Q

Zero-coupon bond

A

Bonds that carry no interest and are a form of deep discount bonds

128
Q

Convertible bonds

A

Convertible bonds give the holder the right to convert to ordinary shares in specified circumstances

129
Q

Callable bonds

A

Bonds that come with a provision where they can be repurchased from the company at a specific price and period

130
Q

Beta coefficient and what it measures?

A

The beta coefficient is a measure of the systematic risk in a individual risky asset relative to that of the market portfolio. It measures the responsiveness of a security to movements in the market portfolio.

131
Q

Interpretation of Beta < 0

A

Asset moves in the opposite direction to the market

132
Q

Interpretation of Beta = 0

A

Movement of the asset is unrelated to the market movements

133
Q

Interpretation of 0 < Beta < 1

A

Movement of the asset is generally in the same direction but is less pronounced than market movements

134
Q

Interpretation of Beta = 1

A

Movement of the asset is generally in the same direction as and similar to market movements

135
Q

Interpretation of Beta > 1

A

Movement of the asset is generally in the same direction but more pronounced than market movements

136
Q

What does the CAPM relate? And what does this relationship mean in terms of investor actions?

A

CAPM relates the expected return on an asset to its risk. This relationship is positive so investors will only accept increased risk if compensated by increased return

137
Q

What is the main criticism of the CAPM?

A

It is impossible to construct a portfolio that contains every single security, so any test of the CAPM that uses a market proxy will be testing that specific portfolio and not the true market portfolio. This means that the CAPM is empirically untestable because the underlying market portfolio is unobservable

138
Q

Give 7 factors that influence the level of risk for an individual security

A
  • Leverage or gearing
  • Industrial sector
  • Age
  • State of the economy
  • Management experience
  • Geographic location
  • Company size
139
Q

The basic lesson of MM theory is that the value of a firm is dependent on…

A

the total cash flows of the firm

140
Q

When a company has spare cash, it can either…?

A

Pay out a dividend or invest the money in the business with the view to pay out the extra income as a dividend

141
Q

What are the 2 methods that can be used to find an estimation for Beta?

A

Using the formula or use regression techniques to find the characteristic line

142
Q

What are the 3 determinants of Beta?

A
  • Cyclicity of revenues
  • Operating leverage
  • Financial leverage (gearing)
143
Q

Explain the relationship between cyclicity of revenues and Beta

A

A cyclical firm is more responsive to movements in the market. Firms whose revenues are more responsive to movements in the economy will generally have higher betas

144
Q

Explain the relationship between operating leverage and Beta

A

Operating leverage magnifies the cyclicality of a firm’s revenues, leading to a higher beta

145
Q

Explain the relationship between financial leverage and Beta

A

The beta value for a levered firm will be higher than the beta of a similar but unlevered company’s equity

146
Q

State the efficient market hypothesis

A

An efficient capital market is one in which share prices fully reflect available information. This is known as the efficient market hypothesis

147
Q

What can an efficient capital market do?

A

An efficient capital market is able to process new information and rapidly incorporate that information into the price of a security

148
Q

State the 3 market conditions that Andrei Shleifer believes will lead to market efficiency

A
  • Rationality
  • Independent deviations from rationality
  • Arbitrage
149
Q

What are the 3 types of efficiency?

A
  • Weak - market incorporates past prices
  • Semi-strong - market incorporates past prices and publicly available information
  • Strong - market incorporates past prices and all available information (publicly and privately available)
150
Q

Give 4 sources of evidence of market efficiency

A
  • Serial correlation
  • Event studies
  • Investment fund performance
  • Insider trading
151
Q

Give 5 empirical challenges to market efficiency

A
  • Earnings/ bonuses
  • Limits to arbitrage
  • Value vs growth
  • Size
  • Crashes and bubbles
152
Q

Merger

A

The combination of two companies into one new company

153
Q

Acquisition

A

Purchase of one company to another

154
Q

Takeover premium

A

Difference between the share price before the offer and the offer price

155
Q

Synergy

A

Where combining two separate units creates value

156
Q

What are the 3 types of mergers?

A

Strategic, financial and conglomerate

157
Q

Are strategic mergers friendly or hostile?

A

Friendly

158
Q

Are financial mergers friendly or hostile?

A

Hostile

159
Q

Conglomerate

A

A combination of two or more corporations engaged in entirely different businesses so it is a multi-industry company

160
Q

Give 3 advantages of a congolmerate

A
  • Enhances flexibility
  • Avoids some information problems
  • Increases debt capacity
161
Q

Give 2 disadvantages of a conglomerate

A
  • Conglomerates regularly misallocate capital
  • Reduce information content of stock prices
162
Q

What are the 3 classifications of acquisitions?

A

Horizontal, vertical and conglomerate

163
Q

Multinational companies (MNCs)

A

MNCs are companies with significant foreign operations

164
Q

Exchange rate

A

The price of one country’s currency expressed in terms of another country’s currency

165
Q

Spot rate

A

Exchange rate currently offered for immediate delivery

166
Q

What does FX markets stand for?

A

The foreign exchange market

167
Q

Bid price

A

The price at which a trader buys a currency for

168
Q

Offer price

A

Is the price at which a trader will sell a currency for. It is also known as the ‘ask’ price

169
Q

Spread

A

The difference between the bid price and offer price

170
Q

Cross rate

A

The implicit exchange rate between two currencies when both are quoted in a third country’s currency

171
Q

Triangular arbitrage

A

The ability to make a riskless profit from converting money across 3 countries. However, given the efficiency of the global FX market, it is exceptionally unlikely that triangular arbitrage opportunities last very long

172
Q

Spot trade and what exchange rate does it use

A

An agreement to exchange currency ‘on the spot’ which means the transaction is completed or ‘settled’ within 2 business days. The exchange rate on a spot trade is called the spot exchange rate

173
Q

Forward trade and what exchange rate does it use

A

An agreement to exchange currency at some time in the future. The exchange rate that will be used is called the forward exchange rate. Forward trades are usually settled within 12 months

174
Q

Interest rate parity (IRP)

A

A method of predicting foreign exchange rates based on the hypothesis that the difference between interest rates in two countries should offset the difference between the spot rate and the forward foreign exchange rates over the same period

175
Q

F(t)

A

Forward exchange rate for settlement at time t

176
Q

R(HC)

A

Home currency nominal risk-free interest rate

177
Q

R(FC)

A

Foreign currency nominal risk-free interest rate

178
Q

S(0)

A

Spot exchange rate

179
Q

Exchange rate risk

A

The natural consequence of international operations where relative currency values fluctuate

180
Q

3 types of exchange rate risk

A
  • Short-term exposure
  • Long-term exposure
  • Translation exposure
181
Q

Political risk

A

Changes in value that arise as a consequence of political actions

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