Objectives and investment appraisal Flashcards
Discuss, with reference to relevant theories, why pay an ordinary dividend in order to increase the company’s share price, rather than an investment proposal (The traditional school of thought)
The traditional school of thought regarding dividends states:
- Shareholders would prefer dividends today rather than dividends or capital gains in the future
- This is because cash now is more certain than cash in the future
- However, this implies that future payments would be discounted at a higher rate to take account of the uncertainty
- Risk does not necessarily increase over time, it is related to the activities and operations of the business, and so the discount rate applied to dividends should reflect this
Discuss, with reference to relevant theories, why pay an ordinary dividend in order to increase the company’s share price, rather than an investment proposal (Modigliani and Miller)
Modigliani and Miller (MM)
- Argued that share value is determined by future earnings and the level of risk
- The amount of dividends paid will not affect shareholder wealth, providing the retained earnings are invested in profitable investment opportunities and any loss in dividend income will be offset by gains in share price
- Shareholders can create home-made dividends and do not have to rely on the company’s dividend policy; if cash is needed, they can sell some shares instead
- Taxes, share transactions costs and share issue costs will have an effect
Discuss, with reference to relevant theories, why pay an ordinary dividend in order to increase the company’s share price, rather than an investment proposal (Other issues)
- Informational content: Dividends mean that management is confident of the future (the signalling view)
- Clientele Effect: Investors have a preferred habit. That is, they seek a company with a particular dividend policy that suits them. If shares are unpopular due to an inconsistent dividend policy, then the share price will suffer.
- Agency: separation of ownership from management of a company can lead to sub-optimal decisions being made. Agency costs are borne by shareholders. Managers may often make decisions that do not increase shareholder wealth and dividends may suffer as a result.
- Dividend commitments can reduce agency costs. A high dividend payout and low retentions leads to greater scrutiny of the firm’s investment decisions by outsiders (due to the need for external funds)
- Tax: Some shareholders may prefer income to capital gains
Discuss, with reference to relevant theories, why pay an ordinary dividend in order to increase the company’s share price, rather than an investment proposal (Overall)
- Evidence seems to support MM - valuation not closely related to levels of dividends
- Clientele effect seems to operate
- Dividends do not affect the value of shares, provided the shareholders know the dividend policy of the company. It is important to establish a consistent policy and stick to it.
- Lack of consistency means that shareholders will leave, and as a result the share price is likely to fall
Explain what is meant by peer-to-peer lending
P2P lending connects established businesses looking to borrow with investors who want to lend, via a specialised online platform.
- P2P lending is potentially available for any type of lending, whether short or long-term or secured or unsecured. - However, most loans in P2P lending are unsecured personal loans.
- Platforms usually require borrowers to have a trading track record, to submit financial accounts, and will perform credit checks as part of the credit assessment.
- If the company is an established manufacturer, P2P lending will work for them as they will be able to offer security to potential investors.
- P2P lending also allows customers and family or friends to share in the returns of the business.
- Investors can lend small parts of individual loans, which encourages a wide range of lenders to participate
- They can also fund loans for several million pounds but this requires access to a large enough group of lenders willing to invest in the company
What are the advantages of P2P lending?
- Can be cheaper than using a traditional bank loan: the greater competition between lenders results in a lower interest rate and lower organisation fees
- Access to this sort of finance could therefore reduce the overall cost of capital of the company
- As P2P lending platforms are typically online, this makes the application process quick and convenient.
- For those companies that operate in a competitive environment, securing the funds quickly to commence the investment could be a valuable option
- Most P2P platforms have a waiting list of investors to provide loans to borrowers which, when combined with an automated matching process, means turnaround time on accessing finance can also be very quick
- Using external finance, such as P2P lending, allows the companies to proceed with the investment while also paying out the cash dividend financed from internal funds.
What are the disadvantages of P2P lending?
- The company must pass a credit check and other internal checks to acquire the loan
- Borrowers who apply for P2P loans usually have low credit ratings that prevent them from obtaining conventional sources of finance
- If a company is a listed company with an established trading history, they are more likely to pass the credit checks and be able to access the required amount of finance
- The loan is still likely to include an arrangement fee payable to the P2P firm, however this is likely to be cheaper than the fee attached to traditional bank borrowings
What issues could influence a company’s decision as to how often to replace an asset?
- The NPV analysis ignores prices changes of all descriptions. A change in the price of a new machine, for example, could easily alter the conclusion. The same would be true for all of the input factors.
- The NPV approach assumes that replacement will take place with an identical machine. The machine may be technologically superseded. The company may conclude that it no longer has a need for such a machine. In practice it seems unlikely that many such assets are replaced with identical models on a continuing basis.
- The timing of the cash outflows on new machines could be an issue in practice, ie., making payments every fourth year may cause less of a cash flow problem than every third year
Discuss the potential attractions of lease finance over outright purchase of an asset
Why leasing may be a preferred source of finance:
- Tax: The tax effects of owning an asset compared to using one under a lease are different and can lead to a preference for leasing as a source of finance
- Capital rationing: Firms, in particular small firms, who may encounter difficulties raising conventional loan finance, are effectively able to use the asset required as security to overcome such potential funding problems.
- Cash flow: Leasing means avoiding the large cash outlay at the outset. Lease payments will be predictable which aids business planning
- Cost of capital: The implicit cost of borrowing in the lease can be lower than that in a conventional bank loan
- Flexibility: Examples such as ease of arrangement; lower payments in early stages; combining other elements into overall package - service, insurance, secondary lease terms
Explain what is meant by the term ‘real options’. Give two examples.
The concept of ‘real options’ relates to the strategic implications attaching to undertaking a particular project - the value of such ‘real options’ would not ordinarily be included in a traditional NPV calculation.
Two ‘real options’ are:
1 - Follow-on option: The opportunity to add further acquisitions in due course to gain the benefits of increased economies of scale/market share
2 - Growth option: The opportunity to broaden the range of services on offer in due course
Discuss the view that a business, by using the wrong cost of capital figure, ‘destroys shareholder value’
The cost of capital is the cost of funds that a company raises and uses. and the return that investors expect to be paid (commensurate with the risk of exposure) for putting funds into the company
It is therefore the minimum return that company must make on its own investments, to earn the cash flows out of which investors can be paid for their return
If a company calculates its cost of capital at too high a figure then it is likely to reject investment opportunities that it should be taking on (ie.., would provide a positive NPV)
If it is too low, then it is likely to take on investment opportunities it shouldn’t be taking on (i.e., those with a negative NPV)
Both of these outcomes would be detrimental to shareholder value
Distinguish between systematic risk and non-systematic risk
Systematic Risk:
- Also known as market risk
- It is that element of risk which cannot be eliminated by diversification
- It affects all markets within the economy systematically
- Examples would be changes in macroeconomic variables, for example, changes in interest rates, inflation rates, capital allowances or other tax rate changes
Non-systematic (unsystematic) risk:
- Also known as unique or specific risk
- It is that element of risk that can be eliminated by diversification
- It is related to factors that affect the return on individual investments in unique ways
- Examples may be a decrease in demand for the product below projections, unexpected actions of competitors or an increase in component costs
What are the different types of real options?
- Follow on options: launching further versions. The right to invest in later versions is a call option
- Abandonment option: If the product is a failure, then management can terminate the project early and sell the equipment, giving them a put option
- Timing option: It may be possible to delay the introduction of a project, particularly if the demand estimates are uncertain, effectively a call option. THe longer the possible delay, the more valuable to option but that company would need to protect its position, e.g, from a competitor establishing a strong market position, by using patents.
- Growth option: If the project or product is more successful than envisaged, the company has the (call) option to expand production facilities (ie, the opposite of the abandonment option)
