Objectives and investment appraisal Flashcards
Problems with CAPM
- Rm estimated on future rather than historic returns
- Rf - gilts are not risk free
- beta calculation too simplistic
- assumes fully diversified shareholders
- shareholders are not only stakeholders
- assumes objectives of company are to maximise shareholder wealth
Value drivers to increase shareholder wealth
1 Increase the rate of growth of sales
2 Increase the operating profit margin (increase selling price/decrease variable costs)
3 Reduce the investment in non-current assets (acquire for less than £1.5m)
4 Reduce the investment in working capital (less than 10%)
5 Reduce the firm’s cost of capital (change capital structure)
6 Extend the life of the project
Areas where directors and shareholders interests conflict
Takeovers
- directors defend against takeover for their jobs
- shareholders make huge returns off takeovers
Time horizon
- directors judged on short term achievements, short term interests
- shareholder wealth is long term, long term interests
Risk
- directors dependant on success of the firm they work at
- shareholders hold diversified portfolio and are therefore open to risk
Advantages of a business combination
(a) Synergistic savings – administration, economies of scale, use of common investment, leaner management structures, access to under-utilised assets
(b) Risk reduction – more stable cash flows, so less risk, so lower WACC
(c) Reduced competition in the market
(d) Fast way of expanding, compared to organic growth
(e) Vertical integration
Advantages and disadvantages of cash offer
+ certain cash flow
+ attractive to seller
- could create liquidity problems - more borrowings
- tax implications
Advantages and disadvantages of share for share transfer?
+ preserves liquidity
+ no tax implications
- extra shares increase dilution of ownership
- uncertain valuation
- dealing costs (when selling)
What is a finance lease?
- transfers substantially all risks and rewards of ownership to the lessee
- one lease for the life of the asset
- ownership usually passes to the lessee at end of term at bargain price or peppercorn rent
- cannot usually be cancelled unless penalty of remaining liability
- substance is purchase of asset financed by loan from lessor
What is an operating lease?
- lease period less than useful life of the asset
- lessor relies on income and eventual sale of the asset
- lessor responsible for repairs and maintenance
- can sometimes be cancelled at short notice
- substance of transaction is short term rental
Attractions of lease finance over outright purchase
- tax effect
- capital rationing - small firms especially able to use asset as security
- less of a cash outlay, predictable cash flows
- cost of borrowing the lease can be less than borrowing the cash to buy the asset
- flexibility
What is uncertainty?
Possible outcomes known but probability attaching to each are unknown
What is the risk of a decision outcome?
Outcomes as well as the respective probabilities attaching to each of these possible outcome are known.
What is meant by the term ‘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.
What is cost of capital?
- cost of funds that a company raises and uses, and the return that investors expect to be paid
- minimum return that a company must make on its own investments, to earn the cash flows out of which investors can be paid their return.
What are the implications of an inaccurate cost of capital figure?
Too high - likely to reject investment opportunities it should be taking on (it lowers NPV)
Too low - likely to take on unprofitable investment opportunities
What is systematic risk + examples?
It is that element of risk that cannot be eliminated by diversification
It affects all companies, investors should be compensated
Examples: war, interest rates, recession
What is non-systematic risk?
It is that element of risk that can be eliminated by diversification
Specific to a company and therefore do not need to compensate investors as they can diversify
Examples: employee strikes, chairman leaving, regulatory changes
On a sensitivity question, if they ask on sales price how should it be laid out?
Sales price x volume
Less: Tax
On a sensitivity question, if they ask on sales revenue how should it be laid out?
Sales contribution x volume
Less: tax
Advantage and disadvantage of NPV
+ values the future cash flow of the project taking into account risk and time value of money
- inputs into the model are critical in arriving at a reliable estimate for value
Difference between an offer for sale and an offer for subscription?
For sale
- shares sold to issuing house
Subscription
- shares sold direct to public
What are the 4 ‘real options’?
- follow-on option - expand into other areas
- abandonment option - sell off early
- timing option - option to delay project and monitor competitors
- growth option - expand operations when competitor leaves market
What is the efficient market hypothesis (EMH)?
- stock markets considered efficient (all prices fair)
- returns expected based on the risk taken
- info rapidly and accurately incorporated into share value
- when all share prices reflect all available information, the market they are in is said to be efficient
- cannot mate consistently above average returns other than by chance
What are the three levels of market efficiency?
- weak form
- semi-strong form
- strong form
Describe weak form (market efficiency)
- prices only change when info available
- no anticipation
- info arrives at random
- technical analysis does not hold up
- past prices cannot be used to earn consistently abnormal profits
Describe semi-strong form (market efficiency)
- prices reflect all information about past price movements and all knowledge that is publicly available/anticipated.
- can anticipate price changes before new information is formally announced.
- market is efficient in the semi-strong form if publicly available information CANNOT be used to earn consistently abnormal profits
Describe strong form (market efficiency)
- share prices reflect all information about past price movements, all knowledge publicly available/anticipated and insider knowledge.
- market is efficient in the strong form if all information (private and public) CANNOT be used to earn consistently abnormal profits.
What are the behavioural effects which question the validity of the EMH?
- overconfidence of investors in own ability
- investors ignore bigger picture and focus on smaller areas (narrow framing)
- extrapolative expectations - investors expect rising prices to keep on rising
Reactions to a company diversifying
Stock market: might not be welcome as diversified companies trade at a conglomerate discount. May assume the company does not have expertise
Shareholders: Already fully diversified so would not welcome
For cash flows that are already in money terms, how would a change in inflation affect the NPV
It would change the NPV favourably or adversely depending on the movement
For cash flows not in money terms, how would a change in inflation affect the NPV
Will not affect NPV as it will further inflate money cost of capital and discount rates
Advantages of sensitivity analysis
- facilitates subjective judgment (by management for example)
- Identifies areas that are critical to the success of a project, e.g. sales volume, materials price
- Straightforward
Disadvantages of sensitivity analysis
- assumes that changes to variables can be made independently
- ignores probability
- does not point to a correct decision
Advantages of simulation
More than one variable at a time can be changed
It takes probabilities into account
Disadvantages of simulation
- It is not a technique for making a decision
- time consuming and expensive
- assumptions that need to be made could be unreliable
What is a suitable dividend payout ratio for a listed company?
Constant with some growth
