QB Flashcards
IRR definition and decision rule
Cost of capital at which NPV = 0
Accept if IRR % > cost of capital (usually)
IRR formula
a + (NPVa ÷ (NPVa - NPVb)) × (b - a)
a = lower discount rate b = higher discount rate
1 advantage and 2 disadvantages of IRR
Advantage:
- % return easy to understand
Disadvantages:
- Doesn’t calculate absolute change in wealth so may be wrong when ranking projects
- Non-conventional cash flows can create more than one IRR
NPV discount formula
(1 + r) ^-n
r = cost of capital n = years
Dividend discussion
- Prefer divs now rather than CG later (certainty)
- MM:
> Share value future earnings/level of risk
> Divs paid don’t affect wealth if reinvested
> Create home-made divs
> Taxes/transaction costs/issues costs have effect - Signalling
- Clientele effect (habitat)
- Agency (sub-optimal decision)
- Agency costs
- Tax (IT vs CGT)
Cost of material - not in stock so have to buy
Purchase cost
Cost of material - in stock, in regular use
Current replacement cost
Cost of material - in stock, no other use
Current resale value
Scrap value lost
Cost of material - in stock, scarce, if used cannot replace
Opportunity cost
Cost of labour and variable overheads - spare capacity
Nil labour cost plus variable overhead only
Cost of labour and variable overheads - full capacity, workforce available for hire
Current rate of pay plus extra variable overhead incurred
Cost of labour and variable overheads - full capacity, no workforce available
Opportunity cost
Projects when no capital rationing
All with a positive NPV
Projects when limited in first year and independent + divisible
Rank by NPV ÷ investment
Can do a portion of a project
Projects when limited in second year and independent + divisible
Never = -ve NPV / consumes funds in rationing year Always = +ve NPV / generates funds in rationing year
Rank projects by NPV ÷ investment in rationing year
Check whether -ve NPV outweighed by capital released
Projects when limited in first year and independent + INdivisible
Figure out combination options
Choose combination with highest NPV
7 finance lease characteristics
- Transfers substantially all the risks/rewards of ownership to lessee
- 1 lease for whole/major part of useful life
- Ownership may pass at the end of the lease
- May be bargain price in secondary lease period
- Lessor does not usually deal directly in type of asset
- Cannot be cancelled without penalty (rest of cost)
- Substance is purchase of asset by lessee finance by loan from lessor
6 operating lease characteristics
- Lease period less than useful life
- Lessor depends on subsequent leasing to generate profit
- Lessor carries on trade in type of asset
- Lessor responsible for repairs and maintenance
- Can sometimes be cancelled at short notice
- Substance is short-term rental of asset by lessee
5 attractions of lease over purchase (CC FTC)
- Cash flow predictable/spread
- Cost of capital lower
- Flexibility
- Tax
- Capital rationing
4 drawbacks replacement analysis
- Ignores price changes
- Assumes replacement is identical
- Beneficial timing of cash flows not considered
- Effects of taxation ignored
Risk and uncertainty definition
Risk = possible outcomes and probabilities known
Uncertainty = possible outcomes known but probabilities unknown
Real options definition
Strategic implications attaching to undertaking a project
Not normally included in the traditional NPV calculation
5 types of real option (FAT GF)
- Follow-on (R+D)
- Abandonment (alternative uses)
- Timing (wait and see)
- Growth (delay/complete only part of a project)
- Flexibility (future proofing)
CAPM cost of equity formula (given in exam)
ke = rf + βj (rm - rf)
ke = cost of equity rf = risk-free rate βj = beta of security j rm = expected return on the market portfolio
WACC formula
(MVe × ke) + (MVd × kd)
__________________
MVe + MVd
MVe = MV of issued shares MVd = MV of debt
Net of tax cost of debt formula
Pre-tax cost of debt × (1 - 0.17)
MVe formula
Share capital ÷ share value × ex-div MV
MVd formula (debentures)
Balance sheet × ex-interest ÷ nominal value
MVd formula (bank loan)
Balance sheet figure
Gordon growth (dividend valuation) model formula (given in exam)
Ke = D0*(1 + g)
_______ + g
P0
Ke = cost of equity
D0 = current dividend per ordinary shares
g = annual dividend growth rate
P0 - current ex-dividend price per ordinary share
Growth earnings retention model formula
g = r × b
g = growth in future dividends r = return on equity b = proportion of profits retained
Dividend formula
Share price × dividend yield
Retentions rate formula
Proportion of profits retained (r)
1 - ((Dividend ÷ EPS) × 100) × 100
Shareholder return formula
Return on equity (b)
PAT = EPS ÷ number of shares in issue Return = PAT ÷ (total equity - (number of shares in issue × (EPS - dividend)) * 100
Gearing formula (given in exam)
βe = βa (1 + (D(1-T)÷E))
βe = beta of equity in geared firm βa = ungeared (asset) beta D = MV of debt E = MV of equity T = corporation tax rate
For degearing find βa
APV cost of equity/beta
Ungeared
2 consequences of higher WACC
- Lower NPV
- Lower value of company
Opening shareholder funds formula
End of year balance - retained profits
If first NPV for IRR is negative
Use lower discount %
Earnings formula
EPS × number of shares
Cum div formula
Ex-div + dividend
Preference shares cost of debt
(% ÷ nominal value) ÷ ex-div value
MVd formula (pref shares)
Balance sheet ÷ share value × ex-div MV
4 WACC underlying assumptions
- Historical proportions of debt and equity will remain unchanged
- Business risk remains unchanged
- Finance raised is not project specific
- Project is small in size relative to size of company
Preference shares equity or debt
Debt
3 key assumptions when using cost of equity in CAPM
- Objective is to maximise wealth of shareholders
- All shareholders hold market portfolio (fully diversified)
- Shareholders are only participants in firm
Advantages futures contracts as opposed to forward contracts when hedging foreign currency exposure
- Transaction costs of future should be lower and they can be traded
- Exact date of receipt or payment of foreign currency does not need to be known because futures contract does not have to be closed out until underlying transaction takes place
Disadvantages futures contracts as opposed to forward contracts when hedging foreign currency exposure
- Contracts cannot be tailored to exact requirements
- Hedge inefficiencies cause by standard contract sizes and basis
- Only a limited number of currencies are available with futures contracts
- Procedure for converting between 2 currencies neither of which is $ is more complex with futures compared to forward contract
Interest - forward rate agreement (borrower)
As a borrower ___ should buy a ___ and can thereby fix a borrowing rate of __
Interest rates have risen:
(1) Bank will pay = loan × (spot rate - FRA borrowing rate)% × x÷12months
(2) Loan payment = spot rate × loan × x÷12months
(3) Net payment = (2) - (1)
(4) Effective interest rate = FRA borrowing rate
Interest - futures contract (borrower)
___ will need to sell ___ interest rate futures contracts
Interest rate risen:
(1) No. contracts = loan / standard contract size × x÷xmonths
(2) Sell at todays trading price
(3) Buy at future trading price
(4) Gain = (2) - (3)
(5) Futures outcome = (4) × standard contract size × x÷12months × (1)
(6) Loan payment = loan × spot rate × x÷12months
(7) Net payment = (6) - (5)
(8) Effective rate = spot rate - (4)
7 risks of trading abroad
- Government stability
- Political and business ethics
- Economic stability
- Import restrictions
- Remittance restrictions
- Special taxes, regulations for foreign companies
- Trading risk - physical, credit , liquidity
