QB Questions Flashcards
Advantages of Shareholder Value Analysis (SVA)? (2)
- Based on PV of future cash flows, so future looking
- Considers 7 value drivers which link to company strategy
What is the modern view on optimum gearing?
It is is a balance between the benefits of the tax shield and bankruptcy costs
What does a lower gearing mean for market value?
It has a positive impact
Per M&M theory, share value is determined by what?
Future earnings and the level of risk
Per M&M theory, will dividends affect shareholder wealth?
No (unless the retained earnings are invested in profitable investment opportunities)
What does traditional theory state on dividends and shareholders timing?
Shareholders would prefer dividends today
Three facts on forward contracts and money market hedges?
Both are fixed, binding and have no upside/downside
Calculating forward rate from interest rates and spot rate?
Average spot rate * (1+ Avg foreign rate)/(1 + Avg UK rate)
Advantages of NPV valuation? (3)
- Values future cash flows of the company
- Takes risk into account
- Takes into account the time value of money
Advantage of multiples valuation? (2)
Disadvantage of multiples valuation?
- Values a company by comparison to its peers
- Reflects future growth potential of the market
- No company is truly comparable with another
Define underwriting
Why use it?
Main disadvantage of it?
A form of insurance which ensures all securities are sold
To ensure all funds are obtained
Is costly
ICO vs IPO: two main differences (for an ICO)
ICO: initial coin offering
1. An investor receives a token, which is a utility token that gives entitlement to use a product or a service
2. Payment is made in a cryptocurrency
Limitations of the gordon growth model (5)
- Relies on accounting profits
- assumed b and r remain constant
- can be distorted by inflation
- relies on historic information
- assumes all new finance is from equity or that gearing is held constant
what does a higher equity beta reflect?
higher systematic risk
Define a convertible debenture
Advantages of these? (5)
Disadvantages? (2)
They are fixed return securities that can be either secured or unsecured, which can be converted into OSC at a future date
- Lower interest rate than redeemable debentures
- Possible future profits for investors
- Introduces short-term gearing
- Avoids redemption if conversion rights are taken up
- Equity can be issued cheaply
- Dilution of future control
- Uncertainty as to whether conversion will take place
Unlike currency futures, forwards are ________ _______
tailored specifically
Advantage of a currency future over a forward?
It has a secondary market
What three factors affect the time value of index options
- Time to maturity
- The risk-free rate
- Volatility
Future contracts can be ______ but cannot be ________
cheaper
tailored
For hedge accounting, the directors’ attitude to _____ is important in deciding which strategy to pursue (e.g. whether a future, forward, OTC etc.)
risk
What is the issue with having a low hurdle rate for investment decisions? (relates to CAPM, dividend growth stuff)
Too low a figure can lead to poor investment decision being taken (e.g. a 3% hurdle rate allowing a 4% project, when there are 8% and 9% ones as well)
What does the beta value do in CAPM theory?
It’s a measure of systematic risk against market average
When is it appropriate to use adjusted present value (APV) approach to investment appraisal?
If capital structure changes maybe the cost of capital will as well
For new cost of capital, need new MV of company’s shares and the NPV, which cannot be calculated without the new cost of capital
This is circular, so we assume that finance is issued in such a way as to leave the gearing unchanged
So;
1. Calculate the base cost of the project
2. Calculate the PV of the tax shield
3. Adjust for issue costs
Problems with historic net assets as a valuation method? (3)
- Tends towards low historic values, so an undervaluation
- Intangibles are ignored
- Future earnings are ignored
What information is needed for the SVA approach? (7)
- Length of project
- Sales growth rate
- Profit margin
- Fixed assets investment
- Working capital investment
- Tax rate
- Discount rate
Name the four traditional valuation models
- Asset
- Earnings
- Dividend
- DCF
Why will a theoretical ex-rights price differ from actual price per share? (2)
- If the rights are fully taken up
- If the proceeds are invested in positive net present value projects
Advantages and disadvantages of debt vs equity; what categories do these broadly fall under? (6)
- Control issues
- Obligation to return capital
- Interest vs dividends
- Issue costs
- Liquidation of the investment
- risk/reward
Forms of finance a management team is likely to need? (3)
- Management team invest in equity
- A venture capital provider invests in equity and debt
- Other financiers (banks etc.)
Possible exit routes for financiers contributing to the funding of a management buyout? (4)
- Selling the company
- A secondary MBO
- Floating the company on the stock exchange
- Liquidation
What information will be needed in the financial section of a business plan? (5)
- Historical financial analysis
- Amount and timing of the finance provided
- Key risks and a contingency plan
- Anticipated gearing
- Purpose of finance required
Two issues with OTC currency options?
- Expensive
- No secondary market
3 issues with currency futures?
- Not tailored, so need to round number of contracts
- Requires a margin to be deposited at the exchange
- Need for liquidity if margin calls are made
Since futures require margins, they are not a perfect hedge due to ______ and _______ risk
rounding
basis
What is an interest rate parity?
An interest rate parity links the forward exchange rate with interest rates in an exact relationship, because risk-free gains are possible if the rates are out of alignment (use the mid spot * 1+int / 1+GBP formula thing)
Define economic risk
How can this be mitigated? (5)
The risk that longer-term exchange rate movements might reduce the international competitiveness of a company
- Diversify operations world-wide
- Carefully decide which markets to operate in
- Product management
- Pricing strategy to respond to risk of fluctuations in exchange rates
- Production management; economic exposure may influence the supply and location of production
Issuing debentures is likely ______ than issuing a rights issue
cheaper
Issues to consider in debenture vs rights issue? (6)
- Level of gearing
- Interest cover
- Dilution of control (rights)
- Date of repayment (debs)
- Issue costs (rights > debs)
- Tax shield (debs)
What are the two main dividend policy theories?
- M&M; share value is determined by future earnings and level of risk
- Traditional; shareholders prefer dividends today rather than dividends or capital gains in the future
What is required for calculating standard deviation?
A normal distribution
In a normal distribution, plus or minus two SDs from the mean correspon to approximately ___% of the distribution
95
For two projects (one with high profit, one with low profit), why might using SD be a poor means of comparison
The higher profit project may have a higher SD simply because the expected profits are higher
Two problems with highly variable cash flows?
- Planning is more difficult
- Operating risk is increased
How do FRAs differ from interest rate futures?
FRAs allow lenders/borrowers to fix a rate of interest. The bank will pay/receive any difference between the agreed rate and the actual rate paid/received
Interest rate futures are similar tovFRAs in that they are contracts on an interest rate, but the terms, amounts and periods are standardised
What is Shareholder Value Analysis?
The process of analysing the activities of a business to identify how they will result in increasing shareholder wealth
What is the over-riding objective of companies?
To create long-term wealth for shareholders
How can a cost of equity be calculated that reflects the systematic risk of a project?
By using an equity beta from a similar company as a surrogate in the CAPM/other dividend Ke model
An increase in WACC is associated with a ______ in value, but assuming the project has a positive NPV this could result in an _____ in value
reduction
increase
Systematic vs unsystematic risk?
Systematic risk: the risk that all companies are exposed to. Cannot be eliminated through diversification
Unsystematic risk: affects a particular market sector or individual company. Most of this risk can be diversified away by investing in a portfolio of randomly selected securities
What does portfolio theory show that?
The only logical portfolio to hold is one which is fully diversified
Reaction of stock market and shareholders to diversification?
Stock market: diversified companies usually trade at a conglomerate discount, so the stock market is unlikely to welcome the diversification
Shareholders: for shareholders already holding a well-diversified portfolio, they are unlikely to welcome the company diversifying
If financing of a project results in a change in the capital structure, what should not be used? What should be used instead?
WACC/NPV should not be used
APV should be used (the project will be appraised as if it were only financed by equity, to arrive at a base case NPV. The base NPV is then adjusted for the PV of costs and benefits of the actual type of finance used, including the PV of the tax shield on interest paid)
Risks of trading overseas, that are non-forex? (7)
- Physical risk (e.g. goods being lost)
- Credit risk (customer defaulting)
- Trade risk (customer refusing delivery)
- Liquidity risk (inability to finance credit given to customers)
- Local finance costs
- Tax systems
- Dividend restrictions
For purchasing a company’s shares, p/e and enterprise value are most relevant why? (2)
- They are forward looking
- They are based on profits/earnings
What type of valuation might you expect to be used for sale of a company’s shares that is intended to be broken up?
Asset valuations (as they are based on historic figures and the BS)
What three assumptions are implied for using WACC to appraise projects?
- The company’s historic proportions of debt and equity are not to be changed
- The company’s systematic business risk is not to be changed
- The finance is not project-specific (e.g. cheap government loans)
If there is diversification and a change in the level of systematic risk, is it suitable to keep using the existing WACC?
No
In the money options vs out of the money options difference?
In the money; would be exercised, have an intrinsic value equal to the difference between the exercise price and the current share price
Out of the money; would not be exercised. Zero intrinsic value
How is time value calculated?
Deducting intrinsic value from option premium
What factors will affect the time value of an option? (3)
- The time period to expiry
- The volatility of the market price of the underlying item
- The general level of interest rates
Disadvantages of sensitivity analysis? (3)
- Assumes that changes to variable can be made independently
- It ignores probability; only identifies how far a variable needs to change to result in a zero NPV
- It is not an optimising technique and does not point directly to a correct decision
Why might simulation be a better alternative to sensitivity analysis? (one main advantage)
It allows the effect of more than one variable changing at the same time to be assessed. This gives more information about the possible outcomes and their relative probabilities and it is useful for problems that cannot be solved analytically
For annual equivalent cost (AEC) analysis, what limitations are there? (5)
- Changing technology, leading to obsolescence
- Changes in design
- Inflation- affecting estimates and the replacement cycles
- How far ahead can estimates be made and with what certainty
- Ignores taxation
Gearing ratio? (2 possibilities)
- D/E
- D/(D+E)
Interest cover ratio?
Earning before interest and taxes / interest
A listed company seeks to give ordinary shareholders a _______ dividend with some growth. This cannot be achieved by having a policy of maintaining a constant ______ ratio, since dividends rise and fall with profits
constant
payout
Advantages of an interest rate swap? (7)
- Arrangement costs are significantly less than terminating an existing loan and taking out a new one
- Interest rate savings are possible, either out of the counterparty or out of the loan markets by using the principle of comparative advantage
- They are available for longer periods than the short-term methods of hedging such as FRAs, futures and options
- They are flexible since they can be arranged for tailor-made amounts and periods
- They are reversible
- It is possible to obtain the type of interest rate, fixed or floating, that the company wants
- Swapping to a fixed interest rate assists in cash flow planning
Current WACC should be used for an investment if…? (3)
- Historical proportions of debt and equity will not change
- The systematic business risk of the firm will not change
- The new finance is not project-specific
Sensitivity analysis advantages? (3)
- It facilitates subjective judgement
- It identifies areas critical to the success of a project
- It is relatively straightforward
Simulation advantages? (2)
- More than one variable at a time can be changed
- It takes probabilities into account
Simulation disadvantages? (3)
- It is not a technique for making a decision
- It can be time consuming and expensive
- Certain assumptions that need to be made could be unreliable
What is the major problem with asset valuations for justifying the price per share?
What is preferable for an issue price to based on? (3)
They do not reflect the earning capacity of the assets
- P/E ratio
- Enterprise value
- Income
SVA is based on _____ free cash flows that the company generates, which are forecasted using ______ value drivers. Cash flows will be forecast over a planning horizon, typically 3 to 5 years, and then a _____ value will be calculated
future
seven
terminal
Problems with SVA? (4)
- Estimating the inputs into the model
- Estimating growth
- Length of the planning horizon
- The terminal value dominates the valuation
What key factors are there for consideration of a divestment? (3)
- How much will be received?
- When will it be received?
- How certain are we that we’ll receive it?
Debt vs equity questions will often lead to gearing and interest cover figures. How do we digest and talk about these? (3)
- State the gearing ratio and interest cover
- State where these figures fall relative to the industry maximum, minimum and average
- State the implications of where it stands
Debt is generally less expensive than equity since it is less _____ than equity for the debt holders
risky
Define a special dividend
A special dividend is a ‘one off’ dividend payment in addition to the ordinary dividend
Define a share repurchase
A share repurchase is an alternative to dividend payments. Instead of paying dividends a company may consider using the cash to repurchase issued shares
Is having a constant payout ratio a suitable dividend policy for a listed company? Why? What is a better alternative?
No, as dividends will rise and fall with profits, which may cause signalling problems.
A better alternative may be paying a constant dividend with some growth
What is purchasing power parity (PPP) theory?
What is it based upon?
What does it state on changes in the exchange rate?
PPP is the theory that in the long-term, exchange rates between currencies will tend to reflect the relative purchasing power of the currency of each country.
The theory is based on the idea that a basket of goods n one country will, after the effect of the exchange rate, cost the same no matter where it is traded.
The impact of different inflation rates in different countries will cause prices to change at different speeds. So even if parity is achieved, disequilibrium will be created. PPP predicts that the disequilibrium will be removed by changes in the exchange rate
Explaining the Gordon Growth model:
1. What is it based on?
2. What is its main premise?
3. Where is this used, and what is this assuming?
GGM:
1. Is based on proportion of dividends that are retained and the rate of return on those retained profits
2. Based on the premise that profits are the only source of funds
3. This is used in the dividend valuation model to get the cost of equity, assuming that the value of a share = PV of growing future dividends
Explaining CAPM model:
1. What does it assume about risk?
2. How is the beta value calculated, and what does this show?
- As unsystematic risk can be diversified away by investors, it is assumed that investors are rational and have a diversified portfolio. Systematic risk cannot.
- A company’s beta value is calculated from the performance of its share price against the market average and is taken as a measure of the market’s view of the risk attached to the security in question
How does agency conflict arise within portfolio theory?
Rational investors will attempt to reduce risk by diversifying.
Managers may want to diversify in order to protect their own jobsl; investors do not want this
A company diversifying may be dangerous if they _____ _______ the industry they’re entering
don’t understand
Why might a project with a negative NPV be accepted?
Because of real options associated with it
An issue of debt could give a ____ ______ advantage
tax shield
What does the Efficient Market Hypothesis (EMH) posit?
What does it say on efficiency?
What is the alternative to EMH? What does it state
That there are no patterns to share prices; markets have no memory, and past prices have no influence on future prices.
Efficiency means that shares cannot be bought cheaply and then sold quickly at a profit. When share prices, at all times, rationally reflect all available information, the market in which they are traded is said to be efficient.
Behavioural finance; this considers investors’ irrational tendencies, leading to a weakening of market efficiency
Key differences between forwards and futures?
A forward contract is a binding agreement to buy/sell a specified quantity of one currency in exchange for another item for settlement at a future date and at a price agreed today. Forward contracts are not always easily available
A currency future is a standardised exchange-traded contract to buy/sell a quantity of one currency in exchange for another notional delivery at a set date in the future. The contracts cannot be tailored to the user’s exact requirements. There may be hedge inefficiencies; rounding of contracts and basis risk. Limited currency available
For a normal distribution graph, the probability of being within 1 SD from the mean is _____%
68.2%
NPV analysis only considers the cash flows relates directly to the _______
project
Companies have a corporate responsibility to take the needs of _____ ______ into account
wider stakeholders
Although conventional dividend theory states that dividends for listed companies should be left at a level where they can grow each year, what did M&M say in their Dividend Irrelevancy Theory on the pattern of dividends?
That the pattern of dividends over time is irrelevant in determining shareholder wealth; dividends should only be paid when there no positive NPV projects to invest in
Why will an interest rate risk not be perfectly hedged by futures contracts? (2)
- The number of contracts; because the contracts are a standard size, it is not possible to hedge a perfect amount and the number of contracts will have to be rounded
- Basis risk; the price of futures will normally be different from the spot price on any given date. This difference is called the basis. The effect of basis is to prevent hedges from being 100% efficient
Interest rate parity (IRP) links _______ & ______ market
currency
money
Per the dividend valuation model, shareholder benefit from owning a share in what two ways? How does this affect current share price?
- Receiving dividends into the future
- Having a capital gain on the value of the shares
The PV of these two benefits creates the price of the shares; this share price is determined by expected future dividends discounted at the investor’s required rate of return (Ke)
Explain the CAPM model (3 main points)
- There is systematic risk that can’t be diversified away
- A company’s beta is calculated from the performance of its share price against the market average and is taken as a measure of the market’s view of the risk attached to the security in question
- The higher the perceived risk, the higher the beta figure and thus the higher the equity return required by investors
Equity beta factors indicate a company’s total level of _____ business and financial risk
systematic
Asset beta factors indicate the systematic business risk of an ______ business
ungeared
What behavioural effects can lead to irrational investment decisions, which questions the validity of the EMH? (9)
- Overconfidence
- Representativeness (investors judgement may be too focussed on a representative observation rather than statistical evidence)
- Narrow framing (investors may just focus on one specific factor and not the wider picture)
- Miscalculation of probabilities
- Ambiguity aversion
- Extrapolative expectations
- Cognitive dissonance (holding long-term beliefs despite contrary evidence being presented against them)
- Availability bias (paying more attention to recent events)
- Conservatism
For issuing bonds, what formula is used? What parameters do we need (in order)?
=PV
Rate of return required over the period
No. periods
Amount of int paid in a single period
FV (paid at maturity)
Present value (issue price)
Main benefit of green bonds?
More attractive to ethical investors, so risk of failure of issue is less
Hard vs capital rationing?
Hard capital rationing: when external capital markets limit the supply of funds to a company
Soft capital rationing: when the firm imposes its own internal constraints on the amount of funds used to finance projects
Three main assumptions of the dividend valuation model?
- Shares have value because of the dividends
- Dividends either do not grow, or grow at a constant rate
- Estimates of future dividends are based on historical data
When are each of the following methods most useful?
1. P/E method
2. Enterprise value
3. Assets methods
4. SVA
- Useful for growth companies and reflects the industry sentiment regarding a particular sector
- Is simplistic and a lot of information from many value drivers is distilled into a single number
- Not that useful; does account for earnings potential, doesn’t necessarily reflect realisable value of assets, doesn’t include closure & redundancy costs
- Evaluates future free cash flows and is more representative of the true value of the company
Issues of valuing a start up company? (5)
- No track record of profit/(losses)
- Unpredictable market acceptance of products
- Unknown competition
- Inexperienced management
- Difficulties in valuing digital assets and associated income streams
Predictive analytics vs prescriptive analytics?
Predictive analytics: historical and current data is used to create predictions about the future
Prescriptive analytics: combines statistical tools utilised in predictive analytics with artificial intelligence and algorithms to calculate the optimum outcome from a variety of business decisions
Characteristics of forwards? (6)
- Binding
- Inflexible
- No upside potential
- Arrangement fee &/or poor rate
- Tailored to specific needs, OTC
- Simple to arrange
Characteristics of futures? (5)
- Traded on an exchange
- Requires initial margin & top up - cash flow implications
- Rounding of contracts and basis risk can cause inefficiencies
- No upside potential
- Can close out contract if no longer needed
Characteristics of options? (6)
- Call = right to buy
- Put = right to sell
- Can be OTC (tailored) or traded
- Expensive premium
- Greater flexibility
- Can benefit from upside by abandoning option
TERP formula?
(MV shares pre-rights - rights + rights proceeds + NPV) / No. shares ex-rights
Dividend payout ratio?
Dividends / earnings
Dividend yield?
Dividend per share / share price
Price-earnings ratio?
Share price/Earnings per share
What are the real options? (5)
- Follow on options
- Abandonment options
- Timing options
- Growth options
- Flexibility options
Terminal value calculation?
Profit latest year * (1+growth of sales)/(discount rate - growth of sales) * annuity factor
Dividend yield ratio?
Dividend per share / market price per share
Earnings per share ratio?
Profits distrib to ordinary shareholders / no. OSC
P/e ratio?
Market price per share / EPS
Enterprise value equation?
Equity value equation?
Enterprise value multiple * EBITDA
Enterprise value - market value of debt + cash & equivalents
