Revision Pack Flashcards
List and describe four foreign direct entry strategies that could be adopted by Transform Plc as it invests in various countries
transaction based – exporting (spot transaction)/ with foreign agent
- licensing (property owner permits other parties to use property)
- franchising (Party Passes on knowledge, trademarks so other party can sell product under business’ name)
- joint venture (agreement btw two or more parties to pool resources to achieve task)
- wholly owned subsidiary
Explain the four broad approaches to risk management
Transfer
Accept
Reduce
Avoid
Assuming company has limited funds for new projects and that the proposed project will compete against other projects within the company for funding. You are required to state and explain the technique that should be employed to evaluate these projects.
- Capital rationing – This is a situation where the finance available for new projects is limited to the amount which prevents acceptance of all new projects with a positive NPV.
- Types – Soft & hard capital rationing.
- Ranking investment projects by absolute NPV may not lead to correct investment decision
- Technique to be used is profitability index – projects are ranked by NPV generated per £ of rationed capital used.
- Profitability index will cause NPV to be maximised for the level of investment finance involved.
General problems of payback technique
- Cash –flow figures after the payback period is ignored in the decision making process.
- Tends to favour short term projects.
- Ignores size and timing of cash flows.
- Unable to distinguish between projects with the same payback period.
- Takes account of the risk of the timing of cash-flows but not the variability of those cash-flows.
Discuss two risks associated with Foreign Direct Investment (FDI), indicating how they can be managed.
Remittance of projected cash flow and restrictions by host government
Government financial assistance , inflation and grants
Foreign currency exchange and hedging methods
Foreign taxation and double taxation agreements
Timing of project cash flow and parent company cash flow mis-match
Explain what is meant by cost of capital
The cost of capital is the minimum acceptable return on an investment.
It is the return that a company has to offer finance providers to induce them to buy and hold a financial security. This rate is determined by returns offered on alternative securities with the same risk class. It is generally computed at a discount rate for use in investment appraisal exercises. As companies raise capital from different sources they can calculate a Weighted Average Cost of Capital which would reflect the rate at which different groups of investors will expect to be compensated to hold the company’s securities. A distinction could be made between a company’s real cost of capital and its nominal cost of capital.
Compare two methods that can be used to calculate the cost of equity.
A company’s cost of equity can be calculated using either the dividend growth model or the Capital Asset Pricing Model (CAPM). The two models are based on different assumptions which lead to different estimates of cost of equity. Both models have been criticised for having unrealistic assumptions
The dividend growth model is a forward looking model. It assumes that the current share price is equal to the present value of all the stock’s future dividend payments.
It assumes that the growth rate in dividends has to be constant over time.
The model is best suited for firms with well-established dividend payout policies that they intend to continue into the future.
The CAPM is based on the notion of a relationship between risk and return. It uses historical returns to calculate a company’s cost of equity. Using a measure known as the beta it evaluates risk and return of a company’s stock compared to the market average. The CAPM states that a security’s return is equal to the risk-free rate plus the individual security’s risk premium. The model makes assumptions about investors and the financial markets. It assumes that financial markets are perfect and that investors are risk averse and rational, can both lend and borrow at the risk free rate and have homogeneous expectations about the future and about the expected returns and risks of available investments.
Explain the traditional theories about capital structure and their limitations.
There exists an optimal capital structure. At an optimal point, the overall cost of capital is minimized and the value of the company is maximized. This based on the following propositions:
•As gearing increases the cost of equity rises due to the increase in financial risk, but this is outweighed by the lower cost of debt and so the overall cost of capital decreases;
•As gearing continues to increase the cost of equity rises more sharply such that this effect is greater than the effect of the lower cost of debt and the cost of capital rises;
•Therefore there exists a minimum optimal cost of capita
Limitation
The theory is useful in as much as it highlights the fact that financing and capital structure may affect a company’s value but it gives no suggestion as to where that optimal level lies.
Explain the Modigliani and Miller theories about capital structure and their limitations.
The value of a company is determined by the available investment potential not the capital structure. The optimal capital structure comprises of 99.9% debt. Without tax, WACC will remain unchanged. Unrealistic assumptions • No transaction costs • Information is freely available • Individual can borrow on the same terms as companies • Bankruptcy cost • Tax exhaustion • Agency costs
Management Buy Out (MBO)
It involves the purchase of part or all of a business from its parent company by the existing management of the business. MBOs are normally financed using a mixture of debt and equity, although there has been a trend towards leveraged MBOs – high level of debt is used.
Management Buy In (MBI)
This is where a group people (external management team) purchase of part or all of a business from a parent company. This may be due to subsidiary management having insufficient skills.
Sell off
This involves the sale of part of a company’s operations to a third party, usually for cash. A sell off is most likely to occur in a multi-product company.
Spin off
A spin-off is another name for a demerger. It is involved taking part a business, placing it inside a new business and issuing shares to shareholders in the original business in proportion to their holdings and no cash is raised. The technique is normally used to avoid takeover the whole of the business.
Using examples, explain why synergy might exist when one company merges with or takes over another company.
Where value of the combined firms exceeds value of the separate firms combined.
Economies of scale – common in horizontal mergers, spreading fixed costs. Can be realised through production, marketing, management and accounting etc e.g. one head office with less staff than exists in the two companies currently.
Economies of vertical integration – value added as a step backward or forward no longer needed.
Complementary resources - can take several forms e.g. one firm strong in production but weak in marketing can merge with one that has opposite characteristics.
Use of surplus funds –e.g. firms in mature industries/where firm has few attractive prospects on its own.
In the case of horizontal mergers, lack of competition may result in operating economies e.g. the advertising budget may be reduced.
How does the method of financing affect the cost of a merger to the bidding company’s shareholders?
Cost of a merger- premium paid for the target. Depends on method of financing and terms of merger. When financed by cash, cost = cash paid out less value of target.
When financed by shares, value of shares after the merger important. Cost = value of shares issued less vale of target. Cost depends on merger gains which are reflected in post-merger share price.
Discuss the advantages and disadvantages of cash as a form of payment from the viewpoint of bidding company’s shareholder and the target company’s shareholders.
Advantages for bidding company/acquirer:
•shareholders certain of how much is paid
•shareholders retain control of their firm;
•will not alter ownership structure and nor lead to dilution of EPS,
•greater chance of early success.
Disadvantages for the acquirer:
•strain in cash flow,
•may become highly geared as a result of financing takeover.
Advantages for the target shareholders:
•certain value, able to spread investments,
•can adjust portfolio without incurring selling costs
Disadvantages: may produce capital gains tax liability
Discuss the objectives of working capital management
Two main objectives:
Profitability: related to shareholder wealth maximisation
Liquidity: meet short-term obligations
Two goals often conflict
Explain the different strategies that a company could follow in order to finance its cumulative working capital requirements
It is important to match the financing with the life of assets. We can analyse assets into non-current assets, permanent current assets and fluctuating current assets.
Permanent current assets, being ‘core’ current assets which are needed to support normal levels of sales, should be financed from a long-term source.
The working capital policy chosen should take account of the relative risk of long- and short-term finance to the company and the need to balance liquidity against profitability.
An aggressive financing policy will use short-term funds to finance fluctuating current assets as well as to finance part of the permanent current assets.
A conservative financing policy will use long-term funds to finance permanent current assets as well as to finance part of the fluctuating current assets.
An aggressive policy will be more profitable but more risky.
In 2020, the cash conversion cycle of the firm is expected to be 120 days, discuss whether the firm has to increase its working capital investment.
The longer CCC, the greater the amount of investment required in working capital. Good WCM looks for ways to minimise this period.
The firm has accumulated more cash for working capital needs. Advice on appropriate policies for managing such short-term cash surplus
Appropriate policies for managing short-term cash surplus: • Invest short-term cash surpluses in appropriate short-term instruments. • Must be no risk of capital loss. • Choice of investment depends on: i. size of the cash surplus ii. maturity of the short-term asset iii. yield required iv. any penalties for early encashment.
Why do companies issue rights at a discount?
Rights issues are made at a discount on the current market price of the shares as:
•There is an inevitable delay between fixing the rights issue price and the actual rights issue. This period could see a fall in the shares’ market price to one below the rights issue price. If the rights issue is not priced at a substantial discount, such a fall in price could cause the failure of the rights issue. The normal discount is in a range of 20 – 40%. In the market conditions existing at the beginning of 2003 you could expect the discounts to be deeper than normal. (Here the discount is 57.5p (137.5p-80p) – a discount of 41.8%)
•The discount puts pressure on share holders either to take up the shares offered or to sell the rights to someone who will. Nowadays, companies will do this automatically for shareholders. As we will see in the next scenario, shareholders who do nothing will lose out financially by allowing the right to lapse.
•The discount does not represent a gift from the company. As we will see in the next scenario, the right issue price will not affect a shareholder’s wealth either positively or negatively – unless the shareholder does nothing.
Why do companies normally make rights issues for new equity capital rather than public issues?
Rights issues are the most popular form of new share issue. This is because:
•The legal requirements surrounding a rights issue to existing shareholders are much less stringent than those relating to an issue to the public
•It is much cheaper to make a rights issue – the company has a register of the present shareholders and can contact each one direct.
•Ownership is not diluted with a rights issue.
•As mentioned above in section f, rights issues are normally a success.
From the company’s viewpoint, how critical is the pricing of a rights issue likely to be?
The pricing of the rights issue is not likely to be of any great concern provided that it is below the market price of the shares at the date of the issue and provided that the number of shares issued at the chosen price is sufficient to meet the company’s objective in raising the finance. It can easily be shown that the wealth of individual shareholders is not affected by the rights issue price as shown above.
Explain briefly why a share price may be different from the theoretical ex rights price after a rights issue
The actual ex rights price may be different from the TERP as a result of differing investor expectations about the state of the economy, the proposed use of funds by the company, the future level of earning of the company and the expected level of dividends. These expectations affect investors buying and selling preferences and market prices
Outline why a company would underwrite a rights issue.
Underwriters are financial institutions such as investment banks, pension funds and insurance companies. Underwriting provides a useful way for companies to protect themselves against the possibility of adverse prices after the announcement of a new equity issue when raising new capital. For a fee, underwriters are prepared to hold the stock in the event that not all shareholders subscribe. The main underwriter also advises the company on a rights issue. An unsuccessful rights issue would result in the company failing to raise the finance it is seeking and also could damage the company’s reputation. This could make it more difficult for the company to raise funds in the future
