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Finance > Term 2 > Flashcards

Term 2 Flashcards

1
Q

Formula: Equity Cost of Capital

A

Ke = (D1/P0) + g

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2
Q

Formula: Preference Share Cost of Capital

A

Kps = D/P0

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3
Q

Formula: Irredeemable Bond Cost of Capital

A

Kib (before tax) = interest / P

Kib (after tax) = Kib (before tax) x (1 - tax rate)

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4
Q

What is meant by cost of capital?

A
  • min. acceptable return on an investment
  • return company offers finance providers to induce them into buying and holding a financial security
  • determined by returns offered on alternative securities with same risk class
  • computed at a discount rate for use in investment appraisal
  • distinction between real and nominal cost of capital
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5
Q

Dividend Growth Model as method to calculate cost of equity

A
  • forward-looking
  • assumed P0 equal to all future dividend payments
  • assumes constant dividend growth rate
  • suited for firms with well-established dividend payout policies
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6
Q

Capital Asset Pricing Model as method to calculate cost of equity

A
  • based on notion of relationship between risk and return
  • uses historical returns to calculate firm’s cost of equity
  • uses beta measure to evaluate firm’s risk and returns compared to market
  • states that securities return is equal to risk-free rate plus individual’s security risk premium
  • assumptions: perfect market, investors risk-averse and rational, both have same expectations about future, expected return and risk
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7
Q

Transaction Risk

A

to what extent will an exchange rate change alter the value of a foreign-currency transaction already entered into
Examples: - buying/selling goods
- repaying loan/ interest
- dividends

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8
Q

Translation Risk

A

risk of changes to foreign currency denominated assets and liabilities in the balance sheet due to exchange rate movements

  • arises on consolidation
  • no cash implication but may affect ratios
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9
Q

Economic Risk

A

to what extent will firm’s value change due to exchange rate change
- can’t be avoided, difficult to hedge against
= long-term form of transaction risk

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10
Q

Expected future spot rate - formula

A

Today’s spot rate x ((1 + foreign inflation rate)/(1 + UK inflation rate))

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11
Q

Internal risk management techniques

A
  • home currency
  • netting
  • matching
  • leading and lagging
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12
Q

External risk management techniques

A

external meaning service is bought from bank or money market

  • forward exchange contract (FEC)
  • money market hedge
  • currency futures
  • currency options
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13
Q

Internal risk management techniques - Home currency

A
  • invoice in home currency to remove currency risk and transfer risk to customer/supplier
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14
Q

Internal risk management techniques - matching

A

If you have a sales transaction with one foreign customer, and then a purchase transaction with another (but both parties operate with the same foreign currency) then this can be efficiently dealt with by opening a foreign currency bank account
- works for transaction and translation risk

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15
Q

Internal risk management techniques - netting

A
  • If you owe your Japanese supplier ¥1m, and another Japanese company owes your Japanese subsidiary ¥1.1m, then by netting off group currency flows your net exposure is only for ¥0.1m
  • i.e. Company nets off foreign currency balances of subsidiaries at group level and only net exposure is hedged externally
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16
Q

Internal risk management techniques - leading and lagging

A

Leading – making payment before it is due,

Lagging – delaying payment for as long as possible

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17
Q

External risk management techniques - forward exchange contract

A
  • an agreement, entered into today, to purchase or sell a fixed quantity of a foreign currency on a fixed future date at a rate fixed today.
  • exchange rate is agreed today but the currencies are exchanged in the future.
    -once entered has to be executed
    + can be customised
    + CFs only on execution
    + protects against adverse movements in exchange rates
  • no gains from favourable changes
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18
Q

External risk management techniques - money market hedge

A

If foreign currency receipt (asset) expected:
- Borrow in foreign currency now (create liability)
- Convert borrowed foreign currency into domestic currency at spot rate
- Deposit £ to invest and earn interest
- Repay foreign currency loan plus interest out of future foreign currency receipt.
+ have money now rather than later so can use it now

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19
Q

External risk management techniques - futures contract

A

Futures are exchange-traded contracts to buy or sell a standard quantity of a financial instrument or foreign currency at an agreed price on an agreed date.

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20
Q

Exchange rate appreciates and depreciates meaning

A
  • apreciates = becomes stronger
  • dereciates = becomes weaker
    Example: was USD 1.50 / £1, now USD 1.40 / £1 £ has depreciates
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21
Q

difference spot rate and forward rate

A
  • spot rate now (transaction finalised within 2d)

- forward rate later (next 3 or 6 month)

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22
Q

Interpret following USD to £ rate:

1.5002 - 1.5013

A
  • higher rate is what you get if you sell USD

- lower rate is what you get if you buy USD

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23
Q

Does the economic risk apply to a company that is not trading overseas?

A

Yes, because competitors may be trading overseas
Example: Have a UK shoe company, only trade in UK but competitor buys everything from China so can sell shoes at cheaper prices which will affect my prices

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24
Q

Explain PPP - Purchasing Power Parity

A
  • one should be able to buy the same products for the same money in different countries
  • if there are price differences the exchange rate will change
    Example: USD/£ = 2/1, shoes = £4 so should be USD 8 but are only USD6 what happens? people will buy shoes in US and sell in UK which means demand USD goes up and USD gets stronger
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25
Q

Difference between matching and netting

A

matching matches receipts and payments exactly whereas netting doesn’t perfectly align them so have to find a way to account for risk of the difference

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26
Q

Difference between forwards and futures contracts

A
  • forwards contract is custom made whereas a futures contract is a standard contract that will lead to imperfect hedging meaning a small unprotected amount remains, i.e. a basis risk
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27
Q

factors to consider before using forex markets

A
  • amount
  • frequency - may ignore hedges if one-off transaction
  • possible matching of receipts and payments
  • speculative reasons
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28
Q

Options

A
  • contract giving buyer right to buy a fixed amount for a fixed rate at fixed date/ fix interest rates and the seller the obligation to sell at those terms
  • have to pay premium
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29
Q

Types of options

A

Over the counter options: customised to clients needs, cannot be traded, caps fix lowest rate; floors fix lowest rate and collars fix range
Traded options: standardised and traded in secondary market with cycles of 3 or 6 month where put option is right to sell/lend and call option is right to buy/borrow

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30
Q

Traded Options - Advantages and Disadvantages

A

+ flexibility, no obligation
+ standardised and tradable
- imperfect hedges - over/ under hedging
- cost of premium

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31
Q

What factors affect premiums of traded options?

A
  • higher strike price for puts reduces cost
  • rates: depreciation in £:$ increases value of $ call option
  • option’s value increases in volatile times
  • the longer the time to expire the higher the option value
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32
Q

Internal interest rate risk management

A

Smoothing: keep portfolio of fixed and floating rate debt so losses of one covered by benefits of other
Matching: match assets and liabilities with same rate
Netting: if difference between assets and liabilities hedge difference

33
Q

External interest rate risk management

A

Forward rate agreement: fixes future rate, if rate higher than market rate bank will pay compensation, if lower company pays bank - no gains/losses
Interest rate guarantees: custom written rate offered by bank, only applies if company benefits, premium charged
Interest rate futures: standardised, duration 3m
Interest rate options: only on interest rates, not loans
Interest rate swaps: 2 companies swapping interest commitments if one fixed, no concerns and one floating concerned

34
Q

Advantages and disadvantages of swaps

A

+ longtime, up to 30yrs
+ lower fees than options
+ flexible - tailored to company
+ access to restricted long term hedging market
+ able to alter currency of expected CFs
- locked into agreed rate, no benefit from favourable changes
- counterparty risk if don’t make payments
- counterparty may default, exposed to risk again

35
Q

How to select hedging method?

A
  • hedge internally as much as possible
  • for non-standard exposure use tailor-made derivates
  • use options if direction of rate change not known
  • bank-created products better for SMEs
36
Q

Advantages of risk management

A
  • remain competetive
  • reduce bankruptcy risk
  • avoid cost of financial distress
  • reduce CFs volatility
  • enhance debt-capacity
37
Q

Disadvantages of risk management

A
  • instruments complicated
  • costs
  • risky, i.e. Enron, Societe Generale
  • diccicult to account for and determine tax treatment
38
Q

Political risk

A
  • being affected by political events in host country or changes in relationship between host country and home country
    Risk management through: insurance, negotiation, structuring operating and financing policies
39
Q

Calculating Cash Conversion Cycle

A

CCC = Inventory Days + Receivable Days - Payable Days
Inventory Days = (Inventory/COS) x 365
Receivable Days = (Receivables/Sales) x 365
Paybale Days = (Payables/COS) x 365

40
Q

When does overtrading occur?

A

company increases sales volume and therefore increases debtors, stock, creditors but doesn’t have necessary liquidity so needs to take out short term finance

41
Q

Symptoms of overtrading

A
  • increases turnover, current assets, fixed assets
  • increased short term financing, i.e. trade creditors, bank overdrafts
  • liquidity ratios decrease
  • liquidity deficit
42
Q

Solutions for overtrading

A
  • finance from share issues, retained profits etc.
  • improve stock/debtor control
  • postpone expansion plans
  • maintain/increase long term finance
43
Q

foreign direct entry strategies to adopt if company wants to invest in different countries

A

–transaction based – exporting (spot transaction)/ with foreign agent

  • licensing
  • franchising
  • joint venture
  • wholly owned subsidiary
44
Q

objectives of hedging strategy

A
  • objectives must be clearly defines

- decide if treasury is cost or profit centre

45
Q

Key elements of a risk management policy

A
  • Types of derivative that can be used
  • Limits on the volume and principal amount of derivatives transactions
  • Regular assessment of market value of company’s derivatives positions
  • Systems and procedures to detect or prevent unauthorised transactions
  • Senior level responsibility for compliance
46
Q

WCM objectives

A
  • remain profitable and ensure SHWM
  • remain liquible to meet short-term obligations
  • both may conflict
47
Q

Strategies to finance WC requirements

A
  • match financing with asset life: analyse assets into non-current,permanent current and fluctuating current assets
  • permanent current assets are financed through long-term sources and need to support every day sales
  • WC policy chose need to account for long and short term risk, liquidity and risk must be balanced
  • aggressive policy uses short-term finance for fluctuating and part of permanent assets
  • a conservative policy uses long term finance for permanent and part of fluctuating assets
  • aggressive policy more profitable and more risky
48
Q

The current CCC is 152d. In one year CCC is expected to be 120d. Does the organisation need to increase capital?

A

The longer CCC, the greater the amount of investment required in working capital. Good WCM looks for ways to minimise this period.

49
Q

Policies for managing short-term cash surplus

A
  • invest short term cash in short-term instruments
  • only if no risk of capital loss
  • choice of investment depends on: size of surplus, maturity of short-term asset, yield required,penalties for early cashing out
50
Q

Cost of sales

A

COS = opening inventory + purchases - closing inventory

51
Q

Discuss two risks associated with Foreign Direct Investment (FDI), indicating how they can be managed

A

Foreign currency exchange and hedging methods

Foreign taxation and double taxation agreements

52
Q

Disadvantages of debt factoring

A

Debt factor will only be willing to factor credit worthy invoices . This might inhibit sales to riskier customers which under normal circumstances may be considered as worthwhile. Debt factor may be more aggressive in its collection policies. This can damage customer relations and future sales.
Use of factoring can cause a reduction in how a company’s financial stability is perceived

53
Q

Examine policies that a company can use to manage the stock, creditors and cash elements of working capital.

A

Stock control – improvements using computerised systems and techniques such as economic order quantity and just-in-time stock control. Achieving faster stock turnover can reduce costs of stockholding.
Cash control – use of cash flow forecasts can help identify likely surpluses and deficits of cash. Surpluses can be invested and short–term overdrafts arranged to cover deficits.
Creditors – it may be possible to delay payments to creditors but this can have adverse effects on relationships with suppliers and the company could incur interest payments on overdue accounts.

54
Q

Credit analysis system

A

Reduce risk of bad debts by assessing and reviewing creditworthiness of new customers. Obtain information from bank references, trade references, published information, credit agencies and the company’s own experience

55
Q

Credit control system

A
  • Customer accounts should be kept within agreed credit limit.
  • Credit limits should be reviewed periodically.
  • Invoices should be dispatched promptly.
  • Statements should be sent out regularly where appropriate.
56
Q

Trade receivables collection system

A
  • Costs of debt collection should not exceed amounts recovered.
  • Aged trade receivables analysis must be regularly performed and late payers chased.
  • Company should establish procedure for pursuit of late payments.
  • Company could consider charging interest on overdue bills.
57
Q

Is factoring good for long-term financing?

A

No, because finance provided by the factor is an accelerated cash flow derived from trade receivables. Rather, it should be used for a short-term need, such as the payment of trade payables or meeting forecast cash needs. In general, the matching of assets and liabilities is recommended. That said permanent current assets should be financed from a long-term source.

58
Q

Problem with reducing period of CCC

A

CCC refelct business’ needs in different areas. Reducing inventory might mean reducing customer satisfaction, reducing receivables might make customers turn to competitors and increasing payables could mean problems with suppliers. Overall capital level with fluctuate with business activity and depend on company’s risk attitude, i.e. an aggressive policy would work to reduce CCC and increase profitability but also risk.

59
Q

Methods of managing trade receivables

A
  • factoring
  • invoice discounting
  • using receivales as security for bank loan
  • discounting bills of exchange
60
Q

Why are Foreign Direct Investment (FDI) decisions more difficult to evaluate than domestic investments?

A
  • Foreign currency project cash flows will need to be evaluated
  • Foreign taxation systems may differ from the domestic taxation system
  • Project cash flows and parent cash flow will be different
  • Remittance of project cash flow may be restricted
61
Q

Difference between WACC and COC

A

The cost of capital is the return that a company has to offer financial providers to induce them to buy and hold a financial security. Companies tend to have a mixture of the different types of capital in their structure and, when considering the cost of capital used to finance a project, it is common to use the cost of the mix of capital held by the company ie the weighted average cost of capital (WACC).

62
Q

Why does asymmetric information push companies to raise external funds by borrowing rather than by issuing ordinary shares?

A
  • asymmetric information means that the information between managers and investors is different. Managers are more informed of their company prospects, risks and values than the outside investors.
  • according to the pecking order theory, a company is being pessimistic by issuing shares and therefore sends a wrong signal that the share price may be overvalued. According to the pecking order theory, investment should be financed first by internal funds, then debt and lastly equity.
  • The information cost/ information discount is lower for debt than for equity
63
Q

FD estimates that if the company takes on more debt finance and repurchases shares at MV WACC will decrease. Mention what possible inaccuracies come with this proposal.

A
  • difficult to estimate SP after buying back shares
  • no allowances for repurchasing shares at premium to MV which may be needed to convince SHs
  • no allowance for transaction costs for repurchase and bond issue
  • difficult to estimate increase in SH and preference SHs required COC due to increased risk
  • cost of debt is after-tax cost but taking on more debt might change company’s tax position
64
Q

Dividend Irrelevance Theory

A

Investors act rational as to maximise SHW, they don’t care whether they receive dividends or CGs. Company needs to maximise its value so invests in all positive NPV projects. If funds insufficient, raise more equity. If surplus can pay out as dividend. If SHs want cash can sell some shares (=home-made dividends). Based on assumptions.

65
Q

Dividend Irrelevance Theory - Assumptions

A
  • no transaction costs for converting shares into cash or for selling shares
  • no taxes
  • markets are perfectly efficient so no capital constraints
  • companies financed by equity only
66
Q

Are home-made dividends possible?

A

no, because markets aren’t perfect:

  • brokerage fees
  • time-intensive
  • sales could lower SP
  • may trigger CG Tax liability
67
Q

Traditional view - dividend relevance

A

dividends are preferred to CGs because investors prefer a certain dividend now to leaving the amount in an uncertain investment (bird in hand argument). Therefore, shares of companies with higher dividends are seen as more valuable. Hence, dividend policy plays a key factor in determining SP.

68
Q

Define implications of information asymmetry in relation to dividend policy.

A
  • declaring dividends has information effect: unexpected increase seen as good news, increases SP
  • BUT: dividend increase could be due to decrease in attractive projects meaning little future growth prospects whereas dividend decrease could mean company invests in more projects
69
Q

Clientele effect

A

SHs have different needs and prefernces, e.g. pensions funds and insurance companies rely on regular dividends. Also depends on SHs tax position if they prefer to pay CG tax or income tax. Clientels form as SHs select companies that meet their preferences.

70
Q

Dividend policies - Fixed % payout ratio

A 
- pay fixed % of profits as dividends
\+ easy to operate
\+ sends signals to investors about performance
- dividends fluctuate with earnings
- inflexible
71
Q

Dividend policies - zero dividend payment

A

+ for investors who want CGs
+ cheap and easy to operate, i.e. no admin costs
+ company can reinvest earnings
- unacceptable to most investor groups

72
Q

Dividend policy - constant or steadily increasing dividend

A

+ acceptable to most investors

  • SH expect increase in dividend but company may not be able to afford
  • limits company ability to invest
73
Q

Scrip dividends

A
  • additional shares as alternative to cash dividend
  • often higher value than cash dividend
  • taxed as income
  • company retains cash
  • decreases gearing
  • share price unchanged if markets efficient
74
Q

Share repurchases

A
  • return cash to SHs if believed they can use it better
  • enhances value of remaining shares
  • increases ROCE, EPS and gearing
  • market value increases
75
Q

Special dividends

A

cash payments > dividend payment

76
Q

Non-pecuniary benefits

A

discounts or special offers on company products/services if SH owns minimum amount of shares, e.g. 25% discount if more than 500 Next shares

77
Q

Limitations of Portfolio Theory

A
  1. unrealistic to borrow at risk-free rate: companies and individuals not risk free and will be charged a premium to reflect risk level
  2. difficult to identify market portfolio: need knowledge of risk and return of all risky investments & correlation coefficients
  3. expensive to construct market portfolio: transaction costs making it impossible for small investors
  4. composition of market portfolio constantly changes: shifts in risk-free rate of return and envelope curve
78
Q

Correlation Coefficient

A

= relative measure of risk p. unit
= standard deviation / expected return
Limitation: question is not which investment has more risk p. unit of return but how much increase in risk does investor accept for increase in return? I.e. how risk-averse are they?

Finance (3 decks)

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