Test Flashcards
Financial managers types (3)
- Chief financial officer: Top financial manager
- Treasurer: Oversee’s cash management, credit management, capital expenditure and financial planning
- Accountant: Oversee’s taxes, cost accounting, financial accounting and data processing
What do financial managers do and what decisions do they make? (3)
Attempt to answer business finance questions.
- Capital budgeting: Long term investments?
- Capital structure: Paying for assets? Debt v Equity?
- Working capital management: Managing everyday finances?
Investments
Working with financial assets such as shares and bonds. Risk versus return and asset allocation.
Investment job opportunities (4)
- Stockbroker
- Financial advisor
- Portfolio manager
- Security analyst
Financial institutions
+ Examples (3)
Companies that specialise in financial matters.
- Banks
- Insurance companies
- Brokerage firms
Financial institutions job opportunities (1)
- Client advisor
International finance characteristics (5)
- Area of specialisation in finance
- Assists work internationally regularly
- Requires knowledge of exchange rates and political risk
- Requires knowledge of countries customs
- Bilingual is beneficial
Basic areas of finance (4)
- Corporate finance
- Investments
- Financial Institutions
- International finance
Why study finance? (4)
- Marketing (Budgets, marketing research, marketing financial products)
- Accounting (Dual accounting and finance function, preparation of financial statements)
- Management (Strategic thinking, job performance and probability)
- Personal finance (Budgeting, retirement planning, uni planning, everyday cash flow management)
Forms of business organisation (3)
- Sole proprietorship
- Partnership: General or Limited
- Corporation
Sole proprietorship
Business owned by one person.
Sole proprietorship advantages (4)
- Easier to start
- Least regulated
- Owner keeps all profits
- Taxed once as personal income
Sole proprietorship disadvantages (4)
- Limited to life of owner
- Equity capital limited to owners personal income
- Unlimited liability
- Difficult to sell ownership interest
Partnership
Business owned by two or more people.
Partnership advantages (4)
- Two or more owners (more skills)
- More capital available
- Relatively easy to start
- Income taxed once as personal income
Partnership disadvantages (3)
- Unlimited liability: General partnership/Limited partnership
- Difficult to transfer ownership
- Partnership dissolves when partner dies/wants to sell
Corporation
A legal ‘person’ distinct from owners.
Corporation advantages (5)
- Limited liability
- Unlimited life
- Separation of ownership and management
- Easy to transfer of ownership
- Easy to raise capital
Corporation disadvantages (2)
- Separation of ownership and management
- Taxation of company profits can be an issue
Goals of financial management (corporation)
- Maximise current value per share of company’s exisiting shares?
Agency relationship
Principal hires an agent to represent their interests. Shareholders (principal) hire managers (agents) to run the company.
Agency problem
Conflict of interest between principal and agent.
Management may act in best interest, rather than consider shareholder’s interest, which may contradict goals.
Management goals and agency costs.
Methods to reduce agency problems (4)
- Managerial compensation: carefully structured incentives can be used to align management and shareholders.
- Corporate control
- Threat of takeover may result in better management.
- Other stakeholders (Increase institutional ownership of shares)
Financial markets
Cash flows to the firms.
- Primary v Secondary markets (Dealer market (OTC) & Auction market)
- Listed v Private companies
Balance sheet + Balance sheet identity
A snapshot of a firm’s assets and liabilities at a given point in time.
A = L + Shareholders Equity
Liquidity
Speed and ease of conversion to cash without significant loss of value. Important to avoid financial distress.
Market value
Price at which assets, liabilities or equity can actually be bought or sold.
Book value
Initial cost - accumulated depreciation
Income statement + Process (4 steps)
Measures performance over a specified period of time.
- Report revenue, then deduct expenses
- End result = Net income
- Dividends paid to shareholders
- Addition to retained earnings
Non cash items
Expenses charged against revenue that do not affect cash flow. (Depreciation)
Taxes (2)
Tax payable depends on tax law, which can be amended by political will.
- Corporate tax = 30%
- Personal income tax = marginal (% paid on next dollar earned), average, GST
Taxation of dividends: An imputation system (4)
- Company advises shareholder of company tax amount already paid on dividend.
- Shareholder adds amount of tax to each dividend they received.
- Shareholder pays personal tax on grossed-up amount.
- Shareholder receives a tax credit equivalent to the amount of tax paid by company.
Ratio analysis characteristics (4)
- Allows better comparison over time
- Allows comparison between companies in same industry
- Used internally to see how firm is performing
- Used externally by analysts to value company
Categories of financial ratios (4)
- Liquidity (short-term solvency)
- Financial leverage (long-term solvency)
- Profitability
- Market value
Present value (PV)
Current value of future cash flows discounted at the appropriate discount rate.
Value of t = 0.
Future value (FV)
Amount an investment is worth after one or more periods.
“Later” money on a timeline.
Interest rate “r” (5)
- Discount rate
- Cost of capital
- Opportunity cost of capital
- Required return
- Terminology depends on usage
Effects of compounding (2)
- Simple interest: Interest earned only on original principal.
- Compound interest: Interest earned on principal and on interest received.
Present value and discounting
Current value of future cash flows discounted at the correct discount rate.
Value at t=0 answers… (2 questions)
- How much do i have to invest today to have a particular amount in the future?
- What is the current value of a particular amount to be received in the future?
Why is present value less than face value? (3)
- Opportunity cost
- Risk and uncertainty
- Discount rate = F (time, risk)
Limited partner
A business partner whose potential financial loss in the partnership will not exceed his/her investment in that partnership.
‘Hiring outside accountants to audit company’s financial statements’ is an example of what…
An agency cost
Depreciation for a tax paying firm…
Increases expenses and lowers taxes.
How to find discount rate (r) and the number of periods (t)?
Rearrange the basic PV equation
Annuity
Finite series of equal payments that occur at regular intervals.
Ordinary annuity
First payment occurs at the end of the period.
Annuity due
First payment occurs at the beginning of the period.
Perpetuity
Infinite series of equal payments.
PV = (PMT / r)
Bond valuation debt
5
- not an ownership interest
- creditors have no voting rights
- interest considered a cost of business and is tax deductible
- creditors have legal recourse if interest/principal payments are missed
- excess debt can lead to financial distress
Bond valuation equity
- ownership interest
- ordinary shareholders vote for board of directors and other issues
- dividends are not considered a cost of doing business and not tax deductible
- dividends not a liability and shareholders have no legal recourse
- all-equity firms cannot bankruptcy
Par value (bond) (3)
- face amount
- repaid at maturity
- assumes $10,000 for corporate business
Coupon interest rate (bond) (3)
- stated interest rate
- usually =YTM at issue
- multiply by par value to get coupon payment
Maturity
Years until the bond must be repaid
Bond value equations (2)
BV = PV (coupons) + PV (par) BV = PV (annuity) + PV (lump sum)
As interest rates rise, present value…
Decreases, and visa versa
Interest rate risk
- if holding bond and interest rates change, will suffer capital gains/losses
- the lower the coupon rate, greater the interest rate risk
Zero coupon bonds (5)
- make no periodic interest payments
- entire yield to maturity comes from the difference between the purchase price and face value
- cannot sell for more than face value
- also known as zeroes/discount bonds
Ex. Bank bills
Inflation and interest rates
The ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation.
Fisher effect
The relationship between real rates, nominal rates and inflation:
(1 + R) = (1 + r) (1 + h)
R = nominal rate r = real rate h = expected inflation rate
Yield curve
Graphical representation of the term structure
Normal-upward slopping
Long term yields are higher than short-term yields
Inverted-downward sloping
Long-term yields are lower than short-term yields
Factors affecting required return (4)
- default risk premium: bond ratings
- liquidity premium: bonds that have more frequent trading will generally have lower required returns
- maturity premium: longer term bonds will tend to have higher required returns
- anything else that affects the risk of the cash flows to bondholders
If you own a share, you can receive cash in two ways:
- company pays dividends
- you sell shares, to investor, market or back to company
Estimating dividends: special cases
- constant dividend
- constant dividend growth
- supernormal
- constant dividend: firm will pay a constant dividend forever, which is like a preference share. price is computed using the perpetuity formula.
- constant dividend growth: firm will increase the dividend by a constant percentage every period.
- supernormal: dividend growth is not consistent initially, it settles down eventually.
Zero growth (of a dividend)
If dividends payments are to remain the same and are expected at regular intervals forever.
- a preference share usually has fixed dividends
Constant growth shares
Dividends are expected to grow at a constant percentage per period.
Dt = Do (1 + g)^t
where Do = dividend just paid
Dt = expected dividends
Features of ordinary shares
- voting rights (3)
- other rights (3)
voting rights
- shareholders elect directors
- proxy voting
- classes of shares
other rights
- share proportionally in declared dividends
- share proportionally in remaining assets during liquidation
- right to buy new share issue to maintain proportional ownership is desired
Dividends are treated as… (3)
- not a liability of the firm until declared by board of directors.
- firm cannot go bankrupt, for not declaring dividends.
- not tax-deductible for a firm, taxes as ordinary income.
Features of preference shares: Dividends (3)
Dividends
- stated dividend must be paid before dividends can be paid to ordinary shareholders.
- these are not a liability, and preference dividends can be deferred indefinitely.
- most preference dividends are cumulative - any missed preference dividends have to be paid before ordinary dividends can be paid
Risk-return trade off
(lesson from capital market history
There is reward for bearing risk, where the greater the potential reward, the greater the risk.
Efficient market hypothesis (3)
- Stock prices in equilibrium
- Stocks are ‘fairly’ priced
- Informational efficiency
If true, not able to earn ‘excess’ returns. They do not imply that investors cannot earn a positive return on the stock market.
Common misconception about EMH
EMH does not mean that you will make money
What does EMH mean? (3)
- You will earn a return appropriate for the risk undertaken.
- There is no bias in prices that can be exploited to earn excess returns.
- Market efficiency will not protect you from wrong choices if you do not diversify.
Forms of market efficiency (3)
- Strong form
- Semi-strong form
- Weak form
Strong form of market efficiency (3)
- prices reflect all information (public and private)
- investors cannot earn abnormal returns
- markets are not strong form efficient
Semi-strong form of market efficiency (3)
- prices reflect all publicly available information (trading info, annual reports, press releases)
- investors cannot earn abnormal returns
- implies fundamental analysis will not lead to abnormal returns
Weak form of market efficiency (4)
- prices reflect all past market information (price and volume)
- investors cannot earn abnormal returns
- implies technical analysis will not lead to abnormal returns
- markets are generally this form
Dollar returns
Total dollar return = return of an investment measured in dollars.
$return = dividends + capital gains
Capital gains
Capital gains = price received - price paid
Percentage returns
Total percentage return = return of an investment measured as a percentage of the original investment.
%return = $return + $invested
Expected returns
Average returns, if process is repeated many times
Variances and standard deviation (4)
- measure variability of returns
- employ unequal probabilities for entire range of possibilities
- weighted average of squared deviations
- standard deviation = square root of variance
Portfolios
A collection of assets.
- An assets risk and return is important in how it affects the risk and return of the portfolio.
- Risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, as with individual assets.
Portfolios expected returns
The weighted average of the expected returns for each asset in the portfolio.
weights (wj) = percentage of portfolio invested in each asset
Portfolio variance
1) compute portfolio return for each state
2) compute overall expected portfolio return using same formula as for an individual asset
3) compute portfolio variance and standard deviation using same formulas as for an individual asset
Systematic risk
Factors that affect a large number of assets (changes in GDP, inflation and interest rates).
Unsystematic risk
Factors that affect a limited number of assets (labour strikes, part shortages).
Diversification (3)
- Can substantially reduce returns variability without equivalent reduction in expected returns.
- Reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another.
- Minimum level of risk that cannot be diversified away and that is the systematic portion.
Diversification risk
Risk that can be eliminated by combining assets into a portfolio.
Total risk
Total risk = systematic risk + unsystematic risk
standard deviation of returns is a measure of total risk
Measuring systematic risk (using beta)
Beta of 1 = assets has same systematic risk of overall market
Beta of < 1 = asset has less systematic risk than overall market
Beta of > 1 = asset has more systematic risk than overall market
Beta
The weighted average of the betas of the assets in the portfolio.
Beta and risk premium
Risk premium = Expected return - risk free rate
- the higher the beta, the greater the risk premium.
Security market line
Representation of market equilibrium slope of security market line (SML) = reward-to-risk ratio
SML = increase in expected return/ increase in beta
Capital asset pricing model
Defines the relationship between risk and return.
Factors affecting expected return (3)
- Pure time value of money: measured by the risk-free rate
- Reward for bearing systematic risk: measured by the market risk premium
- Amount of systematic risk: measured by beta
Examples of potential projects (3)
- initial expenditure
- cash flow projections
- risk considerations
Net present value
Difference between market value at a project and its costs. It measures how well a project will achieve the goal of increasing shareholder wealth.
How much value is created from undertaking an investment?
Net-present value process) (3 steps
1) estimate expected future cash flows
2) estimate required return for projects at this risk level
3) find present value of cash flows and subtract initial value = net present value
Decision rule of NPV
Accept project if NPV is positive
What does it mean if NPV = 0
Project’s inflows are ‘exactly’ sufficient to repay the invested capital and provide required rate of return.
Payback period
How long it takes to recover the initial cost of a project.
Payback period process (2 steps)
1) estimate cash flows
2) subtract future cash flows from initial cost until initial investment is recovered
Decision rule of Payback period
Accept if the payback period is less than some preset limit.
Advantages of Payback (3)
- easy to understand
- adjusts for uncertainty of later cash flows
- biased towards liquidity
Disadvantages of Payback (4)
- ignores time value of money
- requires an arbitrary cut-off point
- ignores cash flows beyond cut-off date
- biased against long-term projects
Average accounting return formula
(average net income)/(average book value)
Decision rule of AAR
Accept project if AAR is greater than target rate.
Advantages of AAR (2)
- easy to calculate
- needed information usually available
Disadvantages of AAR (4)
- not true rate of return
- ignores time value of money
- uses arbitrary benchmark cut off rate
- based on accounting net income x book value, not on cash flows and market values
Mutually exclusive projects
If you choose one, you cant choose the other.
- always choose project with higher NPV
Profitability index
Measures the benefit per unit cost, based on the time value of money.
What does a profitability index of 1.1 indicate?
For ever $1 of investment, we create an additional $0.10 in value.
Decision rule of PI
Accept if PI is greater than 1.0
Advantages of PI (3)
- closely related to NPV
- easy to understand and communicate
- useful when available investment funds are limited
Disadvantages of PI (1)
- may lead to incorrect decisions in comparisons of mutually exclusive investment
Incremental cash flows
Cash flows that should be included in a capital budgeting analysis are those that will occur only if the project is accepted.
Types of cash flows (5)
- sunk costs: costs accrued in the past
- opportunity costs: costs of lost opportunities
- changes in net working capital
- financing costs
- tax effects
Capital budgeting relies on…
Pro-forma accounting statements, which project future operations.
Operating cash flow (formula)
Net income + Depreciation
Cash flows from assets (formula)
Operating cash flow - Net capital spending - Changes in WWC
Tax shield approach to calculate OCF (formula)
OCF = (sales - costs)(1 - T) + depreciation x T
Form used when major incremental cash flows are purchase of equipment.
Depreciation tax shield (formula)
(Depreciation)x(Marginal tax rate)
Prime cost depreciation (formula)
(Initial cost)/(Number of years)
After-tax salvage
If salvage value differs from book value of an asset, there is a tax effect.
= salvage - T(salvage - book value)
Net salvage cash flow
Selling price - (Selling price - Book value)x(Tax rate)
Forecasting risk (NPV)
How sensitive is NPV to changes in cash flow statements?
More sensitive = Greater forecasting risk
Scenario analysis (best and worst cases)
Best case - Revenues high and costs low
Worst case - Revenues low and costs high
Sensitivity analysis
A subset of scenario analysis, where we asses effects of specific variables on NPV.
*Greater validity in NPV, larger forecasting risk and more attention needed to estimation.
Why cost of capital is important? (4)
- return earned on assets depends on assets risk
- return to an investor = cost of capital
- cost of capital indicates how market views risk of assets
- cost of capital helps determine required return for capital budgeting projects
Required return
Appropriate discount rate, based on risk of cash flows, and need to compute NPV.
Cost of equity
Return required by equity investors given the risk of the cash flows from firm.
Methods for determining cost of equity (2)
- dividend growth model
- SML or CAPM
Advantages of growth model (1)
Easy to understand and use.
Disadvantages of growth model (4)
- applicable to company’s currently paying dividends
- not applicable if dividends not growing constant rate
- sensitive to estimated growth rate
- does not consider risk
Advantages of SML method (2)
- adjusts for systematic risk
- applicable to all companies, if beta is available
Disadvantages of SML method (3)
- must estimate expected market risk premium
- must have estimated beta
- relies on past to predict future (not reliable)
Cost of debt + process (2 steps)
Required return on a company’s debt.
1) compute YTM on debt
2) use estimates of current rates based on bond rating expected on new debt
Preference share valuation is treated as a…
Perpetuity
Weighted average cost of capital
Required return on firm’s assets, based on markets perception of risk of assets.
Capital structure weights
- E
- D
- V
E = market value of equity D = market value of debt V = market value of firm = D+E
Factors that affect WACC (3)
- market conditions
- capital structure and dividend policy
- investment policy
Risk-adjusted WACC
Project that is not same risk level as firm.
Pure play approach process (4)
1) find one or more companies that specialise in the product/service being considered
2) compute beta
3) take average
4) use beta and CAPM to find return
Subjective approach
If project more risky than firm, use discount rate greater than WACC and visa versa.
Types of cash dividends (4)
- regular cash dividend
- extra cash dividend
- special cash dividend
- liquidating dividend
Declaration date
Board declares the dividend and it becomes a liability of the firm.
Ex-dividend date
Occurs one business day before date of record.
- if buy share, on or after share, will not receive dividend
- share price usually drops by dividend amount
- cum dividend: shares before ex-dividend date
Date of record
Holders of record are determined and will receive dividend payment.
Date of payment
Cheques are mailed.
Dividends matter
Share value is based on present value of expected future dividends.
Dividend policy may not matter
Dividend policy is decision to pay dividends versus retaining funds to reinvest in the firm. If firm reinvests capital now, it will grow and can pay higher dividends in future.
Factors favouring low payout (3)
- taxes: individual in upper income tax brackets might prefer lower dividend payouts
- floatation costs: low payouts can decrease amount of capital that needs to be raised, thereby floatation costs
- dividend restrictions: debt contracts may limit percentage of income that can be paid out as dividends
Factors favouring high payout (3)
- desire for current income
- uncertainty that higher future dividends will materialise
- taxes: tax-exempt investors don’t have to worry about differential treatment between dividends and capital gains
Clientele effect
Argument goes that shares attract particular groups based on dividend yield and the resulting tax effects. Share prices will rise with unexpected increases in dividends and fall with unexpected decreases in dividends.
Other dividend policys (2)
- residual policy
- stable policy
Share repurchase
- tender offer
- open market
Company buys back shares.
- tender offer: company states a purchase price and a desired number of shares.
- open market: company buys shares in open market.
Advantages of paying dividends (4)
- cash dividends underscore good results and provide a support to stock price
- dividends may attract institutional investors
- stock price usually increases with new/increased dividends
- dividends absorb excess cash and may reduce agency cost
Disadvantages of paying dividends (3)
- taxed to recipients
- can reduce internal sources of funding
- cuts are hard to make without adversely affecting a firms stock price
Share dividends
Pay additional shares instead of cash. Increase number of outstanding shares.
Share splits
Share dividends expressed as a ratio. To return price to a more desirable trading range.
Reverse share splits
Reduce number of shares outstanding.
- transaction costs less for investors
- liquidity might be improved
- too low a price not considered ‘respectable’
- exchange minimum price per share requirements
