Theory Flashcards
Payback definition and decision rule
Time taken for cash inflows to equal cash outflows
Accept if payback < target
ARR formula (initial investment)
(Average annual profit from investment ÷ initial investment) × 100
Profit = after depreciation
ARR formula (average investment)
(Average annual profit from investment ÷ average investment) × 100
Average investment = (initial outlay + scrap value) ÷ 2
Profit = after depreciation
ARR decision rule
Accept if ARR > target
NPV definition and decision rule
Change in wealth of investor as a result of investing in project
Accept if NPV is positive (usually)
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 giving NPVa b = higher discount rate giving NPVb)
NPV discount formula
(1 + r) ^-n
r = cost of capital n = years
Cost of material - not in stock so have to buy
Current replacement cost
Cost of material - in stock, in constant use, if used must replace
Current replacement cost
Cost of material - in stock, no other use, if used no need to replace
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
2 general rules for CAs
- 18% on reducing balance basis
- No CAs in year of sale (balancing allowance/charge instead)
3 tax assumptions
- Whole tax payment is made at the end of the year to which it relates
- CT is 17%
- Working capital flows have no tax effect
Fisher equation
(1 + m) = (1 + r) × (1 + i)
m = money (nominal) rate r = real (effective) rate i = general inflation rate
Discounting money method
1) Adjust individual cash flows using specific inflation rates to convert to money cash flows
2) Discount money flows using money rate
EAC formula and decision rule
NPV of one cycle replacement ÷ AF for this cycle length
Lowest EAC
Sensitivity formula
(NPV of project ÷ PV of cash flows subject to uncertainty) × 100%
CAPM formula (given in exam)
rj = rf + βj (rm - rf)
rj = expected return for security j rf = risk-free rate βj = beta of security j rm = expected return on the market portfolio
When applied to shares rj = cost of equity capital (ke)
Alpha value current return formula
Expected return ± alpha value
Spot and forward rate relationship formula
Spot rate x ((1+if) ÷ (1+iuk)) = forward
if = overseas interest rate iuk = domestic interest rate
Dividend payout ratio formula
Dividend ÷ earnings after tax and pref divs
Ex-rights price formulas
(Market value of shares pre-issue + rights proceeds + project NPV) ÷ number of shares ex-rights
PV of new total dividends ÷ number of shares ex-rights
If NPV not given, assume nil
Dividend yield formula
(Dividend per share ÷ market price per share) × 100
EPS formula
Profit distributable to ordinary shareholders ÷ number of ordinary shares issued
Price-earning (P/E) ratio formula
Market price per share ÷ EPS
Total shareholder return formula
Dividend yield + capital gain
Annual interest on loan stock formula
Coupon rate × nominal value
2 capital gearing formulas
Debt ÷ equity
Debt ÷ (debt + equity)
Interest cover formula
Earnings before interest and tax ÷ interest
AIR
Asset increasing = reduce
Market value of investment formula
Cash flows from investment discounted at investors’ required rate of return
Equity investors’ required rate of return formula - dividends remain constant
Ke = D0÷P0
Ke = equity investors’ required rate of return
D0 = dividend paid at time 0
P0 - ex-dividend market value of equity
Equity investors’ required rate of return formula - dividends grow at constant rate (given in exam)
Ke = (D0(1+g) ÷ P0) + g
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
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
Cost of preference shares formula
kp = D ÷ P0
D = constant annual dividend P0 = ex-div market value
Net of tax cost of debt formula
Pre-tax cost of debt × (1 - 0.17)
Cost of debt formula
kd = (interest × (1 - 0.17)) ÷ P0
P0 = market price of bond ex-interest Interest = interest paid on bond kd = required return of debt holder
WACC formula
(MVe × ke) + (MVd × kd)
__________________
MVe + MVd
MVe = MV of issued shares MVd = MV of debt
Income gearing formula
EBIT ÷ interest
Value of business formula
Post-tax earnings discounted to perpetuity @ WACC
βe 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
Maximum price formula
MV of combined businesses - MV of bidder before bid is made
Price-earning (P/E) ratio VALUE formula
PE ratio ÷ earnings
Enterprise value formula
Enterprise value multiple × EBITDA
Equity value formula
Enterprise value - market value of debt + cash
Dividend yield formula
(Dividend per share ÷ market price of shares) × 100
Present value of future dividends formula
d0 (1 + g)
_______
ke - g
d0 = dividend at time 0 g = growth rate ke = cost of equity
NPV Proforma
Operating cash flows:
- Sales revenue X
- Costs (X)
Net X
Tax (X)
Asset:
- Purchase (X)
- Scrap X
- Tax on WDAs X
Working capital (X)
Net flows X
Discount factor X
PV of cash flows X
7 key drivers of value
1) Life of projected cash flows
2) Sales growth rate
3) Operating profit margin
4) Corporation tax rate
5) Investment in NCA
6) Investment in working capital
7) Cost of capital
Project worth formula
Traditional NPV + value of real options
6 methods for dealing with risk
- Probability distributions
- Expected values
- Simulations
- Portfolio theory
- Capital asset pricing model
- Risk-adjusted discount rates
5 methods for dealing with uncertainty
- Maximum payback period
- Increasing discount rare
- Prudent estimates
- Assessing best/worst situations
- Sensitivity analysis
3 advantages / 3 disadvantages of sensitivity analysis
Advantages:
- Form which facilitates subjective judgement
- Identifies areas critical to success
- Relatively straightforward
Disadvantages:
- Assumes changes can be made independently
- Ignores probability
- Not optimising technique (doesn’t point to decision)
3 advantages / 3 disadvantages of simulations
Advantages:
- Shows effect of more than variable changing
- Gives more info about outcomes and probabilities
- Useful for problems that cannot be solved analytically
Disadvantages:
- Not optimising technique (doesn’t point to decision)
- Expensive in designing and running
- Requires assumptions which may be inaccurate
2 advantages / 4 disadvantages of expected values
Advantages:
- Average is easily understood
- Info reduced to a single number
Disadvantages:
- Probabilities may not be accurate
- Average may not correspond to any outcome
- Average only achieved if made many times
- Ignores risk
Shares to buy if market expected to rise (bull market)
High beta = aggressive
Shares to buy if market expected to fall (bear market)
Low beta = defensive
1 advantage / 7 disadvantages of CAPM
Advantages:
- Clearly shows discount rates related to project’s risk
Disadvantages:
- Shareholders may not be diversified
- Shareholders are not only participants
- Depends on perfect capital marker
- Need to determine excess return
- Need to determine risk-free rate
- Errors in statistical analysis to calculate betas
- Unable to forecast accurately returns for companies with low P/E ratios
APM 4 key factors
- Unanticipated inflation
- Changes in expected level of industrial production
- Changes in risk premium on bonds
- Unanticipated changes in term structure of interest rates
APT formula
E(ri) = rf + (E(rA)-rf)βA + (E(rB)-rf)βB
(E(rA)-rf)βA = risk premium on factor A (E(rB)-rf)βB = risk premium on factor B
Fame-French 3 factors
- Return on market portfolio - risk-free rate of interest
- Size factor (difference in return between smallest/largest stocks)
- Value factor (balance sheet)
Bond yields plus premium approach
Bond yields + fixed premium
Fundamental beat 3 risk factors
- Nature of business operations
- Level of operating gearing
- Level of financial gearing
Number of contracts formula
MV of portfolio ÷ value of 1 contract
Hedge efficiency formula
(Gain on futures ÷ loss on portfolio) × 100%
Intrinsic value formula
Current share price - exercise price
Out of money options = zero
Time value formula
Actual value - intrinsic value
2 advantages / 3 disadvantages FRAs
Advantages:
- Protect from adverse movements
- Tailored to amount/duration required
Disadvantages:
- Loans of at least £500,000
- Difficult to obtain for over 1 year
- Remove upside potential
Price of interest rate futures contract formula
Price = 100 - interest rate
Maturity mismatch number of futures contract formula
(Loan ÷ futures contract size) × (length loan ÷ 3 months)
Effective interest rate formula
(Net payments ÷ loan amount) × (inverse pro-ration)
5 advantages / 3 disadvantages swaps
Advantages:
- Enable switch from floating/fixed
- Costs significantly less
- Make interest rate savings
- Available for longer periods
- Flexible
Disadvantages:
- Risk counter party will default
- Risk of unfavourable movements
- FS misleading
4 ways of controlling transaction risk without using capital markets
- Invoicing in home currency
- Matching receipts and payments
- Matching assets and liabilities
- Leading and lagging
4 ways of controlling transaction risk using capital markets
- Forward contracts
- Money market hedges
- Futures market
- Options market
ADDIS
Add discounts, subtract premiums
3 advantages / 4 disadvantages swaps
Advantages:
- Transaction date flexibility
- Regulated market (reduced risk)
- Highly liquid market
Disadvantages:
- Cannot be tailored
- Limited number currencies
- Need to use a broker (fees)
- Need deposit/maintain margin account
1 advantages / 4 disadvantages currency options
Advantages:
- Leaves upside potential
Disadvantages:
- Cost 5%
- Paid for when bought
- Lack negotiability
- Not available in every currency
Value of right to subscribe formula
Ex-rights price - subscription price
4 advantages convertible loans
Advantages:
- Lower rate of interest
- Encouraging potential investors
- Avoids redemption problems
- Issue equity cheaply
4 disadvantages with earning retention model
Disadvantages:
- Reliance on accounting profits
- Assumptions r and b are constant
- Inflation distorts accounting rate of return if historical cost basis
- Assumes all new finance comes from equity
5 disadvantages with dividend valuation model
Disadvantages:
- Not true that shares have value because of dividends
- Not true that dividends either don’t grow or grow constantly
- Estimates of future dividends based on historic data
- Share price subject to volatility
- Growth may not mirror past dividends
3 disadvantages of WACC
Disadvantages:
- Which sources of finance to include
- Loans without market values
- Cost of capital for small companies
M+M formulas
Vg = Vu Vg = Vu + DT
Vg = value of debt + value of equity in geared firm Vu = value of equity in equivalent ungeared firm DT = tax shield on debt (d=MV of debt)
Disadvantages of M+M theory
Disadvantages:
- Assumes capital markets are perfect
- Ignores bankruptcy risk
- Ignores loan covenant restrictions
- Must be in taxpaying position
Adjusted present value (APV) formula
Base case value + present value of tax shield
APV decision rule
Accept if positive
1 disadvantage of APV
Disadvantages:
- Agency costs/financial distress may affect attractiveness of debt finance but not reflected
3 advantages and 3 disadvantages of NRV valuation
Advantages:
- Simple
- Assets more certain than income
- Useful for asset strippers if valuable tangible assets
Disadvantages:
- Book values likely out of date
- Ignores future earnings
- Services businesses undervalued
2 advantages and 2 disadvantages of income based valuation
Advantages:
- Best method especially for service businesses
- Incorporates all relevant cash flows and time value of money
Disadvantages:
- Estimation may be too optimistic
- Calculating discount rate problematic especially for unlisted companies
2 advantages and 3 disadvantages of P/E valuation
Advantages:
- Reflects stock market’s view
- Considers earnings creating potential
Disadvantages:
- Industry average won’t properly reflect company
- Earnings can be manipulated by accounting policies
- Past earnings may not reflect future potential
4 advantages and 4 disadvantages of EV/EBITDA valuation
Advantages:
- Unaffected by capital structure or dep’n policies
- Takes net debt into account
- Enables direct comparison between companies with different policies
- Technique most commonly used by investors
Disadvantages:
- Simplistic
- Ignores capex and tax
- Past earnings may not reflect future potential
- Industry average won’t properly reflect company
1 advantage and 2 disadvantages of dividend valuation
Advantages:
- Most effective when looking for dividend income
Disadvantages:
- Payments and growth may not be stable
- Industry average won’t properly reflect company
Format of business plan
1) Executive summary
2) History and background
3) Mission statements and objectives
4) Products or services
5) Market information
6) Resources employed
7) Financial information
8) Summary action plan containing milestones
9) Appendices (past accounts/market research)
