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FM > Theory > Flashcards

Theory Flashcards

1
Q

Payback definition and decision rule

A

Time taken for cash inflows to equal cash outflows

Accept if payback < target

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2
Q

ARR formula (initial investment)

A

(Average annual profit from investment ÷ initial investment) × 100

Profit = after depreciation

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3
Q

ARR formula (average investment)

A

(Average annual profit from investment ÷ average investment) × 100

Average investment = (initial outlay + scrap value) ÷ 2

Profit = after depreciation

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4
Q

ARR decision rule

A

Accept if ARR > target

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5
Q

NPV definition and decision rule

A

Change in wealth of investor as a result of investing in project

Accept if NPV is positive (usually)

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6
Q

IRR definition and decision rule

A

Cost of capital at which NPV = 0

Accept if IRR % > cost of capital (usually)

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7
Q

IRR formula

A

a + (NPVa ÷ (NPVa - NPVb)) × (b - a)

a = lower discount rate giving NPVa
b = higher discount rate giving NPVb)
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8
Q

NPV discount formula

A

(1 + r) ^-n

r = cost of capital
n = years
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9
Q

Cost of material - not in stock so have to buy

A

Current replacement cost

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10
Q

Cost of material - in stock, in constant use, if used must replace

A

Current replacement cost

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11
Q

Cost of material - in stock, no other use, if used no need to replace

A

Current resale value

Scrap value lost

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12
Q

Cost of material - in stock, scarce, if used cannot replace

A

Opportunity cost

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13
Q

Cost of labour and variable overheads - spare capacity

A

Nil labour cost plus variable overhead only

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14
Q

Cost of labour and variable overheads - full capacity, workforce available for hire

A

Current rate of pay plus extra variable overhead incurred

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15
Q

Cost of labour and variable overheads - full capacity, no workforce available

A

Opportunity cost

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16
Q

2 general rules for CAs

A
  • 18% on reducing balance basis

- No CAs in year of sale (balancing allowance/charge instead)

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17
Q

3 tax assumptions

A
  • 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
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18
Q

Fisher equation

A

(1 + m) = (1 + r) × (1 + i)

m = money (nominal) rate
r = real (effective) rate
i = general inflation rate
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19
Q

Discounting money method

A

1) Adjust individual cash flows using specific inflation rates to convert to money cash flows
2) Discount money flows using money rate

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20
Q

EAC formula and decision rule

A

NPV of one cycle replacement ÷ AF for this cycle length

Lowest EAC

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21
Q

Sensitivity formula

A

(NPV of project ÷ PV of cash flows subject to uncertainty) × 100%

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22
Q

CAPM formula (given in exam)

A

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)

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23
Q

Alpha value current return formula

A

Expected return ± alpha value

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24
Q

Spot and forward rate relationship formula

A

Spot rate x ((1+if) ÷ (1+iuk)) = forward

if = overseas interest rate
iuk = domestic interest rate
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25
Q

Dividend payout ratio formula

A

Dividend ÷ earnings after tax and pref divs

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26
Q

Ex-rights price formulas

A

(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

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27
Q

Dividend yield formula

A

(Dividend per share ÷ market price per share) × 100

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28
Q

EPS formula

A

Profit distributable to ordinary shareholders ÷ number of ordinary shares issued

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29
Q

Price-earning (P/E) ratio formula

A

Market price per share ÷ EPS

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30
Q

Total shareholder return formula

A

Dividend yield + capital gain

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31
Q

Annual interest on loan stock formula

A

Coupon rate × nominal value

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32
Q

2 capital gearing formulas

A

Debt ÷ equity

Debt ÷ (debt + equity)

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33
Q

Interest cover formula

A

Earnings before interest and tax ÷ interest

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34
Q

AIR

A

Asset increasing = reduce

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35
Q

Market value of investment formula

A

Cash flows from investment discounted at investors’ required rate of return

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36
Q

Equity investors’ required rate of return formula - dividends remain constant

A

Ke = D0÷P0

Ke = equity investors’ required rate of return
D0 = dividend paid at time 0
P0 - ex-dividend market value of equity

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37
Q

Equity investors’ required rate of return formula - dividends grow at constant rate (given in exam)

A

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

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38
Q

Growth earnings retention model formula

A

g = r × b

g = growth in future dividends
r = return on equity
b = proportion of profits retained
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39
Q

CAPM cost of equity formula (given in exam)

A

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
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40
Q

Cost of preference shares formula

A

kp = D ÷ P0

D = constant annual dividend
P0 = ex-div market value
41
Q

Net of tax cost of debt formula

A

Pre-tax cost of debt × (1 - 0.17)

42
Q

Cost of debt formula

A

kd = (interest × (1 - 0.17)) ÷ P0

P0 = market price of bond ex-interest
Interest = interest paid on bond
kd = required return of debt holder
43
Q

WACC formula

A

(MVe × ke) + (MVd × kd)
__________________
MVe + MVd

MVe = MV of issued shares
MVd = MV of debt
44
Q

Income gearing formula

A

EBIT ÷ interest

45
Q

Value of business formula

A

Post-tax earnings discounted to perpetuity @ WACC

46
Q

βe formula (given in exam)

A

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
47
Q

Maximum price formula

A

MV of combined businesses - MV of bidder before bid is made

48
Q

Price-earning (P/E) ratio VALUE formula

A

PE ratio ÷ earnings

49
Q

Enterprise value formula

A

Enterprise value multiple × EBITDA

50
Q

Equity value formula

A

Enterprise value - market value of debt + cash

51
Q

Dividend yield formula

A

(Dividend per share ÷ market price of shares) × 100

52
Q

Present value of future dividends formula

A

d0 (1 + g)
_______
ke - g

d0 = dividend at time 0
g = growth rate
ke = cost of equity
53
Q

NPV Proforma

A

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

54
Q

7 key drivers of value

A

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

55
Q

Project worth formula

A

Traditional NPV + value of real options

56
Q

6 methods for dealing with risk

A
  • Probability distributions
  • Expected values
  • Simulations
  • Portfolio theory
  • Capital asset pricing model
  • Risk-adjusted discount rates
57
Q

5 methods for dealing with uncertainty

A
  • Maximum payback period
  • Increasing discount rare
  • Prudent estimates
  • Assessing best/worst situations
  • Sensitivity analysis
58
Q

3 advantages / 3 disadvantages of sensitivity analysis

A

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)
59
Q

3 advantages / 3 disadvantages of simulations

A

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
60
Q

2 advantages / 4 disadvantages of expected values

A

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
61
Q

Shares to buy if market expected to rise (bull market)

A

High beta = aggressive

62
Q

Shares to buy if market expected to fall (bear market)

A

Low beta = defensive

63
Q

1 advantage / 7 disadvantages of CAPM

A

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
64
Q

APM 4 key factors

A
  • Unanticipated inflation
  • Changes in expected level of industrial production
  • Changes in risk premium on bonds
  • Unanticipated changes in term structure of interest rates
65
Q

APT formula

A

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
66
Q

Fame-French 3 factors

A
  • Return on market portfolio - risk-free rate of interest
  • Size factor (difference in return between smallest/largest stocks)
  • Value factor (balance sheet)
67
Q

Bond yields plus premium approach

A

Bond yields + fixed premium

68
Q

Fundamental beat 3 risk factors

A
  • Nature of business operations
  • Level of operating gearing
  • Level of financial gearing
69
Q

Number of contracts formula

A

MV of portfolio ÷ value of 1 contract

70
Q

Hedge efficiency formula

A

(Gain on futures ÷ loss on portfolio) × 100%

71
Q

Intrinsic value formula

A

Current share price - exercise price

Out of money options = zero

72
Q

Time value formula

A

Actual value - intrinsic value

73
Q

2 advantages / 3 disadvantages FRAs

A

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
74
Q

Price of interest rate futures contract formula

A

Price = 100 - interest rate

75
Q

Maturity mismatch number of futures contract formula

A

(Loan ÷ futures contract size) × (length loan ÷ 3 months)

76
Q

Effective interest rate formula

A

(Net payments ÷ loan amount) × (inverse pro-ration)

77
Q

5 advantages / 3 disadvantages swaps

A

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
78
Q

4 ways of controlling transaction risk without using capital markets

A
  • Invoicing in home currency
  • Matching receipts and payments
  • Matching assets and liabilities
  • Leading and lagging
79
Q

4 ways of controlling transaction risk using capital markets

A
  • Forward contracts
  • Money market hedges
  • Futures market
  • Options market
80
Q

ADDIS

A

Add discounts, subtract premiums

81
Q

3 advantages / 4 disadvantages swaps

A

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
82
Q

1 advantages / 4 disadvantages currency options

A

Advantages:
- Leaves upside potential

Disadvantages:

  • Cost 5%
  • Paid for when bought
  • Lack negotiability
  • Not available in every currency
83
Q

Value of right to subscribe formula

A

Ex-rights price - subscription price

84
Q

4 advantages convertible loans

A

Advantages:

  • Lower rate of interest
  • Encouraging potential investors
  • Avoids redemption problems
  • Issue equity cheaply
85
Q

4 disadvantages with earning retention model

A

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
86
Q

5 disadvantages with dividend valuation model

A

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
87
Q

3 disadvantages of WACC

A

Disadvantages:

  • Which sources of finance to include
  • Loans without market values
  • Cost of capital for small companies
88
Q

M+M formulas

A 
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)
89
Q

Disadvantages of M+M theory

A

Disadvantages:

  • Assumes capital markets are perfect
  • Ignores bankruptcy risk
  • Ignores loan covenant restrictions
  • Must be in taxpaying position
90
Q

Adjusted present value (APV) formula

A

Base case value + present value of tax shield

91
Q

APV decision rule

A

Accept if positive

92
Q

1 disadvantage of APV

A

Disadvantages:

- Agency costs/financial distress may affect attractiveness of debt finance but not reflected

93
Q

3 advantages and 3 disadvantages of NRV valuation

A

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
94
Q

2 advantages and 2 disadvantages of income based valuation

A

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
95
Q

2 advantages and 3 disadvantages of P/E valuation

A

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
96
Q

4 advantages and 4 disadvantages of EV/EBITDA valuation

A

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
97
Q

1 advantage and 2 disadvantages of dividend valuation

A

Advantages:
- Most effective when looking for dividend income

Disadvantages:

  • Payments and growth may not be stable
  • Industry average won’t properly reflect company
98
Q

Format of business plan

A

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)

FM (3 decks)

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