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Financial management > Things To Know (ARGH) > Flashcards

Things To Know (ARGH) Flashcards

1
Q

What is the assumed objective for finance?

A

The company should make investment and financing decisions with the aim of maximising long-term shareholder wealth.

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2
Q

What is shareholder wealth?

A

Maximising shareholder wealth means maximising the flow of dividends to shareholders through time.

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3
Q

How to help reduce principal agent problems?

A

Need to align the actions of senior management with the interests of shareholders (goal congruence)
Can:
- Link rewards to shareholder wealth improvements
- Sackings
- Selling shares and takeover threat
- Information flow

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4
Q

How to calculate simple interest?

A

future value = present value * (1+ rate * no. of years)

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5
Q

How to calculate simple interest?

A

future value = present value * (1 + rate)^ no. of year

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6
Q

How to calculate annuities?

A

Same as discounting cash flows but use annuity instead (A/(1+rate)…
OR
1-1/(1+rate)^no. years all over rate then * annuity.
OR
present value of annuity table * annuity

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7
Q

How to calculate perpetuities?

A

Annuity/ interest rate

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8
Q

How to discount semi-annually?

A

present value*(1+[rate/2])^2

Quarterly=
present value*(1+[rate/4])^4

Daily=
present value*(1+[rate/365])^365

Quarterly after x years=
present value(1+[rate/4])^4x

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9
Q

How to work out the rate of interest?

A

square root to the no of years the future value / present value then - 1.

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10
Q

How to determine the number of years in an investment period?

A

n = log(F/P) all over log(1+rate)

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11
Q

How to work out continuous compounding?

A

Use the exponential function (2.71828)
= present value * 2.71828 ^ rate * no. of years.

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12
Q

What things go into the time value of money?

A

Compensation will be required for at least three things:
Impatience to consume
Inflation
Risk

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13
Q

How do you work out the risk free return?

A

(1+ required pure time value return)*(1+ inflation) - 1

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14
Q

How do you work out the required return?

A

Risk free rate + risk premium

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15
Q

What is the risk premium?

A

The return an investor will expect to receive/ expect to receive from holding a risky market portfolio.

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16
Q

How do you discount cash flows?

A

cash flow/ (1+ rate)^no. of years

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17
Q

What are the decision rules for NPV?

A

NPV>0 = Accept
NPV<0 = Reject

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18
Q

What is a perpetuity?

A

Cash flows that keep paying out forever.

PV of a perpetuity = periodic cash flow/ interest rate

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19
Q

How do you discount perpetuities?

A

Work out the perpetuity - cash flow/ discount rate

Then you have to discount this back the number of years required (if it arises one year later year 3, it has to be discounted back 2 years) - perpetuity/ (1+rate)^no. of years.

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20
Q

What does the IRR tell you?

A

The rate of return you will receive by putting your money into a project, how much cash inflows exceeds cash outflows.

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21
Q

What are the decisions for the IRR?

A

IRR> required rate of return (cost of cap) - NPV = positive ACCEPT

IRR = required rate of return - NPV = 0

IRR< required of return - NPV = negative REJECT

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22
Q

How do you guess the second % to use for the IRR?

A

If NPV = +ve, IRR is higher than cost of capital so guess a higher rate and recalculate.

If NPV = -ve, IRR is lower than cost of capital so guess a lower rate and recalculate.

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23
Q

What is the IRR formula?

A

Lower rate+ NPV lower rate/ (NPV lower rate - NPV higher rate) * (high rate - low rate)

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24
Q

What are the decisions surrounding IRR and opp. cost?

A

If opp. cost> IRR REJECT

If opp. cost< IRR ACCEPT

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25
Q

What are some problems with the IRR?

A

-Multiple solutions
-Sometimes it is better to find projects with a higher NPV than IRR

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26
Q

What are the methods of investment appraisal ?

A

Payback and discounted payback period

Accounting rate of return

NPV

IRR

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27
Q

What is the payback method?

A

The time it takes for a project to repay its initial investment.

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28
Q

How do you work out the payback period?

A

No. of years = add up the cash flows from each year until the sum is greater than the investment.

No. of weeks = (last -ve cumulative c.f. / the regular c.f. from the +ve year) * 52

*12 to get months

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29
Q

What are the advantages and disadvantages of the payback method?

A

Ads
- Simple and easy to understand
- Helps managers make quick decisions
- Preference for liquidity
- Useful in uncertainty

Disads
- Ignores time value of money
- Doesn’t consider all cashflows
- Not realistic

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30
Q

What is the discounted payback period?

A

The payback period that accounts for the time value of money.

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31
Q

What is the accounting rate of return (ARR)?

A

Formula used to calculate net income expected from an investment compared to the initial cost of investment.

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32
Q

How do you calculate the ARR?

A

Average annual profit/ average investment

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33
Q

What are the advantages and disadvantages of ARR?

A

Ads
- Simple to calculate
- Accounts for dep.

Disads
- Ignores time value of money
- Ignored cashflows
- Ignores risk and uncertainty

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34
Q

How to calculate ARR (annual basis)?

A

Include dep. (profit - dep.)

Profit after dep./Use value of asset (book value) at start of year

Add up all the ARR for each year and divide it by 1/no. of years.

35
Q

How to calculate ARR total investment basis?

A

Average annual profit/ initial capital invested * 100

36
Q

How to calculate ARR average investment basis?

A

Average annual profit/ average capital invested *100

37
Q

What is not included in relevant cashflows?

A

Depreciation
- it is not an expense that results in a cash flow
*If taken must be added back

38
Q

What is working capital?

A

Increase in cash floats
Increase in stocks
Increase in debtors
Less increase in creditors

39
Q

How is working capital recorded in relevant cash flows?

A

It is deducted in year 0 but added back to the last years cash flows.

*Scrap value is also added to last year

40
Q

How to work out net operating cash flow?

A

Profit before dep. - periodic investment in net working capital

41
Q

How to record stock and creditors in relevant cash flows?

A

Stock
Opening stock
Closing stock
Net stock adjustment = difference in closing and opening
*Net stock adjustment is added/taken to cash flows.

Creditors
Startof year
End of year
Cash flow effect of creditors = difference in EOY and BOY
*Cash flow effect is what is added/taken to cash flows IF NEGATIVE IS ADDED, IF POSITIVE IS TAKEN

42
Q

How to work out incremental cash flows?

A

Cash flow for firm with the project - cash flow for firm without project

43
Q

How to work out the annual equivalent annuity of replacement cycles?

A

Annuity = Present value / annuity factor

*Present value = Initial investment (-ve) + discounted cash flows

44
Q

What is a make or buy decision?

A

An act of choosing between manufacturing a product in-house or purchasing it from an external source.

45
Q

How to determine the max price a company should pay to an outside supplier for components?

A

VC saved + opp. cost = max price

46
Q

How to calculate the profitability index (capital rationing)

A

Gross present value/ initial outlay

47
Q

How to calculate benefit-cost ratio (capital rationing)?

A

NPV/ initial outlay

48
Q

How to allocate tax to calculate corporation tax?

A

*Scrap value = the WD value of the last year (add back in)

  1. Calculate the annual WDA
    - year 0 = initial investment of machine
    - Year 1 = initial investment * % of declining WDA = WDA
    ^ then take this amount from the written down value of the year before
    - Year 2 = written down value of year 1 * % of WDA
    ^ then take this amount from the year before written down value.

THEN (layout)
Net income before WDA and tax (cash flows)
Less: WDA
Incremental taxable income
Tax at _%
*^ taxable income * % of tax

49
Q

How to allocate tax in relevant cash flows?

A

LAYOUT
Cash flow before tax
Add: sale of machine (last year)
Less: tax
Net cash flow
Discounted cash flows
NPV

50
Q

What is Fisher’s equation?

A

Relationship between real rates of return and money rates of return and inflation.

(1+money rate of return) = (1+real of rate of return) * (1+ rate of inflation)

50
Q

What are independent and conditional events?

A

Independent = outcome does not depend on outcome of previous event

Conditional = outcomes of two or more events are related (second outcome dependent on first outcome)

51
Q

What is the risk adjusted rate?

A

Risk-free rate + risk premium

52
Q

How do you calculate the expected return (standard deviation)?

A

sum of return * probability

= (returnprobability)+(returnprobability)+…

53
Q

How do you work out standard variation?

A

LAYOUT
Returns
Expected returns
Deviations (returns - expected returns)
Variance (deviation squared*probability) SUMMED
Standard deviation (square root of variance)

54
Q

What does the standard deviation show?

A

A higher standard deviation is shown to be more risky.

55
Q

How do you calculate the coefficient of variation? What does it show?

A

Standard deviation/expected return

A lower coefficient of variation means the investment is less risky.

56
Q

How do you calculate the return of holding period returns?

A

(Dividends received+(share price at end of period - purchase price)) / purchase price

57
Q

What is covariance?

A

It measures the total variation of two random variables from their expected values. We can only gauge the direction of the relationship.

58
Q

What is the correlation coefficient?

A

The correlation coefficient is a measure of the strength of a linear relationship between two variables.

-1 = perfect negative
(values in 1 series rise as those in the other decline)
0 = independent
+1 = perfect positive

As long as the returns of constituent assets of a portfolio are not perfectly +ve, diversification can reduce risk.

59
Q

How do you work out the expected return on two asset portfolios?

A

(weight of asset A* expected return of A) + (weight of asset B* expected return of B)

60
Q

What is the standard deviation of two asset portfolio?

A

Square root of:
percentage of A^2 * variance of A + (1- percentage of A)^2 * variance of B + 2*percentage of A * (1- percentage of A) * covariance of A and B

61
Q

How do you calculate covariance of two asset portfolios?

A

SUM OF: deviation of A * deviation of B * probability

62
Q

How do you calculate the correlation coefficient?

A

covariance of A and B / (standard deviation of A * standard deviation of B)

63
Q

What is equity capital?

A

Ordinary shares

64
Q

What is debt capital?

A

Borrowing
Lenders have no control.

65
Q

How do you calculate the ex-rights price of a rights issue?

A

Existing share price * no. of shares in rights issue.
THEN add price of one new share.

Value of one share ex-rights = above / no. of shares in rights issue + 1.

66
Q

How do you calculate the value of a right on one new share?

A

market value of share ex-rights - subscription price (value of one new share).

67
Q

How do you calculate the value of a right on one old share?

A

[market value of share ex-rights - subscription price (new price)] / no. of old shares requires to purchase one new share

68
Q

How do you calculate the rate of return on a bond?

A

square root to the power of the no. of years
redeemable price / issue price
THEN - 1.

69
Q

What are convertible bonds?

A

Bonds that carry a rate of interest, they give the holder the right to exchange the bonds at some stage in the future into ordinary shares.

70
Q

How do you work out conversion price?

A

Price of bond/ no. of shares it can be converted into.

71
Q

How do you calculate the conversion premium?

A

(conversion price - current market price) / current market price

72
Q

How do you work out conversion ratio?

A

Nominal (par) value of bond / conversion price

73
Q

How do you work out conversion value?

A

current share price * conversion ratio

73
Q

What are the advantages of convertible bonds?

A
  • Lower interest
  • Interest is tax deductible
  • Self liquidating
  • Fewer restrictive covenants
  • Underpriced shares
  • Cheap way to issue shares
  • Available finance when straight debt and equity are not available
73
Q

How do you work out the cost of debt?

A

risk free rate + risk premium

74
Q

How do you calculate the weight of debt / equity?

A

Weight of debt = weight of debt finance / (weight of debt + weight of equity)

Weight of equity = weight of equity finance / (weight of debt + weight of equity)

74
Q

What is the WACC formula?

A

(cost of equity* weight of equity) + (cost of debt less tax* weight of debt)

74
Q

How to calculate the enterprise value in WACC?

A

amount of cash flow / WACC

74
Q

How to work out the tax in WACC?

A

cost of debt * (1 - tax rate)

74
Q

How do you work out CAPM? (cost of equity)

A

risk free rate + beta * (risk premium)

75
Q

How to calculate the cost of preference share capital?

A

price of preference shares = annual preference dividend / investors required rate of return

76
Q

What are some difficulties in calculating the WACC

A
  • Calculating the cost of each source of finance is a challenge as some securities are rarely traded
  • Difficult to estimate the Beta
  • Accuracy of cost of equity depends of models used
  • use of historical data to estimate costs can be misleading
  • risk free rate used to estimate costs of bonds may not match terms of companys debt
  • complex securities are difficult to value
  • WACC changes overtime
77
Q

What is the gordon growth model?

A

Preference share price = dividend / (rate of return - share growth rate)

Financial management (4 decks)

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