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7211AFE > Topic 6 - Cost of Capital Concepts > Flashcards

Topic 6 - Cost of Capital Concepts Flashcards

1
Q

Why is cost of capital important?

A

The return to an investor is the same as the cost to the company. Cost of capital provides an indication of how the market views the risk of the firm’s assets.

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2
Q

Define Required rate of return

A

Discount rate = hurdle rate = cost of capital

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3
Q

What is the difference between required rate of return and the cost of capital?

A

Required rate of return is from an investors point of view. Cost of capital is from the firm’s point of view

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4
Q

What is the cost of capital if the firm is financed by debt and equity?

A

it is a mix of the cost of equity and the cost of debt.

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5
Q

Who determines the cost of equity and debt?

A

The market.

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6
Q

Who determines the mix of D/E

A

The firm

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7
Q

How do you calculate the cost of capital?

A

Calculate the cost of equity
calculate the cost of debt
calculate the proportion of each type of finance capital

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8
Q

What is the most common way to calculate the cost of equity

A

CAPM
Drawbacks - have to estimate beta and the market premium and we are using the past to predict future which is not always reliable

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9
Q

How does beta influence business risk?

A

plays a central role

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10
Q

What factors influence beta

A

industry effects - cyclical vs non-cyclical companies
operating leverage - mix of fixed and variable costs

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11
Q

What is financial risk?

A

as the firm borrows, they create interest payments that make earnings more volatiles. This increases earnings volatility which increases equity beta

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12
Q

What are the characteristics of preferred stock?

A
  • pays a constant dividend
  • dividends are expected to be paid forever
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13
Q

WACC

A

the required return on our assets based on the markets perception of risk of those assets

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14
Q

Do you use WACC for project cost of capital?

A

only if the project has the same risk as the firms current operations

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15
Q

What is divisional cost of capital

A

used if a company has more than one division with different levels of risk

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16
Q

What is pure play approach?

A

discount rate unique to a particular project. Look at similar companies and calculate average WACC for those

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17
Q

What is the subjective approach?

A

consider the project’s risk relative to the overall risk of the firm

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18
Q

What tools are used for forecasting risk?

A

sensitivity analysis
scenario analysis
simulation analysis

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19
Q

What is sensitivity analysis

A

Investigation of what happens to NPV when only one variable is changed.

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20
Q

What is scenario analysis

A

The determination of what happens to NPV estimates when more than one variables are changed.

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21
Q

What is simulation analysis

A

A combination of scenario and sensitivity analysis used to construct a distribution of possible NPV estimates.

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22
Q

What are the options for long term financing?

A

ordinary shares, preferred shares, long-term debt,
internal financing - retained earnings

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23
Q

Debt Vs Equity

A
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24
Q

What is an equity share

A

Basic ownership claim in a corporation
Shareholders share directly in the corporation’s profits and losses
If the firm is liquidated ordinary shareholders are paid last
Shareholders elect a board of directors by casting votes at an annual meeting.
Not all shares have equal voting rights
Most shareholders in Australia do not actively engage in meetings. They are ‘passive’ investors

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25
Q

What is a preference share

A

Also represent an ownership interest in a company
If the firm is liquidated, preference shareholders rank above ordinary shareholders
Have a fixed dividend and in this respect resemble bonds
Convertible preference shares can be converted into ordinary shares
Usually issued at $100 and have a set dividend for 5 years
At this time the holders may accept the reset terms of the issue, redeem at face value or convert to ordinary shares

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26
Q

What is a primary market?

A

Primary Markets
New issues of securities are sold in the primary market.
The primary offering of shares is called an initial public offering (IPO).
The seller receives the proceeds of the IPO and investors receive the shares.

27
Q

What is the secondary market?

A

Secondary Markets
Any trade after the security’s primary issue is a secondary market transaction.
The company obtains no additional capital from secondary market trading.
The market price is determined in the secondary market, and this will determine whether and under what conditions the firm can access finance in the future.

28
Q

What are the advantages of IPOs

A

IPOs can raise large amounts of new capital for growth
Publicly traded shares serve as currency for acquisitions
Listed share (options) can be used to attract top managers
Entrepreneurs enjoy personal wealth and liquidity
IPOs serve as advertising for companies and their products/services

29
Q

What are the disadvantages of IPOs

A

High financial costs, with no guarantee of success: cash expenses of an IPO often approach $1 million
Managerial costs of planning and executing IPO
Companies need to focus on share price and deal with shareholders
In public companies, severe constraints are placed on managerial discretion
Have to disclose operating and sensitive data publicly
Must follow public company governance rules set by ASIC

30
Q

What are special types of IPOs

A

equity carve out, spinoff, reverse LBO, tracking stock

31
Q

What is a seasoned equity offering

A

issuing shares after IPO

32
Q

What is a rights offering?

A

Preemptive rights: shareholders can purchase shares first in a SEO at a discount
Give ordinary shareholders the right to maintain their proportionate ownership in the corporation.

33
Q

What is a private placement?

A

Sale of a security directly to one or a group of investors.
Accredited investors in private placements are financially sophisticated.
Corporations, institutional investors, wealthy individuals, pension and mutual funds, and venture capitalists.
Much quicker and with fewer costs involved than rights or other SEOs.
Heavily regulated with limits on amount of private placement (15%), unless authorised by existing shareholders.

34
Q

What are loan covenants?

A

Things the borrower ‘must do’, such as:
Maintain satisfactory accounting records in accordance with GAAP.
Maintain a minimum level of net working capital.
Maintain life insurance on ‘key employees’.
Spend borrowed funds on a specific project.
Things the borrower ‘must not do’, such as:
Fixed asset restrictions.
Issue additional debt, unless company requires that additional debt be subordinated.
Avoid certain types of leases or other fixed-payment obligations.

35
Q

What is the primary goal of financial managers?

A
  • maximise stockholder wealth
  • choose optimal capital structure
  • maximise the value of the firm
  • minimise the WACC
36
Q

What is financial leverage?

A

the extent which a firm relies on debt financing

37
Q

What is capital restructuring

A

recapitalisation
involves changing the amount of leverage a firm has without changing the firms assets

38
Q

how do you increase leverage

A

issue debt and repurchase outstanding shares

39
Q

how do you decrease leverage

A

issue new shares and retire outstanding debt

40
Q

What is the effect of leverage

A

increases interest expense
amplifies variation in both EPS and ROE

41
Q

What is a managerial option?

A

Option to expand, abandon, wait, strategic options

42
Q

Option to expand

A

if the project is successful, it is possible to increase production and expand

43
Q

Option to abandon

A

if the project does not break even, is it possible to scale down or abandon?

44
Q

Option to wait

A

even if it has positive NPV, it may be better to wait

45
Q

What are the most important costs and benefits of becoming a publically traded firm?

A

The benefits of going public include: raising new capital for the company, providing publicly traded securities that can be used in acquiring other companies, having listed shares that can be used to compensate and retain key employees and providing personal wealth and liquidity for entrepreneurs.

46
Q

What are the drawbacks of becoming a publically traded firm?

A

Key drawbacks include the high financial cost of an IPO (transactions fees for doing the deal), high managerial costs (management time taken up in managing the deal rather than the core business), external pressures to maximise share price once the firm has gone public, and required, continuing information disclosures.

47
Q

What questions would you ask before advising whether or not an entrepreneur’s firm should go public?

A

Important questions to ask an entrepreneur are: what are the firm’s needs for future financing, how quickly is it growing, how reliable is his/her management team, how sound is the business model, and what are estimated revenues and costs for the company.

48
Q

What are loan covenants?

A

Loan covenants are contractual clauses that place specific operating and financial constraints on the borrower. Covenants protect bondholders, reduce bondholder-shareholder conflicts and lower the cost of debt because of those protections. Protective covenants reduce the risk of the loan and may allow a riskier borrower to obtain debt.

49
Q

What purpose do loan covenants serve in a debt agreement? What are two types of covenants?

A

Covenants protect bondholders, reduce bondholder-shareholder conflicts and lower the cost of debt because of those protections. Protective covenants reduce the risk of the loan and may allow a riskier borrower to obtain debt.

There are two types of covenants: positive and negative. Positive covenants specify things that a borrower must do. E.g., the borrower must maintain all the facilities in good working order. Negative covenants specify what a borrower must not do. E.g., many debt agreements prohibit borrowing additional long-term debt unless the company requires that the additional borrowing be subordinated to the original loan.

50
Q

What are the major factors that affect the cost of long-term debt?

A

The four major factors are maturity (when the debt must be repaid), loan size (how much is borrowed), borrower risk and the basic cost of money. The cost of money is the basis for determines the actual interest rate charged. Generally, the rate on Australian government bonds with equivalent maturities is considered the basic cost of money.

51
Q

Define term loan,

A

A term loan is a loan made by a financial institution to a company. It lasts at least a year and generally lasts 5-12 years. Typically, term loans are made to finance permanent working capital needs, to pay for machinery and equipment or to liquidate other loans.

52
Q

Define a balloon payment

A

A balloon payment occurs when the loan requires small intermediate payments and a final large payment at the maturity of the loan.

53
Q

Define a share purchase warrant

A

Share purchase warrants are generally used as sweeteners to a risky loan agreement, allowing the lender to purchase shares, and therefore share in the upside potential if the company does well.

54
Q

What is a Eurobond? Why did these bonds come into existence? Why do Eurobond investors like the fact that these are typically ‘bearer bonds’? What risk does an investor run from holding bearer bonds rather than registered bonds?

A

A Eurobond is a bond issued by an international borrower and sold to investors in countries with currencies other than the currency in which the bond is denominated. This market was developed to satisfy European investors who wanted to hold dollar-denominated bearer bonds. Bearer bonds were desirable because they could shelter investment income from taxation, since bearer bonds were unregistered, and the interest paid to investors is not reported to tax authorities by the issuer. Under-reporting tax income is, however, illegal. Dollar-denominated bonds also provided protection against exchange rate risk.

55
Q

Key advantages of leasing

A
  • May permit the company to increase its liquidity by converting assets into cash, which can then be used as working capital.
  • Leasing provides 100% financing. Many loan agreements require a down payment.
  • When a company reorganises or goes insolvent, the lessor can take back its leased assets quickly and relatively easily. A borrower may hold one of many claims against a company’s assets in the event of insolvency.
  • The company may avoid the cost of obsolescence if the lessor does not accurately anticipate the obsolescence of assets and sets the lease payments too low.
  • The lessee avoids potentially restrictive bond covenants.
  • Leasing may provide more financing flexibility.
56
Q

Disadvantages of leasing

A
  • A lease does not have a stated interest cost, and borrowing may be less costly for the company.
  • At the end of a lease agreement, the lessor realises the salvage value, not the lessee.
  • A lessee is generally prohibited from making improvements on a leased property or asset without the approval of the lessor.
  • If a leased asset becomes obsolete, the lessee must still make lease payments over the remaining life of the lease.
57
Q

How should a corporation estimate the amount of financing that must be raised externally during a given year? Once that amount is known, what other decision must be made?

A

The amount of financing a corporation needs depends on the capital budgeting projects that it wishes to accept and on its capability to generate financing internally. The rule is to accept all positive net present value projects. A corporation must also cover its additional working capital needs.

Once it knows how much financing it requires, then it must decide whether this amount is externally or internally financed. If externally financed, then how much is financed with debt, hybrid securities or equity? If internally financed, how much of the corporation’s net income should be retained and how much paid out as dividends?

58
Q

Define the term financial intermediary. What role do financial intermediaries play in US corporate finance? How does this compare to the role of non-US financial intermediaries?

A

A financial intermediary is an institution, such as a bank, that raises capital by issuing liabilities against itself, or a commercial bank or other entity that lends to corporations.

Financial intermediaries play less of a role in financing US corporations than they do for non-US corporations. In many countries, intermediaries play a corporate governance role, for example, helping set the operating and financial policies of the firms they have invested in by serving on corporate boards and monitoring the performance of senior managers. In the US, commercial banks are largely prohibited from exercise a corporate governance role.

59
Q

What financing options do firms have?

A
  • corporate bond market
  • equity markets
  • bank finance, etc
60
Q

Equity carve out

A
  • parent sells minority state in subsidiary to public
  • raises cash for parent
61
Q

Spin-off

A

Parent distributes all of a subsidiaries shares to shareholders, creates a new independent company

62
Q

Reverse LBO

A

Company goes public again after LBO

63
Q

Tracking stock

A

Shares mirror performance of division but not legally separate from parent

7211AFE (7 decks)

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