Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

Financial Accounting and Analysis > Week 10 > Flashcards

Week 10 Flashcards

1
Q

Sources of finance

A

Equity financing

Debt financing

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Equity financing

A

Equity holders have a residual claim to the cashflows
generated by the assets of the company.
e.g. ordinary shares; preference shares

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

DEBT FINANCING:

A

Debt providers have a contractual right to the cashflows
generated by the assets of the company.
e.g. term loans (long-term bank loans); debentures;
bonds (government bonds and/or corporate bonds)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

CHARACTERISTICS OF Debt vERSUs Equity

A

photo 27/9

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Intrinsic value of an asset

A

The present value of the stream of expected cash flows discounted at an appropriate required rate of return

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

The value (or price) is determined by three elements:

A
  1. The required rate of return by investor
  2. The riskiness or uncertainty of expected cash flows
  3. The amount and timing of expected cash flows
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

A bond

A

A bond refers to a contract that is issued by either a government or a corporation (the issuer) promising to pay the holder:

(1)A pre-determined amount of interest payments;
and
(2) The face value at maturity.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

A bond represents

A

A bond represents a form of interest-only direct

finance loan.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

A bond pays

A

A bond pays fixed coupon payments at fixed intervals and pays the par value at maturity

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Bond terminology

A

Par value (or face value)

Maturity date

Coupon rate

Coupon payments

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Par value (or face value)

A
  • The principal amount to be repaid on the maturity date.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Maturity date

A

The date at which the principal amount is payable.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

Coupon rate

A

The annual coupon payments divided by the face value.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

Coupon payments

A
  • The fixed interest payments that are payable at fixed intervals
    until the maturity date.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

Valuation of Bonds

A

The value (or price) of a bond is determined by the present value of all the cash flows that the bond is expected to produce in the future up to and including the maturity date.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

The expected cash flows for a bond consist of:

A

(1) All coupon payments (paid at fixed intervals until the maturity date);
and

(2) The principal amount or Face Value (paid at the maturity date).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

Valuation of Bonds photo

A

27/9

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

Time Path of the Value of a 10% coupon, $1,000 Par Value Bond When Interest Rates are 8%, 10% and 12%

A

27/9

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

VALUATION OF BONDS

General Rule:

A

If the Coupon rate = Interest rate:
The bond will sell for its par value (i.e. par bond).

If the Coupon rate > Interest rate:
The bond will sell for a premium (i.e. premium bond).

If the Coupon rate < Interest rate:
The bond will sell for a discount (i.e. discount bond).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

VALUATION OF BONDS CONCLUSION

A

Bond prices are inversely related to interest rate movements:

- If interest rates increase, bond prices will fall and thus sell at a discount; and
- If interest rates decrease, bond prices will rise and thus sell at a premium.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

The Relationship between Bond prices and interest rates

A

PHOTO 27/9

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

SHARES

A

The main types of equity securities are ordinary shares

and preference shares.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

Preference shares are:

A

A form of hybrid security;
Similar to bonds in that fixed dividends that must be paid to preference shareholders before dividends can be paid to ordinary shareholders;
Similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders:

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

Similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders:

A
  • Companies can omit dividend payments to preference shareholders without fear of defaulting and pushing the company into bankruptcy.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

Preference shares terms

A

Par value

Cumulative dividends

Maturity date

Priority to Assets and Earnings

Control of the Company (Voting Rights)

Convertibility:

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

Par value

A

Establishes the amount due to preference shareholders in the event of company liquidation event;
The preference dividend is generally set as a % of par value.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q

Cumulative dividends

A

A protective feature on preference shares that requires preference dividends not paid in previous periods to be paid to preference shareholders before dividends can be paid to ordinary shareholders.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
28
Q

Maturity date

A

In general, preference shares have no specific maturity date.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
29
Q

Priority to Assets and Earnings

A

Preference shareholders have priority over ordinary shareholders but not debtholders. Dividends must be paid on preference shares before ordinary shares.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
30
Q

Control of the Company (Voting Rights)

A

Preference shares are typically ‘non-voting’, with preference shareholders having neither the right to elect the Board of Directors nor vote on corporate issues.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
31
Q

Convertibility:

A

Many preferred shares include an option to convert to ordinary shares.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
32
Q

Valuation of preference shares perpetuity

A

With fixed dividend payments and no maturity date, preference shares can be valued like a perpetuity.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
33
Q

Valuation of preference shares formula

A

PV = D / r

where:
D = Fixed dividend payment for each year
(in dollars);

r = Required rate of return
(i.e. interest rate or discount rate).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
34
Q

Ordinary shares

A

Ordinary shares represent equity or claims to ownership of the company. Ordinary shares are variable-income securities

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
35
Q

Ordinary shares represent equity or claims to ownership of the company.

A

Ordinary shareholders have residual claim to any earnings that remain:

      (1st) only after interest payments are made to debtholders;
      (2nd) only after corporate tax is paid to the government; and
      (3rd) only after dividends are paid to preference shareholders.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
36
Q

Ordinary shares are variable-income securities:

A

Companies have no (contractual or implied) obligation to pay dividends to shareholders;

Dividend amounts are not fixed;

Dividends depend on earnings.

37
Q

Ordinary shares terms

A

Maturity date

Priority to assets and earnings

Control of the Company (Voting Rights):

38
Q

Maturity date

A

Like preference shares, ordinary shares have no specific maturity date.

39
Q

Priority to assets and earnings

A

Both debtholders and preference shareholders have priority over ordinary shareholders. Both interest payments on debt and dividends on preference shares must be paid before dividends can be paid on ordinary shares.

40
Q

Control of the Company (Voting Rights):

A

Ordinary shares come with voting rights, with ordinary shareholders having the right to elect the Board of Directors and vote on corporate issues such as shareholders’ proposals, mergers and changes to the company’s constitution.

41
Q

Valuation of Ordinary Shares

A

The market value of a share is the present value of all expected cash flows to be received from the share, discounted at a rate of return that reflects the riskiness or uncertainty of the expected cash flows. The expected cash flows to be received from a share are all the future dividend payments for the share.

42
Q

When you sell or buy an ordinary share

A

When you sell a share, you are selling the right to receive
all future dividends from that point onwards. Conversely, when you buy a share, you are buying the right to receive all future dividends from that point onwards.

43
Q

THE Dividend DISCOUNT Model

A

But, how do we estimate all future dividends from now to infinity?

After all, since company performance and earnings will
necessarily vary over time, dividend payments are also
likely to fluctuate in the future.

44
Q

THE DIVIDEND Growth MODEL

A

The valuation process is greatly simplified if we can
assume that dividends are expected to grow at a
constant rate over time (i.e. simply assume that
dividends will grow by the same percent each year).

This assumption creates the ‘dividend growth model’:

45
Q

Divided growth model formula

A

PV = D / r - g

where:
D = Dividend payment (in dollars);

r = Required rate of return
(i.e. interest rate or discount rate);

g = Growth rate (of dividend).

46
Q

Dividend

A

A dividend is a payment that is made out of a company’s (retained) earnings to its owners (or shareholders). Dividends are usually paid in the form of cash.

47
Q

Types of cash dividends include:

A

regular dividends;
extra dividends;
special dividends;
liquidating dividends.

48
Q

THE DIVIDEND PAYMENT PROCESS terms

A

Declaration date

Ex-dividend rate

Cum dividend

Record Date

Payment date

49
Q

Declaration date

A

The date on which the company’s board of directors publicly announces the amount and the specifics (such as the payment date) of the next dividend payment.

50
Q

Ex-dividend rate

A

The date on which the legal right to the next dividend payment no longer accompanies a share:

  • shareholders that sell shares on or after the ex-dividend date will still be entitled to receive the next dividend payment, although the new owner will not;
  • usually, shares that trade immediately after the ex-dividend date will be accompanied by a decline in the share price that is equivalent to the amount of the next dividend payment.
51
Q

Cum dividend

A

The situation where the legal right to the next dividend payment accompanies a share:

  • when investors purchase shares that are cum dividend, they are entitled to receive the
    next dividend payment on the payment date;
  • conversely, when investors sell shares that are cum dividend, they will not be entitled to receive the next dividend payment on the payment date.
52
Q

Record Date

A

The date on which the company determines the list of shareholders that will receive the next dividend payment. In Australia, the record date typically occurs 4 business days after the ex-dividend date.

53
Q

Payment date

A

The date on which the company actually makes the dividend payments to the shareholders on its record.

54
Q

MANAGMENT Dilemma

Fundamental question

A

Should a company use its retained earnings to:

Finance profitable investment opportunities?

or

Pay dividends to shareholders?

55
Q

MANAGEMENT Dilemma dividend policy

A

A company’s dividend policy seeks to address this dilemma and communicate this information to its shareholders .

56
Q

Theories of dividend policy

A

Fundamental Question:
Does dividend policy affect the share price of a company?

Two opposing viewpoints:

  1. Dividend Irrelevance Theory
  2. Dividend Relevance Theory
57
Q
  1. Dividend Irrelevance Theory
A

Argues that the market value of a company is determined by the basic earning power and business risk of the company.

Therefore, the market value of a company depends only on the net income (or positive cashflows) produced by the company and not on how it splits its retained earnings between financing investments for future growth versus dividend payments to shareholders.

Dividend Irrelevance Theory contends that investors care only about the total returns they receive, and not whether they receive those returns in the form of dividends, capital gains or both.

58
Q
  1. Dividend Relevance Theory
A

In contrast, Dividend Relevance Theory contends that a company’s dividend policy can affect its market value due to investor preferences for either dividends or capital gains:

A. Bird in hand theory

B. Tax preference theory

59
Q

A. Bird in hand theory

A

Argues that investors would prefer to receive dividends today rather than receive capital gains in the future, because current dividend payments are more certain than future capital gains.

60
Q

B. Tax preference theory

A

Argues that, since dividends are taxed immediately whereas capital gains are not taxed until the share is sold (with potentially indefinite deferral of tax), investors would prefer to defer tax by receiving capital gains in the future rather than receive dividends today and be taxed immediately.

61
Q

POSSIBLE EFFECTS OF DIVIDEND POLICY ON COST OF EQUITY

A

Photo 27/9

62
Q

POSSIBLE EFFECTS OF DIVIDEND POLICY ON market share price

A

Photo 27/9

63
Q

Practical implications

A

Photo 27/9

64
Q

Residual Dividend Policy

A

A policy in which the company only makes dividend payments when there is retained earnings left over after having financed all profitable investment opportunities. The residual dividend policy dictates that dividend payments to shareholders should only be paid out of leftover earnings.

65
Q

Residual Dividend Policy

Key implications

A

Minimizes the overall cost of capital for the company by reducing the need to raise capital through issuance of new equity.

But the ‘residual dividend policy’ will result in variation of dividend payments to shareholders due to fluctuations in retained earnings and the cost of pursuing profitable investment opportunities.

This variation of dividend payments sends conflicting signals to investors, that might, in turn adversely affect the company’s share price.

66
Q

Constant Payout Ratio Dividend Policy

A

A policy in which the company distributes a fixed proportion of its earnings to shareholders in the form of dividend payments:
For example, a constant payout ratio of 30% means that, for every dollar of earnings, 30 cents will be paid out to shareholders as dividends.

67
Q

Constant Payout Ratio Dividend Policy

Perfect implications

A

Although the dividend payout ratio is constant, the dollar value of dividend payments will fluctuate as earnings change over time. Again, this variation of dividend payments sends conflicting signals to investors, that might, in turn adversely affect the company’s share price.

68
Q

. Stable Dollar Dividend Policy

A

A policy in which the company pays a fixed dollar amount of
dividend payments to shareholders each year such that the
annual dollar dividend is relatively predictable for investors.

69
Q

. Stable Dollar Dividend Policy

Key implications

A

The stability and predictability of dividend payments sends a
positive signal to investors that will, in turn, help to attract more
investors maintaining or boosting the company’s share price.

70
Q

Low Regular Dividend Plus Extras Dividend Policy

A

A policy in which the company pays a low regular dollar dividend to shareholders plus an extra (or special) year-end dividend in prosperous years when the company is performing well financially.

71
Q

Low Regular Dividend Plus Extras Dividend Policy

Key implications

A

Represents a compromise between the ‘stable dollar dividend policy’ and the ‘constant payout ratio dividend policy’. Provides the company with flexibility while ensuring that shareholders eceive at least a minimum amount of dividend payments. By identifying year-end dividend as an ‘extra’, the company avoids signalling to investors that this is a permanent dividend, thus providing the company with flexibility to reduce or eliminate the year-end dividend in the future without adversely affecting its share price.

72
Q

4 dividend policies

A

Residual Dividend Policy

Constant Payout Ratio Dividend Policy

Stable Dollar Dividend Policy

Low Regular Dividend Plus Extras Dividend Policy

73
Q

Share repurchases

A

Also known as ‘share buy-backs’. Involves distribution of earnings by a company to its shareholders by purchasing its own shares from existing shareholders. There are two main forms of share repurchases in Australia:

On market repurchase

Off market repurchase

74
Q

On market repurchase

A

Involves purchasing shares offered for sale by investors on the share market through normal share market trading mechanism.

75
Q

Off market repurchase

A

Involves making a formal offer to purchase shares from all existing investors based on offer terms outlined in the offer document.
Off-market repurchases are not processed through the normal share market trading mechanism.

76
Q

Share REPURCHASES

Primary Reasons for Share Repurchases:

A

(1) To distribute excess funds to shareholders:
(2) To adjust the company’s capital structure:
(3) To adjust the company’s capital structure:
(4) To protect or defend against a takeover attempt:

77
Q

(1) To distribute excess funds to shareholders:

A

Especially when the company’s share price is perceived as under-valued.

78
Q

(2) To adjust the company’s capital structure:

A

When the company has more equity than its target capital structure suggests.

79
Q

(3) To adjust the company’s capital structure:

A
  • Reduce the dilution effect that occurs when employee options are exercised,
    thus ensuring no marked change to company’s overall issued capital.
80
Q

(4) To protect or defend against a takeover attempt:

A

By

(a) driving up the share price and making it more costly for other parties to acquire the company; and

(b) concentrating the ownership of company shares
in the hands of company management to fend off the hostile takeover.

81
Q

Advantages of share repurchases

A

(1) To distribute excess cash to shareholders:
2) To adjust the company’s capital structure:
(3) To adjust for employee share-based compensation:
(4) Signal to investors:

82
Q

(1) To distribute excess cash to shareholders:

A
  • This is achieved without increasing the amount of dividends.
83
Q

2) To adjust the company’s capital structure:

A
  • Effective method to change the company’s capital structure when there is
    substantially higher proportion of equity than its target capital structure.
84
Q

(3) To adjust for employee share-based compensation:

A
  • Reduce the dilution effect that occurs when employee options are exercised,
    thus minimizing the effect on the company’s share price.
    (4) Signal to investors:
85
Q

(4) Signal to investors:

A
  • Allow company managers to signal to investors that they perceive the
    company’s share price as under-valued, and thus represent a bargain.
86
Q

Disadvantages of Share Repurchases:

A

Company might overpay for shares:

Irregular interval between share repurchases:

87
Q

Company might overpay for shares:

A

This is especially so when substantial amounts of shares are repurchased
on the market, which might cause a marked increase in share price.

88
Q

Irregular interval between share repurchases:

A
  • Since the interval between share repurchases are generally irregular, participating investors cannot rely on the cash that they receive from share repurchases.
  • As a result, some investors might prefer to receive cash through regular dividend payments rather than through share repurchases by the company.

Financial Accounting and Analysis (15 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2025 Bold Learning Solutions. Terms and Conditions