Workbook Questions Flashcards
What is the financial objective of a profit making company?
Maximising shareholder wealth
One of the most important financial management potential conflicts is between shareholders (_____) and directors (_____)
Principals
Agents
What are the ESG objectives?
Environmental, social and governance
Poor environmental behaviour can lead to what? (3)
Fines
Loss of reputation
Legal claims
Poor governance can lead to what? (3)
Poor decision making
Taking on too much risk
Fraud
Define payback
The time taken for cash inflows from a project to equal the cash outflows
Payback decision rule:
Accept if payback ___ target
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- Define ARR
- Give both formulas for ARR
- For ARR, profit is before or after depreciation?
- Accounting rate of return
- i) (average annual profit from investment) / (initial investment) * 100
ii) (average annual profit from investment) / (average investment) * 100, where average investment = (initial outlay + scrap value) / 2 - After
ARR decision rule:
accept if ARR __ target
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Define NPV
Net Present Value: the maximum an investor would pay for a given set of cash flows compared to the actual amount he/she is being asked to pay
NPV decision rule:
Accept is NPV is _____ (usually)
Positive
Define IRR
Internal rate of return: a cost of capital at which the NPV of a project is £0
IRR decision rule:
Accept if IRR % __ cost of capital (usually)
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Give the IRR interpolation formula using two discount rates
IRR = a + (NPVa / (NPVa - NPVb)) * (b - a)
a = the lower discount rate giving NPVa
b = the higher discount rate giving NPVb
Define relevant cash flows
Future, incremental, cash flows arising from the decision being made
The figures out into NPV working must be relevant to the decision being considered:
1) cash flows only, ie _____ should be ignored
2) _____ amounts only
3) ______ relevant costs only
4) finance related cash flows
5) _____ costs, ie include costs incurred or revenue lost from diverting existing resources from their existing use
Depreciation
Future
Directly
Opportunity
Does working capital form part of the taxable cash flows?
Yes
What are the two effects taxation has on investment appraisal?
- Tax payments on operating profit
- Tax benefit from capital allowances on capital expenditure
Calculate capital allowances at ____ on a reducing balance basis
18%
Are there capital allowances in the year of sale?
No; a balancing allowance/charge is calculated instead
Corporation tax is assumed to be paid at ____
25%
Although large companies make tax payments in four equal instalments during the accounting year, what do we assume for examination purposes?
The whole tax payment is to be made at the end of the year to which it relates
True or false:
The tax rate can be assumed to be constant over the life of the project
True
True or false:
It should be assumed that working capital flows have no tax effects
True
What are the real rates of interest?
The rates of interest that would be required in the absence of inflation in the economy
Give the Fischer Equation
(1 + m) = (1 + r) * (1 + i)
m = money (nominal) rate
r = real (effective) rate
i = general inflation rate
The money method uses the money (nominal rate). Give two issues with this methodology
- General inflation may not be constant
- Longer term estimates become more prone to error
What are the four environmental costs to consider?
- Environmental prevention costs
- Environmental appraisal costs
- Environmental internal failure costs
- Environmental external failure costs
When is the equivalent annual cost (EAC) the quickest way to determine the optimal replacement cycle?
Give the EAC formula
When cash flows do not inflate
EAC = (NPV of one cycle of replacement) / (AF for this cycle length)
AF = annuity factor
Define capital rationing
The situation where insufficient funds exist to undertake all positive NPV projects, so a choice must be made between projects
What is the difference between hard rationing and soft rationing?
Hard rationing: external limits exist on funds available
Soft rationing: internal constraints are imposed
Profitability Index (PI) = ?
NPV / Outlay (outlay is the funds required)
Define an indivisible project
A project which must either be completed in full or not at all
Rank the following in correct order
A) implement and control
B) determine mission and objectives
C) analyse the current position of the business
D) identify and select strategies
C), B), D), A)
Define Shareholder Value Analysis (SVA)
The process of analysing the activities of a business to identify how they will result in increasing shareholder wealth
Below are four key drivers of value for SVA. What are the remaining three?
Sales growth rate
Operating profit margin
Corporation tax rate
Investment in non-current assets
Investment in working capital
Cost of capital
Life of projected cash flows
Real option equation:
Project worth = Traditional NPV + ?
Value of any real options
Overseas investment can include political risk, product risk and _____ risk
Cultural
What is the difference between risk and uncertainty?
Risk: probabilities are both known and can be quantified
Uncertainty: possible outcomes are known but probabilities are unknown
The following techniques are used for handling what?
1) setting a maximum payback period for projects
2) increasing the discount rate subjectively in order to submit the project to a higher ‘hurdle’ rate in investment appraisal
3) making prudent estimates of outcomes to assess the worst possible situation
4) assessing the best and worst possible situations
5) using sensitivity analysis to measure the margin of safety on input data
Uncertainty
Sensitivity analysis equation?
Sensitivity = (NPV of project) / (PV of cash flows subject to uncertainty) * 100%
Sensitivity analysis is a formalised approach to incorporating ______ ______ in the project evaluation
Alternative forecasts
Strengths of sensitivity analysis:
- Presented in a form which facilitates subjective ______
- Identifies areas which are _____ to success
- The theory is not ______
Judgement
Critical
Complicated
Weaknesses of sensitivity analysis:
- Only one _____ at a time can be analysed
- If assumes that changes to ____ can be made indecently
- It only identifies how far a variable needs to change, it does not look at the…?
- It provides information on the basis of which decisions can be made, it does not …?
- Factor
- Variables
- Probability of such a change
- Point directly to the correct decision
What two types of data does predictive analytics use to create predictions about the future?
Historic and current
Define linear regression
A statistical technique which quantifies the relationship between a dependent variable and an independent variable so that forecasts can be made
Linear regression advantages:
- They are ___ to use and _____ to explain
- Can be used to predict the impacting of expanding variables beyond _____ estimates
Simple, easy
Current
Limitations of regression analysis:
- Not always a ______ relationship between variables and outcomes
- _______ models are needed to consider multiple variables
- _______ relationship between variables and outcomes may be identified
- The data collected may be _____ or there may be a large error variable
Linear
Complex
Spurious
Inaccurate
Define decision trees
A statistical technique used to identify the impact of different decisions and variables on the outcome of an investment
Two advantages and disadvantages of decision trees
- Simple decision trees are easy to explain and logical to use
- Can be used to analyse different outcomes based on a number of variables
- Variables have to be simplified and restricted to avoid over complicating the decision tree
- Large decision trees can be difficult to interpret
Define simulation
A technique which allows the effect of more than one variable changing at the same time to be assessed
What is the Monte Carlo simulation?
A simulation technique based on the use of random numbers and probability statistics to investigate problems
If outcomes are less widely dispersed about the mean, the standard deviation will be ______
Smaller
Advantages of simulation:
- It gives more ______ about possible outcomes
- It gives more information about the impact of ____ costs on new ventures
- It is useful for problems which cannot be solved ______
Information
Environmental
Analytically
Limitations of simulation:
- Only obtains information, not a technique for _______ making
- Can be ______ due to complexity
- Requires _____ to be made about probability distributions which may turn out to be inaccurate
Decision
Expensive
Assumptions
Define selection bias
When data is not selected randomly and leads to a sample that is not representative of the population
Define self-selection bias
Occurs when individuals select themselves to be part of a sample
Define observer bias
Occurs when observing and recording results and relates to interpretation
Define cognitive bias
Relates to human perception and includes bias depending on how data is presented
The higher the standard deviation, the…?
Give the excel function for this
Wider the data spread and the greater the risk of the expected return
=STDEV
Give the coefficient of variation equation
What does a higher percentage of this mean?
Standard deviation / mean * 100
The wider the dispersion of data around the mean
What is a normal distribution?
Any distribution of data which is symmetrical around the mean
Define portfolio
A combination of investments
What type of risk can be eliminated by diversification?
Which risk can’t?
Unsystematic/specific risk
Systematic/market risk cannot be eliminated by diversification
Give the Capital Asset Pricing Model (CAPM) equation
rj = rf + Bj (rm - rf)
rj = required rate of return on investment j
rf = risk-free rate of interest
rm = return on the market portfolio
Bj = index of systematic risk for security j
For CAPM:
Shares with higher betas are termed ______
Shares with betas of less than 1 are termed ______
Aggressive
Defensive
The great advantage of using the CAPM for project appraisal is that it clearly how’s that the discount rate should be related to…?
The projects risk
What is the use of CAPM?
In the setting of minimum required returns for new capital investment projects
Issues with the alpha value in CAPM:
Reflects only ______, abnormal returns
Will tend towards ____
Temporary
Zero
CAPM: if the alpha value is positive, what will happen?
Investors not already holding shares will be tempted to buy. Current investors will hold shares
The arbitrage pricing model (APM) assumes what?
That the return on each security is based on a number of independent factors
In what way is Arbitrage Pricing Theory (APT) similar to CAPM?
It assumes that investors are fully diversified, so only systematic risks influence the returns
Give the APT general model:
E(ri) = rf + (E(rA) - rf)BA + (E(rB) - rf)BB + ….
(E(rA) - rf)BA = risk premium on factor A, etc. for rest
What are the three factors that Fama and French suggest are for the APM?
- Return on the market portfolio less the risk free interest of interest
- Size factor measured as the difference in return between a portfolio of the smallest stocks and a portfolio of the largest stocks
- The value factor: a share with a high balance sheet (book) value per share when compared to the market share price will have a higher return than a share with a low book value compared to the market price
Define derivative
A financial security whose value is derived from the value and characteristics of an underlying security
Define a forward contract
A binding agreement to exchange a set amount of goods at a set future date at a price agreed today
Define a future
A standardised contract to buy or sell a specific amount of a commodity, currency or financial instrument at a particular price on a stipulated future date
What is the difference between a forward and a future?
A future is traded on an organised exchange
Define hedge efficiency.
Give the formula for it
The extent of risk neutralisation that the hedge delivers
Gain in futures / loss on portfolio * 100%
What is the difference between a future and a forward?
The holder of an option can choose whether or not to go through with the transaction and buy or sell the asset
A _____ option, means an investor is entitled to buy the shares at the exercise price within the specified period
Call
A _____ option means an investor has the right to sell the shares at the exercise price within the specified period
Put
The cost of an option to a purchaser is known as the option ______
Premium
What’s an over-the-top (OTC) for options mean?
Options may be traded on an exchange or agreed between two parties
If a company buys a put option on shares, what are they doing?
Buying an option to sell the shares
The intrinsic value of an option is computed by assuming that what?
It’s expiry date is today
‘In the money’ options would be exercised and have an intrinsic value equal to the difference between the ______ price and the current ______ price
Exercise
Share
When are ‘out of the money’ options not exercised?
When they have zero intrinsic value
How is the time value for an option computed?
The difference between actual value and intrinsic value
Three factors impact the time value of an option, which are the time period to expiry of the option, volatility if the underlying share price and what?
The general level of interest rates
Who is responsible for managing the company’s cash and borrowings in order to repay debts as they fall due and to minimise the risks surrounding interest payments and receipts?
Corporate treasurers
What is a Forward Rate Agreement (FRA)?
An FRA allows borrowers or lenders to fix their future rate of interest
A borrower will _____ a FRA whilst an investor will _____ a FRA
Buy
Sell
5.75-5.70 means that you can fix a _____ rate at 5.75% and a _____ rate at 5.70%
Borrowing
Deposit
Borrowers will wish to hedge against an interest rate by selling futures now and by…?
Buying futures in the day that the interest rate is fixed
What is maturity mismatch?
Give the formula
Maturity mismatch occurs if the actual period of lending or borrowing does not match the notional period of the futures contract (3 months)
Number of futures contracts = (amount of actual loan or deposit / futures contract size) * (length of loan / 3 months)
How is the pricing of an interest rate futures contract determined?
By the interest rate (r) and is calculated as (100 - r)
What is an interest rate swap?
A contractual arrangement for two organisations to exchange future interest rate payments
What is the purpose of an interest rate swap?
To switch from paying one type of interest (E.g. fixed) to another (E.g. floating) much more cheaply than renegotiating existing debt
A risk of swaps is that the counterparty will ______ before completion of the agreement
Default
A risk of swaps is that it may lead to _______ _____ of the party involved being misleading
Financial statements
What is the spot rate?
The exchange rate currently offered on a particular currency quoted for immediate delivery of the currency
(Exchange rates): what is a direct quote?
The amount of domestic currency required to buy one unit of foreign currency
(Exchange rates) what is an indirect quote?
The amount of foreign currency needed to buy one unit of domestic currency
Define transaction risk (exchange rates)
The risk of adverse exchange rate movements occurring in the course of normal international trading transactions
Define translation risk (exchange rates)
The risk that the organisation will make exchange losses when the accounting results of its foreign branches or subsidiaries are translated into the home currency
Define economic risk (exchange rates)
The effect of exchange rate movements on the international competitiveness of a company
A forward exchange contract is:
A) an immediately firm and ____ contract
B) at a rate of exchange _____ at the time the contract is made
C) for for the purchase or sale of a ______ quantity of a stated foreign currency
D) for performance at a _____ time which is agreed
Binding
Fixed
Specified
Future
Option forward contracts are forward exchange contracts where the customer has the option to call for the performance of the contract of either which two?
1) any date from the contract being made up to a specified date in the future, or
2) at any date between two dates both in the future
Give the forward rate formula (exchange rates)
Spot rate * (1 + if) / (1 + iuk)
if = overseas interest rate
iuk= domestic interest rate
What does interest rate parity theory state?
That the difference between the spot rate and forward rate can be predicted by the difference in interest rates between the two countries
To buy a currency futures contract is agreeing to _____ the contract currency
Receive
Whose position is riskier: debt holders or shareholders?
Why?
The shareholders’ position is riskier- they suffer the downside of any loss but also expect a higher rate of return
Dividend payout ratio equation = ?
Dividend / (earnings after tax and preference dividends)
What is the theoretical ex-rights price?
The price at which the shares will settle after the rights issue has been made
Give the ex-rights price equation
= (market value of shares pre-rights issue + rights proceeds + project NPV) / (number of shares ex-rights)
= (PV of new total dividends) / (number of shares ex-rights)
(If acquisition doesn’t give NPV of the project in which the funds are invested, assume it is nil)
Value of right = _______ - _________
Value of right = TERP - right price
What are the two ways of issuing new shares?
- Through an issuing house (investment bank)
- Direct offer, which is direct to the general public
Define underwriting
The process whereby in exchange for a fixed fee, usually 1-2% of the total finance to be raised, an institution or group of institutions will undertake to purchase any securities not subscribed for by the public
Dividend yield ratio?
(Dividend per share) / (market price per share) * 100
Earnings per share ratio?
(Profits distributable to ordinary shareholders) / (number of ordinary shares issued)
Price-earnings ratio?
What does this reflect?
(Market price per share) / EPS
This reflects the market’s appraisal of the share’s future prospects - the more highly regarded a company, the higher will be its share price and its P/E ratio
Total shareholder return = ?
Dividend yield + capital gain
Define venture capital
The provision of risk bearing capital, usually provided in return for an equity stake, to companies with high growth potential
What is an Initial Coin Offering?
The investor receives a token, for a share or for a utility
Payment is made in a cryptocurrency
A ‘white paper’ is issued providing details of the venture and the tokens
Define loan stock
Debt capital in the form of securities
Coupon interest rate equation?
Coupon rate * nominal value of the stock
Define convertible loans
Fixed return securities (either secured or unsecured) which may be converted, at the option of the holder, into ordinary shares in the same company
Define loan stock with warrants
Loan sticks which cannot themselves be converted into equity, but give the holder the right to subscribe at fixed future dates for ordinary shares at a predetermined price
Gearing ratio equation?
Debt / equity
Or
Debt / (debt + equity)
Interest cover equation?
(Earnings Before Interest and Taxes) / Interest
Give the three forms of finance available in international money markets, and define each
Eurocurrency: short-term borrowing and lending in currencies other than that of the country in which the bank is based in
International bond market: where bonds are issued by large companies or sovereign governments and sold to international investors
International syndicated loans market: for very large medium to long term loans. Syndicated loans spread the credit risk among participating lenders
It is often easier for a large multinational to raise very large sums quickly on the ______ markets than in a _____ financial market
International
Domestic
True or false:
Eurocurrency loans generally require no security
True
Core components of green loan principles:
1. Loan proceeds are used for _____ projects
2. Process for project evaluation and selection is ______ communicated
3. Proceeds of a green loan are ______ tracked
4. Borrowers should provide ___ ____ ____ information on the use of proceeds
Green
Clearly
Appropriately
Up to date
What is an issue with automatic (algorithmic) trading on electronic share dealing platforms with volatility?
If a number of algorithms all react to news released to the market in the same way, it can lead to stock market volatility, which can reduce the efficiency of the stock market
What are the three forms of efficiency identified by the efficient market hypothesis?
Weak form, semi-strong form and strong form
Give the three traits of weak form efficiency in the EMH
- Share price reflects information about past price movements
- Share prices follow a random walk
- Future price movements cannot be predicted from past price movements
Give the three traits of semi-strong form efficiency in the EMH
- Share prices incorporate all publicly available information
- The market cannot be beaten by examining publicly available information- it will already be incorporated in share prices
- The market can only be beaten if an investor has inside information
Give the two traits of strong form efficiency in the EMH
- Share prices reflect all information, published or not
- No investor could beat the market by having superior information as it does not exist
What does behavioural finance suggest could significantly affect share price movements
Irrational investor behaviour
The Gordon Growth Model:
The current share price is totally determined by the _______ dividends, discounted at the investor’a required rate of return
Anticipated
Gordon Growth Model:
What are the two most convenient assumptions about dividends?
Give the formula for each of these
Dividends remain constant:
P0= D0 / Ke
Or
Ke= D0 / P0
Dividends grow at constant rate:
Ke= ((D0(1+g)) / P0) + g
P0= ex-dividend market value of equity
D0= dividend paid at time 0
Ke= equity investors’ required rate of return
When is the cum-div stage (dividends)?
The period prior to the payment of dividends, where the price rises in anticipation of the payment
What is the growth rate formula for dividends?
N * ((newest dividend) / (oldest dividend))^0.5 - 1
N= periods of growth
Why does the issuing of a bonus issue makes shares more attractive?
The fall in price makes the shares more attractive to buy/sell
What is the earnings retention model equation?
g = rb
r= earnings / (opening book value of equity)
g= growth rate in future dividends
r= the return on equity
b= the proportion of profits retained
Problems with the earnings retention model:
1. Its reliance on ______ profits
2. The assumption that r and b will be ______
3. ________ can substantially distort the accounting rate of return if assets are valued on an historical cost basis
4. The model assumes all new finance comes from ______ - it therefore ignores the use of debt in a company’s capital structure
Accounting
Constant
Inflation
Equity
What are three issues with the assumptions of the dividend valuation model?
- Shares have value because of dividends
- Dividends either do not grow or grow at a constant rate
- Future dividends estimates are based on historical data
Give the capital asset pricing model (CAPM). Additionally, describe it
ke = rf + Bj * (rm - rf)
Bj = the beta which measures a share’a (systematic) risk
rm = the return on the market
rf = the risk-free rate of interest
The CAPM provides a relationship between risk and return
Net of tax cost of debt = pre-tax cost of debt * ?
(1-T)
Give the irredeemable debt equation
kd = Interest * (1-T) / P0
P0= price of bind ex-interest
Interest= interest paid on the bond
kd= required return of debt holder
Give the weighted average cost of capital (WACC) equation
k = ((MVe * ke) + (MVd * kd)) / (MVe + MVd)
MVe = total market value of issued shares (market capitalisation)
MVd = total market value of debt
The Weighted Average Cost of Capital (WACC) can only be used for project appraisal if:
1. The historical proportions of debt and equity are…?
2. The business risk is…?
3. The finance is not project specific
Not to be changed
Not to be changed (same for both parts)
Define business risk
The variability in earnings before interest and tax associated with the industrial sector in which a firm operates
Define financial risk
The additional variability in returns as a result of having fixed-interest debt in the capital structure
Define operating gearing
The extent to which a firm’a operating costs are fixed, as opposed to variable, measured by establishing the ratio of total contribution to earnings before interest and tax (EBIT)
Define financial gearing
The extent to which debt is used in the capital structure
Give the two ways of measuring financial gearing
- Capital terms:
Debt/equity or debt/(equity+debt) - Income terms using interest cover:
EBIT/Interest
