Written Questions Flashcards
Discuss the relative advantages and disadvantages of a forward contract hedging technique
- A forward contract is tailored specifically for the organisation
- However, there is no secondary market
- Would be recommended if the intention is to maximise the receipt
- If an exchange rate is involved, they may lock them into an exchange rate and not allow for upside potential
Discuss the relative advantages and disadvantages of a money market hedge
- More difficult to set up than a forward contract
- Might use up credit lines (credit line is a flexible loan from a bank or financial institution)
- Uses funds or credit lines earlier than a forward contract
- There is no secondary market
- Specifically tailored for the company
- If an exchange rate is involved, they may lock them into an exchange rate and not allow for upside potential
Discuss the relative advantages and disadvantages of an OTC currency option
- Allows the organisation to exploit upside risk potential and protect downside risk
- Options/premiums may be expensive
- There is no secondary market
- Would be preferred if the directors wish to retain upside risk potential
Explain the challenge that an organisation’s directors may have in determining an appropriate value for a newly formed digital technology company
It is difficult to use an asset based valuation because most of the assets are digital assets which are difficult to value
They cannot apply an earnings (or dividends) based valuation if it is a newly formed company with no previous earnings (or dividends)
It will be difficult to predict future earnings due to an inexperienced management team
Additionally, the future performance of technology companies can be difficult to predict as they are likely to have:
- Unpredictable market acceptance of the products
- Unknown competition
Without previous experience, it would be difficult to value the potential synergies that could be achieved by the two companies working together
Why may a dividend policy be considered appropriate? (MM Theory)
- Shareholders’ wealth will not be increased by paying dividends. Their wealth will be increased by investing in projects with a positive NPV (M&M Theory)
- If a company is able to achieve significant growth, as a result of reinvesting profits
- Some shareholders may prefer to receive capital gains rather than dividends for tax purposes (tax effect)
- If shareholders need cash now then they can raise this by selling some of their shares (DIY dividends)
- Using retained earnings before a rights issue or new issue of shares is consistent with the pecking order theory (The pecking order theory states that managers display the following preference of sources to fund investment opportunities: first, through the company’s retained earnings, followed by debt, and choosing equity financing as a last resort)
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Why may an organisation’s dividend policy be considered inappropriate?
- Shareholder’s may prefer to receive money today rather than dividends or capital gains in the future (traditional theory/bird in the hand theory)
- The shareholders may not want the company to make this investment but they are not being given a choice (agency problem)
What may a reaction be to a change in dividend policy?
- May not be the dividend shareholder’s were expecting
- Changing the dividend policy may have sent out a worrying or confusing signal to the market (signalling)
- Some shareholders will have invested in the company based on the policy of paying low dividends and reinvesting profits (clientele effect/tax)
- The share price may have fallen/fluctuated as a result of the uncertainty caused by the change in the dividend policy
Identify the potential ethical and legal issues relating to the plan to automatically renew employers’ subscriptions without telling them
- Not telling employers that the subscription fees will automatically update would be dishonest and shows a lack of integrity or transparency
- Taking money automatically from the employers without making them aware of the automatic renewal could be fraud which would be illegal
What is a special dividend and when is it considered appropriate?
- A special dividend is a ‘one-off’ dividend in addition to the ordinary dividend
- Special dividends can be used to pay extra dividends to shareholders without disrupting the normal dividend pattern
- This would only be appropriate if the directors believed that the increase in dividend was temporary and would eventually return to a lower dividend per share. If market circumstances suggest otherwise, this would be inappropriate.
What is a repurchase of shares and when would it be appropriate? What effect would it have?
A repurchase of shares may be achieved by buying shares in the stock market, inviting shareholders to tender their shares or by arrangement with particular shareholders
- This method would only be appropriate if the directors wanted to release cash to shareholders on a ‘one-off’ basis. If market circumstances suggest otherwise, this would be inappropriate.
- This would reduce equity, which would have an impact on the dividends per share in future years (and would increase gearing)
Explain the difference between predictive and prescriptive analytics and how these could be used to evaluate alternative pricing options
Predictive analysis:
- Uses historical and current data to create predictions about the future
- Predictive analytics could be used to forecast the impact of each alternative
Prescriptive analytics:
- Prescriptive analytics combines statistical tools utilised in predictive analytics with Artificial Intelligence and algorithms to calculate the optimum outcome from a variety of business decisions.
- Prescriptive analytics could be used to identify the optimum pricing policy
Briefly describe the unique characteristics of start-up technology companies that will make valuation difficult
- No track record of profit (often loss making)
- Unpredictable market acceptance of products
- Unknown competition
- Inexperienced management
- Difficulties in valuing digital assets and associated income streams
What is the most appropriate method for valuing a start-up technology company?
- Initially they are not likely to have substantial assets nor earnings so valuing on these bases is not appropriate
- It is possible to use market multiples however it may be difficult to find other similar companies and to obtain their initial valuations
- Despite the problems with estimating future cash flows, the DCF approach is likely to be the most valid approach
Discuss the strengths and weaknesses of the net assets (historic and net realisable value) valuation method
- Asset methods do not take into account the earning potential of the assets and ignores goodwill
- The balance sheet values do not always reflect the realisable values of the assets
- Even when the assets are revalued there is no guarantee that the asset can be sold for the NRV estimates
- Closure and redundancy costs should be included
Discuss the strengths and weaknesses of the P/E multiple valuation method
The P/E method is useful for growth companies and reflects the industry sentiment regarding a particular sector.
It may not be appropriate if the p/e ratio reflects the market sentiment towards that particular company
It may be more appropriate to use an industry sector average
Discuss the strengths and weaknesses of the Enterprise Value (EV/EBITDA) valuation method
- Enterprise Value/excludes the affect of the way in which the company is financed
- It excludes CAPEX and therefore you can compare companies in the same industry that have different levels of CAPEX
- However the method is simplistic and a lot of information from many drivers is distilled into a single number
Discuss the strengths and weaknesses of the shareholder value analysis valuation method
Shareholder value analysis evaluates future free cash flows and is more representative of the true value of a company. However, the method relies upon assumptions that might be unrealistic.
Such problems include:
- Estimating future growth rates for the primary period and the terminal value
- Setting the time horizon
- Calculating the discount rate
State the assumptions underlying the use of the dividend valuation model to calculate the cost of equity and briefly discuss their practical relevance
Shares have value because of the dividends:
- This is not always true
- Some companies have a deliberately low payout policy, which can attract investors who prefer capital gains to an income stream
- Some companies pay no dividends at all
Dividends either do not grow, or grow at a constant rate:
- the former is unrealistic, the latter is true in the long term if one takes the view we are estimating a long-term average
- Nevertheless, short-term variations in expected dividend growth would change the share price
You can predict future dividends based on historical data:
- Such as historical growth rate and retention rates
- Implicitly assume dividend patterns will remain unchanged
- It would be more useful to consider future market conditions, investor confidence, economic conditions, and so on when making the estimate of future dividends
Explain what is meant by systematic and unsystematic risk and give two examples of both of these risks
Systematic risk:
- The type of risk that all companies are exposed to no matter which market sector they operate in
- Systematic risk cannot be eliminated by diversification
- Examples of systematic risk include: interest rate changes, recession, oil price changes, wars
Unsystematic risk:
- The risk that affects a particular market sector or individual company
- Most of this risk can be diversified away by investing in a portfolio of 5-20 randomly selected securities
- Examples include: the chairman resigning, strikes by the employees of a company, changes in regulations that affects a particular market sector
With reference to portfolio theory, discuss why a company should diversify its operations and how the stock market and shareholders might react to an announcement that the project is going ahead
Portfolio theory sows that the only logical portfolio to hold is one, which is fully diversified to eliminate all unsystematic risk
Each groups reactions might be:
- The stock market might not welcome the diversification since diversified companies usually trade at conglomerate discount
- The stock markets might assume that the company does not have the expertise to operate in their sector
Shareholders:
- Those who hold a well-diversified portfolio would not welcome the company diversifying its operations i.e., not doing anything that they haven’t already done for themselves, so market value might fall
- Only undiversified shareholders
Identify the legal and ethical implications for you as an ICAEW Chartered Accountant of board members buying shares in an organisation before a public announcement is made about the project
- Board members buying shares in the organisation prior to the announcement would be insider trading and illegal, so don’t!
- You should act with integrity and display professional behaviour with regard to the suggestion made by the board member and you should advise the board accordingly
‘KSR’s board is considering exporting into the Eurozone and would receive payment in euro’
Explain the economic risk arising for KSR as a result of this proposal and suggest two ways that this risk might be mitigated. KSR currently buys its products $
KSR buys its products in $ and is considering exports to the Eurozone and will, therefore, receive payments in euro
IF over a period of several years the pound depreciates against the dollar and appreciates against the euro the sterling value of KSR’s costs will rise and its income will fall therefore its net cash flows will decline. The business will be worth less (PV cash flows).
Points that can be mentioned to mitigate economic exposure include:
- Diversify operations world-wide both for purchasing raw materials and selling its product.
- Market and promotional management, the company must carefully decide in which markets to operate
- Product management, economic exposure may mean high-risk product decisions
- Pricing strategy must respond to the risk of fluctuations in exchange rates
- Production management, economic exposure may influence the supply and location of production
Explain the difference between hard and soft capital rationing
- Hard capital rationing is when external capital markets limit the supply of funds to a company (e.g., the company will only be able to raise a certain amount of finance and no other funds are available)
- Soft capital rationing is when the firm imposes its own internal constraints on the amount of funds used to finance projects
Identify the benefits of issuing green bonds and suggest reasons why bonds may qualify as green finance
Benefits to Eco: (if they apply to question)
- Issue fewer bonds
- Pay less interest
- Less money to redeem the bonds
- Green bonds may be more attractive to ethical investors so risk of failure of issue is less
Reasons;
- If the company are investing in (or have invested in) renewable energy
- If their mission is to minimise their environmental impact
What factors should you consider when deciding whether the finance required should be raised by a rights issue or an issue of redeemable bonds?
- Whether the bonds would be secured against assets of the investment so assets can’t be disposed of easily
- The bonds will be redeemable/the shares may not need to be repaid
- The bonds will increase gearing/the shares will reduce gearing
- The new finance will have an impact on other ratios (e.g., earnings per share, interest cover)
- Additional annual dividends may need to be paid after the rights issue
- Changes in finance are unlikely to have an impact on the company’s cost of capital
- Issue costs are lower for debt
- Industry gearing, interest cover etc
Identify and explain risks (other than forex risk) a company is exposed to as a result of trading overseas
- Political risks: political action may restrict opportunities to export the products or make the process more expensive
- Cultural risks: The product design may not be compatible with cultural preferences in overseas markets
- Physical risks: goods may be lost or stolen in transit, or the documents accompanying the goods may be lost or stolen
- Credit risk: the risk of default by the customer
- Trade risk: the risk of the customer refusing to accept the goods on delivery, or cancellation of the order in transit
- Liquidity risk: the inability to finance the credit given to customers
Discuss how an organisation’s shareholders may react to the company declaring a lower dividend than in previous years (if the manager suggests they may be willing to accept a lower dividend) (Negative)
- If an organisation’s dividends have increased steadily, changing the policy may send out a worrying signal to the market (signalling)
- Some shareholders will have invested in the company based on the policy of paying steadily growing dividends (clientele effect)
- Shareholders’ may prefer to receive money today rather than dividends or capital gains in the future (traditional/bird in the hand theory)
- Some shareholders may prefer to receive dividends rather than capital gains for tax purposes (tax effect)
- The shareholders may not want the company to make this investment, but they are not being given a choice (agency problem)
- There is a risk that this investment may make a negative NPV
Discuss how an organisation’s shareholders may react to the company declaring a lower dividend than in previous years (if the manager suggests they may be willing to accept a lower dividend) (Positive)
Will be willing to accept a lower dividend for the following reasons:
- Shareholders’ wealth will not be increased by paying dividends. Their wealth will be increased by investing in projects with a positive NPV (M&M)
- The investment is currently expected to generate a positive NPV
- If shareholders need cash now then they can raise this by selling some of their shares (DIY dividend)
- Using retained earnings before a rights issue or new issue of shares is consistent with the pecking order theory
Explain what is meant by the term ‘real options’ and identify two real options associated with a 3D printer investment
NPV only considers cash flows relating directly to a project.
However, a project with a negative (or low) NPV may be accepted for strategic reasons. This is because of (real) options associated with a project that outweigh the poor NPV.
- Follow on options: there may be future investments in 3D printing which would not incur the same one-off set-up costs and could benefit further from the additional revenue which is forecast to grow increasingly.
- The option to delay (timing): the directors may decide to delay the investment decision until there is more information on future tax rates or until sufficient cash is available
- Option to abandon: the product may be abandoned before the end of the project if there is a risk the investment will not make enough money (i.e., if the corporation tax rates increase part-way through the investment)
- Growth options: There may be opportunities to use more of the additional capacity that the investment in 3D printing equipment will create eg selling abroad
