6. Financing Capital Projects

Question 1

What are ordinary shares?

Answer 1

The owners of the business who have voting rights but are only paid dividends and the discretion of the directions

Question 2

What are preference shares?

Answer 2

Usually a fixed dividend with limited or no voting rights

Question 3

In the event of liquidation, which rank first: ordinary shares or preference shares?

Answer 3

Preference shares

Question 4

Can preference shares be secured against a company’s assets?

Answer 4

No

Question 5

What are participating preference shares?

Answer 5

Preference shares that carry the right to fixed dividends plus an additional dividends when ordinary dividends exceed a certain level

Question 6

What are convertible preference shares?

Answer 6

Shares that can be converted into ordinary shares after a specified time, if the market value of the ordinary shares exceeds the preference share value

Question 7

What are bonds?

Answer 7

A negotiable instrument offering a fixed interest rate over a period of time and with a fixed redemption value

Question 8

What are two other terms for bonds?

Answer 8

Loan stock or debentures

Question 9

What is convertible date?

Answer 9

Debt that can either be redeemed or converted to a predetermined number of shares at a future date

Question 10

What is venture capital?

Answer 10

VC firms provide equity instruments to potential growth businesses

Question 11

What are grants?

Answer 11

Non repayed government funding for particular purposes

Question 12

What is an equity warrant?

Answer 12

A security issued by a company giving the holder the right be allocated ordinary shares in the company on terms specified in the warrant

Question 13

What is traded on the capital markets?

Answer 13

Debt (bonds) or equity (shares) > 12 months

Question 14

What are the 5 functions of the stock market?

Answer 14

1. Enable companies to raise new finance
2. Enable existing investors to buy/sell
3. Aid takeovers
4. Enable private companies to realise their investment by floating the company
5. Enable companies to offer shares in incentive schemes

Question 15

What are the 4 methods of issuing share capital?

Answer 15

1. Rights Issue
2. Public Offer - Offer for Sale
3. Public Offer - Public Issue
4. Placing

Question 16

What is a rights issue of shares?

Answer 16

An invitation to existing shareholders to purchase additional shares

Question 17

What is an offer for sale?

Answer 17

Shares offered via issuing house (underwritten) to the public at a fixed price

Question 18

What does it mean if a share offer is underwritten?

Answer 18

The underwriter guarantees to buy any unbought shares

Question 19

What is a public issue?

Answer 19

Shares offered directly to the public that are not underwritten

Question 20

What is share placing?

Answer 20

Issuing shares to a select group of institutional investors

Question 21

What are fixed charges?

Answer 21

Security on debt through charges on specific assets the company holds

Question 22

What are floating charges?

Answer 22

Security on debt through charges on underlying assets of the company that are subject to changes e.g. inventory

Question 23

What are covenants?

Answer 23

The actions of the borrower are restricted e.g. restricted dividends or minimum liquidity ratios

Question 24

What are the 4 types of bond?

Answer 24

1. Irredeemable
2. Redeemable
3. Convertible
4. Warrant attached

Question 25

Who requires a higher return on investment - equity investors or debt issuers?

Answer 25

Equity investors

Question 26

What is higher, the cost of debt or the cost of equity?

Answer 26

Cost of equity

Question 27

What is the equation for cost of capital for shares with zero growth dividends?

Answer 27

Dividend / Ex-dividend share price

Question 28

What is the equation for cost of capital for shares with dividends with constant growth?

Answer 28

(Dividend in 1 year / Ex-dividend share price) + growth %

OR

(Dividend just paid*(1 + growth %))/Ex-divident share price) + growth %

Question 29

What is Gordon’s model for estimating growth rate of dividends?

Answer 29

g = r x b
r = ROCE
b = proportion of funds reinvested in the business

Question 30

What is the formula used to estimate dividend growth using historic growth?

Answer 30

g = nth root (latest dividend/historic dividend) - 1

Question 31

What is the equation for cost of capital for preference shares?

Answer 31

Dividend / Ex-dividend share price

**Pref gives constant dividend so we use the zero growth equation

Question 32

Why is debt cheaper to the business than equity? (2)

Answer 32

1. Lower risk so lower returns required

2. Tax relief on interest but not on dividends

Question 33

What is the equation for cost of irredeemable debt?

Answer 33

( interest * (1 - tax rate) ) / current ex-interest price

Question 34

How do we calculate the cost of redeemable debt?

Answer 34

Find the cost of capital that equates the inflows to the outflows
I.e. the IRR calculation for (Ex int market value) + discounted interest payments net of tax + discounted redemption amount = 0

Question 35

What is the yield to maturity calculation for irredeemable debt (from the investor’s perspective)?

Answer 35

Annual interest / Ex-interest market value of debt

Question 36

How do we calculate the yield to maturity of redeemable debt?

Answer 36

The same as the cost to the investee (IRR) but not removing tax

Question 37

For convertible debt, how do we calculate the cost of convertible debt?

Answer 37

The IRR calculation, with the redemption amount set as the higher of the redemption value and the value of the ordinary shares

Question 38

What is the cost of a bank loan?

Answer 38

Interest rate x (1 - tax)

Question 39

What is the formula for weighted average cost of capital?

Answer 39

cost of equity x (Market val of shares / total market value of debt and equity)
+
cost of debt net of tax x (Market val of debt/ total market value of debt and equity)

Question 40

Do we want projects with returns higher or lower than our WACC?

Answer 40

Higher