A2. Financial strategy formulation Flashcards

Question

Price/earnings (P/E ratio).

Answer 1

The higher the better: it reflects the confidence of the market in high earnings growth and/or low risk. P/E ratio will be affected by interest rate changes, a rise in rates will mean a fall in the P/E ratio as share become less attractive. P/E ratio also depends on market expectations and confidence. P/E ratio= (Current market price per share)/EPS

Answer 2

Considers the number of times a company could pay its interest payments using its profit from operations (generally 3 is safe but depends on business). Interest cover=PBIT/(Interest expense)

Answer 3

Interest yield= (Coupon rate)/(Market price ) x100%

Answer 4

Factors affecting comparability: • Different accounting policies. E.g. One company may revalue its property; this will increase its capital employed and (probably) lower its ROCE. Others may carry their property at historical cost. • Different accounting dates. E.g. One company has a year ended 30 June, whereas another has 30 September. If the sector is exposed to seasonal trading, this could have a significant impact on many ratios. • Different ratio definitions. E.g. This may be a particular problem with ratios like ROCE as there is no universally accepted definition • Comparing to averages. Sector averages are just that – averages. Many of the companies included in the sector may not be a good match to the type of business being compared. Some companies go for high mark-ups, but usually lower inventory turnover, whereas others go for selling more with lower margins. • Possible deliberate manipulation (creative accounting). Different managerial policies e.g. different companies offer customers different payment terms • Use of historical/ out of date information. Might be of limited use if business has recently undergone or is about to undergo substantial changes • Ratio analysis on its own is not sufficient for interpreting company accounts.

Answer 5

Compare ratios with • Industry averages • Other businesses in the same business • With prior year information

Answer 6

The higher a company’s gearing, the more the company is considered risky. An acceptable level is determined by comparison to companies in the same industry. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A greater proportion of equity provides a cushion and is seen as a measure of financial strength. The best-known examples of gearing ratios include • debt-to-equity ratio (total debt / total equity), • interest cover (EBIT / total interest), • equity ratio (equity / assets), and • debt ratio (total debt / total assets).

Answer 7

* Need to cover high fixed costs, may tempt companies to increase sales prices and so lose sales to competition * Risk of non-payment of a fixed cost and litigation * Risk of unsettling shareholders by having no spare funds for dividends * Risk of lower credit rating * Risk of unsettling key creditors

Answer 8

These are the things you need to think about when asked about raising finance - so just put all these in your answer and link them to the scenario. • Gearing and financial risk. Equity finance will decrease gearing and financial risk, while debt finance will increase them • Target capital structure. The aim is to minimise weighted average cost of capital (WACC). In practical terms this can be achieved by having some debt in capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers from the costs of financial distress) • Availability of security. Debt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a specified class of assets). • Economic expectations. If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are more attractive than when difficult trading conditions lie ahead. • Control issues. A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors.

Answer 9

As the proportion of debt increases in a company’s financial structure, the level of financial distress increases and with it the associated costs. Companies with high levels of financial distress would find it more costly to contract with their stakeholders. For example, they may have to pay higher wages to attract the right calibre of employees, give customers longer credit periods or larger discounts, and may have to accept supplies on more onerous terms. • Less financial distress may therefore reduce the costs of contracting with stakeholders. • Having greater equity would also increase the company’s debt capacity. This may enable the company to raise additional finance • On the other hand, because interest is payable before tax, larger amounts of debt will give companies greater taxation benefits, known as the tax shield. Reducing the amount of debt would result in a higher credit rating for the company and reduce the scale of restrictive covenants.

Answer 10

The dividend decision is related to how much a firm has decided to spend on investments and also to how much of the finance needed for investments is being raised externally (financing decision); this illustrates the interrelationship between these key decisions.

Answer 11

Dividend capacity is the cash generated in any given year that is available to pay to ordinary shareholders (free cash flow to equity). Dividend capacity= profits after interest,tax and preference dividends- debt repayment,share repurchase,investment in assets+ depreciation,any capital raised from new share issues or debt

Answer 12

When deciding on the dividends to pay out to shareholders, one of the main considerations of the directors will be the amount of cash they wish to retain to meet financing needs. The decision will also be influenced by: • The need to remain profitable. Dividends are paid out of profits, and unprofitable company cannot go on indefinitely paying dividends out of retained profit made in the past. • The law on distributable profits. Companies legislation may make companies pay dividend out of accumulated net realised profits. The government may impose direct restrictions on the amount of dividends that can be paid. • Any dividend restraints imposed by loan agreements and covenants. • The effect of inflation. There is need to retain some profit to maintain businesses operating capability. • The company’s gearing level. The sources of funds used should strike balance between equity and debt finance. • The company’s liquidity position. Dividends are cash payment, so company must have enough to pay. • The need to repay debt in the near future. • The ease with which extra finance from other sources can be raised.

Answer 13

Signalling effect. The ultimate objective in any financial management decisions is to maximise shareholder’s wealth. This wealth is basically represented by the current market value of the company, which should largely be determined by the cash flows arising from the investment decisions taken by management. Therefore, the dividend declared can be interpreted as a signal from directors to shareholders about the strength of underlying project cash flows. Investors usually expect a consistent dividend policy from the company, with stable dividends each year or, even better, steady dividend growth. A large rise or fall in dividends in any year can have marked effect on the company’s share price. Stable dividends or steady growth are usually needed for share price stability. Could be used in takeover i.e. increase dividends, so investors think future prospects have improved thus driving share price higher and making the company more expensive to take over.

Answer 14

Dividend policy often changes during the curse of business’s lifecycle. Young company will have zero or low dividend, as it has high growth/investment needs and wants to minimise debt, as cash flows are unstable. Mature company will have higher dividend pay-outs, as it has lower growth investment needs and debt is more suitable as cash flows stabilise.

Answer 15

Companies will formulate and communicate their policy to ensure that shareholders have realistic expectations regarding the dividends they are likely to receive: • Constant pay-out ratio – logical but can create volatile dividend movements if profits are volatile • Stable growth – set at a level that signals growth prospects of the company, but may be difficult to maintain if circumstances change • Residual policy – only pay a dividend after all positive NPV projects have been funded.

Answer 16

The residual theory of dividend policy can be summarised as follows. • If the company can identify projects with positive NPV’s it should invest in them; • Only when these investment opportunities are exhausted should dividends be paid. Dividends should therefore be the amount of after-tax profits left over (the residual amount) after setting aside money to invest in all viable business opportunities.

Answer 17

Modigliani & Miller (M&M) proposed that in a perfect capital market (no taxation, no transaction costs, no market imperfections), shareholders are indifferent between dividends and capital gains, and the value of the company is determined solely by the ‘earning power’ of its assets and investments. M&M argued that if a company with investment opportunities decides to pay a dividend so that retained cash are insufficient to finance all its investments, the shortfall in funds will be made up by obtaining additional funds from outside sources. As a result of obtaining outside finance instead of using retained cash, there would be a reduction in the value of each share. However, M&M argued that this reduction would equal the amount of the dividend paid, thereby meaning shareholder wealth was unaffected by the financing decision. M&M argued that if a company with investment opportunities decides not to pay a dividend, then the share price would rise due to the investments being financed but shareholders would not receive a cash dividend. Again this leaves shareholders’ wealth unchanged (and shareholders who wanted a dividend could "manufacture" their own by selling some of their shares).

Answer 18

Practical influences, including market imperfections, mean that changes in dividend policy, particularly reductions in dividends paid, can have an adverse effect on shareholder wealth: • M&Ms view assumes that there is no personal or corporation tax. However, differing rates of taxation on dividends and capital gains can create a preference among investors for either high dividend or high earnings retention (for capital growth); • Dividend retention should be preferred by companies in a period of capital rationing. • Due to imperfect markets and the possible difficulties of selling shares easily at a fair price, shareholders might need high dividends in order to have funds to invest in opportunities outside the company. • Markets are not perfect. Because of transaction costs on the sale of shares, investors who want some from their investments will prefer to receive dividends rather than to sell some of their shares to get the cash they want. • Information available to shareholders is imperfect, and they are not aware of the future investment plans and expected profits of their company. Even if management were to provide them with profit forecast, these forecasts would not necessarily be accurate or believable (signalling) • Strongest argument against M&M view is that shareholders will tend to prefer a current dividend to future capital gains (deferred dividends) because future is more uncertain.

Answer 19

Shareholder perks. Scrip dividends. Share buybacks. Special dividends.

Answer 20

Some companies (e.g. hotels) offer discounts to shareholders on room bookings and restaurant meals. A number of transport companies offer reductions in fares. Some retailers provide discount vouchers, which are sent to shareholders at the same time as the annual report and accounts.

Answer 21

A company will sometimes offer a scrip dividend (extra shares) instead of cash. Compared to cash dividend, a scrip dividend boosts a company’s cash flow and may benefit shareholders if the cash is re-invested in positive NPV projects that could not otherwise have been financed. An enhanced scrip dividend involves giving the shareholder a choice over whether to take cash or shares but offering a generous amount of shares so that it is likely that shareholders will choose to take shares instead of cash.

Answer 22

As an alternative to a cash dividend, a company can choose to return significant amounts of cash to shareholders by means of a share buyback (or repurchase). Advantages: • Avoids increasing expectations of higher dividends in future • Provides disaffected shareholders with an exit route, in this sense it is a defence against a takeover • Taxed as capital gain which may be advantageous if the tax on capital gains is below the rate used to tax dividend income • If shares are under-valued, the company may be able to buy shares at a low price which will benefit remaining shareholders. • Fewer shares will improve EPS and DPS ratios. • It helps to control transaction costs and manage tax liabilities • Share buybacks are normally viewed as positive signals by markets and may result in an even higher share price. • Changing the gearing level of the company

Answer 23

Another way to of returning significant amounts of cash to shareholders is by a special dividend; a cash payment far in excess of the dividend payments that are normally made. This has a similar effect of returning significant amounts of cash to shareholders, but unlike a share buyback it impacts all shareholders. A special dividend is more attractive than a share buy-back if shares are over-valued, and avoids shareholders potentially diluting their control by participating in a share buyback.

Answer 24

* Are dividends growing at a stable rate? * What is the company’s dividend pay-out ratio ( Divs / PAT)? A reduction in dividends paid is looked poorly upon by investors. * What is the company’s dividend cover (PAT / dividends)? * Are the company’s earnings growing steadily? * What happen if profits will fall? Will the dividends be reduced? If so, it may cause unnecessary fluctuations of the share price or result in a depressed share price. * You should take into account factor such as taxation implications.

Answer 25

* In order to generate returns for shareholders a company will need to accept a degree of risk. * Shareholders can diversify away some of the risk that they face themselves. * If risk management is unnecessary then the time and expenses it involves, it could be argued, reduces shareholder wealth.

Answer 26

The main arguments in favour of risk management are based on the idea that in reality there is no guarantee that firms will be able to raise funds to finance attractive projects. It can reduce the volatility of a company’s earnings and can have a number of beneficial effects: • Attracting investors: because there is a lower probability of the firm encountering financial distress • Encouraging managers to invest for the future: especially for highly geared firms, there is often a risk of underinvestment because managers are concerned about the risk of not being able to meet interest payments. Risk management reduces uncertainty and the risk of loss and therefore incentive to invest. Therefore, risk management in reducing financial distress by reducing the volatility of the corporation’s cash inflows may help the management to obtain an optimal mix of debt and equity, and to undertake profitable projects. • Attracting other stakeholders: suppliers and customers are more likely to look for long-term relationships with firms that have a lower risk of financial distress. • Taxation. Risk management may help in reducing the amount of tax that a corporation pays by reducing the volatility of the corporation’s earnings. Where a corporation faces taxation schedules that are progressive by reducing the variability of that corporation’s earnings and thereby staying in the same low tax bracket will reduce the tax payable. • Risk management can help a corporation obtain an optimal capital structure of debt and equity to maximise its value. Since risk management stabilises the variability of cash inflows, this would enable a corporation to take more debt finance in its capital structure. Stable cash flows indicate less risk and therefore debt holders would become more willing to lend to the corporation. Since debt is cheaper to finance than equity because of lower required rates of return and the tax shield, taking on more debt should increase the value of the corporation

Answer 27

Business risk. Arises from the type of business and organization is involved in and relates to uncertainty about the future and the organization’s business prospects (risk that the business won't meet its objectives = profit maximization). Business risk identification is literally putting yourself in the shoes of the management (can use PESTEL for identification). Business risk is a mixture of systematic and unsystematic risk. The systematic risk comes from such factors as revenue sensitivity to macro-economic factors and the mix of fixed and variable costs within the total cost structure. Unsystematic risk is determined by such company-specific factors as management mistakes, or labour relation issues, or production problems.

Answer 28

Political risks – the risk of government action which damages shareholders wealth: eg current government may be unstable and if there is a change of government, the new government may impose restrictions. The Company will need to assess the likelihood of such restrictions (import quotas, exchange control, shareholding – subsidiay).

Answer 29

Economic risks eg. The risk of downturn in the economy, inflation.

Answer 30

Fiscal risk – including changes in tax policies which harm shareholders wealth

Answer 31

Operational risk – Refers to potential losses arising from the normal business operations. Are managed at risk management level and can be managed and mitigated by internal controls. Human error, breakdown in internal procedures and systems or external events.

Answer 32

Reputational risk – Any kind of deterioration in the way in which the organisation is perceived. Damage to an organization’s reputation can result in lost revenues or significant reductions in shareholder value. Can be seen as consequence of operational risk

Answer 33

Regulatory risk – change in employment legislation, ani-monopoly laws.

Answer 34

Strategic risks. Refers to the positioning of the company in its environment. Typically affect the whole of an organisation and so are managed at board level.

Answer 35

Legal, or litigation risk arises from the possibility of legal action being taken against an organisation

Answer 36

Technology risk arises from the possibility that technological change will occur

Answer 37

Environmental risk arises from changes to the environment over which an organisation has no direct control, e.g. global warming, or occurrences for which the organisation might be responsible, e.g. oil spillages and other pollution

Answer 38

Business probity risk related to the governance and ethics of the organisation.

Answer 39

Health and safety risks include loss of employees' time because of injury and the risks of having to pay compensation or legal costs because of breaches. Health and safety risks can arise from: o Lack of health and safety policy o Lack of emergency procedures

Answer 40

Entrepreneurial risk. The risk associated with any new business venture. In Ansoff terms, it is expressed the unknowns of the market reception. It also refers to the skills of the entrepreneurs themselves. Entrepreneurial risk is necessary because it is from taking these risks that business opportunities arise.

Answer 41

Non-business risk may arise from and adverse event (accident/natural disaster) or to risks arising from financial factors (financial risk).

Answer 42

Financial risk: the volatility of earnings due to the financial policies of a business. Long-term financial risks are mainly caused by the structure of finance; the mix of equity and debt capital, the risk of not being able to access funding, and whether the organization has a sufficient long-term capital base for the amount of trading it is doing (overtrading).

Answer 43

Short-term financial risk also exists and need to be managed. • Exchange rate and interest rate risk. Risks arising from unpredictable cash flows due to interest rate or exchange rate movements • Credit risk. Late or non-payment by a customer • Liquidity risk. If a business suddenly finds that it is unable to cover or renew its short-term liabilities, there will be a danger of insolvency if it cannot pay its debts. However current liabilities are often a cheap method of finance (trade payables do not usually carry an interest cost). Businesses may therefore consider that, in the interest of higher profits, it is worth accepting some risk of insolvency by increasing current liabilities, taking the maximum credit possible from suppliers.

Answer 44

A business with high business risk may be restricted in the amount of financial risk it can sustain because, if financial risk is also high, this may push total risk above the level that is acceptable to shareholders. It will be important for the financial strategy of an organization facing high business risk to minimise debt finance, and to hedge a greater proportion of its currency and interest rate exposure, ie to minimise financial risk. • Business risks will affect the FS if not addressed by management • Business risks can lead to errors on specific areas of the FS (eg. Technological change leading to obsolete stock) • Business risk can have a more general effect on FS (eg. Poor controls leading to errors) • Business risks can lead to going concern problems. This too would be a FS risk (wrong basis of accounting)

Answer 45

Financial Statement Risk. Simply the risk that the FS are materially misstated (before any audit procedures). The risk comes from potential errors or deliberate misstatements

Answer 46

5 step process: • Identify Risk. Make list of potential risks continually. Identify risks facing the company - through consultation with stakeholders. • Decide on acceptable risk. Decide on acceptable risk - and the loss of return/ extra costs associated with reduced risks • Analyse Risk. Prioritise according to threat/likelihood. Assess the likelihood of the risk occurring - management attention obviously on the higher probability risks. • Plan for Risk. Look at how impact of these risks can be minimised - through consultation with affected parties. Avoid or make contingency plans (TARA). • Monitor Risk. Assess risks continually. Understand the costs involved in the internal controls set up to manage these risks - and weighed against the benefits.

Answer 47

* Transfer (low frequency, high severity) – insure risk or implement contingency plans. Reduction of severity of risk will minimise insurance premiums. * Accept (low frequency, low severity) – risks are not significant. Keep under review, but costs of dealing with risks unlikely to be worth the benefits. * Reduce or control (high frequency, low severity) – take some action e.g. enhanced control systems to detect problems or contingency plans to reduce impact. * Abandon or avoid (high frequency, high severity) – take immediate action, e.g. changing major suppliers or abandoning activities.

Answer 48

All projects are risky. When a capital investment programme commences, a framework for dealing with this risk must be in place. This framework must cover: • Risk awareness • Risk assessment and monitoring • Risk management (i.e. Strategies for dealing with risk and planned responses should unprotected risks materialise)

Answer 49

In appraising most investment projects, reliance will be placed on a large number of estimates. For all material estimates, a formal risk assessment should be carried out to identify: • Potential risks that could affect the forecast • The probability that such a risk would occur. Risks may be strategic, tactical and operational. Once the potential risks have been identified, a monitoring process will be needed to alert management if they arise.

Answer 50

A useful way to manage risk is to identify potential risks (usually done in either brainstorming meetings or by using external consultants) and then categorise them according to the likelihood of occurrence and the significance of their potential impact. Decisions about how to manage the risk are then based on the assessment made. These assessments may be time consuming and the executive will need to decide: • How they should be carried out? • What criteria to apply to the categorisation process? • How often the assessments should be updated? The essence of risk is that the returns are uncertain. As time passes, so the various uncertain events on which the forecasts are based will occur. Management must monitor the events as they unfold, reforecast predicted results and take action as necessary. The degree and frequency of the monitoring process will depend on the significance of the risk to the project’s outcome.

Answer 51

Strategies for dealing with risk: can be either accepted or dealt with. Possible solutions for dealing with risk include: • Risk mitigation • Risk diversification

Answer 52

Behavioural finance considers the impact of psychological factors on financial strategy. Behavioural finance attempts to explain how decision makers take financial decisions in real life, and why their decisions might not appear to be rational every time and, hence, have unpredictable consequences. Behavioural finance seeks to examine the following assumptions of rational decision making by investors and financial managers: • Financial decision makers seek to maximise their utility and do so by trying to maximise portfolio or company value. • They take financial decisions based on analysis of relevant information. • The analysis of financial information that they undertake is rational, objective and risk-neutral.

Answer 53

* Overconfidence. * Entrapment * Agency issues

Answer 54

``` Some psychological factors affecting investors are: • Search for patterns • Herd Behaviour. • Narrow framing • Availability bias • Conservatism • Mental Accounting. • Confirmation Bias. ```

Answer 55

Risk mitigation – the process of transferring risks out of a business. This can involve hedging or insurance or even avoiding certain risks completely. A certain level of risk is inevitable and even desirable in business. Process of risk management should consider whether company requires risk mitigation strategy by considering costs of such strategy, the existing level of business and financial risk, and the risk preferences of the company.

Answer 56

Risk diversification – reducing the impact of risk by investing in different business areas (projects). However, benefits from diversification can normally be gained by shareholders building portfolios of different shares. If this has already been done then diversification by a company may not benefit shareholders unless it involves moving into business areas that shareholders cannot access by themselves (international markets with restrictions), or if the diversification creates synergy with existing operations.

Answer 57

• Overconfidence. Tendency to overestimate their own abilities. This may help to explain why many acquisitions are overvalued or why many boards believe that stock market undervalues their shares. This can lead to managers taking actions that may not be in their shareholders’ best interests, such as delisting from the stock market or defending against a takeover bid that they believe undervalues their company.

Answer 58

• Entrapment – managers are also reluctant to admit that they are wrong (they become trapped by their past decisions. This helps to explain why managers persist with financial strategies that are unlikely to succeed (delaying decision to terminate the project as seen as failure).

Answer 59

• Agency issues – managers may follow their own self-interest, instead of focusing on shareholders. Analysis of these types of behavioural factors can help to evaluate possible causes behind a failing financial strategy.

Answer 60

Herd Behaviour. We mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice. The common rationale that it's unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don't.

Answer 61

Narrow framing – many investors fail to see a bigger picture and focus too much on short-term fluctuations in share price movements (with big portfolio bad performance of one share should not have big impact, but it does).

Answer 62

Availability bias – people often focus more on information that is prominent (available). Prominent information is often the most recent information; may explain why share price move significantly after financial results get published.

Answer 63

•Conservatism – investors may be resistant to changing their opinion (share price may not react significantly to better profits as investors underreacted).

Answer 64

Mental Accounting. Some investors divide their investments between a safe and a speculative portfolio - all this work and money spent separating the portfolios, yet his net wealth will be no different than if he had held one larger portfolio.

Answer 65

Confirmation Bias. We all have a preconceived opinion. So we selectively filter and pay more attention to information that supports our opinions, while ignoring the rest. An investor "sees" information that supports her original idea and not the contradictory info If the stock markets are not behaving in a rational way, it may be difficult for managers to influence the share price of their company and the share price may not be a reliable estimate of the company’s value.

Answer 66

• Search for patterns – investors look for patterns which can be used to justify decisions. This might involve analysing a company’s past return and using this to extrapolate future performance or comparing peaks and troughs in stock market to historical ones. This can lead to herding.

A2. Financial strategy formulation Flashcards

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