CF final exam study

Question 1

Sustainability - lecture 5
Define:
Corporate social responsibility?
Negative screening?
Stranded assets?
TBL?
Universal owner?

Answer 1

CSR = approach to business which factors in economic, social, environmental and ethical impacts to mitigate risk, decrease costs, improve brand image

Negative screening = investment approach which excludes some companies based on their policies, actions, or products.

Stranded assets = assets that may be written down in value as a result of future changes

TBL = economic, social, environmental

Universal owner = tied to market as a whole because of broad investments

Question 2

Sustainability - lecture 5

Contrast the four core investment approaches

Answer 2

1. Negative screening = provides transparency + restricts investment where legislation is likely to come in later and lessen returns, yet restricts investment pool
2. Positive screening = allows investment in positive future
3. Best in class = Good for passive investment, however bad because allows dirty companies in too, also restricts investment pool
4. Thematic approach = allows investor to clearly invest in personal convictions, however limits investment pool

Question 3

Sustainability - lecture 5

Outline two broad investment approaches?

Answer 3

Active shareholder engagement = invest wherever you choose, and aim to make positive change through shareholder engagement = fail to do so results in divestment

ESG ratings = invest on the basis of ESG ratings

Question 4

Ethics - lecture 6
Define:
Ethics
Values
Consequentialism
Catergorical moral reasoning

Answer 4

Ethics = set of moral principles or values
Values = core beliefs about what is important and how one should behave across a wide variety of situations

Consequentialism = Ethical view that whats right or wrong depends on the consequences of ones actions

Categorical moral reasoning = Ethical view that whats right or wrong depends on the intrinsic quality of the act

Question 5

Ethics - lecture 6

outline the three areas of normative ethics?

Answer 5

Consequentialism = Consequences guide actions
Deontology = duties, obligations, principles guide actions
Virtue ethics = integrity guides actions = depends on each persons personality

Question 6

Ethics - lecture 6
Name the three areas of particular interest concerning ethics in finance and approaches for managing these issues

What are the whistleblowers obligations to employer

Answer 6

1. Conflict of interest = utilise independent monitoring + commit to being objective + use rules/policies to prohibit gifts
2. Insider trading = manage information asymmetry through the timely and well monitored release of information
3. Whistleblowing = implement a whistleblowing policy = trained staff for dealing with issues, procedure for reporting issues, commitment to taking appropriate action (contractual obligation founded by company in first place), a guarantee against retaliation

Whistleblowing = Whistle-blowing is the voluntary release of non-public information, as a moral protest, by a member or former member of an organisation to an appropriate audience outside the normal channels of communication regarding illegal and/or immoral conduct in the organisation that is opposed to the public interest.

Obligation s = duty of loyalty to protect confidential information and to act in their best interest + no obligation to do anything outside their job.

Question 7

Ethics - lecture 6
Discuss why the Law cannot be used as a standard for ethics
Who is responsible for enforcing the law concerning corporations in Australia?
Which law is most important for corporations?

Answer 7

The law cannot be used as a standard for ethics because it takes time to adjust + it is different in each country

ASIC
Corporations act 2001 = duties of directors, officers, employees. Shareholder rights. Financial reports and audits

Question 8

Payout policy and valuation - lecture 7
Which two payout policy options are available?
Are dividends paid out only as cash?
How can a firm use a DRP to payout higher dividends without using more cash?

Three issues associated with a DRP?

Answer 8

Payout policy = dividends or share repurchases

Dividends = no, they can be paid out in terms of shares as part of a DRP (discount to market price + no transaction costs)

higher dividend payout = depending on the DRP rate = cash is reinvested in the bussiness by those who choose to use the DRP = this reinvested cash can be paid out as extra to those who didnt use the DRP (1/1-0.2) = 1.25

Issues of DRP:

1) retain too much cash
2) price discount adds up to more than savings on issue costs
3) Non-participants suffer whenever a price discount is offered

Question 9

Payout policy and valuation - lecture 7
What are three advantages of share buybacks?
What are the findings of Brav, graham, Harvey, Michaely?

Answer 9

Advantages:

1) payoff particular investors
2) Shrink the firm and equity
3) good for distributing surplus cash

BGHM = managers concern lies with dividend changes and not with the set dividend level itself. hence to avoid reducing dividends, managers will smooth them using the formula Div1 - Div0 = adjustment rate x ((target ratio x EPS) - Div 0)
- Dividend changes follow shifts in long-run sustainable earnings

Question 10

Payout policy and valuation - lecture 7

Contrast the inherent information in share repurchases vs Dividends up/down?

Answer 10

Share repurchases = may signal firm is running out of uses for cash or may signal firm confidence shares are underpriced (= why they are buying them back)

Dividends up = signals firm confidence in long-term earnings
Dividends down = signal cash or earnings shortfall

Question 11

Payout policy and valuation - lecture 7

Summarise the irrelevancy of payout policy in a perfect capital market?

Answer 11

If the company uses surplus cash to pay dividends then the ex-dividend share price will drop by the dividend amount. However shareholder wealth will remain the same as the price drop will be offset by the dividend they just received

If the company uses surplus cash to repurchase shares then share price will remain the same as the total number of outstanding shares drops in proportion to the drop in company Assets ( = Assets current value - surplus cash used for buybacks) = shareholder wealth remains the same….

Question 12

Payout policy and valuation - lecture 7

Outline the first approach for calculating share price

Answer 12

Approach 1:
Here we calculate the present value of cash flows and divide this by the number of outstanding shares. The result is the PV of the company cash flows per person i.e. the price of a share
Alternatively if there is dividend growth we can simply use the dividend perpetuity growth formula to value shares

Question 13

Payout policy and valuation - lecture 7

outline the second approach for calculating share price (where total shares are changing due to share repurchases)

Answer 13

Lets assume dividends are paid and also some share repurchases are made AND FCF is a set amount continuing for the foreseeable future ….
First: Calculate ex dividend price
Second: Calculate how many shares are left outstanding after share repurchases are made at the ex-dividend price. (Dividends come first)
Third: calculate the FCF per share using the new amount of outstanding shares.
Fourth: subtract the original FCF per share from the new FCF per share and divide by the old FCF per share to find the growth rate
Fifth: use the dividend perpetuity with growth to calculate the new share price

Question 14

Payout policy and valuation - lecture 7
When is cash considered surplus and payout necessary?
Outline the payout policy of a firm in regards to its lifecycle.

Why are high-payout stocks valued?

Answer 14

1: Positive NPV projects exhausted and FCF likely to continue
2: Debt levels are prudent and manageable
3: sufficient rainy day funds

At first no payout policy as surplus cash is used for positive NPV projects. Once these projects start to run out the surplus cash will be used for share repurchases. The preference for repurchases before dividends stems from the flexibility of repurchases (if the company experiences financial stress they will have to lower their dividends, and as BGHM have shown, managers dont want to do this) Then comes an announcement of regular dividends and then finally the announcement of growth for dividends and/or larger repurchases

High-payout stocks = less surplus cash = less agency problems.

Question 15

Payout policy and valuation - lecture 7

State the three conclusions on Share repurchases and DCF models of share prices

Answer 15

1: Today’s market capitalisation and share price are not affected by how payout is split between dividends and repurchases
2: Shifting payout to repurchases reduces current dividends but produces an offsetting increase in future earnings and dividends per share
3: When valuing cash flow per share, it is double counting to include both the dividends per share and cash received from repurchases (you don’t get any subsequent dividends after repurchases)

Question 16

Does debt policy matter - lecture 8
When a firms splits its capital structure, who receives payment first?
What is MM propositions 1?

Answer 16

First payment = when a company splits its capital structure, using debt and equity, debt-holders will be paid first through an established cash stream which is relatively safe.

MM proposition 1 = “the market value of a firm is independent of its capital structure” = firm value is determined by its real assets and not the securities it issues

Question 17

Does debt policy matter - lecture 8

How could we show that the Value of a levered firm must equal to the value of an unlevered firm?

Answer 17

Vl = Vu: For this we must first consider the very important fact that two investments with the same payoff must have the same cost in order to avoid arbitrage.

Now, consider buying 10% of a levered firms shares. The return on this investment will be 10% of the levered firms profits - the interest they pay due to their use of debt (levered). As you own 10% of the company and are hence entitled to 10% of their after interest profits

Next consider an equivalent investment where you take a loan equivalent to 10% and use this loan to buy 10% of an unlevered firms shares. Your return will be the same since you will receive your 10% of profits (10% ownership) - the interest you pay due to your use of debt. Now consider the first notion concerning arbitrage… As these investments both have the same cost they must also have the same return, hence the value of a levered firm must equal that of an unlevered firm.

When investors can borrow personally just as easily and cheaply, company borrowin will not increase value and shareholders wealth

Question 18

Does debt policy matter - lecture 8
Recall the graph of EPS vs operating income for a n unlevered firm and a levered firm. There is a break even point of operating income where a levered firm begins to generate higher EPS then an all equity firm. Why is this so?

Why then, if the EPS goes up does the share price remain unchanged?? How would we use Beta to support this fact?

Answer 18

This is because the levered firms issuance of debt will be used to repurchase shares and as such EPS will go up once the operating income exceeds the interest the company owes.

The share price remains unchanged because the company now has higher risk and as such the extra EPS serves as the reward premium for investors holding this extra risk (because the levered company will generate an eps of 0 if operating income is < interest). therefore the discount rate to be applied for future earnings (in order to determine share price) will also rise.

To support this fact we could use the weighted beta formula to show that an a 50/50 levered firm has 2 x the beta of an unlevered firm.

Question 19

Does debt policy matter - lecture 8
What does MM proposition 2 state?
how do we calculate rA?
Contrast the variability of return on shares for a levered and an unlevered firm?

Answer 19

Proposition 2 states that the expected rate of return on equity increases in proportion to the debt-equity ratio

rA = expected operating income / market value of all securities

Variability of returns = For a levered firm the variability of returns stems from both business risk and financial risk. For an unlevered firm the variability of returns stems solely from the business risk

Question 20

Does debt policy matter - lecture 8
Contrast the traditional position with the MM view concerning rE, WACC and rA

What is the problem with the traditionalist view?

Answer 20

MM believe rE rises just enough with leveraging to keep rA and WACC constant no matter the capital structure.

Traditionalists believe that rE does rise, however it does so to a different degree. At first it will rise slower than MM predict (thus rA will decline at first) and then it will shoot up really fast (with excessive borrowing) (thus rA and WACC will begin to rise) *(not stay constant as MM predict)

Problem with traditionalist view = if this were in fact the case, then there would be a point in which rA is minimised. However demand for these “premium” shares would push rA back to equilibrium

Question 21

Does debt policy matter - lecture 8
When we begin to consider tax within our capital structure, we are able to utilise the tax shield. What is the overall effect of utilising this tax shield?

What is the equation for the interest tax shield?

What does the tax shield depend on?

Answer 21

Debt repayments are not taxed, however equity payments are taxed. So by using more debt we reduce our total tax paid. Henceforth the tax savings increase the total income to shareholders + debtholders.

The tax shield will provide extra income in the amount of tax rate x interest (as this is the amount saved by lowering our total tax)

The tax shield depends on two things:

1. the marginal corporate tax rate
2. The ability of a firm to earn enough income to cover interest payments

Question 22

Does debt policy matter - lecture 8
MMs proposition 1 as corrected to reflect corporate income tax becomes:
After-tax value of firm = value if all equity financed + PV (tax shield)

How does this change if the debt is permanent?

Answer 22

If the debt is permanent then the PV(tax shield) can be simplified to Tc x D

Question 23

Optimal financing policy - lecture 9
outline the RAF
How do we calculate Tpe (considering tax rate on dividends as well as tax on realised capital gain)

Answer 23

RAF = (1-Tp)/ ((1-Tpe)(1-Tc))

Raf > 1 debt is better
RAF < 1 equity is better
RAF = 1 debt policy irrelevant
if Tp = Tpe then RAF simplifies to 1/(t-Tc) and will hence be greater then 1 and so debt is better

RAF = The RAF formula allows us to determine if the taxpayer (given their specific tax rates on different income sources and the company tax rate) is better off lending to the company or buying shares in the company only in terms of the tax they will pay

Tpe = (dividend payout ratio x dividend tax rate) + (retention ratio x capital gain tax rate)

Question 24

Optimal financing policy - lecture 9

Consider financial distress, where is the optimal debt ratio determined?

Answer 24

The optimal debt ratio is determined at where the marginal benefit of tax shield due to additional borrowing is just offset by the marginal increase in PV(costs of financial distress)

Question 25

Optimal financing policy - lecture 9

Outline the two costs associated with financial distress?

Answer 25

Direct bankruptcy costs = the direct and indirect costs of using the legal mechanism allowing creditors to take over when a firm defaults

Costs of financial distress short of bankruptcy = agency costs = Conflicts of interest between debtholders and shareholders of firms in financial distress may lead to distorted investment decisions

Question 26

Optimal financing policy - lecture 9
Outline the Trade-off theory
Outline the implications of the trade-off-theory
What does the trade-off-theory not accurately explain?
How can we explain what the trade off theory fails to do as per the above question?

Answer 26

Trade-off-theory = firms have a target debt ratio that balances the costs of financial distress against the benefits of interest tax shields

implications =

1. Companies with safe, tangible assets and plenty of taxable income ought to have high target debt ratios
2. Unprofitable companies with risky, intangible assets ought to use little debt

The trade-off-theory fails to accurately explain why in reality the most profitable firms commonly borrow the least. Under the theory, high profits should mean more debt-servicing capacity and a stronger tax incentive to use that capacity, so should give a higher target debt ratio

The pecking-order theory explains this.
POT = firms prefer to use internally generated cash flow to finance investments, if external funds are required, firm will prefer new issues of debt, followed by hybrid securities and new equity issues as a last resort
Therefore: most profitable firms borrow the least because they dont need outside money. Less profitable firms borrow more because debt is next on the pecking order when internal funds are exhausted.

Question 27

Optimal financing policy - lecture 9
Why is the pecking order theory what it is?
How can a firm avoid issue costs and information problems completely?

Answer 27

the pecking order theory stems from asymmetric information.

if the manager is optimistic about a project and believe it will raise the shareprice, the firm would rather use debt than give away a free gift to new shareholders by issuing debt at the current low shareprice

If the manager is pessimistic about future prospects they would rather issue debt then watch the shareprice drop due to the markets belief that issuing new securities is a sign of the securities being overpriced.

By generating enough internal cash flow

Question 28

Optimal financing policy - lecture 9
Outline the findings of Rajan and Zingale in relation to company debt ratios.

What is financial slack?

Answer 28

Size = positive relation (trade-off-theory)
Tangible assets = positive relation = if they can easily sell assets because they are tangible then of course the company has a better capacity to service its debt in-case of financial distress
profitability = negative relation (pecking order theory = enough internally generated cash so debt, which is 2nd on pecking order, is not needed)
Market-to-book ratio = negative

Question 29

Optimal financing policy - lecture 9

What is financial slack + bright/dark side of financial slack?

Answer 29

Financial slack = Having financial slack means having cash, marketable securities, readily saleable real assets and ready access to the debt markets or to bank financing

Without sufficient financial slack, firms that have worked down the pecking order may be forced to choose between issuing undervalued shares, borrowing and risking financial distress, or passing up positive-NPV investments

Too much of financial slack tempts managers to overinvest, expand their perks, or empire-build with surplus cash that should be paid back to shareholders, making agency problems between shareholders and managers worse

Question 30

Estimating the firms cost of capital, WACC - lecture 10
When a firm undertakes a project, what two factors must we consider when calculating the relevant WACC (discount rate of the future cash flows of the project)?

Answer 30

We must consider the Debt to equity ratio as well as the firms current rE and rD.

When calculating the WACC we must use the firms debt to equity ratio as well as the firms current rE and rD. We must not use the debt to equity ratio used to finance the project nor should we use the rE / rA of the project.

However! if the project will lead to a permanent change in the debt to equity ratio of the company then we should by now know that due to MM propositions, a change in the debt to equity ratio will result in a change in the companies current rE and rD. As such we should use the new debt to equity ratio to calculate the new rE and new rD.

Question 31

Estimating the firms cost of capital, WACC - lecture 10

if a firm is Tax exempt what capital structure do we expect they will have?

If a firm has a target debt ratio, and aims to accept a project that will change this debt to equity ratio should we assume the change is permanent or temporary. How will this effect our final WACC?

Answer 31

Tax exempt = no debt tax incentive = all equity

Target debt ratio = we should assume the change is only temporary unless told otherwise, as the firms target debt ratio has been carefully calculated for a reason and the firm will likely want to revert back to this ratio. This is important because if the change is permanent then we will have to use the new capital structure to calculate wacc, however if it is only temporary we ignore it and we use the old capital structure.

Question 32

Estimating the firms cost of capital, WACC - lecture 10

Given a firms income statement, what is a very important factor to consider when calculating FCF?

If given the income statement and after you have figured out the FCF, how would you go about deducing share price?

Answer 32

When calculating the FCF remember to add back depreciation after you have deducted change in working capital and investment in assets.

To deduce share price we would need to first calculate the PV of the company by calculating the PV of each known FCF (using the WACC) and then add the PV at t=0 of the horizon value (which is calculated using the PV dividend growth perpetuity formula. We then add the two to produce the PV of the company. Finally we deduct debt from PV and divide by number of shares to produce the final price per share.

Very logical process, very easy if you understand it.

Question 33

Discuss dividend payout and price to earnings ratio in relation to:
Risk
One-time event
Growth prospects

Answer 33

Risk = high risk companies tend to have low payout and low P/E
One time event = companies that have suffered a temporary decline in profits tend to have high payouts and high p/e
Growth prospects = companies that expect to have a decline in profits tend to have low payout and low p/e

Question 34

We have just had a capital structure change and as such have calculated a new rE. How do we calculate EPS to price ratio?

Answer 34

the EPS to price ratio is equivalent to rE.

Question 35

What do we and do we not include when calculating WACC?

Answer 35

Use all equity securities and long and short term interest bearing debt

Accounts payable, other current liabilities, deferred taxes, accrued interest and provisions are excluded because they are not interest-bearing debt

for short term or floating rate interest loans the face value is the market value

for healthy firms book value of debt is usually not far from MV so just use BV as MV

issue costs are disregarded

Share capital, reserves and retained earnings are collectively reflected in the market value of outstanding shares, and should not be separately listed as a source of financing