Chapter 2 - measuring returns to shareholders Flashcards
how can a profit seeking company find financial performance
short term financial performance can be found using ratio analysis
how to measure long term performance
profit shouldn’t be the sole indicator, doesn’t consider long term finance that has been invested in the firm
how can you measure capital employed
- long term debt finance eg long term loan
- preference shares = shares paying a fixed dividend
- ordinary shares (equity finance) = ordinary shareholders are owners of the company, these shares don’t pay a fixed dividend so can vary year on year
what is capital
capital is total amount of long term finance committed by investors
what is ROCE
return on capital employed
measures a company’s current success by relating amount of profit to value of resources employed in generating it
(efficiency)
two ROCE formulas
profit before interest and tax / long term debt plus equity
AS A %
profit before interest and tax / total assets - current liabilities
AS A %
what is operating profit
profit before interest and tax
how else can capital be measured
can be measured in terms of how the long term finance has been invested
ie. assets that have been purchased (short term liabilities)
can include non current assets (long term) like land/buildings
or current assets eg inventory or trade receivables
how does the figure for capital change
is usually averaged out between beginning and end of the year
ROCE can also be based solely on value of capital employed at end of year
what is earnings per share
shows maximum dividend that could be paid to the owners of the business out of that years profit after all payments have been made to other providers of finance
EPS formula
EPS = profit after interest, tax and preference dividend / number of issued equity shares
difference between EPS and ROCE
EPS shows return earned by ordinary shareholders only
unlike ROCE which considers the return generated to all the investors including those who have just lent money to the company
what do ROCE or EPS not show
don’t show whether the level of returns being achieved are acceptable to the owners of the business
what is risk free rates
rate of return that is available on risk free investments will be low = risk free rates
how can the risks associated with investments be classified
SYSTEMATIC RISK = risk associated with market sector eg car industry if there is a recession it may be affected most because a new car isn’t a necessity
UNSYSTEMATIC RISK = associated with a specific company because of unique factors. eg a product recall by specific car manufacturer. shareholders can reduce exposure by investing in number of companies
what is another way of saying return expected by shareholders
return expected by shareholders = cost of equity
can be used to assess whether the level of return that has been achieved is acceptable to shareholders
how does value of shares change
value of shares depends on a company’s future cash flow potential not just current profitability
what is discounting future cash flows
when valuing a share on basis of future cash flows we need to recognise that money expected to be received in future is worth less than money received today
adjusted to reflect time value of money
what is free cash flows to equity
the cash flows generated by a business in a particular year after interest and tax and investment spending
in what ways are cash flows to equity available
available either to pay as a dividend or to keep within a business - either way this cash is a benefit to ordinary shareholders
what are free cash flows to the firm
cash flows generated by a business in a particular year after tax and investment spending but BEFORE interest
available to pay to all investors whether shareholders or providers of debt finance
what is a perpetuity
the present value of a constant cash flow that is expected for the foreseeable future
present value to perpetuity formula
= cash flow / cost of capital (cost of equity)
what is the impact of the value of company’s shares
value of company’s shares directly influences shareholder wealth
future cash flows depend on state of economy but also management have influence over cash flows so can increase share price
