Core Activity C: Recommend Financing Strategies

Question 1

What criteria should we consider when choosing a source of finance?

Answer 1

• Cost of the different sources of finance
• Duration
• Lending restrictions (security and debt covenants)
• Gearing Level/Capital Structure
• Liquidity Implications
• Currency of the cash flows associated with the new project
• Impact of different financing options
• Availability

Question 2

What are the equity methods of financing?

Answer 2

IPO
Placing
Rights issue

Question 3

What is an IPO?

Answer 3

Initial public offering, Shares offered for sale to investors through an issuing house.

Question 4

What is a placing?

Answer 4

Sale of securities to a relatively small number of select investors as a way of raising capital. Placement does not have to be registered or publicly announced. Cheaper and quicker to arrange.

Question 5

What is a rights issue?

Answer 5

New shares are offered for sale to existing shareholders, in proportion to the size of their shareholding. Issue price must be set which is low enough to secure acceptance of shareholders but not too low to avoid excessive dilution of EPS.

Question 6

What are some debt methods of finance?

Answer 6

Bank Finance
Capital Market (bonds)
International debt finance

Question 7

What is bank finance?

Answer 7

First port of call for borrowing money would be the banks. T&C’s are negotiable dependent on the term of the borrowing, amount borrowed and the credit rating of the company.

Question 8

What is capital market (bonds)

Answer 8

as an alternative to borrowing from a bank, a listed company can issue (long term) bonds or (short term) commercial paper in the capital markets. Bond is a debt security in which the issuer owes the holders a debt and is obliged to pay interest and/or to repay the principal at a later date

Question 9

What is international debt finance?

Answer 9

Large companies can borrow money in foreign currency from banks at home or abroad. Main reason to borrow in foreign currency is to fund a foreign investment project or foreign subsidiary.

Question 10

What is the criteria for selecting debt finance?

Answer 10

Liquidity
Timescale
Cost

Question 11

What are some other sources of finance?

Answer 11

Retained Earnings/existing cash balances
Sales and leaseback
Grants
Debt with warrants attached
Covertible debt
Venture capital
Business angels
Government assistance

Question 12

What is debt with warrants attached?

Answer 12

warrant is an option to buy shares at a specified point in the future for a specified price.

Question 13

What is convertible debt?

Answer 13

Convertible debt is where the debt itself can be converted into shares at a predetermined price at a date or range of dates in the future.

Question 14

What is venture capital?

Answer 14

Provided to young unquoted entities to help them expand. Venture Capitalists generally accept low levels of dividends and expect to make most of their returns as capital gains on exit.

Question 15

What is lease v buy?

Answer 15

• Compare cost of leasing to borrowing and buying
• Discount both at the post-tax cost of borrowing
• Ignore operating cash flows arising from the use of the asset
• For the borrow and buy option, always ignore cash flows to/from the bank

Question 16

What are the key considerations of dividend policy?

Answer 16

Modigliani and Miller’s (M&M) Dividend irrelevancy argument
Clientele effect
Bird in hand argument
Signalling effect
Cash need of the entity

Question 17

What is M&M dividend irrelevancy argument?

Answer 17

Pattern of dividend payout should be irrelevant. As long as companies continue to invest in positive NPV projects, the wealth of the shareholders should increase whether or not the company makes a dividend payment each year.

Question 18

What is the clientele effect?

Answer 18

Companies should be consistent in the dividend policy they follow, to ensure that they gather to them a clientele of shareholders who like and want that particular policy.

Question 19

What is the bird in hand argument?

Answer 19

Some investors may find capital gains more tax-efficient that dividends and some investors will avoid transaction costs if their returns are delivered in the form of capital gains rather than dividends. Investors generally have a strong preference for dividends. Dividends are certain and investors prefer a certain dividend now, to the promise of uncertain future dividends.

Question 20

What is the signalling effect?

Answer 20

Investors read signals into the company’s dividend decision and that signals say as much about the company’s future financial performance as they say about its past financial performance

Question 21

What are the four practical dividend policies?

Answer 21

Stable dividend policy
Constant payout ratio
Zero dividend policy
Residual approach to dividends

Question 22

What is a stable dividend policy?

Answer 22

paying a constant or constantly growing dividend each year. This offers investors a predictable cash flow, reduces management opportunities to divert funds to non-profitable activities, works well for mature firms with stable cash flows.

Question 23

What is a constant payout ratio?

Answer 23

Paying out a constant proportion of equity earnings. Maintains a link between earnings, reinvestment rate and dividend flow but cash flow is unpredictable for the investor.

Question 24

What is a zero dividend policy?

Answer 24

All surplus earnings are invested back into the business. This is common during the growth phase and should be reflected in increased share price.

Question 25

What is a residual approach to dividends?

Answer 25

Dividend is paid only I no further positive NPV projects available. Popular in the growth phase and without easy access to alternative sources of funds. However, cash flow is unpredictable for the investor and gives constantly changing signals regarding management expectations.

Question 26

What is a scrip dividend?

Answer 26

Also known as a bonus issue or scrip issue. Company gives extra shares to its shareholders at no cost instead of giving them a cash dividend. It can be beneficial for shareholders who want to put their dividends back into the company without paying fees.

Question 27

What is a share repurchase?

Answer 27

Return surplus cash to shareholders. Tends to be used whe the company has no positive NPV projects to invest the cash in.

Question 28

What is the impact on ratios of a change in dividend policy?

Answer 28

* Dividend cover and dividend yield are immediately affected by a change in dividend policy * Look out for other impacts too e.g. reducing the level of dividend paid out once year could increase funds available for reinvestment, leading to an increased level of growth in profit (EPS)

Question 29

What is a scrip dividend?

Answer 29

No change in total shareholders’ equity, No change to the gearing ratio

Question 30

What is the impact of a share repurchase?

Answer 30

Impact on shareholder wealth is the same as the impact of a cash dividend being paid but impact on ratio is different. After a share repurchase, there will be fewer shares in issue so EPS will increase.

Question 31

What is valuations?

Answer 31

Not a precise, scientific process. Affected by: Reported sales, profits and asset values Forecast sales, profits and asset values Type of industry Level of competition Range of products sold Breadth of customer base Perspective

Question 32

What are some valuation methods?

Answer 32

Asset based valuation Price earnings ratio model Dividend valuation model PV of future free cash flow to equity

Question 33

What is asset based valuation model?

Answer 33

Company is viewed as being worth the sum of the value of its net asset. Remember to deduct borrowing when arriving at an asset value if just the equity is being acquired.

Question 34

What are the strengths and weaknesses of asset based valuation model?

Answer 34

Strengths - Valuations are readily available, the provide a minimum value of the entity. Weaknesses - Future profitability expectations are ignored, SFP valuations depend on accounting conventions which may lead to valuations that are very different from market valuations, difficult to allow for the value of intangible assets.

Question 35

What is price earnings ratio model?

Answer 35

Not a method of valuing shares of quoted firms. P/E ratios are the product of valuation. High P/E ratio indicates that a company is expected to grow its earning rapidly in the future.

Question 36

What is dividend valuation model?

Answer 36

Value of the equity is the present value of the expected future dividends discounted at the shareholders required rate of return.

Question 37

What is the strengths and weaknesses of the dividend valuation model?

Answer 37

Strengths – Value is based on the PV of the future dividend income stream so methos has a sound theoretical basis, Useful for valuing minority shareholdings where the shareholder only receives dividends from the entity Weaknesses – difficult to forecast dividends and dividend growth, can be difficult to estimate the cost of equity.

Question 38

What is CAPM?

Answer 38

Capital asset pricing model Enables us to calculate the required return from an investment given the level of risk associated with the investment (measured by its beta factor

Question 39

What is unsystematic risk?

Answer 39

risk of the company’s cash flows being affect to some extent by macro-economic factors such as tax rates, unemployment of interest rates. Can be eliminated by diversification.

Question 40

What is systematic risk?

Answer 40

risk of the company’s cash flows being affected to some extend by general macro-economic factors such as tax rates, unemployment of interest rates. Cannot be eliminated.

Question 41

What is beta?

Answer 41

Beta is the measure of a share’s volatility in terms of market risk. Beta of the market as a whole is 1. Market risk makes market returns volatile and the beta factor is simply a yard’s stick against which the risk or other investments can be measured. Beta factor risk will be dependent on the level of business risk and the level of financial risk associated with an entity Beta factor for a geared company will be greater than the beta factor for an equivalent ungeared company

Question 42

If beta is above 1 what does it mean?

Answer 42

Shares have more systematic risk that the stock market average

Question 43

What is efficient market hypothesis?

Answer 43

Level of efficiency in the market is very important when considering value of a business. Share price reflects and includes all known information about a company.

Question 44

What is weak efficient market hypothesis?

Answer 44

prices follow a random walk. Share price incorporates all information from historical share price trends.

Question 45

What is semi strong efficient market hypothesis?

Answer 45

prices take into account public information. Share price will reflect all information that is publicly available.

Question 46

What is strong efficient market hypothesis?

Answer 46

Prices take into account all information whether publicly known or not. Share price reflects all information, including what is not yet public.