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FM (Test) > E Section C Theory > Flashcards

E Section C Theory Flashcards

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1
Q

How can the financial acceptability to shareholders of the proposal to buy back loan notes can be assessed?

A

By calculating whether shareholder wealth is increased or decreased as a result

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2
Q

Advantage of bank overdraft?

A

Availability (most companies are offered overdrafts by their banks) and flexibility (the level of finance automatically adjusts to requirements).

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3
Q

Disadvantage of bank ovedraft?

A

Risk of the bank asking the overdraft to be repaid at short notice (technically repayable on demand)

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4
Q

Advantage of trade credit from suppliers

A

There are no issue costs or arrangement fees

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5
Q

Disadvantage of trade credit from suppliers

A

Risk of losing early payment discounts and if excessive credit is taken, credit is refused in the future

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6
Q

What is a bill of exchange?

A

Written acknowledgement of a debt to be paid at some time in the future (e.g. by an overseas customer)

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7
Q

What is commercial paper?

A

Commercial paper is short-term (usually less than 270 days) unsecured debt issued by high quality companies

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8
Q

Advantage of commercial paper for issuer?

A

Large sums can be raised relatively quickly and cheaply and no security is required

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9
Q

Disadvantage of commercial paper for issuer?

A

Commercial paper market is only open to companies with very good credit ratings

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10
Q

Main advantage of retained earnings?

A

It is fast (assuming the company has cash available) and avoids the transactions costs often involved in taking external credit

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11
Q

Main disadvantage of retained earnings?

A

If a company is loss making, internal finance is unavailable

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12
Q

What is a rights issue?

A

Involves issuing shares to the existing shareholders in proportion to their existing holding

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13
Q

Why use a rights issue (cheaper)

A

Cheaper to arrange than a public issue but the amount of finance raised is limited as there is a finite amount that shareholders will be willing to invest

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14
Q

What is private placing?

A

When a company, usually with the assistance of an intermediary, seeks out new investors on a one-to-one basis. Shares are normally issued to financial institutions when performing a placing rather than to individuals

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15
Q

What is private placing useful for?

A

Useful source of new equity for an unlisted company but control of the company will be diluted as a result

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16
Q

What is a public offer?

A

If the company is listed, it may undertake a public offer whereby shares are offered for sale to the public at large

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17
Q

Advantage of public offer?

A

Allow very large amounts of equity finance to be raised, and will also give a wide spread of ownership

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18
Q

Disadvantage of public offer?

A

An expensive way of issuing shares as there are significant regulatory costs involved and like the placing, control of the existing shareholders will be diluted

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19
Q

What is an IPO?

A

If the company is not listed, it can list through the process of an IPO which will raise equity at the same time

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20
Q

Why is IPO the most expensive method of raising equity finance?

A

There are further regulations having to be complied with, increasing costs. Consequently, only a large company wishing to raise a significant amount of finance would consider this option

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21
Q

What does the signalling effect suggest when reducing a dividend?

A

Dividend announcement will send a message or “signal” to the market. Generally, a reduction in dividend (such as proposed here) could be interpreted as bad news by investors and result in a fall in LaForge Co’s share price

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22
Q

What does the clientele effect suggest when reducing a dividend?

A

When company consistently paid dividends in the past so switching to a lower/zero pay-out could alienate some shareholders

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23
Q

What does liquidity preference suggest when reducing a dividend?

A

It is thought that shareholders, even those who prefer low pay-outs/high reinvestment, still wish to receive some dividend now as this is a certain return

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24
Q

Issue price and rights issue?

A

Rights issues shares are offered at a discount to the market value. It can be difficult to judge what the amount of the discount should be

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25
Relative cost and rights issue?
Cheaper than other methods of raising finance due to lower transactions costs
26
Gearing and rights issue?
Increasing the weighting of equity finance in the capital structure can decrease its gearing and its financial risk
27
How are profits shared in a Mudaraba (equity finance)?
Profits are shared between the partners in the proportions agreed in the contract, while losses are borne by the provider of finance
28
How are profits shared in a Musharaka (venture capital)?
Profits are shared between the partners in the proportions agreed in the contract, while losses are shared between the partners according to their capital contributions
29
Certificates in Sukuk (debt finance)?
Certificates are issued which are linked to an underlying tangible asset and which also transfer the risk and rewards of ownership
30
What happens in a Murabaha (trade credit)?
Payment by the buyer is made on a deferred or instalment basis
31
How are returns made in an ijara (lease finance) contract?
Returns are made through the payment of fixed or variable lease rental payments
32
When to use current WACC as the discount rate in appraising an investment project (business risk)
It does not change the current levels of business risk and financial risk faced by the company
33
When to use current WACC as the discount rate in appraising an investment project (capital structure)
A way that mirrors the current capital structure of the company, as financial risk is then likely to be unchanged
34
Advantage of using convertible loan notes as a source of long-term finance (attractive to investors)
Issue convertible loan notes to raise long-term finance even when investors might not be attracted by an issue of ordinary loan notes, because of the attraction of the option to convert into ordinary shares in the future
35
Advantage of using convertible loan notes as a source of long-term finance (lower interest rate)
Option to convert into ordinary shares has value for investors as ordinary shares normally offer a higher return than debt
36
Advantage of using convertible loan notes as a source of long-term finance (facilities planning)
An issue of fixed-interest debt such as convertible loan notes can be attractive to a company as the fixed nature of future interest payments facilitates financial planning
37
Advantage of using convertible loan notes as a source of long-term finance (debt capacity)
When conversion occurs, its gearing and financial risk will decrease and its debt capacity will increase because of the elimination of the loan notes from its capital structure
38
How can inventory levels be reduced?
Just-in-time policies
39
Problems with tighter credit control and payment delays to suppliers?
May worsen relations with customers and suppliers
40
Problem with selling assets?
Sale could reduce the borrowing capacity of the company by reducing the availability of assets to offer as security
41
Issue with a one-off high payment for dividends?
A payment is normally made if a company has surplus cash and does not have plans to use it
42
What is business risk?
The variability in shareholder returns that arises as a result of business operations
43
How can business risk be assessed?
Through calculating operational gearing
44
What is financial risk?
Variability in shareholder returns that arises due to the need to pay interest on debt
45
How can financial risk be measured?
Gearing and interest cover
46
What is systematic risk?
Systematic risk is the sum of business risk and financial risk. Systematic risk is the risk that remains after a shareholder has diversified investments in a portfolio
47
How can systematic risk be measured?
Equity beta of the company
48
What does the dividend growth model calculate?
Apparent cost of equity in the capital market, provided that the current market price of the share, the current dividend and the future dividend growth rate are known
49
Issue with DGM when calculating cost of equity?
It is very difficult to find an accurate value for the future dividend growth rate
50
Why is CAPM preferred to DGM when calculating the cost of equity?
Sound theoretical basis, relating the cost of equity or required return of well-diversified shareholders to the systematic risk they face through owning the shares of a company.
51
Disadvantage of CAPM?
Finding suitable values for the variables used by the capital asset pricing model (risk-free rate of return, equity beta and equity risk premium) can be difficult
52
What does placing involve?
Raising finance through the sale of shares to selected institutional investors
53
What are traded loan notes?
Debt securities issued onto the capital market in exchange for cash received by the issuing company
54
What is the redemption date for the cash raised on traded loan notes?
Usually between five and fifteen years after issue
55
How do traded loan notes reduce the risk to the lender?
Loan notes are usually secured on non-current assets of the issuing company
56
Why does equity finance not need to be redeemed?
Ordinary shares are truly permanent finance
57
The return to shareholders which have a loan note interest?
Return to shareholders in the form of dividends depends on the dividend decision made by the directors of a company, and so these returns can increase, decrease
58
What is the risk that can be removed through portfolio diversification?
Unsystematic risk
59
Assumptions of CAPM (capital market)
The CAPM assumes a perfect capital market, with no taxes, no transaction costs
60
Assumptions of CAPM (single-period transaction)
CAPM assumes that all returns are over a standard single-period transaction horizon, usually taken to be one year
61
Assumptions of CAPM (systematic risk)
CAPM considers only systematic risk, as it makes the assumption that all investors hold diversified portfolios
62
Gearing problems (earnings volatility)
High gearing increases the volatility of company's earnings as the interest payable is unaffected by any change in the activity level
63
Gearing problems (debt capacity)
Gearing will affect company's ability to raise new debt finance and how much debt it can support
64
Gearing problems (bankruptcy risk)
Increased risk unable to pay all its interest following on unexpected reduction in cash flow
65
What is the risk return relationship?
Result in company's shareholders and lenders having different required rates of return
66
Why do the equity holders have no guaranteed return?
Company is under no obligation to pay a dividend each year and capital growth is not guaranteed
67
Why do debt holders have less risk than equity sharehodlers?
There interest is a contractual obligation and must be paid
68
Does a fall in share price affect lenders?
Not directly affect the lenders as they do not participate in any capital growth/decline
69
Why are loan notes more expensive than a bank loan?
Loan notes are irredeemable and thus have no guaranteed repayment date
70
Why are market values preferable to book values when calculating WACC?
They reflect the current value of the company's capital
71
Problem if book values are used isntead of market values?
Seriously understate the proportion that equity represents in the company's capital striucture
72
When cost of the equity on WACC is understated?
The WACC is understated, skewing investment appraisal process as a lower discount rate is used
73
What is crowdfunding?
Allows a company to access finance by using an online crowdfunding platform to pitch for finance from a large number of investors
74
What is peer-to-peer lending?
Connects established businesses looking to borrow with investors who want to lend via an online platform
75
What does P2P lending allow?
Allows customers and family/friends to share in the returns of the business
76
What is security token offering?
Investor receives a token
77
Assumption of DGM (dividend growth rate)
The growth rate is assumed to be constant
78
What is at the top of the creditor hierarchy?
Secured debt (loan notes and bank loans), these have the lowest relative return on finance provided
79
What comes below secured debt in the creditor hierarchy?
Unsecured debt (unsecured loan notes). Have a higher rate of return than secured debt
80
What comes below unsecured debt in the creditor hierarchy?
Preference shares
81
When must a preference share dividend be paid?
Must be paid in full before any ordinary dividends are paid
82
What is at the bottom of a creditor hierarchy?
Ordinary shares. have the highest rate of return as all other financial must be paid before getting to ordinary shareholders
83
What does M&M structure suggest for WACC?
WACC is primarily determined by its business activities rather than its capital structure
84
What is an example of aggressive regearing?
Only way a company's capital structure can affect WACC is by introducing more debt and thereby increasing the tax shield
85
Why would WACC fall when there is an increase in gearing (traditional theory)
Cost of debt is lower than cost of equity
86
Problem when gearing continues to increase?
The benefit of cheap debt finance is outweighed by the cost of more expensive equity and WACC starts to rise
87
Issue when borrowing gets larger for equity investors?
Equity investors see their risk increasing as more debt interest has to be paid before they receive a return on their equity
88
What does the current WACC reflect?
The required returns of existing providers of finance
89
What should discount rate reflect in investment appraisal?
The risk of investment project cash flows
90
What does wealth creation in Islamic finance require?
A shared risk and reward between the provider of finance and user of finance
91
What must Murubaha and Sukuk have?
A direct link in underlying assets
92
What does business risk depend on?
The size and scope of business operations as well as on their nature
93
When will financial risk remain unchanged?
If investment project is financed in such a way that relative weighting of existing sources of finance is unchanged
94
Problem of high financial gearing (restructive conditions)
Lenders are more likely to impose more restrictive conditions in loan agreements with highly geared companies, to protect their investment
95
What are directors concerned about in gearing?
Exceeds the average industry gearing

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