F9 - General Techniques Flashcards
When using the Miller-Orr formula, what is the relationship between the variance and the standard deviation?
The variance is the standard deviation squared
How to calculate the perpetuity of an investment project?
Timings CF DF@% PV
to (Initial outlay) 1.000
t1-n Constant CF AF
_____
NPV X
What is the Miller-Orr model of cash management?
The model sets upper and lower control limits on cash. Cash in excess of the uppoer limit is transferred to deposit or short-term investments.
What is overtrading?
Overtrading is where a company expands rapidly but does not have enough capital to fund the required increase in the working capital. This leads to liquidity problems.
Why does interest rate on debt fluctuates using the yield curve
The term structure of interest rates refers to the way in which the yield (return) of a debt instrument varies according to the term of the security.
The yield curve is a analysis of the relationship between the yields on debts with different periods to maturity.
The shape of the curve at any point is the result of three theories.
- liquidity preference theory = investors naturally prefer more liquidity (shorter maturity). Therefore requires a higher return if there are deprived of cash for a longer period.
- expectations theory = the normal upwards sloping yield curve reflects the expectation that inflation and therefore interest rates will increase in the future.
- market segmentation theory = there are different players in the short term end of the market and the yield curve is therefore shaped according to the supply and demand of securities within each maturity length.
Dealing with projects with multiple internal rate of return
An investment project may have multiply rates of return if it has unconventional cash flows ( cash flows that change signs over the life of the projects eg. Mining operations - initial cash outflows, inflows then outflows for decommissioning and environmental repair) solution is to use NPV instead of IRR.
1) The traditional view of capital structure and assumptions made
At low levels of gearing - equity holders perceive risk as unchanged so the increase in the proportion of cheaper debt will lower the WACC.
At high levels of gearing - equity holders perceive increase volatility of returns as debt interest must be paid first. This results in
- Increase financial risk
- Increase in the cost of equity outweighs the extra cheaper debt being introduced.
- WACC starts to rise
————-> the assumptions made by the traditional view are:
- No taxation
- The company pays out all its earnings as dividends
- the earnings of the company are expected to remain constant into perpetuity.
- business risk is constant
- the gearing of a company can be change immediately by issuing debt to repurchase shares or vice versa.
- there are no transaction cost.
2) Modigliani & Miller (M&M) - 1958 theory no taxation
M&M argued that - as investors are rational, the required return of equity is directly proportional to the increase in gearing. There is thus a linear relationship between the cost of equity and gearing (debt/equity).
The increase is cost of equity exactly offsets the benefits of cheaper debt finance and therefore the WACC remains unchanged.
Summary - the WACC and therefore the value of the firm are unaffected by the changes in the level of gearing and gearing is thus irrelevant.
Implications - the choice of finance is irrelevant to shareholder wealth company can use any mix of funds.
assumptions - no tax, perfect capital markets, no transaction cost, debt is risk free.
3) M&M - 1963 theory with tax
Following criticism of the ‘with out tax’ theory and is assumptions, The theory is adjusted to include tax as debt interest is tax deductible - the impact of tax could not be ignored.
Investors are still rational and the cost of equity is still proportional to the increase in gearing. Increase in ke offsets the benefit of cheaper debt.
The theory is adjusted to reflect that debt interest is tax deductible - so overall cost of debt is cheaper to the company.
Lower debt cost results in less volatility in returns for the same level of gearing = equals lower increases in Ke
The increase in Ke does not offset the benefits of the cheaper debt finance and therefore the WACC falls as gearing increases.
Summary - gearing up reduces the WACC and increase the MV of the company - optimal capital structure is 99.9%
4) Pecking-order theory
This theory propose no search of a optimal capital structure, rather firms will rise new funds as follows :
- ———> internally generated funds
- ———> debt
- ———> new issue of equity
Firms will use internally generated funds first then move down the pecking order to debt and then finally issuing new equity. Firms will follow a line to least resistance to establishing the capital structure.
The efficient market hypothesis (EMH)
The EMH states that security prices fully and fairly reflect all relevant information. This means that it is not possible to consistently outperform the market by using information that the market already knows, except through luck.
The idea is that new info is quickly and efficiently incorporated into assets prices at any point in time, so that old information cannot be used to Ferrell future price movements.
3 levels of efficiencies are distinguished.
—— > Market inefficiency = the value of securities is not always an accurate reflection of the information available. Markets may also operate in this way due to low volume of trades.
Typical of under and overpriced securities with scope for excess returns and loss
(1) ——> weak form efficiency = share price reflects information about all past price movements. Past movements do not help in identifying positive NPV trading strategies.
Follows random walk - no patterns or trends , raise and fall depends on next news.
Summary stock market is weak form as future price cannot be predicted by past movement. Chartism/analysis cannot provide consistent gain.
(2) ——> Semi-strong = share price already has all past information and all publicly available information (i.e. A semi-strong is also a weak form efficient market as publicly available info is past information).
Shares prices reacts 5-10 mins after new info release. Reacts to news good or bad, goes up or down.
Summary - market is almost semi-strong form efficient so
- analysis of publicly available Info will not be enough for constant gain
- trading in first few minutes can beat market
- public information is past infor so a semi strong market is also a weak market.
(3)——-> strong form efficiency = share price reflects all information (public, private and unpublished info).
Insiders (directors) have access to private info. In a strong form market
Share price wouldn’t move when news broke (as would already move moment decision was made) in reality they do.
Would be no need to ban insider dealing - insider can’t make return by trading before news broke.
Summary - market is not strong form so
- insider dealing banned and illegal.
- stock exchange encourage quick release of new info to prevent insider dealing info.
- insiders forbidden from trading their own shares at crucial times
What is the difference between ‘hard capital rationing’ and ‘soft capital rationing’ ?
Hard capital rationing is an absolute limit on the amount of finance available is imposed by the lending instuitions.
Soft capital rationing: a company may impose its own rationing on capital. This is contrary to the rational view of shareholder wealth maximisation.
