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Financing Flashcards

(38 cards)

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1
Q

Interest cover calculation

A

PBIT / Interest expense

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2
Q

Theoretical Ex-Rights Price (TERP) calculation

A

(Value of existing shares + value of rights shares + NPV of project) / New total shares

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3
Q

How to calculate gearing?

A

Debt / Equity

Could be debt / equity + debt (depending on question)

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4
Q

What to consider when choosing between debt/equity

A
  • Industry averages
  • Impact on shareholders (more debt = more risk so cost of equity may increase / investors may divest)
  • Will the source of finance last as long as the project?
  • Debt is cheaper than equity
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5
Q

If Beta is above one, is it exposed to more risk or less risk?

A

More risk

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6
Q

Advantages and disadvantages of using CAPM method to calculate ke?

A

Advantages:
- Directly links levels of risk associated with investment to required rate of return

Disadvantages:
- Assumes the investor is diversified, therefore only focused on systematic risk
- Assumes investor can deposit and borrow at risk free rate
- Assumes all systematic risk can be grouped into one measurement (B)
- Uses historic figures

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7
Q

How to calculate a change of risk (re-gearing a Beta)?

A

1) Choose suitable company in new sector and take their Beta.

2) Simplify the formula by calculating the bracket part (using new company’s debt and equity figures).
This will give Be = Ba x (X)

3) Using the new company’s Be, we will be able to calculate Ba (ungeared asset Beta).

4) Once we have Ba, put it back into the equation using our company’s MVs etc.

5) This will give us the Be for our company in the new sector.

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8
Q

How to calculate ex-div and ex-interest price?

A

Ex div = cum div - div per share

Ex interest = cum interest - interest in next period

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9
Q

Dividend growth rate calculation?

A

periods ^ √ (most recent dividend per share / oldest dividend per share) -1

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10
Q

How to calculate dividend growth using earnings retention model (Gordon’s growth model)?

A

growth = arr x err

arr = PAT / Opening equity

err = % of earnings not paid as dividends

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11
Q

How to calculate MV of shares?

A

Ex-div price x # of shares

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12
Q

Advantages and disadvantages of using dividend growth model to calculate ke?

A

Advantages:
- Calculates ke using real market data

Disadvantages:
- Constant dividend growth is assumed and is unrealistic
- Based on historic data
- Assumes the value of the company is based on dividends

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13
Q

Difference in calculating cost of preference shares using dividend valuation model?

A

Same formula without including growth.

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14
Q

What to do to dividend growth model in order to re-arrange it to calculate price of current ex-div shares?

A

Swap ke and Po around

Move the last +g to -g from Ke

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15
Q

How is cost of irredeemable debt calculated?

A

Similar to dividend growth model, but:

Do = I (interest paid in period per bond)
G = T (tax rate)
Po = current ex-interest price per bond

kd = I(1-T)/Po

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16
Q

How to calculate cost of redeemable debt?

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A

Using rate function.
1) Number of periods
2) Interest per period (if 6 months, just the interest in that period)
3) Current ex-interest price (negative value)
4) Redeemable value

If interest is 6 monthly, multiply cost by 2 to get cost for year.

Then adjust for tax rate!! Remember!

17
Q

How to calculate cost of convertible debt?

How to calculate expected share price if not given?

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A

Same as redeemable debt - PV function.

FV will be higher value of:
- Redeemable value of debt
- Expected share price at conversion

Remember to adjust for tax rate!

Expected share price:
Share price now x (1 + growth rate) ^ years

18
Q

How to calculate MV of debt?

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A

Ex-interest price x # of debentures (can calculate from book value)

19
Q

How to calculate cost of a regular bank loan?

MV value?

Study These Flashcards
A

Interest - tax rate

MV is just book value

20
Q

If calculating MV of debt using the PV function (valuing new debt), what can be used as the redemption yield?

Study These Flashcards
A

Kd from the rate function

21
Q

When is it appropriate to use the WACC %?

Study These Flashcards
A
  • On companies that have the same business risk as us
  • There will be no change to the long term capital structure of the company
  • Project is relatively small, so the NPV won’t have an affect on the MV of equity
22
Q

What risk does the Beta in CAPM represent?

Study These Flashcards
A

Systematic risk (external environment)

23
Q

Practical aspects to consider in the capital structure decision?

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A

Business risk - gearing adds financial risk, so companies with high risk tend to have lowing gearing

Assets - firms with tangible assets tend to find it easier to borrow (use as securities)

Size of business - small businesses are less attractive to lenders, so they rely more on equity

Cost - Debt is cheap. For equity, cheapest to most expensive: retained earnings, rights issues, new shares

Tax rate: the higher the tax rate, the more desirable debt becomes

24
Q

Why is debt cheaper?

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A
  • Debt holders face lower financial risk, therefore require a lower rate of return
  • Debt is generally secured
  • Debt holders are paid BEFORE shareholders
    Returns on debt are more certain as a result
25
What happens when gearing increases? Goal of optimal gearing?
Cost: ke increases due to increased risk Increases value of WACC MV: Proportion of debt to equity increases As kd is cheaper than ke, decreases WACC Finding the right level of finance - equity where it reduces cost but doesn't increases the level of gearing to the point it drastically increases ke
26
Traditional theory on optimising WACC?
- As a company introduces debt, WACC will initially fall due to the initial benefit of cheaper finance. - As gearing continues to increase, cost of equity will increase due to the increase risk to the investors. Conclusion: - There is an optimal level of gearing (around industry average) - There is no precise method to calculate it
27
M&M 1958 theory on optimising WACC (no tax affect)? Issues with the theory?
- As debt is introduced, cost of equity rises. - As there is no tax benefit, the saving on debt only offsets the increase in cost of equity. Therefore WACC stays the same and there is NO optimal capital structure. Issue: done on the assumption the markets are perfect, debt is risk free, investors are rational and there is no tax.
28
M&M 1963 theory on optimising WACC (with taxation)?
- With the presence of taxation, it is more beneficial to increase gearing due to the tax savings on interest. Therefore the optimal structure is a geared one.
29
Issues with high levels of gearing?
- Investors will demand a higher return to compensate for the increased risk - In order to prevent directors favouring shareholders over debt lenders, loan covenants will often restrict the dividends payable - Benefit of tax relief on interest will only benefit up until the point the taxable profits become zero
30
What was M&M's theory on dividend policy? Why is it flawed?
The pattern of dividends over time is irrelevant in determining shareholder wealth. If a shareholder isn't happy with the level of dividend, they could: - sell shares to create extra income - if too high, use excess to buy more shares This theory is flawed as in reality, tax and transaction costs would affect the decision of shareholders.
31
Why dividend policy matters? (6 reasons)
- Shareholders invest because of the dividend policy, if it changes they may divest - A dividend is cash in the hand now, and is more certain than possible future return - Reducing dividend may signal bad news and affect the share price - Shareholders might be concerned directors could act in their own interest otherwise - Dividends and capital gains are taxed differently - Dividends can only be paid if there is cash available
32
Three alternatives to regular dividends?
Share buy-back - returns cash to the shareholder without disrupting regular dividends (reduces equity + increases gearing) Special dividend - makes it clear the increased dividend is a one off above sustainable levels Scrip dividends - a company may offer free shares instead off cash. This would help the liquidity of a company. Gives potential future capital gain to shareholders
33
When calculating redeemable debt cost, what should you do after if interest is 6 monthly?
Multiply by 2 to get annual cost Adjust for tax rate
34
What should you not include in growth formula or div per share price?
Special dividend
35
How to calculate opening shareholder funds on balance sheet?
Ordinary shares + reserves - profit for the year - dividends
36
Three different degrees of market efficiency, what the share price reflects and when a positive NPV project would be reflected in the share price?
Weak form efficiency - Share price: Information about past price moves and past information. NPV: When it's value has been evidenced (reflect in accounts) Semi-strong efficiency - Share price: All publicly available information. NPV: when the project is announced Strong form efficiency - Share price: All information about a company. NPV: When the board agree to undertake the project.
37
4 examples of raising finance via new technology and what they are?
Crowdfunding - using online platform to pitch project to potential investors. ICO (Initial Coin Offering) - like an IPO, but instead the receives a token (redeemable for a share or entitlement to a product/service). Peer to peer lending - connects businesses to investors using an online platform (for short and long term lending). Revenue based finance - investors receive a percentage of ongoing revenues in exchange for investment.
38
What are the factors that contribute to an efficient market? (5 factors)
- Share prices are fair (shares not bought for cheap and immediately sold on for profit) - No individual dominates the market - Transaction costs are not significant - Share prices rise with good news and fall with bad news - Share prices change quickly to reflect new information

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