Financing Capital Projects Flashcards
(113 cards)
1
Q
When would a company be able to afford a large investment project without external sources of finance?
A
having a large cash surplus
2
Q
What are the 3 sources of external finance?
A
capital markets
banks and finance houses
government and similar sources
3
Q
what is equity?
A
shares or ownership rights in a business
4
Q
What is a share?
A
fixed identifiable unit of capital in an entity which normally has a fixed nominal value which may be quite different from its market value
5
Q
what do shareholders receive in return for their shares?
A
returns in the form of dividends
capital growth in the share price
6
Q
what are ordinary shares?
A
voting rights as they are equity shares
paid at directors’ discretion
subordinate to other creditors i.e get money last
7
Q
what are preference shares?
A
return is a fixed dividend
paid before ordinary hence the name
subordinate to other creditors but receive payout before ordinary
8
Q
why are preference shares considered to behave in a similar way to debt finance?
A
as the return is a fixed % of the nominal value as which is similar to interest payments opposed to ordinary shares which are decided by director
9
Q
how are preference shares different from debt finance?
A
- paid out of post tax profits so no tax benefit
- does not have the obligation to pay annually (when insufficient profits) unlike debt interest
10
Q
what is a cumulative preference share?
A
dividend must be rolled forward and paid following year if unpaid
11
Q
what is a non-cumulative preference share?
A
can miss dividends
12
Q
what is a participating preference share?
A
holder gets fixes dividends + extra earnings based on performance of business
13
Q
what is a convertible preference share?
A
can be exchanged for a specified number of ordinary shares on some given future date
-might be more profitable if share price increased than to accept cash
14
Q
what is a redeemable preference share?
A
holder will be repaid capital (usually at par) at a pre-determined future date
15
Q
why are convertible preference shares attractive to investors?
A
participation in hot growth companies means price will be high at conversion
for a profit, share price at conversion must be higher than amount paid on original investment
16
Q
what is the primary function of a stock market?
A
enable companies to raise new finance through equity or debt
-can communicate with a large pool of investors
17
Q
what condition must a UK company be before raising public finance?
A
must be a plc
18
Q
what is the secondary function of the stock market?
A
enable investors to sell their investment to other investors
19
Q
why are listed companies more attractive to investors than unlisted?
A
they are more marketable as they can be sold amongst investors
20
Q
why are private limited companies (ltd) not offered publicly?
A
lighter disclosure requirements
21
Q
what does limited by shares mean?
A
the shareholders liability is limited to the initial investment
- nominal value of shares and any premium paid in return for issue of shares
- protection of personal assets in insolvency but money invested will be lost
22
Q
is a plc listed or unlisted?
A
can be both
23
Q
what is a stock exchange listing?
A
quotation for its shares on stock exchange
aka flotations or IPO
24
Q
what are the advantages of a listing?
A
- once listed, market will provide a more accurate valuation than before
- creates a mechanism for buying and selling shares in the future at will
- raises profile of entity
- raises capital for future investment
- employee share schemes more accessible, some are offered them as salary package
25
disadvantages of a listing
- costly for small entity
- making enough shares available may lead to loss of control
- reporting requirements
- stock exchange rules for obtaining quotation stringent
26
what are the 2 important capital markets in the UK?
LSE-for larger companies, high cost and scrutiny but extremely marketable
AIM-alternative investment market for smaller companies with lower costs and less stringent entry criteria
27
how are share prices determined?
supply and demand:perform well, shares more attractive, creates demand; perform badly, more on sale, increased supply driving prices down
28
what role do investment banks play in share issue?
- appointing specialists enroute.g lawyers
- stock exchange requirements
- forms of any new capital to be made available
- number of shares issues and price
- underwriting arrangement
- publishing the offer
29
what role do stockbrokers provide in a share issue?
provide advice on methods of obtaining a listing
| -may work with IBs on identifying institutional investors who are involved with smaller issues and placings
30
what role do institutional investors play in share issue?
are investors from large organisations e.g pensions funds
- have little direct involvement other than as investors
- may be used to test how much to buy and at what price
- after issue, have major influence on the evaluation and market for the shares
31
what do registrars to an issues do?
provide admin functions such as collecting potential investor info, monitoring payments and advise regarding share issue to stock exchange, investors and issuing entities
32
what do reporting accountants do?
provide advice regarding impact on the financial statements of any potential share issues
-must consider wider ramifications on economic decisions enroute.g implications on loan covenants
33
what role do underwriters play in share issue?
help raise finance by taking on the risk of new issue and attempting to promote the new share to 3rd party investors
-retain part of proceeds from raising the finance in return for bearing the risk
34
What are the most commonly used methods of issuing new shares?
IPO
placing
rights issue
35
What is an IPO?
when a company is listed on the stock exchange for the first time
36
Who are shares offered to investors through for IPOs?
issues houses
37
How are IPO shares offered?
fixed price set by company
| tender offer
38
How does a tender offer work?
subscribers tender no/ shares and share price above a preset minimum
after offers received, 'strike price' determined
shares allocated to all bidders who offered above strike price
bidders pay strike price
39
What is a strike price?
the price at which the company will be able to raise required amount of finance
it is the price all successful bidders pay for the share
40
what is placing shares?
when shares are places directly with certain investors on a pre-arranged basis
41
what type of investors receive placing shares?
normally institutions
- not offered to public
- cheaper and quicker
- not a very active market
42
What is right issue?
new shares are offered for sale to existing shareholders only, in proportion to the size of their shareholding
-cheaper to organise than public offering
43
What is pre-emption rights?
the right to buy new shares ahead of outsider investors
| -prevents dilution of stake
44
How are pre-emption rights regulated?
protected by law
| can only be waived with consent of shareholders
45
What is the criteria for issue price of a right issue?
- low enough to secure acceptance of shareholder i.e not same as MPS (prevailing market price)
- high enough to avoid excessive dilution of EPS
46
What is the usual discount on rights issue price?
20%
47
How is issue quantity determined?
issue price set first then the quantity of shares issued
- issue price affects EPS and dividend cover
- then Q calculated
48
Why does the MPS usually fall after the ANNOUNCEMENT of rights issue?
due to uncertainty about:
- consequences of the issue
- future profits
- future dividends
49
Why does the MPS usually fall after the actual rights issue?
- more shares in issue (EPS)
| - new shares issued at a discount (TERP)
50
what is cum rights (CRP)?
during rights issue, allows an existing shareholder to subscribe to a rights offering declared by a company
this right is knows as cum rights
51
what is ex rights?
on the first day of dealings in the newly issues shares, the rights no longer exist and the old shares are now traded 'ex rights' i.e without rights
52
What is TERP?
theoretical 'ex rights' price
| theoretical price that the rights issue shares will trade on the first day of issue
53
How is TERP calculated?
[(new share x CRP) + old shares x MPS]/ total amount of shares
54
What are the implications of rights issue on shareholders?
- option to buy are preferential price
- option to withdraw cash and sell rights
- able to maintain their existing relative voting position by exercising the rights
55
What are the implications of rights issue on the company?
- simple and cheap to implement
- usually successful i.e fully subscribed
- if often provides favourable publicity
56
What is debt finance?
loan of funds without conferring ownership rights
| creates obligation to repay capital and interest repayment based on arrangement
57
what are the key features of debt financing?
- interest is paid out of pre-tax profits as an expense of the business
- carries a risk of default if interest and principal payments are not met
58
What are the 2 types of security/charges lenders require?
fixed charge
| floating charge
59
what is a fixed charge?
debt secured against a specific asset
- usually land or building
- preferred as front of queue at liquidation
- mortgage is similar to fixed charge
60
what is a floating charge?
debt secured against underlying assets that fluctuate in value
- e.g inventory
- not front of queue in the event of liquidation
- still ahead of other creditors with no security
61
What is a covenant?
specific limitations/requirements laid down as a condition on taking debt finance
62
What are the different types of covenants?
dividend restrictions: limit of level of payout to prevent excessive payments that may weaken future cash flows and place lender at risk
financial ratios: specified levels set
financial reports:regular accounts and financial reports to be provided to the lender to monitor progress
issue of further debt:amount and type of debt that can be issued
63
what is a bond?
debt security which the issuer owes the holders a debt and is obliged to pay interest and/or to repay the principal at a later date i.e formal contract to repay borrowed money with interest at fixed intervals
64
What are the differences between bonds and shares
- ownership rights of shares vs creditor stake
| - bonds have defined maturity whereas shares are not redeemed at a certain date
65
what are the 3 groups of a bond market?
issuers, underwriters and purchasers
66
what are issuers in DCMs?
sell bonds in the capital markets to fund the operations of their organisations
mostly consists of governments, banks and corporations
67
why do issuers issue bonds?
govt: help fund country's operations
| banks & corporations: to finance operations
68
what are underwriters?
typically investment banks and other fin institutions that help the issuer to sell the bonds in the market
- prepare for offering e.g create prospectus and other docs
- need greatest for corporate debt market as there are more risks associated with this type of debt
69
Who can underwriters place bonds with?
- with specific investors (bond placement)
- sell more widely on market
- medium term note(MTN) programme where the issuer via the UW can issue debt securities on a regular or continuous basis
70
who are purchasers in a bond market?
the final players who purchase the bonds
| -investors such as individuals, banks etc
71
how do governments play a large role in the market?
- borrow and lend money to govts and banks
- invest in foreign bonds if they have excessive reserves of that country's money as a result of trade between countries e.g Japan is a major holder of US govt debt such as US gilts
72
what are alternative sources of finance other than equity or debt?
```
cash RE: use existing cash, profits might not be liquid
sale and leaseback
grants
debt with warrants attached
convertible debt
venture capital
business angels
```
73
what is a sale and leaseback?
selling good quality fixed assets such as high street buildings and leasing them back over many years (25+)
- funds are released without any loss of the use of the assets
- potential capital gain foregone
- popular means of funding for retail orgs with substantial high street property e.g Tesco
74
what are grants?
-tech, job creation or regional policy
of particular importance to small and medium-sized businesses i.e unlisted
-don't need to be paid back
-provided by local governments, national governments and other larger bodies
75
what are debt with warrants attached?
warrant
- option to buy shares at a specified point in the future for a specified (exercise) price, often issues with bond to encourage investors to purchase bonds
- offers a potential capital gain where the share price may rise above the exercise price
- holder has option to buy the share on the exercise date but can also choose to sell the warrant before that date with no impact on the bond
- bond and warrant are separate items once issued
76
What is convertible debt?
similar to attaching warrant to a debt instrument but option to convert shares cannot be detached and traded separately
- can convert into shares at a predetermined date
- could result in capital gains if share value is greater than value of debt
- otw investor should retain the debt until maturity
77
what is venture capital?
finance provided to young, unquoted profit-making entities to help them expand
- usually equity finance, but can be mix of debt and equity
- accept low levels of dividends and expect to make most of their returns as capital gains on exit
- exit=IPO or flotation where VC can sell stake on stock market
78
what is a business angel?
similar to VC however they are wealthy investors who provide equity finance to small businesses
-VC are rarely interested in investing in small businesses as this is uneconomic
79
What are the benefits of equity vs debt finance to businesses?
no default risk; high default risk for debt
| dividends are discretionary; for debt, minimum servicing annually (interest)
80
What are the benefits of debt vs equity from an investor point of view?
cheaper form of finance; equity can be expensive in periods of strong performance
easily accessible; for equity uptake depends on market conditions and shareholder appetite
81
why is debt cheaper than equity?
lower risk so accept less ownership/returns
82
what's the difference between ordinary shares and preference shares?
ordinary: carry voting rights, discretionary dividends, returns are proportional
preference: no voting rights, guaranteed dividends, fixed proportion
83
What is the WACC?
weighted average cost of capital
| the average cost of an entity's finance
84
How is the WACC calculated?
sum of cost of capital x proportion of capital
85
what is the cost of equity?
the rate of return that ordinary shareholders expect to receive on the investment
86
what are the 2 methods of calculating cost of equity?
dividend valuation model (DVM) for constant dividends
-preference shares
DVM with growth
-ordinary shares
87
what is the fundamental theory of share valuation?
assumption that the market price of a share is related to the future dividend income stream from that share, in such a way that the market price is assumed to be the present value of that future dividend
88
what is the ex div value of a share?
the value just after a dividend has been paid
89
what is the cum div price?
price just before payment
90
how is the ex div price calculated from the cum div price?
cum div price - dividend=ex div (P0)
91
what are the 2 methods of calculating growth?
the averaging method
-when time and diff share prices given
the growth model based on profit retention rate
-when proportion of funds given
92
what are the assumptions of the growth model based on retention rate?
- entity must be fully finance by equity
- retained profits are the only source of additional investment
- a constant proportion of each year's earnings is retained for reinvestment
- projects finances from retained earnings earn a constant rate of return
93
what is the rationale behind the growth model retention rate?
an increase in the level of profits (due to profits not paid out as dividends) will give rise to increases (and therefore growth) in future dividends
94
what formula is used to calculate cost of preference shares and why?
constant dividend: k=d/P0
- constant level of dividend
- quotes as a percentage of nominal value
95
what is the cost of debt?
the rate of return that debt providers require on the funds that they provide
96
what is the cost of debt assumed to be?
the present value of its future cash flows
97
what are the benefits of debt?
interest is tax deductible so interest payments are always net of tax
98
what is the coupon rate?
the interest paid on debt
-stated as a percentage of nominal value
E.g 7% convertible bonds
99
how is the interest paid on debt calculated?
coupon rate x nominal value of debt
e.g 4% 100 par
4% x 100 is interest paid
100
when can you use the same formula for irredeemable bonds as redeemable?
when the redemption value is equal to the current market price or as an approximation for long-dated debt
101
what is IRR?
internal rate of return
| -discount rate which gives a zero NPV
102
What are the 3 steps to calculating the cost of debt (IRR)?
1. cash flows
2. discounting to calculate 2 NPVs
3. calculate IRR
103
what assumption is made to calculate the cost of convertible bonds?
that all investors will make the same decision
104
how will investors choose whether to pick cash or shares on redemption date?
compare value of cash option (value at par) vs value of conversion option (nx(current price x growth^t)
105
are bond values or market values used in WACC calculations?
market value
106
what are the issues with WACC calculation?
- doesn't include short-term finance as it is a tool for long term investment appraisal but if short-term finance is used to fund long-term projects then it should be
- loans do not have market value like bonds so their weightings are approximations
- the cost of capital for small entities
- -if unquoted, obtaining cost of finance is much more difficult
- -lack of liquidity offered by the entity's securities plus the smaller size of the entity tend to make finance more expensive
107
what conditions have to be met for WACC to be used as a discount rate?
1. constant capital structure otw weightings will change
2. new investment does not carry different risk profile or change strategy significantly
3. new investment is marginal to the entity
108
how is yield to maturity (YTM) different to cost of debt?
YTM is calculated from the investor's perspective
| -doesn't adjust for tax
109
what is a yield?
return received on a debt instrument in the form of annual interest (coupon) and, if redeemable, the final redemption payment
110
What does YTM help the investor decide?
an informed method of considering whether the method is worthwhile via % of return
111
what is the YTM defined as?
effective average annual percentage return to the investor relative to the current market value of the bond
112
is tax deducted from the YTM?
no as investors obtain no tax relief from the interest received
113
how is YTM calculated for redeemable and irredeemable debt?
redeemable: (annual interest received/current market value of debt)x100%
irredeemable: IRR of bond price
