Lecture 6 Flashcards Preview

Introduction to Finance > Lecture 6 > Flashcards

Flashcards in Lecture 6 Deck (30):
1

Ordinary (common shares) (3)

- Voting rights
- Owners of the firm
- What shareholders receive depends on how well the company is managed

2

Preference shares (4)

- Usually fixed rate of dividend each year
- No obligation to pay dividends
- Dividend for preference shares paid before anything else paid to ordinary shareholders
- No voting power

3

Advantages of shares (2)

- No obligation to pay dividends
- Capital doesn't have to be repaid

4

Disadvantages of shares (4)

- High cost to list firm
- Costly to produce return required by shareholders
- Loss of control
- No tax deductibility of dividends

5

Asset valuation model =

Market value of any investment asset is the present value of expected future cash flows (DCF model)

6

Price of shares =

Dividends / Discount rate

7

Dividend discount model is based on

Asset valuation model

8

To calculate share price, need: (2)

- Future dividend amount
- Appropriate discount rate

9

Zero growth model to calculate share price =

Dividends remain at the same level forever (Div 1 = Div 2 = Div n)
Po = Dividend / R

10

Constant growth model to calculate share price =

Dividends grow at a constant rate (g) forever
Po = Div 1 / (r - g)

11

Cost of capital =

Rate of return a company must offer finance providers to encourage them to buy and hold financial securities

12

Cost of debt determined by: (3)

- Prevailing interest rates
- Risk of default
- Benefit derived from the interest being tax deductible

13

Traded debt =

Easily bought / sold eg bonds

14

Untraded debt =

Cannot easily buy/ sell eg bank loan

15

Rate of return on shares =

Risk free rate + Risk premium (return rate firm needs to offer)

16

Risk free rate gives a return sufficient to compensate for

Impatience to consume and inflation

17

Two methods to estimate risk premium =

- Gordon Growth model method
- Cost of preference share capital

18

Gordon Growth model method

Earnings, dividends and reinvestment grow continuously each year (based on perpetuity formula)
P = D1 / (Ke - g) OR Ke = (d1 / P) + g

19

Issues with gordon growth model method = (3)

- Can derive g in other ways
- Dividends differ between firms and their sizes
- Difficult to obtain accurate estimate of future growth rates

20

Cost of preference share capital =

Pp = d1 / Kp OR Kp = d1 / Pp (kp = cost of preference share) Pp = price of preference share

21

Weighted average cost of capital (WACC) =

Expected rate of return on a portfolio of all a firm's securities, adjusted for tax savings due to interest payments

22

WACC formula

(Cost of equity x weight of equity) + (cost of debt x weight of debt)

23

Lowering WACC due to tax shield

(Ke x We) + (Kdat x Wd)

24

Kdat (cost of debt after tax) =

Kd ( 1 - T)

25

Which valued should be used to calculate WACC?

Market values

26

Short term debt is for

Operating, not financing activites

27

WACC with three of more types of finance (debt, common equity and preference shares)

(Ke x We) + (Kdat x Wd) + (Kp x Wp)

28

We =

Ve / (Ve + Vd + Vp)

29

Wd =

Vd / (Ve + Vd + Vp)

30

Wp =

Vp / (Ve + Vd + Vp)