LUBS2206 - Corporate Financial Management Flashcards
(181 cards)
1
Q
What is agency theory?
A
Agency theory provides a description of the relationship between management and shareholders
2
Q
Asymmetric information
A
Different groups knowing varying amount of detail about a business. For example, managers tend to know more about a business compared to shareholders
3
Q
Type I agency relationships
A
When a principal hires an agent to represent their interests
4
Q
Type II agency relationship
A
This is the relationship between majority and minority shareholders
5
Q
Who are agency issues between in a widely held firm?
A
In widely held firms, there is a separation between ownership and control with agency issues between managers and shareholders
6
Q
Who are agency issues between in a closely held firm?
A
In closely held firms, the manager and shareholder incentives are aligned and the agency issues are between controlling and non-controlling shareholders
7
Q
What happens in a bank based system? Give 2 examples of where this system is implemented
A
In bank based systems, banks are central to the process of moving funds between demanders and suppliers of capital which means that there is more active monitoring.
Examples include Germany and Japan
8
Q
What happens in a market based system? Give 2 examples of where this system is implemented
A
In market based systems, securities markets are as important and can be significantly more important. This requires external discipline.
Examples include the US and UK
9
Q
Corporate governance
A
Corporate governance is the system by which companies are directed and controlled
10
Q
What is the impact of effective corporate governance?
A
Effective corporate governance leads to good risk management and internal control, accountability to stakeholders and it means that the business is behaving in an ethical and effective way
11
Q
6 OCED principles of good governance
A
1) Ensuring the basis for an effective corporate governance framework
2) The rights of shareholders and key ownership functions
3) The equitable treatment of shareholders
4) The role of stakeholders in corporate governance
5) Disclosure and transparency
6) The responsibilities of the board
12
Q
In addition to implementing corporate governance using OCED principles, what are the two committees a business should have?
A
Remuneration committee
Audit committee
13
Q
Capital structure
A
Capital structure refers to the mix of equity and debt making up a company’s long-term capital
14
Q
Suppose 100 shares of equity have a par value of £2 each and are sold to shareholders for £10 per share. What is the total additional paid-in capital?
A
(10 - 2) x 100 = £800
15
Q
Suppose 100 shares of equity have a par value of £2 each and are sold to shareholders for £10 per share. What is the total called up share capital?
A
2 x 100 = £200
16
Q
Treasury shares
A
Shares the company has bought back from the market
17
Q
What are treasury shares a form of?
A
Share repurchase
18
Q
If the number of treasury shares increase, what happens to leverage and EPS?
A
Leverage increases and the number of shares outstanding is reduced so earnings per share (EPS) increases
19
Q
What does the basic MM theorem state?
A
The basic theorem states that the value of a firm is unaffected by how that firm is financed.
20
Q
MM Proposition I (no taxes)
A
The value of the levered firm is the same as the value of the unlevered firm because individuals can undo the effects of leverage through homeamade leverage
21
Q
MM Propositions (no taxes) assumptions
A
1) No taxes
2) No transaction costs
3) Individuals and firms can borrow at the same rate
22
Q
MM Proposition I (no taxes) formula
A
V(Levered) = V(Unlevered)
23
Q
Homemade leverage
A
An investor can recreate the effects of corporate leverage by borrowing or lending personally
24
Q
Describe the relationship between leveraged equity, risk and expected return
A
Leveraged equity has greater risk, therefore should have a greated return as compensation. This means that expected return on equity is positively related to leverage because the risk to equity holders increases with leverage
25
MM Proposition II (no taxes) idea
The cost of equity rises with leverage because the risk to equity rises with leverage
26
MM Proposition II (no taxes) formula
R(S) = R(0) + (B/S) (R(0) - R(B))
where R(S) is the cost of equity capital, R(0) is the cost of unlevered equity capital, (B/S) is the debt-equity ratio and (R(0) - R(B)) is the cost of debt capital
27
Weighted average cost of capital formula
WACC = (S/(S+B)) x R(S) + (B/(S+B))
x R(B) x (1-t)
28
Explain the impact of corporate taxes and the 'tax shield'
Corporate leverage lowers tax payments. The interest tax shield means that leverage reduces cash outflows and thus adds to corporate value.
29
MM Propositions (with corporate taxes) assumptions
- Corporations are taxed at the rate t on earnings after interest
- No transaction costs
- Individuals and companies borrow at the same rate
30
MM Proposition I (with corporate taxes) formula
V(L) = V(U) + tB
Where tB is the present value of the tax shield
31
MM Proposition II (with corporate taxes) formula
R(S) = R(0) + (B/S) * (1 - t) * (R(0) - R(B))
32
3 types of financial distress costs
Indirect, direct and agency costs
33
Give 3 examples of indirect costs
- Impaired ability to conduct business
- Suppliers demand cash
- Loss of staff/trust
34
Give 3 examples of direct costs
- Lawyers and other advisors
- Admin and accounting fees
- Expert witnesses
35
Give 3 examples of agency costs
- Excessive risk taking
- Under-investment
- 'Milking' the property
36
Describe how agency costs occur
When bankruptcy threatens, there is often conflict between shareholders and bondholders which creates agency costs
37
Describe 'milking' the property
'Milking' the property occurs when the business pay out extra dividends in times of financial distress which leaves less in the firm for the bondholders and causes conflict between the shareholders and bondholders
38
What is a protective (restrictive) covenant?
An agreement that requires the borrower to either take or abstain from specific actions
39
Give 2 advantages of protective covenants
- Maintain working capital at a minimum level
- Furnish periodic financial statements to the lender
40
Disadvantages of protective covenants
- Limitations on the amount of dividends a company may pay
- Cannot pledge any of its assets to other lenders
- Cannot merge with another firm
- Cannot sell or lease major assets without approval of the lender
- Cannot issue additional long-term debt
41
What is the consolidation of debt?
The act of combining several loans or liabilities into one loan to reduce conflicts
42
Value of the unlevered firm formula
V(U) = [EBIT(1-t)] / R(0)
43
What do the articles of incoporation set out?
They set forth the number of shares that can be issued
44
Give 3 examples of things that convince managers to work in the best interest of the shareholders
- Compensation based on the value of equity
- Share option plans
- Threat of a proxy plan
45
The proposition that the cost of equity is a positive linear function of capital structure is called...
MM Proposition II
46
The optimal capital structure will tend to include more debt for firms with...
...lower probability of financial distress
47
When is WACC at its minimal point?
When a firm is operating with the optimal capital structure the WACC is at its minimal point
48
What is signalling theory?
Investors may be able to treat changing debt levels as a signal of firm value because rational firms are likely to raise debt levels when profits are expected to increase
49
What is the order of preference for sources of finance in the pecking order theory?
1) Retained earnings
2) Debt
3) Preference shares
4) Equity shares
50
Give 3 implications of the pecking order theory
- There is no target amount of leverage
- Profitable firms use less debt
- Companies like financial slack
51
Principles of market timing theory
- Firms will have more equity if they need funds when their market to book values are high
- Firms will have more debt if they need funds in low market to book periods
52
When does financial distress occur?
Financial distress occurs when a firm's operating cash flows are not sufficient to satisfy current obligations
53
Symptoms of financial distress
- Dividend reductions
- Plant/ store closures
- Losses
- Layoffs/ redundancies
- CEO resignations
- Plummeting share prices
54
Give 3 possible reasons for financial distress
- High leverage ratio
- Poor operating performance
- Recession
55
Insolvency
The inability to pay debts
56
When does value-based insolvency occur?
Value-based insolvency occurs when a firm has a negative net worth
57
When does flow-based insolvency occur?
Flow-based insolvency occurs when operating cash flow is insufficient to meet current obligations
58
Firms that cannot emerge out of financial distress have two options, what are they?
Liquidation and reorganisation
59
What is liquidation?
Liquidation is the option of terminating the firm as a going concern. It involves a 'fire sale' of the assets and transfer of the proceeds to the creditors in order of an established priority of claims
60
What does liquidation require?
Court approval
61
What is reorganisation?
Reorganisation is the option of keeping the firm a going concern. It sometimes involves issuing new securities to replace old ones
62
What is the order of priority of claims according to the absolute priority rule (APR)? Hint: there are 9 items in the list
1) Admin expenses associated with liquidating the bankrupt's assets
2) Unsecured claims arising after the filing of an involuntary bankruptcy petition
3) Wages, salaries and commission
4) Contributions to employee benefit plans arising within a set period before the filing date
5) Consumer claims
6) Tax claims
7) Secured and unsecured creditors' claims
8) Preference shareholder claims
9) Ordinary shareholder claims
63
What happens in administration?
In an administration, the administrator will attempt to restructure the liabilities, look for a buyer for the whole business or break up into viable parts
64
What is pre-packaged administration?
The combination of private workout and legal bankruptcy and is the process of selling the assets of a company immediately after it has entered administration
65
Give 3 advantages of pre-packed administrations
- The firm emerges from administration quickly with less cost
- It enables the administrator to realise a greater amount for the assets due to business continuity and the goodwill of the company being preserved
- Employees of the company are usually transferred to the new company preserving jobs
66
Z-score models??
67
What are the 3 valuation techniques for the levered firm?
1) Adjusted present value (APV)
2) Flow-to-equity (FTE)
3) Weighted average cost of capital (WACC)
68
R(0)
Unlevered cost of equity for an all equity firm (unlevered cost of capital)
69
R(S)
Levered cost of equity for a firm with debt in its capital structure
70
R(B)
Pre-tax cost of debt (interest on debt)
71
B
Amount of debt
72
t
corporate tax
73
B/S
Debt-equity ratio
74
R(B) * (1-t)
Post-tax cost of debt
75
R(F)
Risk-free rate
76
R(M)
Market rate of return
77
Describe how to use the APV valuation technique
Discount unlevered cash flows (UCF) by unlevered cost of equity R(0) to calculate the NPV.
Add financing cash flows discounted by the cost of debt R(B) to calculate the APV.
APV = NPV + NPVF
78
Describe the Flow to Equity (FTE) method to find the NPV
Discount the levered cash flows (LCF) by the levered cost of equity R(S) to calculate the NPV
79
When is it appropriate the use the FTE method?
Use when the firm's target debt-to-value ratio applies to the project over its life
80
Describe the WACC method to find the NPV
Discount unlevered cash flows (UCF) by the weighted average cost of capital to calculate the NPV
81
What is asset risk? When is it the same? What value is it reflected in?
Asset risk only reflects the operating risk of a company. It is the same for all companies which have similar business operations. Asset risk is reflected in R(0) (unlevered cost of equity) and in R(S) (levered cost of equity)
82
What is leverage risk? What value is it reflected in?
Leverage risk is the risk due to debt since leverage 'magnifies' the underlying risk of the business. It is reflected in R(S) (levered cost of equity)
83
Market risk premium formula
R(m) - R(f)
84
CAPM equation
R(i) = R(f) + Beta(i) * (R(m) - R(f))
where R(i) is the expected return on a security, R(f) is the risk-free rate, Beta(i) is the beta coefficient and R(m) - R(f) is the market risk premium
85
What are the 2 types of risk?
Systematic and unsystematic
86
What does CAPM represent/show? What is the most important variable?
CAPM summarises the relationship between the risk and return. The beta coefficient is the most important variable here since the beta value for a levered company's equity will be higher than the beta of a similar but unlevered company's equity
87
The connection between MM proposition II and the CAPM means that it is possible to establish a mathematical relationship between...?
Asset beta and equity beta
88
What is asset beta?
Asset beta is the beta of an unlevered company
89
What is equity beta?
Equity beta is the beta of an levered company
90
What are cash dividends?
A payment by a company to its shareholders. It is paid out of operating profits and usually paid twice a year
91
What are stock dividends? Explain what a 2% stock dividend means.
When a company issues new stock. For example, a 2% stock dividend means giving one new share to every 50 shares owned
92
What are stock splits? Explain what happens in a 3:1 stock split
A bit like a stock dividend but is much larger. For example, a 3:1 stock split means that one share becomes 3 new shares
93
4 stages in the standard method of a cash dividend payment
Declaration date
Record date
Ex-dividend date
Payment date
94
What happens on the declaration date of a cash dividend payment?
The board declare a dividend
95
What is the significance of the record date of a cash dividend payment?
Declared dividends are distributable to shareholders on record on a specific date
96
What happens on the ex-dividend date of a cash dividend payment?
A share of equity becomes ex-dividend on the date the seller is entitled to keep the dividend
97
State the dividend irrelevancy theorem
The firm cannot increase or decrease its value based on the dividend policy it chooses because of homemade dividends
98
What is share repurchase? What does it effectively do?
A process by which a company buys back its own shares from the capital market, thereby reducing the number of outstanding shares. Since the shares on the market are owned by shareholders, it is effectively a payment by a company to its shareholders
99
Give the 3 approaches to share repurchase
Open-market purchase
Tender offer
Targeted repurchase
100
Give 4 reasons for favouring a high dividend policy
- Desire for current income
- Agency costs
- Behavioural finance
- Dividend signalling
101
What are the preferences of a high-tax individual regarding shares and dividends?
Don't like dividends and desire zero to low-payout shares
102
What are the preferences of a low-tax individual regarding shares and dividends?
Like some dividends and desire low to medium-payout shares
103
What are the preferences of a tax-free institution regarding shares and dividends?
Like dividends and desire medium to high-payout shares
104
Describe the catering theory of dividends when there are too few or too many dividend paying shares
Too few leads to excess demand which pushes attractiveness of dividends
Too many leads to excess supply which reduces attractiveness of dividends
105
Give 3 advantages of paying dividends
- Dividends appeal to investors who desire stable cash flow
- Managers may increase dividends in order to signal their optimism concerning future cash flow
- The board can use dividends to reduce the cash available to spend thrift managers
106
Give 3 disadvantages of paying dividends
- Dividends are taxed as ordinary income
- They can reduce internal sources of financing and they may force the firm to forgo positive NPV projects or to rely on external equity financing
- Once established, dividends cuts are hard to make without adversely affecting a firm's share price
107
The dividend-irrelevance proposition depends on what relationship between investment policy and dividend policy?
The investment policy is set before the dividend decision and not changed by the dividend policy
108
What are the 2 types of public offering equity?
Initial public offering (IPO)
Seasoned equity offering (SEO)
109
What is an initial public offering?
IPO is the sale of a company's shares to the public for the first time
110
What is a seasoned equity offering?
SEO is a new share issue when the company's shares are already publicly traded to raise additional equity
111
Give 5 advantages of a stock market listing
- Access to wider pool of finance
- Easier to seek growth by acquisition
- Original owners selling shares
- Enhances public image
- Improved marketability of shares
112
What is the general role of an underwriter?
Underwriters agree to buy at the issue price any shares which are not taken up by the investing public. They reduce the risk for the company for a fee
113
What guarantee does an underwriter have to commit to? Where does the risk lie?
Underwriters must guarantee that it will sell all of the stock for the company at the offer price so the risk of not being able to sell them is on the underwriter, not the firm.
114
How is the price set for an auction IPO?
Rather than setting a price itself and then allocating shares to buyers, the underwriter takes bids from investors and then sets the price
115
How is underpricing of IPOs beneficial? And for the same reason, who is does it not benefit?
Underpricing helps the new shareholders since it provides immediate profit but it is an indirect cost of issuing new shares for the existing shareholders and the company
116
Give an example of a passive portfolio strategy
When IPOs are systematically underpriced so there is always a significant first-day return
117
Winner's curse
When an offer is oversubscribed, investors cannot get all the shares they want because the issuer allocates the available shares pro-rata
118
Give 4 disadvantages of a stock market listing
- Greater public regulation, accountability and scrutiny
- Wider circle of investors often with more demanding requirements
- Greater legal requirements, and stock exchange regulation
- Additional costs including brokerage commission and underwriting fees
119
What is a cash offer?
A type of SEO in which a firm offers new shares to investors at large
120
What is a rights offer or rights issue?
A type of SEO in which a firm offers the new shares only to existing shareholders and this prevents dilution
121
Explain what the subscription price is and what a rational shareholder would do when there are rights offered?
The subscription price is the price that existing shareholders are allowed to pay for a share of equity. A rational shareholder will subscribe to the rights offering only if the subscription price is below the market price of the equity on the offers expiration date
122
Ex-rights date
The date after which an investor will not receive the new issue rights and so is the date that the share price will fall
123
In comparison to debt issuance expenses the total direct costs of equity issues are...?
Considerably greater
124
Bonds
Bonds are long term debt capital raised by a company on which interest is paid, usually semi-annually and at a fixed rate
125
Give 4 forms of bond
Deep discount bond
Zero-coupon bond
Convertible bond
Callable bond
126
Deep discount bond
Loan notes issued at a price whihc is at a large discount to their par value but which are redeemable at par when they mature
127
Zero-coupon bond
Bonds that carry no interest and are a form of deep discount bonds
128
Convertible bonds
Convertible bonds give the holder the right to convert to ordinary shares in specified circumstances
129
Callable bonds
Bonds that come with a provision where they can be repurchased from the company at a specific price and period
130
Beta coefficient and what it measures?
The beta coefficient is a measure of the systematic risk in a individual risky asset relative to that of the market portfolio. It measures the responsiveness of a security to movements in the market portfolio.
131
Interpretation of Beta < 0
Asset moves in the opposite direction to the market
132
Interpretation of Beta = 0
Movement of the asset is unrelated to the market movements
133
Interpretation of 0 < Beta < 1
Movement of the asset is generally in the same direction but is less pronounced than market movements
134
Interpretation of Beta = 1
Movement of the asset is generally in the same direction as and similar to market movements
135
Interpretation of Beta > 1
Movement of the asset is generally in the same direction but more pronounced than market movements
136
What does the CAPM relate? And what does this relationship mean in terms of investor actions?
CAPM relates the expected return on an asset to its risk. This relationship is positive so investors will only accept increased risk if compensated by increased return
137
What is the main criticism of the CAPM?
It is impossible to construct a portfolio that contains every single security, so any test of the CAPM that uses a market proxy will be testing that specific portfolio and not the true market portfolio. This means that the CAPM is empirically untestable because the underlying market portfolio is unobservable
138
Give 7 factors that influence the level of risk for an individual security
- Leverage or gearing
- Industrial sector
- Age
- State of the economy
- Management experience
- Geographic location
- Company size
139
The basic lesson of MM theory is that the value of a firm is dependent on...
the total cash flows of the firm
140
When a company has spare cash, it can either...?
Pay out a dividend or invest the money in the business with the view to pay out the extra income as a dividend
141
What are the 2 methods that can be used to find an estimation for Beta?
Using the formula or use regression techniques to find the characteristic line
142
What are the 3 determinants of Beta?
- Cyclicity of revenues
- Operating leverage
- Financial leverage (gearing)
143
Explain the relationship between cyclicity of revenues and Beta
A cyclical firm is more responsive to movements in the market. Firms whose revenues are more responsive to movements in the economy will generally have higher betas
144
Explain the relationship between operating leverage and Beta
Operating leverage magnifies the cyclicality of a firm's revenues, leading to a higher beta
145
Explain the relationship between financial leverage and Beta
The beta value for a levered firm will be higher than the beta of a similar but unlevered company's equity
146
State the efficient market hypothesis
An efficient capital market is one in which share prices fully reflect available information. This is known as the efficient market hypothesis
147
What can an efficient capital market do?
An efficient capital market is able to process new information and rapidly incorporate that information into the price of a security
148
State the 3 market conditions that Andrei Shleifer believes will lead to market efficiency
- Rationality
- Independent deviations from rationality
- Arbitrage
149
What are the 3 types of efficiency?
- Weak - market incorporates past prices
- Semi-strong - market incorporates past prices and publicly available information
- Strong - market incorporates past prices and all available information (publicly and privately available)
150
Give 4 sources of evidence of market efficiency
- Serial correlation
- Event studies
- Investment fund performance
- Insider trading
151
Give 5 empirical challenges to market efficiency
- Earnings/ bonuses
- Limits to arbitrage
- Value vs growth
- Size
- Crashes and bubbles
152
Merger
The combination of two companies into one new company
153
Acquisition
Purchase of one company to another
154
Takeover premium
Difference between the share price before the offer and the offer price
155
Synergy
Where combining two separate units creates value
156
What are the 3 types of mergers?
Strategic, financial and conglomerate
157
Are strategic mergers friendly or hostile?
Friendly
158
Are financial mergers friendly or hostile?
Hostile
159
Conglomerate
A combination of two or more corporations engaged in entirely different businesses so it is a multi-industry company
160
Give 3 advantages of a congolmerate
- Enhances flexibility
- Avoids some information problems
- Increases debt capacity
161
Give 2 disadvantages of a conglomerate
- Conglomerates regularly misallocate capital
- Reduce information content of stock prices
162
What are the 3 classifications of acquisitions?
Horizontal, vertical and conglomerate
163
Multinational companies (MNCs)
MNCs are companies with significant foreign operations
164
Exchange rate
The price of one country's currency expressed in terms of another country's currency
165
Spot rate
Exchange rate currently offered for immediate delivery
166
What does FX markets stand for?
The foreign exchange market
167
Bid price
The price at which a trader buys a currency for
168
Offer price
Is the price at which a trader will sell a currency for. It is also known as the 'ask' price
169
Spread
The difference between the bid price and offer price
170
Cross rate
The implicit exchange rate between two currencies when both are quoted in a third country's currency
171
Triangular arbitrage
The ability to make a riskless profit from converting money across 3 countries. However, given the efficiency of the global FX market, it is exceptionally unlikely that triangular arbitrage opportunities last very long
172
Spot trade and what exchange rate does it use
An agreement to exchange currency 'on the spot' which means the transaction is completed or 'settled' within 2 business days. The exchange rate on a spot trade is called the spot exchange rate
173
Forward trade and what exchange rate does it use
An agreement to exchange currency at some time in the future. The exchange rate that will be used is called the forward exchange rate. Forward trades are usually settled within 12 months
174
Interest rate parity (IRP)
A method of predicting foreign exchange rates based on the hypothesis that the difference between interest rates in two countries should offset the difference between the spot rate and the forward foreign exchange rates over the same period
175
F(t)
Forward exchange rate for settlement at time t
176
R(HC)
Home currency nominal risk-free interest rate
177
R(FC)
Foreign currency nominal risk-free interest rate
178
S(0)
Spot exchange rate
179
Exchange rate risk
The natural consequence of international operations where relative currency values fluctuate
180
3 types of exchange rate risk
- Short-term exposure
- Long-term exposure
- Translation exposure
181
Political risk
Changes in value that arise as a consequence of political actions
