Theory

Question 1

Assumptions of Miller-Modigliani model

Answer 1

Large number of participants, no market power. No transaction costs. Full and costless information. No taxes.

Question 2

Adjustment ratio

Answer 2

Volatility of earnings. Liquidity position of company.

Question 3

Target payout ratio

Answer 3

Investment opportunities- use retained earnings to minimise the transactions costs of asymmetric information. Volatility of earnings.

Question 4

Litner’s (1956) model

Answer 4

Companies set long-term target payout ratios-= express in relation to earnings. Only part of any change in earnings is likely to be permanent. Dividend policy determined by- target payout ratio(z)- speed of adjustment of dividends towards target(s)

Question 5

UK taxation and treatment of finance leases

Answer 5

Finance lease defined for tax purposes where PV of lease payments is 90% of asset’s value. Calculate implied interest rate from lease- tax deductible expenses in income statement. Tax depreciation calculation from capital cost of loan- charge based on expected useful life of asset.

Question 6

Circumvent capital expenditure controls

Answer 6

Exist in number of organisations -public sector organisations -central and local government -small and large private companies. Periodic lease payments allow firms to remain within annual capital expenditure budgets- important role in growth of private-public partnerships.

Question 7

Manipulation of accounting statements

Answer 7

Manipulation of accounting performance- operating lease reduces asset on balance sheet -increases assets based performance metrics. Manipulation of accounting liabilities- reduces debt on company balance sheet -company perceived as less risky. In efficient markets analyst undo accounting manipulations.

Question 8

Transaction costs

Answer 8

Favourable to lease short-term assets -legal ownership changes prohibitive for buying and selling short-term use assets -trade-off against agency costs of lessee misusing asset -lease asset on short-term basis and buy long-term basis -hire vs buy car for vacation use.

Question 9

Reduction in uncertainty

Answer 9

At end of lease asset has residual value -lessor bears risk if asset is leased -lessee firm bears risk if asset has been purchased. Advantageous to lease where -lessee is small/new risky company -lessor can more easily sell on asset.

Question 10

Tax status and leasing

Answer 10

Most important reason for leasing (HRWJJ) -in competitive market lessor must pass on part of tax benefit to lessee -tax benefits from tax depreciation and interest payments. Positive NPV to both parties through reduced tax payments to government. As with taxes, both parties benefit if lessor passes part of lower cost on to lessee -charging lower lease payment on asset.

Question 11

Assumption of lease analysis

Answer 11

Discount rate on lease equivalent to risk on secured bond issued by lessee -use after-tax rB rather than after-tax company WACC. Risk of tax shields equivalent to risk of debt -tax shields likely to be more risky in practice> depends on ability to generate profits >subject to changes in corporate tax rates. In practice managers use rB for lease and buying.

Question 12

Reasons for leasing

Answer 12

GOOD -differential tax status, maintenance of leased asset, reduction in uncertainty, transaction costs. BAD- manipulation of accounting income, manipulation of accounting liabilities, circumvent capital expenditure controls.

Question 13

EOQ assumptions

Answer 13

Demand is known with certainty and is uniform over time. The order level(Q) is constant. The order cost is fixed -is unrelated to the order size -total annual cost falls as the number of order falls. Shortages, leading to stock-outs, do not occur. The lead time for orders is zero in the basic model.

Question 14

Economic order quantity model

Answer 14

Determines the optimal order to replenish the stocks of an item -indirectly the optimal average level of stocks. Appropriate where the demand for an item is stable. Optimal order size determined by trading off -holding costs -ordering costs.

Question 15

Valuation of securities

Answer 15

Technical analysis- looking for patterns in historic prices and returns and use these to predict future trends. Fundamental analysis - aim to find the intrinsic value of assets by examining their expected future cash flows and their risk characteristics. Both believe it is possible to identify mispriced securities in financial markets. Focus here on methods to determine intrinsic value of assets.

Question 16

Approaches to valuation

Answer 16

Intrinsic value- estimates the present value of future cash flows discounted back to the present day at the appropriate cost of capital to reflect the risk of the cash flows. Relative valuation- estimates the value of an asset relative to a peer group of ‘comparable’ assets or companies using a common multiplier variable -earnings, cash flows, assets, revenues.

Question 17

Intrinsic value and market efficiency

Answer 17

In efficient markets, the share value reflects the best estimate, on average, of intrinsic value. Individual investors and analysts may differ on their esimates of intrinsic value and formulate investment strategies accordingly. For an investor to consistently produce superior estimates of value, one of the following must hold -the market is inefficient -the marketis semi-strong efficient but the investor possesses inside information -the market is in temporary disequilibrium -the investor is more astute than everyone else in the market.

Question 18

Historical averages

Answer 18

Involve extrapolating past stock price returns to the future using either arithmetic or geometric averages. Arithmetic returns tend to overstate performance while geometric returns tend to understate performance. Theoretically, neither approach is correct.

Question 19

Discounted cash flows

Answer 19

Involve restating dividend or earnings valuation models to derive expected returns given the current stock price. Theoretically, this method brings future cash flows back to the present day. In practice, it is not popular given the assumptions required involving constant or non-constant growth rates in future dividends.

Question 20

CAPM

Answer 20

States that the return on a stock is increasing with the risk free rate and the market risk of a stock (beta) multiplied by the market risk premium. This approach is popular although practical difficulties are involved in the use of market risk premium and beta. In practice, managers often use historical estimates of these figures and extrapolate forward.

Question 21

Firm maximise its value and minimise cost of capital

Answer 21

Firm can increase EPS and value by taking on debt. Firm value increases where firm’s fit from the interest tax shield on debt. Earnings per share increases but this is reflected in the higher return on geared equity capital and simply reflects compensation for financial risk as the firm takes on more debt. Managers must be aware that as they take omm mmore debt, equity cost of capital and EPS will increase but that is simply a reflection of the higher risk of financial distress to which the firm is subject.

Question 22

Leasing rather than buying

Answer 22

Many firms have historically used leasing as an alternative to buying an asset in order to keep the liability associated with the leased asset off the firm’s balance sheet This would reduce the reported leverage ratio of the business and reduce the apparent financial risk of the firm. In an efficient market this should not matter since analysts can read the footnotes to the financial statements and amend reported leverage. Moreover, IFRS require firms to report the present value of financing lease obligations as a liability on the balance sheet, and so this incentive should be of reduced importance in recent times.

Question 23

Trade-off model of capital structure(1)

Answer 23

Basic tax benefits of debt, agency costs of equity/benefits of debt which encourage the company to borrow more. Costs of debt relate to agency conflicts between shareholders and debtholders and direct and indirect costs of bankruptcy. Predictions of the model are that leverage id increasing with profitablility, tangible assets and firm size, but decreasing with growth prospects, volatility of operating cash flows and the availability of non-debt tax shiels. Shortcomings empirically are that profitable firms have less debt, firms appear to time equity issuance, and the negative stock price response to seasoned equity offerings.

Question 24

MM payout policy

Answer 24

MM argue that ‘packaging’ of cash flows does not imoact the value of the firm, but that the investments of the business generating these cash flows are what matters. This does not contradict the Gordon growth model because under MM low or zero dividends today reflect that the company may be investing in positive NPV projects that will generate higher cash flows in the future, increasing the ability to pay higher dividends at this time.

Question 25

Trade-off model of capital structure(2)

Answer 25

Trade off model status that firms balance the tax benefits of debt at the corporate level against the higher direct and indirect costs of bankruptcy from having more debt in the capital structure. Interest payments on debt are a tax deductible business expense, whereas dividends to equity investors are paid from post-tax profits. However, as the firm takes on more debt it suffers to a greater degree from bankruptcy risk. Direct and indirect costs of bankruptcy. The limitations in practice include profitable firms having little debt, market timing, and stock price decline on equity issuance announcements.

Question 26

Difference between operating and financial lease

Answer 26

Operating leases are shorter term, and tend to be for a shorter period than the expected useful life of the asset, the lessor is required to maintain the asset, and the lessee has the option to cancel the contract. Assets leased tend to include computer equipment, plant hire equipment, cars, photocopier, etc. Financing leases tend to be longer term and for the full economic life of the asset. The lessor does not generally maintain or service the asset, the lessee does not generally have the option to cancel the contract but does have the ability to extend the contract on expiration. Financing leases are more of a direct alternative to borrowing to purchase the asset. Assets leased tend to include plant and large machinery, such as aeroplanes.

Question 27

Maintenance of a leased asset

Answer 27

Operating leases typically require the lessor to maintain the asset. This is a cost that would otherwise be borne by the lessee were they to purchase the asset. Under perfect markets this would not provide an incentive to enter into the lease contract.However, there are generally economies of scale in the cost of maintaining and purchasing spare parts for machinery for the lessor relative to the lessee that would allow them to reduce the lease payment and produce a net advantage to leasing for both parties.

Question 28

Efficient markets hypothesis

Answer 28

Market efficiency states that the price of a security is the present calue of all future cash flows. When information is released it is immediately reflected in a company's stock price, which means that knowing information when it is released does an investor no good. Three main forms of market effiency are weak form; semi-strong form; and strong form efficiency. These differ in terms of what is meant by all available information. Under weak form the information set includes past informatio; semi-strong form includes past and all publicly available information; and strong form includes the privately held information in addition to the previous. The implications for financial managers are that accounting choice has no impact on firm value, that managers cannot time security issuance decisions, there are no price pressure effects from security issuance, and that managers and investors can trust financial markets.

Question 29

Deep discounting

Answer 29

Basic premise that companies can use a larger subscription price to ensure that the value of a right to purchase one new share in the offering remains positive even if the current market price declines over the rights period. The greater the discount, the less chance there is of the TERP dropping below the subscription price for new shares. The more shares the company has in issue, the lower the earnings per share of the comapny. AS the subscription price discount increases, the number of shares to be offered in exchange for the required funds must also increase, leading to a greater dilutive impact on earnings oer share. Total earnings accruing to the investor for a fixed capital investment are the same irrespective of the subscription price discount.