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Things To Know (ARGH) Flashcards

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1
Q

What is the assumed objective for finance?

A

The company should make investment and financing decisions with the aim of maximising long-term shareholder wealth.

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2
Q

What is shareholder wealth?

A

Maximising shareholder wealth means maximising the flow of dividends to shareholders through time.

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3
Q

How to help reduce principal agent problems?

A

Need to align the actions of senior management with the interests of shareholders (goal congruence)
Can:
- Link rewards to shareholder wealth improvements
- Sackings
- Selling shares and takeover threat
- Information flow

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4
Q

How to calculate simple interest?

A

future value = present value * (1+ rate * no. of years)

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5
Q

How to calculate simple interest?

A

future value = present value * (1 + rate)^ no. of year

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6
Q

How to calculate annuities?

A

Same as discounting cash flows but use annuity instead (A/(1+rate)…
OR
1-1/(1+rate)^no. years all over rate then * annuity.
OR
present value of annuity table * annuity

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7
Q

How to calculate perpetuities?

A

Annuity/ interest rate

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8
Q

How to discount semi-annually?

A

present value*(1+[rate/2])^2

Quarterly=
present value*(1+[rate/4])^4

Daily=
present value*(1+[rate/365])^365

Quarterly after x years=
present value(1+[rate/4])^4x

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9
Q

How to work out the rate of interest?

A

square root to the no of years the future value / present value then - 1.

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10
Q

How to determine the number of years in an investment period?

A

n = log(F/P) all over log(1+rate)

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11
Q

How to work out continuous compounding?

A

Use the exponential function (2.71828)
= present value * 2.71828 ^ rate * no. of years.

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12
Q

What things go into the time value of money?

A

Compensation will be required for at least three things:
Impatience to consume
Inflation
Risk

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13
Q

How do you work out the risk free return?

A

(1+ required pure time value return)*(1+ inflation) - 1

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14
Q

How do you work out the required return?

A

Risk free rate + risk premium

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15
Q

What is the risk premium?

A

The return an investor will expect to receive/ expect to receive from holding a risky market portfolio.

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16
Q

How do you discount cash flows?

A

cash flow/ (1+ rate)^no. of years

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17
Q

What are the decision rules for NPV?

A

NPV>0 = Accept
NPV<0 = Reject

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18
Q

What is a perpetuity?

A

Cash flows that keep paying out forever.

PV of a perpetuity = periodic cash flow/ interest rate

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19
Q

How do you discount perpetuities?

A

Work out the perpetuity - cash flow/ discount rate

Then you have to discount this back the number of years required (if it arises one year later year 3, it has to be discounted back 2 years) - perpetuity/ (1+rate)^no. of years.

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20
Q

What does the IRR tell you?

A

The rate of return you will receive by putting your money into a project, how much cash inflows exceeds cash outflows.

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21
Q

What are the decisions for the IRR?

A

IRR> required rate of return (cost of cap) - NPV = positive ACCEPT

IRR = required rate of return - NPV = 0

IRR< required of return - NPV = negative REJECT

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22
Q

How do you guess the second % to use for the IRR?

A

If NPV = +ve, IRR is higher than cost of capital so guess a higher rate and recalculate.

If NPV = -ve, IRR is lower than cost of capital so guess a lower rate and recalculate.

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23
Q

What is the IRR formula?

A

Lower rate+ NPV lower rate/ (NPV lower rate - NPV higher rate) * (high rate - low rate)

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24
Q

What are the decisions surrounding IRR and opp. cost?

A

If opp. cost> IRR REJECT

If opp. cost< IRR ACCEPT

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25
What are some problems with the IRR?
-Multiple solutions -Sometimes it is better to find projects with a higher NPV than IRR
26
What are the methods of investment appraisal ?
Payback and discounted payback period Accounting rate of return NPV IRR
27
What is the payback method?
The time it takes for a project to repay its initial investment.
28
How do you work out the payback period?
No. of years = add up the cash flows from each year until the sum is greater than the investment. No. of weeks = (last -ve cumulative c.f. / the regular c.f. from the +ve year) * 52 *12 to get months
29
What are the advantages and disadvantages of the payback method?
Ads - Simple and easy to understand - Helps managers make quick decisions - Preference for liquidity - Useful in uncertainty Disads - Ignores time value of money - Doesn't consider all cashflows - Not realistic
30
What is the discounted payback period?
The payback period that accounts for the time value of money.
31
What is the accounting rate of return (ARR)?
Formula used to calculate net income expected from an investment compared to the initial cost of investment.
32
How do you calculate the ARR?
Average annual profit/ average investment
33
What are the advantages and disadvantages of ARR?
Ads - Simple to calculate - Accounts for dep. Disads - Ignores time value of money - Ignored cashflows - Ignores risk and uncertainty
34
How to calculate ARR (annual basis)?
Include dep. (profit - dep.) Profit after dep./Use value of asset (book value) at start of year Add up all the ARR for each year and divide it by 1/no. of years.
35
How to calculate ARR total investment basis?
Average annual profit/ initial capital invested * 100
36
How to calculate ARR average investment basis?
Average annual profit/ average capital invested *100
37
What is not included in relevant cashflows?
Depreciation - it is not an expense that results in a cash flow *If taken must be added back
38
What is working capital?
Increase in cash floats Increase in stocks Increase in debtors Less increase in creditors
39
How is working capital recorded in relevant cash flows?
It is deducted in year 0 but added back to the last years cash flows. *Scrap value is also added to last year
40
How to work out net operating cash flow?
Profit before dep. - periodic investment in net working capital
41
How to record stock and creditors in relevant cash flows?
Stock Opening stock Closing stock Net stock adjustment = difference in closing and opening *Net stock adjustment is added/taken to cash flows. Creditors Startof year End of year Cash flow effect of creditors = difference in EOY and BOY *Cash flow effect is what is added/taken to cash flows IF NEGATIVE IS ADDED, IF POSITIVE IS TAKEN
42
How to work out incremental cash flows?
Cash flow for firm with the project - cash flow for firm without project
43
How to work out the annual equivalent annuity of replacement cycles?
Annuity = Present value / annuity factor *Present value = Initial investment (-ve) + discounted cash flows
44
What is a make or buy decision?
An act of choosing between manufacturing a product in-house or purchasing it from an external source.
45
How to determine the max price a company should pay to an outside supplier for components?
VC saved + opp. cost = max price
46
How to calculate the profitability index (capital rationing)
Gross present value/ initial outlay
47
How to calculate benefit-cost ratio (capital rationing)?
NPV/ initial outlay
48
How to allocate tax to calculate corporation tax?
*Scrap value = the WD value of the last year (add back in) 1. Calculate the annual WDA - year 0 = initial investment of machine - Year 1 = initial investment * % of declining WDA = WDA ^ then take this amount from the written down value of the year before - Year 2 = written down value of year 1 * % of WDA ^ then take this amount from the year before written down value. THEN (layout) Net income before WDA and tax (cash flows) Less: WDA Incremental taxable income Tax at _% *^ taxable income * % of tax
49
How to allocate tax in relevant cash flows?
LAYOUT Cash flow before tax Add: sale of machine (last year) Less: tax Net cash flow Discounted cash flows NPV
50
What is Fisher's equation?
Relationship between real rates of return and money rates of return and inflation. (1+money rate of return) = (1+real of rate of return) * (1+ rate of inflation)
50
What are independent and conditional events?
Independent = outcome does not depend on outcome of previous event Conditional = outcomes of two or more events are related (second outcome dependent on first outcome)
51
What is the risk adjusted rate?
Risk-free rate + risk premium
52
How do you calculate the expected return (standard deviation)?
sum of return * probability = (return*probability)+(return*probability)+...
53
How do you work out standard variation?
LAYOUT Returns Expected returns Deviations (returns - expected returns) Variance (deviation squared*probability) SUMMED Standard deviation (square root of variance)
54
What does the standard deviation show?
A higher standard deviation is shown to be more risky.
55
How do you calculate the coefficient of variation? What does it show?
Standard deviation/expected return A lower coefficient of variation means the investment is less risky.
56
How do you calculate the return of holding period returns?
(Dividends received+(share price at end of period - purchase price)) / purchase price
57
What is covariance?
It measures the total variation of two random variables from their expected values. We can only gauge the direction of the relationship.
58
What is the correlation coefficient?
The correlation coefficient is a measure of the strength of a linear relationship between two variables. -1 = perfect negative (values in 1 series rise as those in the other decline) 0 = independent +1 = perfect positive As long as the returns of constituent assets of a portfolio are not perfectly +ve, diversification can reduce risk.
59
How do you work out the expected return on two asset portfolios?
(weight of asset A* expected return of A) + (weight of asset B* expected return of B)
60
What is the standard deviation of two asset portfolio?
Square root of: percentage of A^2 * variance of A + (1- percentage of A)^2 * variance of B + 2*percentage of A * (1- percentage of A) * covariance of A and B
61
How do you calculate covariance of two asset portfolios?
SUM OF: deviation of A * deviation of B * probability
62
How do you calculate the correlation coefficient?
covariance of A and B / (standard deviation of A * standard deviation of B)
63
What is equity capital?
Ordinary shares
64
What is debt capital?
Borrowing Lenders have no control.
65
How do you calculate the ex-rights price of a rights issue?
Existing share price * no. of shares in rights issue. THEN add price of one new share. Value of one share ex-rights = above / no. of shares in rights issue + 1.
66
How do you calculate the value of a right on one new share?
market value of share ex-rights - subscription price (value of one new share).
67
How do you calculate the value of a right on one old share?
[market value of share ex-rights - subscription price (new price)] / no. of old shares requires to purchase one new share
68
How do you calculate the rate of return on a bond?
square root to the power of the no. of years redeemable price / issue price THEN - 1.
69
What are convertible bonds?
Bonds that carry a rate of interest, they give the holder the right to exchange the bonds at some stage in the future into ordinary shares.
70
How do you work out conversion price?
Price of bond/ no. of shares it can be converted into.
71
How do you calculate the conversion premium?
(conversion price - current market price) / current market price
72
How do you work out conversion ratio?
Nominal (par) value of bond / conversion price
73
How do you work out conversion value?
current share price * conversion ratio
73
What are the advantages of convertible bonds?
- Lower interest - Interest is tax deductible - Self liquidating - Fewer restrictive covenants - Underpriced shares - Cheap way to issue shares - Available finance when straight debt and equity are not available
73
How do you work out the cost of debt?
risk free rate + risk premium
74
How do you calculate the weight of debt / equity?
Weight of debt = weight of debt finance / (weight of debt + weight of equity) Weight of equity = weight of equity finance / (weight of debt + weight of equity)
74
What is the WACC formula?
(cost of equity* weight of equity) + (cost of debt less tax* weight of debt)
74
How to calculate the enterprise value in WACC?
amount of cash flow / WACC
74
How to work out the tax in WACC?
cost of debt * (1 - tax rate)
74
How do you work out CAPM? (cost of equity)
risk free rate + beta * (risk premium)
75
How to calculate the cost of preference share capital?
price of preference shares = annual preference dividend / investors required rate of return
76
What are some difficulties in calculating the WACC
- Calculating the cost of each source of finance is a challenge as some securities are rarely traded - Difficult to estimate the Beta - Accuracy of cost of equity depends of models used - use of historical data to estimate costs can be misleading - risk free rate used to estimate costs of bonds may not match terms of companys debt - complex securities are difficult to value - WACC changes overtime
77
What is the gordon growth model?
Preference share price = dividend / (rate of return - share growth rate)

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