The flashcards below were created by user
on FreezingBlue Flashcards.
What are the three main theories of capital structure?
- Modigliani and Miller (M&M) approach
- Static (tradeoff) theory
- Pecking order theory
What is M&M proposition I?
The market value of any firm is independent of its capital structure. Firm value is determined solely by the earnings generated by the assets of the firm. Whether these assets are financed by equity or debt is irrelevant. It incorporates the pie model which says that firm value is the same, no matter how the firm’s earnings is divided up (between shareholders, debt holders and other providers of capital)
What is the assumed goal of the firm?
To maximise the market value of the firm (equity) to its owners. This is given by share price of the company x number of shares.
How do we classify assets and liabilities?
Assets and liabilities can be classified as current (having a life less than one year) or non-current (having a life longer than one year).
What is net working capital?
The difference between a firm’s current assets and current liabilities. Net working capital is usually positive in a healthy firm.
What is capital budgeting?
The planning and managing of a firm’s investment in non-current assets. It involves evaluating the size of future cash flows, timing of future cash flows and risk to future cash flows.
What are the 5 types of markets?
- Financial markets bring together the buyers and sellers of debt and equity securities
- Money markets involve the trading of short-term debt securities
- Capital markets involve the trading of long-term debt securities.
- Primary markets involve the original sale of securities
- Secondary markets involve the continual buying and selling of issued securities.
What is a sole partnership?
Business owned and operated by one person. Most common form of business association and normally are small businesses. Such as shops, restaurants and trade professions (such as builders and plumbers)
What is a partnership?
Business owned and operated by two or more people. Business governed by a partnership agreement. Common with professional occupations (such as lawyers or accountants)
What are the advantages of a partnership?
Owners have greater control of the running of the business and keep all the gains (profits) earned
What are the disadvantages of a partnership?
Liability of owners is unlimited and extends to their personal assets. Difficult to transfer or liquidate ownership. More difficult to raise additional funds to expand. Income taxed at personal tax rates
What are the two types of companies?
Listed and unlisted
What is a listed (public) company?
- Represents a separate ‘legal’ entity, with similar rights to individuals
- Owners are the shareholders who purchase the company’s ordinary shares
- Shareholders have a ‘residual’ claim to assets of the company on liquidation, etc.
- Can also use other forms of finance
- Most of these companies are run by ‘independent’ managers appointed by the Board of Directors (representing the shareholders)
What are the advantages of a listed company?
- Can access and raise large amounts of capital
- Ownership (shares) is easily transferable between owners
- The liquidity can reduce transaction costs and in turn the cost of equity
- Liability of owners is limited
What are the disadvantages of a listed company?
- Costly to set up initially and many on-going costs (such as ASX listing fees, company registration, reporting and disclosure requirements, provision of reports and information to shareholders)
- Many regulatory and information requirements that need to be met (but information transparency can reduce equity costs)
- Complicated organisational structure and tiered decision-making and coordination framework
- Responsibility to pay dividends and other distributions to shareholders into infinity
- Small shareholders have no real power or voice in company decision-making
What are the characteristics of the 'traditional' listed company that give rise to agency problems?
Owned by many different shareholders including large shareholders: institutional investors (e.g. life insurance companies and superannuation funds), individual block holders and many small shareholders. Shareholders elect a Board of Directors to act on their behalf. Board of Directors appoints a management team (CEO, CFO etc) to run the company. Problem arises as the interests of shareholders and management differ
What are some examples of agency problems?
- Management focus on size (empire-building) as a measure of prestige/success or to maximise pay.
- Consumption of perquisites (such as luxurious offices and company jets).
- Cutting out R&D expenditure as it will lower current profits, even though it may lead to profitable future projects and higher share prices.
- Agency conflicts between shareholders and other parties (such as debtholders) including paying a high dividend to shareholders and investing in excessively risky projects
- Conflicts between controlling (family) shareholders and minority shareholders - the case of Seven Network.
What are agency problems?
Separation of ownership from corporate control - principal (owners) engage the agent (manager) to act on their behalf, with decision-making power passing to the agent. Agent typically has a minimal ownership stake. Conflicts and agency problems arise when their interests are not aligned. Shareholders need to incur costs to limit such divergence, known as agency costs (represent losses to the wealth of shareholders).
What are some possible methods to resolve agency problems?
- Management pay linked to company performance targets such as use of bonus or option and share ownership plans to encourage greater focus on increasing the share price.
- Monitoring of management
- Threat of takeovers
What are the three main areas of concern in corporate finance?
Investment, finance and dividend decisions, and asset management.
What are the two types of investment projects?
- Independent, where acceptance does not affect the cash flows or acceptance of any other project so you can accept any or all of them. Acceptance of a project occurs if NPV is greater than 0.
- Mutually exclusive, where only one project is selected from a group. Accepting one precludes acceptance of another, so acceptance is usually of the project with the highest NPV (and as long as it is greater than 0). Common for firms to have multiple similar options (particularly assets like machinery or buildings).
What is the effect of the NPV of an investment on a firm's share price if they accept the investment?
The share price should change by the NPV per share of an investment.
What are the advantages of the NPV?
- Takes into account the time value of money.
- Takes into account all cash flows.
- Has an intuitive target value for decision making.
- Makes the decision which maximises the wealth of shareholders.
- Indicates the actual dollar amount of increased value
What is the internal rate of return?
The discount rate that equates the PV of a project’s cash flows with its initial cost. At this rate the project NPV will be equal to zero, or a break-even outcome will result.
What is the IRR decision rule?
If IRR > r (the required rate of return for the project), then the project should be accepted, as it provides a higher return than that required given the risk of the project
How to calculate IRR?
Equate NPV to 0 and solve for IRR.
What are the advantages of the IRR method?
Summarises project information into one easily understood number
What are conventional projects?
A cash outflow (the initial cost outlay) occurs at the beginning of the project. This is then followed by a series of cash inflows. Hence there is one change of signs (from –ve to +ve); if so it is classed as conventional. Conventional projects usually have a unique IRR
What are non-conventional projects?
The most common is a cash outflow to set up the project, followed by a series of cash inflows, then a terminal cost to complete the project (e.g., repair a damaged site). Hence there can be two or more changes of signs. Multiple, or no internal rates of return, can occur in these cases (i.e., where a project has more than one sign change in the series of CFs).
What is the present value index?
Also known as the benefit-cost ratio, it is the ratio of the present value of the future cash flows to the initial investment cost. Accept the project if PVI>1.0
What are the disadvantages of the PVI?
Problems with mutually exclusive investments
What are the advantages of the PVI?
Useful when available investment funds are limited. Easy to understand and communicate. Correct decision when evaluating independent projects
What is the discounted payback period?
Calculates the time required for the sum of an investment’s discounted CFs to equal its initial cost (same decision rule as payback period, with time value of money)
What are the advantages of the discounted payback period?
Takes into account the time value of money
What are the disadvantages of the discounted payback period?
Still an arbitrary cut-off date. Cash flows beyond cut-off date are still ignored
What is the ARR?
Accounting rate of return = average net profit/average book value of investment. Decision rule is to compare to a pre-determined minimum return requirement, and accept if ARR is greater.
What are the disadvantages of the ARR?
Doesn’t consider cash flows or market values. Ignores the timing of the earnings stream. Ignores risk differences between projects. An arbitrary measure, based on a ratio of accounting numbers, so it is sensitive to the methods used. No guidance on the target level of ARR
What is the payback period?
Used to determine how long does it take to get the initial investment back in a nominal sense. Calculation involves estimating the CFs and subtracting the future CFs from the initial cost until the initial investment has been recovered. Decision rule is to accept a project if the project payback period is less than some prescribed value (cut-off period).
What are the advantages of the payback period?
Simple to apply and easy to understand. Provides information on how long funds are committed to a project (measures risk and liquidity)
What are the disadvantages of the payback period?
Time value of money is ignored as there is no discounting. Risk is not taken into account. Ad hoc determination of acceptable payback period. Cash flows after payback period are ignored.
What is the prime cost (straight line) depreciation method?
A constant rate (r) is applied to asset’s initial cost (book value at time t = 0 = BV0) to identify allowable deduction each year (NB. D is a fixed amount). It is given by D = r × BV0
What is the reducing balance (diminishing value) method of depreciation?
A constant rate (r) is applied to asset’s beginning-of-year book value (BVt-1) to identify allowable deduction each year (in this case, Dt is a variable amount which declines over time). It is given by Dt = r × BVt-1
What is the modified accelerated cost recovery system (MACRS) depreciation method?
Each type of asset is assigned to a ‘class’, and depreciation is charged over the asset’s class life.
What is working capital?
Cash employed to run day-to-day operations of a firm (e.g., investment in inventory). Not consumed but rather employed for a period of time. Increase in WC during a period means more cash is employed, i.e., cash outflow. Decrease in WC during a period means less cash is employed, i.e., cash inflow
What are the three impacts of taxes?
- Income tax represents a cash outflow
- Tax shield - depreciation provides a tax deduction which results a tax saving
- Capital gains tax (CGT) (Lowers the net profit made from the sale of an asset but may result in a tax saving when a loss is made from the sale of an asset)
What is net working capital?
Current assets - Current liabilities
What are the methods used to compare projects of different lives?
- Lowest common multiple of lives
- Constant chain of replacement (NPV in perpetuity) method
- Annual equivalent cost/value method
What is the lowest common multiple method?
Calculates the NPV over the lowest common life period for two projects. If Project A - 4 years, Project B = 6 years - Lowest common life (LCL) = 12 years. NPV calculated for both projects over a 12-year period: Project A is replaced in years 5-8 and 9-12 with a project with the same cash flow pattern (both initial cost and annual cash flows) and Project B is replaced with an identical project for years 7-12.
How to calculate constant chain of replacement (NPV in perpetuity) method?
- Where NPV0 = net present value of original project, r = the required rate of return, n = the life of the original project
How to calculate the opportunity cost of leasing
OC = PV of lease payments (premiums) & residual value – price (buying cost) of the asset
How to calculate the net advantage of leasing?
- NAL = (Tax savings from leasing – Tax savings from borrowing) – Opportunity cost.
- If NAL > 0, then leasing is preferred to borrowing; otherwise, buying is preferred
What are some reasons for underpricing IPOs?
- To ensure that issues are fully subscribed (a short-fall in subscriptions sends a very bad signal about the company’s future)
- To attract knowledgeable investors (such as major institutional investors), expecting others to follow their lead
- Due to the ‘winner’s curse’, where informed investors crowd out uninformed investors
- To provide a benefit to investors so they will support future share issues
- Agency problem of issuing (Underwriter’s commission is proportional to the aggregate value à incentive to set price higher. But if issue is unsuccessful, no commission is paid - incentive for a low price.)
What is underpricing?
Underpricing means that companies tend to issue shares at a price below their ‘fundamental’ value. Evidenced by significant 'stag' premiums or returns on the first trading date.
What is underwriting?
Underwriting is a service provided by a stockbroker or investment bank. For a fee, the underwriter contracts to purchase all shares for which share applications have not been received from interested investors by the closing date of the issue. Effectively, the issuing firm sells all of the shares to the underwriter (commonly at a discount to the stated subscription price), and leaves the underwriter to sell the shares to the investing public (or to sub-underwriters)
What are some reasons for underwriting?
Means of transferring the risk of under-subscription associated with an IPO (particularly in relation to full underwriting). Also a means of involving an outside party in the whole issue process, as the underwriter is also normally involved in the pricing and marketing of an issue
What is the ex-rights date?
The date on which a share begins trading ex-rights. The right is not attached to shares from and after this date. Expect the share price to fall on ex-rights date by the value of the right because the share no longer carries the right.
What are private placements?
- Private placement involves the issue of large parcels of shares to institutional investors or clients of a stockbroker. Normally required to be issued at a discount to encourage investors to acquire a large parcel. No prospectus or underwriting required. Represents a low-cost and quick way for firms to raise relatively large amounts of capital
- Existing shareholders do not like private placements as they dilute their proportional shareholdings and allow other shareholders to purchase shares at a discount (they would prefer the company to use rights issues)
What is yield to maturity?
the interest rate that will make the present value of a debt security’s cash flows equal to its current market price