List and describe the 3 key decisions that a firm faces
- Investment: (capital budgeting) decision. What long term investments should the firm make
- Financing: (capital structure) decision – how should the firm finance its investments, via equity, debt or its own internal stores of cash
- Dividend: (payout) decision- What should the firm do with excess cashflows it has generated, pay them out as dividends or reinvest them in the firm
Managerial agency conflicts
- Type of agency conflict
- Where managers make decisions that personally benefit them but which are detrimental to shareholder wealth.
Explain why shorter term bonds (generally called notes) typically do not pay coupons whereas longer term bonds typically do
With short term bonds given that the repayment of the bond’s face value will be soon, investors would be willing to lend without receiving coupons (effectively interest payments) whereas they wouldn’t prepared to do so with long term bonds, as it could be a very long time until they receive the face value back with no other payments in the interim.
Explain why a financial manager would be interested in the profitability index of an investment even though it is similar to NPV
- It gives the manager another piece of information to use when making an investment decision and in particular.
- Shows how high is the ratio of the PV of the future cashflows to the initial cost, which the NPV doesn’t show.
Given that the NPV perpetuity method and the EAV method lead to the same decision, why would a financial manager still be interested in calculating the EAV when they have already calculated the NPV perpetuity of a proposed investment?
- Because the EAV shows the equivalent annual cash flow received from a project into perpetuity and this is an additional piece of information a financial manager can use in
- addition to the NPV infinity number, which lacks intuitive meaning.
Describe risk and how its measured
Risk is defined as uncertainty of outcomes and is measured with variance or standard deviation.
- A ratio between SD and the return.
- Tells you for 1% return, how much risk do you take?
- Decision rule: choose lowest value.
Given the asset classes of Cash, Bonds, Property, Domestic shares and international shares, which has the lowest risk-return trade off and which has the highest?
Cash has the lowest risk-return trade off while International Shares has the highest.
Define risk averseness
Demand for compensation of higher expected return for taking on more risk. The standard assumption in finance is that investors are risk averse.
What does CAPM stand for? Describe the components of the model and what the model is used for
- CAPM stands for the capital asset pricing model and it is used to obtain the expected return of a security through systematic risk.
- It does so by adding a risk premium to the risk free rate.
- The risk premium is calculated using beta, the measure of a security’s systematic risk to the market
How to find after tax cost of borrowing given perpetual interest payments and bond price
1. How to calculate value of unlevered firm.
2. New value if decide to borrow and repurchase stock
3. What is the new value of equity
- 1. Minus tax from earnings before tax then divide by cost of equity
- 2. Calculate tax shield (debt x tax) and add to previous value
- 3. new firm value minus debt
Identify the 5 characteristics (MM) that may make the firm's value dependent on its capital structure.
- 1. Information asymmetry exists:
- - Shareholders are not as informed as firm management.
- - Firm management better informed as to when it is worthwhile to leverage the firm.
- - Shareholders therefore entrust management to ‘add value’ by leveraging
- upwards to maximize shareholder returns.
- 2. Bankruptcy costs matter
- - Direct Insolvency Costs include out of pocket costs (i.e. fees paid to lawyers,
- accountants, etc.)
- - Indirect Insolvency Costs include changes to the behaviour of those
- people/firms that deal with the company in financial distress.
- - Behaviour changes include supplier firms requiring ‘cash on deliver’, resulting
- in a loss of trade credit, and potential delays in supply.
- - Employees of distressed firm may leave to other employment, making
- retention of key staff difficult.
- - Also, if firm enters into formal insolvency process, then must have all future
- investments approved by an insolvency judge adding further delays/costs to
- the firm.
- 3. Tax matters
- - Interest on debt is tax-deductible, making it less costly to distribute cash to
- investors/security holders through interest payments than through dividends.
- - Value added to a firm with debt is referred to as the corporate tax shield.
- 4. Agency Costs matter
- - Agency costs occur because of the conflict in goals between owners of the
- firm and the managers (agents) who run the firm on a day to day basis.
- - Debt can provide discipline to agents, as they must ensure that the financial
- obligations inherent in the debt are met. Managers must then concentrate on
- maximizing the cash flows since interest and principal payments are
- - Not meeting these obligations can destroy a manager’s career so they have
- strong incentives to meet these.
- - Such pressure on managers prevents from investing in negative –NPV projects
- that benefit the manager but not the owners. (i.e. corporate jets)
- 5. Transaction Costs matter.
- - Pecking Order Theory. Cash generated internally has the lowest costs, whilst debt funding is relatively still low costs relative to equity funding.
There are a number of alternatives to companies paying cash dividends to their investors. List these alternative methods and give a brief description for each
- Share Buy Back (1 mark for identification + up to 4 marks for same or similar
- o These method involves return cash to investors by buying back existing
- shares. There are a number of different approaches including the
- o Equal access buyback. Here the offer is made to all shareholders to
- purchase the same percentage of the shares they own.
- o On-Market Buy Back. Here the repurchase takes place via the normal
- stock exchange.
- o Selective Buy Back. Here, offers are made only to selected
- shareholders. This requires a more formal approval process, requiring
- approval from all investors.
- o Share buy backs are taxed differently to dividends. Under a classical
- tax system, dividends are taxed as additional income. In contrast,
- when an investor sells their shares, they are taxed on a ‘capital-gain’
- basis as profit from the sale. In situations where capital-gains tax is
- less than income tax, then share buy backs may be more attractive.
- Bonus Issues ( 1 mark for identification + up to 3 marks for same or similar
- o This involves companies providing to shareholders new shares on a
- pro-rata basis without cost to the shareholder.
- o The only change that takes place is that the company will now have
- more shares in circulation, and the share price will reduce
- proportionally to the number of new shares issued. The investor’s
- wealth does not change as they now have more shares.
- o It can be argued that the bonus issue is performed so that investor
- interest in the company can be generated, however, it may also be
- because the management considers the price of the shares have risen
- to a level that is not favoured by investors, and the bonus issue allows
- the dilution of the price down to a level that is more favourable.
- Share split (1 mark for identification + 2 marks for same or similar description)
- o This method is similar to a bonus issue, but can think of share split as a
- division of an existing share into more than one shares.
- o Usually quoted as a multiple of new shares per the number of old
- shares. (i.e. 3 shares for every 2 shares currently held.)
- Dividend Reinvestment Scheme ( 1 mark for identification + 2 marks for same
- or similar description)
- o DRPs offer shareholder to opportunity to use all or part of their
- dividend payments to buy additional new shares in the company
- without incurring brokerage fees. Sometimes the new shares
- purchased can be bought at a discount to the market price.
- o Usually operated by larger companies although more firms are
- implementing these schemes.