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Briefly describe 3 forms of business organisation: a sole trader; a partnership and companies
- Sole trader: a business owned by one person. Unlimited liability
- Partnership: consists of two or more owners joined together legally to manage a business. Unlimited liability.
- Companies: legal entities able to do business in its own right. Limited liability.
Between the bond holder (buyer) and the bond issuer (seller) which party is borrowing money and which is lending money?
- The bond holder (buyer) is the lender.
- The bond issuer (seller) is the borrower.
Explain why there is an inverse relationship between interest rates (YTM) and bond prices
- As the YTM increases beyond the coupon rate of a bond, the bond price falls as it is no longer as attractive an investment to other bonds of the same type that are newly issued at a higher coupon as set by the higher YTM.
- The only rationale for an investor to buy the more poorly performing bond would be if its price fell by a discount til the coupon paid on it represents a yield that matches higher YTM.
- Conversely, if YTM decreases below the coupon rate, the bond price rises as it becomes a more attractive investment to other bonds of the same type that are newly issued at a lower coupon as set by the lower YTM.
- So investors would be willing to pay a premium price for this bond until the coupon represents a yield on a higher price that matches the lower YTM.
Should the credit rating of a bond be upgraded, what is the likely effect upon the required rate of return of the bond? Explain why such an effect occurs.
- An upgrade in credit rating represents a reduction in the default risk of the bond.
- This will lower the required rate of return on the bond as investors would require less compensation for lower default risk.
How to valuate bonds based on P/E valuation
Divide market price by earnings per share (EPS)
How to calculate fair value of stocks using dividend discount model (DDM) given dividends paid in perpetuity and do not grow.
- Dividend per share/ discount rate.
- Sell if this price is lower than market price.
- The market will eventually correct itself and its value will go down.
- Buy if fair value is higher than market price.
What is the capital budgeting process? Why is the capital budgeting decision considered the most important decision made by a company's management?
- Capital budgeting is the process by which management decides which
- projects and productive assets the company should invest in. (1 marks)
- Capital budgeting decisions are considered the most important decisions made by management because:
- Capital expenditures involve large amounts of money. (0.5 mark)
- Capital expenditure decisions are critical for achieving the company’s strategic plans. (0.5 mark)
- Capital expenditure decisions define a company’s line of business over the long term. (0.5 mark)
- Capital expenditure decisions determine the company’s profitability for years to come. (0.5 mark)
Why is net present value (NPV) method for capital budgeting decisions considered to be superior to alternative methods?
- The net present value (NPV) method leads to better investment decisions
- than other techniques because the NPV method does the following:
- NPV uses the discounted cash flow valuation approach, which
- accounts for the time value of money (1 mark)
- NPV provides a direct measure of how much a capital project is expected to increase the dollar value of the company. (1 mark)
- NPV is consistent with the top management goal of maximizing
- shareholders’ wealth. (1 mark)
What is the payback period method? What are its advantages? What are its disadvantages?
- The payback period is a measure of the length of time it will take for the cash flows from a project to recover the cost of the project. (1 mark)
- Decision rule is to choose the projects with short payback periods less than or equal to hurdle period (1 mark)
- Simple to apply and easy to understand. (0.5 mark)
- Simple measure of liquidity risk because it tells management how quickly the company will get its money back. (0.5 mark)
- Ignores the time value of money. (0.5 mark)
- Does not take account of cash flows recovered after the payback period. (0.5 mark)
- Biased in favor of short-lived projects. (0.5 mark)
- o Arbitrarily hurdle period. (0.5 mark)
What is the accounting rate of return (ARR) method? Why is this method not recommended as a capital expenditure decision-making tool?
- The ARR is based on accounting numbers, such as book value and net income, rather than cash flow data. (0.5 mark)
- Based on three variants
- o based on initial investment (0.5 mark)
- o based on average book value (0.5 mark)
- o based on initial and final book value (0.5 mark)
- Decision rule for ARR is that ARR is greater than required rate of return (0.5 mark)
- It is not recommended as a capital expenditure decision tool because:
- ARR does not represent a true rate of return. (0.5 mark)
- ARR does not discount a project’s cash flows over time. It simply gives us a number based on average figures from the income statement and balance sheet. (0.5 mark)
- ARR does not have an economic rationale for establishing hurdle rates. (0.5 mark)
- o ARR does not account for the size of the projects when a choice between two projects of different sizes must be made. (0.5 mark)
- Has variants that result in different ARRs (0.5 mark)
- Used when asked to compare 2 options with different lives.
- First calculate NPV for each project.
- -> initial outlay less present value of future net cash flow
- Then use NPV perpetuity formula.
- Both formulas in formula sheet.
- First formula is just the annuity PV formula switched around.
Describe how investing in more than one asset can reduce risk through diversification
- An investor can reduce the risk of his or her investments by investing in two or more assets whose values do not always move in the same direction at the
- same time.
- This is because the movements in the values of the different investments will partially cancel each other out.
Describe the Capital Asset Pricing Model (CAPM) and what it tells us
- The CAPM is a model that describes the relation between systematic risk and the expected return.
- The model tells us that the expected return on an asset with no systematic risk equals the risk-free rate.
- As systematic risk increases, the expected return increases linearly with beta.
- The CAPM is written as
- E(Ri) = Rrf + i(E(Rm) – Rrf).
What is the weighted average cost of capital?
- The weighted average cost of capital (WACC) is the weighted average of the costs to the different sources of capital used to fund a company,
- The WACC is often used as an estimate of the cost of financing a new project given the company’s current mix of debt and equity
Which type of risk has the tendency to increase the company's cost of capital?
- Markets adjust the cost of capital according to the level of systematic risk in a project.
- Therefore, the project with the greatest level of systematic risk will have the greatest positive impact on the cost of capital for the company, even if it has the lowest level of nonsystematic risk.
In your analysis of the cost of capital for an ordinary share, you calculate a cost of capital using a dividend discount model that is much lower than the calculation for the cost of capital using the CAPM model.
Explain a possible source for the discrepancy.
- Comparing the two formulas for the 2 methods we have:
- Given these two sources of information, we see that the only variable that we
- are not able to get directly from the market is the growth rate in dividends
- (note that future dividends are also a function of this growth rate), which is an estimate.
- Since our dividend discount method provided a lower cost of capital
- than the CAPM, it seems likely that we estimated the growth rate lower than what the aggregate market has assumed.
- Of course, this assumes that the market is efficiently pricing the share.
- If the market price is incorrect, then this might lead to a difference.
Under Modigliani and Miller’s Proposition 1, where all three of the assumptions remain in effect, explain how the value of the company changes due to changes in the proportion of debt and equity utilised by the company
Under Modigliani and Miller’s Proposition 1, the value of the company is independent of the proportion of debt and equity utilised by the company.
Equation to use when need to find current cost of equity capital
Discuss how the legal costs of financial distress may increase with the probability that a company will fall become insolvent, even if the company has not reached the point of insolvency
- If a company is anticipating insolvency to a greater extent, then it will increase its legal efforts to protect the company from creditors when and if the company reaches that point.
- Therefore, the legal costs of insolvency will increase with financial leverage even if the company has not yet declared insolvency.
Dividend policy and company value: Explain how the repurchase new securities by a company can produce useful information about the issuing company. Why does this information make the shares of the company more valuable, even if this information is confirmation of existing information about the company?
- When issuing new securities, the issuing company must submit to a process that amounts to a special audit by outsiders such as investment bankers and other experts.
- This additional production of information increases the level of monitoring concerning the company’s actual financial status.
- In a sense, it reduces the variability in the information that the company may already have released.
- If the production of this information reduces the level of risk borne by investors, then the issue of repurchasing new securities could actually increase the value of the securities issued by the company and, in turn, the total value of the company.
You are the CFO of a large publicly traded company. You would like to convey positive information about the company to the market. If you intuitively understand
(and agree with) the results from the Lintner study, then will you keep paying your currently high dividend or will you raise that dividend by a small amount?
- Although the current high level of dividends certainly suggests that the company has the ability to sustain a high payout to investors, that high payout does not convey any new, positive information to the market. However, by increasing the dividend, the CFO would be telling the market that the company will be able to support an even higher level of cash payout in the future.
- Therefore, you think it would be better to increase the dividend