FM Definition

Risk

Variability of potential returns.

(Returns variable and uncertain)

Increase in risk required increase in returns provided

Techniques for dealing with risk and uncertainty in appraisal (chp6)

1. Expected value EV : simplifies the appraisal by incorporating the variation in outcome into a single figure. However require knowledge of not only the individual outcome but also their probability of occurence which can be difficult. It also only has any meaning for repetitive events

2. Sensitivity Analysis where the impact on a projects NPV due to a change in a key variable can be quantified. The allows key, sensitive variables to be identifies dir further investigation and ongoing otiject monitoring. Unfortunately, it doesn't give any indication of the likelihood of occurence of the changes and only allow one variable to be changed at a time (interdependance between variable ignored)

3. Simulation addresses one of the weaknesses of sensitivity Analysis by calculating the effect of changes in multiple variable at a time. Main disadvantage are it’s complexity (time consuming and required the proba for the variable change) but give a good indication of potential outcome

4. Adjusted Payback by reducing the maximum payback benchmark and the longer payback, more uncertain projects will be rejected. This is subjective however and the CFs returned after payback ignored. Payback measures how long in years the project broke even in CFs.

5. Risk adjusted discount rate: discount rate in an NPV calc should be determined by the risk within the project being undertaken. For higher risk project, discount rate should be increase to allow for the increased return required by finance provider. Can use CAPM or just adding return premium

6 ST sources of finance

Bank overdraft (flexible used as needed)

Bank loans (secure but require collateral assets)

Better management of working capital (profitability vs liquidity decisions)

Leasing (allow spread cost asset over time - can be more expensive overall but better cfs)

Sale and leaseback (generated immediate cash)

3 Long Term Finance of raising equity

1- Internally generated funds (RE - quick and cheap)

2- Rights issue (TERP/ Value of a right/ can either take up the right, sell the right, renounce part and take up remainder or do nothing means loosing wealth)

3 - New external share issues (more expensive and may fall, may required business to be quoted, dilution of control for existing shareholders) can be by placing, entreoruse investment scheme, public offer, fixed price offer, offer for sale by tender. Can be insured known as underwriting to make sure enought cash raised

Long Term Finance via debt

Bonds = written acknowledgement of a debt by a company (debenture or loan note)

Coupon rate = yearly interest on nominal value (usually 100)

Irredeemable, interest paid into perpetuity

Nominal value doesn't change, market value does

May be secured (fixed charge over asset or floating charge)

Debt vs equity

For investor:

Debt low risk, low return, BUT no voting rights (no control)

For company:

Debt cheap (low returns as less risky), predictable (know how much interest), doesn't dilute control (no change in ownership)

BUT

Inflexible, increase risk at high level of gearing, must be repaid compare to dividend thatcan be cut if can’t afford

Other type of debt

Deep discount loan notes: issued at a discount to nominal and redeemable at nominal or at a premium

Zero coupon loan note: no interest paid so capital gains only in redemption

Hybrid loan note - convertibles (right to convert into other securities like ordinary shares at future date) - with warrants (rights to buy ordinary shares at predetermined price in the future)

Leasing Finance (risk and rewards lessee, would need to maintain but don't own so can't clair writing down allowance)

Venture Capital (provide founds to small fast growing companies and often advise company too - participation in equity until listed on stock market at a huge profit)

Bank loans (ST or LT, restrictive as terms set up by the bank, secured against asset)

SMEs founding

Issue: small nb of owners with limited capital available, lack of business history or proven record, lower level of public scrutiny over accounts and records, lack internal control, lack tangible assets for security.

Funding: business angels (usually under 100k) or venture capitalists (>250k)

Government grant, bank loan and overdraft, seed capital (family, owners), crowdfunding, personal guarantee.

Maturity gap: easier to obtain LT finance but would prefer short to medium finance to match the term of its assets against liabilities and keep funding costs down

Islamic Finance

Sharia law: sharing P&L, no interest (riba) allowed, restricted accepted transaction (no alcohol, gambling)

Mudaraba (equity finance): profit sharing arrangement for a venture between an investor and company. Profit shared pre-arranged ratio. Only capital provider bear any losses (to extend of net capital provided) and no role in management

Musharaka (Venture Capital): company + investor(s) contribute capital to a joint venture. Net profit divided pre-arranged ratios. Losses bear proportion net capital investment and all parties can be involved in management of ghe venture.

Murabaha (trade credit): IFI Islamic finance institution would purchase asset for project and then sell them to company who would pay the IFI fixed installment and no management involved by IFI

Ijara (lease): IFI purchase assets for the project and give right of use asset to company in exchange fir payments to IFI like conventional lease. No management involved.

Sukuk (bonds): investor owns a share of an asset and receive share of profit generated by that asset until maturity of sukuk and investment repaid.

Dividend Irrelevancy Theory (Modigliani & Miller)

There exist a perfect capital market, no transacgion costs in buying selling shares, no taxes or both dividends and capital gains taxed in the same way.

Theory: the pattern of dividend payouts should be irrelevant because as long as company continue to invest in positive NPV projects, the wealth of shareholders should increase whether or not dividend paid.

So company should focus on investment rather than dividend and if shareholder required income they can sell shares.

Residual Theory of Dividends

Raising new cash funding fron the market may be more expensive than using cash that was to be paid as dividend ti fund fhe project instead (irrelevance theory said dont matter which one).

So dividend should only be paid out if there are no positive NPV projects available for investment

2 type of risks

Systematic risk: caused by general, macro-economic factors (recession, interest rates, exchange rates)

Unsystematic risk: caused by factors specific to the company or industry (system failure, R&D, Success, Strikes)

If Investor chose well and diversify portfolio, can reduce unsystematic risk. Systematic risk cannot be eliminated by diversification.

CAPM Capital Asset pricing model gives a required return for a given level of systematic risk

CAPM Assumptions

• Well diversified investors who only need to be compensated for systematic risk (reality might need a higher return as not fully diversified)

• Perfect capital market: no taxes, no transactions costs, perfect info (reality investor not fully informed and transactjon costs payable - so need higher return)

• unrestricted borrowing/lending at risk free rate (reality bank would charge a premium to reflect risk lending to individual or companies)

• CAPM valid for one period usually a year (investors hold shares for longer)

• Efficient market where possible to diversify away Unsystematic risk and no transaction cost (level of complexity can be added to reflect genuine market condition)

Operational Gearing

Measure extent to which a forms operating costs are fixed rather than variable as this affect risks.

The higher proportion of fixed costs, fhe higher the gearing, the riskier the EBIT

Financial Gearing

Measure of thr extent to which debt is used in the capital structure.

High gearing would have increased variability of returns to shareholders hence increase risk for the equity investor.

Problems of high gearing

Bankruptcy risk

Agency costs (restriction by existing lenders on management action)

Tax exhaustion (no tax liability left against which to offset interest charges)

Impact of borrowing/debt capacity (no further assets on which to secure debt reduces lenders willingness to lend)

Difference between risk tolerance levels between directors and shareholders (managements unwillingness to take risks that we’ll diversified investors would accept)

Restriction in the articles of association (borrowing limit)

Increase in cost of borrowing as gearing increase (due to Bankruptcy risk and lack of assets for security)

Pecking order theory

No search for an optimal capital structure but

1 Internally generated funds (already available, cheap)

2 debt (less contentious than share issue, moderate issue costs)

3 New issue of Equity (could be perceived as a sign of problems, expensive)

Purposes for business valuation

To establish terms for takeovers and mergers

For informed by and hold decisions

To provide valuation for companies entering the stock market

To ascertain value of shares owned by departing directors

For fiscal matters

In divorce settlements

Ultimately, real worth only known once purchase has been made after negociation. Tolerabce and mutual respect as negociation will involve understanding each other’s point of view to reach agreed price

Problems with asset based valuation

Adding up the value of the business assets and deducting value of liabilities, we can calculate value of equity

♡ valuation fairly readily available and provide a minimum value if the entity

□ future profitability expectations ignored (right of future earnings, CF)

□ SFP valuation depend on accounting conventions dif than market valuation

□ ignore intangible assets such as goodwill so can significantly undervalue business

Income based Valuation method

Particularly useful when valuing majority shareholding.

♡ commonly used and well understood, relevant for valuing a controlling interest in an entity

□ based on accounting profits rather than CF. Difficult go establish relevant level of sustainable earnjngs

Dividend Valuation Model DVM

Used valuing minority shareholding in a company (little influence on how earnings spent and relying on dividends as source of income)

□ problems estimating a future growth rate, growth assumed to be zero or at a constant rate

□ high sensitivity to changes in the assumptions used

♡ few advantages over earnings based methods for controlling onterests

Discounted CFs DCF basis

Value of equity derived by estimating future annual free CFs and discounting these CF at appropriate cost of capital (reflect systematic risk of the flow)

♡ best method as the PV of future CF represent sharehokder wealth Increase, can be used to value all or part company

□ relies on estimates of CF and discounting rates, difficulty choosing a time horizon, difficulty valuing company’s worth beyond this time horizon, assume disciunt eaten tax and inflation are constant over the period

The efficient market hypothesis

An efficient market is one in which security prices fully reflect all available information.

Efficiency:

• Weak: reflect info about past share price movements (no patterns or trends, price follow if next piece of news good or bad, future price movements cannot be predicted)

• Semi Strong: all past ibfi and all publicly available information. (Share price react within 5-10min of any new information, publicly info only will not provide opportunity to beat the market as would need to trade after first minutes) - this is the max level

• Strong: share prices incorporate all info whether public or private (including not yet published) - insider dealing is banned, stock exchange encourage release of new info quickly to prevent insider dealing opportunities, insiders are forbidden fron dealing in their shares at crucial times.

Behavioural finance: why did investors make seemingly irrational decisions when buying and selling?

• Market paradox (they must believe the market is inefficient in order for it to be efficient)

• Herding (they follow trends rather than make their own rational decisions)

• Stock market bubble (unsustainable rise in price of an investment due to herding for ex)

• Noise traders (those who follow trends rather than make prof decisions)

• Lisss aversion (focus to avoid loss rather than make a gain)

• Momentum effect (trend of rising prices leads to optimism and further price rises…)

Creditors Hierarchy

The creditors hierarchy gives the order of preference for the settlement of financial claims when a company is liquidated

1. Top of the creditor hierarchy is secured debt (loan notes, bank loans with fixed charge over NCAsset of the company) - lowest before tax cost, lowest return as lower risk

2. Unsecured debt (do not have a charge over NCAsset)

3. Preference shares

4. Ordinary shares request the highest level of return of any provider of finance to a company.

CAPM Capital Asset Pricing Model vs DGM Dividend growth model

CAPM explicitly consider rusk specifically systematic risk since model assumes all investors hold diversified portfolios vs DGM does not consider risk in explicit terms

DGM assumed to be constant growth rate when historically it changes frequently

DGM weakness ignores taxation and issue costs (but model can be modified to add)

CAPM weakness can be difficult to establish values for the model keys variable:

• The equity risk premium (found from statistical analysis of historical data over long period and different studies provides dif data)

• Risk free return (risk free asset doesn’t exist so based on yield on short dated gov debt

• Equity beta (calc on historical data so can’t predict future vakue with any certainty)

In perfect world and perfect data, both will give same value

Proforma NPV

Operating Cash Inflow - Outglow = Net operating CF

• - TAX on net op CF

• - Initial investment

• + Scrap Value

• + Tax savings from Tax allowable depreciation

• + working capital (total = 0)

= TOTAL NET CF x discount factor = Present values

sum = NPV

Lease vs buy and replacement

Use post tax cost of capital

Lease = payment & tax savings (timimg from T2)

Buy = purchase & tax saving from tax allowable depn + incremental cost

Replacement decision uses Equivalent Annual cost = PV costs / Annuity factor

Choose smaller EAC

If different duration uses Equivalent Annual Benefit EAB = NPV project / AF

Choose highest EAB