BFC2140

What is valuation principle?

• The benefits and cost of a decision should be evaluated

• the decision will increase market value when benefits exceeds costs

What is Franking credit?

The credit used by individual shareholder to reduce his/her own taxation liability

Define Agency problem

When managers, despite being hired as the agents of shareholders, put their own self-interest ahead.

What is limited partners?

• Have limited liability

• no management authority and cannot legally be involved in the management of the business

Define imputation system

• Overcome the double taxation of corporate profits

• allowing company to transfer a tax credit to the shareholder for the amount of the tax the company has paid

What is Arbitrage?

The practice of buying and selling equivalent goods in different markets to take advantage of a price difference

Law of one price

• Market tries to push towards equilibrium where cashflow must have the same price.

Define Perpetuity

• A stream of equal cash flows that occur at regular interval that lasts forever

• Arrives at the end of the first period (payment in arrears)

Define Annuity and the type of annuity

• A stream of equal cash flows that ends after some fixed number of payments.

 

Ordinary Annuity:

• Pays at the end of the period

 

Annuity due:

• Pay at the start of the period

What is a bond?

• A tradeable debt security, usually issued by a government or semi government body to raise money

• Received a fixed rate over a period of time

• Repaid with interest on predetermined maturity date

What is a share trading when Coupon rate = discount rate?

the bond trade at par

What is a share trading when Coupon rate < discount rate? How does this affect the price and value?

price < par value the bond trade at discount

• price is less than par value

• which is not valuable to investors

What is a share trading when Coupon rate > discount rate? How does this affect the price and value?

par value The bond trade at a premium

• Price is more than par value

What are the factors that would impact the bond price?

1. Interest rate changes

• Market interest rate increase =the YTM also increases

• Higher YTM = investors demand for a higher return for the bond

• Leads to higher discount rate =reducing present value and the bond's price

  2. Time affect

• Zigzag pattern

• Price slowly rising as coupon payment nears

• Drop after payment has been made

  3. Interest rate risk

• Unexpected changes in interest rate --> risk that arises for bond owners

• Greater time to maturity = greater interest rate risk

• Lower coupon rate = greater interest rate risk

What is share equity?

• Corporate create and issue shares to raise equity capital, and incur a cost of equity

• More difficult to value due to uncertainty of promised cash flow and have no maturity

• Part ownership in a company

What are the types of shares?

• ordinary shares

• preference shares

• partly paid shares

Define ordinary shares

• Carry no special or preferred rights

• The right to vote and participate in any dividends or an distribution of assets

Define preference shares

• Priority or preference over ordinary shareholders to payments of dividends

• Voting rights are restricted

• Many different types of preference shares

Define partly paid shares

• Issued without the company requiring payment of the full issue price

• The company is entitled to call for all or part of the outstanding issue price

• Shareholder is legally obliged to pay for the call

• Similar rights as ordinary shareholder

What is the difference between a public and private corporation?

Public corporation is listed on the ASX and their shares are traded on an exchange, while shares of private corporation are not traded on a public exchange.

What is the difference between primary and secondary market?

A primary market is where the company sells shares of itself to investors. The secondary market is where investors can buy and/or sell the company's shares with other investors.

What is a corporation’s key objective?

The corporation key objective is to generate a profit and maximise the wealth of its shareholders, as well as generating a long term value.

What are the key tasks a corporation financial manager should undertake?

1. Investment decision-Includes weighing the benefits and cost of a potential investment to be qualified as good use of money

2. Financing decisions-Whether to raise more capital or obtain a bond during difficult financial situation

3. Management of cash flow from operating activities-ensure the business has enough cash on hand to meet day-to-day activities

What is a bond issuer?

• View the bond as a liability

• Received the money from the bond

• Obligated to pay the periodic interest payments

• Obligated to pay the principal amount and the final coupon payment

What is a bond holder?

• a lender (investor) --> seek a steady stream of income

• View the bond as an asset

Highlight the difference between yield and coupon rate.

• Coupon rate is the interest rate on the bond issued by the issuer, and is determined by the issuer

• Yield rate is the required rate of return demanded by the bond investor, and is determined by the investors

Define NPV

• The difference between the net present value of the benefit and net present value of cost

• A range of discount rate

How to evaluate projects with different lives?

Using Matching cycle or replacement chain approach or EAA

What are the advantage and disadvantage of NPV?

Advantage:

• Uses cash flows

• Discount cash flow properly

• consider the time value

• Direct application of value principle

Disadvantage:

• Relies on accurate estimate of discount rate

• can be time consuming to compute

Define IRR

• Sets NPV of cash flows equal to zero = average return of investment

• Summarises the merit of a project

• The higher the IRR = the better it is

• When IRR<k = generates insufficient return

• IRR > k = project's rate of return is greater than cost

• The required rate of return is the minimum return that a project must earn in order to be acceptable

Define EAA

• Intention of comparing projects with different lives

• Takes NPVs and spread across the lives

• Computing the annuity = PMT

Define conventional CF projects

A negative cash flow is followed by a series of positive cash flows

Define non-conventional CF projects

Two or more changes of signs - different cash flows

What is payback period?

• Number of years required to cover a project's cost

• Only accept if the payback period is within the specified want

What are the pitfalls of IRR?

• Mutually exclusive projects = where k<crossover rate creates a conflict between IRR and NPV, but k>crossover rate there is no conflict

• IRR is not feasible

• Multiple rates of returns, such as non-conventional cfs

• Lending project and borrowing project can have the same IRR

Define profitability index

• For project ranking and capital restrictions

• When have capital rationing issue

• Investment return measurement

• Finds the ratio

• Higher PI = better

What to leave out in an incremental cash flow?

• sunk cost

• research cost

• accounting income

• allocated overhead

• financing cost

What is a free cash flow?

• the left over cash after counted for investments in working capital and long term assets

• amount that is generated for a project

What is NWC?

• Short term in nature

• To be settled in cash within a year

• Managing working capital is critical to a firm because the working capital usually ties up funds that could be deployed elsewhere in the firm to earn returns or distribute to shareholders

• Minimising NWC to maximise FCF/ the firm value

If depreciation expense is not a cash flow, why do we have to subtract it and add it back? Why not just ignore it?

It is important to include depreciation because it provides a tax saving or tax shield, where it affects the cash flow positively by reducing the taxable income.

Define break even analysis

• A financial tool used to determine the point at which a business or project generates enough revenue to cover its total costs

• The minimum level of sales or output to break even

• The level of a parameter  = NPV is zero

Define sensitivity analysis

• A capital budgeting tool that determines how the NPV varies as a single underlying assumption is changed

• How responsive is the output to changes in variables

• Assessing the sensitivity of NPV calculation to the uncertainty about the cost of capital used as the discount rate

Define scenario analysis

• Determines how the NPV varies as the number of the underlying assumptions are changed simultaneously

• Analysis situations involving major economic shocks

Define Decision tree analysis

• Evaluate risky investments that involve sequential decisions

• Enable decision maker to study the various decision points in relation to subsequent chance, events and choose from alternatives

• Shows magnitude, profitability and inter-relationship of all possible outcomes

• Relationship between present decision and future events

• Taking account of the probability of various events occurring and the effect of those decisions on the NPV of the project

How do you calculate average daily COGS or sales?

COGS/365 or sales/365

What does negative cash conversion mean?

The firm generally receives cash before it pays its supplier.

What is a trade credit?

• An agreement between customer and supplier

• Customer can purchase goods without paying cash upfront but at later scheduled date

• The difference between receivables and payables that is the net amount of a firm's capital consumed as a result of those credit transactions

• For buyer can calculate the cost of giving up the discount of EAR = (1+r)^n-1, where n is 365/days (full term days- days pay before discount) and r is dollar of discount/amount left to paid

Trade credit : Pros and Cons for buyers

Pros for buyers:

• Improve cash flow because payment is not due till later

• Simple and easy access to financing at no extra cost

• Improves the customer's business profile as well as the relationship with the suppliers

 Cons for buyers:

• High cost if payment are not made on time due to penalty charges or negative impact on the business profile

Trade credit : Pros and Cons for sellers

Pros for sellers:

• Strong relationship with its clients and encourage customer loyalty

• Higher sales volumes as buyers are more likely to purchase more when there are no additional cost

 

Cons for sellers:

• Delayed revenue = may impact operating cost

• Risk of buyers not paying

What should the firm do when the effective annual cost of buyer is more than interest rate?

• A high EAR is the cost the buyer will bare if they choose not to take the discount

• If bank charge less interest compared to the EAR then the buyer should take the discount because when they borrow money the cost is less than not choosing to take the discount and they can use the money to pay for the supply to get that benefit.

What are the type of accounts receivable managements

Accounts receivable days:

• The average number of days that it takes a firm to collect on its sales

Aging schedule:

• Categorises  accounts by number of days they have been on the firm's books

• Can be prepared using either the number of accounts or the dollar amount of the accounts outstanding

Payment patterns:

• Provide information on the percentage of monthly sales that the firm collects in each month after the sales

Explain what is stretching payable account and the consequences.

• When a firm pays its account payable after the term days.

• Cheaper cost of borrowing

• However, could impose cash on delivery or discontinue any business with the firm altogether.

Inventory management

• Holding appropriate level to help prevent stock outs

• Holding too much inventory can be costly = acquisition cost +carrying cost

• Just in time (JIT) inventory management = when a firm acquires inventory precisely when needed so that inventory balance is always zero or very close to it

What is the importance of cash management?

• Cash earns zero to no interest

• The cash can be used for day to day operation needs, precautionary balance (unexpected losses) and compensating balance (bank requirements)

• Cash can also be used for alternative investments, such as short term investments that can be turned into cash easily

Define measuring return

• Measure of profit on an investment

• Can be measured over any interval of time

• Higher risk requires higher return = expected return

• Risk is uncertainty associated with future possible outcome

• doesn’t provide good indication even with decade long of historical data = share are volatile

Define variance

average value of squared deviations from mean. A measure of volatility

Define standard deviation

• square root of variance and a common proxy for risk

Holding period return (HPR)

• Total return received by an investor from holding an asset or a portfolio of asset over a period of time

• Useful to compare returns on investment purchased at different periods of time

• Considers not only the appreciation of the asset but also the income payments

What are the methods to calculate expected return?

• Using a probability distribution (Individual security)

• Using a time series approach

probability distribution (Individual security) method

• There is uncertainty associated with returns from shares

• Assuming that we can assign probabilities to the returns expected

• The sum of return of the product of return* probability

• Risk is measured in terms of how much a particular return deviates from an expected return

Time series method

• Use historical stock market data

• Assume that the distribution of the past returns can be useful in some way to estimate the possible future returns for the investors

• N is minus 1 because it is a sample historical data

Define coefficient of variation

• Statistical measure that compares the risk-to-return relationship among different assets/securities

• How much risk faced by an investor on a security per unit of return

• The lower the cv the better

Define a portfolio

• A collection or combination of many assets that are of different asset classes such as stocks, bonds, cash, real estate and more

• To balance risk and return based on the investor's risk tolerance, time horizon and investment goals = diversification = risk minimization

• Weighted average of the return of all the assets in a portfolio

• Portfolio risk is not a weighted average

Define correlation

• Combining the two assets in the same portfolio may reduce the portfolio risk = if they are not perfectly or positively correlated with another asset

• Measure of the extent to which two securities' returns tend to move together

• Closer to 1 = the assets are highly correlated so when one asset decrease the other also decreases

• Closer to -1 = the assets are less correlated so when one asset decrease the other may increase

• Range from -1 to +1

• Degree of co-movement

Define Covariance

Covariance = a measure of correlation = (-infinity, infinity)

Unsystematic risk

• Risk factors affecting only that firm

• Also called diversifiable risk

• Can be removed by holding a well diversified portfolio

systematic risk

• Economy-wide sources of risk that affect the overall stock market

• Depend on its sensitivity to the effects of these market-wide factor

• Risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk

• No relationship between volatility and average returns for individual securities

Define beta

• Best measure of the risk of a security in a large portfolio

• Measure the responsiveness of a security to movements in the market portfolio

If:

• Beta =1, stock is as risky as the market

• Beta >1, stock is riskier than the market

• Beta <1 stock is less risky than the market

• Beta = 0, the security has no relationship with the market

Define CAPM

• Expected return= risk-free rate +risk premium for systematic risk

• Expected return = risk-free rate + (beta*market risk premium)

• Only high systematic risk will result in higher expected return

• Used to determine the expected return on investment based on its systematic risk

• Calculate required rate of return considering risk-free rate of return, expect market return and the systematic risk of that investment

• allows to infer beta based on historical data = more accurate estimates of returns for shares than historical average return

Security market line

• The linear relationship between expected returns for individual securities and systematic risk, measured by beta

• The line can move because of inflation = expecting a higher compensation

• Above the SML = underpriced because it is generating a higher expected return than the systematic risk provided

• Below the SML = overpriced because it is generating a lower expected return than the systematic risk provided

Define cost of capital

• The rate of return the firm must earn to maintain its market value and attract investors

• Project > COC = profitable and adds to the firm's value

• Project < COC = will harm the firm's value

Types of cost of capital

Also known as WACC

• Combination of cost of debt and cost of equity

Cost of debt

• The required rate of return on the company’s debt

• It is the YTM to an existing debt and not the coupon rate

• Interest paid on debt is tax deductible

• Kd*(1-T) = because interest expense reduces tax liability

Cost of preference share

• Pay a constant dividend every period = perpetuity

• R= d/p

Cost of equity

Return required by investors given the risk of the cash flow from the firm

• dividends are not tax deductible so there is no impact on the cost of equity

WACC

• it is the average required return on the asset based on market’s perception of those risk

WACC with preference shares

Why is cost of capital important?

• Provides an indication of how the market views the risk of the companies assets

• Can help determine the required return for capital budgeting

What are the assumptions to value a project using WACC?

Average risk:

• assume that the market risk of a project is equal to the average market risk of the firm’s investment

Constant debt-equity ratio:

• assume that the firm adjusts its leverage continuously to maintain a constant ratio of the market value of debt to the market value of equity

Limited leverage effects:

• assume that the main effect of valuation follows from interest tax deduction

What are the limitation of WACC?

• WACC is only appropriate to evaluate projects with systematic risks that are exactly the same as those for the company as a whole

• only used to evaluate projects varying levels of risk = discount rate may be too low or too high in some cases

When should WACC be used to evaluate individual security?

• the level of systematic risk for that project is the same as the overall portfolio of projects that currently comprised in the company

• the project uses the same financing mixed

What is a perfect capital markets?

• Securities are fairly priced. = same set of securities are traded at competitive market prices equal to the present value of their future cash flows

• No tax consequences or transactions costs or other cost associating with financing decisions or security trading

• Investment cash flows are independent of financing choices. = are not based on financing decisions but by return on investment

Define leverage

• Levered equity is where the firm has outstanding debt

• leverage will increase the risk of the firm’s equity and raise its equity cost of capital

What is Modigliani and Miller theory in a perfect market?

• in an unlevered firm, cash flows to equity equal the free cash flows from the firm’s asset

• in a levered firm, the cash flows are divided between debt and equity holders

• The total to all investors equals the free cash flows generated by the firm’s asset

What is MM proposition 1 ?

• In a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and not affected by its choice of capital structure

• VL= E+D = Vu

What is home made leverage?

• investors use leverage in their own portfolios to adjust firm’s leverage

• it is a perfect substitute for firm leverage in perfect capital markets

What is MM proposition 2 ?

• The cost of equity increases in a manner to offset exactly the use of cheaper debt funds, to compensate the associated risk

• the cost of levered equity equals to the cost of unlevered equity, plus a premium proportional to the debt-equity ratio

• the more debt used, the more return equity investors are expected to compensate for the increased risk

What is interest tax shield?

• When a firm uses debt = provides a corporate tax benefit each year

• The value of the tax saved due to deductibility of interest expense

• Increases amount paid to investors

• Interest tax shield = corporate tax rate * Interest payments

If increasing debt also increases the firm value, why not shift to 100% debt?

• With more debt, there is greater chance that the firm will default on its debt obligations

• a firm that has trouble meeting its debt obligation is in financial distress

What is trade off theory?

• the total value of a levered firm is equal to the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financing distress cost

• suggests that an optimal level of debt exists = when marginal cost and benefits are equaled = levered firm is maximised

• cost of financial distress decreases the value of the firm = increases with probability of default = increase level of debt

• Agency costs can reduce the firm’s value = if there is excessive risk taking or under investment problem

What are the qualitative factors used to determine the pv of financial distress cost?

1. the probability of financial distress

2. the magnitude of the direct and indirect costs related to financial distress that the firm will incur

What does trade off theory resolve about leverage?

1. the presence of financial distress cost can explain why firms choose debt levels that are too low to fully exploit the interest tax shield

2. Differences in magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries

What is asymmetric information?

• When managers’ information about the firm and its future cash flows is likely to be superior to that of outside investors

• managers use leverage to convince investors that the firm will grow

What is market timing?

• Market timing is an asymmetric information

• the proposition that managers sell new shares when they believe the share is overvalued, and rely on debt

• retained earnings if they believe the share is undervalued

What is Pecking order Hypothesis?

• managers have a preference to fund investment using retained earnings, followed by debt, and will only choose to issue equity as last resort

• different from trade off theory

• does not suggest an optimal capital structure, but rather addresses the impact of information asymmetries between company managers and outsiders

How should a financial manager determine the right capital structure for the firm?

The firm should increase its leverage to a point at which the tax savings resulted from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.

What is Efficient Market Hypothesis? (EMH)

• The price of the security accurately reflect the information available

• If the market processes new information efficiently, the reaction of the market prices to new information will be instantaneous and unbiased

• Investors cannot earn abnormal returns by using information that is already available

Define Overreaction

• Initial price movement can be expected to be reversed

Define Underreaction

• Initial price movement can be expected to continue

Define weak form efficiency

• the information contained in the past sequence of prices of a security is fully reflected in the current market price of that security