One of the questions on the Compulsory Section (Section A) of your paper requires you to write briefly on a number of topics. There is a small choice in that you must complete five out of seven topics. There is a limited range of areas that are examined and certain topics tend to repeat over a number of examination sessions.
You do not need to write a thesis on each subject but a couple of well chosen sentences (as below in Section B) will suffice. Where appropriate a numerical example will help you to get your message across and put some order on your solution.
You should regard this question as a “banker” and if you have done your work you should be well capable of attaining almost maximum marks (20 marks in total, 4 per topic).
Professor I Altman researched 66 companies that experienced corporate failure to determine whether or not their ultimate failure could have been predicted? His summarised findings are known as Altman‟s Z-Score Model. This model suggests that if five key financial ratios are calculated and weighted, and, if the result lies outside stated parameters, then the business faces a heightened risk of future corporate failure. The model is used by investors and analysts to inform them of the financial risk associated with potential investments because of its usefulness in predicting corporate failure.
Beta as a Measure of Market Risk
One of the fundamental principles of financial theory is that individual shares (or more generally individual securities) will relate to the average market risk in a fairly consistent manner. Empirical statistical research of a share‟s actual performance (in terms of its returns and the variation in such returns) will indicate whether it is more prone to variation than the market as a whole – i.e. either more or less risky than the market. The risk of a particular share relative to the market as a whole is measured by that share‟s unique “beta” value. The beta value reflects differences in systematic risk characteristics and is most frequently used in CAPM calculations. The beta value for the market as a whole is usually set at 1.0, and so any share with a Beta greater than 1.0 is considered to a relatively riskier investment than a portfolio of shares representative of the market as a whole.
Capital Asset Pricing Model
The CAPM is a model which sets out in mathematical form the relationship between the return on any individual security, the risk free rate of return, and the return on the market portfolio. It may be summarised as follows:
Rp = Rf + ( Rm – Rf)
in the equation above (the „Beta‟ factor) is a variable which attempts to capture the Systematic Risk associated with the business activity of a company. The model is significant in that it is premised on the view that the return on any given security is associated with the non-diversifiable (systematic) risk associated with the security.
Capital rationing refers to a situation where there is a budget ceiling or constraint on the amount of funds available to a firm for investment purposes during a specific period of time. The significance of such a circumstance is that firms facing a capital rationing constraint must attempt to identify and implement the optimal selection of investment opportunities which will maximise the value of the firm while remaining subject to the given constraint. In theory, however a firm should accept all projects that yield a positive NPV when evaluated at an appropriate cost of capital. A selection process which causes firms to select only a limited number of potentially value enhancing projects is by definition sub-optimal. Typically when firms consider themselves to be subject to some capital constraint, it is probably untrue to say that capital is simply not available. Rather the more likely explanation of a capital shortage is that firms believe the cost of capital to be too high, and so they express a reluctance to continue raising further capital. Ultimately though the test of whether the cost of capital is too high should centre on the positive/negative nature of the resultant NPV outcome.
Centralised Treasury Management
Companies of significant size are often diverse in terms of trading activities and/or geographic spread. Many such companies choose to centralise their treasury function. This involves expert staff conducting the treasury management function for all parts of the business, however diverse. This decision will be reached for a combination of the following reasons:
- Ability to afford specialist staff
- Increased purchasing power given the increased value of borrowings/investments
- Foreign currency set-off potential
- Better control over activities
- Improved risk monitoring
- Improved tax planning
- The ability to “offset” negative cash balances in one unit against the positive cash balances in another
Convertible Loan Stock
Convertible loan stock is a debt instrument issued by firms which offers the holder the right to have the debt redeemed in the usual way at the redemption date. Alternatively, the holder of the loan stock may exercise a right to convert the debt into equity at some pre-determined conversion rate. The buyer of convertible loan stock usually accepts a slightly lower rate of interest on the instrument as part of the price to be paid for holding what amounts to a bet on the future movement of the share price – the holder of loan stock in effect enjoys an option on the firm‟s equity. This lower rate of interest makes loan stock attractive to the issuer, as does the fact that conversion into equity represents an in-built form of liquidation of the instrument and removes the necessity to raise further debt in order to redeem the initial loan stock.
Corporate raider is a title given to organisations/individuals who target companies to acquire, and, if successful, will in the post acquisition period carve the business into its component parts with a view to selling/strip the individual parts at a profit. Ultimately, the corporate raider may retain ownership of a small element (if any) of the acquired enterprise.
Corporate raiders are also known as „asset strippers.‟
Deep Discount Bonds
A Deep Discount Bond is a bond which is usually issued at a price considerably lower than its par value. The investor in these bonds is, therefore, given the opportunity to buy a bond at a very cheap price. Typically, the trade-off for this benefit is that the bond will carry a lower coupon rate of interest than other comparable debt instruments. The investor, therefore is essentially attracted by a potential capital gain, while the issuer of the loan stock will be attracted by the relatively lower service costs of the loan stock. This latter feature can be particularly attractive to companies which wish to raise capital for a new business venture and where the future cash flows may be uncertain in the early years of the project, thereby putting a strain on servicing a higher cost loan stock.
Dividend Policy – Considerations in Determining
It should always be remembered that ordinary shareholders are not prima facie entitled to receive an annual dividend. The decision whether or not to declare a dividend and if declared, the extent of same, rests with the Board of Directors. Each year the Board will consider the dividend decision. The key considerations when making this decision will include:
- Profitability – what are the profits for the period for which the dividend is to be decided?
- Legality – in short, only realised gains can be distributed
- Cash Flow – has the company the cash reserves from which to pay dividends?
- Taxation – is it more tax efficient for equity shareholders to receive dividends or capital growth, or the optimum mix thereof?
- Signalling Effect – what will the declaration of any size dividend (including a nil declaration) signal to the investment community?
- Expectations – what are shareholders expecting as a dividend and how any change will impact on their investment behaviour?
- Residual Theory – can the company use profits to invest in projects which will increase the capital value of shares by more than the dividend that could be paid?
Dividend Yield as a Method of Company Valuation
The dividend yield is the ratio of the most recent dividend to the market price of the security under review. In this sense the dividend yield is a measure of the “rate of return” on equity capital which might serve as a comparable ratio to the percentage yield on loan stock. However, as dividends are paid net of withholding tax, it is usually necessary to calculate the grossed up equivalent of the dividend and use this figure in working out the dividend yield. Such an approach allows yields on equity to be compared more directly to yields on interest bearing loan stock. By convention, a normal yield gap implies that the return on equity should be higher than that on debt. Nevertheless it can occasionally be observed that the dividend yield can be less than yields on debt. In the long run, however, it is true to say that investors expect their return on equity, in terms of dividend yield and capital gains, to exceed the yield debt.
Efficient Market Hypothesis
The efficiency of a stock market means the ability of the market to price shares quickly and fairly to reflect all the available public information in respect of each share.
The Efficient Market Hypothesis proposes that a particular stock market is an efficient stock market. This is because of the role that well informed institutional investors and their market analysts play.
How efficient the market is at responding to such information is considered to vary between:
- Strong form efficiency
- Semi-strong form efficiency
- Weak form efficiency
There has been much research carried out on the topic of measuring market efficiency, with varying and sometimes contradictory findings.
Equivalent Annual Cost
Equivalent annual costs are employed when considering the optimum cycle within which to replace capital assets, or in other circumstances when assessing the repayments on a loan over a given schedule of years. In effect, EACs are the direct reciprocal of annuity factors. This technique becomes useful when an analyst is examining assets with different life spans and so the question of replacement cycles cannot be easily addressed given that in any particular year one or more of the assets being considered will still have some period of its useful life left to run. The EAC may perhaps best be understood by reference to the concept of annuity factors. For example, whereas annuity factors allow the analyst to reduce a known and constant future cash flow to a present value using an uncertain discount factor , the EAC method facilitates the conversion of a known present value capital cost to an unknown future stream of (notional) cash flows over a defined period of time. This restructuring of the financial data can allow a more direct comparison to be made between assets with different useful lives and thereby allow decisions to be made on optimal replacement cycles.
Factoring of Debtors
The factoring of debtors is a financial service usually provided by a specialist agency, such as a department within a bank. Typically, it involves the administration of a client companies debtors, the collection of its debts, the elimination or at least tighter control of bad debts, and the advancement of certain sums of cash on the basis of invoices issued to date. The provision of factoring services therefore represents – on the part of the Factor – the ability to develop specialist expertise, operating economies of scale, and an access to a level of liquidity which is only likely to be available to a major financial institution such as a bank. Factoring services are not however simply a means of resolving the problems of financially distressed or illiquid companies, but rather are only likely to be available to reputable companies with an established trading record. Most banks will be reluctant to take on the administration of a particularly troublesome debtors‟ ledger containing many unknown client firms.
Flotation costs arise in the context where a company is offering its securities – either debt or equity – for sale in the capital market. These costs can be significant and in most cases the amount of funds the firm receives is less than the aggregate value suggested by the price at which the issue in question has been sold. Typically flotation costs can involve all or any of the following items – underwriting expenses, audit and legal fees, fees to corporate bankers or their financial advisors, public relations fees, costs of printing, advertising and circulating the offer for sale, and stock market fees. Although these costs can be significant, most firms tend to tale the prudent view that they cannot afford to avoid them entirely. This is particularly so in relation to underwriting costs and the fees associated with professional advice on the issue price for the particular security in question. This latter aspect is especially important as failure to strike the correct issue price could undermine the success of the entire issue.
Internal Rate of Return
The internal rate of return is the discount rate that equates the present value of cash inflows with the present value of cash outflows (often the initial investment associated with the project). In other words, it is the discount rate that yields an NPV of zero for the project. For the investor, the IRR of a project represents a form of cut off rate for project financing. If the investor concerned can manage to raise funds at a rate lower than the IRR, the NPV of the project will be positive and the investor would proceed with the proposed investment. If on the other hand the cost of funds was greater than the IRR then the investor would recognise that the return on the investment would not be sufficient even to remunerate the capita, committed, much less create additional wealth by way of a positive NPV outcome.
Management Buyouts (MBOs)
When an organisation decides to divest itself of part of its business for whatever reason (cash absorber, lack of strategic fit etc.) it may receive offers from many parties. Occasionally, the management of the part of the business being sold may decide to mount a bid for the purchase. This is known as a management buyout. Research has shown than MBOs tend to be more successful than 3rd party acquisitions. This is for many reasons including knowledge of the industry and the specific business being bought as well as increased levels of motivation to make the business a success.
Often with MBOs the most difficult challenge is to raise sufficient finance.
Money Markets and Capital Markets
The capital market is the market where various long term financial instruments (ordinary shares, bonds etc.) are initially raised and subsequently traded. It is the market where business seeks long term financial capital which will support the company and its ongoing operations. The capital market also represents a structured interface between those with surplus funds who are seeking out remunerative opportunities (investors), and those agents with a capital deficit who need to raise additional finance (borrowers). By contrast, the money market is essentially a market for short term investments only. The money market does not necessarily need a physical location in which to operate, and is better understood as a loose network of traders and financial institutions engaged in an ongoing process of electronic trading. Typically the instruments traded mature in a matter of days or months, and usually involve investors with short term surplus cash or those interested in tactical or speculative trading. The instruments traded do not form part of the fundamental financial structure of a business. Typical instruments traded on the money market are, short dated government stock, certificates of deposit, repurchase agreements, and commercial paper.
Operating gearing describes the relationship between the fixed and variable costs of production. Operating gearing can be measured either as the percentage change in earnings before interest and tax for a percentage change in sales, or as the ratio of fixed to variable costs. Companies whose costs are mostly fixed are said to have high operating gearing. These companies are highly vulnerable to the need to generate consistently high revenue earnings in order to cover the high fixed costs. High operating gearing therefore is perceived to increase business risk, and empirical tests have tended to support the view that such companies should have relatively higher Beta factors (Study Unit 17 above). In terms of an influence on a company‟s Beta factor, the analogy between financial and operating gearing is quite strong.
An operating lease is distinguished from a finance lease in that the lease period is usually less than the useful life of the asset. The lessor therefore relies upon either subsequent leasing or the eventual sale of the asset to cover the initial outlay involved in acquiring the asset. Under an operating lease, the lessor is usually responsible for repairs and maintenance, and therefore retains the risks and rewards of ownership of the asset. In effect then, an operating lease involves the short term rental of an asset.
The term “overtrading” refers to a situation where a company is unable to finance the level of operations which it has achieved. Usually this can arise where a company is undercapitalised at the outset, or where providers of long-term capital remain unwilling to inject further funds as the business grows and expands in volume terms. In such cases, the continued growth of the business will put increasing strains upon working capital, as the company realises it has little option but to have further recourse to short term borrowing and securing finance through the non payment of creditors. Very often, overtrading occurs where a company significantly expands its sales (and accordingly its volume of operations) through the introduction of generous credit terms without enjoying any corresponding credit concessions from its creditors. Such an arrangement will inevitably place a strain on the company’s liquidity which is only likely to be finally resolved through some form of financial restructuring involving access to long term capital.
Portfolio Theory A portfolio is the collection of different investments that make up an investor‟s total holding. A portfolio might be the investment in stocks and shares of an investor or the investments in capital projects of a company. Portfolio theory is concerned with establishing guidelines for building up a portfolio of stocks and shares, or a portfolio of projects. The same theory applies to both stick market investors and to companies with capital projects to invest in.
There are five major factors to be considered when an investor chooses investments, no matter whether the investor is an institutional investor, a company making an investment or a private individual investor:
- Security – Investments should at least maintain their capital value.
- Liquidity – Where the investments are made with short-term funds, they should be convertible back into cash at short notice.
- Return – The funds are invested to make money. The highest return compatible with safety should be sought.
- Spreading Risks – The investors who puts all his funds into one type of security risks everything on the fortunes of that security. If it performs badly his entire investment will make a loss.
- Growth Prospects – The most profitable investments are likely to be businesses with good growth prospects.
Price Earnings Multiple
This is a way of determining the worth of a share/a business. It is normally used in the context of an acquisition whereby the target company is valued at a multiple of its profit before tax. It is a widely recognised indicator of value by the investment community. The multiple which will be used in each case is normally industry dependent. For example an IT based industry may have a different P/E multiple than the retail industry, given the differences in the two industries such as; risk profile, life cycle stage etc. In practice, the final agreed multiple paid would be influenced greatly by the negotiation skills of both parties. It should be noted that using the P/E multiple is not the only way in which shares/business can be valued. Other methods include asset-based valuations.
Public/Private Funding Partnerships
This is a new and increasingly popular method of funding public capital projects e.g. schools, infrastructure projects etc. In essence, the capital cost of the project is borne by the private enterprise and the public body will pay for the use of the facility over an extended contractual period. At the end of the period the facility will revert to public ownership. The attraction to the private enterprise is the security, and hopefully, the guaranteed financial return of contracting with government departments. Examples of public/private partnerships include the much delayed and much publicised new Cork School of Music.
Reverse Yield Gap
A Yield Gap refers to a position whereby it is normally expected that the yield on equities will be greater than that available on debt. This is so because equity is considered to be more risky than debt, and so in order to compensate shareholders for accepting this extra risk, a higher level of reward must be offered. In some rare instances though, it can emerge to be the case that the yield on debt is actually greater than the yields on equity – this position is referred to as a reverse yield gap. However such a situation should emerge as a temporary phenomenon only. If the yield position did not correct itself (i.e. showing a higher return on equities once again),then the entire investment market for equities would eventually collapse. It is likely that such a build up of sentiment against equities would serve as the very stimulus necessary to depress share prices and so bring dividend yields into a more normal position.
Scrip dividends are shares given to shareholders instead of – or in addition to – cash. Firms may elect to pay a scrip dividend in circumstances where competing pressures on cash reserves might render it unattractive to make a more conventional cash payment – this could be the case where the firm is experiencing liquidity difficulties or where surplus cash may be target on a potential capital investment. In such circumstances a firm may pay a scrip dividend in order to be seen to be remunerating shareholders‟ investment in the firm without placing an unwelcome strain on current cash resources.
Semi-Strong Form Efficiency in Capital Markets
Semi-strong form efficiency is one of three categories described in that aspect of capital market theory concerned with the efficiency with which the market processes relevant information. This is a significant question as it allows analysts to arrive at a view as to how well informed a particular capital market is. In this context, the phrase „well informed‟ can be taken to mean that actors on the market have access to all pertinent information, and that they enjoy the capacity to understand and interpret that information with a view to basing subsequent trade decisions on that insight. Semi-strong efficiency refers to a context where investors are in possession of all historical information pertaining to a particular financial instrument, as well as all published information relating to the instrument. This is considered to be the circumstance which best describes most capital markets. To make any stronger claims would move the investor into a position of privileged or insider information, which would in turn move the market towards strong form efficiency.
Strong Form Efficiency
Strong form efficiency refers to a position in the capital markets where the market is considered to be so efficient at filtering relevant information, whether of a public or private nature, that the prices of all financial securities traded on that market are thought to embody all such information. In this sense then, and under conditions of strong form efficiency, “insider trading” could not conceivably happen, since no sooner would an individual have identified a reason to adopt a particular trading position, than market prices would have immediately adjusted to reflect this rationale, and any envisaged gains from trade in such securities would thereby be dissipated.
Systematic risk refers to the inherent risk of a particular investment which cannot be diversified away. This systematic risk simply reflects the fact that some business activities are naturally more risky than others and any investor wishing to invest in the financial securities of such a business, must accept the associated level of risk which cannot be detached from the business. Normally, investors will expect to earn a higher reward for taking this additional level of risk. This need to earn a higher reward is captured by the beta term of the capital asset pricing model which serves to quantify the amount of risk premium to be associated with the particular financial security.
Traditional View of Gearing and the WACC
The traditional view of the relationship between gearing and the Weighted Average Cost of Capital is that the two variables are directly correlated. Graphically this relationship is shown as a “U” shaped curve, suggesting that as the level gearing rises from an initial level of zero indebtedness, the WACC initially falls, bottoms out to a minimum position, and then begins to rise again as the level of gearing rises with more and more debt being added to the capital mix. The simple reason for this characterisation of events was that because the return on debt was necessarily lower than the return on equity (because of the different risk profiles), then introducing debt into the capital mix must inevitably lead to a fall in the overall cost of capital. This view, of course, presupposes that that at low levels of gearing, equity holders would not be alarmed by the initial introduction of debt and that accordingly their expected rate of return would not change. However at high levels of gearing, the equity holders begin to perceive a significantly changed risk environment and they therefore seek compensation by way of higher returns. This then leads to a subsequent rise in the WACC.
The particular significance of the traditional view was that because it suggested that the WACC could possess minimum point (i.e. a gearing level where the WACC was at its lowest), then this in turn implied that the value of the firm would alter in line with changes in gearing and that management could, by virtue of some creative financial engineering, manipulate the value of the firm.
The role of the Venture Capitalist as a source of finance has in many countries increased in profile over the last number of years. A Venture Capitalist, as the name suggests is an organisation which provides finance for new and developing businesses. A Venture Capitalist typically takes the form of a department of an established financial services organisation or as a private asset management expert.
Venture Capitalists carefully vet proposals put to them by businesses that require funding. Only those businesses that are operationally and technologically feasible have market appeal and are financially viable are likely to be backed by the Venture Capitalist.
Once backing is agreed the Venture Capitalist will fund an agreed percentage of the venture. This funding, typically, will be a mixture of equity and debt. Venture Capitalists will require board representation in order to help protect their interest by having influence (voting rights) over policy and strategic decision-making. Venture Capitalists do not expect to retain interests in businesses they back for the long term. A typical “get-out” to liquidate their investment would be in the form of “going public”.