You may be expected to write briefly on a number of topics, as part of one of the questions. This is an opportunity to gain some very valuable marks for a small amount of effort. There is a limited range of areas that can be examined and certain topics may repeat over a number of examination sessions.
You do not need to write a thesis on the 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.
This section can also assist you in your revision, immediately prior to the exam.
Adjusted Present Value
Adjusted Present Value (APV) represents an alternative approach to WACC in terms of valuing a business and its operations. All DCF calculations involve discounting forecast future cash flows to a present value equivalent at a discount rate which reflects accurately the particular risk of the business. The approach taken under APV is to separate operational and financial effects, and to discount the former at some base-line cost of capital in order to arrive at a basic calculation of present value. As a separate and subsequent step, the cash flow consequences of alternative project financing options are discounted and added to the baseline present value. In effect the introduction of the term “adjusted” in APV reflects a concern to evaluate separately, the side effects of project financing. The attempt to identify and trace the consequence of each side effect involves the APV analyst in a series of separate DCF calculations. This added computational burden might help to explain some earlier reluctance to use APV, although the widespread use of sophisticated spreadsheets in recent years tends to diminish the significance of this argument.
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 shares 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.
A call option gives its owner the right to buy a financial instrument at a specified price – sometimes referred to as the striked price. Where the call option can only be exercised on a given date in the future, it is known as a European call option. Where the option can be exercised on any day up to and including a defined future date, it is known as an American call option. Where the exercise price of a call option is below the current market price of the financial instrument in question, the option is said to be “in the money”. Conversely where the exercise price of the option is above the current market price of the financial instrument in question, it is said to be “out of-the money”.
Options are a secondary market activity affecting only the two parties involved – there are no consequences for the company which originally issued the financial instrument. The party which issues the call option is known as the “writer” of the call.
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 + β ( Rm – Rf)
β 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.
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
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.’ Example of such a business would be Hanson Industries Plc, quoted in the U.K.
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 therefrom 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, 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.
This is the process which should confirm the reliability of the information which has been provided and has been used in making an investment decision. Changes in these primary assumptions may have a significant impact on the price to be paid and possibly even raise questions on the wisdom of proceeding with the transaction. This is a very useful process and at minimum will provide additional information on the potential target.
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. Thus, the possibility of a “speculative bubble” is minimised.
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.
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, stamp duties, 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 take 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
Foreign Exchange Exposure
Foreign exchange exposure arises from exchange rate functions. Transaction exposure arises where an exporter or importer is vulnerable to adverse movements in foreign exchange rates when there is a period of credit involved (as there almost always is). For example if an exporter sells goods to the USA for US$57,600 when the exchange rate is US $1.6 to RWF1, he would expect to earn RWF36,000 from the sale.
However if the customer is allowed credit of three months and the exchange rate alters to US $1.8 to RWF1 in this time, the eventual income would be only RWF32,000, which is RWF4,000 less than expected.
Forward Exchange Rate
The risk inherent in foreign exchange dealings can be overcome by entering a forward exchange contract which involves an importer/exporter in buying or selling a specified amount of foreign currency, at some specified date in the future, and at an agreed and fixed rate of exchange to be determined when the contract is established. Under these arrangements therefore, the importer/exporter can lock in to a certain financial outcome and does not have to live with the uncertainty of not knowing what spot rate may prevail on the date of the anticipated transaction, thereby remaining unsure of the financial consequence of the transaction itself. The Forward Exchange Rate is derived by adjusting the spot rate (ie the rate prevailing on the day when the contract is made) by the interest rate differential which exists between the two currencies. It always remains possible however that an importer/exporter who enters into a Forward Rate agreement, may discover that s/he would have been better off to have completed the transaction at the eventual spot rate on the date set for final payment.
Forward Exchange Contracts
These are contracts entered into with a financial institution to reduce the risk associated with foreign currency transactions. An organisation can guarantee the domestic currency value of a future foreign currency receipt or payment. The rate agreed is essentially the spot rate as adjusted by a premium or discount to allow for the differential in the interest rates between the economies of the two relevant currencies.
Interest Rate Options
Organisations with debt commitments will have to pay interest thereon. They may have negotiated a fixed or variable rate of interest. However, such an organisation may wish to purchase an option to vary the basis of their interest rate exposure at/by a future date. This is known as an interest rate option.
An example would be in times of falling interest rates, an organisation presently paying interest at a fixed rate may wish to exercise the interest rate option in order to pay interest at the lowering variable rate
Interest Rate Parity Theorem
The Interest Rate Parity Theorem essentially says that differences in forward and spot rates of exchange are caused by differences in interest rates in the economies in question. This may be summarised as follows:
(1+r$) / (1+rRWF) = (For rate $ to RWF) / (Spot rate $ to RWF)
Under the terms of this relationship therefore, only a divergence between interest rates in the $ and RWF economies will cause a difference to occur between the forward and spot rates. Specifically, if interest rates are higher in the domestic country than in the foreign country, then the foreign country’s currency will sell at a premium in the forward market. If on the other hand, interest rates are lower in the domestic country, then the foreign currency will sell at a discount in the forward market.
Interest Rate Swap
An interest rate swap arises where two parties (usually two firms) agree to exchange interest repayment commitments on existing loans. This would often involve a situation where one company with fixed rate interest commitments might wish to change to floating rate interest commitments, and it would therefore seek out a counter-party with the correct fit. Swaps are usually arranged by banks on behalf of client companies. Despite the fact that a Swap might e arranged, both parties retain legal responsibility for the cost of servicing the original loans taken out.
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 betas. In terms of an influence on a companies beta, 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.
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 investor 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.
A Value Gap refers to a situation where the publicly quoted price for a company’s ordinary share differs from the value which might be attributed to that share based upon one of the conventional share valuation models (e.g. fundamental share valuation of price = d/r, P/E basis , or free cash flows). Value gaps can arise in cases where a particular economic significance might be attached to information about the business and its operations (e.g investment in brands, new technologies, know how etc), but where capital markets are sufficiently information inefficient to allow the significance remain concealed. In such cases investors on the capital market remain unaware of the underlying economic potential of a particular company and so its share price might remain unduly low. Value gaps can also arise in circumstances of poor “corporate parenting” where a business may simply be badly managed thereby allowing a potential predator to believe that the company, under new and improved management could be made to perform more profitably. In these circumstances the predator could be motivated to make a take-over offer for the company in question at a price in excess of the share’s publicly quoted market price. This would be done in the belief that such a Value Gap will be more than adequately redeemed by way of an improved operating performance.
A Venture Capitalist, as the name suggests is an organisation which provides finance for new and developing businesses. Venture Capitalists typically take the form of a department of an established financial services organisation or as private asset management experts e.g. Hibernia Capital Partners.
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”.
A classic example of a successful Venture Capital backing would be Cisco Systems, a Californian based internet infrastructure provider, the most successful global company in its field.