Finance In class test

Ordinary (equity) share capital can be raised in the following ways:

Ordinary (equity) share capital can be raised in the following ways: Private subscription: Shares are subscribed by a small number of individuals privately and are most common across private limited companies. Public issue: listed or listing companies on and shared are offered directly to the public through a prospectus, which contains information in line with Stock Exchange/Companies Acts requirements. The issue may either be at a fixed price or involve tendering. (reserve price and striking price are set. Private placing: Shares are placed with financial institutions that will either sell them or hold them as an investment - The approach is often used for relatively smaller capital amounts or when companies come to the stock market for the first time Rights issue: - Existing shareholders are given the right to buy an allocation of shares (e.g. 5 for each 100 held) at a price slightly below current market price - The 'right' may either be exercised by buying the shares allocated or sold for someone else to exercise. (you can sell the right to buy the 5 more or you can buy the 5) Bonus issue: - Not a method to raise new capital; but to make more existing capital (reserves) permanent (ordinary shares), moves cash around.

Profitability index

PI = Profitability index When dealing with capital rationing, NPV can be used to calculate profitability index - which is NPV per £ of initial capital outlay. Profitability index = NPV / initial investment When faced with capital rationing, a profit-maximising company should choose its projects in order of PI, provided the projects are divisible. It says that we can do a certain percent of a project and don't have to do the full thing. You will pick the project with the most profitability per pound investment. Weight average profitability index = WAPI LOOK AT EXAMPLE IN NOTES but shows that all the money if invested should be invested in to which projects

Payback period

Payback period = the length of time it will take for cash inflows to cover the initial investment outlay. Since it is a cash flow model it is far less manipulated than profits. Can be easily calculated by working out the cumulative net cash flows for each project. Method can be modified to accept discounted cash flows to give the discounted payback period (see 'Discounting' on later slides) Decision rule: - Accept project if the payback period is within the company's target payback period - Choose project with the shortest payback period However it only takes into accounts how to payback the investment but ignores everything after that point and ignores all extremes. Ignores the returns and liabilities after.

Inflation: nominal vs real:

Real cash flow projections: project future volumes, but at current prices Nominal cash flow projections: project future volumes, at expected future prices (= current prices increased for inflation) - Use nominal discount rate to discount nominal cash flows. - Use real discount rate to discount real cash flows (i.e., cash flows at today's prices) - Both should give the same answer (1 + r nominal) = (1 + r real) x (1 + inflation rate) This can be used to calculated real percentage which is used to convert nominal to real.

Cost of retained earnings:

Retained earnings are readily available funding for the business which we have characterised as equity, internal and long term. Retained earnings should NOT be regard as a cost-free form of financing, retained on behalf of the equity shareholders. Cost of retained earnings = cost of equity, ke. (Although a practical difference is the absence of issue costs)

Shares

Share Capital - Ordinary (or "Equity") Shares: Essential for limited companies Holders are entitled to all the final profits after other claim holders have received their due (e.g., debt interest and preference dividends) Holders are also last in the order of assets claim in the event of business liquidation Holders have voting rights Note (recall): no legal obligation for companies to pay ordinary dividends Share Capital - Preference Shares: Holders usually receive a fixed level of dividends ahead of ordinary holders (2% preference shares, preference dividends get paid first ahead of equity shares, they are preferred, behind debt providers in queue to be paid back) Also given priority over the claims of ordinary shareholders in the event of liquidation Holders do not usually have voting rights Different forms: - "Standard" - Cumulative - Participating (if the company does particularly well they may get extra dividends but there is a limit. - Convertible (may change its nature) - Redeemable (infinite and some are repayable.

Shareholders and directors and therefore agency theory

Shareholders and directors: Separation of ownership and control - Considering, particularly, public companies with diverse shareholder groups Shareholders are the owners of the company: - Profits and gains accrue to them, Via dividend and capital gain - Losses are borne by them, up to the amount invested Management is delegated to directors - May be appointed/removed by shareholders - May themselves be shareholders - A board of directors may comprise both executive and non-executive (independent outside) directors Agency Theory: 'We define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.' (Jenson and Meckling) For example: an estate agent, a solicitor, a manager

Primary objective

The primary objective of a firm's financial management is to maximise the wealth of its shareholders. (standard economics and neoclassical paradigm of objectives for firms) Are the needs of shareholders superior to the other stakeholders? What about the needs of other stakeholders? (they are all connected and therefore if you want to maximise wealth you have to consider the other stakeholders for example treating workers well will make them more productive)

Modigliani and Miller

They made 9 assumptions to simplify the points down to a mathematical approach of the world by taking out the complexities. Explicit and implicit assumptions: 1. Capital markets are frictionless (untrue but not too bad - doesn't make too much difference) 2. Individuals can lend/borrow at the risk-free rate (half true because you can lend sudo risk free but not borrow) 3. There are no costs to bankruptcy [BSL] (force to sell everything, no long term partnering, tendency of firms to gamble their way out ) (big one which affects modigliani and millers theory) 4. Firms issues only two types of claims: risk-free debt and (risky) equity (preference shares,multiple types of debt and funding - half true because equity is risky but debt is not risk free - not too important) 5. All firms are assumed to be in the same risk class [BSL] (type of business they are in and lots of different sectors - not too important) 6. Corporate taxes are the only form of government levy (not true, types of tax and import duties (very untrue but can get around it) 7. All cash flow streams are perpetuities (i.e., no growth) (not true because firms go through periods of success) 8. Corporate insiders and outsiders have the same information (i.e., no signalling opportunities) 9. Managers always maximise shareholders' wealth (i.e., no agency costs) (taking out agency theory and therefore not true.)

Constant dividend growth model

This is where the dividends are growing by a constant g. SHOULDNT BE ON INCLASS TEST BUT: Ke = d1/S0 + growth Ke = d0 (1+g)/ S0 + growth

Capital structure

To the provider of finance, the risk of debt is less than risk of equity and thus the cost of debt is lower than the cost of equity. Traditional view is that there is some optimal capital structure (minimum WACC) at finite leverage. Market value of debt, B divided by the value of equity, s. Market value of debt, b divided by the total value which is debt and equity. Alternatives instead of market values may be book values (balance sheet approaches). On finance course we will look at market value. Which uses D, E and I Approaches/ideas: 1. Traditional (discursive) 2. Pecking order (discursive) 3. Modigliani and Miller (theoretical, algebraic)

Agency theory

We define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf. Characterisation of the setting (key info): 1. Asymmetric information (agent and principal have different information sets. The agent knows more about the details and setting than the principals.) 2. Bounded rationality (no matter how hard the agent tries, they have restricted resources, time, and perfect data) 3. Moral hazard (opportunity of the agent to act unobserved by the principal, some things can't be seen by the principal, and therefore self interested behaviour can slip in unnoticed) Agency costs: - Contracting costs - audit - monitoring - bonding - residual loss Industry cares massively about agency costs and you want to reduce them as much as you can to reduce the total costs. Shareholder control mechanisms: Calling for and voting on corporate resolutions • The shareholders may resolve to appoint/remove directors • The directors in turn select the management team • Competition in the managerial labour market may force directors / managers to perform in the best interests of the shareholders, otherwise they will be replaced. (constant turnover causes incentive to do well.

Components of rate of return

What is in a rate of return? Three components - Pure time preference (always) (Price of time, risk free rate) - Inflation (nominal rates) - Risk (volatility, risk return trade-off) Three components would be a nominal, risky loan. Most rates have all three components. There are no truly risk free investments or projects. Sudo risk free is as close to being risk free as you can. On sudo risk free projects you can drop the risk premium. Sudo free is when you lend money to the sovereign governments which are stable. They will always be able to payback and they are willing to because it would cause an economic crisis. Pure time preference shows us that there is a reduced investment opportunity set because some opportunities have been lost when you get the money back.

What does β measure in the capital asset pricing model:

β measures SYSTEMATIC RISK which is the sensitivity of returns on the asset to changes in returns on the market portfolio. May be positive, zero or negative If the asset is a share, the returns and risk will change. If things go well for our share in comparison to the entire market. Sources of systematic risk have economy-wide effect but that does not mean they affect every firm to the same extent. Sources of non-systematic risk impact on particular firms. Systematic risk: changes in any policy Non systematic risk: loss of key staff, non general strikes

Debt, equity risk/return

• From the investor perspective - Debt is less risky; kd is a return - Equity is more risky; ke is a return - kd is lower than ke (A standard risk/return association) • From the company perspective - Debt is more risky; kd is a cost of capital (Increased financial risk and stress, insolvency) - Equity is less risky; ke is a cost of capital (if things go wrong, don't have to pay dividend) - So, a trade off: debt is cheaper but more risky (topic 4) The cost of equity share capital may be approached via various methods, includings: Dividend valuation models - The constant dividend model - The constant dividend growth model • The capital asset pricing model (CAPM)

International capital budgeting decisions

• International capital budgeting decisions, e.g. foreign direct investment (FDI), joint ventures etc. Complexities: - Exchange controls: project cash flows ≠ parent cash flows - Intercompany transfer of assets and profits - Exchange rate fluctuation where cash flows are in foreign currency. - Differential tax rates: project tax outflows ≠ parent tax outflows - Political risk - Cannibalisation The investment decision principle remains the same: invest if the (foreign) project increases shareholders' wealth. • i.e., invest if NPV (properly discounted) > 0 International project should only be evaluated based on the parent's cash flows Exchange controls - restrictions placed by host countries on foreign-owned local companies to remit profit/fund to their parents • In the absence of exchange controls, the parent's CF ≈ project's CF • In the presence of exchange controls, the parent's CF ≠ project's CF

Stakeholders

A Stakeholder is a person or organisation to which some extent relies upon the business; and upon whom to some extent the business lies. Investors/owners (how well have business/managers performed? Should we invest?) Lenders (Should we lend money to this organisation? Bank, they want money back and interest) Suppliers/creditors (Are we going to get our money back?, supply goods for money in the future) Employees (How can we secure our jobs?) Customers (Will they be around to serve me in the future?) Government (How much tax should they be paying?) The public (How socially responsible are they?) Managers (What decisions to make?, what requires a decision?

APR and EAPR:

APR is the annual percentage rate which is simply the rate per period multiplied by the number of periods in a year. For example, a monthly-applied interest rate of 0.5% would imply and APR of 6%. Effective annual percentage rate (EAPR) or effective annual rate (EAR) considers the impact of compounding or discounting more frequently than annually. So, the monthly-applied interest rate of 0.5% would imply an EAPR of: This is from a monthly rate to a yearly rate. (1 + 0.005)^12 - 1 = This one is from yearly to monthly: 12 sqrt 1+0.005

ARR evaluation (Evaluation of the four techniques)

ARR evaluation: Advantages: • Simple to understand and easy to calculate • Popular and similar to ROCE Disadvantages: • It does not consider the time value of money • Uses accounting profits (instead of cash flows) which are susceptible to arbitrary and opportunistic adjustments by management • Relative measure (%) and hence ignores the relative size of competing projects

Further NPV

Ability to accurately predict the timing, direction and magnitude of future cash flows. Ability to accurately calculate the appropriate discount rate. NPV analysis may give a conservative PV since all cash flows are deemed to occur at the end of discounting periods. (we assume it arrives at the end of the year and give it full discounting thus it is conservative.) Shortcuts to discounting long streams of the same periodic amount of cash are available, re: annuities and perpetuities The appropriate discount factor depends on whether the cash flows are projected including or ignoring inflation (nominal vs real discount rates) Use nominal discount rate to discount nominal cash flows Use real discount rate to discount real cash flows.

Accounting rate of return

Accounting rate of return = (Average annual profit)/(average investment) and that times 100. Average annual profit can be calculated by taking the total profit divided by the number of years and then the average investment can be calculated by taking the initial investment and adding the residual value and dividing by two. The ARR decision rule is: - Accept a project if its ARR ≥ company's target ARR -Accept the project with the highest ARR (when deciding between projects)

IRR evaluation (Evaluation of the four techniques)

Advantages: • Incorporates the time value of money into calculation • It takes all cash flows into consideration • It uses cash flows instead of accounting profit Disadvantages: • Relative measure (%) and hence ignore the absolute values of payoff • Multiple and indeterminate IRRs are possible - and NPV has to come to the rescue (see Part 2 (D)) • Inherent logic may be difficult to justify and hence explained to non-financial managers

NPV evaluation (Evaluation of the four techniques)

Advantages: • Incorporates the time value of money into calculation • It takes all cash flows into consideration • It uses cash flows instead of accounting profit • It considers projects in absolute terms (instead of %) and the NPV obtained reflects the effects of the projects on shareholders' wealth Disadvantages: • The NPV concept may not be easily explained to non-financial managers

Payback Period (Evaluation of the four techniques)

Advantages: • Simple to understand and easy to calculate • Useful when rapid recovery of investment is important Disadvantages: • It does not consider the time value of money - But this can be remedied by the use of the discounted payback method. • It ignores all cash flows beyond the payback point • It provides little useful information other than the speed of fund recovery

Annuities and Perpetuities

An annuity means receiving the same cash flow each and every period, starting one period hence, for a finite number of periods. Finding the present value of an annuity by discounting each and everyone of its cash flows would be very time consuming and boring. So you do cash flow multiplied by this: (1/r) x ( 1- (1/(1+r)^n)) Perpetuities A perpetuity means receiving the same cash flow each and every period forever, starting one period hence. Cash flow multiplied by 1/r.

Capital investment decision

Are long term, substantial capital decisions and basically question whether you should invest in a project or not. (also known as capital budgeting decisions or investment appraisal decisions)

Weighted average cost of capital (WACC)

Companies are funded by a variety of different sources of finance • Different type of finance have different costs of capital • WACC calculates the value weighted average cost of capital to the business overall If the company's projects/activities deliver a return which exceeds its WACC, then firm value is increased and shareholder wealth is increased Therefore, WACC is commonly used as a hurdle rate in new project appraisal Conditions for WACC: Which is appropriate if funding, investing in and completing the project does not affect the company's overall. You take proportion of the total value for that share or whatever and then times that by the cost of the capital to give you a percentage which you add on to the others.

Debt vs equity advantages disadvantages

Companies must balance the advantages and disadvantages of using debt finance, e.g.: - Cheaper cost of debt capital (as compared to equity) (year by year servicing cost on debt is cheaper) - Tax deductibility of debt interest payments (paying debt interest is tax deductible making it cheaper) - Increased financial risk (increased risk with debt) - Increased risks of financial distress and insolvency (we have to pay the interest back on debt and if there is a rough time with trading it can cause massive problems.)

capital asset pricing model:

Cost of equity = risk free rate of interest + the equity beta of the share times (the expected return on the market portfolio minus the risk free rate of interest. Rf is the same for any economy or share and therefore the only variable which varies from share to share is the beta which is the one which gives different kes.

Compounded/discounted more frequently than anually

Discounting can occur more frequently than yearly = r is annual ... - Half-yearly rate = r/2 - Quarterly rate = r/4 - Monthly rate = r/12 There is then an effective annual rate which higher than the 'headline' annual percentage rate - Sums will grow faster if compounded more frequently than annually - Sums will diminish faster if discounted more frequently than annually As you change the discount period you must increase the amount of periods.

Discounting

Discounting: (discount value = rate) = PV = FV x (1/(1+r)^n) E.g. The present value of £5,000 to be received in 5 years' time with a prevailing interest rate of 10%: PV = £5,000 × . = £5,000 x 0.621 = £3,105 This shows us that getting money now is more valuable than getting money later. Future cash flows need to be discounted in order to take into account the opportunity cost of an investment (OCI) - funds used in one project could have been used elsewhere, they are also costly because the returns you compensate for what you could have made elsewhere. It has to include risk tho.

Cost of capital:

Each category is confronted with a different type of risk ... and each requires a different rate of return. The rate of return required (demanded) by each category of investor/lender is the cost of that type of capital to the business. Equity providers face higher risk and therefore demand a higher return. Debt providers face lower risk and therefore demand a lower return. Each projects net cash flow earnings, on risk adjusted basis, must be enought to: Pay investors expected rates of return Repay the principal amount of originally provided Increase the wealth of shareholders Overall cost of capital is the minimum risk-adjusted rate of return that a project must make in order to be acceptable to shareholders.

Debt versus equity:

Equity: the right to participate beyond an pre-defined limit in distributions. You get whatever is left over, could be nothing but could be anything. Debt does not have the right to participate beyond any predefined limit in distributions. No matter how much is left you get everything.

Modigliani and Miller propositions from their assumptions:

First about value, second about cost of equity, third about weighted cost 1 = Value = Net operating income times (1 minus the corporation tax rate), divided by rho (cost of equity of the firm) if there is no debt in the finance. Plus (B the market value of debt times the tax rate) 2 = Cost of equity = rho + (1-tax rate) (rho - cost of debt) (market value of debt over market value of equity) (linear relationship between amount of debt in the structure and cost of equity) 3 = WACC (weighted cost) = rho (1-tax times debt as proportion of all finance) (subtracted after it is multiplied) NOTES

Rights issue versus bonus issue

For existing shareholders, offer them the right to acquire new shares, which will be allocated in proportion to existing shareholdings (e.g., 1 new share for 4 existing shares) Right to acquire shares itself has a value and can be sold Shareholders decide whether to take up the rights (additional investment) or sell the right to acquire new shares (income) Control of existing shareholders is not diluted if they take up the offer Relatively cheap (although still expensive for large firms) and straightforward; with high chance of success since appealing to existing shareholders (still has costs with telling people about the offerents) Usually offers shares at a discount to current market price, which makes the offer seem attractive but may not be Bonus or Scrip Issue • Provide new shares to existing shareholders, in proportion to existing shareholdings BUT shareholders don't pay (moves retained profits into share capital) moves something from potentially being long funding to definitely long funded. • New ordinary shares are "funded" by a transfer from reserves • So a bonus issue is not a way to raise additional capital • It is a way to switch part of the owners capital (reserves) to permanent capital

Four techniques for investment appraisal

Grouped in two pairs: Those that ignore the time value of money (including risk) - Accounting rate of return (ARR) - Payback period (PP) Those that consider the time value of money (including risk) - Net present value (NPV) - Internal rate of return (IRR)

IRR graphs

IN LECTURE SLIDES

Value of the firm

In finance, the value of the firm, V, is the total value of all the financing: Value of equity Value of other shares Value of debt In simple terms, the value of equity (S) plus the value of debt (B) V = S + B And value is NOT as per the numbers in the financial accounting balance sheet, but market (true) value

Corporate governance

In simple terms, concerns the way in which companies are directed and controlled. Narrow view - Focuses on the relationship of the company and its shareholders - Traditional finance paradigm; expressed in agency theory Broader view - More inclusive - Considers a web of relationships between the company and a range of stakeholders Importance of corporate governance: -CG has attracted considerable attention over recent years, in the light of corporate scandals in the USA and Europe - new regulation

Different types of business entity

In the national economy there are two different types of business entities. The profit making sector and the non profit making sector. The profit making sector is all manufacturing businesses such as sole trades, partnerships and companies. The non profit making sector is all economic sectors, the central government, the local government, social organisations and the quasi government. Sole proprietorship = unlimited liability Partnership = Jointly and severally liable. Company = limited liability

Sources of finance

Internal - funds that are generated within the firm: without obligations and relatively cheaper to obtain External - funds that are obtained from external parties (individuals and institutions): usually with conditions attached, and more costly to obtain. Sources of finance internal: Short term is the efficient working capital management Retained profit: reinvestment of profits to fund growth Advantages: • no additional costs • no annual interest cost • no obligations created with outside parties beyond that implicit with the shareholders (shareholders will demand a return but there is no specific annual return.) Disadvantages: • mismatch between the growth of funds internally and the investment opportunities (when you have funds you may not want to invest) • some shareholders and other owners rely upon dividends or drawing as a main source of income • potential adverse impact on the stock market's perception of the company Advantages of debt factoring: Leave credit management to specialists Convenient and free up staff for more profitable activities Insure against bad debts for non-recourse factoring Ease cash flows Disadvantages: Expensive factoring fees and interest charges Loss of management of customer database/interface (less connection with customers)

Internal rate of return (IRR)

Internal rate of return is the discount factor which gives you 0 NPV. - Have to make an estimate - Another discounted cash flow method of investment appraisal - IRR is the yield earned on an investment over the course of its economic life Decision rule: Accept project if IRR ≥ company's cost of capital - Accept project with the highest IRR Formula: IRR = r1 + ((NPV/(NPV1 - NPV2)) x (r2 - r1)) r1 = discount rate which gives a positive NPV1 r2 = discount rate which gives a negative NPV2 On this unit the difference between r1 and r2 can't be larger than 10%

Constant dividend model (preference shares aswell)

Ke = D/S0 Cost of equity = Ke Dividend = D Share price right now with paid dividend = S0 Cost of preference shares: (constant dividend model is most appropriate - assumes preference shares are perpetual) Same equation but P0 instead of S0

NPV

LOOK AT FORMULA AND EXAMPLE IN NOTES - TOPIC 1 Net present value (NPV): - Discounted cash flow method of investment appraisal - It involves discounting all relevant cash flows to their present value - The sum of all present values less the initial costs gives the net present value (NPV) Decision rule: - Accept project if NPV > 0 - Accept project with the highest NPV The further into the future you get the less the pound is worth which is shown with the decreasing PV factors. Add all the present values to get NPV.

Sources of financing:

Long term: Ordinary and preference share capital Reserves: retained profits and other reserves Long term loans / bonds (secure or unsecured; fixed or variable interest rates) Medium term; bank loans (usually for a specific project; security usually required) leasing / hire Purchase Short Term: Bank Overdraft (bank can request money back whenever they want) Factoring and invoice discounting Trade creditors

Time value of Money

Looks at interest and compound interest. Intuition: 1 pound today will be worth more than a pound in the future. Savings account will give you the right interest. Compounding: FV = PV × (1 + r)^n where FV = future value, PV = present value, r = interest rate per period, n = number of periods E.g. Investment of £100 @ 10% for 5 years gives: FV = 100 × 1 + 0.10 = 100 x 1.6105 = £161.05

Wealth vs Profit

Maximising Profit is a short term objective and does not focus on cash generation. Does not consider either timing or risk. Maximising wealth is a longer term and overriding objective, and is properly focused on cash flows and considers timings and risk.

Other cooperate objectives other than maximising wealth

Maximize profit Achieve a 'satisfactory' level of profits (= 'satisficing') Maximize sales Achieve a target market share Minimise employee turnover Maximise managerial income/prestige Technical innovation Limit environmental damage Provide gainful employment Contribute to society None of these should be pursued in isolation without serving a wealth maximisation objective. A combination of them can be used as tactics.

OCI

OCI = Opportunity cost of Investment The OCI is also known as the 'minimum required rate of return', 'project cost of capital', or 'discount rate'.