3 dangers of over-reliance 1. If discounts are being foregone, the effective cost of this should be evaluated.
on trade credit as a 2. If the company gains a reputation for slow payment this can damage its
source of finance credit standing and it may be difficult to obtain credit from suppliers in the
future.
3. Suppliers who are having to wait for money may seek recompense in other
ways.
4. Suppliers may place the company “on stop” until the account is paid
significance of trade The net working capital of a business can be defined as its current assets less it
payables in a firm’s current liabilities. The management of working capital is concerned with
working capital cycle ensuring that sufficient liquid resources are maintained within the business. For
the majority of businesses, particularly manufacturing businesses, trade
payables will form the major part of the current liabilities figure. It follows that
the trade credit period taken will be a major determinant of the working capital
requirement of the company. A link can also be made between working capital
and liquidity by means of the cash conversion cycle. This measures the length of
time that elapses between a firm paying for its various purchases and receiving
payment for its sales.
How the ‘’profitability Objective is the maximisation of total NPV of the chosen projects cash flows at
index’’ can be used when the cost of capital. Use the PI ratio to rank projects to enable the optimum
a company faces a combination to be undertaken. The ratio indicates which investments make the
problem of capital best use of the limited resources available. The project with the highest PI will
be selected first and projects will continue to be selected on this basis until the
rationing
supply of capital is used up (Divisible, non deferrable and non repeatable
projects only)
Raise fund through Debt is cheaper than equity due to the lower risk and the tax shield therefore
corporate bond issue -> initially adding debt to the capital structure should reduce the overall WACC
impact on WACC compared to an all equity company. At low levels of gearing investors do not
react to the addition of debt. As gearing rises investors start to get concerned
about the risks of bankruptcy and as they perceive the increase in the financial
risk then they respond by demanding a higher return on equity. This starts to
increase the overall WACC and as gearing goes above 50% the WACC will
increase rapidly as equity investors get nervous. Many could sell their shares,
leading to a lower market value and thus an even higher gearing level. There is
an optimal point at which the WACC is lowest but there is no empirical or
theoretical way to find this – companies have to do it by trial and error. There
are norms by industry and over time but this changes.
Discount rate in appraisal The discount rate represents the cost of capital for the project and should
reflect the cost of the funds used to make the project investment
Use WACC as DR for It is appropriate to use the company WACC to appraise the project if the
project Business risk is the same. Financial risk is the same. The project is marginal in
relation to the overall size of the company.
Ordinary shares Ordinary shares Owners of the company Normally 1 share carries 1 vote
Rights of shareholders Entitled to receive the annual report Entitled to participate in the business
through voting at AGMs Entitled to receive a dividend if one is declared
Entitled to a share of the residual net assets of the organisation in the event of
a liquidation
Stock exchange in helping Stock exchanges have 2 key functions
companies to raise Primary market – to allow companies to raise funds
finance Secondary market – to allow shareholders to buy/sell shares
By offering an exit route the existence of the exchange encourages investors
to buy as they can get out if their risk preferences change or if the performance
of the company changes MN10311 May/Jun 2016 Suggested Solutions 6
The stock exchange provides a place where buyers and sellers can be matched
without an investor having to find an individual who wants to buy what they are
selling – it is thus an efficient way to trade
The stock exchange provides transparency of price – all are able to see the
, price at which shares are trading
The stock exchange encourages investment providing and easy and cost
efficient way for investors to make investments
The regulations on the stock exchange give confidence to the investor that
they are not going to be scammed and therefore they are more willing to invest
Stock markets make investment more efficient =- allocation efficiency,
information efficiency, transaction efficiency, operating efficiency
All of the above give the investor confidence and enable them to invest
at the lowest cost with maximum safety
P/E ratio P/E ratio is the price to earnings ratio and it compares the market value of a
and relationship with share to the earnings per share. The P/E ratio for companies in a sector tend to
market value of a share be similar and if a company has a higher P/E ratio that its competitors this
indicates that the market has confidence in this company as they are prepared
to pay a higher price now in expectation of greater earnings in the future.
Clientele effect The clientele effect is due to investors looking for a particular type of return
and rela with market clustering around companies that offer the return they are looking for – income
value of a share or capital.
Shareholders actively prefer a particular type of return e.g. high dividends and
hold shares in companies which offer a high pay-out.
Capital growth companies retain their profits and reinvest.
A company that has a history of one or the other may lose investors if they
change policy
Investors will sell their shares and these sales will drive down the share price.
Efficient Market Market efficiency evolved from perfect competition which assumed perfect
Hypothesis knowledge. Information is historic, current or forecast and information will
cause shifts in price. The better the information and the more its impact on
price is understood the better the market value will be as it will reflect the true
underlying value of the company. Insiders will have better knowledge of the
company that investors and institutional investors are normally better informed
than individuals. This inequality in information is known as “information
asymmetry”.
The EMH offers 3 states – weak, semi-strong and strong. As efficiency improves
it gets harder to earn abnormal profits – competition between well informed
investors reduces the opportunities for profitable speculation and share prices
tend to intrinsic values.
Theoretical arguments The theoretical issues are concerned with whether or not the value of a
whether varying the company may be increased by changing the proportions of debt and equity in
proportions of debt of its capital.
equity in a company’s Shareholder wealth is based on the MV of the company, which is based on the
MV of the future cash flows discounted at the company’s cost of capital. If the
capital will affect value of
company can minimise the cost of capital they can maximise the MV.
company
M&M no tax stated that the MV of the company was based on earnings and
therefore would not change whatever mix of equity and debt was used.
M&M with tax said that because of the tax shield the more debt you introduced
into the capital structure the better and so the best position would be 100%
debt.
The modern traditionalists say that because debt is cheaper then some debt
will lower the overall cost of capital. Initially equity holders will be relaxed
about the addition of a small proportion of debt so they will not require a
higher return. As debt increases however they will get nervous and equity
required returns will go up. Initially they will go up slowly but as debt
proportions increase and the risk of financial distress increases at higher levels
of debt, the increase in the return required by equity will go up faster than the
debt will reduce the cost and so the WACC will increase again. The
traditionalists believe there is an optimum debt equity mix which minimises
debt but there is no formula to find this point.
on trade credit as a 2. If the company gains a reputation for slow payment this can damage its
source of finance credit standing and it may be difficult to obtain credit from suppliers in the
future.
3. Suppliers who are having to wait for money may seek recompense in other
ways.
4. Suppliers may place the company “on stop” until the account is paid
significance of trade The net working capital of a business can be defined as its current assets less it
payables in a firm’s current liabilities. The management of working capital is concerned with
working capital cycle ensuring that sufficient liquid resources are maintained within the business. For
the majority of businesses, particularly manufacturing businesses, trade
payables will form the major part of the current liabilities figure. It follows that
the trade credit period taken will be a major determinant of the working capital
requirement of the company. A link can also be made between working capital
and liquidity by means of the cash conversion cycle. This measures the length of
time that elapses between a firm paying for its various purchases and receiving
payment for its sales.
How the ‘’profitability Objective is the maximisation of total NPV of the chosen projects cash flows at
index’’ can be used when the cost of capital. Use the PI ratio to rank projects to enable the optimum
a company faces a combination to be undertaken. The ratio indicates which investments make the
problem of capital best use of the limited resources available. The project with the highest PI will
be selected first and projects will continue to be selected on this basis until the
rationing
supply of capital is used up (Divisible, non deferrable and non repeatable
projects only)
Raise fund through Debt is cheaper than equity due to the lower risk and the tax shield therefore
corporate bond issue -> initially adding debt to the capital structure should reduce the overall WACC
impact on WACC compared to an all equity company. At low levels of gearing investors do not
react to the addition of debt. As gearing rises investors start to get concerned
about the risks of bankruptcy and as they perceive the increase in the financial
risk then they respond by demanding a higher return on equity. This starts to
increase the overall WACC and as gearing goes above 50% the WACC will
increase rapidly as equity investors get nervous. Many could sell their shares,
leading to a lower market value and thus an even higher gearing level. There is
an optimal point at which the WACC is lowest but there is no empirical or
theoretical way to find this – companies have to do it by trial and error. There
are norms by industry and over time but this changes.
Discount rate in appraisal The discount rate represents the cost of capital for the project and should
reflect the cost of the funds used to make the project investment
Use WACC as DR for It is appropriate to use the company WACC to appraise the project if the
project Business risk is the same. Financial risk is the same. The project is marginal in
relation to the overall size of the company.
Ordinary shares Ordinary shares Owners of the company Normally 1 share carries 1 vote
Rights of shareholders Entitled to receive the annual report Entitled to participate in the business
through voting at AGMs Entitled to receive a dividend if one is declared
Entitled to a share of the residual net assets of the organisation in the event of
a liquidation
Stock exchange in helping Stock exchanges have 2 key functions
companies to raise Primary market – to allow companies to raise funds
finance Secondary market – to allow shareholders to buy/sell shares
By offering an exit route the existence of the exchange encourages investors
to buy as they can get out if their risk preferences change or if the performance
of the company changes MN10311 May/Jun 2016 Suggested Solutions 6
The stock exchange provides a place where buyers and sellers can be matched
without an investor having to find an individual who wants to buy what they are
selling – it is thus an efficient way to trade
The stock exchange provides transparency of price – all are able to see the
, price at which shares are trading
The stock exchange encourages investment providing and easy and cost
efficient way for investors to make investments
The regulations on the stock exchange give confidence to the investor that
they are not going to be scammed and therefore they are more willing to invest
Stock markets make investment more efficient =- allocation efficiency,
information efficiency, transaction efficiency, operating efficiency
All of the above give the investor confidence and enable them to invest
at the lowest cost with maximum safety
P/E ratio P/E ratio is the price to earnings ratio and it compares the market value of a
and relationship with share to the earnings per share. The P/E ratio for companies in a sector tend to
market value of a share be similar and if a company has a higher P/E ratio that its competitors this
indicates that the market has confidence in this company as they are prepared
to pay a higher price now in expectation of greater earnings in the future.
Clientele effect The clientele effect is due to investors looking for a particular type of return
and rela with market clustering around companies that offer the return they are looking for – income
value of a share or capital.
Shareholders actively prefer a particular type of return e.g. high dividends and
hold shares in companies which offer a high pay-out.
Capital growth companies retain their profits and reinvest.
A company that has a history of one or the other may lose investors if they
change policy
Investors will sell their shares and these sales will drive down the share price.
Efficient Market Market efficiency evolved from perfect competition which assumed perfect
Hypothesis knowledge. Information is historic, current or forecast and information will
cause shifts in price. The better the information and the more its impact on
price is understood the better the market value will be as it will reflect the true
underlying value of the company. Insiders will have better knowledge of the
company that investors and institutional investors are normally better informed
than individuals. This inequality in information is known as “information
asymmetry”.
The EMH offers 3 states – weak, semi-strong and strong. As efficiency improves
it gets harder to earn abnormal profits – competition between well informed
investors reduces the opportunities for profitable speculation and share prices
tend to intrinsic values.
Theoretical arguments The theoretical issues are concerned with whether or not the value of a
whether varying the company may be increased by changing the proportions of debt and equity in
proportions of debt of its capital.
equity in a company’s Shareholder wealth is based on the MV of the company, which is based on the
MV of the future cash flows discounted at the company’s cost of capital. If the
capital will affect value of
company can minimise the cost of capital they can maximise the MV.
company
M&M no tax stated that the MV of the company was based on earnings and
therefore would not change whatever mix of equity and debt was used.
M&M with tax said that because of the tax shield the more debt you introduced
into the capital structure the better and so the best position would be 100%
debt.
The modern traditionalists say that because debt is cheaper then some debt
will lower the overall cost of capital. Initially equity holders will be relaxed
about the addition of a small proportion of debt so they will not require a
higher return. As debt increases however they will get nervous and equity
required returns will go up. Initially they will go up slowly but as debt
proportions increase and the risk of financial distress increases at higher levels
of debt, the increase in the return required by equity will go up faster than the
debt will reduce the cost and so the WACC will increase again. The
traditionalists believe there is an optimum debt equity mix which minimises
debt but there is no formula to find this point.
