Ch 6 - Theory of Finance

Question 1

Types of Mergers

Answer 1

Horizontal
Vertical
Conglomerate

Question 2

The financial manager will need to consider two basic issues

Answer 2

Capital budgeting decision

Financing decision

Question 3

Capital budgeting decision

Answer 3

Considers the choice of projects, and hence real assets, in which the firm should invest

Mainly the remit of the controller/CFO

Complicated in practice because:

May be more than one apparently profitable project

Very difficult to estimate the future profitability of a project

Question 4

Financing decision

Answer 4

How to best raise the required finance

Mainly the responsibility of the treasurer who:
Looks after the company’s cash
Raises new capital
Maintains relationships with banks, shareholders and other investors

Question 5

Investment in fixed capital, however, often involves complex decisions between

Answer 5

Alternative capital assets
Dates of commencement
Methods of financing

Question 6

Financial manager

Answer 6

responsible for the financial operations of the firm. Is the link between the firm’s operations and the financial markets

Question 7

Real assets

Answer 7

asset used by the company in its normal line of business to generate profits – can be either tangible or intangible

Question 8

Financial analysis

Answer 8

In capital budgeting involves bringing together estimates and ideas from a variety of disciplines in order to reveal their financial implications

Basically analyse the financial implications of different possible courses of action

It can help with the decision making progress with respect to the following:

Delineate the risks involved in the project

Highlight the salient factors

Suggest risk mitigation for the various risks

Question 9

Two methods in which to do a financial analysis

Answer 9

Leave the investment appraisal to the people who are most concerned to see the project accepted - May need input from the experts listed above

Likely not to be objective

Use a specialist finance function in an attempt to enforce impartiality and realism

But may lack specialist knowledge of the particular project under consideration

Question 10

Agency theory

Answer 10

Is a principle that is used to explain and resolve issues in the relationship between business principals and their agents.

Relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform a service on their behalf. Most commonly, that relationship is the one between shareholders, as principals, and company executives/managers, as agents. Agency theory assumes that the interests of a principal and an agent are not always in alignment.

Considers issues such as the nature of the agency costs, conflicts of interest and how to avoid them, and how agents may be motivated and incentivised

Question 11

Separation of ownership and management can lead to principal-agent problems, which is

Answer 11

Where the interests of owners and managers diverge

This gives rise to agency costs

Question 12

Agency costs examples

Answer 12

The costs associated with monitoring the action of others

and seeking to influence their actions

and the lower returns to the principles than would be the case if the company was run in line with the principles best interests

Question 13

Horizontal merger

Answer 13

Involves two firms engaged in similar activities

Question 14

Horizontal merger motives

Answer 14

I ECO

Inefficient resources eliminated

Economies of scale
Complementary resources (have access to)
Opportunities that would otherwise be unavailable can be accessed - only available for larger organisations

Question 15

Vertical merger

Answer 15

Involve companies engaged in different stages of a production process

Question 16

Vertical merger motives

Answer 16

CAC

Co-ordination and administration can be improved
Access to complementary resources may be improved

Question 17

Conglomerate merger

Answer 17

Involve firms in unrelated lines of business

Question 18

Conglomerate merger motives

Answer 18

TEST FED

Tax - Utilisation of unused tax benefits
EPS - Enhancing of earnings per share
Surplus - Utilisation of surplus funds
Takeover - Protection against threat of takeover

Financing - Exploitation of lower financing costs
Economies of scale
Diversification

Question 19

Behavioural Finance

Answer 19

The field of behavioural finance relates to the psychology that underlies and drives decision-making behaviour. Looks at a variety of mental biases and decision-making errors that affect financial decisions

Question 20

Types of Behavioral Finance

Answer 20

O EM(M)O FAP

Overconfidence

Estimating probabilities
Myopic loss aversion
Mental accounting
Options - Effect of options

Framing
Anchoring and adjustments
Prospect theory

Question 21

Anchoring and adjustments

Answer 21

Anchor is based on past experience or ‘expert’ opinion

And then investors amend to allow for evident differences to the current conditions

Question 22

Prospect theory

Answer 22

Value is based on gains and losses relative to some reference point

People are typically risk-averse when considering gains relative to the reference point

And risk-seeking when considering losses relative to the reference point

Thus there is a point of inflection at the reference point

This theory suggests that the decision made depends on how a problem is ‘framed’ and is thus associated with the concept of framing

Question 23

Framing

Answer 23

The way a choice is framed and, particularly, the wording of a question in terms of gains and losses, can have an impact on the decision made

Question 24

Myopic loss aversion

Answer 24

Less risk-averse when faced with a multi-period of ‘gambles’ - i.e. if they think long-term rather than the immediate short-term gamble then investors are less risk-averse

Thus myopic loss aversion is when an investor only considers the immediate short-term gamble and ends up having less risky assets, to the detriment of their best interests

Question 25

Estimating probabilities

Answer 25

Dislike of negative events - Underestimate the probability

Representative heuristics

People find more probable that which they find easier to imagine

Increase in detail, apparent likelihood increases but true probability decreases

‘stereotyping’

Availability heuristic

People are influenced by the ease with which something can be brought to mind

e.g. car crashes vs cancer

‘memory’

Question 26

Overconfidence

Answer 26

People tend to overestimate their own abilities, knowledge and skills

Discrepancy between accuracy and overconfidence increases as the respondent is more knowledgeable

May be a result of

Hindsight bias

Events that happen = thought of as predictable prior to the event

Events that don’t happen = thought of as unlikely prior to the event

Confirmation bias

Look for evidence that confirms their point of view and dismiss evidence that does not justify it

Question 27

Mental accounting

Answer 27

People show a tendency to separate related events and decisions and find it difficult to aggregate events

Question 28

Effect of options

Answer 28

Range of options or choices presented to people may influence their decision

Note:
Status quo bias

Regret aversion

Ambiguity aversion – people are prepared to pay a premium for rules. Or prepared to pay a premium for info to reduce the uncertainty of a decision to be made

Question 29

Long-term FP

Answer 29

Also called capital budgeting

Commonly looks 3 to 5 years ahead

LT FP is concerned with the assessment of the total amount of capital required for long-term projects and the raising of the company’s required long-term capital

The development of financial plans should begin by consideration of an organisation’s business plans – it’s anticipated product development and sales objectives

Will need to consider the organic development of existing activities and also plans for new developments

These are then converted into financial plans, which convert the business plans into future cashflows

Primarily a responsibility of the finance function within the organisation, liaising with senior management to ensure the production of a financial plan that is consistent with business plans

Analysis of the anticipated need for working capital and growth in fixed assets, together with considerations for tax, dividend and interest payments, will enable the financial manager to plan for capital budgeting and structure (amount and type of capital that must be raised)

Will also consider non-operational issues such as:
Possibility of breaching financial covenants
Impact of borrowing on credit ratings
Level of gearing on balance sheet

Financial planning therefore focuses on the sources and uses of funds as well as the implications for borrowing and financial structure

Sensitivity analysis should be used when developing the plans

Financial – allow for changes in the financial environment

Business – explore business plans under a range of scenarios. I.e. future trading conditions

Question 30

Short-term FP

Answer 30

Also called cash management

Often takes the form of a 12-month ‘rolling’ plan

Revolves around the analysis of working capital requirements

Closely associated with operational issues, since it will involve consideration of credit policy and possible deferment of settling accounts payable

It involves the consideration of (i.e. these are components in working capital):
Trade credit management
Cash management
Stock and inventory policy
Non-cash elements in the projected accounts * - know these

Question 31

Working capital

Answer 31

Is the company’s short-term assets and short-term liabilities

Question 32

Fixed capital or capital goods

Answer 32

Long-term assets that are used to produce goods and services on an ongoing basis - e.g. machinery

It is not used directly in the production process, but it is likely to depreciate over time

Fixed capital outlays often have a serious bearing on the direction and pace of a firm’s growth – because of large sums committed for long periods of time

Question 33

Merits of incentivising managers through share option packages (6)

Answer 33

Help attract and retain quality management

Align the interests of the managers with the shareholders/owners - this is in line with good corporate governance

It is more tax efficient to offer share options than additional salary or other benefits

Difficult to devise a package with enough downside risk to the management

Management may focus on actions to increase short-term value, rather than on improving the company’s long-term prospects

The option is not appropriate if the shares are tightly held by a few investors, or not listed and restrictions need to be imposed on when management may sell shares