Chapter 6 Flashcards
(111 cards)
1
Q
What are the two key decisions in corporate finance?
A
- Capital budgeting decision (what to invest in)
- Financing decision (how to finance that investment)
These decisions are crucial for determining a firm’s investment strategy and financial structure.
2
Q
What does capital budgeting involve?
A
Choosing projects that generate revenues exceeding costs to create profits
It focuses on the selection of projects and real assets for investment.
3
Q
What is the role of the financial manager?
A
Acts as a link between the firm’s operations and financial markets
Responsible for making investment and financing decisions.
4
Q
What is the financing decision?
A
Determining how to raise the required finance for projects
This decision involves assessing capital raising methods such as loans or issuing equity.
5
Q
Who typically looks after a company’s cash and raises new capital?
A
The treasurer
The treasurer maintains relationships with banks, shareholders, and other investors.
6
Q
What are tangible assets?
A
Physical assets used in company operations to generate profits
Examples include machinery, buildings, and inventory.
7
Q
What are intangible assets?
A
Non-physical assets that represent value to a company
Examples include patents, trademarks, and goodwill.
8
Q
What is working capital?
A
Funds used for day-to-day operations of a business
It includes current assets minus current liabilities.
9
Q
What is fixed capital?
A
Long-term investments in physical assets that are used over time
Examples include buildings, machinery, and equipment.
10
Q
What complicates the capital budgeting decision?
A
Estimating future profitability and selecting among multiple profitable projects
Projections can be uncertain and require careful analysis.
11
Q
What is the importance of capital budgeting?
A
It involves complex analysis and the cost of mistaken decisions is high
Decisions affect long-term growth and opportunities for the firm.
12
Q
What does financial analysis in capital budgeting entail?
A
Analyzing financial implications of different possible courses of action
It often requires input from various disciplines.
13
Q
What is agency theory?
A
A theory addressing the relationship between directors and shareholders
It explores how directors make strategic decisions on behalf of shareholders.
14
Q
True or False: The board of directors usually delegates responsibility for large financial decisions.
A
False
Large financial decisions are rarely delegated.
15
Q
What is typically the remit of the Chief Financial Officer (CFO)?
A
Overall responsibility for the company’s financial operations
The CFO oversees both the treasurer and controller.
16
Q
Fill in the blank: The _______ decision considers how to best raise finance for projects.
A
[financing]
17
Q
What are the main parties involved in the financing decision?
A
Treasurer, CFO, banks, shareholders, and other investors
Each party plays a role in funding and financial management.
18
Q
What is the relationship between capital budgeting and product development?
A
Capital budgeting decisions are tied into plans for product development, production, and marketing
Managers from various departments are often involved in these decisions.
19
Q
What can complicate investment decisions in fixed capital?
A
Choices among alternative capital assets, financing methods, and commencement dates
Each option has various advantages and disadvantages.
20
Q
What does agency theory address?
A
The relationship between directors and shareholders, and the conflicts that arise from the separation of ownership and management
Agency theory examines principal-agent problems and agency costs.
21
Q
What are principal-agent problems?
A
Conflicts that arise when the interests of the owners (shareholders) and managers diverge
These conflicts can lead to agency costs.
22
Q
What are agency costs?
A
Costs associated with monitoring the actions of others and influencing their actions
Agency costs arise from the principal-agent relationship.
23
Q
What can cause conflicts of interest in a business?
A
Diverging interests between owners, managers, and other stakeholders
Information asymmetries can reinforce these conflicts.
24
Q
What types of stakeholders may experience conflicts of interest?
A
- Lenders
- Shareholders
- Junior management
- Other employees
- Customers
- Suppliers
- Pensioners
- The state
25
How can the interests of lenders and shareholders differ?
Lenders typically seek short-term security, while shareholders are interested in long-term company development
## Footnote
This divergence can complicate financial decision-making.
26
What is a horizontal merger?
A merger between two firms engaged in similar activities, like two supermarket chains
## Footnote
Such mergers aim to achieve economies of scale.
27
What is a vertical merger?
A merger between companies at different stages of a production process, such as a supermarket and a food production company
## Footnote
This type of merger improves coordination and control over supply.
28
What is a conglomerate merger?
A merger between firms in unrelated lines of business, such as a supermarket chain and a financial services provider
## Footnote
Conglomerate mergers were historically common but have decreased in recent years.
29
What is one motive for conglomerate mergers?
* Utilisation of unused tax benefits
* Utilisation of surplus funds
* Protection against takeover threats
* Diversification
* Enhancement of earnings per share
* Exploitation of lower financing costs
30
Why might diversification through mergers be criticized?
Shareholders could achieve similar diversification by adjusting their shareholdings instead of through mergers
## Footnote
Critics argue that management should focus on shareholder value.
31
What does behavioral finance study?
The impact of mental biases and decision-making errors on financial decisions
## Footnote
It contrasts with traditional economic theories that assume rational behavior.
32
What assumption does traditional economic theory make about investors?
That they always act rationally to maximize expected utility
## Footnote
This assumption is challenged by evidence of irrational behaviors.
33
How do contrarian investment funds operate?
By taking advantage of errors made by other investors
## Footnote
These funds rely on the premise that market prices may not reflect true value due to behavioral biases.
34
What does expected utility suggest about market behavior?
It may not always reflect actual behavior in capital markets.
## Footnote
Expected utility theory posits that individuals make decisions to maximize their expected satisfaction, but behavioral finance indicates deviations from this assumption.
35
What is a contrarian fund?
A fund that takes the opposite view to the market, buying when others sell and vice versa.
## Footnote
Contrarian funds exploit market inefficiencies by acting against prevailing market sentiment.
36
What is the primary focus of behavioral finance?
The influence of psychological factors on investor behavior and market outcomes.
## Footnote
Behavioral finance examines how cognitive biases affect decision-making in financial contexts.
37
What two components are required for managing an investment portfolio?
* An investment strategy
* A choice of investment management structure
38
How can behavioral finance arguments be applied to investment consultancy?
To justify proposed investment management structures based on identified mental biases.
## Footnote
Understanding biases can help in structuring portfolios that mitigate these biases.
39
What are common themes found in research on behavioral finance?
* Anchoring and adjustment
* Prospect theory
* Framing
* Myopic loss aversion
* Estimating probabilities
* Overconfidence
* Mental accounting
* The effect of options
40
Define anchoring in the context of decision-making.
A cognitive bias where individuals rely heavily on the first piece of information encountered (the anchor) when making decisions.
## Footnote
Anchoring can skew judgment, leading to estimates that are unduly influenced by initial values.
41
What does prospect theory explain?
How people make decisions under risk and uncertainty, focusing on gains and losses relative to a reference point.
## Footnote
It contrasts with traditional utility theory by demonstrating that people value gains and losses differently.
42
What is the typical behavior of individuals regarding risk in prospect theory?
* Risk-averse when considering gains
* Risk-seeking when considering losses
43
What is the impact of framing on decision-making?
The way choices are presented can significantly affect decisions, particularly when framed in terms of gains or losses.
## Footnote
Minor changes in wording can lead to different preferences among individuals.
44
What is myopic loss aversion?
A tendency to avoid losses in the short term, leading to risk-averse choices over repeated decisions.
## Footnote
This concept builds on prospect theory, emphasizing how individuals react to potential losses in a series of choices.
45
What was the outcome of Kahneman and Tversky's experiment regarding risk?
80% preferred a certain gain over a probabilistic higher gain, while 92% preferred a probabilistic loss over a certain higher loss.
46
What is myopic loss aversion?
It relates to investors' aversion to short-term losses and their reduced risk aversion when faced with repeated choices rather than a single gamble.
## Footnote
Myopic loss aversion suggests that investors may take a long-term view when making investment decisions, viewing them as a series of repeated short-term gambles.
47
How does frequency of choice influence investment decisions?
The frequency of choice and length of reporting period can influence investors' short-sightedness and their risk aversion towards short-term losses.
## Footnote
For example, a pension fund reporting annually may be more risk-averse than one reporting every three years.
48
What biases may affect investors' probability estimates?
* Dislike of negative events
* Representative heuristics
* Availability bias
## Footnote
These biases can lead to underestimating the likelihood of negative outcomes or overestimating the likelihood of more vivid or publicized events.
49
What is overconfidence in the context of investing?
It is the tendency of people to overestimate their own abilities, knowledge, and skills, especially in investment decisions.
## Footnote
Overconfidence can lead to poor investment choices as individuals may believe they are better than they actually are.
50
What is hindsight bias?
It is the tendency to view events as having been predictable after they have occurred.
## Footnote
This can lead to an inflated sense of one's predictive abilities regarding investment outcomes.
51
What is confirmation bias?
It is the tendency to seek out evidence that confirms one's preconceptions while dismissing evidence that contradicts them.
## Footnote
For instance, failing an exam might reinforce the belief that the exam system is unfair, rather than reflecting a lack of preparation.
52
Define mental accounting.
It is the tendency for people to separate related events and decisions into different mental categories rather than viewing them as a whole.
## Footnote
This can lead to irrational financial decisions, such as preferring to pay off a mortgage early while still holding savings.
53
What is the primary effect in decision-making?
It is the tendency for people to favor the first option presented to them.
## Footnote
This can significantly influence choices made in investment scenarios.
54
What does the recency effect refer to?
It refers to the tendency for people to prefer the last option discussed in a series of choices.
## Footnote
The timing of the decision can affect whether the first or last option is chosen.
55
What is status quo bias?
It is the preference for keeping things the same rather than changing them.
## Footnote
This bias can lead individuals to avoid making potentially beneficial changes in their investment strategies.
56
What is regret aversion?
It is the tendency to minimize the possibility of regret by sticking with existing arrangements.
## Footnote
This can prevent investors from making necessary changes to their portfolios.
57
What is ambiguity aversion?
It is the preference for known risks over unknown risks, often leading to a willingness to pay a premium for clarity in investment options.
## Footnote
This behavior contradicts standard financial theories that assume investors can accurately assess risks.
58
What does portfolio theory assume about investors' knowledge?
Investors know the actual distribution of future investment returns when making their investment choices.
59
What are the terms used to refer to uncertainty about future investment returns?
Ambiguity and uncertainty.
60
How does an investor who dislikes ambiguity tend to behave?
They tend to err on the side of caution when making an investment choice.
61
What might an investor be prepared to pay for?
Further information that reduces the degree of uncertainty faced.
62
What are the two types of financial planning?
* Long-term (capital budgeting) * Short-term (cash management)
63
What does long-term financial planning focus on?
A company's long-term investment decisions and capital requirements.
64
What is primarily the responsibility of the finance function within an organization?
Long-term financial planning.
65
What does short-term financial planning involve?
The management of short-term or working capital requirements.
66
What does credit policy relate to?
The trade credit a company gives to its customers.
67
What factors must a company determine for each customer regarding credit?
* How much credit to advance * Over what period to advance the credit * The rate of interest to be charged
68
What is the typical time frame for long-term planning?
3 to 5 years, or up to 10 or 12 years for capital projects.
69
What should the development of financial plans begin with?
Consideration of an organization's business plans.
70
What is sensitivity analysis used for in financial planning?
Exploring business plans under a range of scenarios.
71
What are capital budgeting decisions related to?
The total amount of capital required.
72
What are capital structure decisions related to?
The mix of the capital raised between different types of debt and equity.
73
What must the financial plan also consider?
Non-operational issues such as financial covenants and credit ratings.
74
What is short-term financial planning often based on?
A 12-month rolling plan.
75
What are current assets and liabilities collectively known as?
Working capital.
76
What does credit management refer to?
The collection of revenues from trade creditors.
77
What is a disadvantage of holding buffer stocks?
The opportunity cost of the capital tied up in the stocks.
78
What is a key element in short-term financial planning?
The translation of sales and production plans into cashflow projections.
79
What are the main classes of current assets?
* Cash * Accounts receivable * Inventory
80
What are the main classes of current liabilities?
* Accounts payable * Short-term debt * Accrued liabilities
81
What is the main advantage of holding cash?
Liquidity and ability to respond to unexpected expenses.
82
What is the main disadvantage of holding cash?
Opportunity cost of not investing that cash.
83
What two basic issues does finance involve?
* What real assets should the firm invest in? * How should the cash for the investment be raised?
84
Who are the main parties involved in financing decisions?
* Treasurer * Controller/Chief Financial Officer * Board of directors
85
What is agency theory concerned with?
The conflicts of interest between owners and managers.
86
What are the three forms of mergers and acquisitions?
* Horizontal * Vertical * Conglomerate
87
What is a motive for horizontal mergers?
Economies of scale.
88
What are the three forms of mergers and acquisitions?
* Horizontal
* Vertical
* Conglomerate
## Footnote
Horizontal involves firms engaged in similar activities, vertical involves firms engaged in different stages of a production process, and conglomerate involves firms in unrelated lines of business.
89
What are the motives for horizontal mergers?
* Economies of scale
* Access to opportunities that would otherwise be unavailable
* Access to complementary resources
* Elimination of inefficient resources
## Footnote
These motives aim to improve efficiency and market reach.
90
What are the motives for vertical mergers?
* Improved coordination and administration
* Access to complementary resources
## Footnote
Vertical mergers enhance operational efficiency by integrating different stages of production.
91
What are the motives for conglomerate mergers?
* Utilisation of unused tax benefits
* Utilisation of surplus funds
* Protection against threat of takeover
* Diversification
* Enhancement of earnings per share
* Exploitation of lower financing costs
## Footnote
Conglomerate mergers often focus on diversification and financial stability.
92
What does behavioural finance study?
The psychology that underlies and drives financial decision-making behaviour.
## Footnote
It examines how psychological factors influence investors' decisions and market outcomes.
93
List eight common themes in behavioural finance.
* Anchoring and adjustment
* Prospect theory
* Framing (and question wording)
* Myopic loss aversion
* Estimating probabilities
* Overconfidence
* Mental accounting
* Effect of options
## Footnote
These themes highlight various cognitive biases affecting financial decisions.
94
What is long-term financial planning commonly associated with?
Capital budgeting that looks 3 to 5 years ahead.
## Footnote
It assesses the capital required for long-term projects and involves developing business plans.
95
What does short-term financial planning revolve around?
Analysis of working capital requirements.
## Footnote
It typically takes the form of a 12-month rolling plan.
96
What elements are considered in short-term financial planning?
* Trade credit management
* Cash management
* Stock and inventory policy
* Non-cash elements in projected accounts
## Footnote
These elements help manage liquidity and operational efficiency.
97
Define tangible assets.
Assets that physically exist, such as machinery and buildings.
## Footnote
They can be seen and touched, in contrast to intangible assets.
98
Define intangible assets.
Assets that do not physically exist, such as goodwill, trademarks, and brand names.
## Footnote
Despite lacking physical presence, they can generate profits for the company.
99
What is working capital?
The company's short-term assets and short-term liabilities.
## Footnote
It is often interpreted as the difference between short-term assets and short-term liabilities.
100
What does fixed capital refer to?
Long-term assets used to produce goods and services, such as machinery and plant.
## Footnote
Fixed capital primarily consists of tangible assets.
101
What is the financing decision in finance?
The question of how the cash required for investment should be raised.
## Footnote
Key parties involved include the treasurer, financial controller, and board of directors.
102
What are agency costs?
Costs incurred when managers do not attempt to maximise the value of the company.
## Footnote
Shareholders incur costs monitoring managers and attempting to influence their actions.
103
How can the interests of management be aligned with those of shareholders?
By linking management's remuneration to the performance of the company's shares.
## Footnote
This can be done through share option schemes.
104
What are economies of scale?
The situation in which long-run average costs decrease with the level of output.
## Footnote
They can arise from fixed cost spreading, production specialization, and cheaper finance access.
105
What might argue against merging purely for diversification?
Shareholders can achieve diversification more quickly and cheaply through their portfolios than through company mergers.
## Footnote
This highlights the inefficiencies of corporate diversification strategies.
106
What are financial covenants?
Restrictions placed on a borrower requiring them to meet specified financial criteria.
## Footnote
These criteria often relate to interest and asset coverage on long-term debt.
107
List the main classes of current assets.
* Stocks of raw materials, finished and partly finished goods
* Trade receivables or debtors
* Cash
* Short-term securities held
## Footnote
These are essential for daily operations and liquidity.
108
List the main classes of current liabilities.
* Trade payables or creditors
* Outstanding dividend and tax payments
* Short-term borrowings and loans
## Footnote
These represent the company's short-term financial obligations.
109
What are the possible costs involved in holding buffer stocks?
* Storage costs
* Spoilage costs
* Obsolescence
## Footnote
These costs can impact overall profitability and operational efficiency.
110
What is the main advantage of holding cash for a company?
It allows the company to cope with unexpected eventualities.
## Footnote
Holding cash provides a buffer against unforeseen expenditures.
111
What is the main disadvantage of holding cash?
Foregoing higher returns from investing in financial securities or core business operations.
## Footnote
This opportunity cost can affect long-term profitability.
