financial decison making

Question 1

advantages and disadvantages of ‘unincorported buisiness structures such as sole trades/partnerships

Answer 1

A: cheap and easy to establish
ownership and control concentrated
no requirement to publish accounts
D: difficult to sell = finite life
business=owner= unlimited liability
dificult to raise funds as banks do not want to loan to risky businesses

Question 2

definition of incorporated business structure

Answer 2

where the business has a separate legal identity to the owner

Question 3

advantages and disadvantages of incorporated business structure

Answer 3

A: ownership can be transferred by selling shares= infinite life
limited liability for owners
funds can be raised publically through equity and debt markets
D: difficult and expensive to establish
tax disadvantages
management is separate from owners
requirement to publish accounts

Question 4

what is the primary stock market

Answer 4

where companies raise new equity finance by issuing new securities/shares to new investors
Includes IPO’s + rights issued: secondary offerings

Question 5

what is the secondary stock market
motivated by?

Answer 5

where investors buy and sell existing shares
Information and liquidity motivated
Big bang :1986 oct
Big bang 2 : 1997 oct

Question 6

Advantages of trading in the secondary stock market

Answer 6

find opposite party that works for you
lots of liquidity due to volume of buying and selling
information of others is reflected in the stock price - gives correct valuations

Question 7

what is an IPO

Answer 7

initial public offering

Question 8

what is a P/E ratio

Answer 8

price earning ratio
share price/ earnings per share

Question 9

What is EAR

Answer 9

effective annual rate, more interest compounds the more frequently interest is paid
EAR = ((1+r/m)^m)-1
When investing c for t years at a flat rate of r per year compounding m times
FV = C(1+r/m)^(mxt)

Question 10

why raise capital

Answer 10

plan to expand
Growth - new technology, must grow otherwise will be crowded out
pay off debt - initial loans for companies are taken out at high intrest rates
More wages to pay
Mergers/acquisitions

Question 11

how to raise capital

Answer 11

Angel finance - successful business people (capped at ~ 100k)
non - securities debt - bank loan/loan from another firm
venture capital - billionaires who own companies invest into the business on the companies behalf
listing on the stock market

Question 12

Methods of conducting an IPO - initial public offering

Answer 12

offer for sale - all shares listed must be sold, anyone can buy, expensive as underwritter has the risk of buying unsold shares
placing - only institutional investors
offer for subscription
intermediaries offer
introductions

Question 13

what is finance

Answer 13

finance is about the valuation of future cash flows and what effects them

Question 14

5 elements of finance

Answer 14

time, money, risk, information, taxation

Question 15

4 perspectives on finance

Answer 15

corporate finance : real investment, capital budgeting, financing liquidity for working capital
investments
financial markets and intermediaries: banks and pension funds
Government

Question 16

what happens to standard dievation of risk as portfolio size increasesd

Answer 16

standard deviation goes down, risk decreases
systemtic risk
unsystematic risk is removable via diversification of portfolio

Question 17

Role of the CFO

Answer 17

Chief financial officer
internal and external financial reporting, stewardship of a company’s assets, and ownership of cash management

Question 18

PLC characteristics

Answer 18

Public Limited company
established by shareholders
financed by share(permanent) and debt capital (money borrowed for fixed periods)
shareholders have limited liability and establish a board of directors

Question 19

unincorporated business definition

Answer 19

a privately owned business, often owned by one person who has unlimited liability as the business is not legally registered as a company

Question 20

why do share prices change

Answer 20

to reflect new information about a company
new announcement

Question 21

characteristics of informational efficiency

Answer 21

prices reflect all information available to investors
prices react immediately to reflect new information

Question 22

how will share price react in an informationally inefficient market

Answer 22

over/underreaction and gradual adjustment to correct price
slow reaction
we can therefore predict unexpected returns
allowing us to earn returns above the level required to compensate for the risk

Question 23

why invest in a portfolio instead of individual securities

Answer 23

unless there is perfect correlation
the standard deviation of a portfolio will be less than the weighted average of separate securities

Question 24

difference between systematic and unsystematic risk

Answer 24

systematic risk : risk that influences a large number of assets. They have a market wide influence

Unsystematic risk : risk that effects a single asset or a small group of assets, negligible by diversification

Question 25

Key elements of finance

Answer 25

Money Time Uncertainty/risk Information Taxation

Question 26

Pre big bang problems

Answer 26

Single capacity : stock jobbers , stock brokers - increased concentration/ reduced job competition - fixed brokerage commissions - LSE membership restricted - jobbers undercapitalised - international competitiveness

Question 27

Post big bang

Answer 27

Dual capacity - broker/dealer - market makers - trading floor v. SEAQ& telephone Big bang 2 - more changes to the trading system

Question 28

Definitions of annuity and perpetuity

Answer 28

Annuity - is a series of regular and consistent cash flows for a period PV = C (1-(1/1+r)^t)/r Perpetuity - an annuity where cash flows continue forever PV = C/r

Question 29

Bond features definition (face value, coupon, maturity)

Answer 29

Face value - principal, nominal value, Coupon rate- % of face value that the bond pays in interest Coupon - amount of interest Maturity - the date when the issues repays face value

Question 30

Business structures in other countries

Answer 30

- most countries have a similar structure relating to incorporated and unincorporated though some rules and regulations are different - a ‘partnership’ is deemed to be a corporate entry in the UK but not in Germany - directors of incorporated firms are elected in 2 main ways: single tier board - shareholders elect a board of directors who then select managers; 2 tier board executive managers board, and a supervisory board

Question 31

Discounting and present values

Answer 31

What is the value of £2000 now in 5 years, growing at 11% per year 2000 x 1.11^5 How much do we need to invest now at 11% per year to have £2,000 in 5 years 2000/(1.11^5) FV = PV(1+r)^t

Question 32

Real vs nominal interest rate

Answer 32

Nominal interest rates = actual market rates nominal - Invest £100 at 10% interest per year = £110 Real - But if inflation is 7% 110/1.07 = 102.8

Question 33

Definition of bonds and shares

Answer 33

Bonds - governments, local authorities, companies Shares - companies

Question 34

Government gilts lengths

Answer 34

<5 years = short 5-15 years = medium >15 years = long

Question 35

What are the different goals a firm can have

Answer 35

Maximise: the size of the firm Costumers satisfaction Firms sales Profits Dividend growth Shareholder wealth - occurs if product and labour markets work efficiently

Question 36

How to apply the NPV rule

Answer 36

Add up the cash flows in all the years, adjusting for the investors requires rate of return If NPV> 0 accept the project If NPV< 0 reject the project

Question 37

What is fishers separation theorem

Answer 37

If capital markets for borrowing and lending are well functioning Companies can make their investment decision independently of individual shareholders consumption decisions by using the NPV rule

Question 38

Perfect capital markets

Answer 38

No transaction costs, interest rate on borrowing = interest rate on investing Access is free and equal, no participants have the power to influence prices All participants have the same information about prices and security/firm characteristics No distorting taxes Other stakeholders in the firm face competitive prices NPV of projects = 0

Question 39

Advantages of using payback method

Answer 39

Easy to compute and understand Encourages cash generation Values early cash flow over late cash flow

Question 40

Disadvantages of payback

Answer 40

Adds cash flows ignoring the time value of money Choice of cut off period is arbitrary Ignores cash flows after the cut off period Biased towards rejection long lived projects possibly with + NPV’s Biased towards accepting short lived projects possibly with - NPV’s

Question 41

ARR

Answer 41

Accounting rate of return Investments average accounting profits each year/ average book value of assets invested each year

Question 42

Advantages of ARR

Answer 42

Easy to compute because the firm collects the accounting information anyway

Question 43

Disadvantages of ARR

Answer 43

Ignores the time value of money choice of ARR is arbitrary Based on earrings not cash flows, uses accounting deprecation , tax charged based on accounting earnings No standard calculation methods Not a true return on investment

Question 44

Profitability index

Answer 44

PI = PV of future cash flows / initial investment

Question 45

How to prepare capital budgets

Answer 45

1. Search for investment opportunities 2. Screening: Is the project consistent with the strategic plan? Is it feasible? 3. Definition of project and alternatives 4. Evaluation 5. Authorisation 6. Monitoring & Post-Audit

Question 46

Definition of capital budgeting

Answer 46

Capital budgeting is the process of deciding which new project to take on behalf of the company. By project we mean any new decision that requires investment

Question 47

How does volatility of returns correlate to rate of return required

Answer 47

The greater the volatility of returns, the greater is the required rate of return.

Question 48

What does a profitability index >=1 indicate

Answer 48

That a project is profitable

Question 49

Difference between geometric and arithmetic average

Answer 49

Arithmetic - sum the returns and divide by total Geometric ((1+r1)(1+r2)…..(1+rn))^1/n

Question 50

2 main characteristics of a return

Answer 50

Average return : measures what you expect to earn each period Standard deviation: variability or volatility gives a measure of how far from the average you expect the return to be in any 1 period

Question 51

Implications of IE for investors

Answer 51

- prices are the best indicator of value - prices reflect fundamentals - active traders, on average, perform no better than passive investors - uniformed investors can expect a fair return

Question 52

Why does IE imply random price changes

Answer 52

IE means prices change unexpectedly only to new information New information, by definition, is independent of previous information If information is already known it will already be reflected in the share price

Question 53

A bond's coupon rate is equal to the annual interest divided by

Answer 53

face value

Question 54

what type of bond would be affected more by changes in interest rate

Answer 54

bonds with longer maturities bonds with lower coupons

Question 55

a high interest rate on a bond =

Answer 55

more risk that it carries