theory of finance

Question 1

the financial manager (who is responsible for the financial operations of the firm) stands between:

Answer 1

 the firm’s operations (ie the purchase of real assets, which are then used by the firm to undertake projects in order to generate profits) and 

 the financial markets (where investors hold the financial assets issued by the firm to obtain money). 
The role of the financial manager as the link between the firm’s operations and the financial markets is summarised by the following diagram.

Question 2

What are tangible and intangible assets?

Answer 2

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Question 3

Finance involves two basic issues:

Answer 3

Capital budgeting and financing

1. What real assets should the firm invest in? (the investment or capital 
budgeting decision) 

2. How should the cash for the investment be raised? (the financing 
decision).

Question 4

Capital budgeting decision

Answer 4

Firms use real assets to undertake projects – a firm can essentially be thought of simply as a collection of projects. These projects generate revenues and incur costs. The aim of the firm should be to undertake those projects for which the revenues exceed the costs in order to generate profits on behalf of the owners of the firm – typically the shareholders. The capital budgeting decision considers the choice of projects, and hence real assets, in which the firms should invest.

Question 5

In practice, the capital budgeting decision is often complicated by the fact that:

Answer 5

 there may be more than one apparently profitable project between which to choose 

 it is very difficult to estimate the future profitability of a project.

Question 6

Financing decision

Answer 6

The typical project requires a significant expenditure prior to the receipt of the first revenues. In addition, it may be several years before incoming revenues first exceed outgoing costs and so the project becomes profitable. A net investment will therefore be required to get the project off the ground. The financing decision considers how best to raise the required finance. 


Question 7

The second question is the responsibility of the treasurer who:

Answer 7

 looks after the company’s cash, 

 raises new capital and 

 maintains relationships with banks, shareholders and other investors. 
The first question is normally the remit of a controller or, in many instances, the Chief Financial Officer (CFO). 
In principal the CFO has overall responsibility for the company’s financial operations and as such the treasurer is normally subordinate to him or her. However, in a small company, the controller and the treasurer may be the same individual.

Question 8

capital budgeting decisions

Answer 8

ill be tied into plans for product development, production and marketing and so will involve managers from these areas (as well as any staff specialising in corporate planning).
Responsibility for financial issues will, ultimately, rest (by law or custom) with the board of directors. In practice, boards usually delegate decisions for small or medium-sized matters. However, responsibility for large financial decisions is rarely delegated.
The importance of capital budgeting is due to the complexity of the analysis involved and the cost of mistaken decisions. It is difficult to project the prospective cashflows arising from a particular project with any great confidence. Further complications arise when allowing for different possible scenarios, incorporating options into the analysis and discounting the cashflows.
Investment in working capital is largely routine and involves few complications or risks.

Question 9

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

Answer 9

 alternative capital assets, each with various advantages and disadvantages 

 dates of commencement and 

 methods of financing – eg bank loan, issuing debt, issuing equity. 
These choices are both complex and critical, given the scope for (and very high cost of) erroneous decisions. Moreover, fixed capital outlays often have a serious bearing on the direction and pace of a firm’s growth. As such, they determine the opportunities open to a firm and the directions in which it can move.because fixed capital choices can involve the commitment of large sums of money for long periods of time.

Question 10

Even where it is impossible for financial analysis to improve the actual fortunes of a particular project, it may nevertheless be able to: 


Answer 10

 delineate the risks involved in the project, 

 highlight the salient factors – ie those that lead to the greatest uncertainty 

 possibly suggest methods by which these risks might be reduced.

Question 11

What is working capital? What is fixed capital?

Answer 11

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Question 12

Financial analysis in capital budgeting

Answer 12

involves bringing together estimates and
–ideas from a variety of disciplines –

marketing, 
technology, 
accounting, 
tax, 
law – 
in order to reveal their financial implications.  

simply means
analysing the financial implications
of different possible courses of action.

An in-depth financial analysis of a project may require
input of experts from
each of several different disciplines
such as those listed above.

Question 13

problems of capital budgeting in any enterprise are both

Answer 13

1. financial and political.
2. Leaving the investment appraisal of a project
   - -to be conducted by the very people who are most concerned to see the project accepted –
   - -the department primarily interested in the project – is to expect impossible objectivity.

Question 14

The use of a specialist finance function is an attempt to

Answer 14

enforce impartiality and realism.
However, the possible downside of this is that the finance function
–may lack specialist knowledge of the particular project under consideration.

Question 15

What is the financing decision? Who are the main parties involved in the financing decision?

Answer 15

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Question 16

Summary of agency theory

Answer 16

1. directors of a company make strategic decisions on behalf of its shareholders,
   –whilst delegating operational decisions to managers.
   2 separation of ownership and management can lead to
   –principal-agent problems and
   –agency costs
   –if the interests of the owners and managers diverge.

Question 17

Conflicts of interest may also arise between other stakeholders in a business, notably between

Answer 17

1. lenders and the providers of equity capital, and
2. may be reinforced by information asymmetries.
3. Agency theory 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 18

When are agency costs incurred?

Answer 18

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Question 19

How might the interests of a company’s management be aligned with those of the shareholders?

Answer 19

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Question 20

separation of ownership and management has advantages

Answer 20

reedom for ownership to change without affecting operational activities,

freedom to hire professional managers

Question 21

separation of ownership and management has disadvantages

Answer 21

1. if the interests of the owners and managers diverge.
2. Such conflicts are referred to as principal – agent problems, and
   - -give rise to agency costs.
3. These include the costs associated with
   - -monitoring the actions of others, and
   - - seeking to influence their actions.

Question 22

The scope for conflict between owners and managers is evident

Answer 22

– managers may be motivated by objectives which are at variance with the desires (and interests) of the shareholders. Conflicts of interest may equally arise between other stakeholders – junior management, other employees, customers, suppliers, pensioners, and the state. Of particular interest is the potential for conflict between providers of finance, notably lenders (such as banks and bondholders) and the providers of equity capital (the shareholders). Fundamentally, this can be characterised as the difference between the lenders’ short-term desire for security and the shareholders’ long-term interest in the development of the company. At times, however, the interests of different sub-groups of financiers may diverge. Such problems may be easier to resolve if all parties share the same insights into the fortunes of the company. However, information asymmetries will often exist between the various classes of stakeholder. Written agreements between the various classes of stakeholder may specify key aspects of the relationship between them, but cannot realistically cover all possible future eventualities. Such agreements therefore need to be supplemented by less formal understandings and arrangements.

Question 23

Mergers with (or acquisitions of) an existing operation can often provide the greatest scope for

Answer 23

principal — agent problems and the destruction of shareholder value.For example, managers may take over other companies as an exercise in empire building rather than for the strict benefit of shareholders.
Consideration of the motives for, and the assessment of, mergers and acquisitions is therefore a very important topic.

Question 24

Mergers and acquisitions can be classified in three forms:

Answer 24

1. horizontal 

   
   2. vertical 

   3. conglomerate.

Question 25

A horizontal merger involves

Answer 25

two firms engaged in similar activities – for example, two supermarket chains. Such mergers are usually undertaken to benefit from economies of scale, such as sharing core services common to both organisations. Another reason is to exploit complementary resources or to access opportunities only available to larger organisations. A more aggressive motive may be to eliminate inefficiencies (including underperforming management). An example of complementary resources might be where two supermarket chains have shops located in two different countries. If each wishes to expand its operations into the other country, then it might be quicker and easier to do so via a merger, than by setting up a new operation from scratch. An example of an opportunity available only to larger organisations might be the provision of a utility service such as electricity on a national (as opposed to a local or regional) basis. Underperforming management could of course be eliminated without recourse to a takeover. However, it is often easier for outsiders/newcomers to restructure the management of a company than for existing insiders. In addition, the elimination of inefficiencies might also be a motive for the other types of merger discussed below.

Question 26

Vertical mergers are those involving

Answer 26

companies engaged in different stages of a production process – for example, a supermarket chain and a food production company. Merged, the new company spans (and controls) a greater part of the process from raw materials to the final consumer. In this way, co-ordination and administration can be improved. So the supermarket is better able to control the supply of food to its stores. Equally, access to complementary resources may be improved (as with horizontal mergers).

Question 27

the majority of mergers fall into the third category, conglomerate mergers, as they involve

Answer 27

firms in unrelated lines of business – for example, a supermarket chain and a financial services provider. (However, in recent years, this process has gone into reverse with the break-ups of many conglomerate organisations. )

Question 28

Motives for conglomerate mergers include:

Answer 28

  utilisation of unused tax benefits – if two different companies have different tax positions, then one may take over the other in order to make sure that any valuable unused tax shields will definitely be used 
   utilisation of surplus funds – for example, if a company has surplus funds and few profitable investment opportunities, then it could use its cash to purchase another company’s shares.   protection against threat of takeover – by increasing the size of the business 
   diversification – which reduces the exposure of the merged company to the 
fortunes of either sector 
   enhancement of earnings per share – a company may be able to increase its earnings per share by taking over another company with a lower price earnings ratio. The earnings per share of the merged company will increase if the merger reduces the total number of shares in existence without affecting total earnings. 
   exploitation of lower financing costs – often large companies are able to obtain finance more cheaply, perhaps because they are deemed to be more creditworthy, as each merged firm can guarantee the borrowings of the other. 
In addition, there could be scope for other economies of scale.

Question 29

How were economies of scale defined in Subject A102?

Answer 29

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Question 30

Some of the above motives for conglomerate mergers might equally apply to the other types of merger.

Answer 30

For example, a horizontal merger might be motivated both by a desire to eliminate inefficiencies and also by a desire to utilise unused tax benefits. 
It should be said that not all these motives are without critics. Indeed, it must be questioned whether motives such as utilisation of surplus funds and diversification are proper for the management of a company, given that the shareholders could achieve a similar result themselves, if desired – by adjusting their own shareholdings to obtain a suitably diversified portfolio. For example, it is often argued that a company with few profitable investment opportunities should simply return the surplus funds to its shareholders, by means of either dividends or share repurchases. 


Question 31

Why can conglomerate mergers lead to economies of scale?

Answer 31

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Question 32

Why might it be argued that a company definitely shouldn’t merge purely to achieve diversification on behalf of its shareholders?

Answer 32

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