2 Terminology and the Financial System

Question 1

Whats the most important elements to a better answer

Answer 1

Add some context with simple examples

Question 2

What is a real asset?

Answer 2

• Identifiable assets with intrinsic value
• Doesn’t have to be tangible
• Can be strong workforce or patent

Question 3

What is a financial asset?

Answer 3

• Asset that derives value from contractual claim
• Such as a share or bond
• Claim to a future cashflow and not any underlying asset

Question 4

What is capital expenditure?

Answer 4

Capital expenditure or capital expense is the money an organization or corporate entity spends to buy, maintain, or improve its fixed assets, such as buildings, vehicles, equipment, or land.

Question 5

What are financing decisions?

Answer 5

Financing decisions refer to the decisions that companies need to take regarding what proportion of equity and debt capital to have in their capital structure.

Question 6

What is a closely held company?

Answer 6

Typically a smaller company that is not publicly traded

Question 7

What is a public company?

Answer 7

A company which is listed on the stock exchange for anyone to buy

Question 8

What is limited liability?

Answer 8

When the company has been incorporated and has a separate legal entity. The owners are only exposed to the amount of their investment

Question 9

What is limited liability?

Answer 9

When the company and the owner are the same entity and all their assets can be held to service debt

Question 10

What is the objective of an organisation?

Answer 10

Make shareholders as wealthy as possible by investing in real assets

Question 11

Describe the separation of ownership and management

Answer 11

Typically the owners of a large firm are not the management. So they employ a board of directors to run it on their behalf. Shareholders do not have a right of access to the company (cant just walk into the office) and only see the annual accounts. Therefore there is a misalignment of power to the managers who are likely to act in short term benefits

Question 12

What are the objectives of shareholders?

Answer 12

When writing questions do not assume things. If the person is young then say that they are likely to be spending more time at work and might prefer passive investing but you would need to ask more questions. This is ok in the exam and will get high marks.
Another example is if they are older could say that would need to find out if they need to live on to dividends and this would be the course of action if they did

Question 13

Describe the agent principle relationship

Answer 13

When there is a relationship of trust between two parties. A principle employs an agent to carry out a contractual duty

Question 14

What is the opportunity cost of capital?

Answer 14

The opportunity cost of capital is the incremental return on investment that a business foregoes when it elects to use funds for an internal project, rather than investing cash in a marketable security

Question 15

Formula for gross yield

Answer 15

Gross dividend / Market Price

Question 16

Market capitalisation formula

Answer 16

Market price x No. Shares

Question 17

Interest yield formula

Answer 17

Interest / Market Price

Question 18

Interest formula

Answer 18

Coupon rate x Nominal Debt

Question 19

Internal rate of return

Answer 19

• The project rate of return that gives zero NPV
• A firm should accept an investment project if the opportunity cost of capital is less than the internal rate of return
• Some projects have multiple IRRs
• Issue with IRR is it doesn’t take into account the scale of the project just the % so need to use in conjunction with NPV to see total returns

Question 20

What is the quoted price on the stock market?

Answer 20

Often media will quote the ‘mid-market’ price which is the halfway between:
Bid and Offer prices at last quote

Question 21

What is spread?

Answer 21

The difference between bid and offer

Question 22

What affects spread?

Answer 22

• The size of this ‘spread’ will depend on the company and the conditions prevailing
• The smaller the spread the more efficient the markets as the market makers are pushed on their margins

Question 23

What are the two parts of return?

Answer 23

Dividend ‘received’ + a capital gain/deficit

Question 24

What is dividend cover?

Answer 24

The number of times the latest reported earnings cover the latest declared dividend

Question 25

How useful is P/E?

Answer 25

• Nothing on its own without comparison
• Generally, companies operating in the same industry should have similar P/E ratios -they are all affected by similar market factors.
• It might be said that a high P/E ratio indicates investors’ positive expectations and vice versa

Question 26

What does a high P/E suggest?

Answer 26

• Expectations of a faster rate of growth than other companies in the same sector
• Or that it is overpriced

Question 27

What is the purpose of the financial system?

Answer 27

Facilitate the flow of funds from those with surplus to those with deficit looking to make capital investment decisions

Question 28

Describe market efficiency

Answer 28

• How costly is it to move the funds from surplus to deficit
• This includes commissions and taxes that reduce flow of funds

Question 29

What are the main types of market efficiency

Answer 29

1. Operational
2. Pricing
3. Dynamic

Question 30

Benefits of market regulation

Answer 30

• Protection of investors
• Gives confidence in the working of the system

Question 31

Limitations of market regulation

Answer 31

• Cost (administration and compliance) Therefore, less efficient
• Stifling competition and innovation

Question 32

What is risk?

Answer 32

• The chance that you might get a different (positive or negative) expected return
• Can be mitigated by pooling and hedging

Question 33

What is pooling?

Answer 33

• By collecting assets together with independent outcomes, it reduces risk
• For instance, if you own a house there is a chance it could burn down
• You could decided to insure it with a company who insure other houses
• As the risk of one burning durn is independent of the others
• The risk to the insurance company is less than the risk if the individual self insured
• As the assets are covered by other assets

Question 34

What is hedging?

Answer 34

• This is one where two parties are subject to exactly opposite risks, say one person bears the risk of event A happening and the other of event A not happening.
• If these two people can get together and agree on a transaction before the outcome of A is known, they will both have hedged their risk.
• For example, a producer of cocoa wishes to know how much cocoa to grow next year. He will be influenced by the price of cocoa prevailing next year, which he would like to know now.
• Similarly, a manufacturer of chocolates wishes to plan his production of sweets and would like to be assured of future supplies at fixed prices. If the producer and manufacturer get together to agree today on a price for cocoa to be delivered next year, they will both have hedged their risks.
• The producer’s uncertainty of the future price he can get for his cocoa and hence how much he should grow has been resolved. The manufacturer’s uncertainty concerning future prices and supplies of raw materials is removed.
• Both parties have hedged the risk of a change in the price of cocoa – on the manufacturer’s side the risk of cocoa prices going up and on the producer’s side the risk of cocoa prices going down.