2 Terminology and the Financial System Flashcards
Whats the most important elements to a better answer
Add some context with simple examples
What is a real asset?
- Identifiable assets with intrinsic value
- Doesn’t have to be tangible
- Can be strong workforce or patent
What is a financial asset?
- Asset that derives value from contractual claim
- Such as a share or bond
- Claim to a future cashflow and not any underlying asset
What is capital expenditure?
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.
What are financing decisions?
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.
What is a closely held company?
Typically a smaller company that is not publicly traded
What is a public company?
A company which is listed on the stock exchange for anyone to buy
What is limited liability?
When the company has been incorporated and has a separate legal entity. The owners are only exposed to the amount of their investment
What is limited liability?
When the company and the owner are the same entity and all their assets can be held to service debt
What is the objective of an organisation?
Make shareholders as wealthy as possible by investing in real assets
Describe the separation of ownership and management
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
What are the objectives of shareholders?
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
Describe the agent principle relationship
When there is a relationship of trust between two parties. A principle employs an agent to carry out a contractual duty
What is the opportunity cost of capital?
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
Formula for gross yield
Gross dividend / Market Price
Market capitalisation formula
Market price x No. Shares
Interest yield formula
Interest / Market Price
Interest formula
Coupon rate x Nominal Debt
Internal rate of return
- 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
What is the quoted price on the stock market?
Often media will quote the ‘mid-market’ price which is the halfway between:
Bid and Offer prices at last quote
What is spread?
The difference between bid and offer
What affects spread?
- 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
What are the two parts of return?
Dividend ‘received’ + a capital gain/deficit
What is dividend cover?
The number of times the latest reported earnings cover the latest declared dividend
How useful is P/E?
- 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
What does a high P/E suggest?
- Expectations of a faster rate of growth than other companies in the same sector
- Or that it is overpriced
What is the purpose of the financial system?
Facilitate the flow of funds from those with surplus to those with deficit looking to make capital investment decisions
Describe market efficiency
- How costly is it to move the funds from surplus to deficit
- This includes commissions and taxes that reduce flow of funds
What are the main types of market efficiency
- Operational
- Pricing
- Dynamic
Benefits of market regulation
- Protection of investors
- Gives confidence in the working of the system
Limitations of market regulation
- Cost (administration and compliance) Therefore, less efficient
- Stifling competition and innovation
What is risk?
- The chance that you might get a different (positive or negative) expected return
- Can be mitigated by pooling and hedging
What is pooling?
- 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
What is hedging?
- 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.
