Ch 6 - Theory of Finance Flashcards
Types of Mergers
Horizontal
Vertical
Conglomerate
The financial manager will need to consider two basic issues
Capital budgeting decision
Financing decision
Capital budgeting decision
Considers the choice of projects, and hence real assets, in which the firm should invest
Mainly the remit of the controller/CFO
Complicated in practice because:
May be more than one apparently profitable project
Very difficult to estimate the future profitability of a project
Financing decision
How to best raise the required finance
Mainly the responsibility of the treasurer who:
Looks after the company’s cash
Raises new capital
Maintains relationships with banks, shareholders and other investors
Investment in fixed capital, however, often involves complex decisions between
Alternative capital assets
Dates of commencement
Methods of financing
Financial manager
responsible for the financial operations of the firm. Is the link between the firm’s operations and the financial markets
Real assets
asset used by the company in its normal line of business to generate profits – can be either tangible or intangible
Financial analysis
In capital budgeting involves bringing together estimates and ideas from a variety of disciplines in order to reveal their financial implications
Basically analyse the financial implications of different possible courses of action
It can help with the decision making progress with respect to the following:
Delineate the risks involved in the project
Highlight the salient factors
Suggest risk mitigation for the various risks
Two methods in which to do a financial analysis
Leave the investment appraisal to the people who are most concerned to see the project accepted - May need input from the experts listed above
Likely not to be objective
Use a specialist finance function in an attempt to enforce impartiality and realism
But may lack specialist knowledge of the particular project under consideration
Agency theory
Is a principle that is used to explain and resolve issues in the relationship between business principals and their agents.
Relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform a service on their behalf. Most commonly, that relationship is the one between shareholders, as principals, and company executives/managers, as agents. Agency theory assumes that the interests of a principal and an agent are not always in alignment.
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
Separation of ownership and management can lead to principal-agent problems, which is
Where the interests of owners and managers diverge
This gives rise to agency costs
Agency costs examples
The costs associated with monitoring the action of others
and seeking to influence their actions
and the lower returns to the principles than would be the case if the company was run in line with the principles best interests
Horizontal merger
Involves two firms engaged in similar activities
Horizontal merger motives
I ECO
Inefficient resources eliminated
Economies of scale
Complementary resources (have access to)
Opportunities that would otherwise be unavailable can be accessed - only available for larger organisations
Vertical merger
Involve companies engaged in different stages of a production process
Vertical merger motives
CAC
Co-ordination and administration can be improved
Access to complementary resources may be improved
Conglomerate merger
Involve firms in unrelated lines of business
Conglomerate merger motives
TEST FED
Tax - Utilisation of unused tax benefits
EPS - Enhancing of earnings per share
Surplus - Utilisation of surplus funds
Takeover - Protection against threat of takeover
Financing - Exploitation of lower financing costs
Economies of scale
Diversification
Behavioural Finance
The field of behavioural finance relates to the psychology that underlies and drives decision-making behaviour. Looks at a variety of mental biases and decision-making errors that affect financial decisions
Types of Behavioral Finance
O EM(M)O FAP
Overconfidence
Estimating probabilities
Myopic loss aversion
Mental accounting
Options - Effect of options
Framing
Anchoring and adjustments
Prospect theory
Anchoring and adjustments
Anchor is based on past experience or ‘expert’ opinion
And then investors amend to allow for evident differences to the current conditions
Prospect theory
Value is based on gains and losses relative to some reference point
People are typically risk-averse when considering gains relative to the reference point
And risk-seeking when considering losses relative to the reference point
Thus there is a point of inflection at the reference point
This theory suggests that the decision made depends on how a problem is ‘framed’ and is thus associated with the concept of framing
Framing
The way a choice is framed and, particularly, the wording of a question in terms of gains and losses, can have an impact on the decision made
Myopic loss aversion
Less risk-averse when faced with a multi-period of ‘gambles’ - i.e. if they think long-term rather than the immediate short-term gamble then investors are less risk-averse
Thus myopic loss aversion is when an investor only considers the immediate short-term gamble and ends up having less risky assets, to the detriment of their best interests
Estimating probabilities
Dislike of negative events - Underestimate the probability
Representative heuristics
People find more probable that which they find easier to imagine
Increase in detail, apparent likelihood increases but true probability decreases
‘stereotyping’
Availability heuristic
People are influenced by the ease with which something can be brought to mind
e.g. car crashes vs cancer
‘memory’
Overconfidence
People tend to overestimate their own abilities, knowledge and skills
Discrepancy between accuracy and overconfidence increases as the respondent is more knowledgeable
May be a result of
Hindsight bias
Events that happen = thought of as predictable prior to the event
Events that don’t happen = thought of as unlikely prior to the event
Confirmation bias
Look for evidence that confirms their point of view and dismiss evidence that does not justify it
Mental accounting
People show a tendency to separate related events and decisions and find it difficult to aggregate events
Effect of options
Range of options or choices presented to people may influence their decision
Note:
Status quo bias
Regret aversion
Ambiguity aversion – people are prepared to pay a premium for rules. Or prepared to pay a premium for info to reduce the uncertainty of a decision to be made
Long-term FP
Also called capital budgeting
Commonly looks 3 to 5 years ahead
LT FP is concerned with the assessment of the total amount of capital required for long-term projects and the raising of the company’s required long-term capital
The development of financial plans should begin by consideration of an organisation’s business plans – it’s anticipated product development and sales objectives
Will need to consider the organic development of existing activities and also plans for new developments
These are then converted into financial plans, which convert the business plans into future cashflows
Primarily a responsibility of the finance function within the organisation, liaising with senior management to ensure the production of a financial plan that is consistent with business plans
Analysis of the anticipated need for working capital and growth in fixed assets, together with considerations for tax, dividend and interest payments, will enable the financial manager to plan for capital budgeting and structure (amount and type of capital that must be raised)
Will also consider non-operational issues such as:
Possibility of breaching financial covenants
Impact of borrowing on credit ratings
Level of gearing on balance sheet
Financial planning therefore focuses on the sources and uses of funds as well as the implications for borrowing and financial structure
Sensitivity analysis should be used when developing the plans
Financial – allow for changes in the financial environment
Business – explore business plans under a range of scenarios. I.e. future trading conditions
Short-term FP
Also called cash management
Often takes the form of a 12-month ‘rolling’ plan
Revolves around the analysis of working capital requirements
Closely associated with operational issues, since it will involve consideration of credit policy and possible deferment of settling accounts payable
It involves the consideration of (i.e. these are components in working capital):
Trade credit management
Cash management
Stock and inventory policy
Non-cash elements in the projected accounts * - know these
Working capital
Is the company’s short-term assets and short-term liabilities
Fixed capital or capital goods
Long-term assets that are used to produce goods and services on an ongoing basis - e.g. machinery
It is not used directly in the production process, but it is likely to depreciate over time
Fixed capital outlays often have a serious bearing on the direction and pace of a firm’s growth – because of large sums committed for long periods of time
Merits of incentivising managers through share option packages (6)
Help attract and retain quality management
Align the interests of the managers with the shareholders/owners - this is in line with good corporate governance
It is more tax efficient to offer share options than additional salary or other benefits
Difficult to devise a package with enough downside risk to the management
Management may focus on actions to increase short-term value, rather than on improving the company’s long-term prospects
The option is not appropriate if the shares are tightly held by a few investors, or not listed and restrictions need to be imposed on when management may sell shares
