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CIMA > Chapter 4 > Flashcards

Chapter 4 Flashcards

1
Q

What is the financial system?

A

The financial system is the system whereby households, firms and governments can borrow or invest funds.

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2
Q

What is a financial intermediary?

A

At any given point there are always likely to be some parties who have a surplus of funds and some who will have a deficit.

Financial intermediaries (eg banks/building societies) exist in order to make it easier for those with surplus funds who want to invest to be put in touch with those who have a shortage of funds who
want to borrow

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3
Q

What is the difference between direct and indirect finance?

A

‘DIRECT’ finance involves no intermediary whereas ‘INDIRECT’ finance does.

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4
Q

Where else is it possible to invest or borrow funds from directly?

A

Financial markets

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5
Q

What do the financial markets consist of?

A

1) Short term markets (money markets)
2) Long term markets (equity and bond markets)

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6
Q

What are Short term finance sources?

A

-Bank overdraft
-Credit cards
-Credit agreements eg. a lease/hire purchase agreement
-Bills of exchange
-Commercial papers

Some of these are more applicable to individuals than firms and vice versa

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7
Q

What are commercial papers? KEY TERM

A

Commercial papers are unsecured promissory notes (effectively IOUs) issued by companies that generally have a life of less than 270 days

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8
Q

What are long term finance sources?

A

-Share capital/equity. This is value from selling shares and from retaining profits in the business.
-Long-term loans/bonds/debentures. These loans are generally secured on the assets of the business (for individuals the most common is a mortgage on a home)
-Venture capital – often seen in high-risk enterprises (such as new start-ups) whereby a venture capitalist finance risky ventures, whereby the capitalist demands a high return because of the high risks involved (e.g Dragon’s Den!).
-Mezzanine finance – combines aspects of debt and equity/shares. The finance may be initially given as a loan; the lender may then have the right to convert to shares in the company if the
loan is not paid back in time

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9
Q

How does synchronisation apply to governments?

A

Governments need to spend money on different things:

-Government employee salaries and pensions
-Providing public services (eg NHS)
-Purchase and repair of Government buildings
-Welfare payments such as unemployment benefits

They receive money from a number of sources (mostly different types of tax).

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10
Q

Governments often have a lack of synchronisation between payments on receipts..

A

-Governments are likely to have a flow of income which is not identical to their flow of expenditure; there is a lack of synchronisation between payments and receipts. This can also happen in the short, medium or long term.
- If Government revenues exceed expenditure, there is a budget surplus
- Where expenditure exceeds revenues, there is a budget deficit (this will need to be financed)

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11
Q

What are the main categories of financial intermediarys

A

-Clearing banks
-Building societies
-Investment banks
-Insurance companies
-Unit trusts/investment trusts
-Pension Funds
-Stock exchanges
-Venture capitalists

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12
Q

Financial intermediaries: Explain a clearing bank

A

These are sometimes referred to as “retail” banks or “high street” banks (e.g. HSBC, LloydsTSB) and provide the principal medium to help the general public with banking services. Banks take deposits from those who have a surplus of funds and lend these funds on
to those who are looking to borrow

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13
Q

Financial intermediaries: Explain Building societies

A

Provide a similar service to that of the clearing banks although traditionally they have been mutual organisations rather than companies (many mutual building societies
have converted to private companies in the last 10-15 years).

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14
Q

Financial intermediaries: Explain Investment banks

A

Also known as “merchant banks”, they provide services and products to firms and also sometimes wealthy individual

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15
Q

FInancial intermediaries: Explain Insurance Companies

A

Insurance companies. Act as an intermediary by bringing those who want to mitigate or
eliminate risk together with those who are prepared to accept risk for an agreed price

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16
Q

Financial intermediaries: Unit trusts/investment trusts

A

Similar types of organisations that essentially invest in stocks and shares of businesses for clients. They therefore provide funds for companies when new shares
are issued and a long term means for investors to efficiently invest surplus funds.

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17
Q

Financial intermediaries: Pension funds

A

Use pension contributions of individuals and firms to invest in a range of financial assets (equities, bonds etc.)

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18
Q

Financial intermediaries: Stock exchanges

A

Provide the trading platform to bring investors and borrowers in equities and bonds together

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19
Q

Financial intermediaries: Venture capitalists

A

Generally, provide finance for higher risk propositions such as start-up businesses and management buy outs

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20
Q

What are the benefits of using financial intermediaries? (compared to lenders and borrowers talking directly to one another)

A

RAMM
Risk Management
Aggregation
Maturity transformation
Matching borrowers and lenders

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21
Q

RAMM: Risk Management

A

Risk management – individual borrowers and savers are shielded from the bad debt risk of other borrowers and lenders as the bank effectively takes that risk on

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22
Q

RAMM: Aggregation

A

Aggregation. An intermediary can take small amounts from investors and lend on in larger packages. This is a significant benefit as lenders and borrowers don’t need to find people who
want to deal with exactly the same amounts as them

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23
Q

RAMM: Maturity transformation

A

Maturity transformation. The intermediary can provide investors and borrowers with instruments that match their desired timescales. For example, investors may want to invest for
the short term but borrowers may wish for a longer term source of finance.

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24
Q

RAMM: Matching borrowers and lenders

A

Matching borrowers and lenders. A borrower will normally be able to find an intermediary who is prepared to provide them with some funds even if the general market conditions are not that
favourable

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25
Q

What is a financial instrument? KEY TERM

A

A financial instrument is a general term used to describe any form of funding medium. The term is most often used when describing short term money market financing mediums but can be equally used when describing longer term instruments such as shares and bonds

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26
Q

Financial instruments: Cash instruments

A

Cash instruments (e.g. shares and bonds) - the value is determined directly by the market

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27
Q

Financial instruments: Derivative instruments

A

Derivative instruments (e.g. options futures etc) which get their name because their value derives from some underlying asset. (A good example of a derivative instrument is a share option which is valued partly based on what
the price of the share that it relates to is doing.)

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28
Q

What are common financial contracts/assets?

A

-Credit agreements
-Mortgages
-Bills of Exchange
-Certificates of Deposit
-Equities
-Bonds
-Mezzanine Finance
-Venture capital
-Impact of the company: Gearing

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29
Q

FC/A: Credit agreements

A

A generic arrangement whereby a party can obtain goods or services now but make repayments over a period of time (effectively borrowing to make the initial purchase). There are various types of format
to a credit agreement such as credit cards, loans/overdrafts, HP/leasing, supplier credit terms

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30
Q

FC/A: Mortgages

A

A mortgage is a loan that is generally secured over property such that if repayments are not made the mortgagor (e.g. the bank) has a right to take control of the property (repossession) from the
mortgagee (e.g. you!)

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31
Q

FC/A: Bills of Exchange

A

These are commonly used in commercial business trading, particularly when making sales to a customer in another country.

-In general, the lender (supplier) draws up the bill for a specified amount and repayment date (typically 90 days), the borrower (customer) signs the bill as acceptance of the terms.
-There is an active market for trading these bills so that if the lender does not want to wait 90 days for the money they sell it on the secondary market for an amount slightly less than the face value of the bill

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32
Q

FC/A: Certificates of Deposit

A

-A Certificate of Deposit (CD) is a time deposit.
-It is similar to a saving accounts in that it is insured and virtually risk-free.
-It is different from a savings account in that the CD has a specific, fixed term (often three months, six months, or one to five years), and, usually, a fixed interest rate.
-It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest.
-Some CDs are issued in a “negotiable” form which means they can be actively traded (bought and sold in the secondary market) at any point up until the maturity date.

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33
Q

FC/A: Bonds

A
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34
Q

What are the two types of interest?

A

Simple interest and compound interest

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35
Q

What is simple interest

A

Simple interest refers to the interest earned on the amount of the original investment only, so that an equal amount of interest is earned each year

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36
Q

What is compound interest

A

Compound interest refers to the idea that interest is calculated and paid on the original amount invested plus any accrued interest earned and received up to that point. This will mean that the interest earned each year will increase. This is more common than simple interest in all but the moststraightforward of loans.

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37
Q

CALCULATION: How can the future value of an investment using compound interest be calculated?

A

S = X [1+r]^n

X = initial investment (present value)
S = investments value at the end of n periods
n = number of periods investment is held for
r = interest rate as decimal

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38
Q

Tips for compound interest rate

A

Unless you are told otherwise, assume that any interest rates you are given in the exam are compound interest rates. Just be careful of the wording of the question.

If the amount of capital increases or decreases due to additions or withdrawals, you should break the
calculation down into segments for each addition/withdrawal

In the equation 𝑆 = 𝑋 [1 + 𝑟]𝑛, it should be noted that ‘𝑛’ is the number of periods the investment is held for. This ‘period’ may or may not be a year

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39
Q

What does APR stand for?

A

Annual percentage rate

40
Q

What is APR?

A

The APR is the effective annual rate of interest for a given monthly or quarterly rate

41
Q

Formula for APR

A

R = (1+r)^n - 1
(1+R) = (1+r)^n

R= APR
r=interest rate for the period
n=number of periods in a year

Monthly, n = 12
Quarterly n = 4
Six monthly n = 2

42
Q

What is the annual rate of interest sometimes quoted as?

A

a ‘nominal rate’ rather than an effective rate.

For example, a credit card with a 2% monthly nominal interest rate could be quoted as having a 24% annual rate. Similarly, a card with an annual nominal rate of 12% could be quoted as having a 1%
nominal monthly rate.

43
Q

What is an annuity?

A

Some investments generate a constant return (i.e. the same amount received each period for a
number of periods)

44
Q

Calculation: The present value of an annuity

A

PV = S x (1-(1+r)^-n)/r

45
Q

What is the present value calculation for

A

A business will often find itself needing to make a decision today based on estimates of future cash flows and so it will become necessary to work out what the value today is (present value) of all the
future cash flows (future values). This can be done by rearranging the above formula to becom

46
Q

Calculation: what is the present value of a future cash flow

A

X = S x [1 + r]^-n

X= Prevent value
S = Future value
(1 + r)^-n = DISCOUNT FACTOR

Present value = future value * discount factor

47
Q

What is the discount factor

A

(1+r)^-n

In the CBE exam there is a tables and formulae button, and if you click on it, you will see the discount factors for individual cash flows for whole percentages from 1% to 20% for periods 1 to 20 meaning
you do not need to do this calculation, it is provided so you understand it.

In the CBE exam the questions will usually ask for your answer to be to the nearest $10 or $100 because often these questions can be worked out two or three different ways with slight potential rounding consequences. You can be assured that the exam questions have considered rounding issues
and that is factored into the wording.

48
Q

Calculation: The present value of annuity

A

PV = S x (1-(1+r)^-n)/r

S=annual or periodic amount
rest = annuity factor

PV = annual (or periodic) cash flow * annuity factor

***Annuity factor is provided

49
Q

What is a perpetuity?

A

An annuity that lasts forever

50
Q

Calculation: What is the present value of a perpetuity?

A

PV = S * (1/r)

S=annual/periodic cash flow
r= the interest rate/cost of capital

Perpetuities can be advanced or delayed in the same way as annuities and you must be prepared to do those calculations too. Watch the wording in the question to see the relevant time periods

51
Q

What is a net present value

A

-Most investments will involve a series of cash outflows and inflows at different points in time.
-If we calculate the present value of each cash flow and then add all the present values together, we can calculate the Net Present Value (NPV) of the investment.
-This represents the PV of all the future inflows minus the PV of the outflows

With NPV, it is assumed that all cash flows occur on the last day of the year/period except for the initial investment

52
Q

What does the + or - of an NPV mean?

A

Investments with a positive NPV (PV inflows > PV outflows) should be undertaken and those with a negative NPV should not.

53
Q

What do you use as discount rate for NPV?

A

The discount rate used will be the cost of capital (i.e. the retunr required by the investors)

54
Q

What is internal rate of return?

A

The discount factor which gives a zero NPV
-In simple terms the IRR tells us the actual % return that the project generates

For a typical project that involves an initial outflow of cash followed by series of inflows, as the discount factor increases the NPV reduces (i.e. the project becomes less attractive as the cost of
financing increases).

55
Q

What are the benefits of IRR?

A

1) It allows for the time value of money
2) It does not require an exact cost of funds to be known.
3) As a % measure it is familiar to non-accountants
4) It looks at the entire project

56
Q

What are the disadvantaged of IRR

A

1) It doesn’t tell you whether to accept or reject the proposal
2) It is possible to have more than one IRR

57
Q

How do you determine whether or not a project should be accepted using IRR?

A

If IRR > cost of capital -> accept project
If IRR < cost of captial -> reject project

58
Q

Calculation: How do you calculate IRR for a project?

A

Step 1: Find the NPV of project using the discount rate given in the question (or use an estimate if none given in the question).

Step 2: Find the NPV of project using a second discount rate. A general rule to follow here is that if your NPV in step 1 is positive then you should use a higher discount rate in step 2 (and vice versa for a negative answer in step 1).

Step 3: Use the IRR formula below to estimate the IRR

IRR ~~ L + (NPVL/(NPVL-NPVH))(H-L)

Answer = n%

59
Q

In the field of financial instruments, what does a yield refer to?

A

A yield refers to a return to the investor

When placing a value on an investment both the return generated and the risks will need to be taken into account. There are a number of different yield measures that may be calculated

60
Q

within financial instruments, what are the four types of yield calculations

A

1) Running yield
2) Coupon rate (bill rate/nominal yield)
3) Gross redemption yield (yield to maturity)
4) Dividend yield

61
Q

What is the running yield?

A

Running yield = Annual interest/Market Price

This is sometimes called the interest yield

62
Q

What is the dividend yield?

A

Dividend yield = Annual dividend/Market price(or share price)

The dividend yield is similar to the running yield but in relation to shares (equity) rather than bonds. It indicates the current % dividend return in relation to the existing share price.

63
Q

What is a coupon rate (bill rate or nominal yield)

A

This is simply the interest rate offered on a bond and is the % of the nominal (par) value of the bond that is paid as interest each period.

64
Q

Gross redemption yield (yield to maturity)

A

This represents what the overall average return to the investor (bond holder) which takes into account both the interest returns and any capital gain or loss on redemption of the bond.
Calculations of gross redemption yields are not required on the BA1 syllabu

65
Q

How can the overall return to an investor in any given period on equities be measured?

A

TSR - total shareholder return

66
Q

How is the TSR calculated?

A

This is calculated as the dividend in the year plus the change in share price ALL divided by the share price at the start of the year. This will be expressed as a %.

67
Q

What is one of the key factors that affects the return required by investors in any financial instrument?

A

RISK
The higher the perceived risk in any investment the higher the required return will be

68
Q

List financial instruments from low to high risk

A

1- Low - Treasury bills (s/t govt securities)
2- Government bonds (longer term)
3 - corporate bonds
4- equities

Short term gov issues treasury bills are considered to have negligible or zero risk, as there is little risk of the gov defaulting on its short term sterling borrowings

69
Q

Why is investing in ordinary shares of a company highest risk?

A

-Dividends may not be paid ( directors determine this)
-You may not be able to sell the shares

70
Q

What is the yield curve?

A

The yield curve is a graphical representation of the relationship between interest rates on financial securities (e.g. bonds) and the term to maturity (i.e. how long it is until the underlying debt matures).

The yield curve will normally ve represented as an upward sloping line

The actual shape of the yield curve at any particular point in time will depend on the interaction of a number of different forces as well as the above factors. These include market expectations as to what interest rates might do over the short, medium and long term and supply and demand for borrowing
for different lengths of time.

71
Q

Why is it normal to expect bonds with a longer term to maturity to offer a higher yield?

A

1) Liquidity Preference
2) Additional risk
3) Uncertainty on inflation

72
Q

Yield: Liquidity preference factor

A

If an investor is tying their cash up for a longer period of time, then they will need to be
compensated for this lack of liquidity. This is referred to as liquidity preference

73
Q

Yield: Addition risk factor

A

The investor will need to be compensated for the additional risk of investing longer term in that there will be a greater degree of uncertainty surrounding the future performance of the
economy/companies over a longer period

74
Q

Yield : Uncertainty on inflation

A

(Also, the uncertainty about what inflation will do over a longer period (and hence what future interest rates might do) creates greater risk for the longer-term investor). We will consider such
factors in the later chapters

75
Q

what is term to maturity

A

how long it is until the underlying debt matures

76
Q

What is the difference between a nominal and real rate of interest?

A

Real interest rate - the rate of return after inflation, as the return or yield of an investment is eroded away by inflation

Nominal rate = the rate before adjusting for inflation, also referred to as ‘money rate’ sometimes

77
Q

How are the nomial and real rate of interest linked

A

1 + RIR = (1+money rate)/(1+inflation rate)

78
Q

How can central banks impact yield rates?

A

A central bank sets the short term interest rates.
-which can have a direct impact on the yields on other financial securities (e.g. shares and bonds)

e.g. in the UK this is achieved by
open market operations - the central bank buys and sells short term instruments (t-bills and s.t bonds) in the primary markets

Also quantitative easing - see other card

79
Q

How might a central bank boost spending in an economy that is lacking in consumer confidence?

A

By purchasing assests of the government (e.g. government bonds) or private sector (e.g. pension funds).
-This can reduce interest rates via pushing up asset prices and lowering yields such that spending is encouraged again.
- This is referred to as quantitative easing

80
Q

CFA/C: What is Mezzanine Finance

A

-This type of debt finance is used in higher risk lending situations.
-The debt is usually unsecured and carries a higher interest rate than normal secured bank borrowings.
-There may well be equity warrants attached to the debt that allow the holder to purchase some equity shares in the company at a fixed price at some later date

81
Q

CFA/C: What is venture capital

A

Venture capital usually refers to equity financing for higher risk investment scenarios

82
Q

CFA/C: What is ‘Impact on the company: Gearing’

A

A company that uses a large proportion of debt finance relative to equity finance is sometimes referred to as highly geared.

83
Q

CFA/C: What are Equities

A

Equities refer to finance that is raised through the issue of shares.

Two types of shares = ordinary shares and preference shares

84
Q

What is an ordinary share?

A

Ordinary shares, holders of which are the owners of the business. Ordinary equity shares by nature are irredeemable (cannot usually be sold back to the
company). They can be traded, ie sold on, to a third party.
This is the most common type of share.

85
Q

What is a preference share? three examples of a preference share

A

A preference share may contain some characteristics of both debt and equity. It is less likely to give the owner a right to vote in shareholder meetings than an ordinary share.

EG1 Cumulative: if a dividend is not paid one year then it will be added on to dividends paid in later years

EG2 Redeemable: may have rights to be bought back at a later date

EG3 Participating: thave a right to a share in any excess profits over and above a certain amount

86
Q

CFA/C: What is a bond?

A

-A bond is a long-term debt instrument issued by a government or companies.

-The term ‘bond’ relates to the fact that there is a written legal agreement with stated terms and conditions.

-Most bonds are redeemable (i.e. they have a fixed repayment date) although a few irredeemable bonds do exist. Irredeemable bonds such as the 3.5% War Loan pay a fixed
interest every year in perpetuity.

-Bonds are sometimes called debentures (secured bonds) or loan stock (unsecured bonds), although most corporate (company) bonds in the UK are debentures.

87
Q

BONDS: UK specific stuff

A

-UK issued bonds will pay the owner interest based on the bonds “coupon rate” every 6 months.
-Bonds that are issued in the UK but not denominated in £ and bonds that are issued in £ but not in the UK are examples of Eurobonds. Eurobonds pay interest annually. Coupon rates are also
called ‘bill rates
-Government bonds in the UK are referred to as GILTS (Government Index Linked Treasury Stock)

88
Q

What are the difference between gov and corporate bonds

A

Corporate bonds are generally considered to be a slightly higher risk investment than government bonds and so will tend to offer a better yield to the investor

89
Q

How many types of diff bonds are there?

A

There are many different varieties of bond (e.g. zero-coupon, index linked, convertible…) but it is more important that you understand in principle what a bond is than being able to describe lots of different types. Refer to your text book if you are curious.

Commercial papers were defined above as a source of finance. These can also be traded in the market (this is referred to be as being negotiable).

90
Q

How do entities maintain a stable financial position

A

-By balancing or matching their payments and receipts
-Refered to as ‘syncronisation between payments and receipts’

91
Q

What is lack of synchronisation?

A

-When there is not a balance between payments and receipts
-Lack of synchronisation between payments and reciepts can happen in the short, medium or long term.

-Financial intermediates take money from lenders and relend to borrowers to balance the lack of synchroisation

-movement between these bodies in the economic system = flow of funds

92
Q

With annuities and perpetuities, when is the first payment/receipt?

A

It is assumed that the first payment/receipt takes place in one year or periods time

-This is not the case if it is an advanced or delayed annuity perpetuity

93
Q

What is an advanced annuities?

A

The first payment/receipt will be taking place now (T0)
-You simply have to add a years amount which has not been discounted to your normal annuity calculation - you don’t have to account for the time value of money received now

-Could also simply adjust the annuity factor by adding 1 to take account of the first cash flow happeneing at time 0

PV = Annuity x AF + annuity
or Annuity x (AF +1)

be careful for 10 years starting now - = 9 years + advanced

94
Q

what is an delayed annuities?

A

-The first payment/receipt would not be happening until some point after time 1.

PV = Annuity * AF(6)*DF(2)
or
PV - Annuity * (AF(1-8)-AF(1-2))

95
Q

What is a terminal value of an annuity?

A

The terminal value is the final, end value of the amount

Terminal value - annuity * ((1+r)^n -1)/r

CIMA (11 decks)

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