Chapter 6 - The theory of finance

Question 1

Tangible assets

Answer 1

Assets that physically exist

Question 2

Intangible assets

Answer 2

Asset that do not physically exist but can nevertheless be exploited by the company to generate profits

Question 3

Tow basic issues finance involves

Answer 3

• What real assets should the firm invest in? (Capital budgeting decision)
• How should the cash for the investment be raised? (Financing decision)

Question 4

Role of the treasurer in a company

Answer 4

• Looks after the company’s cash
• Raises new capital
• Maintains relationships with banks, shareholders and other investors

Question 5

Working capital

Answer 5

A company’s short-term assets and short-term liabilities

Question 6

Fixed capital

Answer 6

Long-term assets used to produce goods and services on an ongoing basis. Mainly intangible

Question 7

Investing in fixed capital often involves complex choices between (3)

Answer 7

• Alternative capital assets
• Dates of commencement
• Methods of financing

Question 8

Financial analysis

Answer 8

Involves bringing together estimates and ideas from a variety of disciplines in order to reveal their financial implications

Question 9

Agency costs

Answer 9

A principle that is used to explain and resolve issues in the relationship between business principals and their agents.

Most commonly, that relationship is the one between shareholders, as principals, and company executive, as agents

Question 10

Agency costs are incurred when

Answer 10

• Managers (as agents) do not attempt to maximise the value of the company
• Shareholders (as principles) incur costs monitoring the managers and attempting to influence their actions

Question 11

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

Answer 11

By linking management’s remuneration directly to the performance of the company’s shares

Question 12

Types of mergers

Answer 12

• Horizontal
• Vertical
• Conglomorate

Question 13

Horizontal mergers

Answer 13

Merger between two firms engaged in similar activities

Question 14

Reasons for Horizontal mergers

Answer 14

• Often undertaken to benefit from economies of scale
• To exploit complementary resources
• To access opportunities only available to larger organizations
• To eliminate inefficiencies

Question 15

Economies of scale

Answer 15

A situation in which long-run average costs decrease with the level of output

Question 16

Vertical merger

Answer 16

Merger between companies engaged in different stages of a production process

Question 17

Reasons for vertical mergers

Answer 17

• The new company spans a larger part of the process from raw materials to the final consumer and therefore co-ordination and administration may be improved

Question 18

Conglomerate mergers

Answer 18

Merger of firms in unrelated lines of business

Question 19

Reasons for conglomerate mergers

Answer 19

• Utilization of unused tax benefits
• Utilization of surplus funds
• Protection against threat of takeover
• Diversification
• Enhancement of earnings per share
• Exploitation of lower financing costs

Question 20

Behavioral finance

Answer 20

Looks at how a variety of mental biases and decision-making errors affect financial decisions

Question 21

Anchoring and adjustment

Answer 21

Explains how people make estimates. They start with an initial idea of the answer (the anchor) and then adjust away from this to arrive at their final judgement

Question 22

Prospect theory

Answer 22

A theory of how people make decisions based on a concept of value in terms of gains or losses relative to a reference point, generating utility curves with an inflexion point at the reference point

Question 23

Framing

Answer 23

The way a choice is presented (framed) and worded in terms of gains and losses affects the answer given or decision made

Question 24

Myopic loss aversion

Answer 24

Suggests that investors are less risk-averse when faced with a multi-period series of gambles

Question 25

Issues affecting probability estimates

Answer 25

• Anchoring
• Dislike of negative event (Individuals tend to underestimate the probability of a negative event occurring
• Representative heuristics
• Availability

Question 26

Representative heuristics

Answer 26

People find more probable that which they find easier to imagine

Increased detail => increase apparent likelihood (although true probability can only decrease)

Question 27

Overconfidence

Answer 27

People tend to overestimate their own abilities, knowledge and skills. Increased knowledge increases the discrepancy between accuracy and overconfidence

Question 28

Hindsight bias

Answer 28

Events that happen are thought to have been predictable prior to the event

Question 29

Confirmation bias

Answer 29

People tend to look for information that confirms their view

Question 30

Mental accounting

Answer 30

People tend to separate related events and decisions and find it difficult to aggregate events and therefore set up a series of mental accounts instead of netting gains and losses

Question 31

Primary effect

Answer 31

People tend to pick the first option presented

Question 32

Recency effect

Answer 32

People tend to pick the final option presented

Question 33

Status quo bias

Answer 33

People tend to prefer to keep things as they are

Question 34

Financial covenant

Answer 34

Restriction placed on a borrower which require that it meets specified financial criteria