Chapter 6: The theory of finance Flashcards

1
Q

Behavioural finance: (2)

A
  1. The field of behavioural finance looks at how a variety of mental biases and decision-making errors can affect financial decisions.
  2. It relates to the psychology that may underlie and drive financial decision-making behaviour.
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2
Q

Various behavioural finance theories: (6)

A
  1. prospect theory
  2. framing
  3. loss aversion
  4. other approaches (heuristics) and behaviours
  5. mental accounting
  6. the effect of options
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3
Q

Behavioural finance theories: FOAM POEM

A

F - Framing
O - Overconfidence
A - Anchoring and adjustment
M - Myopic loss aversion

P - Prospect theory
O - Options (effect of options)
E - Estimating probability
M - Mental accounting

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4
Q

Prospect theory: (5)

A
  1. Prospect theory is a theory of how people make decisions when faced with risk and uncertainty.
  2. It is the alternative to the conventional risk-averse/ risk-seeking decreasing marginal utility theory.
  3. Prospect theory assumes an asymmetric response to losses vs gains from a particular reference point.
  4. i.e. that individuals suffer more pain from a loss than they benefit from a gain of the same value.
  5. This asymmetry generates utility curves with a point of inflexion at the chosen reference point.
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5
Q

Framing (and question wording):

A

The way a choice is presented (“framed”) and, particularly, the wording of a question in terms of gains and losses, can have an enormous impact on the answer given or the decision made.

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6
Q

Loss aversion

A

A person may be much more sensitive to losses than gains of the same magnitude.

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7
Q

Other approaches (heuristics) and behaviours: (11)

A
  1. Overconfidence
  2. Optimism
  3. Representative bias
  4. Belief preservation
  5. Anchoring
  6. Availability bias
  7. Familiarity
  8. Dislike of negative events
  9. Self-serving bias
  10. Status quo bias - preferring to keep things unchanged
  11. Herding behaviour - following the crowd/ fear of missing out
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8
Q

Overconfidence: (3)

A
  1. People tend to be overconfident when making estimates both regarding the confidence intervals around their estimates and the probability of particular events occurring.
  2. Overconfidence is related to hindsight bias - viewing outcomes as having been predictable.
  3. and confirmation bias - looking for confirmatory evidence.
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9
Q

Overconfidence: (3)

A
  1. People tend to be overconfident when making estimates both regarding the confidence intervals around their estimates and the probability of particular events occurring.
  2. Overconfidence is related to hindsight bias - viewing outcomes as having been predictable.
  3. and confirmation bias - looking for confirmatory evidence.
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10
Q

Optimism

A

People tend to overestimate their own abilities

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11
Q

Representative bias: (2)

A
  1. People are poor at making good inferences about probabilities.
  2. They often put too much emphasis on particular features of the sample as opposed to the likely features of the whole population.
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12
Q

Belief preservation

A

Once people have formed a belief, they tend to be overly reluctant to change it even in the face of strong contrary evidence.

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13
Q

Availability bias

A

When estimating probabilities people tend to focus excessively on more recent and more salient events

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14
Q

Familiarity

A

Familiarity describes the process by which people favour situations or options that are familiar over others that are new.

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15
Q

Dislike of negative events

A

The valence of an outcome (the degree to which it is considered as negative or positive) has an enormous influence on the probability estimates of its likely occurrence.

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16
Q

Self-serving bias

A

Self-serving bias occurs when people credit favourable or positive outcomes to their own capabilities or skills while blaming external forces or others for any negative outcomes.

17
Q

Status quo bias - preferring to keep thing unchanged

A

Status quo is the inherent tendency of people to stick with their current situation, even in the presence of more favourable alternatives and even when no transaction costs are involved.

18
Q

Herd behaviour - following the crowd/ fear of missing out

A

Herd behaviour describes the tendency of people to follow or mimic the actions and decisions taken by others, as a mechanism to deal with uncertain situations.

19
Q

Mental accounting: (3)

A
  1. People show a tendency to separate related events and decisions and find it difficult to aggregate events.
  2. Thus, rather than netting out all gains and losses people set up a series of ‘mental accounts’ and view individual decisions as relating to one or another of these accounts.
  3. For example, all profitable trades may be grouped in one ‘mental account account’ and all losses in another with the value of the gains being easier to remember.
20
Q

Effect of options:

A

Experimental evidence also suggests that the range of options or choices presented to people may influence their choices.

21
Q

Finance involves two basic issues: (2)

A
  1. What real assets should the firm invest in? (the capital budgeting decision)
  2. How should the cash for the investment be raised (the financing decision)
22
Q

Mergers and acquisition can be classified in three forms: (3)

A
  1. Horizontal - involving firms engaged in similar activities
  2. Vertical - involving firms engaged in different stages of a production process
  3. Conglomerate - involving firms in unrelated lines of business
23
Q

Motives for horizontal mergers include: (4)

A
  1. economies of scale
  2. access to opportunities that would otherwise be unavailable
  3. access to complementary resources
  4. the elimination of inefficient resources
24
Q

Motives for vertical mergers include: (2)

A
  1. improved co-ordination and administration

2. access to complementary resources

25
Q

Motives of conglomerate mergers include: (6)

A

T - utilisation of unused Tax benefits

S - utilisaition of Surplus funds
P - Protection against threat of takeover
E - Enhancement of earnings per share
E - Exploitation of lower financing costs
D - Diversification

26
Q

Describe long-term financial planning: (4)

A
  1. Long-term financial planning (capital budgeting) commonly looks 3 to 5 years ahead and assesses the capital required for long-term projects.
  2. It involves the development of business plans setting out the firm’s anticipated product development and sales objectives.
  3. These are then converted into financial plans, which convert the business plans into future cashflows.
  4. Sensitivity analysis should be used when developing the plans
27
Q

Describe short-term financial planning: (6)

A
  1. Short-term financial planning (cash management) often takes the form of a 12-month ‘rolling’ plan…
  2. and revolves around the analysis of working capital requirements

It involves the consideration of:

  1. trade credit management (trade receivables and payables, i.e. debtors and creditors)
  2. cash management
  3. stock and inventory policy (raw materials and finished and unfinished goods)
  4. non-cash elements in the projected accounts.