Chapter 6 - The theory of finance Flashcards
Tangible assets
Assets that physically exist
Intangible assets
Asset that do not physically exist but can nevertheless be exploited by the company to generate profits
Tow basic issues finance involves
- What real assets should the firm invest in? (Capital budgeting decision)
- How should the cash for the investment be raised? (Financing decision)
Role of the treasurer in a company
- Looks after the company’s cash
- Raises new capital
- Maintains relationships with banks, shareholders and other investors
Working capital
A company’s short-term assets and short-term liabilities
Fixed capital
Long-term assets used to produce goods and services on an ongoing basis. Mainly intangible
Investing in fixed capital often involves complex choices between (3)
- Alternative capital assets
- Dates of commencement
- Methods of financing
Financial analysis
Involves bringing together estimates and ideas from a variety of disciplines in order to reveal their financial implications
Agency costs
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
Agency costs are incurred when
- 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
How might the interests of a company’s management be aligned with those of the shareholders
By linking management’s remuneration directly to the performance of the company’s shares
Types of mergers
- Horizontal
- Vertical
- Conglomorate
Horizontal mergers
Merger between two firms engaged in similar activities
Reasons for Horizontal mergers
- Often undertaken to benefit from economies of scale
- To exploit complementary resources
- To access opportunities only available to larger organizations
- To eliminate inefficiencies
Economies of scale
A situation in which long-run average costs decrease with the level of output
Vertical merger
Merger between companies engaged in different stages of a production process
Reasons for vertical mergers
- 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
Conglomerate mergers
Merger of firms in unrelated lines of business
Reasons for conglomerate mergers
- 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
Behavioral finance
Looks at how a variety of mental biases and decision-making errors affect financial decisions
Anchoring and adjustment
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
Prospect theory
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
Framing
The way a choice is presented (framed) and worded in terms of gains and losses affects the answer given or decision made
Myopic loss aversion
Suggests that investors are less risk-averse when faced with a multi-period series of gambles
Issues affecting probability estimates
- Anchoring
- Dislike of negative event (Individuals tend to underestimate the probability of a negative event occurring
- Representative heuristics
- Availability
Representative heuristics
People find more probable that which they find easier to imagine
Increased detail => increase apparent likelihood (although true probability can only decrease)
Overconfidence
People tend to overestimate their own abilities, knowledge and skills. Increased knowledge increases the discrepancy between accuracy and overconfidence
Hindsight bias
Events that happen are thought to have been predictable prior to the event
Confirmation bias
People tend to look for information that confirms their view
Mental accounting
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
Primary effect
People tend to pick the first option presented
Recency effect
People tend to pick the final option presented
Status quo bias
People tend to prefer to keep things as they are
Financial covenant
Restriction placed on a borrower which require that it meets specified financial criteria
