Chapter 6: The theory of finance

Question 1

Behavioural finance: (2)

Answer 1

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.

Question 2

Various behavioural finance theories: (6)

Answer 2

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

Question 3

Behavioural finance theories: FOAM POEM

Answer 3

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

Question 4

Prospect theory: (5)

Answer 4

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.

Question 5

Framing (and question wording):

Answer 5

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.

Question 6

Loss aversion

Answer 6

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

Question 7

Other approaches (heuristics) and behaviours: (11)

Answer 7

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

Question 8

Overconfidence: (3)

Answer 8

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.

Question 9

Overconfidence: (3)

Answer 9

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.

Question 10

Optimism

Answer 10

People tend to overestimate their own abilities

Question 11

Representative bias: (2)

Answer 11

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.

Question 12

Belief preservation

Answer 12

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

Question 13

Availability bias

Answer 13

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

Question 14

Familiarity

Answer 14

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

Question 15

Dislike of negative events

Answer 15

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.

Question 16

Self-serving bias

Answer 16

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.

Question 17

Status quo bias - preferring to keep thing unchanged

Answer 17

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.

Question 18

Herd behaviour - following the crowd/ fear of missing out

Answer 18

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.

Question 19

Mental accounting: (3)

Answer 19

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.

Question 20

Effect of options:

Answer 20

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

Question 21

Finance involves two basic issues: (2)

Answer 21

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)

Question 22

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

Answer 22

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

Question 23

Motives for horizontal mergers include: (4)

Answer 23

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

Question 24

Motives for vertical mergers include: (2)

Answer 24

1. improved co-ordination and administration

2. access to complementary resources

Question 25

Motives of conglomerate mergers include: (6)

Answer 25

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

Question 26

Describe long-term financial planning: (4)

Answer 26

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

Question 27

Describe short-term financial planning: (6)

Answer 27

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:

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