Chapter 6: Theory of Finance

Question 1

Outline the ideas behind

Framing
Overconfidence

Answer 1

Framing

Suggests that the way in which choice is presented or ‘framed’ can have an enormous impact on answer given or decision made
Equally, response to question can be influenced by way its worded

Overconfidence

People tend to overestimate own knowledge and skills. Discrepancy between accuracy and overconfidence increases with knowledge
May result from

Hindsight bias - events that happen/dont happen will be thought of as having been predictable/unlikely prior to event

Confirmation bias - people tend to look for evidence that confirms their point of view (and dismiss evidence that does not justify it)

Question 2

What is meant by anchoring and adjustment

Answer 2

People’s estimates are anchored by past experience or ‘expert’ opinion, and fall to adjust fully to reflect current conditions

Effect grows with size of difference between anchor value - original estimate provided - and pre-anchor estimate - mean estimate people make before exposed to explicit anchor

Effects of anchoring difficult of ignore, even when people aware of effect and aware that anchor is ridiculous

Question 3

Explain what
Is meant by the term estimating probabilities
myopic loss aversion suggests

Answer 3

Estimating probabilities

Investors estimates of probabilities may be influenced by
+Dislike of negative events
+Representative heuristics - as amount of detail describing circumstance or outcome increases, its apparent likelihood may increase (although true probability can only decrease)
+Availability - suggests more generally that people tend to over-estimate probability of events they can easily imagine, and vice versa

Myopic loss aversion

People take short term view in assessing gains and losses, which leads them to overcautious, even when investing for long term

Also, investors are less risk - averse when faced with repeated series of gambles than when faced with single gamble

Question 4

Explain what is suggested by

Prospect theory
mental accounting

Answer 4

Prospect theory

Suggests that whilst investors are typically risk averse when considering gains relative to some benchmark, they are likely to be risk -loving when considering losses - ie they would prefer to take chance on gamble with higher expected losses than to incur certain loss

Mental accounting

Suggests people show tendency to separate related events and decisions and find it difficult to aggregate events and decisions

Rather than netting out all gains and losses, people set up series of mental accounts and view individual decisions as relating to one or another of these accounts

Question 5

Describe how the order of a range of choices may influence choice

give four other influences of the range of options choice

Answer 5

How order of choices may influence choice

+Primary effect suggests people are more likely to choose first option presented
+Recency effect suggests that final option may be preferred
+other research suggests people are more likely to choose an intermediate option than one at either end

Other influences of range or options on choice

+Greater range of options discourages decision making
+status quo bias - people have marked preference for keeping things as they are
+regret aversion - by retaining existing arrangements, people minimise possibility of regret (pain associated with feeling responsible for loss)
+ambiguity aversion - people dislike uncertainty and are prepared to pay a premium for rules

Question 6

Outline what is meant by long term financial planning

Answer 6

Concerned with long term investment decisions and capital requirements

looks several years ahead and develops financial plans based on firm’s business plans - its anticipated product development and sales objectives

uses sensitivity analysis to explore impact of different scenarios

once business plans have been developed, they can be converted into financial plans starting with forecasts of future cash flows

Sensitivity analysis will usually be performed again

considers non - operational issues, e.g. financial covenants and credit ratings

Question 7

Outline what is meant by short term financial planning

Answer 7

Concerned with management of
Working capital requirements (current assets and liabilities)
Trade credit
stock (inventory) policy

Often takes the form of a 12 month rolling plan

Question 8

List the main classes of current assets and current liabilities

Answer 8

Current assets included

Inventories
Trade receivables
cash and short term securities held

Current liabilities include

Trade payable
outstanding dividend and tax payments
short term borrowings and loans