Chapter 7: The theory of finance

Question 1

Finance involves what two issues?

Answer 1

• Capital budgeting decision
• Financing decision

Question 2

Role of the financial manager (diagram)

Answer 2

Responsible for the financial operations of the firm.
Link between the firm’s operations and the financial markets

Question 3

Capital budgeting decision

How is the decision complicated?

Answer 3

Considers the choice of projects, and hence real assets, in which the firm should invest.

Tied into plans for product development, production and marketing.

Mainly the remit of the controller/CFO

Capital budgeting decision often complicated by the fact that:

• may be more than one apparently profitable project between which to choose
• difficult to estimate the future profitability of a project

Question 4

Financing decision

Whose responsibility is this and what do their responsibilities include?

Answer 4

How best to raise the required finance.
The responsibility of the treasurer who:

• looks after the company’s cash
• raises new capital
• maintains relationships with banks, shareholders and other investors

Question 5

Investment in fixed capital involves complex choices between:

Answer 5

• alternative capital assets
• dates of commencement
• methods of financing

Question 6

Real assets

Answer 6

Assets that are used by the company in its normal line of business to generate profits - can be tangible or intangible.

Question 7

Financial analysis

What can financial analysis achieve?

Answer 7

Financial analysis in capital budgeting involves bringing together estimates and ideas from a variety of disciplines to reveal their financial implications.

Impossible for financial analysis to improve actual fortunes of a particular project, but may be able to:

• delineate the risks involved in the project
• highlight the salient factors
• possibly suggest methods by which these risks might be reduced

Question 8

Methods in which to do a financial analysis

Answer 8

Leave the investment appraisal to the people who are most concerned to see the project accepted - department primarily interested in the project

• likely not objective

Use a specialist finance function in an attempt to enforce impartiality and realism

• may lack specialist knowledge of the particular project under consideration

Question 9

Agency theory

Answer 9

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

Relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform a service on their behalf. Most commonly, that relationship is the one between shareholders, as principals, and company executives/managers, as agents. Agency theory assumes that the interests of a principal and an agent are not always in alignment.

Considers issues such as the nature of the agency costs, conflicts of interest and how to avoid them, and how agents may be motivated and incentivised

Question 10

Seperation of ownership and management can lead to principal-agent problems. What are principal-agent problems?

Answer 10

Where the interests of owners and managers diverge.
This gives rise to agency costs.

Question 11

Agency costs examples

Answer 11

• The costs associated with monitoring the action of others and seeking to influence their actions.
• The lower returns to the principles than would be the case if the company was run in line with the principles’ best interests

Question 12

Types of mergers

Answer 12

• Horizontal merger
• Vertical merger
• Conglomerate merger

Question 13

Horizontal merger

Answer 13

Involves two firms engaged in similar activities.

Question 14

Horizontal merger motives

Answer 14

• Undertaken to benefit from economies of scale.
• Exploit complementary resources or to access opportunities only available to larger organisations
• More aggressive motive – eliminate inefficiencies (including underperforming management).

Question 15

Vertical merger

Answer 15

Involves two firms engaged in different stages of the production process.

Question 16

Vertical merger motives

Answer 16

• Coordination and administration can be improved.
• Access to complementary resources may improve.

Question 17

Conglomerate merger

Answer 17

Involves firms in unrelated lines of business

Question 18

Conglomerate merger motives

Answer 18

• Utilisation of unused tax benefits
• Utilisation of surplus funds
• Protection against threat of takeover
• Diversification
• Enhancement of earnings per share
• Exploitation of lower financing costs
• Could be scope for economies of scale

Question 19

Behavioural finance

Answer 19

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

Question 20

Types of behavioural finance

Answer 20

• Prospect theory
• Framing (and question wording)
• Loss aversion (myopic loss aversion)
• Mental accounting
• The effect of options
• Overconfidence
• Optimism
• Representative bias
• Belief preservation
• Anchoring
• Availability bias
• Familiarity
• Dislike of negative events
• Self-serving bias
• Status quo bias
• Herd behaviour

Question 21

Prospect theory

Answer 21

• Theory on how people make decisions when faced with risk and uncertainty
• alternative to the conventional risk-averse/risk-seeking decreasing marginal utility theory
• assumes that individuals suffer more pain from a loss than they benefit from a gain of the same value
• risk-averse when facing gains relative to the reference point
• risk-seeking when facing losses relative to the reference point
• generates utility curves with a point of inflection at the chosen starting point
• this theory suggests that the decision made depends on how a problem is ‘framed’ and is thus associated with the concept of framing

Question 22

Framing (and question wording)

Answer 22

The way a choice is presented and, particularly, the wording of a question in terms of gains and losses can have a large impact on the answer given or decision made.

Question 23

Loss aversion

Answer 23

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

Question 24

Myopic loss aversion

Answer 24

Investors are less risk-averse when faced with a multi-period series of gambles and that the frequency of choice/length of reporting period will also be influential.

Thus myopic loss aversion is when an investor only considers the immediate short-term gamble and ends up having less risky assets, to the detriment of their best interests

Question 25

Overconfidence

Answer 25

People tend to be overconfident when making estimates both regarding the confidence intervals around their estimates and the probability of particular events occuring.

Related to hindsight bias (viewing outcomes as having been predictable) and conformation bias (looking for confirmatory evidence).

Question 26

Optimism

Answer 26

People tend to overestimate their own abilities

Question 27

Self-serving bias

Answer 27

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 28

Status quo bias

Answer 28

Tendency to stick with current situation even in the presence of favourable alternatives & when no transaction costs are involved.

Question 29

Herd behaviour

Answer 29

Tendency to follow or mimic the actions and decisions taken by others as a mechanism to deal with uncertain situations.

Question 30

Representative bias

Answer 30

People are poor at making inferences about probabilities. Put too much emphasis on particular features of a sample as opposed to the likley features of the whole population

Question 31

Belief preservation

Answer 31

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

Question 32

Anchoring

Answer 32

When forming estimates people often start from an initial value which may be more or less arbitrary and then make adjustments from that value. Adjustments tend to be too small so people are said to be anchored on the initial value.

Question 33

Availability bias

Answer 33

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

Question 34

Familiarity

Answer 34

People favour situations/options that are familiar over others that are new.

Question 35

Dislike of negative events

Answer 35

People are prone to underestimating the probability that a negative event may occur.

Question 36

Mental accounting

Answer 36

Tendency to seperate related events and decisions and find it difficult to aggregate events.

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

Question 37

Effect of options

Answer 37

• Primary effect – more likely to choose 1st option
• Recency effect – final option presented may be preferred. Gap between presentation of options and decision may influence this.
• People more likely to choose intermediate option
• Big range of options discourages decision making.
• Higher probability is attributed to options explicitly stated than when included in broader category.
• Regret aversion – retaining existing arrangements = minimise possibility of regret
• Ambiguity aversion – pay premium for rules

Question 38

Noise traders

Answer 38

Someone who is heavily influenced by short-term noise (e.g. news article or another trader’s opinion) and may make prices irrational in the short term.

Question 39

When sentiment is low this has been empirically been followed by

Answer 39

high returns on:

• small stocks
• highly volitile stocks
• the stocks of unprofitable companies
• non-dividend paying stocks
• extremely high growth stocks
• distressed stocks

When sentiment is high these patterns may reduce or reverse.

Question 40

Qualitative measures tthat have been used as proxies to measure sentiment

Answer 40

• average discount on closed-ended funds
• share turnover
• the level and pricing of activity in the IPO market
• the level of issue of new equity
• the level of dividend premium, which is a proxy for the relative demand for dividend payers among investors

Question 41

Spurious herding

Answer 41

Situation where many investors do the same thing without reference to one another

Question 42

Explanations for herding

Answer 42

• idea that investors copy other investors the perceive to be better informed about a particular situation
• incentives facing fund members
• fear of missing out
• intrinsic desire to conform

Linked to regret aversion

Question 43

Cross-sectional momentum

Answer 43

Relatively poor performing stocks continuing to perform poorly and well-performing stocks continuing to perform well

Question 44

Time series momentum

Answer 44

Past 12-month excess return of many instruments has been found to be a positive predictor of their future return over roughly the next year.

Question 45

Mood-based anomolies

Answer 45

Emotions and mood influence human decision-making with good moods being associated with more positive evaluation and a tendency to make more positive choices. Examples include:

• Calendar effects
• Sunshine
• Sports results
• Aviation disasters

Question 46

Direct investigation of individuals’ trades and portfolios

Answer 46

• individuals trade too much, falsely believing they can pick winners, whereas they are actually losing money because of trading costs and poor trades (overconfidence)
• men trade more than women = men to be more overconfident
• disposition effect - individuals are prone to irrationally realise the profits of winning as opposed to losing trades
• individuals tend to hold portfolios that may be far from the optimum and may use inefficient means of diversification

Question 47

Long-term financial planning

Answer 47

Also called capital budgeting

Commonly looks 3 to 5 years ahead and assesses capital required for long-term projects

The development of financial plans should begin by consideration of an organisation’s business plans – it’s anticipated product development and sales objectives and the organic development of existing activities

These are then converted into financial plans, which convert the business plans into future cashflows

Financial planning therefore focuses on the sources and uses of funds as well as the implications for borrowing and financial structure

Sensitivity analysis should be used when developing the plans

• Financial – allow for changes in the financial environment
• Business – explore business plans under a range of scenarios. I.e. future trading conditions

Question 48

What non-operations issues will long-term financial planning consider?

Answer 48

Will also consider non-operational issues such as:

• Possibility of breaching financial covenants
• Impact of borrowing on credit ratings
• Level of gearing on balance sheet

Question 49

Short-term financial planning

Answer 49

Also called cash management

Often takes the form of a 12-month ‘rolling’ plan

Revolves around the analysis of working capital requirements

Closely associated with operational issues, since it will involve consideration of credit policy and possible deferment of settling accounts payable

It involves the consideration of (i.e. these are components in working capital):

• Trade credit management
• Cash management
• Stock and inventory policy
• Non-cash elements in the projected accounts

Question 50

Main advantage and disadvantage of holding cash

Answer 50

Advantage

• Enables the company to cope with unexpected eventualities

Disadvantage

• Company foregoes the higher returns that could be obtained from investing in either financial securities or its main line of business