Chapter 7: The theory of finance Flashcards
Finance involves what two issues?
- Capital budgeting decision
- Financing decision
Role of the financial manager (diagram)
Responsible for the financial operations of the firm.
Link between the firm’s operations and the financial markets
Capital budgeting decision
How is the decision complicated?
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
Financing decision
Whose responsibility is this and what do their responsibilities include?
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
Investment in fixed capital involves complex choices between:
- alternative capital assets
- dates of commencement
- methods of financing
Real assets
Assets that are used by the company in its normal line of business to generate profits - can be tangible or intangible.
Financial analysis
What can financial analysis achieve?
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
Methods in which to do a financial analysis
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
Agency theory
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
Seperation of ownership and management can lead to principal-agent problems. What are principal-agent problems?
Where the interests of owners and managers diverge.
This gives rise to agency costs.
Agency costs examples
- 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
Types of mergers
- Horizontal merger
- Vertical merger
- Conglomerate merger
Horizontal merger
Involves two firms engaged in similar activities.
Horizontal merger motives
- 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).
Vertical merger
Involves two firms engaged in different stages of the production process.
Vertical merger motives
- Coordination and administration can be improved.
- Access to complementary resources may improve.
Conglomerate merger
Involves firms in unrelated lines of business
Conglomerate merger motives
- 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
Behavioural finance
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.
Types of behavioural finance
- 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
Prospect theory
- 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
Framing (and question wording)
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.
Loss aversion
A person may be more sensitive to losses than to gains of the same magnitude.
Myopic loss aversion
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
Overconfidence
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).
Optimism
People tend to overestimate their own abilities
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.
Status quo bias
Tendency to stick with current situation even in the presence of favourable alternatives & when no transaction costs are involved.
Herd behaviour
Tendency to follow or mimic the actions and decisions taken by others as a mechanism to deal with uncertain situations.
Representative bias
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
Belief preservation
Once people have formed a belief, tend to be overly reluctant to change it even in the face of strong contrary evidence.
Anchoring
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.
Availability bias
When estimating probabilities people tend to focus excessively on more recent and more salient events.
Familiarity
People favour situations/options that are familiar over others that are new.
Dislike of negative events
People are prone to underestimating the probability that a negative event may occur.
Mental accounting
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.
Effect of options
- 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
Noise traders
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.
When sentiment is low this has been empirically been followed by
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.
Qualitative measures tthat have been used as proxies to measure sentiment
- 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
Spurious herding
Situation where many investors do the same thing without reference to one another
Explanations for herding
- 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
Cross-sectional momentum
Relatively poor performing stocks continuing to perform poorly and well-performing stocks continuing to perform well
Time series momentum
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.
Mood-based anomolies
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
Direct investigation of individuals’ trades and portfolios
- 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
Long-term financial planning
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
What non-operations issues will long-term financial planning consider?
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
Short-term financial planning
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
Main advantage and disadvantage of holding cash
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
