Chapter 7: The theory of finance

Question 1

Real assets

Answer 1

Asset used by the company in its normal line of business to generate profits – can be either tangible or intangible

Question 2

Financial manager

Answer 2

• Responsible for the financial operations of the firm.
• Is the link between the firm’s operations and the financial markets

Question 3

h. iiIi)main steps involved in financial planning

• Explain the what Capital budgeting decision is and party responsible for it.
• Outline why it may be complicted to carry our in practice.

Answer 3

• It is the choise of capital projects and thus real assets to invest in.
• it is the remit of the controller, or CFO.

Complicated in pratice due to:
- may be more than one apparently profitable project which to choose
- it is very difficult to estimate future profitability of a project

double check what the notes say

Question 4

h. ii)main steps involved in financial planning

Explain the what Financing decision is and parties responsible for it.

Answer 4

Decision on how to best raise required finance for capital projects.

Mainly the responsibility of the treasurer who:

• Looks after the company’s cash
• Raises new capital
• Maintains relationships with banks, shareholders and other investors

In a small organisation, it could be the role of the CFO/controller

Decision will be tied into plans for product development, production and marketing and so involve managers from these areas

Will ultimately decision (by law or custom) rests with BoDs

{decide if card should include treasure roles}

BoDs = board of directors

Question 5

h. ii)main steps involved in financial planning

List the roles of the treasurer

Answer 5

• Look after cash
• Raise new capital
• Maintain relationship with
  Bank:
  o Shareholders
  o Investors

Question 6

h. ii)main steps involved in financial planning

1. Define working capital
2. Outline what is meant by ST financial planning

Answer 6

1. Working Capital:

• Is the company’s short-term assets and short-term liabilities
• =current A - current L

2. ST financial planning:

• 12-month ‘rolling’ plan
• AKA: cash managemnet
• Concerned with managment/analysis of working capital requirements
• Closely associated with operational issues, since it will involve consideration of trade credit policy (creditors and debtors) and possible deferment of settling accounts payable and inventory (stock) policy

Question 7

h. ii)main steps involved in financial planning

List the main classes of current A and current L

Answer 7

Current A:

• Inventories (stocks of raw materials, finished and partly finished goods)
• trade receivables (debtors)
• cash
• short-term securities held (bills and commercial paper)

Current L

• trade payables (creditors)
• outstanding dividends and tax payments
• short-term loans and borrowings

Question 8

h. ii)main steps involved in financial planning

1. Define fixed capital
2. Outline what is meant by LT financial planning

Answer 8

1. Fixed capital

• LT assets (usually tangible) used to produce goods and services on an ongoing basis, e.g., machinery, plant etc.

2. LT financial planning:

• Concerned with LT investment decisions and capital requirements
• Looks several (3-5) years ahead and develops financial plans based on firm’s business plans - its anticipated product development and sales objectives
• Uses sensitivity analysis to explore business plans under a range of scenarios
• Once business plans have developed, they be converted in financial plans starting with forecasts of future cashflows.
• Considers no-operational issues e.., financial covenants and credit ratings.

Question 9

h. ii)main steps involved in financial planning

Outline what is meant by financial analysis and how it can be useful.

Answer 9

Financial analysis:

• Analysis of the financial implication of different possible actions
• requires input from different disciplines
• Must be objective and impartial and real (use specialist finance functions)

usefulness
It can help with :
- Description of risks
- suggestion of mitigation techniques
- highlight uncertain factors

Question 10

Two methods in which to do a financial analysis

Answer 10

• Leave the investment appraisal to the people who are most concerned to see the project accepted - May need input from the experts listed above
  • Likely not to be objective
• Use a specialist finance function in an attempt to enforce impartiality and realism
  • But may lack specialist knowledge of the particular project under consideration

Question 11

*h. i)Motives for mergers and divestitures *

What is the main danger of mergers and acquisitions?

Answer 11

• Can often provide greatest scope for principal agent problems and destruction of shareholder value ( e.g., Overpayment for Target Company, Integration Costs, Loss of Focus) e.g., done as an exercise in empire building
• Important to assess motives for mergers

Question 12

Agency theory

Answer 12

• Is a 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 13

Separation of ownership and management can lead to principal-agent problems, which is

Answer 13

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

Question 14

Agency costs examples

Answer 14

• The costs associated with monitoring the action of others
• and seeking to influence their actions
• and the lower returns to the principles than would be the case if the company was run in line with the principles best interests / Managers (as agents) do not attempt to maximise the value of the company

Question 15

How might the interests of a company’s management be aligned with those of the shareholders

Answer 15

By linking management’s remuneration directly to the performance of the company’s shares

Question 16

*Motives for mergers and divestitures *

List three types of mergers

Answer 16

1. Horizontal mergers
2. Vertical mergers
3. Conglomerate mergers

Question 17

*Motives for mergers and divestitures *

What is a Horizontal merger and are the motives for it:

Answer 17

Horizontal merger:
Involves firms engaged in similar activities

Motives:

• Economies of scale…
  -such as sharing core services common to both organisations (negotiation power, logistics, advertising, admin)
  -spreading fixed costs
  -specialisation in production process
  -ability to obtain finance cheaply
• Exploit complementary resources
• Access to opportunities/resources available to large organisations
• Eliminate inefficient resources (e.g., underperforming management)

Question 18

*Motives for mergers and divestitures *

What is a Vertical merger and are the motives for it:

Answer 18

Vertical merger:
Involve companies engaged in different stages of a production process (super market chain and a food production company)

Motives:

• Improve co-orditation and admin
  -…by spanning and controlling greater part of the process (e.g., super market better supply food to its stores)
• exploit complementary resources

Question 19

*Motives for mergers and divestitures

What is a Conglomerate merger and are the motives for it:

Answer 19

Conglomerate mergers:
Involve firms in unrelated lines of business.

Motives:

• Lower finacing costs - more negotiating power
• Economies of scale (if it allows sharing of functions)
• Takover threat protection (by increasing size)
• Share earnings enhancement (i.e., EPS)
• Benefit from unused tax benefits
• Utilise surplus funds
• Diversification

find acronym ?

test fed
tax ,eps,surpus, takeover, finance cost , economies, diversification

Question 20

h. ii) application of the key findings in behavioural finance

Define behavioural finance

Answer 20

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

Question 21

h. ii) application of the key findings in behavioural finance

Outline three practical situation where key findings in behavioural finance are applied.

Answer 21

1. Contrarian investment funds:

• run on the basis of taking advantage of perceived errors made by other investors
• tends to take the opposite view to the rest of the market, e.g., selling shares when market is high or rising on basis that market tends to overreact to positive news and so likely overvalued

2. Those responsible for investment policy are subject to types of mental bias –> so recommended investment management structure should be chosen to reflect those biases.
3. If markets are influenced by behavioural factors –> investors recognise this may be able to exploit it

see howit was asked and answered in past papers

Question 22

h. ii) application of the key findings in behavioural finance

List the 16 Main behavioural biases

Answer 22

1. Status quo bias
2. Anchoring
3. Dislike of negative events
4. Prospect theory
5. Representative bias
6. Options
7. Overconfidence
8. Familiarity
9. Framing
10. Loss aversion
11. Availiability bias
12. Self-serving bias
13. Herd behaviour
14. Mental Accounting
15. Optimism
16. Belief preservation

SAD PROOF FLASH MOB

bold is the common themes.
rest are heurisric

Question 23

h. ii) application of the key findings in behavioural finance

Outline the ideas behind:

• Framing
• Overconfidence

Answer 23

Framing:

• Suggests that the way in which a choice (in particular a question in terms of gains and losses) is presented or ‘framed’ can have an enormous influence on the answer given or decision made.
• Equally, a response to a question can be influenced by its wording (how long/short)

Overconfidence:

• People tend to be overconfident when making estimates both regarding the confidence intervals around their estimates and the probability of particular events occuring
• this may result from:
  -hindsight bias - events that happen//don’t happen will be thought as having being predictable/unlikely to have prior to event
  -confirmation bias - people tend to look for evidence that firms their point of view (and dismiss evidence that does not justify it).

separate cards ?

Question 24

h. ii) application of the key findings in behavioural finance

Explain what is meant by anchoring and adjustment

Answer 24

• When forming estimates people tend to start at an initial value (an ‘anchor’). From past experience or ‘expert’ opinion.
• To arrive at a final estimate, they will adjust away from this value.
• Investors amend to allow for evident differences to the current conditions
• Experimental evidence suggests the adjustments are too small and so people are said to be anchored heavily on the initial value.

Question 25

h. ii) application of the key findings in behavioural finance

Explain what is meant by the term loss aversion.

Answer 25

• A person may be more sensitive to losses that to gains of the same magnitude
• A related behaviour is myopic loss aversion which considers repeated choices rather than a single gamble

Question 26

h. ii) application of the key findings in behavioural finance

Explain what is meant by the term myopic loss aversion.

Answer 26

• Less risk-averse when faced with a multi-period of ‘gambles’ - i.e. if they think long-term rather than the immediate short-term gamble then investors are less risk-averse
• 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
• length of reporting period influencial, eg., pension scheme reports annually –> more risk averse to short term investments –> forced to invest in less volatile assets to reduce risk of reporting poor returns –> invest less in equities and long-term bonds.

Question 27

h. ii) application of the key findings in behavioural finance

Explain what is suggested by Prospect theory

Answer 27

Prospect theory:

• Its a theory of how people make decisions when faced with risk and uncertainy
• it is an alternative to risk averse/risk seeking decreasing marginal utility
• Assumes asymmetrical response to losses versus gain from a particular starting point
• that individuals suffer more pain from a loss than they benefit from a gain of the same value.
• Thus there is a point of inflection at the reference point
• People are typically risk-averse when considering gains relative to the reference point
• And risk-seeking when considering losses relative to the reference poin
• Suggest decisions depends on whether problem framed as a gain or loss
• Curve convave when faced with a gainst and convex when faced with a loss

Question 28

Explain what is suggested by Mental Accounting

Answer 28

Mental accounting:

• Suggests that people show a tendency to seperate related events and decisions and find it difficult to aggregate events.
• Rather than netting out gains and losses, people to to set up a series of ‘mental accounts’ and view individual decisions s relating to one or another of these accounts.
• e.g., all profitable trades group in one ‘mental ccount’ and losses in another and value of gains easier to remember

Question 29

h. ii) application of the key findings in behavioural finance

• Describe how the order of a range of choices may influence choice.
• Give four influences of the range of options on choice.

Answer 29

Range choices:

• Primary effect suggest that people are more likely to choose first option presented (if decision made sooner)
• Recency effect suggests that final option may be preferred
• Other research suggests that people are more likely to choose an intermediate option other than either end.

other Influences of range:

1. Greater range of choices discourages decision-making
2. status quo bias - people have marked preference for keeping things as they are
3. regret aversion - by retaining existing arrangements, people minimise possibility of regret(pain associted with feeling reponsible for a loss)
4. ambiquity aversion - people dislike uncertainty and are prepared to pay a premium for rules

Question 30

h. ii) application of the key findings in behavioural finance

Outline 8 other behaviours associated with behavioural finance.

Answer 30

1.Optimism - People tend to overestimate their own abilities
2. Representative bias - People often put too emphasis on particular features of a sample as opposed to likely features of whole population
3. Belief presevation- once people have formed a belief they tend to be reluctant to change it even when faced with strong contrary evidence
4. Availability bias - when making estimating probabilities people tend to focus excessively on more recent and salient events
5. Familiarity - process by which people prefer/favour situations/options which are familiar over new ones
6. Dislike of negative events - valence of an outcome hass an enormous influence on probability of its likely occurence.
7. Self-serving bias - tendency of individuals to take credit for positive outcomes (like successful investments) and blame external factors for negative outcomes (like investment losses).
8. Herd behaviour- following the crowd/fear of missing out (explain stock market bubbles)

Question 31

Estimating probabilities

Answer 31

Investor estimates of probabilities are influenced by :

• Dislike of negative events - Underestimate the probability
• Representative heuristics
  -People find more probable that which they find easier to imagine
  -Increase in detail, apparent likelihood increases but true probability decreases
  -‘stereotyping’
• Availability heuristic
  -People are influenced by the ease with which something can be brought to mind
  -e.g. car crashes vs cancer ,car crash reported more
  -‘memory’
• Anchoring
  -starting probablity from past can cause under or overestimation

Question 32

h. ii) application of the key findings in behavioural finance

‘Modern financial economics’ based on premise that ‘agents’ are rational

Outline characteristics of rationality

Answer 32

• basing every decision on max wealth
• trading extra return with extra risk –> risk is volatility of returns
• fully informed on all potential investments
• able to spread pf over a large # of investments without incurring excessive costs
• continuously reviewing all existing investments as well as reviewing potential new investments.

Question 33

h. ii) application of the key findings in behavioural finance

Ouline other features rationality and fetures of noise traders

Answer 33

Rationality

1. Means that when agents receive new information update their beliefs correctly in line with Bayes’ law and they act to max their subjective expected utility over time.
2. if agents rational –> price of security = fundamental value –> incorporates new information –> market prices taken as a measure of fair value
3. if prices deviate from ‘correct’ value –> informed agents make money from this –> prices move back to appropriate levels

noise traders

1. heavily influenced by short-term noise (such as a news article or another trader’s opinion) and ignores other information and fundamentals –> they create herd behaviour and push prices further away from theoretical ‘rational’ price.
2. Behavioural finance is not a certain route to profits –> rational investor may not always take advantage of market price anomalies as irrational agents can make prices even more irrational in the short-term.

Question 34

h. ii) application of the key findings in behavioural finance

List six asset classes that one would expect to give high future returns, starting from a time point where market sentiment is low.

4.2 Market behaviour at a macro level

Answer 34

1. Small stocks
2. Distressed stocks
3. stocks of unprofitable companies
4. non-dividend paying stocks
5. extremely high growth stocks
6. highly volatile stocks

Question 35

h. ii) application of the key findings in behavioural finance

List four ways to measure market sentiment

4.2 Market behaviour at a macro level

Answer 35

1. The average discount on closed-end funds (should be low when sentiment is high)
2. Share turnover (# of shares traded/average # of shares outstanding) - should be high when sentiment is high
3. The level of activity in the IPO market and the level of issue of new equity (should be high when sentiment is high)
4. The level of dividend premium, which is a proxy for the relative demand for dividend payers amoung investors(demand for high dividend shares should be low when sentiment is high)

Question 36

h. ii) application of the key findings in behavioural finance

Outline herding, reasons for itand evidence of it.

4.2 Maket behaviour at a macro level

Answer 36

• when investors make decisions based on what they observe other investors doing
• distinguish this from spurious herding when investors do the same thing without reference to one another, e.g as result of a major adverse economic announcement causing many to rationally sell equities.

is potentially bad for markets –> may increase volatility –> possibly threaten the integrity of the whole system if markets are driven to the extremes.

Reasons:
- following experts
- incentives facing fund managers –> keeping close to peer group or unlikely to be to be sacked if all perform badly
- fear of missing out
- intrinsic desire to conform

Evidence of herding pronounced:
- in times of economic stress
- in less developed markets

Question 37

h. ii) application of the key findings in behavioural finance

Describe cross-sectional and time-series momentum.

4.3 The cross-sectional behaviour of stocks and other securities

Answer 37

Cross sectional momentum:
- An influencial study by Jegadeesh and Titman (1993) shows that what is termed cross-sectional momentum may be an important factor in predicting stock market returns.
- The grouped all stocks traded on the NYSE by return and showed that the decile worst performing stocks over the last six months performed worse than the best performers over the next six months
- Thus, there was a cross-sectional momentum effect with relatively poor performing stocks continuing to perform poorly and well-performing stocks continuing to perform well

Time series momentum:
- what is termed time series momentum effect has also been well documented where the past peformance of many financial instruments, such as equity indexes, currencies, commodities, sovereign bonds is considered in isolation rather than to other instruments.
- The past 12 -month execess return of many instruments has been found to be a positive predictor of their future return over roughly the next year.

Question 38

h. ii) application of the key findings in behavioural finance

Describe four examples where investor mood can affect market returns.

4.4 Particular mood-based anomalies

Answer 38

1.* Calendar effects* - ‘Blue Mondays’ and Good returns Pre-holidays
2. sunshine - daily market returns in the world markets have been found to be correlated with the amount of morning sunshine in the city of the country’s leading stock exchange
3.* Sport results* - loss –> poor returns
4. Aviation disasters have shown to lead to losses of stock market value which is a large multiple of the actual economic losses.

Question 39

h. ii) application of the key findings in behavioural finance

Outline direct investigation of individual’s trades and portfolios

Answer 39

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