Chapter 7: The theory of finance

Question 1

Finance involves what two issues?

Answer 1

• Capital budgeting decision
• Financing decision

Question 2

Parties involved in the financing decision

Answer 2

-CFO
- Board of directors

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.

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

Treasurer’s responsibilities

Answer 4

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

Question 5

Real assets

Answer 5

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

Question 6

Financial analysis

What can financial analysis achieve?

Answer 6

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 7

Agency theory

Answer 7

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 8

Types of mergers

Answer 8

• Horizontal merger
• Vertical merger
• Conglomerate merger

Question 9

Horizontal merger and motives

Answer 9

Involves two firms engaged in similar activities.
Motives:

• Economies of scale.
• Acess to complementary resources
• Access opportunities only available to larger organisations
• Eliminate inefficiencies (including underperforming management).

Question 10

Vertical merger and motives

Answer 10

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

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

Question 11

Conglomerate merger and motives

Answer 11

Involves firms in unrelated lines of business
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

Question 12

Behavioural finance

Answer 12

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 13

Types of behavioural finance

Answer 13

• 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 14

Prospect theory

Answer 14

• 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 15

Framing (and question wording)

Answer 15

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 16

Loss aversion

Answer 16

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

Question 17

Myopic loss aversion

Answer 17

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 18

Overconfidence

Answer 18

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 19

Optimism

Answer 19

People tend to overestimate their own abilities

Question 20

Self-serving bias

Answer 20

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 21

Status quo bias

Answer 21

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

Question 22

Herd behaviour

Answer 22

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

Question 23

Representative bias

Answer 23

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 24

Belief preservation

Answer 24

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

Question 25

Anchoring

Answer 25

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 26

Availability bias

Answer 26

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

Question 27

Familiarity

Answer 27

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

Question 28

Dislike of negative events

Answer 28

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

Question 29

Mental accounting

Answer 29

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 30

Effect of options

Answer 30

• 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 31

Noise traders

Answer 31

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 32

Spurious herding

Answer 32

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

Question 33

Cross-sectional momentum

Answer 33

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

Question 34

Time series momentum

Answer 34

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 35

Mood-based anomolies

Answer 35

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 36

Long-term financial planning

Answer 36

Also called capital budgeting

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

Involves the development of business plans setting out the firm’s anticipated product development and sales objectives

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

Sensitivity analysis should be used when developing the plans

Question 37

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

Answer 37

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 38

Short-term financial planning

Answer 38

Also called cash management

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

Revolves around the analysis of working capital requirements

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

• Trade credit management (trade receivables and payables, ie debtors and creditors)
• Cash management
• Stock and inventory policy (raw materials and finished and unfinished goods)
• Non-cash elements in the projected accounts