Chapter 8 - Financial Markets And The Identification Of Financing Needs

Question 1

Who are the key participants in financial markets?

Answer 1

Investors and lenders
Borrowers
Banks
Regulators
Intermediaries

Question 2

What are the 2 types of financial markets?

Answer 2

1) Capital Markets:
Long term. Composed of primary and secondary markets

2) Money Markets:
Short term. High liquidity. E.g. Treasury bills and commercial paper

Question 3

What are the key differences between private markets and public markets?

Answer 3

Private:

• Transactions are held and executed OTC through private securities dealers.
• Lower liquidity
• Less Regulation
• More risk / chance of higher returns
• Less competition
• No intermediary
• Less investor info

Public:
Companies issue shares in the stock market to:
(a) raise funds for business requirements; or
(b) comply with the requirement of a stock exchange flotation where a minimum proportion of shares must be made available
to the public.
- no qualifications required to enter market
- higher liquidity
- high regulation/transparency
- lower risk / moderate returns
- highly speculative
- shares bought through intermediary
- share price determined through supply/demand

Question 4

Explain Efficient Market Hypothesis

Answer 4

Impossible to “beat the market” if markets are efficient as market prices fully reflect the available information and the stocks are always trading at fair values. A perfect market responds immediately to the information made available to it.

Market price is reflective of
an unbiased intrinsic value, not market value.

Not possible to identify any overpriced or under-priced securities and take advantage of market movements which provides equal opportunity to
everyone.

Question 5

What are the 3 levels of market efficiency?

Answer 5

Weak form
Market prices are reflective of all historical information. Share prices will move up or down based on the next piece of information about the company that reaches the market. Weak form implies it is impossible to predict future prices by reference to past share price movements.

Semi-strong form
Market prices reflect historical data and all data that is publicly available. Investors are unable to gain
abnormal returns by analysing publicly available information after it has been released. Prices will alter
only when new info is published. Share prices can only be predicted if unpublished information were
known (insider dealing).

Strong form
Share prices reflect all available relevant information. Implies even insiders are unable to make abnormal returns as market price already reflects all info.

Question 6

What is budgeting?

Answer 6

Outline of company’s financial plans for next 5 years. Projects income and outflows for the long-term and short-term and shows what the company wants to achieve.

Baseline to compare
actual results. Important tool to manage resources.
Most important = cash budget which is a projection of cash receipts and payments for a future period to help determine any excessive idle cash or cash shortages.

2 types: (1) flexible and (2) static.

Most common = static that projects a fixed level of expected input, output and costs of production. Flexible = adjusts with changes in volume or activity and is adjusted through the year.

Question 7

Explain forecasting

Answer 7

Financial forecasting – projection of a company’s future financial outcomes by examining its historical
and current financial data. Most common = income statement. Indication of what will actually be achieved. Monitored and updated each month.

Cash forecast = estimate of cash receipts and payments for a future period that includes all projected
income and expenses under existing conditions and normally covers 12 months.

Question 8

What is the objective of cash management?

Answer 8

1) ensuring there are adequate cash balances in times of need;

2) ensure surplus cash is
invested or used to repay existing debt to maximise returns for the business; and

3) ensure there is not a
situation of deficit of cash due to unnecessary shortages of funds.

Question 9

What are the 3 basic motives for holding cash under Keynes’ general theory of economics?

Answer 9

1) Transaction motive – maintaining enough cash to meet day-to-day operations e.g. salaries.

2) Precautionary motive – holding cash to meet contingencies and unexpected situations (e.g.
providing a safety net for unexpected events such as COVID-19)

3) Speculative motive – using cash to take advantage of profitable investment opportunities

Question 10

Explain Baumol’s economic order quantity (EOQ) model

Answer 10

Assumptions:
1) Cash needs of organisation are known with certainty and are constant at all points of time
2) Transaction costs are known and are constant
3) Opportunity cost of holding cash is known and constant
Limitation: unrealistic assumption of cash predictability.

Optimum cash level is where carrying costs and transaction costs are minimal (carrying cost = cost of holding cash e.g. interest).

Q = √2((U x P) ÷ S)

Q = optimum cash balance
U = Annual cash demand
P = fixed costs per transactions
S = opportunity cost (interest rate) of holding cash

Question 11

Explain the Miller-Orr cash management model

Answer 11

Expansion on Baumol’s model for when cashflows aren’t known. Overcomes the limitations of Baumol model and provides a more realistic approach.

Introduces 3 control limits:
1) Upper limit (h)
2) Return point or target cash balance (z)
3) Lower limit (o)
When cash balances reach the upper limit. H – Z of cash is invested into securities.
When cash balances reach the lower limit. Z – O of cash is topped up.

Formulae:
Return point = lower limit + (spread (s) ÷ 3)

Spread can be calculated as:
(3 x ∛((0.75 x variance of cash flow x transaction cost)))/(interest rate)

Upper limit = lower limit + spread (s)