Chapter 9 & 10 - Test your knowledge

Question 1

What are internal sources of short-term finance? How can increasing
working capital management efficiency be a good source of short-term internal finance?

Answer 1

Internal sources of short-term finance are funds generated internally by the business in its normal course of operations.

For example, the business can raise short-term finance through cash improvements gained by reducing or controlling working capital.

Similarly, it can sell assets that are no longer really
needed to free up cash or use its internally generated retained earnings.

Internal sources of short-term finance mainly include:

1. reducing or controlling working capital
2. reducing inventories
3. tighter credit control
4. delaying payments to suppliers
5. sale of redundant assets
6. retained profits
   A higher level of working capital represents a large commitment of finance and a significant opportunity cost in interest.

Efficiency savings generated through
efficient management of trade receivables, inventory, cash and trade payables can reduce a bank overdraft and interest charges as well as increase cash reserves that be re-invested elsewhere in the business.

Question 2

How does a primary market differ from a secondary market?

Answer 2

A primary market is a ‘new issues market’ where companies can raise ‘new’
funds by issuing shares or loan stock. A secondary market permits the primary market to operate more efficiently by facilitating deals in existing securities.

Question 3

What are the key advantages of a public market over a private market?

Answer 3

Public markets are markets where the general public can participate in such
as stock market. A person can participate in such a market with as little as
£10.

Public markets also offer greater liquidity, thereby enabling a smooth
purchase or sale. The risk profile of public markets is relatively small because of regulations, transparency and monitoring by seasoned investors and regulators.

Key advantages of public markets over private markets include:

1. no qualification or net worth criteria is required to be fulfilled to enter the
   market;
2. highly regulated and transparent markets, thereby reducing risk; and

3.highly liquid investments

Question 4

Why do companies list their shares on a stock exchange?

Answer 4

Companies issue shares in the stock market to:

1. raise funds for business requirements;
2. to comply with the requirement of a stock exchange flotation where a minimum proportion of shares must be made available to the public;
3. to provide an exit to investors who have invested in the company by providing liquidity to the stocks of the company;
4. to increase the brand image of the company; and
5. for many other reasons.

Question 5

What are the key functions of a stock exchange?

Answer 5

Key functions of a stock exchange include:

1. providing the value of stock of a company;
2. acting as a barometer for the economic performance of the country;
3. ensuring fair dealing between investors;
4. regulating intermediaries and companies; and
5. promoting economic growth

Question 6

What are the three forms of market efficiency?

Answer 6

There are three levels of market efficiency as per the EMH:

1. Weak form:

the market prices are reflective of all historical information contained in the record of past prices. Share prices will follow a ‘random walk’ and move up or down depending on the next piece of information about the company that reaches the market. The weak form implies that it is impossible to predict future prices by reference to past share price
movements.

2. Semi-strong form:

the market prices reflect not just the past and
historical data but all information which is currently publicly available.

Investors are unable to gain abnormal returns by analysing publicly
available information after it has been released.

The price will alter only
when new information is published. With this level of efficiency, share
prices can be predicted only if unpublished information were known.

This would be known as insider dealing.

3. Strong form:

share prices reflect all available relevant information, published and unpublished including- insider information. This implies that even insiders are unable to make abnormal returns as the market price already reflects all information.

Question 7

In what form of market efficiency can money be made by insider
dealing?

Answer 7

Evidence suggests that stock markets are semi strong market efficient at best.

Any new information is rapidly reflected in the share price.

In semi-strong efficiency, all public information is already reflected in the share price. With this level of efficiency, share price can be predicted only if unpublished information is known through insider dealing.

Question 8

Provide an example of exceptions when a sudden price change
is not triggered by new information about the company reaching
the market?

Answer 8

There are times when sudden large price changes do not appear to be triggered by new information reaching the market.

There are also instances when prices change quickly, but not instantaneously, over short periods before price-sensitive information is released by companies. For example, in October 1987 the value of shares on the London Stock Exchange fell by one-quarter during the course of the month with no specific new information identified as the cause of the fall.

In contrast, the steep fall in share prices in 2008 could be associated with
the accumulated impact of the global credit crisis that started with sub-prime lending failures in the US.

Question 9

How can companies raise finance from the following institutional
investors?

Answer 9

1. Private equity

It is perceived to be an investment with relatively high risk for investors. Investors provide finance through placing as they yield higher returns than they would from a stock market listed company. Placing is a way of raising equity capital by selling shares directly to third party investors (usually a merchant bank).

Business angels are a source of private equity finance to start-up and early-stage businesses in return for a share of the company’s equity.

2. Pension funds

A pension fund, also known as a superannuation fund in some countries, is a
fund from which pensions are paid.

Pension funds typically have large amounts of money to invest in both listed and private companies.

Pension funds, along with insurance companies, make up a large proportion of the institutional investors that dominate stock markets.

In most pension funds, there is a surplus of incoming funds from contributions over outgoings as pension payments.

This surplus is invested to maximise the best possible return, while maintaining the security of the funds.