Finance part 3 & 4

Question 1

5 participants in financial markets

Answer 1

Investors/lenders
Borrowers
Banks
Regulators
Intermediaries

Question 2

What is a financial regulator

Answer 2

Institution that supervises and controls a financial system to protect the interest of investors and to guarantee fair and efficient markets and financial stability

Question 3

What is an intermediary

Answer 3

Service providers in the market who facilitate connections between investors and the users of funds. They include investment bankers or investment managers, registrars, brokers, mutual funds, leasing and finance companies

Question 4

Two types of capital markets

Answer 4

Primary
Secondary

Question 5

What is a primary capital market

Answer 5

New shares and bonds are issued to public for first tine - an IPO (initial public offering)

Question 6

What is a secondary capital market

Answer 6

Existing securities are traded after previously having been sold on the primary market

Question 7

2 key differences between private financial market and public financial market

Answer 7

No intermediary in private market
Far less regulation in private market

Question 8

Typical participants (investors) in private market (4)

Answer 8

Banks
Venture capitalists
Private equity investors
Hedge funds

Question 9

Advantages of private market (4)

Answer 9

Less competition
Normally no intermediary
Not tightly regulated, thus less compliance costs
Potential for higher returns

Question 10

Disadvantages of private market (3)

Answer 10

Incomplete information
Investments are less liquid
Highly risky

Question 11

Advantages of public market (3)

Answer 11

No qualification or net worth criteria needed to enter
Highly regulated and transparent - reducing risk
Highly liquid investments

Question 12

Disadvantages of public market (3)

Answer 12

Moderate returns
High compliance burden
Highly speculative

Question 13

What is the Efficient Market Hypothesis theory

Answer 13

Impossible to ‘beat the market’ if markets are efficient because market prices fully reflect all available information and tocks therefore trading at fair values

Question 14

What are the three levels of market efficiency

Answer 14

Weak form
Semi-strong form
Strong form

Question 15

What level of market efficiency are most markets, and why?

Answer 15

Semi-strong form at best, because in a strong market insiders would not be able to make gains, and share prices would not rise on announcement of a takeover (but they do for both)

Question 16

AIM summarised

Answer 16

Alternative investment market with reduced compliance costs, providing opportunity for small companies to benefit from listing

Question 17

7 types of institutional investor

Answer 17

Private equity
Venture capital
Pledge funds
Unit trusts
The Enterprise Investment Scheme
Pension funds
Banks

Question 18

Three reasons why money has time value

Answer 18

Impact of inflation - value of future cash eroded by inflation
Effect of risk - future receipts are uncertain
Potential for earning interest and savings on finance cost

Question 19

How to calculate profitability index

Answer 19

NPV/Original cost of investment

Question 20

What is a discount factor?

Answer 20

Factor which inflow/outflow must be multiplied by to get PV

Question 21

What is an annuity factor?

Answer 21

Sum of discount factors over however many years

Question 22

Three non-probabilistic approaches to project appraisal

Answer 22

Sensitivity analysis
Scenario analysis
Simulation modelling

Question 23

What is sensitivity analysis

Answer 23

Non-probabilistic approach in project appraisal that analyses changes to assumptions made in forecast by ascertaining the sensitivity of changes to critical variables on the decision

Question 24

How to calculate sensitivity

Answer 24

(NPV/PV of flow under consideration) x 100

Question 25

Advantages of sensitivity analysis (3)

Answer 25

Simple theory, easily understood Identifies areas crucial to project success which can be monitored Provides info so that management can make judgements on likelihood of outcomes

Question 26

Disadvantages of sensitivity analysis (3)

Answer 26

One variable changing at a time is unlikely to happen in reality Probability of each assumption is not tested Assistive aid, does not guide decision making itself

Question 27

What is scenario analysis

Answer 27

Non-probabilistic approach providing info on possible outcomes by creating various possible scenarios - usually most likely, optimistic, pessimistic

Question 28

Advantage of scenario analysis

Answer 28

In changing multiple factors at a time, decision makers obtain view of downside and upside potential of project, as well as most likely outcome

Question 29

Disadvantages of scenario analysis (2)

Answer 29

Model can become difficult and time consuming with many variables Does not consider probability of each state

Question 30

What is simulation modelling?

Answer 30

Calculates NPVS based on key variables each with probabilities, runs simulation many times. Allows for more informed decision

Question 31

Disadvantages of simulation modelling (2)

Answer 31

Very complex and not simple to calculate Time and costs involved may outweigh benefits gained

Question 32

How to calculate expected (net present) value

Answer 32

Sum of (probability of outcome x value of outcome)

Question 33

What is an event tree diagram

Answer 33

Tool used for risk mapping, with multiple layers of different outcomes, each being a layer on the tree with an ultimate profitability

Question 34

5 elements of portfolio management

Answer 34

Return - steady returns that at least match opportunity cost Risk reduction - minimise overall risk to an acceptable level Liquidity and marketability - Invest in assets which can be marketed without difficulty Tax shelter - impact from taxes considered Appreciation in value of capital - investments appreciating in value add to dividend yields

Question 35

What is the efficient frontier?

Answer 35

Modern portfolio theory that shows investors the best possible return to be expected for a defined level of risk - aiming for optimal correlation between risk and return

Question 36

What is the dividend valuation model?

Answer 36

Calculates the value of an equity share as the discounted value of all expected dividend payments