financial decison making Flashcards
advantages and disadvantages of ‘unincorported buisiness structures such as sole trades/partnerships
A: cheap and easy to establish
ownership and control concentrated
no requirement to publish accounts
D: difficult to sell = finite life
business=owner= unlimited liability
dificult to raise funds as banks do not want to loan to risky businesses
definition of incorporated business structure
where the business has a separate legal identity to the owner
advantages and disadvantages of incorporated business structure
A: ownership can be transferred by selling shares= infinite life
limited liability for owners
funds can be raised publically through equity and debt markets
D: difficult and expensive to establish
tax disadvantages
management is separate from owners
requirement to publish accounts
what is the primary stock market
where companies raise new equity finance by issuing new securities/shares to new investors
Includes IPO’s + rights issued: secondary offerings
what is the secondary stock market
motivated by?
where investors buy and sell existing shares
Information and liquidity motivated
Big bang :1986 oct
Big bang 2 : 1997 oct
Advantages of trading in the secondary stock market
find opposite party that works for you
lots of liquidity due to volume of buying and selling
information of others is reflected in the stock price - gives correct valuations
what is an IPO
initial public offering
what is a P/E ratio
price earning ratio
share price/ earnings per share
What is EAR
effective annual rate, more interest compounds the more frequently interest is paid
EAR = ((1+r/m)^m)-1
When investing c for t years at a flat rate of r per year compounding m times
FV = C(1+r/m)^(mxt)
why raise capital
plan to expand
Growth - new technology, must grow otherwise will be crowded out
pay off debt - initial loans for companies are taken out at high intrest rates
More wages to pay
Mergers/acquisitions
how to raise capital
Angel finance - successful business people (capped at ~ 100k)
non - securities debt - bank loan/loan from another firm
venture capital - billionaires who own companies invest into the business on the companies behalf
listing on the stock market
Methods of conducting an IPO - initial public offering
offer for sale - all shares listed must be sold, anyone can buy, expensive as underwritter has the risk of buying unsold shares
placing - only institutional investors
offer for subscription
intermediaries offer
introductions
what is finance
finance is about the valuation of future cash flows and what effects them
5 elements of finance
time, money, risk, information, taxation
4 perspectives on finance
corporate finance : real investment, capital budgeting, financing liquidity for working capital
investments
financial markets and intermediaries: banks and pension funds
Government
what happens to standard dievation of risk as portfolio size increasesd
standard deviation goes down, risk decreases
systemtic risk
unsystematic risk is removable via diversification of portfolio
Role of the CFO
Chief financial officer
internal and external financial reporting, stewardship of a company’s assets, and ownership of cash management
PLC characteristics
Public Limited company
established by shareholders
financed by share(permanent) and debt capital (money borrowed for fixed periods)
shareholders have limited liability and establish a board of directors
unincorporated business definition
a privately owned business, often owned by one person who has unlimited liability as the business is not legally registered as a company
why do share prices change
to reflect new information about a company
new announcement
characteristics of informational efficiency
prices reflect all information available to investors
prices react immediately to reflect new information
how will share price react in an informationally inefficient market
over/underreaction and gradual adjustment to correct price
slow reaction
we can therefore predict unexpected returns
allowing us to earn returns above the level required to compensate for the risk
why invest in a portfolio instead of individual securities
unless there is perfect correlation
the standard deviation of a portfolio will be less than the weighted average of separate securities
difference between systematic and unsystematic risk
systematic risk : risk that influences a large number of assets. They have a market wide influence
Unsystematic risk : risk that effects a single asset or a small group of assets, negligible by diversification
Key elements of finance
Money
Time
Uncertainty/risk
Information
Taxation
Pre big bang problems
Single capacity : stock jobbers , stock brokers
- increased concentration/ reduced job competition
- fixed brokerage commissions
- LSE membership restricted
- jobbers undercapitalised
- international competitiveness
Post big bang
Dual capacity
- broker/dealer
- market makers
- trading floor v. SEAQ& telephone
Big bang 2 - more changes to the trading system
Definitions of annuity and perpetuity
Annuity - is a series of regular and consistent cash flows for a period
PV = C (1-(1/1+r)^t)/r
Perpetuity - an annuity where cash flows continue forever
PV = C/r
Bond features definition (face value, coupon, maturity)
Face value - principal, nominal value,
Coupon rate- % of face value that the bond pays in interest
Coupon - amount of interest
Maturity - the date when the issues repays face value
Business structures in other countries
- most countries have a similar structure relating to incorporated and unincorporated though some rules and regulations are different
- a ‘partnership’ is deemed to be a corporate entry in the UK but not in Germany
- directors of incorporated firms are elected in 2 main ways: single tier board - shareholders elect a board of directors who then select managers; 2 tier board executive managers board, and a supervisory board
Discounting and present values
What is the value of £2000 now in 5 years, growing at 11% per year
2000 x 1.11^5
How much do we need to invest now at 11% per year to have £2,000 in 5 years
2000/(1.11^5)
FV = PV(1+r)^t
Real vs nominal interest rate
Nominal interest rates = actual market rates
nominal - Invest £100 at 10% interest per year = £110
Real - But if inflation is 7%
110/1.07 = 102.8
Definition of bonds and shares
Bonds - governments, local authorities, companies
Shares - companies
Government gilts lengths
<5 years = short
5-15 years = medium
>15 years = long
What are the different goals a firm can have
Maximise:
the size of the firm
Costumers satisfaction
Firms sales
Profits
Dividend growth
Shareholder wealth - occurs if product and labour markets work efficiently
How to apply the NPV rule
Add up the cash flows in all the years, adjusting for the investors requires rate of return
If NPV> 0 accept the project
If NPV< 0 reject the project
What is fishers separation theorem
If capital markets for borrowing and lending are well functioning
Companies can make their investment decision independently of individual shareholders consumption decisions by using the NPV rule
Perfect capital markets
No transaction costs, interest rate on borrowing = interest rate on investing
Access is free and equal, no participants have the power to influence prices
All participants have the same information about prices and security/firm characteristics
No distorting taxes
Other stakeholders in the firm face competitive prices
NPV of projects = 0
Advantages of using payback method
Easy to compute and understand
Encourages cash generation
Values early cash flow over late cash flow
Disadvantages of payback
Adds cash flows ignoring the time value of money
Choice of cut off period is arbitrary
Ignores cash flows after the cut off period
Biased towards rejection long lived projects possibly with + NPV’s
Biased towards accepting short lived projects possibly with - NPV’s
ARR
Accounting rate of return
Investments average accounting profits each year/ average book value of assets invested each year
Advantages of ARR
Easy to compute because the firm collects the accounting information anyway
Disadvantages of ARR
Ignores the time value of money
choice of ARR is arbitrary
Based on earrings not cash flows, uses accounting deprecation , tax charged based on accounting earnings
No standard calculation methods
Not a true return on investment
Profitability index
PI = PV of future cash flows / initial investment
How to prepare capital budgets
- Search for investment opportunities
- Screening:
Is the project consistent with the strategic plan? Is it feasible? - Definition of project and alternatives
- Evaluation
- Authorisation
- Monitoring & Post-Audit
Definition of capital budgeting
Capital budgeting is the process of deciding which new project to take on behalf of the company. By project we mean any new decision that requires investment
How does volatility of returns correlate to rate of return required
The greater the volatility of returns, the greater is the required rate of return.
What does a profitability index >=1 indicate
That a project is profitable
Difference between geometric and arithmetic average
Arithmetic - sum the returns and divide by total
Geometric ((1+r1)(1+r2)…..(1+rn))^1/n
2 main characteristics of a return
Average return : measures what you expect to earn each period
Standard deviation: variability or volatility gives a measure of how far from the average you expect the return to be in any 1 period
Implications of IE for investors
- prices are the best indicator of value - prices reflect fundamentals
- active traders, on average, perform no better than passive investors
- uniformed investors can expect a fair return
Why does IE imply random price changes
IE means prices change unexpectedly only to new information
New information, by definition, is independent of previous information
If information is already known it will already be reflected in the share price
A bond’s coupon rate is equal to the annual interest divided by
face value
what type of bond would be affected more by changes in interest rate
bonds with longer maturities
bonds with lower coupons
a high interest rate on a bond =
more risk that it carries
