Firm objectives & Intro to equity markets

Question 1

What is financial management?

Answer 1

The management of finances to achieve financial objectives of the firm.

Question 2

Who are financial managers?

Answer 2

People who ensure the firm has funding to meet short, med and long-term objectives.

Responsible for things such as analysing data, investment, dividend and management decisions.

Question 3

What is a firms primary objective?

Answer 3

It is usually to maximise ordinary shareholder wealth.

May have targets such as
- earnings
- earnings per share
- dividend per share
- profit retention etc

PROFIT MAXIMISATION IS NOT SHAREHOLDER WEALTH MAXIMISATION (profits are a short term measurement)

Question 4

What are corporate objectives?

Answer 4

These may include specific goals that relate to key success. They should be explicit, measurable and realistic.

Financial objectives can help them to achieve these.

Question 5

What are some shareholders and their objectives?

Answer 5

shareholders - maximise wealth (don’t want to invest in stocks then stock price fall)

creditors - want to be paid in full on time

employees - maximise their reward and continuity

management - maximise their reward

government - taxation, grants etc

Question 5

What is agency problems?

Answer 5

Divorce of ownership as managers act as agents for shareholders and do not always act in a way that maximises their wealth.

Methods to synchronise management shareholder objectives include performance related pay, share based rewards.

Question 6

What is ESG?

Answer 6

these are economic, social and government policies that help a company to do well.

Investors select stocks based on these ESG factors and request compensation for companies behaving badly in order with them.

Question 7

What does being listed on the Stock Exchange do?

Answer 7

1) Supervises trading to ensure efficiency. - If efficient, investors will have a high degree of certainty of price of stock & value of the firm.

2) Authorises market participants such as brokers and market markers (Particularly financial institutions)

3) Create an environment of price efficiency without distortion -
Eliminates transaction costs so higher efficiency and will know the value of my portfolio with a high degree of certainty without any distortion.

4) Organisation of the settlement of transactions (costs less to trade when the market is efficient)

5) Regulations of Initial Public Offering (IPO) admissions and regulation of existing firms on the exchange - firms may be delisted due to bankruptcy.

5) Data dissemination - trading data, prices, company announcements etc.

Question 8

Why do firms become listed on the stock exchange?

Answer 8

They become listed so that they can tap into the supply of investment capital.

Market forces determine the fair price of the stock.

Question 9

What happens when the markets are efficient?

Answer 9

• Scarce investment capital is allocated to the most efficient outlets.
• Transaction costs are low which promotes trading/aids investor confidence in trading. (frequent traders benefit)
• investors can easily enter/exit markets without changing prices.
• Investors are unable to consistently “beat the marker” as will always go back to market equilibrium

Question 9

What is market equilibrium?

Answer 9

When the supply and demand of a good or service are equal, this means that the price and quantity are agreed upon by buyers and sellers.

Question 10

Efficient market hypothesis - weak form?

Answer 10

when stock prices incorporate all relevant historical information.

Question 11

Efficient market hypothesis - semi-strong form?

Answer 11

Stock prices incorporate all relevant historical and publicly available information.

Question 12

Efficient market hypothesis - strong form?

Answer 12

stock prices contain all historic, current public and private information.

This is the strictest and hardest to test as trading on inside information is illegal/ nobody will admit if they traded using this way.

This does not mean that prices will be equal to fair values just that deviations are random.

Question 13

What is an initial public offering (IPO)?

Answer 13

When a company issues a common stock/share to the public for the first time, often issued by smaller young firms.

issuer can obtain assistance from an underwriting firm, who can help determine a fair price for the market.

Question 14

What happens when a firm gets an IPO?

Answer 14

1) firm issues additional new shares to raise extra capital simultaneously.

2) capital for new shares goes directly to the firm

3) An IPO permits access to a wider array of investors to provide large capital for growth.

4) Capital not repaid but shareholders possess dividend rights
NOTE NOT ALL SHARES PAY DIVIDENDS

5) Existing shareholders are diluting as more come in.

Question 14

Why should firms have an IPO?

Answer 14

• Extended capital (can be risky for an individual investor as limited historical data to analyse a firm).
• Financial windfall, post IPO shares can increase by a huge margin. Can double wealth in days.
• Repay debts, if the firms initial investment came from a bank loan would make sense to repay it.

Question 15

What are some properties of ordinary shares?

Answer 15

• They have the right to dividends after firm has paid its creditors and preference shares.
• Riskier as paid last, if firm goes bankrupt gets paid back last and during liquidation gets any proceeds from disposal of assets last.
• Potential returns from ordinary shareholders are infinite.
• Ordinary shareholders exercise control over the business through their voting rights (it gives them power to elect and remove managers).

Question 16

What are the properties of preference shares?

Answer 16

• fixed dividend rates each year paid prior to ordinary shareholders.
• no voting rights
• priority during bankruptcy/liquidation.
• Preference share capital offers a fixed rates return (like loan capital)

Question 16

What are 3 of the tax issues?

Answer 16

Both ordinary & preference shares are regarded as part of shareholders funds so dividend is an appropriation of profits.

Tax is payable on the firms profits before any dividends

Lenders don’t have ownership rights so interest is paid irrespective of profit so is a legitimate expenses deducted before tax. (corporate bonds, interest/coupon payments)

Firms don’t have to pay tax on any interest they received.

Question 17

What is a rights issue?

Answer 17

When existing shareholders have the privilege to buy a specified number of new shares from the firm at a discounted price within a specified time.

Question 18

What are the properties of rights issues?

Answer 18

• sold on open market and generally issued on ratio basis
• form of equity financing post IPO

-to give shareholders an incentive discounts of 20% commonly used

• Market value of existing shares has a higher probability of falling following the rights issue.
• Rights issues are always optimal for an investor, they will never lose out (should sell the shares as then will reduce amount they have so not diluted)

Question 19

What are cum-rights?

Answer 19

Shares bought on the stock market that carry the rights issue to the new owner

Question 20

What are ex-rights?

Answer 20

when after a specified cut off date, shares go ex-rights and the new owner does not have the ability to subscribe to the rights issue as they remain with the former owner.

Question 20

What happens if the shareholder does not want to take up the rights issue?

Answer 20

• Law permits the investors to pass the rights onto someone else on the market.

Question 21

What is a scrip issue?

Answer 21

This raises no extra capital and simply gives the shareholders more shares in proportion to existing holdings.

also known as bonus issue.

Question 22

What is a stock split?

Answer 22

A stock split reduced the nominal value of each share in proportion to increase the number of shares. Total book value remains the same.

Question 23

What is the purpose of a stock split?

Answer 23

• keep share prices at a manageable level
• FTSE100 insist prices lie between 310p - 2680p (if firm has higher value may stock split, if lower may reverse stock split)
• splits increase investor costs
• makes comparison of share performance over time difficult
• splits come when earnings peak (historically)

Question 24

What is a share buyback?

Answer 24

when a firms buys its own shares back from shareholders usually at a premium market price, This is a distribution of cash to shareholders.