Introduction to finance

Question 1

If you were to set up a new business manufacturing pine furniture, what resources
would you need?

Answer 1

To set up your new business, you would need fixed assets or fixed capital such as
premises, machinery, tools, computers etc, which will last for many years, as well as
working capital such as stocks of wood, nails, varnish etc, which will be used up in
production and sold.

Question 2

How would you raise the finance to set up your new business?

Answer 2

You might contribute some of your own savings to the business; you might ask friends
and family to contribute their savings; and/or you might ask the bank for a loan. If you
set up as a company, you would sell shares. To help you buy your stocks of materials
you might ask suppliers to give you credit.
We will study the various ways that you could set up your business (eg sole trader,
partnership, company) in Chapter 2 and we will look at the various ways of financing
the business in Chapter 2 and Chapter 4.

Question 3

What is the role of financial management in an organisation? Why is it important?
Why is it difficult?

Answer 3

Financial management involves making careful choices in the raising of finance (the
financing decision) and in the investment of this finance in real assets (the capital
budgeting decision). It is very important because a wrong decision could have very
serious consequences for the business. It is also very difficult because there are often
many options to choose from and the outcomes from any of the options are subject to
great uncertainty. There are many factors to consider and it is important that the financial
team gathers all the available information and examines the options objectively and
realistically

Question 4

Real assets are distinguished from financial assets, such …..?

Answer 4

as shares or bonds.

Question 5

Real assets can be tangible assets, such as ________, or intangible assets such as ________, ___________, and brand names.

Answer 5

Real assets can be tangible assets, such as machinery and buildings, or intangible assets such as goodwill, trademarks, and brand names.

Question 6

To acquire real assets, companies need to raise finance by issuing financial assets such as ______________________________

Answer 6

shares or bonds.

Question 7

Financial managers are responsible for ______________ and financing decisions and act as a link between the firm’s operations and the ________________

Answer 7

Financial managers are responsible for major investment and financing decisions and act as a link between the firm’s operations and the financial markets.

Question 8

Companies aim to increase the value of their shares by______________(Finance and Company Objectives:)

Answer 8

investing in profitable projects and raising finance in a cost-effective way.

Question 9

The ____________ decision considers the choice of projects in which the firm should invest.

Answer 9

capital budgeting

Question 10

Firms undertake projects that generate __________and incur __________.

Answer 10

Firms undertake projects that generate revenues and incur costs.

Question 11

The objective is to undertake projects for which _________exceed the __________to generate _____________for the shareholders.

Answer 11

The objective is to undertake projects for which revenues exceed the costs to generate profits for the shareholders.

Question 12

The financial manager is responsible for two main questions:
1——-
2. _____-

Answer 12

1.what real assets the firm should invest in and 2. how the cash for investment should be raised.

Question 13

The capital budgeting decision is the remit of the ___________

Answer 13

The capital budgeting decision is the remit of the controller or the Chief Financial Officer (CFO).

Question 14

The ____________looks after the company’s cash, raises new capital and maintains relationships with banks, shareholders and other investors.

Answer 14

The treasurer looks after the company’s cash, raises new capital and maintains relationships with banks, shareholders and other investors.

Question 15

_____________and treasurer roles are sometimes performed by the same individual.

Answer 15

CFO and treasurer roles are sometimes performed by the same individual.

Question 16

Responsibility for financial decisions ultimately rests with __________

Answer 16

the board of directors.

Question 17

Importance of Capital Budgeting:

Capital budgeting is essential due to the complexity of ____________and the _____________

Answer 17

Importance of Capital Budgeting:

Capital budgeting is essential due to the complexity of analysis and the cost of poor decisions.

Question 18

It is difficult to project prospective ______________ arising from a particular project.

Answer 18

cash flows

Question 19

Investment in working capital involves few ___and _____.

Answer 19

Investment in working capital involves few complications and risks.

Question 20

Investment in fixed capital often involves ________between various investment options.

Answer 20

Investment in fixed capital often involves complex choices between various investment options.

Question 21

Financial analysis is a key tool for making _______ and_________.

Answer 21

Financial analysis is a key tool for making informed and sensible investment decisions.

Question 22

Financial analysis can delineate the risks involved in a project and highlight the factors that lead to the greatest ___________.

Answer 22

uncertainty.

Question 23

Financial analysis in capital budgeting involves bringing together estimates and ideas from various disciplines such as___.

Answer 23

marketing, technology, accounting, tax, and law to reveal their financial implications.

Question 24

Financial analysis in capital budgeting requires the input of ___________ for an in-depth analysis of a project.

Answer 24

experts from each of these disciplines

Question 25

The problems of capital budgeting in any enterprise are both financial and ________ and leaving the investment appraisal of a project to the department primarily interested in the project can lead to impossible objectivity.

Answer 25

political

Question 26

All decisions are ultimately made by ____________ who are not always ________and _________.

Answer 26

All decisions are ultimately made by human beings who are not always impartial and objective.

Question 27

The use of a specialist finance function is an attempt to enforce _________and ___________.

Answer 27

The use of a specialist finance function is an attempt to enforce impartiality and realism.

Question 28

However, the finance function may lack ________ particular project under consideration, which could be a possible downside.

Answer 28

However, the finance function may lack specialist knowledge of the particular project under consideration, which could be a possible downside.

Question 29

Companies aim to increase the value of their shares since they are mostly owned by _________

Answer 29

shareholders who seek to maximize their investments.

Question 30

The extent to which shareholders aim to maximize their investments depends on the_______ they have over the company and the consideration of other _______.

Answer 30

The extent to which shareholders aim to maximize their investments depends on the control they have over the company and the consideration of other stakeholders.

Question 31

There are many groups involved in running a company, including___________

Answer 31

shareholders, managers, employees, lenders, customers, suppliers, and the government.

Question 32

Shareholders own the company and elect __________to run the company on their behalf.

Answer 32

the Board of Directors

Question 33

__________have ultimate responsibility for financial decisions within a company and act on behalf of the ultimate shareholders.

Answer 33

Directors

Question 34

Directors often delegate operational decision-making to ___________while retaining control of strategic issues.

Answer 34

executives

Question 35

What are the objectives of shareholders?

Answer 35

The objectives of the shareholders might be:
 to obtain a regular dividend
 to make a capital gain, ie to sell the shares for more than they cost
 to maximise the overall return on their investment.

Question 36

Give examples of objectives of:
(i) managers
(ii) banks and other lenders
(iii) employees
(iv) customers
(v) government

Answer 36

Solution 1.5
(i) Managers may aim for:
 job security
 good pay
 good benefits, eg perks such as company cars, long holidays.
 prestige and power.
They may therefore wish the company to aim for:
 growth (salary and prestige are often related to the size of the firm)
 stability (and not to take unnecessary risks)
 a satisfactory level of profit (rather than a maximum level of profit)
(ii) Banks and other lenders may wish the company to:
 remain in business
 to pay a market rate of return on the borrowed funds
 to meet the payment deadlines.
(iii) Employees may wish the company to:
 pay a market rate of pay for the work
 stay in business
 provide safe working conditions
 provide training
 provide a variety of benefits such as pensions, holidays etc.
(iv) Customers may wish the company to:
 remain in business (for after-sales service etc)
 provide goods at reasonable prices
 provide goods of good quality
 produce and market goods ethically.CT2-01: The key principles of finance Page 25
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(v) The government may wish the company to:
 perform well so that it pays more corporate taxes
 perform well so that it provides jobs to as many citizens of the state as
possible
 act morally and responsibly, eg in line with consumer law

Question 37

Give examples of other conflicts that may arise.

Answer 37

Solution 1.6
Other examples of conflicts include:
 The shareholders and managers may wish to invest in labour-saving technology,
but workers fear the loss of jobs and consumers fear a reduction in quality.
 Shareholders, management and employees wish to expand production on a
greenfield site, but the local community and local government fear a reduction in
the quality of life, with greater visual and air pollution and more congestion.

Question 38

Conflicting objectives)
The main objective of shareholders is normally to____________whil some managers may wish to pursue projects of _______ over more profitable projects, take over other companies, have a more ______or _____________working lifestyle, or aim for a __________return rather than a maximum return.

Answer 38

receive a high return on their investment in the company

some managers may wish to pursue projects of interest over more profitable projects, take over other companies, have a more leisurely or luxurious working lifestyle, or aim for a satisfactory return rather than a maximum return.

Question 39

There is potential for conflict between providers of finance, especially lenders (such as banks and bondholders) and_____?

Answer 39

equity capital providers (shareholders).

Question 40

Shareholders may be keener to see the company invest in a potentially high risk and high return project than ______who are more concerned with ensuring they receive the promised interest and capital payments.

Answer 40

lenders

Question 41

This difference can be characterized as the lenders’ ________desire for security and the shareholders’_______interest in the development of the company.

Answer 41

This difference can be characterized as the lenders’ short-term desire for security and the shareholders’ long-term interest in the development of the company.

Question 42

Ways of managing conflict:

Outline Agency Theory:

Answer 42

Agency theory explains the relationship between a principal and agent of that principal, including issues such as the nature of agency costs, conflicts of interest, and how agents may be motivated and incentivised. Divergence of interests leads to the possibility of conflicts of interest.

Question 43

Principal-agent problems: Conflicts of interest may arise between stakeholders, and give rise to agency costs, outline some of these cost?

Answer 43

. These include the costs associated with monitoring the actions of others and seeking to influence their actions.
The agency costs incurred by the shareholders are usually defined as the sum of three different component costs, including those incurred in monitoring the managers,
those incurred in seeking to influence the actions of managers,
and those incurred because the managers do not act in the owners’ best interests.

Question 44

Motivating and incentivizing managers: Two factors that encourage managers to operate in the interests of shareholders are job security and remuneration packages. Managers receive bonuses based on_________________

Answer 44

the company’s earnings or the share price.

Question 45

Shareholders can elect a new board of directors or express their disapproval by__________, which can make the company vulnerable to a _____________

Answer 45

Shareholders can elect a new board of directors or express their disapproval by selling their shares, which can make the company vulnerable to a take-over bid.

Question 46

Information asymmetries: Resolving conflicts is easier if all parties share _____________ into the fortunes of the company.

Answer 46

Information asymmetries: Resolving conflicts is easier if all parties share the same insights into the fortunes of the company. However, information asymmetries will often exist between the various classes of stakeholders.

Question 47

Power-sharing structures: Power-sharing structures exist in some countries that allow __________

Answer 47

employees to have a role in the running of the business, such as worker directors or Works Councils. These measures make more information available and aim to create a better understanding between stakeholders.

Question 48

Role of agreements: Written agreements between stakeholders may specify key aspects of the relationship between them, but cannot_______________________________.Such agreements, therefore, need to be supplemented by less formal understandings and arrangements.

Answer 48

Role of agreements: Written agreements between stakeholders may specify key aspects of the relationship between them, but cannot realistically cover all possible future eventualities.

Question 49

Contractual theory views a firm as ______

Answer 49

a network of contracts, actual and implicit, which specify the roles of the various participants in the organisation and define their rights, obligations, and pay-offs under various conditions.

Question 50

When are agency costs incurred?

Answer 50

Solution 1.7
Agency costs are incurred when:
 managers (as agents) do not attempt to maximise the value of the company
 shareholders (as principals) incur costs monitoring the managers and attempting
to influence their actions.

Question 51

How might the interests of a company’s management be aligned with those of the
shareholders?

Answer 51

Solution 1.8
The interests of a company’s management can be aligned with those of the shareholders
by linking the management’s remuneration to the performance of the company’s shares.
One way of doing this is by giving the managers a stake in the equity of the company,
eg via a share option scheme

Question 52

conflicts of interest may arise between stakeholders, and there are several ways to manage them, including

Answer 52

agency theory, motivating and incentivizing managers, sharing information, power-sharing structures, and written agreements between stakeholders.

Question 53

What information does the capital market provide:
(i) to monitor the financial manager?
(ii) to help the financial manager make decisions?

Answer 53

Solution 1.13
(i) The capital market provides information about the company’s share price and
the prices of the company’s bonds. These are indicators of the financial
manager’s performance. For example, if shareholders hear bad news about a
company’s performance, they are likely to sell their shares and bring about a fall
in the share price. This might affect managers directly if they own shares in the
company, or indirectly, through the expressed displeasure of the shareholders.
So the capital market keeps managers on their toes!
(ii) The capital market provides information on rates of return required from
different types of financial assets such as shares and bonds. This is helpful
when the manager is contemplating sources of finance. It is also helpful in
calculating the cost of capital for use as the discount rate when appraising
investment projects.
By studying the capital market, the financial manager will be able to monitor the
market’s reaction to various policies (either of its own company or others). For
example, if shareholders think a company’s proposed investment is likely to
increase shareholder wealth, the share price will tend to rise.
Managers can also monitor the policies and performance of particular
companies. For example, if Company X is buying other companies that are
involved in a particular line of business, then other such companies will consider
themselves possible targets. A company that has been performing less well than
the sector average and/or has lots of cash will be more vulnerable to a take-over
because the predator will feel that it could make better use of the company’s
resources.

Question 54

The _____________markets refer to the markets for long-term finance for companies, such as the shares and bond markets.

Answer 54

capital

Question 55

The capital markets provide _______that can be used to monitor the financial manager’s performance and to assist in making financial decisions.

Answer 55

important information

Question 56

For large, publicly quoted companies, the stock market serves as a _____________monitor. Share prices reflect the market’s perception of the particular firm’s current and expected future performance. If __________are not performing effectively, it will be reflected in a lower share _________.

Answer 56

For large, publicly quoted companies, the stock market serves as a performance monitor. Share prices reflect the market’s perception of the particular firm’s current and expected future performance. If managers are not performing effectively, it will be reflected in a lower share price.

Question 57

The capital markets’ continuous assessment stimulates _____ and provides incentives to business managers to _______their performance.

Answer 57

The capital markets’ continuous assessment stimulates efficiency and provides incentives to business managers to improve their performance.

Question 58

Key effects of the capital markets on a firm’s decisions include accurate measurement of the cost of ________for sound investment decisions, focus on methods of raising finance due to limitations in the supply of capital, opportunities and threats created by mergers and takeovers, and determining the appropriate role of organizations in dealing with externalities.

Answer 58

Key effects of the capital markets on a firm’s decisions include accurate measurement of the cost of capital for sound investment decisions, focus on methods of raising finance due to limitations in the supply of capital, opportunities and threats created by mergers and takeovers, and determining the appropriate role of organizations in dealing with externalities.

Question 59

A business entity owned and operated by one person, without forming a limited company. is known as?

Answer 59

Sole Trader:

Question 60

Sole traders are found in one-person operations like_____?

Answer 60

freelance journalists, but they may also have employees.

Question 61

Sole traders have unlimited legal liability for their business debts, meaning that ___?

Answer 61

personal wealth including the house and bank deposits of the owner would be available to pay off trading liabilities.

Question 62

WHat documentation is needed for a sole trader

Answer 62

No specific documentation is needed to establish a sole trader business entity.

Question 63

A business entity owned by more than one person without forming a limited company.

Answer 63

Partnership:

Question 64

________are formed when two or more people go into business together, and they are often found in professional firms like accountancy firms and actuarial consultancies.

Answer 64

Partnerships

Question 65

How can a partnership be ownned

Answer 65

Partnerships can be owned in equal or unequal amounts by the partners, and they can have some partners who provide capital and do not participate in the day-to-day operations of the business.

Question 66

Partners have ___________liability and are jointly and severally __________for any business debts.

Answer 66

Partners have unlimited liability and are jointly and severally liable for any business debts.

Question 67

A_________is usually made to set out the rights of individual partners, and the partnership will also need to provide accounts for tax purposes.

Answer 67

partnership agreement

Question 68

A business entity that has a separate legal identity from the owners of the business.

Answer 68

Limited Companies:

Question 69

Limited companies can own ________, make _______, and _______ or be ________ in their own name.

Answer 69

Limited companies can own property, make contracts, and sue or be sued in their own name.

Question 70

Limited companies are set up by issuing _____, and the owners are _________.

Answer 70

Limited companies are set up by issuing shares, and the owners are shareholders.

Question 71

Which of the following explains why companies have systems of internal control?
A External auditors recommend controls.
B Internal controls prevent board fraud.
C Staff might make errors or commit fraud.
D Stock exchange rules require controls.

Answer 71

The correct answer is: C. Staff might make errors or commit fraud.

Internal controls are a set of policies and procedures that are designed to provide reasonable assurance that a company’s assets are safeguarded and that its financial statements are accurate. Internal controls can help to prevent errors and fraud, and they can also help to ensure that a company complies with laws and regulations.

There are many reasons why companies have systems of internal control. One reason is that staff might make errors or commit fraud. Internal controls can help to prevent these errors and frauds by providing a system of checks and balances. For example, a company might have a policy that requires two employees to sign off on all payments. This policy helps to prevent one employee from making a fraudulent payment by requiring a second employee to review and approve the payment.

Another reason why companies have systems of internal control is to comply with laws and regulations. Many laws and regulations require companies to have certain internal controls in place. For example, the Sarbanes-Oxley Act of 2002 requires public companies to have a system of internal control over financial reporting.

Finally, internal controls can help to improve a company’s efficiency and effectiveness. By having a system of internal control in place, a company can be more confident that its assets are safeguarded and that its financial statements are accurate. This can help the company to make better decisions and to operate more efficiently.

In conclusion, there are many reasons why companies have systems of internal control. Internal controls can help to prevent errors and fraud, comply with laws and regulations, and improve a company’s efficiency and effectiveness.

Question 72

In what sense does the stock market serve as a performance monitor of a quoted
company?
A A stock market quotation requires compliance with rules.
B Economic variables can have an impact on share prices.
C The share price responds to management decisions.
D The stock market requires detailed financial statements.

Answer 72

n conclusion, the stock market serves as a performance monitor of a quoted company by providing a mechanism for investors to buy and sell shares of the company’s stock. The share price of a company’s stock is determined by the supply and demand for the stock, and it reflects investors’ expectations about the company’s future performance. When a company makes good decisions, its share price will typically go up, and when it makes bad decisions, its share price will typically go down. This feedback loop helps to ensure that companies are constantly striving to improve their performance.