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Business Finance > Lecture 2 - Return and Risk Investors and companies > Flashcards

Lecture 2 - Return and Risk Investors and companies Flashcards

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1
Q

Return

A

Payment to providers of funds (interest, dividends, capital gains/losses).

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2
Q

Interest Payment to Lenders

A

Percentage of the initial principal amount (P₀).

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3
Q

Dividend Payment to Owners

A

Dividend received (D₁) divided by initial price (P₀).

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4
Q

Capital Gains/Losses

A

Calculated as (P1−P0)/P0(P₁ - P₀) / P₀(P1​−P0​)/P0​.

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5
Q

Timing of Payments

A

Payments occur after the investment decision, making them uncertain.

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6
Q

Expected Return

A

The average of the possible outcomes.

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7
Q

Risk

A

The variability among possible outcomes, indicating the degree of uncertainty.

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8
Q

What do rational investors aim to do?

A

Maximize their wealth while considering the need to use some of their wealth for living expenses (balancing investment vs. consumption).

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9
Q

How do investors behave when expected returns are equal for two investment opportunities?

A

They choose the less risky project.

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10
Q

How do investors behave when the risk level is the same for two investment opportunities?

A

They choose the project with higher returns.

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11
Q

What is the characteristic of a rational investor regarding investment decisions?

A

They make choices that maximize their wealth while accounting for the requirement to use some of their wealth for living.

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12
Q

What do investors consider besides maximizing wealth?

A

The requirement to use some of their wealth to live on (consumption).

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13
Q

What is the decision criterion when expected returns are equal?

A

Choose the less risky project.

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14
Q

What is the decision criterion when the risk level is the same?

A

Choose the project with higher returns.

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15
Q

What are the different attitudes towards risk among investors?

A

Investors have different attitudes towards risk: some are risk-taking while others are risk-averse.

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16
Q

What is the behavior of risk-averse investors regarding risky projects?

A

Risk-averse investors do not invest in any risky project unless they are compensated for taking the risk.

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17
Q

What are some examples of risk-free investments for risk-averse investors?

A

Risk-free investments for risk-averse investors include bank accounts, government bonds, and other similar low-risk options.

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18
Q

What is meant by the term “risk-free rate of return”?

A

The risk-free rate of return is the return provided by an investment with no risk, serving as a benchmark for such investments.

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19
Q

Is the risk-free rate of return equal to zero?

A

No, the risk-free rate of return is not equal to zero; it provides a noteworthy level of return.

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20
Q

What kind of investments require a risk premium on top of the risk-free rate of return?

A

Investments in start-ups and sectors that are prone to business cycles require a risk premium on top of the risk-free rate.

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21
Q

Why do investors require a risk premium for certain investments?

A

Investors require a risk premium for taking on additional risk associated with higher-risk investments like start-ups.

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22
Q

What is an example of an investment prone to business cycles?

A

Sectors that are heavily affected by economic cycles, which can be more volatile, are examples of investments prone to cycles.

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23
Q

Why might a risk-averse investor prefer government bonds?

A

Government bonds are backed by the government and are considered very low-risk, making them suitable for risk-averse investors.

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24
Q

What is the significance of the risk-free rate of return in investment decisions?

A

The risk-free rate of return serves as a benchmark, helping investors compare the potential returns of riskier investments.

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25
Q

How do start-ups compare to traditional investments for risk-averse investors?

A

Start-ups are considered high-risk investments compared to traditional options like bank accounts or government bonds.

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26
Q

How do risk-taking and risk-averse investors differ in their investment strategies?

A

Risk-taking investors seek higher returns by taking on more risk, while risk-averse investors prefer safer, low-risk options.

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27
Q

What does the x-axis represent in the graph shown on slide 8?

A

The x-axis represents the level of risk.

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28
Q

What does the y-axis represent in the graph shown on slide 8?

A

The y-axis represents the expected return.

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29
Q

What is the Risk-Free Rate?

A

The Risk-Free Rate is the baseline return indicated by the intersection of the line with the y-axis. It is the return expected from an investment perceived to have zero risk, such as a government Treasury bill.

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30
Q

How does the Risk-Free Rate vary with the level of risk?

A

The Risk-Free Rate does not vary with the level of risk and remains constant regardless of how much risk is taken on.

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31
Q

What is the Risk Premium?

A

The Risk Premium is the additional return expected for taking on greater risk beyond the Risk-Free Rate. It is represented by the shaded area above the Risk-Free Rate in the graph.

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32
Q

How does the expected return change as risk increases according to the graph?

A

As risk increases, the expected return also increases, indicating a fundamental trade-off in investing.

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33
Q

What does a steeper slope in the graph indicate?

A

A steeper slope indicates a higher risk premium, meaning investors are demanding more compensation for the increased risk. This slope is often referred to as the “market price of risk.”

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34
Q

What two components make up the return on a risky investment?

A

The return on a risky investment consists of the Risk-Free Rate plus the Risk Premium.

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35
Q

What is a company?

A

A company is a business organization that engages in making, buying, or selling goods, or providing services in return for money.

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36
Q

What does ownership of a company entail?

A

A company is owned by individuals or entities that hold its shares, and the collective shares represent its equity.

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37
Q

How is ownership of shares transferred?

A

Ownership of shares can be transferred through buying and selling of shares without affecting the company’s continued operation.

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38
Q

What is the distinction between ownership and management in a company?

A

Shareholders are the owners of the company, while management is hired to handle the company’s operations on behalf of the shareholders.

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39
Q

What is an “Ltd” (Limited Company) in the UK?

A

An “Ltd” is a type of company with shareholders, but its shares do not trade on public stock exchanges and are not available for purchase by the general public.

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40
Q

What is a “plc” (Public Limited Company) in the UK?

A

A “plc” is a type of company whose shares are traded on a stock exchange and can be bought and sold by the public. It is subject to stricter regulations and disclosure requirements.

41
Q

What is the key distinction between “Ltd” and “plc”?

A

The key distinction is that Ltd companies are private and their shares are not publicly traded, whereas plcs are public and their shares are listed on stock exchanges for the general public to buy and sell.

42
Q

What does “Limited Liability” mean for shareholders?

A

“Limited Liability” means that shareholders’ personal financial liability is limited to the amount they invested in the company. They are not personally responsible for the company’s debts beyond their investment.

43
Q

What happens if a limited liability company goes bankrupt?

A

If a limited liability company goes bankrupt, it must settle its debts by liquidating assets. If assets are insufficient, unpaid creditors cannot pursue personal assets of the shareholders.

44
Q

What is liquidation?

A

Liquidation is the process by which a company is brought to an end, and its assets are distributed to claimants. This can occur upon insolvency or when shareholders decide to cease operations.

45
Q

What is the order of paying creditors in bankruptcy?

A

In bankruptcy, creditors are paid in the following order: government (unpaid taxes), employees (unpaid salaries), secured creditors (bondholders), and finally shareholders if any funds remain.

46
Q

What are the objectives of a business?

A

The objectives of a business include profit maximization and shareholder wealth maximization.

47
Q

What is profit maximization?

A

Profit maximization is the strategy of making as much profit as possible, often seen as a short-term goal.

48
Q

What are some common tactics used for profit maximization?

A

Common tactics include cutting R&D, reducing spare capacity, and extending the life of equipment to reduce costs in the short term.

49
Q

What are the consequences of profit maximization?

A

Consequences include short-termism, neglecting future sustainability, and potentially undermining the long-term health and growth of the company.

50
Q

How might shareholder satisfaction vary with profit maximization strategies?

A

Short-term investors may be satisfied with immediate returns, while long-term investors may prefer strategies that invest in the company’s future.

51
Q

What is shareholder wealth maximization?

A

Shareholder wealth maximization is the goal of making the company profitable in both the short term and long term, increasing the overall value of the shareholders’ investment.

52
Q

What preferences might shareholders have regarding wealth realization?

A

Some shareholders may prefer immediate returns in the form of dividends, while others may prefer reinvestment into high-return investments for capital growth and future wealth.

53
Q

What should management aim for in making decisions?

A

Management should aim to make decisions that maximize the wealth of the shareholders, considering the overall returns of the company.

54
Q

How can capital markets benefit shareholders?

A

Capital markets allow shareholders to tailor their personal investment and consumption preferences independently from the company’s decisions by borrowing or lending money.

55
Q

What is the Separation Theorem?

A

The Separation Theorem suggests that a firm’s investment decisions should be made to maximize wealth regardless of the preferences of its owners, as shareholders can adjust their portfolios in the capital market.

56
Q

What does the Modigliani-Miller theorem propose?

A

The Modigliani-Miller theorem proposes that under certain conditions, the value of a firm is unaffected by how it is financed (equity or debt), implying that financing decisions can be made independently of investment decisions to maximize firm value.

57
Q

What is the risk-free rate in the context of investments?

A

The risk-free rate is the minimum return investors would accept from an investment with zero risk, such as government Treasury bills.

58
Q

What does the risk premium compensate investors for?

A

The risk premium compensates investors for the increased uncertainty and risk of an investment beyond the risk-free rate.

59
Q

What is a key trade-off shown in the graph related to investments?

A

The graph shows that as risk increases, the expected return also increases, highlighting the fundamental trade-off in investing.

60
Q

How does the slope of the line in the graph relate to the market price of risk?

A

The slope of the line indicates the market price of risk, showing how much additional return investors demand for taking on more risk.

61
Q

What is the main benefit of limited liability for investors?

A

Limited liability protects investors from being personally liable for the company’s debts beyond their investment, encouraging investment and entrepreneurship.

62
Q

What happens to shareholders’ investments if a company with limited liability goes bankrupt?

A

Shareholders’ loss is limited to their capital investment in the company; they are not liable for any additional debts.

63
Q

Why might companies with limited liability be more attractive to investors?

A

The limitation of risk to their invested capital makes such companies more attractive by reducing the potential downside for investors.

64
Q

How do profit maximization strategies potentially impact a company’s long-term sustainability?

A

Profit maximization strategies may lead to short-term gains but can undermine long-term sustainability by neglecting innovation, capacity building, and equipment maintenance.

65
Q

What is the difference between short-termism and long-term strategic planning in business?

A

Short-termism focuses on immediate financial gains, often at the expense of future growth, while long-term strategic planning balances short-term profits with investments in future sustainability.

66
Q

How can capital markets influence a company’s investment decisions?

A

Capital markets allow shareholders to adjust their portfolios independently, enabling the company to focus on investment decisions that maximize overall firm value rather than individual shareholder preferences.

67
Q

What is the primary goal of shareholder wealth maximization?

A

The primary goal of shareholder wealth maximization is to increase the overall value of the shareholders’ investment in the company, ensuring profitability in both the short term and long term.

68
Q

How do shareholders’ preferences impact company policy on dividends and reinvestment?

A

Some shareholders prefer immediate returns through dividends, while others prefer reinvestment of profits for capital growth and increased future wealth.

69
Q

What is the Modigliani-Miller theorem’s implication for financing decisions?

A

The Modigliani-Miller theorem implies that financing decisions (equity or debt) do not affect a firm’s value under certain conditions, allowing these decisions to be made independently of investment decisions aimed at maximizing firm value.

70
Q

What does the Separation Theorem state for firms regarding investment and financing decisions?

A

The Separation Theorem states that investment decisions and financing decisions can be made separately by managers.

71
Q

Are investment decisions for firms constrained by the funds available to them?

A

No, investment decisions are not constrained by the funds available to firms or the ways to source funds.

72
Q

What must managers consider when making investment decisions?

A

Managers must consider the cost of finance, using the cost of capital (e.g., rate of return required by shareholders, interest rate) as the discount rate when evaluating the feasibility of an investment project.

73
Q

How are investment decisions evaluated in terms of financial feasibility?

A

Investment decisions are evaluated using the cost of capital as the discount rate to determine the feasibility of a project.

74
Q

What is the relationship between wealth, investment, and consumption for investors?

A

Wealth is the sum of investment and consumption.

75
Q

Are investment and consumption decisions constrained by an investor’s current wealth?

A

No, neither investment nor consumption is constrained by the wealth in the presence of a capital market.

76
Q

How can investors adjust their investment and consumption levels?

A

Investors can borrow or lend to adjust their investment and consumption levels.

77
Q

What flexibility does the Separation Theorem provide to investors?

A

The Separation Theorem allows investors to make investment decisions separately from consumption decisions, providing greater flexibility in managing their wealth.

78
Q

How does the presence of a capital market affect investment and consumption decisions for investors?

A

The presence of a capital market allows investors to adjust their investment and consumption independently of their current wealth, enabling them to borrow or lend as needed.

79
Q

What is the key takeaway of the Separation Theorem for both firms and investors?

A

The key takeaway is that both firms and investors can make strategic decisions (investment vs. financing for firms, and investment vs. consumption for investors) independently, allowing for greater flexibility and optimization.

80
Q

Why do investors or potential investors want detailed information on companies?

A

Investors or potential investors want detailed information on companies to make informed decisions about buying shares.

81
Q

What financial statements are UK public limited companies (plc) required to publish annually?

A

UK plc companies are required to publish the income statement, balance sheet, and cash flow statement annually.

82
Q

What is included in a company’s annual report?

A

The annual report includes major information on performance and large amounts of verbal and numerical information.

83
Q

Why do analysts study the information in a company’s annual report?

A

Analysts study this information eagerly for any clues about the company’s future performance.

84
Q

Where can one find precise details about Financial Reporting Standards (FRS)?

A

Precise details can be found at http://www.frc.org.uk/asb/technical/standards/accounting.cfm. These standards are issued by the Accounting Standards Board (ASB) and are part of the Financial Reporting Council (FRC).

85
Q

What three key pieces of information are provided by the income statement?

A

The income statement provides information on how much profit (or loss) was earned, how much taxation was paid, and what happened to the profit (or loss) after taxation.

86
Q

What activities are included in the cash flow statement according to FRS 1 (revised 1996)?

A

The cash flow statement includes operating activities, returns on investments and servicing of finance, taxation, capital expenditure and financial investment, acquisitions and disposals, and equity dividends paid.

87
Q

What does the balance sheet show?

A

The balance sheet shows the company’s assets and liabilities.

88
Q

What is the balance sheet identity used in the module?

A

The balance sheet identity is: Assets = Equity + Liabilities.

89
Q

How can companies be valued according to the balance sheet identity?

A

Companies can be valued by their assets (potential to generate incomes) and by claims (funds made available by shareholders or creditors).

90
Q

What is the purpose of financial ratios derived from financial statements?

A

Financial ratios help summarize large amounts of financial information into useful metrics, including profitability, activity, liquidity, capital gearing, and investors’ measures.

91
Q

What does the profitability ratio measure?

A

The profitability ratio measures profit generation.

92
Q

What does the activity ratio measure?

A

The activity ratio measures asset utilization.

93
Q

What does the liquidity ratio measure?

A

The liquidity ratio measures the use of working capital.

94
Q

What does the capital gearing ratio measure?

A

The capital gearing ratio measures the relationship between equity and debt.

95
Q

What do investors’ ratios measure?

A

Investors’ ratios measure what investors want to know, such as earnings per share, price/earnings ratio, and dividend pay-out rate.

96
Q

What is the gearing ratio used for?

A

The gearing ratio (Debt/Equity or Debt/total capital employed) is used to indicate the possibility of default or potential financial distress and to proxy the capital structure of firms.

97
Q

Why are investor ratios useful?

A

Investor ratios are useful when estimating rates of return for investors or the cost of capital for firms.

98
Q

Draw and explain the expected return graph?

A

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