Module 12 - Finance Theory

Question 1

Why is the level of dividend thought to be important

Answer 1

• regarded as communicating a message about management’s view of current and future profitability (signaling hypothesis)
• a dividend is cash in hand so is more certain
• investors place heavy emphasis on past dividend levels

Question 2

dividend relevancy theories

Answer 2

choice of dividend policy affects the company’s share price

Question 3

Walter’s model

Answer 3

• relevancy theory
• compares cost of capital and rate of return
• if rate of return > cost of capital then all profits should be retained and zero dividend paid
• if company generates a lower rate of return than cost of capital then 100% of profits should be distributed by way of dividends

Question 4

assumptions of Walter’s model

Answer 4

• retained earnings are the only source of finance
• cost of capital and rate of return on investments stays constant
• life of company is endless

Question 5

Residual theory

Answer 5

• company should retain profits needed for investments and projects
• remaining profits distributed
• volatile dividends under this theory
• investors either receive value now as dividend or later in form of capital appreciation
• dividend irrelevancy theory

Question 6

MM-theory

Answer 6

• investor wealth unaffected by dividend payments
• irrelevancy theory
• if paid dividends that they do not want investors can invest further
• if retains profit then company is making an investment that should yield profits in future -> share price should rise
• if they would prefer dividends investors can sell shares

Question 7

Efficient market hypothesis

Answer 7

investors should not be able to beat the market

if the market is efficient returns are linked to the risk level of investments, if investors want to maximise returns they should minimise expenses (invest in fund which tracks performance of an index or market as whole)

Question 8

Insider dealing

Answer 8

occurs when an individual buys or sells shares on the basis of inside info -> criminal offence

Question 9

portfolio theory

Answer 9

how to construct a portfolio of investments or assets in order to maximise investor’s return for any given level of risk

Question 10

Expected return from a single investment

Answer 10

Sum of all scenarios: expected return x probability of occurring

Question 11

expected risk of a single investment

Answer 11

sqrt ( sum of Pi (Xi-X)^2)

where Xi - return expected from scenario i
X - expected return on investment

Question 12

correlation coefficient

Answer 12

measure of the way in which the return on investment movements match each other in response to a particular event

picking securities whose returns are not perfectly positively correlated can reduce risk of return

Question 13

combined return of a portfolio

Answer 13

pr1 + (1-p)r2

Question 14

systematic risk

Answer 14

risk inherent in the political and economic enviro common to all companies - e.g. inflation/interest rate

can never be eliminated

Question 15

specific risk

Answer 15

encompasses a range of risks specific to an individual company such as changes in market demand

possible to diversify away about 95% of risk by spreading investment across 20 carefully chosen securities

Question 16

Return available on investments only rewards investors for the ______ risk

Answer 16

systematic

Question 17

Beta

Answer 17

measures how the return from a particular security typically performs in relation to the average return that has been earned over the same period by all investments in the market

Question 18

stock market beta value

Answer 18

1

Question 19

CAPM formula

Answer 19

k = Rf + B (Rm-Rf)

Question 20

risk premium

Answer 20

Rm-Rf - additional return which the market offers for investing in a broad portfolio of securities