Week 1- Firm objectives and Time Value of Money

Question 1

What is the overriding objective of a firm and why?

Answer 1

To maximise shareholder wealth because shareholders are the owners of the firm (through shares)

Question 2

How do shareholders see the benefits of the maximisation of their wealth?

Answer 2

Increases in share price or payment of dividends

Question 3

How can managers maximise shareholder wealth?

Answer 3

By accepting/investing in projects with positive Net Present Values.

Question 4

Why is Profit not as good as Wealth when judging the success of a business?

Answer 4

Profit relates to past decisions and wealth relates to future ones

Question 5

What are the arguments against the overiding goal of the firm being to maximise shareholder wealth?

Answer 5

Freeman (1984) Stakeholder Theory. Argues that the success of businesses lies in satisfying ALL of its stakeholders because without the support of these groups the business would cease to exist

Question 6

What is the Agent-Principal Problem?

Answer 6

When one party, the principal employs another party, the agency, to perform a task on their behalf creating a conflict of interest

Question 7

What are the three costs for shareholders associated with the Principal- Agent Problem?

Answer 7

1) Monitoring Cost: Principal spends money to monitor that the agent is maximising wealth
2) Bonding: Agent spends money on showing shareholders that they are maximising their wealth
3) Residual Loss: No Materr what each party does, costs will still occur

Question 8

What is the catch-22 associated the costs of preventing the principal agent problem?

Answer 8

Shareholders have to spend money to make sure their wealth is being maximised which further doesn’t maximise their wealth.

Question 9

How can the principal agency problem be fixed? (4 ways)

Answer 9

1) Managerial Reward Schemes (i.e share options) that align the interests of the firm with the interests of the employee
2) Corporate Governance Codes: A balance between non-exec and exec directors
3) Takeovers: The threat of a takeover may result in better management
4) Information requirement: More information requested by shareholders on how their wealth is being maximised

Question 10

Can you compare a present cashflow with a future cash flow?

Answer 10

No

Question 11

What is compounding?

Answer 11

Specifys how money grows at a particular rate of interest. By compounding at a rate equal to time value of money, we can calculate future values of current cash flows

Question 12

What is discounting?

Answer 12

Inverse of Compounding. By discounting at a rate equal to the time value of money we can calculate the present value of future cash flows

Question 13

What is a Conventional Cash flow?

Answer 13

An initial outflow of cash followed by a number of inflows of the same amount

Question 14

What is a non-conventional cash flow?

Answer 14

Cash flows that change ie. different inflows and outflows through the life of a project

Question 15

What is an annuity?

Answer 15

A series of cash flows at regular intervals with a fixed end point.

Question 16

What is an ordinary annuity?

Answer 16

Payment occurs at the end of each period

Question 17

What is an Annuity Due?

Answer 17

Payment occurs at the beginning of each period.

Question 18

What is a delayed annuity?

Answer 18

Annuity with the first payment starting after year 1

Question 19

What is a Growing Annuity?

Answer 19

The payment/ cashflow increases each period at a constant rate.

Question 20

What is a Perpetuity?

Answer 20

When an ordinary annuity lasts forever

Question 21

What is an ordinary perpetuity?

Answer 21

Regular Payments/cashflows starting from end of year/month/ week 1 that go on forever

Question 22

What is a delayed perpetuity?

Answer 22

Regular Payments/cashflows starting after year 1 that go on forever

Question 23

What is a growing perpetuity?

Answer 23

The payment/cashflow increases each period at a constant rate ad continues forever.

Question 24

What is the formula for compounding one single period?

Answer 24

FV= CFo X (1+r)

Question 25

What is the difference between Compound and Simple Interest?

Answer 25

Simple interest is only paid on the value of your initial investment whereas Compound interest is paid on the interest already earnt aswell

Question 26

What is the formula for compounding multiple periods?

Answer 26

FV= CFo X (1+r)^N

Question 27

How do you work out how many years an investment needs to be compounded by?

Answer 27

Divide FV by PV and then use Log

eg. 6000= 5000 X (1.05)^n
1.2=(1.05)^n
Log 1.2= Log(1.05)N
Log 1.2/Log 1.05 =n
n= 3.74 ( or 4 years interest as interest is paid at end of year)

Question 28

What is the compounding formula if an investment is compounded more than once a year?

Answer 28

FV= CFo x (1+ r/m)^mn

Question 29

What is the frequency of compounding for semi-annual payments (M)

Answer 29

2

Question 30

What is Continous Compounding?

Answer 30

When Compounding happens every instant

Question 31

What is the formula for Continuous compounding?

Answer 31

FV = CFo x e^rt

Question 32

Do you earn more or less from continuous compounding compared to frequent compounding?

Answer 32

More

Question 33

What is the difference between the Stated Annual Interest rate and the effective annual interest rate?

Answer 33

The stated annual interest rate does not account for compounding that occurs throughout the year. EAR accounts for intra year compounding on a daily, monthly or quarterly basis.

Question 34

What is the formula for EAR?

Answer 34

EAR= (1+r/m)^mn- 1

Question 35

What is the formula for compounding an Ordinary annuity?

Answer 35

FV= CFo x ((1+r)^N-1/r)

Question 36

Look at Formula Sheet for rest of discount rates

Question 37

3