Theory of finance

Core Reading Unit 8

What is finance?
The process by which the savings of a community are invested in capital assets Capital assets are assets expected to generate future cash cash-flows flows for the owner Capital assets can be: Financial assets, e.g. shares and bonds Real assets, e.g. real estate, machinery and intangible assets

Issues in finance
Project evaluation: how do organisations decide which capital projects to undertake? Financial intermediaries: what is the role of f banks, b k pension i funds, f d mutual t l funds f d and d insurance companies? Financial reporting: how should corporations and financial intermediaries report their performance to investors?

Concepts in finance
Financial instruments are claims to future cashflows held by investors Financial markets are places where financial instruments are issued and traded Financial pricing models are use to calculate the fair price of a financial instrument Portfolio management is how investors divide their savings between different financial instruments

Corporate finance
Corporations must decide: (a) ( ) what capital p g goods to buy y (capital ( p budgeting) (b) how to raise the necessary cash from investors (financial budgeting)

Financial planning
Long term financial planning involves making projections over a 3-5 year period or longer. It includes plans for growth in existing activities, new capital projects, raising longterm finance and dividend policy. policy Short term financial planning is about the management of working capital and cash-flow over a 12-month period. Its aim is to ensure the business has sufficient cash to cover seasonal variations in revenue

Evaluating capital projects

A company must choose between alternative projects involving the purchase of different capital goods A project can be evaluated by projecting its net cash flows over time These cash flows are used to calculate return measures such as Net Present Value (NPV) and Internal Rate of Return (IRR) The choice of project should allow for its risk as well as its expected return

Question 1
A financial manager of a company is considering which of two equally risky projects, A and B, the company should invest in.
Project A Project B Expected IRR 12% p.a. pa 15% p.a. Exp. NPV @ 10% 100m 50m

If the shareholders could obtain an expected return of 12% per annum by investing in the market at the same risk, which of A and B will generate more wealth for the shareholders?

Project finance
The main types of finance used by companies are debt and equity Debt involves a contract to pay the investor interest and re-pay the principal after a specified term. Such investors are creditors Equity gives the investor a share of the ownership rights of the business and a pro-rata entitlement to any profits distributed as dividends. Such investors are shareholders Creditors have priority over shareholders in the servicing and repayment of their capital

Choice of finance
Type of finance raised by a company should depend on: - Its existing level of debt: the cost of loan finance gearing g of the company p y increases with the g - The timing and uncertainty of future profits: equity finance is more suitable when profits are less certain and will take longer to emerge - The comparative tax treatment of equity and debt for both the company and the investor

Maximising shareholder wealth

The shareholders want the company to be run so as to maximise the market value of their shares This means choosing projects expected to generate returns which adequately compensate investors for the risks involved If no such projects exist, the company should return surplus funds to its investors, e.g. by repaying its debts or buying back its own shares

Question 2
What level of gearing would you expect to find in the following types of business: - a water utility y company p y - an engineering company - a property investment company?

Question 3
A company holds cash worth approximately 30% of the market value of its equity. (i) What options does the company have for returning this cash to its investors? (ii) What factors will determine which option is in the best interests of the shareholders?

Mergers and acquisitions

There are three types: - Horizontal: merging with a competitor (but this may be prevented by anti-monopoly laws) - Vertical: acquiring a firm in the same industry at a different stage of the production chain - Conglomerate: acquiring a firm in an unrelated industry

Valid reasons for mergers and acquisitions

Economies of scale: spread fixed costs over a larger production base (horizontal merger) Improve coordination & reduce administration costs (vertical merger) Exploit complementary resources Access opportunities available only to large firms Replace inefficient managers (in a hostile takeover)

Bad reasons for mergers and acquisitions

Diversification (shareholders can diversify their own portfolios) Utilising surplus funds (should return surplus cash to shareholders unless the acquisition creates value) Preventing a hostile take-over (this benefits the managers rather than the shareholders)

Question 4
A multinational company makes an offer of 800p per share for the equity capital of a UK PLC. Before the announcement of this offer, the share price of the UK PLC was 600p. How would the shareholders of each company judge whether this acquisition was in their best interests?

Investor decision-making
Individuals must decide how much of their income to save in any period and what assets to invest in y hypothesis yp assumes that The life-cycle people borrow and save over their lifetime to smooth out their consumption over time Orthodox finance assumes people do this by maximising the expected utility of their lifetime consumption

Orthodox finance
Orthodox finance is based on expected utility theory and rational expectations Rational expectations assumes everyone has a correct probability model of their future income, f t future investment i t t returns, t etc t Hence they can make saving and investment decisions which maximise the expected utility of their consumption This results in all assets being priced correctly, according to the distribution of their future returns

Behavioural finance
Behavioural finance is an alternative to orthodox finance which looks at psychological factors influencing investor decision-making It offers explanations for anomalies such as mis-priced assets and market crashes It identifies examples of individual behaviour inconsistent with expected utility theory or rational expectations.

Problems with utility theory

Individuals are sensitive to changes in consumption relative to a reference point (prospect theory) Status quo bias: if in doubt, people prefer to do nothing because of regret aversion Myopic loss aversion: individuals become more risk averse when they monitor investments over shorter periods Framing: the same risk is viewed differently if presented in different ways

Problems with rational expectations

Representativeness bias: people give too much weight to the recent past in assessing what is likely to happen in the future Overconfidence: people overestimate their ability to forecast the performance of assets they are familiar with Valence effect: people overestimate the probability of good events relative to bad events Snakebite effect: one bad experience results in excessive caution

Question 5
The late 1990s there was a bubble in the market prices of technology stocks, which p in the early yy years of the next collapsed century. What aspects of investor psychology might have contributed to this price bubble?

Taxation of investments
Core Reading Unit 2

Taxing investment returns

The tax charged on investment returns depends on: - The type of assets (equities, bonds, etc) - Th The investment i vehicle hi l (pension ( i fund, f d endowment d assurance policy etc) - The type of return (capital gain or income) - The investors tax status (tax bracket, country of residence, etc)

Income tax
Is the tax levied on bank interest, loan interest, share dividends, rent from property Investment income could be added to earnings from work and taxed at marginal rate Share dividends are paid out of company profits already subject to corporation tax hence they may be taxed at a lower rate to offset the corporation tax already paid If so, shareholders may be imputed with a tax credit on the dividends they receive

Capital gains tax

A capital gain arises when an investment is sold for a profit The profit could be taxed at a special rate or the same rate as marginal income There may be tax free allowances for: - the inflationary part of the gain - aggregate gains below an annual tax-free limit Capital losses may be permitted to offset the aggregate gains arising in any tax year

Tax-exempt vehicles
The government may authorise tax-exempt vehicles to encourage people to save For example: - tax-free accumulation of all investment returns within approved saving or pension schemes - tax-deductible contributions to certain vehicles (typically pension schemes) There will be limits on the amount saved in each vehicle to reduce tax avoidance by the wealthy

Effect of taxation on financial markets

Certain investors may be prefer certain types of investment because they are taxed more lightly E.g. tax-paying investors may prefer assets with low running g yields y if capital p gains g are taxed more lightly than income This will force up the price of low-yielding assets, making them less attractive to tax-exempt investors This is an example of market segmentation

Question 6
How might financial markets be affected by: (i) The abolition of a tax rebate on equity di id d to pension dividends i funds f d (ii) The abolition of capital gains tax on corporate bonds?

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