1. theory of finance

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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

u ure cas - ows or e 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

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insurance companies?

Financial reporting: how should

corporations and financial intermediaries

report their performance to investors?


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Evaluating capital projects

A company must choose between alternative

projects involving the purchase of differentcapital goods

A project can be evaluated by projecting its net

These cash flows are used to calculate returnmeasures such as Net Present Value (NPV)and Internal Rate of Return (IRR)

The choice of project should allow for its risk aswell as its expected return

Question 1 A financial manager of a company is considering

which of two equally risky projects, A and B, thecompany should invest in.

Expected IRR Exp. NPV @ 10%

If the shareholders could obtain an expectedreturn of 12% per annum by investing in themarket at the same risk, which of A and B willgenerate more wealth for the shareholders?

. .

Project B 15% p.a. 50m

Project finance

The main types of finance used by companiesare debt and equity

Debt involves a contract to pay the investorinterest and re-pay the principal after a specifiedterm. Such investors are creditors

Equity gives the investor a share of theownership rights of the business and a pro-rataentitlement to any profits distributed asdividends. Such investors are shareholders

Creditors have priority over shareholders in theservicing and repayment of their capital


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Choice of finance

Type of finance raised by a company should

depend on:

- Its existing level of debt: the cost of loan finance

increases with the gearing of the company

- 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 2What level of gearing would you expect to find

in the following types of business:

- a water utility company

- an engineering company

- a property investment company?


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Question 3

A company holds cash worth approximately

30% of the market value of its equity.

a op ons oes e company ave or

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

Exploit complementary resources

Access opportunities available only to large firms

Replace inefficient managers (in a hostiletakeover)


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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 whatassets to invest in

The life-cycle hypothesis assumes thatpeople borrow and save over their lifetimeto smooth out their consumption over time

Orthodox finance assumes people do this bymaximising the expected utility of theirlifetime consumption


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Orthodox finance

Orthodox finance is based on expected utility

theory and rational expectations

Rational expectations assumes everyone has acorrect probability model of their future income,uture nvestment returns, etc

Hence they can make saving and investmentdecisions which maximise the expected utility oftheir consumption

This results in all assets being priced correctly,according to the distribution of their future returns

Behavioural finance

Behavioural finance is an alternative toorthodox finance which looks at psychologicalfactors influencing investor decision-making

mis-priced assets and market crashes

It identifies examples of individual behaviourinconsistent with expected utility theory orrational expectations.

Problems with utility theory

Individuals are sensitive to changes inconsumption relative to a reference point(prospect theory)

Status quo bias: if in doubt, people prefer to do

Myopic loss aversion: individuals become morerisk averse when they monitor investments overshorter periods

Framing: the same risk is viewed differently ifpresented in different ways


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Problems with rational expectations

Representativeness bias: people give too muchweight to the recent past in assessing what islikely to happen in the future

Overconfidence: people overestimate theirability to forecast the performance of assets theyare familiar with

Valence effect: people overestimate theprobability of good events relative to bad events

Snakebite effect: one bad experience results inexcessive caution

Question 5

The late 1990s there was a bubble in the

market prices of technology stocks, which

colla sed in the earl ears of the next

century. What aspects of investor psychology

might have contributed to this price bubble?

Taxation of investments

Core Reading Unit 2


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Taxing investment returns

The tax charged on investment returns depends on:

- The type of assets (equities, bonds, etc)

- The investment vehicle (pension fund, endowment

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, loaninterest, share dividends, rent from property

Investment income could be added toearnings from work and taxed at marginal rate

Share dividends are paid out of companyprofits already subject to corporation tax hence they may be taxed at a lower rate tooffset the corporation tax already paid

If so, shareholders may be imputed with atax credit on the dividends they receive

Capital gains tax

A capital gain arises when an investment is soldfor a profit

The profit could be taxed at a special rate or thesame 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 theaggregate gains arising in any tax year


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Tax-exempt vehicles

The government may authorise tax-exemptvehicles to encourage people to save

For example:

- tax-free accumulation of all investment returnswithin approved saving or pension schemes

- tax-deductible contributions to certain vehicles(typically pension schemes)

There will be limits on the amount saved in eachvehicle 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 yields if capital gains are taxed

more lightly than income

This will force up the price of low-yieldingassets, 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

v en s to pens on un s

(ii) The abolition of capital gains tax on

corporate bonds?

1. theory of finance

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