Background & Context: Companies & Markets

Comprehensive practice flashcards covering basic corporate finance, definitions, formulas, market efficiency, and key concepts from Topic 1.

What are the three main financial decisions undertaken in a company?

The three main decisions are the Investment decision, the Financing decision, and the Dividend decision.

What is the core financial objective of a firm in financial management?

The core objective is the maximisation of shareholder wealth.

Define corporate finance according to the provided notes.

Corporate finance is concerned with the investment, financing, and dividend decisions made by companies with the objective of maximising shareholder wealth.

What is the formula for calculating Market Capitalisation?

$$\text{Market capitalisation} = \text{Number of shares in issue} \times \text{Current market share price}$$

What is the difference between par value and market share price?

Par value is a fixed legal and accounting value assigned to a share when it is issued, whereas market share price is determined by investor expectations of future returns, dividends, risk, and growth.

Why is shareholder wealth maximisation preferred over profit maximisation as a financial objective?

Shareholder wealth considers cash flows, timing, risk, and the market value of the firm, whereas accounting profit can be short-term, ignores risk and cash timing, and can be manipulated.

What is the agency problem in a corporate context?

The agency problem is the conflict that arises because shareholders own the company (principals) but directors and managers control it (agents), leading managers to potentially pursue their own interests over shareholder value.

How can share options help reduce the agency problem?

Share options give managers the right to buy shares at a fixed price in the future, aligning their interests with shareholders as both benefit when the share price increases.

What is the primary difference between money markets and capital markets?

Money markets are for short-term finance (usually less than one year), whereas capital markets are for long-term finance (more than one year).

What is the difference between a primary market and a secondary market?

In the primary market, new securities are issued for the first time to raise finance; in the secondary market, existing securities are traded between investors, providing liquidity.

What is the formula for Total Shareholder Return (TSR)?

$$\text{TSR} = \frac{\text{Closing share price} - \text{Opening share price} + \text{Dividends received}}{\text{Opening share price}} \times 100$$

Define business risk and financial risk.

Business risk is the risk arising from operations and trading conditions (e.g., falling demand), while financial risk is the additional risk placed on cash flows through the use of debt finance and interest commitments.

What are the common liquidity ratios used to assess a business?

$\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}$ and $\text{Acid test} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$

What are the three components of the time value of money?

The ability to invest money today, the impact of inflation reducing purchasing power, and the inherent risk of future cash flows.

What is the formula for the Present Value (PV) of a single future amount?

$$PV = FV \times \frac{1}{(1 + r)^n}$$

What is the formula for the Present Value (PV) of a perpetuity?

$$PV = \frac{\text{Annual cash flow}}{r}$$

What is the formula for the Present Value (PV) of a growing perpetuity?

$$PV = \frac{\text{Next annual cash flow}}{r - g}$$

Calculate the Present Value (PV) of $\text{£300,000}$ received in 3 years at a discount rate of $10\%$.

$$PV = \text{£300,000} \times \frac{1}{(1 + 0.10)^3} = \text{£300,000} \times 0.7513 = \text{£225,394}$$

Under the Efficient Market Hypothesis (EMH), what does the semi-strong form imply?

Share prices reflect all past price information and all publicly available information (accounts, news, announcements); fundamental analysis should not consistently find mispriced shares.

What information is reflected in share prices under strong form efficiency?

All public information and all private/inside information is reflected in the share price.

Define 'Allocational Efficiency' in financial markets.

This occurs when funds flow to the firms or projects that offer the best risk-adjusted returns, ensuring capital is directed to productive investments.

In the Roadways plc example, why does a strong-form efficient market result in a share price of $\text{£4.52}$ on November 23?

Because all information, including private board information about the 15-year tolling limit, is already reflected in the price before any public announcement.

What is a market anomaly?

A pattern or result that appears inconsistent with market efficiency, such as recurring abnormal returns linked to timing, size, or investor behavior.

What does Gearing measure in the context of financial ratios?

Gearing measures how much of a company's finance comes from debt compared with equity, which indicates financial risk.