Firm Objectives & Time Value of Money
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Questions and Answers

What is the main purpose of holding additional cash beyond operational needs?

  • To pay off debts faster
  • To maximize trade receivables
  • To invest in long-term assets
  • To handle precautionary or speculative needs (correct)

Which of the following best describes the Cash Conversion Cycle (CCC)?

  • Time from receiving inventory to paying suppliers
  • Elapsed time from cash outflow for raw materials to cash inflow from finished goods (correct)
  • Duration before inventory is counted as a loss
  • Time taken to complete production of finished goods

Which component is not part of the Operating Cycle equation?

  • Trade Payables Days (TPD)
  • Trade Receivables Days (TRD)
  • Cost of goods sold (COGS) (correct)
  • Inventories Holding Period (IHP)

What does Trade Payables Days (TPD) measure?

<p>Time between purchasing raw materials and paying for them (C)</p> Signup and view all the answers

What is a key objective of inventory management?

<p>Rapidly turn over inventory without stockouts (A)</p> Signup and view all the answers

What type of inventory includes items under production that are not yet complete?

<p>Work-in-Progress (B)</p> Signup and view all the answers

Which type of inventory cost is associated with the expense of preparing an order?

<p>Ordering costs (D)</p> Signup and view all the answers

Which of the following is a consequence of having no stock available to meet demand?

<p>Stock-out costs (A)</p> Signup and view all the answers

What does the line connecting the risk-free rate and market portfolio M represent?

<p>Capital Market Line (CML) (D)</p> Signup and view all the answers

Which portfolios do investors find unattractive due to dominance?

<p>Portfolios lying along M to B (B)</p> Signup and view all the answers

How do investors with different risk appetites create their portfolios?

<p>By combining market portfolio M and cash investments (A)</p> Signup and view all the answers

In which zone would an investor who wants to achieve returns above M operate?

<p>Borrowing zone (D)</p> Signup and view all the answers

What characterizes the individual investor's optimal portfolio?

<p>The point of tangency with the investor's utility curve and a feasible set (B)</p> Signup and view all the answers

What does the market portfolio consist of?

<p>All risky assets in relation to their market value (A)</p> Signup and view all the answers

What type of assets do investors place in the lending zone of the CML?

<p>Proportion in risky assets and remainder in risk-free investments (C)</p> Signup and view all the answers

What investment strategy is used by investors located on the CML above M?

<p>Borrowing funds to invest more in portfolio M (A)</p> Signup and view all the answers

What does a negative correlation coefficient, which is less than 0 but greater than -1, indicate about the returns of two assets?

<p>The returns of the two assets tend to move in opposite directions. (A)</p> Signup and view all the answers

What is indicated by a correlation coefficient of 0 between two assets?

<p>There is no relationship in the variability of the assets' returns. (C)</p> Signup and view all the answers

Which type of risk can be eliminated through diversification?

<p>Unsystematic Risk (A)</p> Signup and view all the answers

What does the equation for the covariance of a two-stock portfolio involve?

<p>The correlation coefficient and the standard deviations of both stocks. (C)</p> Signup and view all the answers

Which of the following statements correctly describes systematic risk?

<p>It is caused by factors affecting the broader market. (A)</p> Signup and view all the answers

What is the main goal of diversification in investment portfolios?

<p>To reduce total risk by spreading investments across many assets. (A)</p> Signup and view all the answers

What does the concept of 'portfolio' refer to in investment terminology?

<p>A collection of various types of investments summing to 100%. (C)</p> Signup and view all the answers

Which is a fundamental assumption of Portfolio Theory regarding investors?

<p>Investors make decisions based on a single time period framework. (D)</p> Signup and view all the answers

What characterizes the market portfolio in an investment context?

<p>It consists of all companies quoted on the stock market. (A)</p> Signup and view all the answers

Which statement accurately describes the concept of equilibrium market prices?

<p>They reflect the expected return that compensates adequately for the risk involved. (A)</p> Signup and view all the answers

What is the role of the Capital Market Line (CML) in investing?

<p>It illustrates the risk-return relationship for all portfolios. (D)</p> Signup and view all the answers

How many securities are typically enough to eliminate a significant amount of risk through diversification?

<p>15 to 20 different securities. (D)</p> Signup and view all the answers

What is meant by a 'well-diversified' portfolio according to the content?

<p>A portfolio where all unique risk has been eliminated. (D)</p> Signup and view all the answers

What does an efficient portfolio lack according to the Capital Market Line?

<p>Unsystematic risk that can be diversified away. (C)</p> Signup and view all the answers

What does the standard deviation measure in the context of the CML?

<p>The risk of return for an efficient portfolio. (D)</p> Signup and view all the answers

Which portfolio would typically be desired by investors aiming for optimal risk-return trade-off?

<p>Portfolio M, which is the ultimate diversified portfolio. (A)</p> Signup and view all the answers

Which statement accurately describes the role of the Capital Market Line (CML)?

<p>The CML represents the risk-return equation for efficient portfolios. (A)</p> Signup and view all the answers

What is the effect of adding more securities to a portfolio according to the principles of diversification?

<p>Unsystematic risk can eventually become zero. (B)</p> Signup and view all the answers

In the context of investor compensation, what type of risk are investors rewarded for bearing?

<p>Systematic risk, which is market-related risk. (D)</p> Signup and view all the answers

What does a beta (β) value greater than one indicate about a stock?

<p>The stock has higher sensitivity to market changes. (A)</p> Signup and view all the answers

Which assumption is NOT part of the Capital Market Line framework?

<p>Investors have different knowledge about future market conditions. (C)</p> Signup and view all the answers

What primarily distinguishes systematic risk from unsystematic risk in the context of portfolio management?

<p>Unsystematic risk is specific to individual firms or industries. (A)</p> Signup and view all the answers

Which factor most likely does not influence an investor's decisions under the CML assumptions?

<p>Individual preferences for particular securities. (B)</p> Signup and view all the answers

How is return defined in the context of portfolios under the CML?

<p>As the arithmetic mean return from a portfolio of assets. (D)</p> Signup and view all the answers

What does a beta value less than one indicate about a company's sensitivity to market changes?

<p>Lower sensitivity to market changes (C)</p> Signup and view all the answers

What is represented by the numerator of the beta value formula?

<p>Systematic risk of company j (B)</p> Signup and view all the answers

What will a high beta share (β > 1) generally do in relation to the FTSE Index?

<p>Outperform the return on the FTSE Index (B)</p> Signup and view all the answers

The Security Market Line (SML) primarily considers which type of risk?

<p>Non-diversifiable risk (C)</p> Signup and view all the answers

Which of the following describes the relationship between Beta and expected return according to the SML?

<p>Linear relationship (C)</p> Signup and view all the answers

In the Capital Asset Pricing Model (CAPM), what does the expected return from asset j include?

<p>The risk-free return and the market risk premium (C)</p> Signup and view all the answers

What does a beta of 0 indicate regarding the expected return on a security?

<p>The expected return is equal to the risk-free rate (A)</p> Signup and view all the answers

What is the purpose of an Asset Pricing Model like CAPM?

<p>To explain why different assets have different expected returns (D)</p> Signup and view all the answers

Flashcards

Negative Correlation

A relationship where the returns of two assets tend to move in opposite directions.

Liquidity

The ability of a company to meet its short-term obligations.

Zero Correlation

Indicates no relationship between the variability in returns of two assets.

Operating Cycle

Time from receiving raw materials to collecting cash from sales.

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Zero Variance Portfolio

A portfolio constructed with assets that have a correlation coefficient of -1.

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Cash Conversion Cycle (CCC)

Time between paying for raw materials and receiving cash for finished goods.

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Systematic Risk

Risk affecting the overall market, like interest rate changes.

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Inventory Holding Period (IHP)

Time to convert materials to finished goods and sell them.

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Unsystematic Risk

Risk specific to a particular company, such as management decisions.

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Trade Receivables Days (TRD)

Average time to collect cash after a sale.

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Portfolio Diversification

Reducing risk by investing in a variety of assets.

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Trade Payables Days (TPD)

Time between purchasing and paying for raw materials.

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Portfolio

A collection of financial assets (stocks, bonds, etc.), with returns added together to find the total portfolio return

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Inventory Management Objective

Quickly turn over inventory without losing sales due to stockouts.

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Portfolio Theory

A theory that describes the optimal combination of assets, given their characteristics.

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Types of Inventory

Raw materials, work-in-progress and finished goods.

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Optimal Portfolio

The portfolio that maximizes an investor's utility given their risk preferences and the available investment opportunities.

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Market Portfolio (M)

A portfolio containing all risky assets in proportion to their market value.

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Risk-Free Rate (rf)

The return available on a risk-free investment.

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Capital Market Line (CML)

The line connecting the risk-free rate (rf) and the market portfolio (M) in a portfolio optimization model.

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Lending Zone (CML)

A portion of the CML where investors invest a proportion of funds in the market portfolio (M) and the remainder in the risk-free security.

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Borrowing Zone (CML)

Investors in this portion of the Capital Market Line invest their own investment funds in the Market Portfolio (M), but borrow additionally, using rf rate and also investing in M.

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Efficient Frontier

The set of portfolios that offer the highest expected return for a given level of risk.

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Dominated Portfolios

Portfolios that lie along the risky-riskless boundary, giving better combinations of risk and return.

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Market Portfolio

A broad-based equity portfolio representing all publicly traded companies, weighted by market value.

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Proxy for Market Portfolio

A similar portfolio, like the FTSE100 or S&P500, used to represent the market portfolio in analysis.

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Diversification

Reducing risk by holding a variety of different investments.

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Equilibrium Market Price

The price where the expected return is just enough to compensate for the risk.

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Efficient Portfolio

A portfolio with the highest possible return for a given level of risk.

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Capital Market Line (CML)

A graphical representation of the relationship between risk and return for efficient portfolios.

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Well-Diversified Portfolio

A portfolio that eliminates all unique (unsystematic) risks.

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Portfolio risk

Risk due to the variability of returns across the investments within a portfolio

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Capital Market Line (CML)

A line on a graph illustrating the risk-return relationship for efficient portfolios.

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Efficient Portfolio

A portfolio offering the highest return for a given level of risk.

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Systematic Risk

The risk inherent in the overall market.

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Unsystematic Risk

Risk specific to a particular investment.

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Beta (β)

A measure of a stock's sensitivity to market movements.

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Market Portfolio

A portfolio containing all assets in the market.

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Risk-return relationship

The trade-off between expected return and risk.

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Diversification

Reducing risk by holding a variety of assets.

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Beta Value < 1

Indicates a security's sensitivity to market changes is lower than the market's average.

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High Beta (>1)

A security reacting more significantly to market fluctuations than the market itself.

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Security Market Line (SML)

Graphical representation of the Capital Asset Pricing Model (CAPM), showing the relationship between expected return and systematic risk.

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Capital Asset Pricing Model (CAPM)

A model that calculates the expected return of an investment based on its systematic risk, using the risk-free rate and market risk premium.

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Market Risk Premium

Additional return (or expected return) earned on the market portfolio, compared to risk-free return.

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Systematic Risk (Beta)

Risk related to overall market trends, impacting all assets in a portfolio.

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Expected Return (CAPM)

Calculated return based on risk-free return, plus a premium related to the systematic risk.

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Beta

Measure of a security's volatility in relation to the overall market.

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Study Notes

Firm Objectives & Time Value of Money

  • Business corporations are separate legal entities, with ownership separate from management.
  • Shareholders own the company, managers run it.
  • Unlimited life, easy transfer of ownership, easy capital raising, but limited liability.
  • Wealth maximization is the primary objective, maximizing shareholder wealth (market value of ordinary shares).
  • Accounting profit is a reporting tool, not a decision-making tool.
  • Shareholder wealth maximization considers future cash flows and risk.
  • Corporate governance codes, executive/non-executive directors, AGMs, and takeover threats can help align management interests with shareholder interests.
  • Agency costs reflect the loss in value due to conflicts of interest.

Time Value of Money

  • Time value of money: Money received today is worth more than the same amount received in the future.
  • Time value due to
    • Potential for earning interest.
    • Inflationary pressures
    • Effect of risk.
  • Cash flows should be compared considering time value.
  • Types of cash flows: Conventional (outflow then inflows), and non-conventional (multiple sign changes).
  • Annuity: a series of equal payments at fixed intervals.
    • Ordinary/standard annuity (payments at end of period).
    • Annuity due (payments at beginning of period).
    • Delayed annuity (payments after the first period).
    • Growing annuity (payments increase at a constant rate).
  • Perpetuity: constant stream of payments indefinitely.
    • Ordinary perpetuity (payments start after one period).
    • Growing perpetuity (payments increase at a constant rate).
  • Simple interest vs compound interest. Compound interest earns interest on interest.

Investment Appraisal Techniques

  • Techniques for deciding whether to invest in a project or select between competing projects.
  • Payback period (PB): Number of years until cumulative cash flow equals initial outlay.
    • Simple, quick, but ignores later years and time value of money, primarily a screening tool.
  • Net present value (NPV): Present value of future cash flows minus initial investment.
    • Increases shareholder wealth, considers time value and cost of capital, NPV > 0 = accept the investment.
  • Internal rate of return (IRR): Rate of discount where NPV is zero.
    • Represents a break-even point, useful for comparison, but may lead to multiple IRR or no IRR in certain projects.

Working Capital Management

  • Objectives: Maximize shareholder wealth through short-term asset management.
  • Working capital: Short-term assets (e.g., inventory, accounts receivables, cash) and short-term liabilities.
  • Inventory management: Balance ordering costs and carrying costs (storage, obsolescence).
    • Ordering cost: Costs incurred each time an order is placed.
    • Carrying/holding cost: Costs associated with holding inventory.
  • Accounts receivable management: Collect outstanding payments quickly without harming business relationships
    • Effective credit policies, timely collection procedures

Portfolio Theory

  • Risk and return relationship is crucial for portfolio construction.
  • Risk - variability of actual future returns around expected returns. Measured by variance or standard deviation.
  • Risk preferences vary across investors ( risk-averse, risk-neutral or risk-loving).
  • Historical approach and probabilistic approach to estimating assets' risk and return.
  • Diversification - Reduces unsystematic risk (firm-specific).
  • Portfolio theory assumptions, investors are risk averse, and are valuing risk and return relationship for different combination of risky assets.
  • Feasible set, efficient portfolios.
  • Capital Market Line (CML) shows the risk-return relationship for a portfolio with a risk-free asset.
  • Security Market Line (SML) shows the risk-return relationship for an individual asset-or inefficient portfolio.
  • Market portfolio is the portfolio containing all risky assets in proportion to their market capitalisations.

Market Equilibrium

  • Market prices are in equilibrium when returns provide just enough compensation for the risk that an investment entails.
  • Market equilibrium model.

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Description

This quiz explores key concepts related to business corporations, focusing on ownership, management, and the importance of shareholder wealth maximization. Additionally, it delves into the time value of money, highlighting why money received today holds more value than in the future due to factors such as interest and inflation. Test your understanding of these fundamental principles in finance.

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