CIFA Foundation Level

Introduction to Finance and Investments flashcards

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Why is shareholder wealth maximisation preferred to profit maximisation as the goal of a firm?

Profit maximisation ignores the timing of profit, the risk taken to earn it and its effect on the share price. Shareholder wealth maximisation maximises the market value of shareholders' equity, which accounts for the amount, timing and risk of expected future cash flows.

How do you tell a primary market transaction from a secondary market one?

Ask whether new money reaches the issuer. Primary: new securities are issued and sold to raise fresh capital, as in an IPO. Secondary: existing securities change hands between investors, giving liquidity but raising no new capital for the issuer.

On what amount is a bond's coupon calculated, and what does a premium or discount mean?

On the nominal (par or face) value, not on the price paid. A KES 100,000 bond with an 8% coupon pays KES 8,000 a year whatever it later trades at. A bond trading above nominal value is at a premium; below nominal value, at a discount.

How is a forward exchange rate found under covered interest rate parity, and which currency weakens?

Forward = Spot x (1 + domestic rate) / (1 + foreign rate). The currency with the higher interest rate trades at a forward discount, by exactly enough to cancel the interest advantage, so no risk-free arbitrage profit is available.

What are the five steps of the investment process, in order?

1. Set investment objectives and constraints: return, risk tolerance, time horizon, liquidity. 2. Develop an investment policy and asset allocation strategy. 3. Select specific securities or funds. 4. Execute through a market intermediary. 5. Monitor performance and rebalance.

What is maturity matching in the financing decision?

Financing an asset with funds available for a period comparable to the asset's life. Funding a long-term asset, such as a vehicle lasting five years, with short-term debt like a 90-day overdraft creates refinancing (renewal) risk.

What are the formulas for the future value and the present value of a lump sum?

Future value: FV = PV x (1 + r)^n. Present value: PV = FV / (1 + r)^n. Compounding and discounting are exact inverses, worked with the same rate and number of periods. KES 50,000 at 10% for 5 years grows to KES 80,525.50.

How does Gordon's growth model value an ordinary share, and when does it break down?

Value = D1 / (Ke - g), where D1 = D0 x (1 + g) is next year's dividend, Ke the required return on equity and g the constant growth rate. It breaks down if g approaches or exceeds Ke, since the denominator approaches zero or turns negative.

What is the difference between systematic and unsystematic risk?

Systematic (market) risk is common to the whole market, such as interest rates and macroeconomic conditions, and cannot be eliminated by diversification. Unsystematic (specific) risk is unique to one firm or industry and can be reduced or eliminated by holding a diversified portfolio.

How is net present value (NPV) calculated, and what is the decision rule?

NPV = sum of [cash flow(t) / (1 + r)^t] - initial investment, discounting at the firm's cost of capital. A positive NPV means the project is expected to add value, so accept it. Where NPV and IRR conflict on mutually exclusive projects, prefer NPV.

How does finance differ from accounting?