Appendix 3 Suggested answers to review questions
1.4 Preference shares are part of the equity or ownership of the business, usually entit-
ling their owners to the first portion of any dividend paid, but there is no obligation
for the business to pay a dividend, nor usually to redeem the preference shares.
Loan notes represent loans made by people or investing institutions under a con-
tract with the business concerned. The contract would normally specify the rate of
interest to be paid, the date of payment of the interest, and the amount and date of
repayment of the principal of the loan.
Preference shares and loan notes have a superficial resemblance in that they both
tend to attract a fixed annual payment and are redeemed at some point. The essen-
tial difference is that such payments are contractual and can be enforced in the case
of loan notes, but not in the case of preference shares.1.5 Many financing and investment decisions are vitally important to the business
because they involve significant amounts of finance over long periods of time. Thus
misjudgements can have far-reaching, possibly disastrous, effects.
Of course, not all such decisions are so significant, but many tend to be.1.6 Both theory and practice indicate that investors seek higher returns to compensate
them for bearing higher risk. The required return would be a risk-free rate, plus a
risk premium. The risk-free rate would normally be equal to the rate that is available
for very safe investments, like short-term deposits with very safe borrowers, such as
a stable government. The risk premium would relate to the perceived level of risk.2.1 The two criteria are:
lThe information must relate to the objective(s) that is/are being pursuedby the deci-
sion maker. Thus if a decision needs to be made on whether to travel to a particu-
lar destination by car or by train, and the only objective being pursued is to spend
the lowest possible time on the journey, only the time taken is relevant. The cost,
level of comfort and convenience are all irrelevant, given the sole objective of
lowest journey time.
lThe information must be differentbetween the two courses of action. Thus if the
time taken is identical between car and train, the length of time is irrelevant,
given the least journey time objective.2.2 It is considered incomplete because it lacks a timescale. If the objective were to max-
imise accounting profit for next year, this might be easily achievable by taking short-
term actions that could have adverse long-term effects. For example, all research and
development could be abandoned, with resulting cost savings. This would be likely
to have disastrous long-term effects since new products and methods would not be
developed, making it likely the business would lose markets to rivals that had con-
tinued to innovate.2.3 On the face of it, the higher the price that can be charged the better for the share-
holders. However, in the medium and long term, such behaviour may be adverse to
the interests of the shareholders. This may manifest itself in the following ways:
lThe attentions of a regulatory body concerned with monopolies, such as the UK
Competition Commission, may be attracted. This could lead to an order to reduce
prices.
lLarge profits could attract other suppliers to enter the market. Not only would
this lead to price competition and lower prices, but the bad public sentiment of
the market towards the exploiter could well cause the market to favour the new-
comers, even where the price and quality were similar.Chapter 2
BUSF_Z02.qxd 11/19/08 10:32 Page 462