Chapter 20 Guidance to answering the practical exercises

This should be the case, but here are some quick references in case you need to swot them up. There is further reading that you can do over and above the references given, but you will see that there is comparatively little reading to do to gain the basic knowledge that you need.
1. What is the difference between a private and a public company? (see 19.1.6)
2. What is a holding company? (see 19.1.8)
3. What do private equity firms do? (see 18.5.1)
4. What is the role of the board of directors of a company? (see 19.2.2)
5. What is the role of a CEO? (see 19.2.2 and Figure 19.3)
6. What is the role of a chairman? (see 19.2.2 and Figure 19.3)
7. How do companies raise finance? (see 18.5)
8. What is the difference between a secured and an unsecured loan? (see 18.4.5)
9. When is a company insolvent? (see 20.4.1)
10. What is the difference between administration and liquidation? (see 20.4.1)
11. In the accounts of a company, what is the purpose of the profit and loss account and the balance sheet? (see 20.3.4 and 20.3.5)
12. What is the role of a company's auditors? (see 20.3.6)
13. What do you know about shares? (see 18.5.1, 19.4.1 and 20.2.4)
14. What is a stock market? (see 20.2.4)
15. What do we mean by 'wealth'? (see 18.4.1 and Figure 18.1)
16. Why are share prices important economically? (see below)
17. What is an industry sector? (see 18.3.2)
18. What is the difference between micro and macroeconomics? (see 20.1.1)
19. Why are supply and demand so important?(see 20.1.3 and Figures 20.1–3 )
20. What is inflation? (see 20.1.4)
21. Why do interest rates have an effect on the economy? (see 20.1.4 and 20.2.3)

Basic economics
1. What is the difference between micro and macroeconomics? (see above)
2. What is GDP? (see 20.1.4 and Figure 20.4)
3. What is a recession? (see 20.1.4 and Figure 20.5)
4. What are the main causes of inflation, and why does it matter? (see 20.1.4)
5. What are the main causes of unemployment, and why does it matter? (see 20.1.4)
6. What is meant by the balance of payments? (see 20.1.4)
7. What is the difference between fiscal and monetary policy? (see 20.1.4)
8. What role does the Bank of England play in the economy? (see 20.2.1)
9. What are the main financial institutions, and what role does the City of London play in the economy? (see 20.2)
10. What is the deficit? (see 20.1.4)
11. Are you aware of what are the current most widely reported economic issues? As you saw in Chapter 16, it is essential that you keep up to date with topical issues, and this includes economic issues. Keep up to date with the news. Useful sources are newpapers such as the Financial Times and the Economist, radio programmes such as the Today Programme or television programmes such as Newsnight. You can follow these on social media, although some sources may require you to take out a subscription.

To an extent, this is a matter of opinion, but as any good interview candidate will know, you must be able to justify your opinion.

You have seen that economics has been one of the influences on the development of the law, and impacts on many areas: tax and competition law are obvious examples, but economic theory has shaped the law in many other areas, such as welfare and consumer legislation or even family law. Clearly, it helps to understand the economic influences, e.g. Keynesian or monetarist, at work at a particular stage of the development of the law. This knowledge will underpin and help you to understand your academic studies. It is interesting to see that many universities, particularly American universities, now include a Law and Economics module, where economic methods are used to analyse the effect of laws, assess their efficiency and predict in what direction law is developing. There is much academic debate on the value of this.

In practice, you have seen the importance of being able to add value. You may agree with the quote above, but many of your clients will assume a basic knowledge: this assumption can come into any conversation. Imagine the director of a client company says to you:
'Of course we are concerned about the effect of Brexit, but GDP has continued to rise, albeit slowly, so our business is thinking of expanding. We are optimistic that the economy will continue to grow slowly, and we want to maximise our opportunities. With the emphasis on low interest rates for the next few years and falling unemployment, we feel we are thinking of raising further borrowing. Of course, with low interest rates, inflation is always a concern.'

Would you be clear what he means, and why these issues are interlinked? It's not that the client is basing the decision on an in-depth knowledge of economic theory, it's simply that businessmen know the inter-relationship between all of these, and the resulting opportunities and challenges facing the business. Understanding what is behind a decision will help you understand the client's objectives and concerns, (which in economic terms is 'maximising profits').

As you saw in Chapter 17, this inter-relationship is not just about corporate clients. Interest rates impact on the savings of individual clients, including their pension funds, especially at a time where inflation is eating into those savings and reducing "real wages", and can make borrowing more expensive, and lead to lower wages). Brexit may have an effect on consumer confidence, and could well lead to lower demand and ultimately supply, and impact on growth. There are different opportunities and challenges for individual clients, but each are nevertheless equally important when understanding their decisions.

Share prices are important for various reasons:
• Overall share prices tend to reflect the confidence which investors have in the economy as a whole. If share prices go down, it shows that investors are not confident that the economy will grow in the immediate future.
• Shares make up some of the assets or wealth of ordinary investors, so if shares go down, then those investors feel that they have lost some of their wealth and tend to cut back their spending, which, as we have seen is important to stimulate growth particularly in a consumer society.
• The main investors in shares are pension funds. If people are worried about their pensions in the future, they tend to save rather than spend, again contributing to slower growth of the economy.
• Investors tend to pull out of the stock market and move away from investing in shares to safer investments such as bonds or gilts, thus potentially causing further falls in share prices.

If share prices are so important, you need to be aware of these, because they should be a good indicator of what is happening in the economy. The results will depend on when you conducted this exercise. Once you have your results, you should think about these. Did the stock market perform as you would have expected it to do, given what you know is going on in the economy? This will not always be the case.

Fundamentally, the price of shares depends on demand. A number of factors can affect that demand. Here are a few examples:
• Economic, political and geopolitical factors all play a role, e.g. in early 2020 shares in oil companies fell as a result of US- Iran crisis;
• Industry trends are important, e.g. the UK construction industry was badly affected by the slowdown in the housing market uncertainty caused by Brexit;
• Natural disasters: e.g. the cost to insurers of the Australian bushfires in the Australian summer of 2019/20 are expected to run into billions, leading to a fall in the shares of one of most heavily exposed insurance companies, Insurance Group Australia (ASX:IAG.
• Internal company news: if an annual report shows falling profits, or worse still a profits warning from the company then this can impact on the share price, e.g. the online fashion retailer, Asos issued an unexpected profit warning in December 2019, causing its shares to fall by 40%,
• Bad publicity: Patisserie Valerie (see Chapter 15) is an example. Watch out too for companies that fail to meet environmental challenges. Exposure for failure to address climate change will increasingly become a factor that affects share prices.
• Market sentiment: there often appears to be no real reason for a fall in share prices, but investors follow a 'gut instinct' which snowballs as shares in a particular company or companies start to rise or fall.

However, share prices may not react in the way you would expect. For example, immediately following the Brexit vote on 23 June 2016, as you may have expected, the FTSE 100 fell, and expectations were that it would continue to fall. However, by 28 June, it had started to bounce back and has continued to rise since.

[If you were talking about share prices at interview, you can demonstrate commercial awareness by showing the relationship between share prices and sterling. Following Brexit, the pound has fallen against other currencies. This makes international investors more willing to invest in the UK as shares are comparatively cheap. It is interesting to note that the biggest investors in UK listed companies are foreign investors (53%).]

Certainly, if you are interviewing for a firm which acts for companies listed on a stock market, you should know what is happening to the share price of those companies. We've asked you to look at a quality paper at the overall performance of the FTSE 100, but there are some short cuts which you can take, which will be useful for you in practice. Investors' Chronicle is probably the best starting point. You can track the FTSE 100 by typing the name of the company you want to research into the 'Search' box, and you can access up to date information on its share price, as well as other statistics related to the performance of the company, and recommendations by City analysts whether to buy, sell or hold its shares. There are also phone apps with daily share prices, so the information is easily accessible. There is no excuse not to know what is going on.

Having enough cash is the essence of any successful business. Cash flow is the amount of money going through the business, looking at the cash that comes into the business and the cash that goes out. It is not the same as either income or profit. It is perfectly possible to have a business that makes a healthy profit, but nevertheless has cash flow problems for a variety of reasons (for example, because it offers its customers long credit periods). The more cash a business has, the more liquidity, and liquidity is directly related to solvency.

It is important for businesses to maintain a positive cash flow, as without it, the business will be unable to pay its bills. (You have heard of the term 'credit crunch'; you may also hear the term 'cash crunch' which is a lack of cash flow.) A business that consistently pays its bills late will find that its credit rating is downgraded. (You will see how this works in Chapter 18.5.3). A business which is unable to pay its bills as they fall due is technically insolvent. Creditors can then take action to instigate the bankruptcy of a sole trader or partner, or put a company into liquidation or administration.

Again, this is a matter of opinion, but justify it.

The background to this question is the change to the bankruptcy regime, brought about by the Enterprise Act 2002. From April 2004, bankrupts were automatically discharged from bankruptcy after 1 year, as opposed to 3 years. Remember that bankruptcy discharges the debts of the bankrupt, and creditors will generally get only a small proportion of the amount owed to them (a few pence in the pound). Possible arguments for and against early discharge include:

In favour:
• Bankruptcy is not supposed to be a punishment. (It is an administrative process);
• Reduction in the stigma associated with bankruptcy, and less emotional impact on bankrupt
• Bankrupts are given the opportunity of a fresh start
• Long enough to 'learn the lessons' from bankruptcy
• Least impact on employment
• Creditors can object to early discharge
• Continuing sanctions for dishonest or blameworthy bankrupts
• Bankrupt must continue to co-operate with trustee in bankruptcy if administration of bankrupt's estate is not complete, including continuing contributions.

Against:
• Defeats the point of bankruptcy
• Not long enough to 'learn the lessons' of bankruptcy
• Not fair to creditors who suffer as a result of the bankruptcy
• Encourages debtors to declare themselves bankrupt rather than explore other methods of debt relief
• Encourages an irresponsible attitude to debt.